1 George Mason School of Law Contracts I XVI.Output Contracts and Distributors F.H. Buckley

Output and Requirements contracts  UCC § 2-306(1) A term which measures the quantity by the output of the seller or the requirements of the buyer means such actual output or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded. 2

Requirements Contracts  Requirements contract: producer agrees to sell as much of his product as buyer requires 3

Requirements Contracts  Requirements contract: producer agrees to sell as much of his product as buyer requires  Strategic behavior: misincentives as to quantity 4

5 Contract Price > Market Price Market Price > Contract Price Supplier Gulf under- supplies Buyer Eastern Air Lines over- consumes Requirements Contracts and Incentives as to Quantity

6 Contract Price > Market Price Market Price > Contract Price Supplier Empire Gas Empire Gas Over-supplies Buyer American Bakeries American Bakeries under- consumes Requirements Contracts and Incentives

Output Contracts  Output contract: buyer agrees to purchase seller’s entire output 7

Output Contracts  Buyer agrees to buy all of producer’s output Risks to buyer: 8

Output Contracts  Buyer agrees to buy all of producer’s output Risks to buyer:  What if market price < contract price 9

Output Contracts  Buyer agrees to buy all of producer’s output Risks to buyer:  What if market price < contract price  What if buyer can’t use the output Weak demand for buyer’s product Higher costs for buyer 10

Output Contracts  Buyer agrees to buy all of producer’s output Risks to seller:  What if market price > contract price  What if seller’s cost > contract price 11

12 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Price Changes: Output Contracts Assuming that Contract Price > Market Price

13 Contract Price > Market Price Market Price > Contract Price SupplierWoo-hoo!!!! Buyer Price Changes: Output Contracts Assuming that Contract Price > Market Price

14 Contract Price > Market Price Market Price > Contract Price Supplier BuyerWants out Price Changes: Output Contracts Assuming that Contract Price > Market Price

15 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Price Changes: Output Contracts Assuming that Market Price > Contract Price

16 Contract Price > Market Price Market Price > Contract Price SupplierWants out Buyer Price Changes: Output Contracts Assuming that Market Price > Contract Price

17 Contract Price > Market Price Market Price > Contract Price Supplier BuyerWoo-hoo!!!! Price Changes: Output Contracts Assuming that Market Price < Contract Price

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

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

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

Output Contracts: Feld v. Levy p Bakery Levy Distributor Feld Bread crumbs

Output Contracts: Feld v. Levy  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 22

Output Contracts: Feld v. Levy  See excerpt on

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". 24

Output Contracts: Feld v. Levy  Does it make sense to require the baker to lose money? Is there something troubling about the numbers? 25

Output Contracts: Feld v. Levy 26

Output Contracts: Feld v. Levy  What if the baker could sell elsewhere for $1.20 Do you think this might do something to his reported costs, if this affords him an out? 27

Output Contracts: Feld v. Levy  What if the cost of production is now $1.50? 28

Output Contracts: Feld v. Levy 29

Output Contracts: Feld v. Levy  Can a buyer in a requirements contract purchase zero quantities? Posner J. in Empire Gas 30

Output Contracts: Feld v. Levy  Can a buyer in a requirements contract purchase zero quantities? Empire Gas  Can a seller in an output contract sell zero quantities? Feld v. Levy 31

Output contracts and distributorships  Can resemble each other if the distributor is given the right to sell his client’s products 32

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

Exclusive Dealing Wood v. Duff-Gordon 34  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 35  Is this a binding contract?

Exclusive Dealing Wood v. Duff-Gordon 36  Is this a binding contract? Is it too uncertain?

Exclusive Dealing Wood v. Duff-Gordon 37  Is this a binding contract? Is it too uncertain? Does it lack consideration?

Exclusive Dealing Wood v. Duff-Gordon 38  Is this a binding contract? Cardozo: an instinct with an obligation by Wood to use reasonable efforts  The Moorcock: Bowen L.J.: imply a term to give business efficacy to an agreement

Exclusive Dealing Wood v. Duff-Gordon 39  What is the economic rationale for finding a binding contract here?

Exclusive Dealing Wood v. Duff-Gordon 40  What is the economic rationale for implying duties by the distributor? Consider Wood’s incentive to make contract-specific investments

Exclusive Dealing Wood v. Duff-Gordon 41  How would you formulate the duties of the parties, as a matter of legal drafting?

Exclusive Dealing Wood v. Duff-Gordon 42  How would you formulate the duties of the parties, as a matter of legal drafting? Good faith by Duff-Gordon Best efforts by both

Exclusive Dealing Wood v. Duff-Gordon 43  UCC § Every contract imposes upon each party a duty of good faith and fair dealing in its performance and enforcement."

Exclusive Dealing Wood v. Duff-Gordon 44  UCC § 2-306(2) A lawful agreement by either the seller or the buyer for exclusive dealing in the kind of goods concerned imposes unless otherwise agreed an obligation by the seller to use best efforts to supply the goods and by the buyer to use best efforts to promote their sale.

What are Good Faith Standards  Van Valkenburgh p

What are Good Faith Standards  Van Valkenburgh p. 354  Just where did the publisher cross the line? 46

What is best efforts? 47  Bloor v. Falstaff 343

Bloor v. Falstaff 48

Bloor v. Falstaff 49

Bloor v. Falstaff 50  What was the deal?

Bloor v. Falstaff 51  Falstaff buys all Ballantine assets except the brewery for $4M plus a royalty of 50 cents 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 52  Falstaff’s history with the Ballantine brand

Bloor v. Falstaff 53  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 54  Falstaff’s history with the Ballantine brand Remedy?

Bloor v. Falstaff 55  Falstaff to use “best efforts to promote and maintain a high volume” Was this a drafting problem?  Or did they get it just right?

Bloor v. Falstaff 56  Can you articulate a standard by which best efforts can be judged? What would be excessive?

Bloor v. Falstaff 57  Can you articulate a standard by which best efforts can be judged? What would be excessive? Friendly: “Even without the best efforts clause, Falstaff would have been bound to make a good faith effort to see that substantial sales of Ballantine products were made”

Bloor v. Falstaff 58  Can you articulate a standard by which best efforts can be judged? What would be excessive? Friendly: Profit uber alles was the problem

Bloor v. Falstaff 59  Supposing that Falstaff had purchased Ballantine outright. Would profit uber alles have been a problem?

Bloor v. Falstaff 60  Supposing that Falstaff had purchased Ballantine outright. Would profit uber alles have been a problem?  Let’s say that in such a case Falstaff had cut the Ballentine marketing efforts in just the same way

Bloor v. Falstaff 61  Would you expect that the parties would want to bargain for sales efforts that would exceed what Falstaff would expend had it a 100 % equity stake in the Ballantine brand?

Bloor v. Falstaff 62  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?  Would Ballantine be able to pay Falstaff to do so?

Bloor v. Falstaff 63  An agency cost problem

Agency: Common Law 64  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 65  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 66

The two definitions may overlap  Real estate agents  Distributorships (Duff Gordon) 67

The two definitions may overlap  Real estate agents  Distributorships (Duff Gordon)  Partnerships One partners is an agent for his fellow partners 68

But the economic definition is broader  Beneficiaries and trustees 69

But the economic definition is broader  Beneficiaries and trustees  Shareholders and company directors 70

But the economic definition is broader  Beneficiaries and trustees  Shareholders and company directors  Creditors and corporate debtors 71

But the economic definition is broader  Profit-sharing ventures: Falstaff 72

Agency Costs  Because the incentives of agents are not perfectly aligned with those of his principal, the agent may impose costs on him. 73

The Agency Cost Problem  Agent misbehavior 1.Underperformance by agent retained by principal (shirking, or breach of duties of care) 2.Expropriation of an opportunity (breach of duties of loyalty) 74

Shirking 75 Of COURSE I can sell your beautiful house!!!

The Agency Cost Problem  How would a principal respond? Underinvestment Monitoring of agent 76

The Agency Cost Problem  Agency Costs as the sum of Underperformance by agents Underinvestment by principals Monitoring costs 77

Back to Falstaff  The agent (Falstaff) has to decide how much money to spend on marketing the principal’s (Ballantine) beer 78

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

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

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

82 Agency Costs $ Marginal Revenue Marginal Cost of Marketing X Optimal marketing and sales at Quantity X

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

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

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

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

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

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

89 So that Falstaff has an incentive to reduce marketing expenditures $ Marginal Cost of Marketing X MR Falstaff X* MR Falstaff+Ballantine Jensen and Meckling, 3 J Fin Econ 305 (1976)

Falstaff  What are Ballentine’s incentives? It gets 50 percent of the revenues and bear none of the marketing costs. So how much would it want spent on marketing? 90

Falstaff  Neither Falstaff nor Ballantine had perfect incentives Ballantine has an incentive to spend too much and Falstaff too little. 91

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? 92

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? Did the court get it right? 93

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? How would you draft Falstaff’s duties? 94

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? How would you draft Falstaff’s duties?  “best efforts” and “good faith”  “reasonable best efforts”  Non-discrimination 95

Responses to Agency Costs?  Legal standards (e.g., best efforts) 96

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties Cost-sharing Sliding scale 97

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relational contracts 98

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations Contracts  Vertical Integration 99

100 Post-contractual opportunism But see R.H. Coase, The Acquisition of Fisher Body by General Motors, 43 J.L.E. 15 (2000) 100

101 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

102 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) 103

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations and Iterated PD Games  Vertical Integration  Monitoring plus termination rights 104

Wagenseller Scottsdale Memorial Hospital

Wagenseller The moon is out early tonight…

Wagenseller 107  Was she fired for reasonable cause? Should that matter?

Wagenseller 108  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard

Wagenseller 109  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard Developing exceptions to the at will standard  The public policy exception E.g., refusal to commit perjury

Wagenseller 110  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard Developing exceptions to the at will standard  The public policy exception E.g., refusal to commit perjury Did the employer do an end run around this through a “no cause” firing?

Wagenseller 111  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard Developing exceptions to the at will standard  Implied in fact promise of tenure An implied promise to keep the employee on for a period of time

Wagenseller 112  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard Developing exceptions to the at will standard  Implied in fact promise of tenure Is the firm’s personnel manual part of the contract? Does it matter if this is signed?

Wagenseller 113  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard Developing exceptions to the at will standard  “Good faith and fair dealing” Bad faith firing

Wagenseller 114  What standards did the court adopt? Public policy Good faith Implied in fact (employee handbook)

Wagenseller 115  Which rule best protects employees? English or American?

Wagenseller 116  Which rule best protects employees? Are you sure about that? So why not give them tenure? What are the economic arguments for and against tenure or the English rule?

Sysco at  Do the same principles apply in a distributorship agreement?

Sysco 118  What did the agreement say about termination rights?

Sysco 119  You have to terminate a franchisee. How do you do it?

Sysco 120  Franchisors cannot terminate for bad cause … but can do so for no cause

Sysco 121  Who were the parties and why did that matter?

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 122

Note the two-way play  The employee can resign any time Might the employer be unhappy with this?  Labor shortages  Firm-specific assets Training Proprietary info 123

Note the two-way play  The employee can resign any time Can you think of some way in which the employer might bargain around this? 124

Note the two-way play  The employee can resign any time Can you think of some way in which the parties might bargain around this?  Compensation schemes  Non-competes 125

Non-competes: Farber at  Freedom of contract governed in Sysco. Why not in Farber?

Non-competes: Farber at  Freedom of contract governed in Sysco. Why not in Farber?  Who are we protecting by limiting freedom of contract here?

Non-competes: Farber at  What if we were talking about an accountant?

Non-competes: Farber at  What if we were talking about an accountant? Cf. Marcam at 379 Cf. Maltby at 379

Non-competes: Farber at  Just what was excessive year, and just how far do you think the employer could go?

Non-competes: Farber at  How could a severance clause help the employer?

Non-competes: Farber at  Restatement 187: Covenants in restraint of trade are not enforceable if “not ancillary” to an otherwise valid agreement?!?

Non-competes: Farber at  Restatement 187: Covenants in restraint of trade are not enforceable if “not ancillary” to an otherwise valid agreement?!?  Cf Leatherman at 378