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Manufacturer’s Corner: Protecting Against the “Efficient Breach”

Not long ago, we discussed your rights when dealing with a buyer whom you think is or may soon become insolvent.  We also discussed your potential exposure to your buyer if you breach one of your warranties.  Now, the Oregon Supreme Court has given us a great platform to discuss what happens when a buyer simply decides that breaching the contract is a better idea than performing.  It’s an important case to consider, both in your capacity as a seller of goods, and in your capacity as a frequent buyer of goods under long-term sales contracts.  We’ll explain the basics of the case first, and then look at how it should inform your business decisions.

The seller and buyer entered a series of contracts that, collectively, required the buyer to purchase its grass seed from the seller at a fixed price for two years.  The contracts further provided that the buyer would give delivery instructions to the seller periodically, and it appears that those instructions were the trigger for “releasing” each shipment of grass seed.

The price of grass seed dropped dramatically during the contract period, and the buyer stopped giving delivery instructions – essentially refusing to participate in the contract (presumably so it could go buy its grass seed elsewhere at a lower price).  The seller repeatedly requested the instructions, but the buyer repeatedly refused to give them. 

Over the next three years, the seller was able to sell most of the grass seed to other buyers.  Because of the long time period and the price volatility in the market, it resold some of the grass seed above the contract price (apparently the market recovered).  The seller sued the buyer for breaching the contracts.

Before going further, it’s important to understand that, as relevant here, the Uniform Commercial Code provides two remedies to an aggrieved seller: (1) it may resell the undelivered goods and sue for damages equal to the difference between the resale price and the contract price;[1] and (2) it may sue for damages equal to the difference between the market price and the contract price.[2]

Here, the seller resold the grass seed, but nevertheless sought to recover the second measure of damages.  The buyer argued that since the seller resold the grass seed, the seller was required to seek only the first measure of damages, lest the buyer be forced to pay amounts already paid by third-parties in the resale, arguably resulting in a windfall to the seller.

The Court said that resale did not compel the seller to select any particular remedy: it was free to choose any option given to it under the UCC and the buyer, as the breaching party, could not be heard to complain about it.  The Court acknowledged that the end result was that the seller was able to recover more following the breach than it would have been able to recover had the buyer performed under the contract, but it was not troubled by that fact.[3]

Now, what does this mean for your business?  First, if you are in the position of the buyer, you need to think twice before you take the plunge on the so-called “efficient breach” – the one where breaching a contract will cost you less than performing.  I am not confident that other courts would reach the same conclusion the Oregon Supreme Court did in this case,[4] but they well may, and you might find yourself paying damages that you did not expect.

Second, whether you are a buyer or a seller, you need to recognize whether your industry is the kind where efficient breaches are likely to arise.  These are typically industries with high price volatility, or where long-term contracts are common.  To avoid the efficient breach, consider imposing reasonable liquidated damages provisions in your sale contracts, which can be as simple or as complex as needed to match your industry and circumstances.

Third, consider how you manage the risk from a business perspective.  What drives the price volatility in your industry?  Is it the volatility of input costs?  You may be able to hedge the risk of efficient breach by buying or selling the input.  Is your buyer in another country?  Perhaps you can insure the contract through the Export-Import Bank.

Maybe the most unfortunate thing about efficient breach is that it typically removes certainty from your operations when you need it most: during periods of high volatility.  Accordingly, it is essential that you recognize the risk and take steps to control it (though you surely cannot eliminate it).

A final word to the attorneys reading this column: efficient breach, by its nature, is a business decision.  As you might expect, some of the best methods to protect against efficient breach are not legal ones, but business ones.  If you are to advise your clients about the issue effectively, you must keep that in mind.

[Programming Note: I’ll be travelling a fair bit over the next couple of weeks, so I may miss an installment or two.  Thanks for bearing with me.  When I get back, I plan to pick up our discussion of shipping risks.  -RCH]

[1] With adjustments made for incidental damages and costs saved in consequence of the buyer’s breach.

[2] Plus incidental damages, etc.

Determining the market price can be complicated.  Note that “market price” refers to the market price at the time and place where delivery was to be made, not market price at the time and place where the contract was made.  As I’ve pointed out previously, this has important implications in long-term sales contracts or where there’s high price volatility in the product market.

[3] The Court held that, in negotiating a fixed price contract, the parties assumed the risk of price fluctuations.  I’m not sure that’s the most compelling reason for the result reached on these facts.  Clearly the buyer contracted to pay a fixed price, even if grass seed prices dropped.  But it doesn’t follow that the buyer contemplated paying more in the event of an upswing in grass seed prices, which is what made it economically preferable for the seller to resell. In the Court’s formulation, the buyer agreed at the outset to assume the risk of upticks and downticks in price.  The more compelling reasoning is that the buyer breached, and its breach compelled it to accept the risk of upticks and downticks in price. 

[4] I’m not aware of any other courts concluding that a seller who resells may nevertheless still seek market damages.  The Oregon decision itself cites cases to the contrary, but none that reach the same result.  In my opinion, Oregon got it wrong.