1 George Mason School of Law Contracts II Relational Contracts III F.H. Buckley

Output and Requirement Contracts  Vas ist das? 2

Output and Requirement Contracts  Vas ist das? Output contract: producer agrees to sell his entire output to buyer 3

Output and Requirement Contracts  Vas ist das? Output contract: producer agrees to sell his entire output to buyer Requirements contract: producer agrees to sell as much of his product as buyer requires 4

Output and Requirement Contracts  Why enter into such agreements? Output contract: producer locks in to sale, can safely bulk up on inventory 5

Output and Requirement Contracts  Why enter into such agreements? Output contract: producer locks in to sale, can safely bulk up on inventory Requirements contract: buyer assures himself of supply 6

Output and Requirement Contracts  Recognized in UCC Otherwise an indefiniteness problem 7

What happened in Eastern? 8

Eastern  Requirements contract where Gulf was to supply jet fuel 9

So what happened to oil prices in 1974? 10

So what happened to oil prices in 1974? 11

Eastern Air Lines  August 15, 1971: Nixon announces price controls to combat inflation  June 27, 1972: Contract signed  Oct. 6, 1973: Yom Kippur War  Oct. 17, 1973: Arab members of OPEC announce an oil embargo on the US after the Yom Kippur Ware  Nov 27, 1973: Emergency Petroleum Allocation Act 12

With predictable results… 13 Gas lines at the pump, 1974

Eastern Air Lines  So why didn’t the price adjustment clause cover the increase? 14

Eastern Air Lines  So why didn’t the price adjustment clause cover the increase? Based on West Texas Sour (domestic) The Nixon administration imposed price controls, fixing the price of old oil and permitting higher prices only to the extent that new oil was produced. 15

Eastern  Why didn’t they base the price on Gulf’s costs? 16

Eastern Air Lines  UCC § 2-306: good faith duties: were they implicated? 17

Eastern Air Lines  UCC § 2-306: good faith duties: were they implicated? Does good faith imply a price based on market or West Texas Sour?  Do abnormal price increases go to good faith? 18

Eastern Air Lines  UCC § 2-306: good faith duties: were they implicated? Does good faith imply a price based on market or West Texas Sour?  Was the contract meant to cover such price increases? 19

Eastern Air Lines  How would you approach this as an economic question? 20

Eastern Air Lines  How would you approach this as an economic question? Who was in the best position to solve the informational problem? 21

Eastern Air Lines 22 Who predicted the Yom Kippur War?

Eastern  How was Eastern’s fuel freighting relevant? 23

Eastern  How was Eastern’s fuel freighting relevant? A breach of good faith or standard industry practice? 24

Eastern  How was Eastern’s fuel freighting relevant? A breach of good faith or standard industry practice? Suppose Eastern had started to sell jet fuel to other airlines? 25

26 Supplier Buyer Requirements Contracts Price fluctuations and Incentives

27 Contract Price > Market Price Supplier Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

28 Contract Price > Market Price Supplier Supplier wants to sell as much as he can Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

29 Contract Price > Market Price Supplier Supplier wants to sell as much as he can Buyer Buyer wants to buy as little as he can—and it’s buyer’s option Requirements Contracts Price fluctuations and the Incentives of the Parties

30 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

31 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants to sell as little as he can Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

32 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants to sell as little as he can Buyer Buyer wants to buy as much as he can—and it’s buyers option Requirements Contracts Price fluctuations and the Incentives of the Parties

33 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants to sell as much as he can Supplier wants to sell as little as he can Buyer Buyer wants to buy as little as he can Buyer wants to buy as much as he can Requirements Contracts Price fluctuations and the Incentives of the Parties

Eastern Air Lines  Suppose you could purchase gas at $1 per gallon. How much would you want to buy? 34

Eastern Air Lines  Suppose you could purchase gas at $1 per gallon, but were not permitted to resell it. Would this change your driving habits? 35

36 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

37 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Over- consumption Requirements Contracts Price fluctuations and the Incentives of the Parties

38 Contract Price > Market Price Market Price > Contract Price SupplierUnder-supply Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

39 Contract Price > Market Price Market Price > Contract Price SupplierOver-supply Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

40 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Under- consumption Requirements Contracts Price fluctuations and the Incentives of the Parties

41 Contract Price > Market Price Market Price > Contract Price SupplierOver-supplyUnder-supply Buyer Under- consumption Over- consumption Requirements Contracts Price fluctuations and the Incentives of the Parties

42 Requirements Contracts Price fluctuations and the Incentives of the Parties UCC § (1): “no quantity unreasonably disproportionate to any stated estimate

43 Contract Price > Market Price Market Price > Contract Price Supplier Gulf under- supplies Buyer Eastern Air Lines over- consumes Requirements Contracts Price fluctuations and the Incentives of the Parties

Eastern Air Lines  Who was behaving opportunistically? Overinvestment: was Eastern using too much fuel? 44

Eastern Air Lines  Who was behaving opportunistically? Undersupply: Was Gulf looking for an excuse to get out of the contract? 45

Eastern Air Lines  Who was behaving opportunistically? Cf. Orange and Rockland at p

Eastern Air Lines  Who was behaving opportunistically? Cf. Orange and Rockland at p. 330  Buyer increases consumption when gas prices go up, propelling itself to be a large seller of power to other utilities 47

Empire Gas 320  What was the contract? 48

Empire Gas  What was the contract? To buy propane solely from Empire For approximately 3,000 conversion unites, more or less depending upon requirements of buyer 49

Empire Gas  What was the contract? Is the only purpose of the contract to provide the buyer with assurance of supply? 50

Empire Gas  What was the contract? Are there any restrictions on a buyer’s under-consumption on a requirements contract? 51

Empire Gas  What was the contract? Are there any restrictions on a buyer’s under-consumption on a requirements contract? Posner: That would make this an option contract, and requirements contracts are not option contracts 52

Empire Gas  Posner’s good faith duties: Buyer can cancel if a change in his business makes the contract too costly  Southwest Natural Gas 53

Empire Gas  Posner’s good faith duties: Buyer can cancel if a change in his business makes the contract too costly  Southwest Natural Gas Buyer can’t cancel because he has found a cheaper supplier 54

Empire Gas  Posner’s good faith duties: Buyer can cancel if a change in his business makes the contract too costly  Southwest Natural Gas Buyer can’t cancel because he has found a cheaper supplier “more than whim is required” 55

Empire Gas  Here: No reason given by buyer No change in fleet of trucks No business emergency 56

57 George Mason School of Law Contracts II Relational Contracts III F.H. Buckley

Next day  II. The Terms of the Contract 58

Last day: Requirement Contracts  Producer agrees to sell as much of his product as buyer requires Offers manufacturer security as to parts  Eg, GM – Fisher 59

60 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Buyer wants to increase purchases: Eastern Airlines Requirements Contracts

61 Requirements Contracts Price fluctuations and the Incentives of the Parties UCC § (1): “no quantity unreasonably disproportionate to any stated estimate

Output Contracts  Producer agrees to sell his entire output to buyer 62

Output Contracts  Vas ist das? Output contract: producer agrees to sell his entire output to buyer  Which offers him security as to sales 63

Output Contracts  Producer agrees to sell his entire output to buyer Risks:  What if market price > contract price  What if cost of production > contract price 64

65 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Price Changes: Output Contracts Assuming that Cost < Contract Price

66 Contract Price > Market Price Market Price > Contract Price SupplierWoo-hoo!!!! Buyer Price Changes: Output Contracts Assuming that Cost < Contract Price

67 Contract Price > Market Price Market Price > Contract Price SupplierWoo-hoo!!!! BuyerWants out Price Changes: Output Contracts Assuming that Cost < Contract Price

68 Contract Price > Market Price Market Price > Contract Price SupplierWoo-hoo!!!!Wants out BuyerWants out Price Changes: Output Contracts Assuming that Cost < Contract Price

69 Contract Price > Market Price Market Price > Contract Price SupplierWoo-hoo!!!!Wants out BuyerWants outWoo-hoo!!!! Price Changes: Output Contracts Assuming that Cost < Contract Price

70 Contract Price > Market Price Market Price > Contract Price SupplierWants out Buyer Can the supplier opt out if the market price changes?

71 Contract Price > Market Price Market Price > Contract Price SupplierWants out Buyer UCC 2-306: Would Empire gas apply?

72 Contract Price > Cost Cost > Contract Price Supplier Buyer What if Seller’s Costs Increase?

73 Contract Price > Cost Cost > Contract Price SupplierWants out Buyer Output Contracts Cost to Seller

Output Contracts: Feld v. Levy p

Output Contracts: Feld v. Levy p. 329  A renewable one-year contract in which Levy agrees to sell all its bread crumbs to Feld  Levy discovers that the marginal cost ($1.06) exceeds the contract price ($1.00) and cancels 75

Output Contracts: Feld v. Levy  Held: It would be bad faith for Levy to stop crumb production just because their profits aren't as high as they expected, but it would be good faith for Levy to stop crumb production if they incurred losses from such production that were "more than trivial". 76

Output Contracts: Feld v. Levy  Does this make sense? Would you want to know more facts? 77

Output Contracts: Feld v. Levy  Does this make sense? What if there are other suppliers of bread crumbs? 78

Output Contracts: Feld v. Levy  Does this make sense? What if there are other suppliers of bread crumbs?  Can you imagine how the buyer might bargain strategically? 79

Output Contracts: Feld v. Levy  Does this make sense? What if market price is now $1.50?  Now the seller wants out: can it shut down production? 80

Exclusive Dealing Wood v. Duff-Gordon p Lady Duff Gordon

Exclusive Dealing Wood v. Duff-Gordon 82  Wood to have the exclusive right to market her clothes or endorsements  In return to receive one-half of all “profits and revenues”  One year term, renewable unless cancelled on 90 days notice

Exclusive Dealing Wood v. Duff-Gordon 83  Is this a binding contract? Is it too uncertain?

Exclusive Dealing Wood v. Duff-Gordon 84  Is this a binding contract? Is it too uncertain? Does it lack consideration?

Exclusive Dealing Wood v. Duff-Gordon 85  Is this a binding contract? Cardozo: an instinct with an obligation The Moorcock: imply a term to give business efficacy to an agreement

Exclusive Dealing Wood v. Duff-Gordon 86  What is the economic rationale for finding a binding contract here?

Exclusive Dealing Wood v. Duff-Gordon 87  What is the economic rationale for finding a binding contract here? Consider Wood’s incentive to make contract-specific investments

Exclusive Dealing Wood v. Duff-Gordon 88  How would you formulate the duties of the parties, as a matter of legal drafting?

Exclusive Dealing Wood v. Duff-Gordon 89  How would you formulate the duties of the parties, as a matter of legal drafting? Good faith by Duff-Gordon Best efforts by Wood

Good Faith Standards  Van Valkenburgh p

Best efforts clauses  The parties can avoid Duff Gordon problems by stipulating for best efforts by a distributor 91

Best efforts clauses  The parties can avoid Duff Gordon problems by stipulating for best efforts by a distributor  UCC § 2-306(2) 92

Bloor v. Falstaff 93

Bloor v. Falstaff 94

Bloor v. Falstaff 95  What was the deal?

Bloor v. Falstaff 96  Falstaff buys all Ballantine assets except the brewery for $4M plus a royalty of 50 cent on each barrel of Ballantine sold  Buyer to use best efforts to promote and maintain a high volume of sales  Buyer to pay $1.1M per year if it substantially discontinues selling Ballantine

Bloor v. Falstaff 97  Falstaff’s history with the Ballantine brand

Bloor v. Falstaff 98  Falstaff’s history with the Ballantine brand Brieant: nonfeasances and misfeasances  Falstaff stressed profit at the expense of volume  “Falstaff simply didn’t care about Ballantine’s volume”  Falstaff put more effort into the Falstaff brand

Bloor v. Falstaff 99  Falstaff to use “best efforts to promote and maintain a high volume” Was this a drafting problem?  How would you have drafted it?

Bloor v. Falstaff 100  Can you articulate a standard by which best efforts can be judged? What would be excessive?

Bloor v. Falstaff 101  Would you expect that the parties would bargain for sales efforts that would exceed what Falstaff would expend had it a 100 % equity stake in the Ballantine brand?

Bloor v. Falstaff 102  An agency cost problem

Agency: Common Law 103  Legal relationship whereby a principal, expressly or impliedly, authorizes an agent to create a legal relationship between the principal and a third party

Agency: An economic concept 104  Any relationship in which a principal, expressly or impliedly, authorizes an agent to confer benefits or impose costs on the principal

The two definitions may overlap  Real estate agents 105

The two definitions may overlap  Real estate agents  Distributorships (Duff Gordon) 106

The two definitions may overlap  Real estate agents  Distributorships (Duff Gordon)  Partnerships One partners is an agent for his fellow partners 107

But the economic definition is broader  Beneficiaries and trustees 108

But the economic definition is broader  Beneficiaries and trustees  Shareholders and company directors 109

But the economic definition is broader  Beneficiaries and trustees  Shareholders and company directors  Bankers and company directors 110

But the economic definition is broader  Profit-sharing ventures: Falstaff 111

Agency Costs  Because the incentives of agents are not perfectly aligned with those of his principal, the agent may impose costs on him. 112

Back to Falstaff  The agent (Falstaff) has to decide how much money to spend on marketing the principal’s (Ballantine) beer 113

114 Agency Costs How much Ballantine beer to sell? Quantity of beer $ Horizontal axis measures the quantity of beer sold

115 Agency Costs $ Marginal Revenue Assume a constant amount of revenue for each case of Ballantine beer sold

116 Agency Costs $ Marginal Revenue Marginal Cost of Marketing Falstaff has to spend an increasing amount on marketing for additional units of beer sold

117 Agency Costs $ Marginal Revenue Marginal Cost of Marketing X Optimal sales at Quantity X

118 At X* Falstaff can profitably spend more on marketing $ Marginal Revenue Marginal Cost of Marketing XX*

119 At X* Falstaff can profitably spend more on marketing $ Marginal Revenue Marginal Cost of Marketing XX*

120 At X~ Falstaff can profitably reduce marketing expenditures $ Marginal Revenue Marginal Cost of Marketing X X~

121 At X~ Falstaff can profitably reduce marketing expenditures $ Marginal Revenue Marginal Cost of Marketing X X~

122 Now what happens when revenues are shared with an agent? $ Marginal Revenue Marginal Cost of Marketing X

123 The principal’s marginal revenue curve is lowered $ MR Falstaff+Ballantine Marginal Cost of Marketing X MR Falstaff The $0.50 tax

124 So that Falstaff has an incentive to reduce marketing expenditures $ Marginal Cost of Marketing X MR Falstaff X* MR Falstaff+Ballantine

An Application 125

Falstaff  Neither Falstaff nor Ballantine had perfect incentives 126

Falstaff  Neither Falstaff nor Ballantine had perfect incentives Ballantine bears zero marketing costs and would want Falstaff to spend excessively on marketing 127

128 So that Falstaff has an incentive to reduce marketing expenditures $ Marginal Cost of Marketing X MR Falstaff X* MR Falstaff+Ballantine

Falstaff  Neither Falstaff nor Ballantine had perfect incentives Ballantine has an incentive to spend too much and Falstaff too little. 129

Falstaff  Neither Falstaff nor Ballantine had perfect incentives Ballantine has an incentive to spend too much and Falstaff too little. If it’s a question of optimal joint production, it’s no answer that Falstaff was simply looking to the Falstaff bottom line 130

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? 131

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? Did the court get it right? 132

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? How would you draft Falstaff’s duties? 133

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? How would you draft Falstaff’s duties?  “best efforts”  “reasonable best efforts”  Non-discrimination  Good faith 134

Responses to Agency Costs?  Legal standards (e.g., best efforts) 135

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties Cost-sharing Profit-sharing Sliding scale 136

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations and Iterated PD Games 137

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations and Iterated PD Games  Vertical Integration 138

139 Post-contractual opportunism But see R.H. Coase, The Acquisition of Fisher Body by General Motors, 43 J.L.E. 15 (2000) 139

140 Optimal Firm Size Coase, The Nature of the Firm, 16 Economica 386 (1937) People organize production within firms to economize on transaction costs (and opportunism costs) of private contracting

141 Optimal Firm Size Coase, The Nature of the Firm, 16 Economica 386 (1937) People organize production within firms to economize on transaction costs (and opportunism costs) of private contracting People organize production by private contracting to benefit from informational gains which are lost when production is brought within a firm

Optimal Firm Size  Firms might then be too small (GM) or too large (conglomerization) 142

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations and Iterated PD Games  Vertical Integration  Monitoring plus termination rights 143

Wagenseller 144 The moon is out early tonight…

Wagenseller 145  Was she fired for reasonable cause? The English standard vs. the American “at will” standard

Wagenseller 146  Was she fired for reasonable cause? Should that matter?

Wagenseller 147  Was she fired for reasonable cause?  What if the employer had fired her for “bad cause”?

Wagenseller 148  Was she fired for reasonable cause?  What if the employer had fired her for “bad cause”? Should the “public policy” exception have been triggered?

Wagenseller 149  Was she fired for reasonable cause?  What if the employer had fired her for “bad cause”? Should the “public policy” exception have been triggered? Did the employer do an end run around it?

Wagenseller 150  Which rule best protects employees? English or American?

Wagenseller 151  What about not following the employee handbook?

Wagenseller 152  Which rule best protects employees? Are you sure about that? So why not give them tenure?

Wagenseller 153  Which rule best protects employees? Are you sure about that? So why not give them tenure? How often do parties bargain around it?

Wagenseller 154  Which rule best protects employees? Are you sure about that? So why not give them tenure? Can you think of an argument for tenure in the academic world?

Sysco 155  You have to terminate a franchisee. How do you do it?

Sysco 156  Franchisors cannot terminate for bad cause

Sysco 157  But the lack of good cause does not amount to a bad cause termination

Sysco 158  Mum’s the word

Note the two-way play  The employer has a free hand to dismiss the employee under the at- will standard  The employee can resign any time 159

Note the two-way play  The employer has a free hand to dismiss the employee under the at- will standard  The employee can resign any time But can the employer fetter the employee with a non-compete? 160