Lewis Tesser and Timothy Nolen ()
Uniformly, courts have held that UCC §2-306 permits buyers in requirements contracts to order more goods than estimated unless the order is made in bad faith or is “unreasonably disproportionate” to a stated estimate. Courts, however, are split on whether the “unreasonably disproportionate” limitation applies to orders which are substantially lower than estimated.1 New York federal courts have held that the limitation does not apply to low orders, and, although the law is unsettled, commentators—relying on precedent which has been unchallenged for over 40 years—have observed that New York state courts may apply the limitation to low demands.2 This article examines the basis for the split, and questions whether New York state courts are indeed likely to apply the limitation to low demands.
Good Faith Standard
Fixed-price contracts typically specify the requisite quantity, and may measure quantity by the output of the seller (e.g., buyer agrees to buy all the oil that seller produces at $100 per barrel) or requirements of the buyer (e.g., seller agrees to sell to buyer all the oil that buyer requires at $100 per barrel). When quantity is measured by requirements,3 UCC §2-306 defines quantity as “actual output or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate…may be… demanded.”4
UCC §2-306 applies a good faith standard for all requirements, regardless of whether they are above or below estimates. For example, a utility company may contract with an oil company to purchase all the oil necessary to provide heat to its residential customers at $100 per barrel. While the utility company may in good faith benefit from a rise in oil prices, it might be susceptible to a claim that it did not act in good faith if it exploited the below-market price to become a reseller of oil or to significantly and unforeseeably expand its customer base.5 Or, if oil prices plummeted and the utility company delayed its purchase of oil or relied on other fuels to avoid the higher contract price, it would similarly be susceptible to a good faith challenge.
UCC §2-306 also provides that if there is a stated estimate of requirements, orders must be reasonably proportionate to that estimate. It is undisputed that the UCC §2-306 (1) “unreasonably disproportionate” limitation (“the limitation”) applies to demands for goods which are substantially greater than estimated: Courts have repeatedly observed that the clear language of the statute was intended to prevent buyers from unreasonably increasing “demands” to exploit rising costs. On its face, the language of the statute (“no quantity unreasonably disproportionate to any stated estimate…may be…demanded”) does not appear to differentiate between greater- or lesser-than-estimated requirements, and makes it appear as though the limitation is independent of the “good faith” requirement.
The official commentary to UCC §2-306 is unclear concerning whether the limitation applies to lower-than-estimated requirements. Comment 2 suggests that the limitation should not apply: “reasonable elasticity in the requirements is expressly envisaged by this section and good faith variations from prior requirements are permitted even when the variation may be such as to result in discontinuance. A shutdown by a requirements buyer for lack of orders might be permissible when a shutdown merely to curtail losses would not.” Comment 2 does not mention estimates.6
In contrast, Comment 3—which specifically mentions estimates—suggests that the limitation should apply: “If an estimate of output or requirements is included in the agreement, no quantity unreasonably disproportionate to it may be tendered or demanded … the agreed estimate is to be regarded as a center around which the parties intended variation to occur.”
While courts have uniformly applied the “unreasonably disproportionate” limitation to greater-than-estimated requirements, courts are split on whether the limitation applies to lower-than-estimated requirements.
The Majority Approach
Two oft-cited opinions, Judge Richard Posner’s decision for the U.S. Court of Appeals for the Seventh Circuit in Empire Gas Corp. v. American Bakeries Co.7 and the U.S. Court of Appeals for the First Circuit’s decision in Atlantic Track & Turnout Co. v. Perini Corp.8 (which adopted Posner’s reasoning), explain the majority approach. The courts were asked to determine whether the limitation applied to lower-than-estimated requirements (even when the buyer, without explanation, ordered absolutely no goods).
The courts initially discussed why the limitation is applied to greater-than-estimated requirements: “If there were no ceiling, and if the price happened to be advantageous to the buyer, he might increase his ‘requirements’ so that he could resell the good at a profit.” They observed that the same conclusion could be reached applying the “good faith” requirement of UCC §2-306, “thus making the [limitation] redundant.” The redundancy was not problematic, as it was intended to clarify the meaning of “good faith.” They explained that “the aspect of good faith that required explication had only to do with disproportionately large demands.” Thus, they reaffirmed “the dominant [common-law] approach … not to construe the [limitation] literally, but instead to treat the overdemanding and underdemanding cases differently.” They stated that the limitation may have been added to address situations where requirements were disproportionately larger than estimated but did not amount to bad faith.
Posner conceded that Comment 3 “points to symmetrical treatment of the overdemanding and underdemanding cases,” but found there was “no elaboration.” In contrast, Comment 2 was “in tension with” Comment 3, since Comment 2 provided that good faith variations resulting in discontinuance were permissible. He saw no reason why good faith below-estimate requirements should be impermissible “just because the parties included an estimate.”
Importantly, the courts also incorporated public policy considerations: “an obligation to buy approximately a stated estimate of goods would force them to make inefficient business judgments, when the point of entering a requirements contract was to engage supplies without binding themselves to buy more goods than they need.”
While the authors agree that policy often weighs in favor of the majority approach, there may be circumstances in which policy weighs in favor of applying the limitation to low requirements. For example, a supplier who secures a requirements contract which contains a substantial negotiated estimate may invest in new equipment or hire employees in reliance on that estimate. Or, a supplier may negotiate with a buyer to secure an estimate precisely because it may be uneconomical for the supplier to provide goods and incur certain costs and risks unless the goods are purchased in bulk (this would incentivize the supplier to negotiate an estimate).
Allowing disproportionately low requirements after having agreed to an estimate could frustrate the purpose of the contract for the supplier or impose a substantial burden. While it is true that a supplier can negotiate a minimum purchase, it remains that the estimate, when part of the negotiated transaction, should arguably have some significance. Thus, it is unclear to the authors that public policy necessarily weighs in favor of disregarding the limitation in below-estimate requirements.
In any event, relying on the Empire Gas and Atlantic Track decisions, three New York federal District Courts have found that the limitation does not apply to lower-than-estimated requirements.9 The issue has not been addressed by the Second Circuit.
The Minority Approach
Several state courts have applied the “unreasonably disproportionate” limitation to lower-than-estimated requirements. Notably, in Simcala v. American Coal Trade,10 the Alabama Supreme Court examined the language of Comment 3, which states that an estimate “is to be regarded as a center around which the parties intended the variation to occur,” and reasoned that applying the limitation solely to greater-than-estimated requirements would make the language of Comment 3 “mere surplus verbiage.” In rejecting the argument that Comment 2 creates ambiguity, the court observed that “Comment 2 addresses the general limitation of ‘good faith,’ which applies when there is no agreed-upon estimate.” It determined that Comment 2 applied to the good faith language of UCC §2-306, whereas Comment 3 applies (and displaces Comment 2) where there is a stated estimate.
The court distinguished Empire Gas and Atlantic Track on several grounds. Initially, the federal courts “candidly acknowledged that by its plain meaning, the statute prohibits unreasonably disproportionate decreases from estimates.” Then, the court reasoned that jurisdictions which applied the majority approach “emphasize[d] concerns over market impact that would flow from following the plain meaning of the statute,” specifically citing Atlantic Track. The court then concluded: “[w]hile other courts may be willing to look beyond the language chosen by their legislatures, we have repeatedly reaffirmed the fundamental principle of statutory construction that, where possible, words must be given their plain meaning.” It found that the limitation applied to lower-than-estimated requirements.
While the Alabama Supreme Court’s position is the minority approach, the Georgia state courts have taken the same position.11 Importantly, as discussed below, there is reason to believe that the New York state courts may favor this position.
Limitation in State Courts
New York state courts have not squarely addressed whether the limitation applies to lower-than-estimated requirements. There is one case, however, where the Appellate Division, Second Department, suggested, in dicta, a leaning toward the minority approach.12 In Orange and Rockland Utilities v. Amerada Hess Corp.,13 a 1977 case, the Appellate Division first addressed how the limitation applied to greater-than-estimated requirements.
First, the Appellate Division stated that “obviously this ['unreasonably disproportionate'] language is not the equivalent of ‘lack of good faith’—it is an elementary rule of construction that effect must be given, if possible, to every word, clause and sentence of a statute.”14 Thus, the Appellate Division implied that the limitation is distinct from the “good faith” requirement. This suggests that Orange and Rockland may have rejected the reasoning of the federal courts that the limitation is redundant or meant to clarify the “good faith” standard. And, like the Alabama court, it suggests that New York state courts may take a textual approach to interpreting UCC §2-306. The Alabama court’s statement that “words must be given their plain meaning” is similar to the Appellate Division’s observation that “effect must be given, if possible, to every word, clause and sentence of a statute.” The limitation, on its face, appears to apply to both above- and below-estimate requirements.
Second, concerning greater-than-estimated requirements, the Appellate Division noted that the “reasonable elasticity” language of Comment 2 applied, but that under Comment 3 “an agreed estimate shows a clear limit on the intended elasticity.” The court reasoned that Comment 2 applies allowing good faith reasonable variations, but that if there was an estimate, the specific language of Comment 3 (which mentions estimates) would displace Comment 2 (which does not mention estimates) by limiting those variations. This is markedly similar to the Alabama court’s reasoning.
Finally, the Appellate Division discussed the statutory history of the limitation, noting that the inclusion of the limitation was a departure from prior case law “wherein estimates were generally treated as having been made simply for the convenience of the parties.” Thus, “even where one party acts with complete good faith, [UCC §2-306] limits the other party’s risk in accordance with the reasonable expectations of the parties.” This is, again, inconsistent with the federal courts’ conclusion that the limitation merely elaborates the “good faith” standard; instead, it suggests that satisfying the limitation is an independent requirement under UCC §2-306 separate from good faith. In contrast to the Appellate Division, which observed that the limitation was a departure from prior case law, Empire Gas and other federal cases have applied the limitation as consistent with the common law. Thus, it appears New York state courts are leaning toward rejecting the federal courts’ reliance on the common law.
Although not conclusive, all three of these considerations suggest that New York state courts are amenable to the minority approach. The outcome, however, is uncertain. After all, the overwhelming majority of cases—including three New York federal district courts—have declined to apply the limitation to low requirements. Orange and Rockland is a 1977 case, and there has been no New York state court opinion addressing this topic since. And, as one New York district court has noted, Orange and Rockland concerned greater-than-estimated requirements.15 The authors believe its application to lower-than-estimated requirements is unclear.
Given the Orange and Rockland precedent and the uncertainty of the application of the limitation in New York state court, guidance from the Court of Appeals (or even another Appellate Division department) would be beneficial. Until then, the apparent split between New York state court and federal precedent creates an opportunity for litigants. If a party is claiming that requirements were unreasonably and disproportionately low compared to a stated estimate, the party should consider (if possible) filing in New York state court rather than federal. Whereas the bulk of authority in federal court weighs in favor of the majority approach, New York state authority appears amenable to the minority approach. In a requirements contract where the parties have both acted in good faith, the issue of whether low requirements were unreasonably disproportionate to a stated estimate could be determinative.
Lewis Tesser is a senior partner at Tesser, Ryan & Rochman. He is the president of the New York County Lawyers’ Association. Timothy Nolen is an associate at the firm.
1. Compare Canusa Corp. v. A&R Lobosco, 986 F.Supp. 723 (E.D.N.Y. 1997) withSimcala, Inc. v. Am. Coal Trade, 821 So.2d 197 (Ala. 2000).
2. CompareMDC Corp. v. John H. Harland Co., 228 F.Supp.2d 387, 396 (S.D.N.Y. 2002) and Shelly Smith, A New Approach to the Identification and Enforcement of Open Quantity Contracts, 43 Valparaiso University L. Rev. 871, 891-92 (2009); see also Atlantic Track & Turnout Co. v. Perini Corp., 989 F.2d 541, 544 (1st Cir. 1993) (citing New York state case law as an example of the minority approach).
3. This article refers primarily to requirements contracts, although UCC §2-306(1) applies to both requirements and output contracts.
4. UCC §2-306(1) (emphasis added).
5. This example is based loosely on Orange and Rockland, 59 A.D.2d 110.
6. New York state courts routinely apply Comment 2 to good faith determinations. See, e.g., Goaltex Corp. v. Good Will Industries of Rochester, 979 N.Y.S.2d 481 (Sup. Ct. Nassau County 2014).
7. 840 F.2d 1333 (7th Cir. 1988).
8. 989 F.2d 541 (1st Cir. 1993).
9. Canusa, 986 F.Supp. 723; MDC, 228 F.Supp.2d 387; Dienes Corp. v. LIRR, 2002 U.S. Dist. LEXIS 6824 (E.D.N.Y. 2002).
10. 821 So.2d 197 (Ala. 2001).
11. Romine v. Savannah Steel, 117 Ga. App. 353 (Ga. Ct. App. 1968).
12. Some commentators have suggested that New York state courts have adopted the minority approach. See, e.g., Smith, 43 Valparaiso University L. Rev. at 891-92 (2009); see also Atlantic Track, 989 F.2d 541. We disagree with these commentators that New York state courts have decided this issue, as it has only been discussed in dicta in the opinion that these commentators cite.
13. 59 A.D.2d 110 (2d Dept. 1977).
14. Citing McKinney’s Cons Laws of NY, Book 1, Statutes §231.
15. Canusa, 986 F.Supp. at 728.