Document Type

Article

Publication Date

2002

Center/Program

Center for Contract and Economic Organization

Center/Program

Center for Law and Economic Studies

Abstract

Long-term contracts often promise to deliver the seller's full output, the buyer's requirements, or some variation on these. For example, an electric utility might enter into a thirty year contract with a coal mine promising that it will take all the coal needed to supply a particular generating plant. These open quantity contracts have raised two issues. The first is whether the promise was illusory. If the utility had no duty to take any coal, a court could have found that there was no consideration and, therefore, no contract. While there was a time when full output and requirements contracts did not fare well on this ground,1 nowadays their validity is rarely challenged with success.2

The second and more interesting question today concerns the interpretation of the quantity term. What, if anything, limits the buyer's discretion? The answer, both at common law and in UCC §2-306(1), has been "good faith."3 The Code's Official Comment claims that §2-306 entails "the reading of commercial background and intent into the language of any agreement."4 In fact, it does nothing of the sort. Rather, it often involves supplanting the parties' careful balancing of various concerns in the initial contract with a wooden, uninformed reading of the agreement. With no theory to guide them, courts have held that good faith required that producers behave in most peculiar ways - for example, running a plant at below full capacity for the life of the contract, or running the plant to satisfy the needs of its waste remover rather than its customers.

This second question is the focus of the present paper, although some attention will be given to the first as well. The paper is part of a larger project, the intent of which is to make contract interpretation more transactionally sensitive.5 It is the most ambitious of the papers thus far, as it examines a much broader set of cases than had its predecessors.Here, the central concern is the allocation of discretion to one party to respond to changed circumstances and the constraints placed on that flexibility to protect the counterparty's reliance interest.

Long-term contracts cannot completely specify in advance all the obligations of both parties over the life of the agreement.6 In order to adapt their relationship to changed circumstances they will find it necessary to give one, or both, parties the discretion to respond as new information becomes available. In particular, they might find that shifting supply and demand conditions would be better met by giving one party the discretion to vary quantity. Suppose that the party with discretion is the buyer, as in a requirements contract. The seller would have two concerns. First, the buyer could use its discretion opportunistically to rewrite the contract.7 Second, if the seller intended to make decisions in reliance on the continued performance of the buyer, it would want a means of conveying the extent of that reliance, perhaps by setting a minimum quantity or establishing a multi-part pricing regime.

My thesis is that the courts have used good faith as a blunt instrument for providing protection to one party's reliance without asking whether that party would have been willing to pay for such protection in the first place. In effect, the seller wants to confront the buyer with a price reflecting the extent of its reliance. If that price is set too high, both parties lose. It is in their joint interest to fine-tune the protection of the reliance. And, as we shall see below, they can be quite good at it.8

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