Exam feedback memo, Fall 2008

Date: January 26, 2008
To: Contracts students
From: Avery Katz
Re: Feedback on Fall 2008 exam

Potential claims by and against Hewson

The central question here is whether Hewson violated the terms of his employment contract in his dealings with the PSI project and its aftermath. Because his contract bars termination at will, Lotus must show cause to justify termination before the end of the contract term. Of the possible causes listed in his contract, the only one that is plausibly applicable is (iii): intentional breach of company policies. The relevant policies would be the ones identified in Lotus's articles of incorporation: namely, that all corporate funds be devoted to the purpose of employing homeless persons at a living wage. Lotus could thus argue that Hewson breached this policy when he hired non-homeless workers at a market wage to complete production for the Quad Homes contract.

Lotus's argument is unlikely to prevail. First, the articles of incorporation do not require that all funds actually be paid in wages to homeless persons, only that they all be devoted to forwarding that purpose. Hewson's attempts to rescue the failed PSI contract by mitigating with Quad Homes were in service to the overall goal of employing homeless workers; and indeed absent that mitigation, even fewer homeless workers would have been employed. Second and similarly, Hewson's contract requires him to undertake best efforts in service of Lotus's business, and to avoid damage to company assets; saving Lotus from potential bankruptcy by mitigating with the Quad Homes contract is consistent with and arguably necessary to that goal.

Some students pointed out that Hewson might be in violation of his obligation to accept direction from the Board of Directors by not submitting to them this important decision to [arguably] depart from company policy. This is possibly correct, though arguable, but that is a different matter from it being a firing offense. The termination clause makes clear that not all contract breaches by Hewson will justify the extreme remedy of firing; only those that are sufficiently material to qualify under the four categories listed in the clause. Not bringing the mitigation issue to the board may have been bad judgment or even breach of contract, but is unlikely to qualify as "willful failure to substantially perform assigned duties."   Similarly, some students suggested that Hewson acted incompetently by initially entering into the PSI contract under terms that threatened Lotus's solvency. This may be so [though it is not obviously so]. Still, bad business judgment is usually not a breach of contract; and the termination clause appears [perhaps unwisely] to limit Lotus's right to fire Hewson for poor performance.

A few students suggested that even if Hewson had breached one or more of the duties listed in the termination clause, he could argue that such breach was excused on grounds of change of circumstances or impracticability. In my judgment it is more plausible to argue there is no breach at all, because if there is a breach resulting from Hewson's incompetence or insubordination, then it would be hard for him to argue that he had not assumed the risk of the circumstances flowing from the breach.

Even assuming Lotus breached Hewson's contract by firing him without cause, however, it faces little exposure in terms of damages or equitable remedy. Lost wages for the remaining contract term [$10,000/year pro-rated by however many months are left] will be a nominal amount, and will be offset by any increase in tithing or community support Hewson may receive as a full-time minister. Hewson could argue that he suffered a loss in reputation from being fired, but it would be very difficult to measure this loss in terms of dollars.

There is a chance that given the absence of an effective damage remedy for lost reputation, Hewson could seek specific performance in the form of an injunction for reinstatement. Courts have traditionally been reluctant to award specific performance in employment settings, but have been more willing to do so in recent years if the parties' relationship is not damaged beyond repair. The fact that Hewson holds a high management position requiring close consultation with the board, however, makes it rather less likely that an injunction would be awarded.

Claims by and against PSI

Note first that this is a contract for the sale of goods under Article 2 of the Uniform Commercial Code, because prefabricated homes, unlike homes built in place on a parcel of real estate, are movable at the time of identification to the contract [§ 2-105.] Thus sales law doctrines such as perfect tender and battle of the forms are applicable.

Lotus promised PSI to deliver prefabricated homes on a quarterly schedule, and also to provide monthly progress reports. It breached the former promise by failing to deliver the third installment of homes by April 1 [the fact of breach was not explicitly set out in the question, but follows implicitly from the described fact pattern.] It may or may not have breach the latter promise, depending on whether the reports were required to be sent by the first of the month, or received by the first of the month: a question on which the contract does not clearly speak. Course of performance under the contract may suggest that receipt by the first was intended, but analogies to other contract law rules regarding dispatch and receipt may suggest that dispatch by the first of the month was intended. In any event the material portion of the breach was the non-delivery. A late progress report, even if a breach, was not a material breach, especially since no damages from delay were indicated in the fact pattern, and PSI did not even complain about the late report until a week after it was received. And a non-material breach does not entitle the aggrieved party to rescind the contract.

PSI may argue that this is not an ordinary contract in which material breach is required for recission, but an option contract in which Lotus had the option to deliver goods in timely fashion in exchange for payment. Accordingly, there is no recission, but simply a failure on Lotus's part to exercise its delivery option, bringing the contract to an end under its own terms. In defense of this interpretation, PSI will point to its own purchase order, which described the contract as an option and referred to the $1.1 million bond as consideration for the option.

PSI's argument on this point is not frivolous, but it is unlikely to prevail for the following reasons. First, the reference to an option followed previous communications, including project documents and a call for bids, that made no mention of an option arrangement. Second, delays in performance are common in the construction industry; and in the unusual case when time is of the essence, parties will state so specifically. In this context, allusive language in a standard form purchase order that does not call the bidder's attention to this unusual change in terms should be interpreted against the drafter and in favor of the reasonable expectations of the non-drafter.

The interpretation argument could also be analyzed under UCC § 2-207, under which a definite and seasonable expression of acceptance sent within a reasonable time operates as an acceptance even though it states terms additional to or different from those offered or agreed upon, unless acceptance is expressly made conditional on assent to the additional or different terms. Because the call for bids and the bids themselves were not phrased in terms of options, and because the option characterization has such harsh consequences, an acceptance that recharacterizes the contract as an option contract is a material alteration of the offer and fails to make it into the contract under 2-207(2).   [Conversely, if we conclude that there is no contract on the writings and the knockout rule applies, then we need to go to the background rules of the UCC, which incorporate trade usage and would not imply an option contract.]

The late delivery of the April quarterly installment, as opposed to the late progress report, is more plausibly interpreted as a material breach, but since this is a sales contract the issue must be analyzed under § 2-612 on installment contracts. Under this provision, the classic perfect tender rule does not apply. Instead, the buyer may only reject a non-conforming [e.g., late] installment if the non-conformity substantially impairs the value of that installment, and may rescind the entire contract only if the non-conforming installment substantially impairs the value of the whole contract. There are no facts stated that would support such a conclusion, so it it likely that PSI's cancellation of the contract was improper.   [There is also a colorable argument that the cancellation breach the implied duty of good faith, depending on whether we believe that PSI cancelled in order to take advantage of a cheaper alternative, as opposed to any real dissatisfaction with Lotus's performance.]

A few students argued that even if Lotus was in breach, the breach was excused on the doctrine of impracticability. This argument is weak, since the circumstances together with Lotus's offering of a $1.1 million bond make it clear that Lotus was assuming the risk of unreliable performance on the part of its non-traditional workers.

Damages vis-a-vis PSI

Assuming that PSI breached the contract through improper cancellation, Lotus is entitled to recover damages for the difference between the contract price and its resale price under § 2-706. On this measure, Lotus would have to show that it resold in good faith and in a commercially reasonable manner [and similarly, that it acted reasonably under § 2-704 to complete rather than scrap the incomplete houses.] It would also have to comply with the procedural requirements of 2-706, including reasonable notice to PSI.

In terms of a specific numerical calculation, Lotus expected to be paid $4 million dollars for the 20 houses it was to produce, The fact pattern states that it expected to earn a $500,000 profit, suggesting that it would have spent a total of $3.5 million to perform. As it turned out, after reasonable mitigation, it incurred total expenditures of $4.35 million, and collected revenues of only $2.6 million, for a loss of $1.85 million. To restore it to the position of performance under the contract, it will argue, it needs to recover damages of $2.35 million.

[An alternate calculation proceeds as follows: Lotus was never paid the $2 million it was owed on the first half of the contract, so needs to recover that amount now.   In addition, it lost $100K on the second half of the contract, instead of earning $250K profit as it expected. So again, expectation damages are $2.35 million.]

PSI can and should argue that while Lotus's expected profit at the time it entered into the contract might have been $500K, at the time of breach its expected profit was lower because it had lost workers and would have had to hire more workers at extra cost in order to complete on time. Lotus's completion cost for the second ten houses would probably not have been as high as the $2.6 million it spent performing the Quad Hills contract with its accelerated May deadline, but it likely would have been more than the $1.75 million that it spent on the first ten houses.   So the extra amount that Lotus would have had to spend to perform under the PSI contract should be deducted from the initial $4.35 million estimate.

Furthermore, given that PSI's unjustified cancellation was itself a material breach of contract, Lotus has the option to recover off the contract in quantum meruit for the value of the houses it actually delivered. Whether this would be in Lotus's interest depends on what measure of quantum meruit is used.   If a pro-rated proportion of the contract price is used as the measure, then Lotus would receive only $2 million, and expectation damages under 2-706 is a better option [and the same is true if quantum meruit is measured by Lotus's production cost of $1.75 million.] On the other hand, if a court can be persuaded to measure quantum meruit with reference to market value as measured by the price of other producers [a plausible argument because Lotus, as a new company with an unorthodox business model, needed to underbid in order to get the job], then damages would be at least $2.5 million, which is better for Lotus than lost expectation.

It is also worth measuring damages in the less likely event that Lotus is found in material breach so that PSI's cancellation was justified.   In this case, PSI's lost expectation damages are best measured under the cover formula of § 2-712.   PSI expected to get twenty houses for $4 million; they did get twenty houses but had to pay Acme $3 million for the second ten houses. If PSI can show that covering with Acme was reasonable, then to put PSI in the position of performance it would have to pay Lotus the balance of $1 million. [This also corresponds to the proper quantum meruit damages that Lotus deserves as the breaching party. Lotus is entitled to the unpaid $2 million for the first ten houses it delivered, less a $1 million offset for PSI's damages. ] On the other hand, if covering with Acme at a price of $3 million was not reasonable, then PSI would have to measure its damages under § 2-713's contract-market formula. Again, Lotus would be entitled to recover its unpaid $2 million in quantum meruit, less any damages PSI could show under 2-713.

Of course, if Lotus is found in material breach, PSI will argue that it is entitled to keep the $1.1 million bond as liquidated damages. There are two problems with this argument. The first problem is that the bond may not necessarily be interpreted as liquidated damages. A party might offer a bond to ensure that there will be enough money available to cover actual damages, without agreeing that the entire bond will be forfeit. In this case, Lotus promised that the bond would be "payable to PSI in the event of breach by Lotus," but this does not necessarily mean payable in full without regard to the actual value of damages. The second problem is that liquidated damages are only enforceable to the extent they are a reasonable estimate of actual or anticipated damages in light of the difficulty of proving loss or the inconvenience of otherwise obtaining an adequate remedy . If PSI's actual damages are calculated at $1 million under the cover formula of 2-712, then maybe $1.1 million is close enough not to be held a penalty. If PSI's actual damages are calculated under 2-713 as substantially less than $1.1 million, then the liquidated damage clause will not stand.

Finally, PSI will argue that the $1.1 million bond is not liquidated damages, but instead the consideration that Lotus promised to pay under an option contract. This interpretation would give PSI a better chance of keeping the entire bond since courts do not supervise consideration with the same rigor as they do liquidated damages. This argument runs into the same offer and acceptance problems as mentioned above in connection with PSI's earlier option-contract argument, but a further problem here is that it makes no economic sense. Under this interpretation, Lotus would be required to pay $1.1 million as the price of entry to a contract in which it would have to pay the further cost of constructing twenty homes, for an ultimate payoff of $4 million. This is equivalent to being paid a net amount of $2.9 million, which would not be anywhere near enough to cover Lotus's anticipated costs. The only reasonable interpretation, acccordingly, is that the $1.1 million was intended to be payable only in the event of breach.

Question 2: Stellar-Byner dispute

This was the harder question of the two, because it required you first to analyze a complex legal situation and then offer advice for avoiding litigation through renegotiation.

Legal analysis

Stellar's rights

This contract is a mixed contract for goods and services, and under the majority rule for hybrid contracts will be governed by Article 2 of the UCC to the extent that parts manufacture dominates consulting as the primary purpose of the contract, which it appears is the case. [Under the minority rule, it will be governed by Article 2 to the extent it covers the manufacture of precision machine parts, and by the common law to the extent it governs consulting services.

Accordingly, it most likely qualifies as a requirements contract under § 2-306, even though it does not explicitly make mention of Byner's requirements, because it bars Byner from purchasing from itself or from any third party. Thus, if Byner has any requirements for machine parts, it is going to have to buy them from Stellar, which makes it a requirements contract in substance. As such, Byner's discretion regarding how much it purchases is limited by its duty of good faith, together with 2-306's additional requirement that the amount purchased not be unreasonably disproportionate to past requirements.

The contract, signed in January 2007, modifies and replaces an earlier contract between the same parties dated November 2003.   The modification is probably valid under both the common law test [both sides provided fresh consideration: Stellar in the form of a price reduction, Byner in the form of an extension to the contract term] and the good faith requirement of UCC § 2-209. This last section, in contrast to the Restatement, does not require unforeseen circumstances to validate a modification, although there probably were such circumstances. The fact that Byner exercised some economic pressure to obtain the modification does not defeat the element of good faith, although there could be a good faith problem if it falsely stated that it was about to run out of cash when that was not actually the case and Stellar relied on that statement in agreeing to the modification, since under the UCC good faith is defined to include honesty in fact.   If Byner did breach its duty of good faith, however, the modification would be invalid and voidable by Stellar, allowing Stellar to pursue its rights under the original 2003 contract.

There is one other ground on which Stellar might try to avoid the January 2007 modification. Namely, Stellar might argue that Byner was under a duty to disclose that it was looking around for a merger partner in the near future. A merger that would eliminate all of Byner's requirements, depriving Stellar of any gains from the modified contract, would plainly be a material factor requiring disclosure if it were in the works at the time that the modification was negotiated. [Similarly, Stellar could argue that it had been under a unilateral mistake at the time of the modification with regard to a basic assumption of the contract -- i.e., that Byner would continue in business -- and that Byner had reason to know of this mistake and did not correct it. It could also argue fraud, if by witholding this information Byner intended to fraudulently induce Stellar into the contract, but this would be rather more of a stretch.]

The materiality of a forthcoming merger stems from the economic structure of the modified contract -- a price reduction in exchange for a lengthened term. In particular, Byner stood to get all the benefits of the modification up front in the form of an immediate price reduction, while Stellar would not see any benefits until after November 2008, when the original 2003 contract would have expired.   Byner's response to these arguments would be that there was nothing to disclose and thus no mistake or fraud; while it had been looking around for merger partners as a possible solution to its economic problems, no merger was in prospect at the time of the modification, and indeed Byner did not start looking again for merger partners until late 2008, in response to over a year and a half of unfavorable experience under the modified contract.

Assuming the January 2007 contract is valid and still in force, would Byner be breaching if it merged with Triad?   Recall that under the contract, Byner is only obligated to purchase its good faith requirements. It will argue that if it merges with Triad and transfers its production to Triad's subsidiary Rhombus, it will have no more requirements, and so will not be breaching. There are several difficulties with this argument. First, the case law on requirements contracts [and the comments to 2-306] suggest that a shutdown for lack of orders would be in good faith and not unreasonably disproportionate, but a shutdown of a still profitable firm might not be. The facts indicate that Byner was less profitable than it had been in the past, but there was no indication that it was no longer viable, at least not yet.   Second, while selling and shutting down the firm might be a good faith exercise of discretion under some circumstances, the timing of the shutdown [i.e, coming right after Byner had extracted all the benefits of the January 2007 price reduction, and just before Stellar was about to start receiving its benefits from an extended contract term] might not be -- especially given that Byner had been trying to merge without telling Stellar.

Third, while the contract is an implicit requirements contract, it also contains specific affirmative covenants on Byner's part not to purchase machine parts from a third party or produce them for its own use.   Stellar will take the position that Byner's transferring its business to Triad and Rhombus, followed by Rhombus's self-production, would breach these covenants even apart from the requirements issue. This argument is not airtight, in that it would not be Byner purchasing any machine parts or producing for its own use, but Rhombus, who is not a party to and hence not bound by the Byner-Stellar contract. Byner would be out of business by that time. But it is possible that this would be held to be a breach of the covenants, either because Rhombus as successor to Byner's business would be held to Byner's pre-existing contractual obligations, or because the sale, though not itself an instance of self-purchasing, would be sufficiently similar in ultimate effect to be a breach of the duty of good faith. [Note that the successor liability question would not actually be a matter of contract law, however; it would instead turn on the local jurisdiction's rules relating to business organizations.]

Some students suggested that Byner might be excused from its contract with Stellar on grounds of commercial impracticability. This argument is weak, as Byner is not yet losing money, and the commercial risks of loss in a fixed-price requirements contract are generally understood to be allocated by the agreement. Similarly, some students suggested that Stellar might have a promissory estoppel claim against Byner even though it does not have a contract claim. This is also a stretch, since in order to apply promissory estoppel it is necessary to find a promise, and there is no indication that Byner ever promised not to merge into another company. [One could imply a promise as Justice Traynor did in Drennan v Star Paving , but then why not just imply a promise within the contract as Judge Cardozo did in Wood v. Lucy, Lady Duff-Gordon ?]

In addition to any contractual claims by Stellar against Byner, Byner must also worry about Stellar's possible tort claims against Triad, which Byner has agreed partially to indemnify. Whether Triad is liable for intentional interference with contract depends on Triad's knowledge and intention. Triad did know of the contract with Stellar, and indeed refused to consider merging with Byner in July 2006 for that very reason. It also raised the issue in the more recent merger negotiations.   The clause under which Triad obtained partial but not full indemnification from Byner, accordingly, suggests that Triad understood there would be some risk of liability and accepted this risk. In its defense, Triad can argue that Byner's claim that the Stellar contract would come to an end was colorable, and that Triad made at least some reasonable efforts to avoid interfering with Stellar's interests. There is some risk here but it is not clear-cut, depending on one's view of the strength of Stellar's contractual arguments.

It's worth estimating what damages would be payable in the event that Byner and/or Triad were held liable for Stellar's contractual losses.   If Byner abandons its relationship with Stellar and Stellar successfully sues for breach of the 2007 contract, it would in theory be entitled to the profits it would have earned on that contract through 2012. These may be difficult to calculate given that requirements are not certain and Byner's purchases have been declining even apart from a merger, but it may be possible to come up with an estimate based on a time trend.   Alternatively, Stellar might try to claim reliance or restitution damages as a proxy for unmeasurable expectation; these could be based on the price reductions that Stellar gave up and Byner benefited from during the period between January 2007 and the present. [Stellar could also recover these price reductions if it were able to avoid the 2007 contract on grounds of mistake, fraud, failure to disclose, or invalid modification, and sued for unpaid amounts under the original 2004 agreement.] In a tort lawsuit against Triad, punitive damages might also be available.

Finally, specific performance of the Stellar-Byner contract is problematic for all the usual reasons, although there is case law awarding this remedy in the requirement contract setting on the grounds that expectation damages are not reasonably calculable and would not protect Stellar's interest in the security of having a stable market for its products. A negative injunction blocking the Byner-Triad merger, however, is more of a risk [as in Lumley v Wagner , where specific performance was denied but a negative injunction was granted] though still uncertain as a matter of equitable discretion.

Note that Byner has not yet actually repudiated its agreement with Stellar, though it has certainly caused Stellar substantial insecurity regarding whether the contract will go forward. We did not discuss the legal rules governing insecurity, repudiation, and the duty to give assurances; but whether Stellar is entitled to treat Byner's recent behavior as a breach depends on the application of these rules. Assuming Byner does breach, however, the breach is obviously material, entitling Stellar to rescind the contract, and excusing it from undertaking its own obligations under the contract. Accordingly, Stellar would then be free to supply parts to Byner's competitors, and to withhold its technical notes on Byner's designs, though the designs themselves are probably still Byner's property. Stellar's promise not to disclose Byner's trade secrets is a harder issue, and probably would need to be decided under relevant provisions of intellectual property law.

Rights and duties vis-a-vis Triad

Byner's agreement to merge into Triad has not yet been finalized, in that no formal writing has yet been executed, permission from Triad's board of directors is legally required for the merger to go through, and some important details have been left open. On the other hand, most essential terms have been worked out, Dionne controls the board, and this is not a contract that must be in writing as matter of Statute of Frauds. Accordingly, the parties are probably under an obligation to continue their negotiations in good faith, as in TIAA v Tribune . The good faith standard would not allow Byner to back out on the basis of its possible liability to Stellar, since this issue was raised and settled in the prior negotiations. [Alternatively, Byner could be bound to its promises and representations to Triad on an estoppel theory.] On the other hand, these doctrines also protect Byner against the event that Triad wishes to withdraw from negotiations once it finds out about the Stellar situation.

What would damages be if if the merger falls apart and one of the parties sues the other for breach of the duty to negotiate? Specific performance is unlikely given the supervision burden this would require of the course, but damages are a distinct possibility. Lost profits on the deal will be hard to calculate, but some aspects of the deal's value are measurable. For example, if Triad backs out of the deal, Conrad may be able to recover his expected salary, less amounts reasonably available in mitigation. And conversely, if Byner backs out, it will probably still be liable to indemnify Triad for any payments it must make to Stellar as a result of any claim.of tortious interference.

Transactional analysis

Given this background, what is the best way to proceed? Here there was leeway for you to go in different directions with your answer, although any advice should take into account the business basis of the proposed merger and the efficiencies it can provide. In particular, given excess capacity and the shrinking market, it likely still makes sense to consolidate production facilities and eliminate duplicate costs. How this should be done depends on Stellar's and Rhombus's relative production costs; if Stellar can produce more cheaply than Rhombus, then Stellar should stay open and service Byner's needs and Rhombus should close its facilities. On the other hand, Stellar may have mitigation opportunities available to it that Rhombus does not, and given what has happened so far, the trust necessary for Byner and Stellar to work together effectively may have been destroyed.

Some students suggested that Byner should merge with Stellar instead of with Triad, though this would require overcoming the trust issues and would not achieve the economies from consolidating production capacity. In addition, Triad might regard this as a breach of contract, and seek an injunction to prevent it. Thus, Triad would likely have to be brought in on any such deal [perhaps acquiring or contracting with Stellar going forward].

If there is a settlement that allows a merger to go forward, there are several ways to structure it. Among the possibilities you suggested were: buying out of Stellar's contract for a flat fee; giving Stellar royalties on any production by Rhombus following the merger, giving Stellar equity shares in Triad, or identifying economies of specialization in different types of machine parts, and having Stellar produce and sell those types of parts in which it holds a comparative advantage, while allowing Rhombus to produce other types of parts. There are advantages and disadvantages to all these arrangements, both in terms of legal risks, incentive problems, and the kinds of disputes that might arise down the road; and a strong answer should have discussed these advantages and disadvantages.

Some students offered not just substantive advice on how to structure a settlement, but negotiating advice on how to achieve it. To the extent such advice was concrete and based on materials we discussed in class, I gave credit for it.