George Mason School of Law
XVI.
Contracts I
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:
 What if market price > contract price
 What if seller’s cost > contract price
11
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
12
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
13
Woo-hoo!!!!
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Contract Price > Market Price
Contract Price
> Market Price
Supplier
Buyer
14
Wants out
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Market Price > Contract Price
Contract Price
> Market Price
Supplier
Buyer
15
Market Price >
Contract Price
Price Changes: Output Contracts
Assuming that Market Price > Contract Price
Contract Price
> Market Price
Supplier
Buyer
16
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
17
Woo-hoo!!!!
Price Changes: Output Contracts
Assuming that Market Price < Contract Price
18
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
19
Cost > Contract
Price
Output Contracts
Cost to Seller
Contract Price
> Cost
Supplier
Buyer
20
Cost > Contract
Price
Wants out
Output Contracts:
Feld v. Levy p. 332
Bakery Levy
21
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
 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 345
23
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. 341
Lady Duff Gordon
33
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
34
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
35
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
 Is it too uncertain?
36
Exclusive Dealing
Wood v. Duff-Gordon
 Is this a binding contract?
 Is it too uncertain?
 Does it lack consideration?
37
Exclusive Dealing
Wood v. Duff-Gordon
 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
38
Exclusive Dealing
Wood v. Duff-Gordon
 What is the economic rationale for
finding a binding contract here?
39
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
40
Exclusive Dealing
Wood v. Duff-Gordon
 How would you formulate the duties
of the parties, as a matter of legal
drafting?
41
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
42
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."
43
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.
44
What are Good Faith Standards
 Van Valkenburgh p. 354
45
What are Good Faith Standards
 Van Valkenburgh p. 354
 Just where did the publisher cross the
line?
46
What is best efforts?
 Bloor v. Falstaff 343
47
Bloor v. Falstaff
48
Bloor v. Falstaff
49
Bloor v. Falstaff
 What was the deal?
50
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
 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
51
Bloor v. Falstaff
 Falstaff’s history with the Ballantine
brand
52
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
53
Bloor v. Falstaff
 Falstaff’s history with the Ballantine
brand
 Remedy?
54
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?
55
Bloor v. Falstaff
 Can you articulate a standard by
which best efforts can be judged?
 What would be excessive?
56
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”
57
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
58
Bloor v. Falstaff
 Supposing that Falstaff had
purchased Ballantine outright. Would
profit uber alles have been a
problem?
59
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
60
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?
61
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?
62
Bloor v. Falstaff
 An agency cost problem
63
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
64
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
65
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
Agency Costs
How much Ballantine beer to sell?
$
Horizontal axis measures
the quantity of beer sold
Quantity of beer
79
Agency Costs
$
Assume a constant amount of revenue
for each case of Ballantine beer sold
Marginal Revenue
80
Agency Costs
$
Marginal Cost of Marketing
Marginal Revenue
81
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
82
At X* Falstaff can profitably spend
more on marketing
$
Marginal Cost of Marketing
Marginal Revenue
X*
83
X
At X* Falstaff can profitably spend
more on marketing
$
Marginal Cost of Marketing
Marginal Revenue
X*
84
X
At X~ Falstaff can profitably reduce
marketing expenditures
$
Marginal Cost of Marketing
Marginal Revenue
X
85
X~
At X~ Falstaff can profitably reduce
marketing expenditures
$
Marginal Cost of Marketing
Marginal Revenue
X
86
X~
Now what happens when revenues
are shared with an agent?
$
Marginal Cost of Marketing
Marginal Revenue
X
87
The principal’s marginal revenue
curve is lowered
$
Marginal Cost of Marketing
MRFalstaff+Ballantine
The $0.50 tax
MRFalstaff
X
88
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)
89
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?




99
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)
100
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
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
• People organize production by
private contracting to benefit from
informational gains which are lost when
production is brought within a firm
102
Optimal Firm Size
 Firms might then be too small (GM)
or too large (conglomerization)
103
Responses to Agency Costs?





104
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
105
Wagenseller 353
The moon is out early tonight…
106
Wagenseller
 Was she fired for reasonable cause?
 Should that matter?
107
Wagenseller
 Was she fired for reasonable cause?
 The English reasonable cause standard
vs. the American “at will” standard
108
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
109
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
 Did the employer do an end run around this
through a “no cause” firing?
110
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
111
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?
112
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
113
Wagenseller
 What standards did the court adopt?
 Public policy
 Good faith
 Implied in fact (employee handbook)
114
Wagenseller
 Which rule best protects employees?
 English or American?
115
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?
116
Sysco at 362
 Do the same principles apply in a
distributorship agreement?
117
Sysco
 What did the agreement say about
termination rights?
118
Sysco
 You have to terminate a franchisee.
How do you do it?
119
Sysco
 Franchisors cannot terminate for bad
cause … but can do so for no cause
120
Sysco
 Who were the parties and why did
that matter?
121
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
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 372
 Freedom of contract governed in
Sysco. Why not in Farber?
126
Non-competes: Farber at 372
 Freedom of contract governed in
Sysco. Why not in Farber?
 Who are we protecting by limiting
freedom of contract here?
127
Non-competes: Farber at 372
 What if we were talking about an
accountant?
128
Non-competes: Farber at 372
 What if we were talking about an
accountant?
 Cf. Marcam at 379
 Cf. Maltby at 379
129
Non-competes: Farber at 372
 Just what was excessive year, and
just how far do you think the
employer could go?
130
Non-competes: Farber at 372
 How could a severance clause help
the employer?
131
Non-competes: Farber at 372
 Restatement 187: Covenants in
restraint of trade are not enforceable
if “not ancillary” to an otherwise valid
agreement?!?
132
Non-competes: Farber at 372
 Restatement 187: Covenants in
restraint of trade are not enforceable
if “not ancillary” to an otherwise valid
agreement?!?
 Cf Leatherman at 378
133