Georgetown University Law Center
Examination in Contracts
(24 Hours)
Professor Avery Katz
May 10-11, 1995
Instructions:
I will assume for purposes of administering the limit that a typical double-spaced typed page with 1-inch margins contains about 300 standard English words when using 12-pitch fixed-width type (12 words per line times 25 lines per page), or about 250 words when using 10-pitch type. Alternatively, if you use proportional spacing or a different size typeface, you may make a good faith estimate by counting the words in a sample paragraph and extrapolating to the length of your entire exam.
QUESTION 1: 50% of exam; limit of 1500 words.
Crabtree Construction had a contract with the Yellowknife Power Company to build a hydroelectric project in the mountains along the tributaries of the Caniff River; the project would expand Yellowknife's capacity to serve the fast-growing population of the downriver region. Under this contract Crabtree was to receive a flat price of $723 million, but there was a schedule of penalties for late performance. Specifically, Crabtree promised to complete construction by October 1994; for each month's delay past this date, Crabtree would forfeit part of its fee. The amount to be forfeited was $4 million per month for the first six months after October 1994, and $7 million per month thereafter. The lesser amount reflected Yellowknife's estimate of what it would cost to produce the necessary electricity for the downriver region from its nearest neighboring power grid -- plus a 20% markup to cover any unforeseen cost increases. Crabtree furnished a performance bond in the amount of $240 million, though it could not and did not put up the full amount itself. Instead, it contracted with Western Fidelity Co. to act as its surety, paying Western a standard market premium for this guarantee. (Under this surety contract, Western is entitled to recover from Crabtree any amounts it must pay out on Crabtree's behalf. The premium buys insurance only against the event that Crabtree will turn out to be insolvent. )
As part of the project, Crabtree had to construct a dam with a gravity concrete section in its central part. The upstream section of the dam was to be buttressed by a concrete cut-off wall, and covered by a series of slabs resting on the wall as a base. In late 1992, after negotiating with several potential subcontractors, Crabtree entered into a contract with the R.P. Stovall Co. for construction of the dam; all work was to be done in accordance with Yellowknife's specifications. Under this subcontract, Crabtree promised to deliver to Stovall all necessary construction materials, including cement, gravel, sand, and metal work. Stovall was to furnish all labor and equipment, except for two air compressors which were to be installed by Crabtree but operated at Stovall's expense. Stovall was to pay for electric power. Crabtree was to complete the excavation for the concrete gravity section of the dam, but Stovall was to make the excavation for the cut-off wall.
The price at which Stovall agreed to do the work was an especially favorable one for Crabtree, because Stovall was eager to get the job. Stovall was a new company, formed the prior year by two former junior partners in one of the area's established construction firms who wanted to strike out on their own. Stovall's owners hoped that successful performance on a high-profile project such as the Caniff River dam would establish an independent reputation for their new company. They also expected, with reason, that if this project were completed successfully they could expect substantial future business from Crabtree, one of the largest primary contractors in the region. As a result, Stovall agreed to do the construction work on the dam for a price of $89 million, even though most other potential bidders were asking something in the neighborhood of $100 million and though their original cost estimate was actually around $90 million. They hoped if they did the work with their highest efficiency they could avoid any out-of-pocket losses on the contract and earn a handsome return on future contracts with Crabtree or other general contractors.
It was agreed that work on the dam would begin immediately and be completed on or before April 1, 1994. Stovall was to receive progress payments at the end of each month based on estimates of work completed during that month. Originally, Crabtree agreed to pay Stovall 90% of the estimated monthly costs, the remaining 10% to be paid upon completion. Stovall hired a surety to furnish its own performance bond in the sum of $37 million. Crabtree then contracted with various other subcontractors for other parts of the project and for the supply of materials. It contracted with the Portsmouth Cement Co. to buy all the mixed concrete needed for the project (estimated at about 480,000 cubic yards) at a price of $7.15 per cubic yard, and contracted with Skeletarch, Inc., to provide prefabricated steel supports at a price of around $15 million. These supports needed to be cast to Yellowknife's specifications and Skeletarch had to set aside 40% of its manufacturing capacity for 1993 and early 1994 in order to be in a position to meet Crabtree's delivery schedules.
Unfortunately, Crabtree and Stovall fell into disputing almost immediately after the beginning of performance. The first of their disputes concerned the use of the air compressors. Stovall had not seen them at the time the contract was signed and had never attempted to operate steam shovels with compressed air. (It later alleged that Crabtree had orally assured it the compressors would be adequate to the task; Crabtree denies this.) The compressors did not in fact furnish sufficient air to operate the shovels, however, and Stovall had to operate them with steam. Additionally, during most of the time Stovall was on the job, Crabtree was diverting air to other parts of the work. In June 1993 both compressors were damaged by a fire, the cause of which was never established. Crabtree installed a smaller compressor and removed the damaged compressors for repair; the burned compressors were not returned for sixty days and during this time Stovall repeatedly complained to Crabtree about the delay.
Furthermore, though the contract originally required Stovall to excavate the cut-off trench and Crabtree to excavate for the concrete gravity section, Crabtree realized once excavation had started that it would be significantly cheaper for it to do the entire excavation. Stovall was amenable to a modification of the contract in this regard but the two sides were unable to agree on a price allowance. Ultimately, Crabtree did all the excavating; Stovall asked on several occasions to take over the work but Crabtree refused. During most of this time Stovall made demands on Crabtree to speed up the excavation work, claiming that it was being delayed in its other work by Crabtree's failure to dig the cut-off trench rapidly enough. Throughout this time, Stovall also repeatedly complained to Crabtree about delays in furnishing materials, and in the fall of 1993, Stovall warned Crabtree that if the materials were not supplied as needed, it would quit the job and hold Crabtree responsible.
When construction shut down for the winter at the end of 1993, a much smaller portion of the work had been completed than anticipated. In a mutual effort to speed up the work, the parties entered into a supplemental agreement in March 1994, under which Crabtree agreed to pay all the 10% estimates retained under the original contract, and Crabtree waived its right to retain 10% of the monthly estimates so long as construction remained on schedule. This supplemental agreement failed to resolve the parties' differences, however, and Stovall left the job uncompleted in November 1994 with 30% of the work remaining to be done. At this point Stovall had been paid about $58 million, but due to delays in construction and the associated costs, it has spent about $68 million. It estimated that it would cost about $35 million to finish, but it saw little point in doing so. The contract was a loser and there was no longer any value in terms of future reputation. Stovall anticipates it will never do business again with Crabtree, and has little expectation of any referral business arising from this project.
All this forced a further delay in the project while Crabtree found a second subcontractor to finish the job, at a price of $38 million. They estimate that they can complete by November 1995, if there are no further delays. The existing delays, however, have created difficulties with Crabtree's other suppliers and contractors. When Crabtree suspended work last November, Portsmouth notified Crabtree that it could not supply cement past the end of calendar 1994. Then, on December 15, Portsmouth sold the remaining cement and gravel it had planned to supply to Crabtree at the then prevailing market price of $6.95/cubic yard. Portsmouth now says it is willing to supply the same amount of cement-gravel mixture to Crabtree for the completion of the project in 1995, but only at the current market price, which has now risen to $7.25/cubic yard -- and only if it is also reimbursed for its losses on resale in December. Crabtree's situation with Skeletarch is even worse. Skeletarch, which held its manufacturing capacity open as long as possible for the Caniff River project, suffered substantial losses in 1993 and 1994, in part due to this underutilized capacity. It has just notified Crabtree that it has arranged with other customers for the remainder of 1995 and will not be available to do any more work on the project. Crabtree is hoping to persuade Skeletarch to reconsider, since it would be extremely difficult for Crabtree to find another supplier of custom-made steel supports on short notice.
As it turns out, however, the delay in construction does not appear to disadvantage Yellowknife as much as had been originally anticipated. Demand for electricity in the region has grown rather less than Yellowknife anticipated when it initiated the project, in part due to slower population growth and in part due to a slow economy. As a result, Yellowknife will not actually need to use the Caniff River capacity until the winter of 1995-1996. As far as they can tell their current power capacity will be largely sufficient up till then, though they will have to run their generators overtime and wheel in some electricity from their neighboring power grid during peak periods of demand. Crabtree knows all this and has asked Yellowknife to modify the deadline for completion to November 1995 and to waive all penalty payments due under the original contract until that time. So far, Yellowknife has refused to do this. Yellowknife has a low profit margin as it is and faces heavy pressure from the state Public Service Commission to keep its electricity rates low. If it waives its right to collect penalty payments arising from C's delay, it will forego over $70 million in income and this loss may leave it unable to declare a dividend to its common stockholders for fiscal 1994.
You are legal counsel to Crabtree. Write a memo outlining Crabtree's exposure to claims by Stovall, Portsmouth, Skeletarch, and Yellowknife, and any claims it may have against those parties. You may assume that Crabtree is still solvent, so it will be liable for any amounts paid out under the surety bond.
QUESTION 2: 50% of exam; limit of 1500 words. Answer both parts A and B. You may allocate space between parts A and B as you see fit.
Part A. Kellman Sciences is a medium-size chemical company that produces food additives and preservatives. It developed a new artificial fat substitute that it has trademarked under the name of Creduline. Creduline has a molecular structure that in many respects resembles a variety of saturated fats, but unlike these fats it is not broken down by the human digestive system or absorbed into the body. Accordingly, food items prepared with a mixture of Creduline and saturated fats contain substantially fewer calories. Human testers report that low-fat foods made with Creduline, such as cakes, cookies, and candy, have a similar taste and "mouth feel" to the same items made with saturated fats alone. If these results hold up on the general market, Creduline has the potential to revolutionize the diet food industry, much as aspartane has done as a sugar substitute.
In order to produce Creduline in sufficient amounts, Kellman needed to license its manufacture. There were two possible candidates to be licensees -- Agron, a large diversified chemical company, and Ferris-Burnham, a medium-size company. Given its size, technical know-how, and marketing experience, Agron would have been the obvious choice, except for one complication. Ferris-Burnham had developed a fat substitute of its own, called Vivitrine. Vivitrine has a similar though not identical formula to Creduline, and it was unclear whether the different formula would have greater appeal to consumers. Furthermore, there was some possibility of a patent dispute. Kellman owned the rights to certain process patents that were arguably infringed by Ferris-Burnham's manufacturing process for Vivitrine, and Ferris-Burnham held patents, the validity of which was open to challenge, on certain molecules produced at an intermediate stage in the manufacture of Creduline. Kellman needed to reach a settlement with Ferris-Burnham before sinking substantial resources into production and marketing.
Eventually, it was decided that Kellman would grant Agron an exclusive license on Creduline (with the right to grant sublicenses) and a nonexclusive license on all patents necessary for its manufacture. Agron would then negotiate with Ferris-Burnham on Kellman's behalf for cross-licenses of the disputed patents (that is, each side would agree to give up any infringement claims against the other.) The reasoning was that Agron would be in a stronger bargaining position with Ferris-Burnham, especially with the rights to Creduline already under contract. Agron's attorneys drafted the licensing agreement, basing it on their standard license. The license contained a royalty schedule in which Agron promised to pay Kellman a percentage of the revenues it earned on the sale of Creduline; this percentage was to vary depending on the total quantity sold and on Agron's share of the market for artificial fat substitutes. In addition, Agron was to make a single lump sum payment of $2.5 million to Kellman at the outset of the license. Agron would have an option to renew the license every eight years, in exchange for a similar lump sum payment, adjusted for inflation. There was also a clause in which Agron promised to keep confidential any non-patentable trade secrets it learned from Kellman in the course of the relationship, a covenant on Kellman's part not to compete with Agron during the period of the license, and a covenant on Agron's part not to compete with Kellman after the expiration of the license. The contract also provided that Kellman would indemnify Agron for any costs associated with defending the validity of the Creduline patents in court. Additionally, because the parties were concerned that regulations of the Food and Drug Administration might delay production and marketing of Creduline, they also included a force majeure clause, which read:
FORCE MAJEURE. Neither the Licensor or the Licensee will have any claims against each other for delays or other losses that are occasioned by regulations or orders of agencies of the United States government or of any foreign government. In the event that Creduline or any of the component substances necessary to its manufacture are determined to be unfit for human consumption by any United States government agency and this determination is upheld by a court of competent jurisdiction, this License shall be voidable at the option of the Licensor. Additionally, in the event that patents necessary for the manufacture of Creduline are held invalid by a court of competent jurisdiction, this License shall be voidable at the option of the Licensor.
The contract also contained a boilerplate merger clause, which read:
ENTIRE AGREEMENT. This License Agreement constitutes the entire agreement between the parties relating to the subject matter hereof and supersedes all previous writings and understandings. No terms or provisions of this License Agreement shall be varied or modified by any prior or subsequent statement, conduct, or act of either of the parties, except that the parties may amend this License Agreement by written instruments specifically referring hereto.
Kellman and Agron did not include any specific mention of Ferris-Burnham in their agreement, nor did they explicitly condition any of their contractual obligations on Agron's reaching a subsequent settlement with Ferris-Burnham, for fear of jeopardizing Agron's bargaining position in the cross-licensing negotiations. The two parties understood and agreed orally, however, that such a settlement was expected, and that it would be impractical to go forward with the manufacture and marketing of Creduline without such a settlement. Ten days after the Kellman-Agron agreement was signed, Agron sent Kellman a letter asking for a clarification of the indemnification clause; this letter stated that it was Agron's understanding that the clause committed Kellman not just to pay the legal costs of defending the Creduline patents, but also promised indemnification if Agron had to pay damages to Ferris-Burnham for violating the Vivitrine patents. Kellman did not respond to this letter.
Shortly thereafter, Agron commenced negotiations with Ferris-Burnham. It turned out, however, that Ferris-Burnham had a vastly different opinion of the worth of the patents and the merits of any potential infringement claim, or at least was feigning such an opinion in the hopes of getting a better settlement. Additionally, it emerged that previous interactions between Agron and Ferris-Burnham had left the two firms with substantial distrust for each other. As a result, Agron was unable to reach an agreement with Ferris-Burnham, and Ferris-Burnham filed suit asking for an injunction against the manufacture of Creduline. Kellman and Agron believe this demand to be without merit, but Agron no longer wants to have to negotiate with Ferris-Burnham. It has asked Kellman to be released from its licensing agreement. Kellman has refused this request, but Agron has continued to ask for a recission or, failing that, a modification of the agreement. Agron wants Kellman to take over the negotiations with Ferris-Burnham, and to renegotiate the royalty schedule to reflect the fact that its future relationship with Ferris-Burnham in the artificial fat market is likely to be competitive rather than cooperative. The relationship between Kellman and Agron is getting strained. Agron has suggested that if no modification or recission is reached, it may make a formal request for the return of its $2.5 million. It has also dropped some veiled hints about breaching the agreement, signing up with Ferris-Burnham for the manufacture of Vivitrine, and sharing with Ferris-Burnham the experience and information it has gained so far in the performance of the Creduline license. Kellman considers this to be a bluff, but if Ferris-Burnham were to gain access to Kellman's trade secrets relating to Creduline the competitive consequences would be disastrous.
You are in-house counsel to Kellman. How do you advise Kellman to respond to Agron's requests for a modification or recission of the license contract? (Note: do not use any special knowledge you may have about patent law or food and drug regulations to answer the question. Simply take as given the above statements of the parties' legal situation in this regard.)
Part B. Now suppose that the foregoing dispute was resolved by a three-way settlement among Kellman, Agron, and Ferris-Burnham, in which Kellman and Ferris-Burnham settled their respective patent claims and granted each other rights to all relevant patents, and Kellman and Agron adjusted downward the royalty percentages payable under the original license. The settlement contract between Kellman and Agron made no further mention of patent rights or indemnification, but it contained the following clause, adapted from the original license contract.
ENTIRE AGREEMENT. This Amended License Agreement constitutes the entire agreement between the parties relating to the subject matter hereof and supersedes all previous writings and understandings. No terms or provisions of this Amended License Agreement shall be varied or modified by any prior or subsequent statement, conduct, or act of either of the parties, except that the parties may amend this Amended License Agreement by written instruments specifically referring hereto.
Everything went fine for a year, but then a fourth company, Deering Products, began producing an artificial fat substitute that resembled both Vivitrine and Creduline in chemical structure. When Kellman and Agron complained about patent infringement, Deering responded by filing an antitrust suit against all three incumbent firms, challenging the cross-licensing agreement under the Sherman Act as an attempt to monopolize the market for artificial fats, and asking for treble damages and an injunction. It also lobbied the U.S. Department of Justice to look more carefully into the Kellman/Ferris-Burnham and Kellman/Agron contracts. In reaction to these developments and out of fear of further antitrust scrutiny, Ferris-Burnham lowered its prices on Vivitrine and began competing for business much more aggressively than before. This forced Agron to lower its prices on Creduline as well.
Agron then made a formal written request of Kellman for indemnification for costs incurred in the Deering antitrust suit. Kellman refused, stating that the indemnification clause was intended to cover only patent disputes with Ferris-Burnham. Agron has also asked for a further downward adjustment of the royalty percentages, arguing that the existing royalty percentages were premised on the level of competition that existed between Agron and Ferris-Burnham at the time. With the cutthroat competition and antitrust scrutiny that has since emerged, Agron claims it needs a lower royalty percentage to be able to compete successfully and to cover its costs with sufficient profit margin. So far Kellman and Agron have been unable to resolve these issues, and in protest Agron has suspended the payment of royalties for the last two months.
You are still counsel to Kellman. Your client wants you to draft a complaint against Agron and a letter threatening Agron that you will file suit if they do not pay the back royalty and drop their demands for further modification of the agreement. What advice do you give your client?