Protect Expectations with an Adequate Assurances Provision
An often-overlooked issue in contract drafting is whether to include a provision giving each party the right to demand adequate assurances of performance in the event the counterpartys performance becomes uncertain. This oversight presumably owes to the presumption that the right to demand assurances of performance is provided as a matter of lawa presumption that, in different contexts, is actually incorrect.
At common law, a party traditionally had a right to declare a breach and exercise remedies only when a counterparty either (a) failed to perform when due, or (b) unequivocally stated that it would not perform in the future. Until either of these two events occurred, the non-breaching party had to continue to fulfill its obligations under the contract, even in circumstances where reasonable grounds existed to suspect that the other party would not be able to perform.
To address this inequity, the drafters of Article 2 of the Uniform Commercial Code created a right to declare a default at an even earlier point in time. Section 2-609 thus provides that when a contract party has reasonable grounds to be insecure about receiving due performance from the counterpartyas when, for example, a counterparty is having financial difficultiesit may demand adequate assurances of performance and, pending receipt of such assurances, suspend its own performance. Further, if adequate assurances are not provided in a reasonable period of time, the party making the demand may treat the contract as having been repudiated.
This is an extremely powerful right, enabling a contract party to ensure that it need not perform if the ability of its counterparty to perform has materially diminished subsequent to contract execution. Properly invoked, this right can permit a party to end a contractual relationship long before the other party has actually breached or even stated that it would not perform in the future. The right to demand adequate assurances of performance thus protects a bedrock expectation of most contract parties: that each can expect to receive due performance so long as it timely meets its own obligations.
But what happens if a party demands assurances of performance outside of the goods context, for example, in connection with a loan or a services or construction contract? Since the right did not exist at common law, courts have taken differing approaches to this question. Some states, such as New York, have expanded the doctrine only to contracts that are akin to goods contracts (e.g., contracts for the purchase and sale of electricity), provided that the contract is long-term in nature and complex and not reasonably susceptible of all security features being anticipated, bargained for and incorporated in the original contract. Norcon Power Partners, L.P. v. Niagara Mohawk Power Corp. (N.Y. 1998). Observing that New York law, prior to the decision, refrained from expanding the right to demand adequate assurance of performance beyond the Uniform Commercial Code, the Norcon Power Court declined to expand the doctrine to all contractual relationshipseven though it found potential merit in doing so.
Other states have applied the doctrine piecemeal to non-goods contracts, without specifically addressing whether a demand for adequate assurances can be made in all contexts. See, e.g., Carfield & Sons v. Cowling (Colo. 1980) [construction contract]; Drinkwater v. Patten Realty Corp. (Me. 1989) [contract for the sale of land]. Courts inclined to expand the doctrine base their holding not only upon the practical considerations that led to the doctrines creation by the UCC, but also the fact that Section 251 of the Restatement (Second) of Contracts now contains a similar remedy. Other courts, however, have held that they are not prepared to adopt this concept in our general contract law. Mollohan v. Black Rock Contracting, Inc. (W. Va. 1977).
Given the varying applications of the doctrine outside of the goods context, parties may wish to consider specifically contracting for the right to demand adequate assurances in non-goods contracts. Such a clause might simply track the language from the UCC:
"When reasonable grounds for insecurity arise with respect to the performance of either party, the other may in writing demand adequate assurance of due performance and, until he receives such assurance, may if commercially reasonable suspend any performance for which he has not already received the agreed return. Failure to provide adequate assurances in 30 days, when properly demanded, shall give rise to an Event of Default."
Incorporating such a provision will help to ensure that a contract party need not perform when the return performance appears unlikely. Of equal importance, such a provision can inoculate a party against the claim that it has breached the contract by conditioning its own performance upon receipt of a benefit to which it might not have any right.
Eric Fishman is a partner at Pillsbury Winthrop Shaw Pittman, where he represents both industrial companies and financial institutions in complex disputes arising out of purchase and sale agreements, procurement contracts, leveraged leases, credit default swaps, reinsurance contracts, and partnership and LLC operating agreements. These cases also frequently involve fraud, fiduciary breach, and equitable claims. Sara Stinson is an associate in the litigation department at Pillsbury.