Memorandum

Date: January 25, 2006
To: Contracts students
From: Avery Katz
Re: Feedback on Fall 2005 exam

This memo sets out what I considered to be the main issues raised by our Fall 2005 Contracts exam. The memo was composed after I read your exam papers, and so incorporates many of the points that you came up with in writing the exam, as well as those I had identified in advance. As a collective work product, then, it goes well beyond what I expected any individual student to produce on his or her exam paper [not to mention that it substantially exceeds the word limit you were alloted].

Pending permission from the authors, I will also post on the website the top student answers to each of the questions to the exam. What made these answers good was their coverage of arguments, detail and sophistication in their use of facts and in seeing both sides of the issues, and clarity in organization and explanation. If you drew different inferences from the facts than I or the top answers did, you may still have gotten credit, so long as your inferences were plausible and you supported them with legal argument. I did not give credit for merely restating the facts without relating them to the legal or planning issues at hand, and I gave little credit for reciting black-letter law in the abstract without applying it to the facts. A few people did waste some space this way.

For what it is worth, the correlation in student performance between the two questions (r=.31) was lower than on last year's exam. My best inference is that this low correlation was due to the additional time pressure of the eight-hour format (so that more attention to spent on one question meant less for on the other, to a greater extent than on longer exams, even though I wrote more narrowly focused questions this year than in past years.) This may imply that success on the exam in part reflects relative skill in working under such pressure. Your views on this issue would be helpful to me in choosing between the eight-hour and 24-hour format in future years.

As you will have seen, I did not make many written comments on your individual exams; instead, I used a system of symbols to indicate my reaction to particular arguments and inferences. A key to these symbols is attached. If you want to discuss your individual exam, please feel free to contact me. You will find it useful, however, to read this model answer as well as the top answers before we meet.

It was a pleasure teaching the class, and I wish you all well. Please keep in touch. 


 Question 1: Model answer


GrainBelt must consider the possibility of liability to Midwest City and also to Tasty Wheat. Let’s take these in order.

Dispute with Midwest City

Liability: Midwest City will take the position that GrainBelt is obligated to maintain operations in the city, or to pay damages for closing its plant. There are three possible theories that could support liability. The most straightforward is bargain, or classical contract, but Midwest also has a colorable promissory estoppel claim.

Under a bargain theory, the claim is that GrainBelt promised to maintain operations in exchange for the favorable terms it received when purchasing land, and also in exchange for the tax and regulatory breaks it received. There are a few problems with this claim, which GrainBelt can raise in defense. First, there is a question whether either GrainBelt or the city intended to enter contractual relations. Local governments and private developers make deals all the time which are supported by reputation only. In this regard it is relevant that we are not told exactly what the parties wrote down or said to each other in formal negotiation. The public comments made by GrainBelt contain obvious exaggerations and could be considered puffing or mere political rhetoric. Second and similarly, if there is a legal bargain, we do not know exactly what obligations it provides, which creates problems of indefiniteness. It is possible that a promise to maintain operations could be established through other materials, but there would be parol evidence problems if those materials do not appear in the real estate documents. One might expect such an important obligation to be memorialized through detailed documents, if it was really intended to be binding.

Even if there was no intention to contract, however, the city took GrainBelt’s representations seriously and relied by offering tax breaks and perhaps by declining the opportunity to contract with other developers. Such reliance can form the basis of liability under Restatement §90. The lack of specificity of the promise causes problems, however, and many of the considerations that militate against contractual liability could also be used to argue against applying estoppel.

Defenses to liability: If promissory obligation is established, GrainBelt can still argue that changes in the economic and regulatory climate (specifically, the trade dispute with Canada, and GrainBelt’s financial problems) make it impractical to maintain the plant. GrainBelt may have problems, however, making out a frustration or impracticability defense. In order to prevail under such doctrines, GrainBelt must establish that these events were not reasonably foreseeable, that the effect on its ability to perform is significant, and that it did not assume these risks when originally promising. All these elements are contestable. The Canadian regulations have not yet gone into effect, and even if they do this does not prevent GrainBelt from producing in Midwest City and paying higher shipping costs to new customers elsewhere. Additionally, GrainBelt is in the international grain business and arguably should keep track of such risks to its market (and the assumption of risk argument is even stronger for financial difficulties that GrainBelt got into on its own.)

Remedies: If GrainBelt is found liable to Midwest City,, the remedial consequences are uncertain. It will be difficult to measure the city’s expectation losses, both because it is hard to tell exactly what results were expected, and because future economic developments for the city are uncertain. Reliance damages are a possible alternative, either as a proxy for expectation under a bargain theory, or directly under an estoppel theory; but again we do not know what sacrifices the city made in response to GrainBelt’s statements, or whether the city had alternative commercial partners available to it at the time it struck its deal with GrainBelt. Restitution damages are a possibility, as measured by the value of the tax and regulatory breaks given by the city, but since the contract was entered into less than one year ago, most of these benefits have not yet been received by GrainBelt. Using restitution as a proxy for expectation may be more promising, since had the contract been performed, GrainBelt would have received ten years’ worth of such benefits, which should be comparable in amount to the city’s expectation interest if the deal was a sensible one.

Because of the difficulty in establishing damages, GrainBelt must consider the possibility that Midwest City will seek an injunction forcing it to build and maintain the promised plant. Given the magnitude of effort involved, however, as well as the ambiguity of GrainBelt’s original promises and the practical burden of enforcing an order of specific performance, it is unlikely that a court would award such an injunction. A more worrisome possibility is that a court could award a negative injunction prohibiting GrainBelt from establishing operations in California (as in Lumley v Wagner). Again, this is uncertain and will depend on the court’s exercise of equitable discretion, but the risk for GrainBelt is significant.

Dispute with Tasty Wheat

Liability: GrainBelt also runs a risk of liability to Tasty Wheat as a result of its negotiations over a sales contract for flour. There are some significant problems with Tasty Wheat’s case, however. First, the parties seem never to have settled on a contract quantity: the language in Peterson’s fax does not make reference to any specific quantity and appears open-ended. Without a quantity, the contract is too indefinite to enforce (though Tasty Wheat may argue based on context or other evidence that the parties anticipated a requirements contract.) Second, it is unclear whether there was ever any acceptance by GrainBelt of Tasty Wheat’s offer. Rooney’s remark, “looks good,” was quite informal and leaves room for an argument that negotiations were not concluded. Third, the alleged contract would be covered by the Statute of Frauds, Under section 2-201 of the UCC, there would have to be a writing signed by the party to be charged. (There is also a common-law Statute of Frauds issue because the alleged contract was to exceed one year.) The fax from Tasty Wheat may count as a writing, but no one at GrainBelt ever signed it, and it does not state any quantity, as required by 2-201.

The Statute of Frauds defense would probably be fatal to a contract theory of liability, but Tasty Wheat can argue its reliance on GrainBelt’s representations raises an estoppel that prevents GrainBelt from asserting that defense. Most jurisdictions allow estoppel to be raised in this regard, and it does seem that Tasty Wheat relied by signing supply contracts of its own, but there will be an argument whether such reliance was foreseeable (given that no quantity had ever been stated) or reasonable (given that negotiations had not yet been completed or memorialized in a writing as required by law.) The answer may depend on nuances of the context, and how well the parties can argue the equities of the matter.

Damages: In the event of liability, Tasty Wheat will seek expectation damages, but these may be tricky to measure. To even begin, we must make an estimate of the quantity of wheat that would have been traded; let us suppose that 10 tons per month, the amount that GrainBelt proposed to buy from Yummy Kernel, is the best estimate. We are told that the contract price was 20% below market, so the contract-market measure of 2-708(1) will yield zero damages. Measuring damages by the difference between contract price and resale price (pursuant to 2-706) does not help either because Tasty Wheat resold at a higher price. This appears to be a case for 2-708(2)’s lost profit measure, which can be calculated by comparing the 8K contract price to Tasty Wheat’s production cost (which we are told is 7K when output is 10 tons per month). This suggests that Tasty Wheat would have earned 1K profit per ton, times 360 tons over three years, equalling $360K.

We must, however, take into account Tasty Wheat’s savings through mitigation. Tasty Wheat has been able to mitigate by signing several smaller contracts which allow it to earn profits of $2K per ton on 120 tons, or $240K. But given Tasty Wheat’s cost structure, it would have been profitable for Tasty Wheat to enter into at least one of these contracts even if GrainBelt had not breached (i.e., Tasty Wheat is a lost volume seller). Namely, Tasty Wheat could have produced an additional 2K tons of flour per month at $8000 per ton, which it could have profitably sold at $9000 — a total profit of $24K. This $24K must be deducted, leaving mitigation of $212K, and expectation losses of $144K. (Alternate calculation: absent breach, Tasty Wheat would have earned $360K on three years of sales to GrainBelt and $24K on one year of sales to one of the smaller buyers, for total profits of $384K. Instead, Tasty Wheat earns only $240K, so the lost profits are $144K). The above calculation does not take into account mitigation opportunities that could become available in years 2 and 3, so probably overcompensates Tasty Wheat for its loss. But such opportunities will be difficult to prove.

Tasty Wheat will also be entitled to incidental expenses associated with the resale, including the extra costs of dealing with five customers instead of one. Consequential damages are unlikely. GrainBelt’s breach did result in Tasty Wheat breaching with its own suppliers, but those suppliers managed to cover at an equally good price, so it is not clear that they have losses for which Tasty Wheat would be liable. Even if they did, GrainBelt would have a fair argument that these losses are too remote to be foreseeable under the Hadley principle as codified in 2-715.

In addition, from a theoretical perspective Tasty Wheat has also been deprived of the security value of a three-year guaranteed contract. This is obviously a valuable asset (else Tasty Wheat would not have been willing to sell at a 20% discount) but it is difficult to value given that there is no market comparison for such long-term contracts . One possibility would be to estimate that the 20% discount (2K per ton) is a rough equivalent for the value of long-term security, but the estimate is very rough and it is not clear what the statutory rationale for such a figure would be. In general, then, both liability and damages are uncertain, but could be significant in amount, and the probable damages are likely to exceed the $500/ton that GrainBelt saved by switching suppliers from Tasty Wheat to Yummy Kernel.

Some students also analyzed damages in the event that GrainBelt breaches its contract with Yummy Kernel. Since the question did not indicate that this had happened, I did not include it in my exam checklist, but if there were such a breach, there would be no damages under a market-contract measure. Yummy might be eligible for lost-profit damages under 2-708(2), but we do not have enough information to know how large those would be.


Question 2: Model answer

 

Part 1: Potential legal claims

Claims by Microscape

Santos and Tufts may face liability to Microscape for breach of the agreement to negotiate in good faith that Tufts signed in November. Traditionally, such agreements were considered too indefinite to enforce under common law, but today they are enforceable if there is sufficient evidence that the parties intended liability and there is a reasonable basis for awarding a remedy. The formality of the written agreement is likely enough to satisfy the former element; as for the element of remedy, see below.

Santos and Tufts may defend on the grounds that Tufts lacked authority to bind Santos to this agreement. The issue of actual authority is arguable. The partners' agreement required Santos’s approval for unusual transactions, and sale of the company’s main asset surely counts as unusual. Entering into an exclusive contract with a single buyer to negotiate such a sale is a closer case, but such a contract has enough of an effect on the company’s fortunes that there is a colorable argument that Tufts exceeded her authority. From Microscape’s standpoint, however, actual authority is irrelevant, because Tufts had apparent authority to conduct negotiations. Santos consented to Tufts being CEO and delegated to her the running of the company, and senior management are typically charged with initiating merger talks with other companies, even if the shareholders must approve a final transaction.

Given this background, Tufts did not and could not guarantee that Santos would approve the sale,, but she did promise to proceed in good faith. Shopping the offer around, as Santos suggested, may not be a breach of good faith, but shopping without disclosing the fact to Microscape is more problematic, and actually entering into a contract with Netsoft (Microscape’s competitor) without giving Microscape a chance to make a counteroffer most likely would be held to be a breach.

The damages for this breach of contract, however, are quite unclear. Microscape’s expectation loss would be measured by the value it attached to Linker, less the $5 million purchase price, and given the way the market has moved since last February, it would be difficult to show that Linker had value above $5 million. Given the difficulty of establishing damages, Microscape might well be entitled to specific performance, but Microscape appears to have let this opportunity pass by allowing Netsoft to license Linker and build it into its own product Boggler. (Netsoft relied on this delay; and equity will not reward one who sleeps on its rights.)

Claims against Netsoft

It is unclear from the factual statement whether Netsoft ever made the lump-sum $2 million payment required by its January 2004 contract with Santos and Tufts. If it did not, then it is plainly in breach of contract, and Santos and Tufts can declare the contract avoided and deal directly with Microscape if they wish to.

Assuming that Santos and Tufts received their up-front payment, they may still have a claim against Netsoft for failure to pay royalties. The contract provided for “a fair royalty;” while this term is obviously vague, the parties apparently intended a contractual obligation of some sort. How much royalties are due could depend upon further bargaining, or upon comparisons to other comparable contracts in the trade, or upon the assessment of an outside auditor. Assuming that this term can be given specific content, in order to collect on it, Santos and Tufts would have to demonstrate that the Linker software system generated revenues for Netsoft. This could be difficult given that only 10% of Netsoft customers used Linker at all, and many of these would likely have used Netsoft without Linker. There is a good chance, accordingly, that some courts would find this term too indefinite to enforce.

Ordinarily, a contract that conveys an exclusive license to a promoter and that also provides payment in the form of a royalty requires the licensee to exercise best efforts in promoting the licensed product (as in Wood v Lucy, Lady Duff-Gordon). This implied duty may not apply in this specific case, for two reasons. First, the agreement between Netsoft and Tufts that provided that Netsoft would have full discretion in deciding how best to use the Linker software (although we are not told that this provision was put in the formal written contract). Second, Santos and Tufts received additional consideration in the form of the $2 million up-front payment, not just royalties on sales; this means that the best-efforts duty is not needed to provide mutuality, and also that there is less reason to worry about Santos and Tufts being injured by Netsoft’s exercise of discretion.

The fact that Santos and Tufts turned down a $5 million outright payment from Microscape for the Linker software, however, indicates that they were relying on the royalty to provide a significant portion of their consideration under the contracts, and suggests that the better argument is that Netsoft still is obligated to exercise best efforts (although they may retain discretion in doing so). In addition, they still have a duty of good faith in exercising discretion under the contract, and that duty cannot be waived.

We cannot tell from the given facts, however, whether Netsoft breached its duties of good faith or best efforts. Given the turbulent nature of the market and Microscape’s action in releasing its source code, it is possible that abandoning Linker was a reasonable business decision. Santos and Tufts might need to point to specific actions, such as the acts underlying the antitrust complaint, or possibly the appropriation of Linker code in the reconfigured version of Boggler, to establish such a breach. And then showing damages will be difficult.

[Some students suggested that Netsoft might have a defense to liability under the doctrines of commercial impracticability or frustration of purpose, but these doctrines apply to relieve parties in situations where there is no apparent discretion in performance of their duties. In situations like this one where there is substantial discretion, the duties of best efforts or good faith do the work of responding to variations in circumstances . So instead of saying that the parties are excused from exercising best efforts or good faith under the circumstances, we say that under the circumstances what the did was not a violation of good faith, we say that under the circumstances. ]


Part 2: Strategies for negotiation, settlement, and future contracting

Given that both contracts have likely been breached, neither breach is likely to yield a clear award of damages, Netsoft no longer has interest in Linker, and Microscape still does, settling the various outstanding claims and re-licensing to Microscape appears to make the most sense.
From this starting point, however, you could successfully have gone in a number of directions. The following list sketches the main issues you might have considered.

Negotiating with Netsoft

Going forward, Santos and Tufts should be most interested in whether Netsoft retains rights to use the Linker software. If it does, this will create severe difficulties for Santos and Tufts in dealing with Microscape. An obvious settlement would be for Netsoft to release any rights it retains to Linker, and for Santos and Tufts to drop its claims for royalties under the existing contract. Such a deal probably also makes sense for Netsoft also, both because it does not anticipate further need for Linker in its own business, and because holding onto Linker just to keep it away from its rival Microscape will put Netsoft in an awkward position in its upcoming antitrust litigation. (In addition, the possibility of liability to Microscape for intentional interference with contractual relations may further induce Netsoft to be cooperative.)

Negotiating with Microscape

Santos and Tufts face several practical problems in negotiating a new contract with Microscape. First of all, Microscape is likely to lack trust in Santos and Tufts given their past behavior, and so will be wary of any arrangements that do not clearly protect Microscape’s interests. Second, Santos and Tufts are now in a substantially poorer bargaining position than they were back in November. The market for browser-related software is weaker, profits are highly uncertain, and Microscape no longer faces competition from other potential buyers or licensees. Thus it is unlikely that Santos and Tufts will be able to get any deal that is nearly as good as the $5 million offer they had last November.

Terms of exchange

Given this legal and practical background, it is especially important for Santos and Tufts to spell out more of the specific terms of their new contract with Microscape, and not leave matters as open-ended or subject to the parties’ discretion as they did in the past.

The threshold question will be whether the deal should take the form of a sale or license of the Linker software. An outright sale is more straightforward, and does not leave Santos and Tufts subject to Microscape’s discretion in the future, but it may yield Santos and Tufts less revenue given the weakened market, and Netsoft’s problematic history with Linker. The parties may try to share the risk of a weak market, and of uncertain events, by conditioning the sale price on the amount of future sales or by providing some other type of price escalator formula.

If the parties opt for a license, their rights and duties thereunder should be clearly negotiated. It may help to define Microscape’s duties of good faith with more specificity, or to write an explicit best efforts clause into the agreement. The parties could agree to a minimum floor on payments, or to specific promotional actions. Additionally, Santos and Tufts and Microscape will have to decide on a royalty base: either revenues, profits, or some other proxy of Linker’s value. Revenues are easier to measure but are subject to the success or failure of Microscape’s other products; profits are harder to measure but do not give Microscape an incentive to run up unnecessary costs. An obvious problem with either measure is that it may be hard to distinguish revenues or profits earned from Linker from those earned from other Microscape software, given that Linker is likely to be provided in a bundle and given that much of Microscape earnings comes from indirect sources such as advertising, rather than direct software sales or licensing. Accordingly, Santos and Tufts may instead with to take their consideration in the form of Microscape stock, or a small royalty payable on all Microscape revenue sources.

Given the uncertainties that may arise in a future relationship, it may also make sense for the parties to provide particular remedies in their contract. One possibility would be to provide for liquidated damages in the event of breach, which will avoid the problems of litigating actual profits and losses; such a term would play a similar role to a payment floor. Another possibility would be to provide Santos and Tufts with some sort of buyback or reversion rights, so that they could terminate the contract and re-acquire Linker if they felt the product was underperforming under Microscape’s control. Santos and Tufts may also wish to ask for rights to an independent accounting so that they can inspect Microscape’s books if Linker underperforms; Microscape will have obvious business reasons to resist such a term. And finally, the parties may wish to provide for arbitration if they think that litigation in public courts are likely to be especially expensive or to risk bad publicity or the revelation of trade secrets. All these possibilities have advantages as well as disadvantages, and the most effective student answers discussed both.


Key to symbols and abbreviations used to mark exams:

On some exams I also circled particular words or phrases that I found questionable, unclear, or misspelled.   E.g., "parole" instead of "parol" evidence, although this year everyone heeded my warning and spelled the term correctly. The use of "it's" where "its" is intended, unfortunately, has not yet entirely been stamped out; perhaps that will be my next priority in future years.

good point or argument
! excellent point or argument
~ fair point, or incompletely or unclearly expressed
weak point
point needs elaboration
" point already made, repetitive, or unnecessarily restating facts
? unclear
?? very unclear, confused, mixing together separate points
x mistake of law, misstatement of fact, misuse of term
x? point appears mistaken
# irrelevant or tangential point
#? point's relevance unclear
#cl
point irrelevant to interests of client or to your assigned role
abs overly abstract
c-a fails to address counterargumenta
conc conclusory; result of argument stated without reasoning
contra
contradiction
dir? didn't follow exam directions
elab point requires elaboration
exag otherwise valid point is overstated or exaggerated
ff fighting facts: contradicting stated facts or making assumptions inconsistent with them
jg
jargon: using technical language as substitute for analysis
lec lecturing: abstract discussion unconnected to or unnecessary for the problem at hand
ll laundry list: throwing in relevant and irrelevant arguments alike, without distinction
mix mixing together issues that should be discussed separately
ns non sequitur: conclusion does not follow
org? organization unclear
rew reword phrasing or diction
rf repeats facts unnecessarily
sa straw argument: weak or caricatured argument set up merely for sake of rebuttal
sf, spf point is valid, but analysis is overly superficial
sig? point is valid, but of marginal or secondary significance
ss
slow start:  too much space spent restating the issue or getting to the point
ua unsupported assertion
vb verbose; too much space devoted to the point or points in question
vg discussion is vague