Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

In our third and final post today on noteworthy deal protection provisions in the KKR-Sum Total merger agreement, we review Sum Total’s remedies for a breach or termination of the agreement by KKR. (Our first post covered the agreement’s “go shop” and “no shop” provisions and KKR’s break-up fee; our second post discussed the absence of a “financing out” for KKR.)

No Reverse Break-Up Fee

Sum Total is not entitled to a reverse break-up fee if KKR breaches or terminates the agreement under any circumstances.     

Specific Performance

The merger agreement pointedly provides that specific performance constitutes Sun Total’s “sole and exclusive remedy” for breaches of the merger agreement by the KKR merger vehicle or of the guarantee by Accel-KKR Fund III, L.P. Sum Total’s only recourse, in other words, is to get a court order compelling KKR to complete the merger. Sum Total has even agreed that if a court declines to enforce the specific performance remedy and awards monetary damages instead, the company may only collect its court ordered award if KKR is no longer willing to go ahead with the merger. 

The remedies section of the merger agreement appears to have been drafted in the shadow of the Delaware Chancery Court’s ruling in United Rentals v. Ram Holdings. In that case, the target company United Rentals moved for summary judgment on its claim that it was entitled to specific performance from a Cerberus-led private equity fund consortium under the terms of their merger agreement. The court, however, found that the priority of the two remedies provided to United Rentals under the merger agreement -  a reverse break-up fee and a right to specific performance - was ambiguous. Determining that neither United Rentals nor Cerberus was able to demonstrate that its proposed interpretation of the merger agreement was the only one that would be reasonable as a matter of law, the court resorted to extrinsic evidence by applying the forthright negotiator principle to divine the parties’ intent at the time of contract. The remedies section of the KKR-Sum Total merger agreement appears to be closely drafted to memorialize the parties’ intent that Sum Total’s only remedy is specific performance and that KKR’s right to specific performance does not preclude it from seeking its break-up fees.     

NB: The merger agreement also gives Sum Total the right to force the shell holding company serving as KKR's merger vehicle to compel Accel-KKR Fund III, L.P. to finance the purchase price of the merger.

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The private equity sponsors behind the Clear Chanel acquisition – Bain Capital and Thomas H. Lee Partners -- are looking at the possibility of paying a $500 million reverse termination fee to Clear Channel if they are forced to walk away for lack of bank financing. Maybe the sponsors can recover some of this from the lenders who promised to provide the financing – time will tell. The banks committed to provide about $16 billion of new debt, which they may struggle to sell given turmoil in the leveraged loan market.   And even if they do manage to sell it, they might face a mark-to-market hit of about $2.5 billion. Lawsuits recently begun in New York and Texas may clarify whether the banks are responsible for causing the deal to break.

The sponsors will have a hard time arguing that a material adverse change in Clear Channel’s fortunes has occurred, given that the company reported a 52 percent rise in fourth-quarter earnings. Assuming that some or all of the break-up fee has to be paid by the sponsors, who really has to foot that bill – the limited partners in the funds or Bain and THC?

An LBO partnership agreement typically provides that deal expenses, including “broken deal” costs, are paid by the investment partnership, namely, the limited partners. However, these costs are typically offset against the management fee paid by the fund to the sponsors. That provision makes the sponsor ultimately responsible for broken deal costs, but caps the exposure at the amount of the management fee. 

The impact of this situation can be seen in Blackstone’s recent 10K filing. There, in the MD&A section, Blackstone described certain shortfalls in management fee income that occurred during 2007. Prominent among the causes for this shortfall was a reverse termination fee that was paid when Blackstone terminated the acquisition of a subsidiary of PPH Corporation. Here is the relevant portion of Blackstone’s MD&A section:

"An increase in fund management fees of $47.2 million, as a result of $4.68 billion of additional capital raised for BCP V during the year ended December 31, 2007, was entirely offset by increased management fee reductions of $47.4 million. The increase in management fee reductions was due to increases of $38.2 million of broken deal expenses, which included a $24.2 million reverse termination fee incurred in connection with the termination of BCP V’s planned acquisition of a subsidiary of PHH Corporation, and $9.2 million of placement fees paid for additional capital raised by BCP V."

No wonder Bain and THL are suing the banks left and right.

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A recent spate of private equity cases has turned on the question whether the buyer has the right to walk away from a deal and pay a fixed price, known as the reverse termination fee.  Rather than be spurned, the target clutches at the specific performance clause in the merger agreement, and tries to push the deal through.  This year, so far, of the seven announced private equity deals for public companies, all have had reverse termination fees.  Moreover, each of the seven deals explicitly barred specific performance of the agreement.

As a result, private equity sponsors have the option to walk away from the deal for a fixed cancellation price.  In this environment, where guaranteed financing terms just aren't available, probably no other structure is possible for a leveraged deal.

 The recently announced deal to buy Getty Images, the pictures and video distributor, for $2.4 billion including debt, marks this trend.  The private equity firm, Heller & Friedman, rejected specific performance language and even added "no recourse" language directly in the merger agreement.  No recourse language typically states that the seller cannot directly sue the private equity firm for damages or specific performance. In Getty Images the merger agreement language states:

 
“[Getty Images] acknowledges and agrees that it has no right of recovery against, and no personal liability shall attach to, in each case with respect to [The Reverse Termination Fee Liability Limitation], any of the [Hellmann & Friedmann] Parties (other than [Acquisition] Parent to the extent provided in this Agreement and the Guarantor to the extent provided in the Limited Guarantee), through [Acquisition] Parent or otherwise, whether by or through attempted piercing of the corporate, limited partnership or limited liability company veil, by or through a claim by or on behalf of [Acquisition] Parent against the [Private Equity Fund] Guarantor or any other [Hellmann & Friedmann] Party, by the enforcement of any assessment or by any legal or equitable proceeding.”

It seems that parties have become disenchanted with the idea of specific performance as a remedy.  The courts have been reluctant to decree a merger, perhaps due to the significance of the remedy.  After all, how does one order the merger of two parties when one of them has changed its mind?  A merger requires willing parties on both sides to make things work.  Money, careers and even communities hang in the balance. The remedy itself seems unrealistic in the context of business combinations.

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The recent decision of the Delaware Court of Chancery in the case brought by United Rental against the acquisition vehicles formed by Cerberus Capital imposes an affirmative duty to be forthright, or not devious, in the process of contract negotiations. The ruling seems to undo decades, if not centuries, of negotiating wisdom and practice. 

The United Rental court was unable to dispose of the case on summary judgment, as the contract interpretations offered by both sides were plausible. Because no decision as a matter of law could be reached, the court had to delve into the real intention of the parties on the issue whether they intended to provide a specific performance remedy.

To do this, the court heard testimony from 7 witnesses over a 2 day period. United Rental had the burden of proof to show that the parties intended to allow the remedy of specific performance, rather than the $100 million termination payment offered by Cerberus.

After all this testimony, the court remained unable to determine the shared objective intent of the parties. It therefore proceeded to adopt the breathtaking “forthright negotiator” principle:

“in cases where an examination of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle.  Under this principle, the Court considers the evidence of what one party subjectively “believed the obligation to be, coupled with evidence that the other party knew or should have known of such belief.” In other words, the forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

Calling the negotiations “deeply flawed”, because both sides “failed to clearly and consistently communicate their client’s positions”, the Court found that United Rental’s attorney “categorically failed to communicate that United Rental believed it preserved a right to specific performance”. The Cerberus attorney, on the other hand, did clearly communicate his understanding that the agreement precluded specific performance. Because the United Rental lawyer did not continue to repeat his view that the agreement provide for specific performance, and relied instead on the fact that the agreement contained inconsistent provisions, he failed to satisfy the “forthright negotiator” principle.

It may come as a shock to corporate attorneys that deviousness has been barred from contract negotiations. Yet that is law of Delaware:  “United Rental knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if it disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions."

A duty indeed!

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As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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Does Cerberus have the unilateral right to walk away from its deal with United Rental and limit its exposure to a break up fee of $100 million?  Or does United Rentals have the right to specifically enforce the merger agreement?  That's the issue at the heart of lawsuits currently pending in Delaware and New York arising out of this failed acquisition. 

Cerberus had this to say about United Rental's Delaware action for specific performance in a press release issued November 19th:

"We believe that United Rentals has been less than forthright in its legal filings and its communications concerning those filings.  The fact is that RAM negotiated for and obtained the right to withdraw from the Merger Agreement of July 22, 2007 and instead make a one-time payment in the aggregate amount of US $100 million.  This ability to walk away from the transaction with this limited exposure was specifically bargained for, is clearly and unambiguously stated in the Merger Agreement and related documentation, and is not in any way conditional on the occurrence of a material adverse change, the termination of the Merger Agreement by United Rentals or any other event."

Also, according to Bloomberg, Cerberus started its own lawsuit in New York Supreme Court seeking a declaration that its maximum exposure to United Rentals is $100 million. In the suit, Cerberus says United Rentals has no remedy other than the right to pursue the $100 million brake up fee, which serves as a cap for any or all losses or damages relating to or arising out of the merger agreement.

Let's see where that clear and unambiguous statement appears in the merger agreement.  Section 8.2(c) of the agreement says:

"In the event that this Agreement is terminated by [United Rentals] pursuant to Section 8.1(d)(i) or Section 8.1(d)(ii), then [Cerberus] shall pay $100,000,000 to [United Rentals] as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds."

OK then.  Section 8.1(d)(i) says that United Rental can terminate the agreement upon certain breaches by Cerberus of the merger agreement, and Section 8.1(d)(ii) says that United Rental can terminate the agreement if the merger isn't completed by a certain date.  Neither of these things has happened, and United Rentals isn't seeking the fee. 

Later on, in Section 8.2(e), there is a clause limiting liability for termination events to $100 million.  It says that United Rental's right to terminate the merger agreement under Sections 8.1(d)(i) or (ii) and receive the $100 million fee under Section 8.2(c) is the "sole and exclusive remedy" of United Rentals against Cerberus for "any and all loss or damage suffered as a result thereof" and Cerberus shall not have "any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination."  This fee is "the sole and exclusive remedy for recovery" in the event of "the termination of this Agreement by [United Rentals] in compliance with the provisions of Section 8.1(d)(i) or (ii)."  

So far, it looks as though United Rentals has the winning position, as this language pretty clearly says that the $100 million payment is the sole remedy only in the situation where United Rentals has terminated the merger agreement due to a misrepresentation or failed deadline.  Up until now, there isn't any absolute cap on liability if Cerberus breaches the agreement and walks away.

But keep reading.  At the very end of Section 8.2(e), comes the provision that finally supports Cerberus:

"In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [Cerberus] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [United Rentals] seek equitable relief or seek to recover any money damages in excess of such amount from [Cerberus].

That's pretty clear.  Although there is plenty of language in the agreement that appears to support United Rentals' position, this one sentence appearing at the end of Section 8.2(e) seems to cap Cerberus' exposure at $100 million.   The stock market seems to agree as well.

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United Rentals Inc. recently sued the shell companies formed by Cerberus Capital Management to acquire the company after Cerberus informed it that it was not prepared to proceed with the $7 billion deal. Cerberus wants to cancel the deal because of trouble with financing. United Rentals is doing fine, having just reported a great quarter. The lawsuit raises an interesting issue on the interplay between the specific performance remedy and a liquidated damages provision providing for a $100 million payment in the event the merger agreement is canceled.

Cerberus and United Rental agreed to the deal in July 2007. The merger agreement has detailed provisions regarding financing. For example, it provides that if the Cerberus entities are not able to obtain financing from syndicated sources, it will draw down on a $4 billion of bridge financing commitments given by a group of lenders including Banc of America, Credit Suisse, Morgan Stanley and Lehman Brothers. As everyone knows, the syndication market for these deals has dried up, so people are looking at the bridge financing package.

Cerberus went along through the fall and the United Rental shareholder vote as though everything were fine. Several days ago, apparently reacting to pressure from the bridge lenders, it notified United Rental that it was not prepared to impair its relationship with the bridge lenders by forcing them to fund, even though the merger agreement required them to do so. Instead, it notified United Rental that it “elected not to consummate the transaction” and would pay a break-up fee of $100 million.

Cerberus or its advisers also leaked news of the potential breakup to the press and the stock dropped fast, erasing more than $1.2 billion of market cap.

The lawsuit is a study in the remedy of specific enforcement. United Rental wants to force the Cerberus entities to go through with the deal, and wants the Delaware Chancery Court to order Cerberus to draw down the bridge financing. Cerberus on the other hand acts as though it holds an option to buy the company which can be canceled by paying the $100 million break up fee. 

The break up fee section says the fee is due only if the merger agreement is terminated. Cerberus doesn’t seem to have the right to terminate the agreement. Cerberus is counting on the fact that specific performance is not a favorite judicial remedy, especially where the parties have contemplated a specific financial damages remedy, like a break up fee. But this agreement has all the makings of a good specific performance action. 

Right now, the market doesn’t think the chances of United Rentals are so good, as the stock price is substantially below the merger price.

 

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Knowing how to get out of a deal is often as important as knowing how to get in.  When a company blows up, it's easy to find a representation that went awry.  But when things turn sour because of legislation or macro economic issues, you've got to look at the MAC clause.

The MAC, or material adverse change, clause sets the conditions under which a deal may be terminated without penalty. MAC exceptions, which are often appended to such clauses, outline specific circumstances under which the MAC doesn't apply, meaning the deal must proceed even if there is a material change.

During the deal frenzy of the past several years, sellers have had the upper hand in negotiating deal terms, a trend that has extended to the MAC clause. To win deals, buyers have agreed to loose MAC clauses with lots of exceptions, or in some cases have foregone MACs altogether.

The litigation currently pending in Delaware between SLM (Sallie Mae) and J.C. Flowers & Co. will, if it goes that far, shape the understanding of MAC clauses for the next few years.  J.C. Flowers and its partners have sought to walk away from the deal, in part on the basis that new Federal legislation will decrease the earning of the company.  SLM has of course insisted that the deal must go through, and issued a press release saying that "core earnings" at the company will be negatively impacted by only 1.8 to 2.1 percent annually over the next 5 years.  The issue is whether the MAC clause is triggered by the adverse impact of the new Federal legislation.  The clause reads as follows:

"Material Adverse Effect" means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from: ... (b) changes in Applicable Law provided that, for purposes of this definition, "changes in Applicable Law" shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading "Recent Developments" in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority..."

As the highlighted language shows, SLM and JC Flowers were acutely aware of the potential impact of the new Federal legislation on the earnings of Sallie Mae.  This was not a thunderbolt from out of the blue.

SLM's position is that the "core earnings" of the company will only be reduced by 1.8 to 2.1 percent  MORE than what was already presented in the 10-K.  This sets the bar well under the 10% figure which most lawyers and judges would agree is "material".  As the M&A Law Prof Blog points out, the Delaware courts set a high bar for proving a MAC.  Under these cases the party asserting a MAC has the burden of proving that the adverse change will have long-term effects and must be materially significant.

Of course the issue may be settled before any trial.  Justine Strine has been pressing the sides to settle.  A renegotiated price is the likely outcome, as SLM will not likely want to remain in the public eye after this battle.

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The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

Defaults

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

After nonpayment, the most important defaults are those involving covenants. These are not static events. Covenants apply to the activities of the borrower throughout the life of the loan. Failure to comply with a covenant can result in the default of the entire loan agreement, even if the borrower is current in its payment obligations. A covenant default is therefore a powerful tool in the hands of the lender, and lenders frequently use covenant defaults to impose additional restrictions on a borrower or even to accelerate repayment of the loan.

Covenant defaults usually have a cure period. The borrower is given a chance to correct the default before it becomes a reason to accelerate the loan. Covenant defaults are sometimes classified in two groups: those that have short cure periods, such as five days of less, and those that have longer cure periods, usually thirty days. The shorter cure periods are reserved for those important covenants that can’t be readily corrected, such as the delivery of an incorrect financial statement. The longer periods are reserved for the things that can be corrected with proper diligence, such as compliance with laws, removing liens from properties and delivering compliance certificates.

A special class of defaults is reserved for bankruptcy and insolvency. These generally trigger immediate default of the credit agreements.

Remedies

Once a default has occurred and the borrower has run out of time to correct it (if such a right exists) the lender has the ability to accelerate the loan and demand that all amounts due under the loan be repaid immediately. Any obligation of the lender to continue extending credit under a revolving credit facility is canceled. If the borrower fails to immediately prepay the loan, as is generally the case once a default occurs, the lender is then free to exercise the security instruments and liens it carefully acquired when the loan was made. Also at this time the defaulted loan begins to bear a higher, default interest rate.  

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

Like an insurance policy, the first question is how long the coverage lasts. The indemnification sections will say how long the representations and promises will remain in effect. This is generally a year or two after the closing, although certain representations, such as those covering taxes, employee benefits and environmental laws, will last longer as the laws they cover carry exposures that may last many years.

Next, like an insurance policy, the indemnification clause will usually have a threshold or deductible for making any claims at all, on the theory that small or minor claims do not warrant invoking the indemnification process. The size of the deductible will generally vary according to what is considered material in the transaction. A small deal may have a deductible of $10,000 while large deals can have deductibles of $100,000 and more. This issue is usually negotiated in the term sheet. Finally, an indemnification clause may have a cap on the total value of claims that can be made for indemnification, usually expressed as a percentage of the purchase price.

In an asset purchase transaction, the indemnification protection that a buyer gets will cover three events: a misrepresentation or breach of a warranty made by seller; a breach of any covenant or agreement made by the seller; and any liability that seller agreed to retain. For the seller, the indemnification covers the first two items and any liability that buyer agreed to assume but was nonetheless imposed on seller. Indemnification extends to any costs or expenses (including reasonable attorneys fees) that the protected party incurs as a result of the claim or loss, such as the costs of defending against a third party claim and the cost of asserting a claim against the other party to the deal. In fact, the only legal liability added by the indemnification clause is this obligation to pick up costs and expenses, since in the absence of the clause, the aggrieved party would still have a claim for breach of contract in case the other party breaches a warranty or covenant.

The procedures for exercising indemnification claims involve giving the other party notice of the claim and the opportunity to take over the defense of the claim, in the case of a third party liability. The party providing the indemnification generally has the right to settle the matter and both parties must assist in the defense of third party claims.

Related Posts:  What is Indemnification? Part 1 and Part 2

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No one cares about the law of sales and collections until something goes wrong.   When disputes arise, the parties dust off the “boilerplate” provisions printed on the back of their purchase orders and invoices. Often these provisions are in conflict with one another or do not cover the issue that actually exists. In these circumstances, where the contract involves the sale of goods, the parties must look to the provisions of the Uniform Commercial Code for answers. This Code, adopted in every State, provides a uniform body of rules for sales of goods. For sales of services, the common law of contracts applies. 

The success of the Uniform Commercial Code in regulating the sale of goods has crossed over into general contract law, and many provisions of the Code have influenced the development of general contract law.

Article 2 of the Uniform Commercial Code: Contract Terms and Conditions

Article 2 of the Uniform Commercial Code covers how and when contracts for the sale of goods are formed; warranty obligations; how contracts must be performed; what happens when a party breaches a contract; and what remedies are available when a breach occurs.

Forming Contracts

Any sale of goods for a price of $500 or more must be reflected in written form. The writing must be sufficient to indicate that a contract for sale has been made by the parties and must be signed by the party against whom enforcement is sought. However, this requirement is waived in sales between merchants if one party sends a written confirmation of the contract and the other party fails to object within 10 days of receipt.

Apart from this requirement of a “writing,” the rules of contract formation are very liberal. A contract may be made in any manner sufficient to show agreement, including conduct by both parties that recognizes the existence of such a contract.

A written offer by a merchant to buy or sell goods which gives assurance that it will be held open cannot be revoked during the time stated in the offer. If no time is stated, then the offer must remain open for a reasonable period of time, but not in excess of three months.

If the customer’s purchase order contains one set of terms and conditions, and the acceptance or invoice contains another set, the additional terms of the invoice become part of the contract unless the offer limits acceptance to the terms of the offer or they materially alter it. In addition, conduct by the parties that recognizes the existence of a contract will be sufficient to establish a contract, even though the writings do not establish one. Accordingly, written exchanges and conduct must be tightly controlled to avoid inadvertent contracts.

A party may delegate performance of a contract to someone else, unless the other party has a substantial interest in having the original party perform the contract. Either party may assign its rights under a contract except where the assignment would materially impact the other party’s duties, burdens or risks.

Warranties

Unless the parties otherwise provide, the following warranties are assumed to be made by the seller as to the goods:

1. Seller has title to the goods and the right to transfer them.

2. The goods are delivered free from any security interest or other lien (other than those the buyer actually knows of).

3. The goods are “merchantable” (generally, the goods are fit for the ordinary purposes for which they are used).

4. When seller has reason to know any particular purpose for which goods are required and buyer is relying on seller’s skill or judgment to select goods, there is an implied warranty that the goods are fit for such purpose.

5. A statement of fact relating to goods creates an express warranty that the goods conform to the statement.

6. A description of the goods creates an express warranty that the goods conform to the description.

7. A sample creates an express warranty that the whole of the goods conform to the sample.

Special care must be taken to exclude or modify these warranties if they cannot be supported. Generally, the contract should contain express language that excludes warranties, or states that goods are sold “as is” or “with all faults.”         

Performance

The UCC spells out how contracts are to be performed in cases where the parties have omitted the details. For example, if a buyer has paid all or part of the price of goods and the seller becomes insolvent, the buyer may recover the goods from the seller if the seller’s insolvency occurred within 10 days after receipt of the first installment of the price. Also, the buyer has the right to inspect goods at a reasonable place and time and in any reasonable manner before payment is due.

Breach of Contract

When there are defects in the goods, or a defect in their method of delivery, the buyer has the option to reject or accept all the goods or accept any portion that is acceptable and reject the rest. A notice of rejection must be delivered “seasonably,” the buyer cannot delay unreasonably.   In addition, if the buyer rejects the goods while they are in his possession, he must follow the reasonable instructions of the seller with respect to the rejected goods. If no instructions are received, the buyer may store the goods for seller’s account, reship to seller or resell for seller’s account.

On the other hand, once the buyer has accepted the goods, he must pay at the contract price for any goods accepted. Acceptance occurs when the buyer after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming, or fails or make an effective rejection (after having an opportunity to inspect). Although accepted goods may not be reshipped to the seller, buyer retains any claim based on non-conformity of the goods to warranties.

When reasonable grounds exist that make one party feel that performance by the other may be impaired, that party may demand assurances of due performance from the other party. Until he receives such assurances, he may suspend his performance. If the cost of performing the contract suddenly increases dramatically due to an event that undermines a basic assumption of the contract, the seller may delay its delivery or even fail to deliver the goods.

Remedies

When a seller discovers that buyer is insolvent, he may refuse to deliver goods except for cash, including payment for all goods previously delivered. When a buyer receives goods on credit while insolvent, the seller may reclaim the goods on demand made within ten days after the receipt.

When a buyer breaches the contract, typically by not accepting goods or failing to pay for goods already received, the seller may recover damages for non-acceptance or cancel. Damages in the case of non-acceptance of goods is the difference between the market price at the time and place of delivery and the unpaid contract price, less expenses saved as a consequence of buyer’s breach. However, if this measure of damages is inadequate to put seller in as good a position as performance would have done, then the measure of damages is the profit (including reasonable overhead) which seller would have made from full performance. Damages, in the case of non-payment, are the price of goods accepted, plus incidental damages. Alternately, when the buyer has failed to accept goods seller may resell the goods in a commercially reasonable manner and recover the difference between the resale price and the contract price, plus incidental damages. The seller does not have to account to buyer for any profit made on the resale.

When a seller breaches the contract by failing to make delivery or when the buyer rightfully rejects goods, then buyer may cancel and recover so much of the price as has been paid. In addition, the buyer may purchase goods in substitution of those due from seller and recover from seller the difference between the cost of the substituted goods and the contract price, together with incidental and consequential damages, but less expenses saved. Alternately, the buyer may recover damages for non-delivery equal to the difference between the market price at the time the buyer learned of the breach and the contract price, less expenses saved.

The measure of damages for breach of warranty is the difference between the value of the goods accepted and the value they would have had if they had been as warranted. The parties may specify liquidated damages in the agreement, but the measure must be reasonable in light of the harm caused by the breach. Unreasonably large liquidated damages are void as a penalty. Any action for breach of any contract for sale of goods must be commenced within four years after the breach occurs. The parties may shorten the period to one year (but not less).

Article 9 of the Uniform Commercial Code: Security Devices

Article 9 of the Uniform Commercial Code contains a powerful tool to aid in the collection of accounts, although many companies do not take advantage of it. It gives sellers of goods the right to retain a security interest in the goods (or other assets of the buyer) until payment. Without a security interest, the seller must take a back seat to creditors (typically banks) that do take advantage of this law.

Security Interests

A seller of goods can retain a security interest in the goods if the following procedures are adopted:

1. The buyer signs an agreement granting a security interest in the goods.

2. A financing statement is filed in the office of the Secretary of State of the state in which the buyer is located or incorporated.

The advantage of a security interest is that the secured party has a priority to the goods in the event the buyer becomes insolvent. Proceeds from any sale of the secured goods must be paid first to the seller in satisfaction of its account. A security interest in goods disappears once the goods are resold to another buyer in the ordinary course of business.

If buyer defaults in payment, a seller with a security interest in goods may take possession of the goods either by judicial process or without judicial process if it proceeds without breach of the peace. A secured party may also require the debtor to assemble the collateral and make it available to the secured party. The secured party may dispose of the collateral by public or private sale in a commercially reasonable manner. Any proceeds of such a sale must be applied first to the expenses of sale and then to the satisfaction of the debtor’s obligations. The secured party may also accept the collateral in full or partial satisfaction of the obligation under certain circumstances.

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