George Mason School of Law
Contracts I
O. Output Contracts and
Distributors
F.H. Buckley
fbuckley@gmu.edu
1
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
Requirements Contracts and Incentives
as to Quantity
Contract Price
> Market Price
5
Market Price >
Contract Price
Supplier
Gulf undersupplies
Buyer
Eastern Air
Lines overconsumes
Requirements Contracts and Incentives
Contract Price
> Market Price
6
Supplier
Empire Gas
Empire Gas
Over-supplies
Buyer
American
Bakeries
American
Bakeries underconsumes
Market Price >
Contract Price
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
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
14
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
15
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
16
Woo-hoo!!!!
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
17
Wants out
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Market Price > Contract Price
Contract Price
> Market Price
Supplier
Buyer
18
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Market Price > Contract Price
Contract Price
> Market Price
Supplier
Buyer
19
Market Price >
Contract Price
Wants out
Price Changes: Output Contracts
Assuming that Market Price < Contract Price
Contract Price
> Market Price
Market Price >
Contract Price
Supplier
Buyer
20
Woo-hoo!!!!
Price Changes: Output Contracts
Assuming that Market Price < Contract Price
21
Contract Price
> Market Price
Market Price >
Contract Price
Supplier
Woo-hoo!!!!
Wants out
Buyer
Wants out
Woo-hoo!!!!
What if Seller’s Costs Increase?
Contract Price
> Cost
Supplier
Buyer
22
Cost > Contract
Price
Output Contracts
Cost to Seller
Contract Price
> Cost
Supplier
Buyer
23
Cost > Contract
Price
Wants out
Output Contracts:
Feld v. Levy p. 332
Bakery Levy
24
Bread crumbs
Distributor Feld
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 345
28
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. 341
Lady Duff Gordon
39
Exclusive Dealing
Wood v. Duff-Gordon
 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
40
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
41
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
 Is it too uncertain?
 What’s missing?
42
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
 Is it too uncertain?
 Does it lack consideration?
43
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
 Cardozo: decries a “primitive age of
formalism”
 What is the canonical take-away?
44
Exclusive Dealing
Wood v. Duff-Gordon
 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
45
Exclusive Dealing
Wood v. Duff-Gordon
 What is the economic rationale for
finding a binding contract here?
46
Exclusive Dealing
Wood v. Duff-Gordon
 What is the economic rationale for
implying duties by the distributor?
 Consider Wood’s incentive to make
contract-specific investments absent a
binding contract
47
Exclusive Dealing
Wood v. Duff-Gordon
 How would you formulate the duties
of the parties, as a matter of legal
drafting?
48
Exclusive Dealing
Wood v. Duff-Gordon
 How would you formulate the duties
of the parties, as a matter of legal
drafting?
 Good faith by Duff-Gordon
 Best efforts by both
49
Exclusive Dealing
Wood v. Duff-Gordon
 UCC § 2-205. Every contract
imposes upon each party a duty of
good faith and fair dealing in its
performance and enforcement."
50
Exclusive Dealing
Wood v. Duff-Gordon
 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.
51
What are Good Faith Standards
 Van Valkenburgh p. 354
52
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?
 Bloor v. Falstaff 343
55
Bloor v. Falstaff
56
Bloor v. Falstaff
57
Bloor v. Falstaff
 What was the deal?
Judge Charly Brieant
58
Bloor v. Falstaff
 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
59
Bloor v. Falstaff
 Why structure it that way?
 What are the alternatives?
60
Bloor v. Falstaff
 Falstaff’s history with the Ballantine
brand
61
Bloor v. Falstaff
 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
62
Bloor v. Falstaff
 Falstaff to use “best efforts to
promote and maintain a high volume”
 Was this a drafting problem?
 Or did they get it just right?
63
Bloor v. Falstaff
 Falstaff’s history with the Ballantine
brand
 Remedy?
64
Bloor v. Falstaff
 Can you articulate a standard by
which best efforts can be judged?
 What would be excessive?
65
Bloor v. Falstaff
 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”
66
Bloor v. Falstaff
 Can you articulate a standard by
which best efforts can be judged?
 What would be excessive?
 Friendly: Profit uber alles was the
problem
67
George Mason School of Law
Contracts I
O. Output Contracts and
Distributors
F.H. Buckley
fbuckley@gmu.edu
68
Exam
 Laptops
69
Bloor v. Falstaff
 How to establish what is the right
amount of effort to require of Falstaff
in pushing Ballantine beer?
70
Bloor v. Falstaff
 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
71
Bloor v. Falstaff
 Supposing that Falstaff had
purchased Ballantine outright. Would
profit uber alles have been a
problem?
72
Bloor v. Falstaff
 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
73
Bloor v. Falstaff
 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?
74
Bloor v. Falstaff
 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?
75
Bloor v. Falstaff
 An agency cost problem
76
Agency: Common Law
 Legal relationship whereby a
principal, expressly or impliedly,
authorizes an agent to create a legal
relationship between the principal and
a third party
77
Agency: An economic concept
 Any relationship in which a principal,
expressly or impliedly, authorizes an
agent to confer benefits or impose
costs on the principal
78
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
Agency Costs
How much Ballantine beer to sell?
$
Horizontal axis measures
the quantity of beer sold
Quantity of beer
93
Agency Costs
$
Assume a constant amount of revenue
for each case of Ballantine beer sold
Marginal Revenue
94
Agency Costs
$
Marginal Cost of Marketing
Marginal Revenue
95
Falstaff has to spend an increasing amount
on marketing for additional units of beer sold
Agency Costs
$
Marginal Cost of Marketing
Marginal Revenue
X
Optimal marketing and sales at Quantity X
96
At X* Falstaff can profitably spend
more on marketing
$
Marginal Cost of Marketing
Marginal Revenue
X*
97
X
At X* Falstaff can profitably spend
more on marketing
$
Marginal Cost of Marketing
Marginal Revenue
X*
98
X
At X~ Falstaff can profitably reduce
marketing expenditures
$
Marginal Cost of Marketing
Marginal Revenue
X
99
X~
At X~ Falstaff can profitably reduce
marketing expenditures
$
Marginal Cost of Marketing
Marginal Revenue
X
100
X~
Now what happens when revenues
are shared with an agent?
$
Marginal Cost of Marketing
Marginal Revenue
X
101
The principal’s marginal revenue
curve is lowered
$
Marginal Cost of Marketing
MRFalstaff+Ballantine
The 50 percent tax
MRFalstaff
X
102
So that Falstaff has an incentive to
reduce marketing expenditures
$
Marginal Cost of Marketing
MRFalstaff+Ballantine
MRFalstaff
X*
X
Jensen and Meckling, 3 J Fin Econ 305 (1976)
103
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
Agency Costs
$
Marginal Cost of Marketing
Marginal Revenue
X
Optimal marketing and sales at Quantity X
107
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?




113
Legal standards (e.g., best efforts)
Incentivize the parties
Relations Contracts
Vertical Integration
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?





115
Legal standards (e.g., best efforts)
Incentivize the parties
Relations and Iterated PD Games
Vertical Integration
Monitoring plus termination rights
Wagenseller 356
Scottsdale Memorial Hospital
116
Wagenseller 353
The moon is out early tonight…
117
Wagenseller
 Was she fired for reasonable cause?
 Should that matter?
118
Wagenseller
 Was she fired for reasonable cause?
 The English reasonable cause standard
vs. the American “at will” standard
119
Wagenseller
 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
120
Wagenseller
 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?
121
Wagenseller
 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)
122
Wagenseller
 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?
123
Wagenseller
 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
124
Wagenseller
 Which rule best protects employees?
 English or American?
125
Wagenseller
 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?
126
Wagenseller
 Which rule best protects employees?
 Should the parties be permitted to
bargain for the employment regime they
want?
127
Sysco at 362
 Do the same principles apply in a
distributorship agreement?
128
Sysco
 What did the agreement say about
termination rights?
129
Sysco
 You have to terminate a franchisee.
How do you do it?
130
Sysco
 Franchisors cannot terminate for bad
cause … but can do so for no cause
131
Sysco
 Who were the parties and why did
that matter?
132
Note the two-way play
 The employer has a free hand to
dismiss the employee under the atwill 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 372
 Freedom of contract governed in
Sysco. Why not in Farber?
137
Non-competes: Farber at 372
 Freedom of contract governed in
Sysco. Why not in Farber?
 Whom are we protecting by limiting
freedom of contract here?
138
Non-competes: Farber at 372
 What if we were talking about an
accountant?
139
Non-competes: Farber at 372
 What if we were talking about an
accountant?
 Cf. Marcam at 379
 Cf. Maltby at 379
140
Non-competes: Farber at 372
 Just how many years is excessive?
141
Non-competes: Farber at 372
 How could a severance clause help
the employer?
142
Restatement
 Restatement 186: Covenants
unreasonably in restraint of trade are
not enforceable
143
Restatement
 Restatement 186: Covenants
unreasonably in restraint of trade are
not enforceable
 Ancilliary vs non-ancilliary?
144
Ancilliary Restraints on Trade
 Restatement 188: If ancilliary to a
valid contract, covenants in restraint
of trade may be enforceable
145
Ancilliary Restraints on Trade
 Restatement 187: If not ancilliary to
a valid contract, covenants in
restraint of trade deemed not
enforceable
146
Non-competes
 What is an ancilliary agreement?
 Cf Leatherman at 378
147