1 George Mason School of Law Contracts I O.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: 11

Output Contracts  Buyer agrees to buy all of producer’s output Risks to seller:  What if market price > contract price 12

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 13

14 Contract Price > Market Price Market Price > Contract Price Supplier Buyer 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 Contract Price > Market Price

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

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

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

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

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

21 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

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

23 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 for $1/lb.  Feld thinks he can resell at $1.50/lb. 25

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 26

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". 27

Output Contracts: Feld v. Levy  See excerpt on

Output Contracts: Feld v. Levy  Does it make sense to require the baker to lose money? 29

Output Contracts: Feld v. Levy  Does it make sense to require the baker to lose money? Is there something troubling about the numbers? 30

Output Contracts: Feld v. Levy 31

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? 32

Output Contracts: Feld v. Levy  What if the cost of production is now $1.50? 33

Output Contracts: Feld v. Levy 34

Output Contracts: Feld v. Levy  How is this case like Empire Gas? 35

Output Contracts: Feld v. Levy  Can a buyer in a requirements contract purchase zero quantities? Empire Gas 36

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 37

Output contracts  Good faith standards imposed in both cases 38

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

Exclusive Dealing Wood v. Duff-Gordon 40  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 41  Is this a binding contract?

Exclusive Dealing Wood v. Duff-Gordon 42  Is this a binding contract? Is it too uncertain?  What’s missing?

Exclusive Dealing Wood v. Duff-Gordon 43  Is this a binding contract? Is it too uncertain? Does it lack consideration?

Exclusive Dealing Wood v. Duff-Gordon 44  Is this a binding contract? Cardozo: decries a “primitive age of formalism”  What is the canonical take-away?

Exclusive Dealing Wood v. Duff-Gordon 45  Is this a binding contract? Finds “an instinct with an obligation” imperfectly expressed 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 46  What is the economic rationale for finding a binding contract here?

Exclusive Dealing Wood v. Duff-Gordon 47  What is the economic rationale for implying duties by the distributor? Consider Wood’s incentive to make contract-specific investments absent a binding contract

Exclusive Dealing Wood v. Duff-Gordon 48  How would you formulate the duties of the parties, as a matter of legal drafting?

Exclusive Dealing Wood v. Duff-Gordon 49  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 50  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 51  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? 53

What are Good Faith Standards  Van Valkenburgh p. 354  What is the answer to the query at the bottom of 354? 54

What is best efforts? 55  Bloor v. Falstaff 343

Bloor v. Falstaff 56

Bloor v. Falstaff 57

Bloor v. Falstaff 58  What was the deal? Judge Charly Brieant

Bloor v. Falstaff 59  Falstaff buys all Ballantine assets except the brewery for $4M plus a royalty of 50 cents on each barrel of Ballantine sold over a 6 yr. period  Buyer to use best efforts to promote and maintain a high volume of sales  Buyer to pay up to $1.1M if it substantially discontinues selling Ballantine

Bloor v. Falstaff 60  Why structure it that way? What are the alternatives?

Bloor v. Falstaff 61  Falstaff’s history with the Ballantine brand

Bloor v. Falstaff 62  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 63  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 64  Falstaff’s history with the Ballantine brand Remedy?

Bloor v. Falstaff 65  Can you articulate a standard by which best efforts can be judged? What would be excessive?

Bloor v. Falstaff 66  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 67  Can you articulate a standard by which best efforts can be judged? What would be excessive? Friendly: Profit uber alles was the problem

68 George Mason School of Law Contracts I O.Output Contracts and Distributors F.H. Buckley

Exam  Laptops 69

Bloor v. Falstaff 70  How to establish what is the right amount of effort to require of Falstaff in pushing Ballantine beer?

Bloor v. Falstaff 71  How to establish what is the right amount of effort to require of Falstaff in pushing Ballantine beer? The case is made easier by the finding that Falstaff maximized Falstaff profits and not the joint venture’s profits

Bloor v. Falstaff 72  Supposing that Falstaff had purchased Ballantine outright. Would profit uber alles have been a problem?

Bloor v. Falstaff 73  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 74  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 75  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? Would you pay $10 to make $9?

Bloor v. Falstaff 76  An agency cost problem

Agency: Common Law 77  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 78  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 79

The two definitions may overlap  Real estate agents  Distributorships (Duff Gordon) 80

The two definitions may overlap  Real estate agents  Distributorships (Duff Gordon)  Partnerships One partners is an agent for his fellow partners 81

But the economic definition is broader  Beneficiaries and trustees 82

But the economic definition is broader  Beneficiaries and trustees  Shareholders and company directors 83

But the economic definition is broader  Beneficiaries and trustees  Shareholders and company directors  Creditors and corporate debtors 84

But the economic definition is broader  Profit-sharing ventures: Falstaff 85

Agency Costs  Because the incentives of agents are not perfectly aligned with those of his principal, the agent may impose costs on him. 86

The Agency Cost Problem  Agent misbehavior 1.Underperformance by agent retained by principal (shirking, or breach of duties of care) 87

Shirking 88 Of COURSE I can sell your beautiful house!!!

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) 89

The Agency Cost Problem  How would a principal respond? Monitoring of agent Underinvestment in agency relationships 90

The Agency Cost Problem  Agency Costs as the sum of Underperformance by agents Underinvestment by principals Monitoring costs 91

Back to Falstaff  The agent (Falstaff) has to decide how much money to spend on marketing the principal’s (Ballantine) beer 92

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

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

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

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

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

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

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

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

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

102 The principal’s marginal revenue curve is lowered $ MR Falstaff+Ballantine Marginal Cost of Marketing X MR Falstaff The 50 percent tax

103 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 bears none of the marketing costs. So how much would it want spent on marketing? 104

Falstaff  Neither Falstaff nor Ballantine had perfect incentives Ballantine has an incentive to spend too much and Falstaff too little. 105

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? 106

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

Falstaff  If the goal is optimal joint production, how would you formulate the legal standard? How would you draft Falstaff’s duties? 108

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 109

Responses to Agency Costs?  Legal standards (e.g., best efforts) 110

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties Cost-sharing Sliding scale 111

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relational contracts 112

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations Contracts  Vertical Integration 113

114 Post-contractual opportunism But see R.H. Coase, The Acquisition of Fisher Body by General Motors, 43 J.L.E. 15 (2000) 114

Responses to Agency Costs?  Legal standards (e.g., best efforts)  Incentivize the parties  Relations and Iterated PD Games  Vertical Integration  Monitoring plus termination rights 115

Wagenseller Scottsdale Memorial Hospital

Wagenseller The moon is out early tonight…

Wagenseller 118  Was she fired for reasonable cause? Should that matter?

Wagenseller 119  Was she fired for reasonable cause? The English reasonable cause standard vs. the American “at will” standard

Wagenseller 120  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 121  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 Could one bargain around this?

Wagenseller 122  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 Is this a question of free bargaining? (Sysco)

Wagenseller 123  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 124  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 vs. no-cause firing

Wagenseller 125  Which rule best protects employees? English or American?

Wagenseller 126  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?

Wagenseller 127  Which rule best protects employees? Should the parties be permitted to bargain for the employment regime they want?

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

Sysco 129  What did the agreement say about termination rights?

Sysco 130  You have to terminate a franchisee. How do you do it?

Sysco 131  Franchisors cannot terminate for bad cause … but can do so for no cause

Sysco 132  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 133

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 134

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? 135

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 136

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?  Whom 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 how many years is excessive?

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

Restatement 143  Restatement 186: Covenants unreasonably in restraint of trade are not enforceable

Restatement 144  Restatement 186: Covenants unreasonably in restraint of trade are not enforceable Ancilliary vs non-ancilliary?

Ancilliary Restraints on Trade 145  Restatement 188: If ancilliary to a valid contract, covenants in restraint of trade may be enforceable

Ancilliary Restraints on Trade 146  Restatement 187: If not ancilliary to a valid contract, covenants in restraint of trade deemed not enforceable

Non-competes 147  What is an ancilliary agreement? Cf Leatherman at 378