Adequate assurance: what to do when you fear the other side will not perform

New York, nineteen eighty nine. An independent power producer in Pennsylvania signs a twenty five year contract to sell electricity to a public utility, Niagara Mohawk. In the first period the utility pays six cents per kilowatt-hour. In the second and third periods the price is tied to the utility's avoided cost, with floors and ceilings, and an adjustment account tracks the difference between what the utility actually pays and what it would have paid at pure avoided cost.
In the third period, whatever balance has built up in the account must be paid back.
In February nineteen ninety four the utility writes to the producer. Its revised estimates show the account will reach over six hundred and ten million dollars in the utility's favour by the end of the second period. The utility does not believe the producer will be able to repay that. It demands that Norcon provide adequate assurance to Niagara Mohawk that Norcon will duly perform all of its future repayment obligations.
The producer goes straight to federal court. It says New York law gives no such right. The contract is not for goods, so the Code does not apply, and the producer is solvent, so the old insolvency exception does not apply. The utility must live with the security it bargained for and nothing more. The federal courts agree that no such right exists in New York, and the Second Circuit certifies the question to the New York Court of Appeals.
So here is the question. Nobody has repudiated. Nobody has breached. The repayment is years away. One party is frightened about the other's ability to pay a bill that has not come due. Can it demand reassurance now, and treat silence as a repudiation? Think about it before I go on, because this is the newest doctrine in the course, and it exists to solve the problem the last lecture left you with.
And now the question I keep asking. What exactly did these people promise each other? Electricity for twenty five years at a formula price, and repayment of whatever the formula leaves owing. The New York court put the problem better than I can. When the apparently breaching party's actions are equivocal or less certain, then the nonbreaching party who senses an approaching storm cloud, affecting the contractual performance, is presented with a dilemma, and must weigh hard choices and serious consequences.
Here is the dilemma, in words the court quoted from a commentator. If the promisee regards the apparent repudiation as an anticipatory repudiation, terminates his or her own performance and sues for breach, the promisee is placed in jeopardy of being found to have breached if the court determines that the apparent repudiation was not sufficiently clear and unequivocal.
If, on the other hand, the promisee continues to perform, and it is later found that a repudiation took place, the promisee may be denied recovery for post-repudiation expenditures. That is Taylor against Johnston seen from the other side.
Here is the first line for the board. Section two six oh nine. A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.
Second line, the teeth. After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract. The doubt is converted into a demand, and the silence into a repudiation. The insecure party no longer has to guess.
Third line. The Restatement carried the idea into the common law, in section two fifty one.
Where reasonable grounds arise to believe that the obligor will commit a breach by nonperformance that would of itself give the obligee a claim for damages for total breach, the obligee may demand adequate assurance of due performance and may, if reasonable, suspend any performance for which he has not already received the agreed exchange until he receives such assurance. Failure to give it within a reasonable time may be treated as a repudiation.
Fourth line, and it is the limit. The demand must rest on reasonable grounds, judged objectively, and it may ask only for assurance of the performance the contract promises. It may not be used to add security the other party never agreed to give, or to rewrite the deal. A demand for more than you are owed is not a demand for assurance. It can itself be a repudiation.
Now the case. Norcon Power Partners against Niagara Mohawk, New York Court of Appeals, nineteen ninety eight, Judge Bellacosa. The court began with anticipatory repudiation, from which the doctrine springs, and the two forms a repudiation can take, in the Restatement's words.
A statement by the obligor to the obligee indicating that the obligor will commit a breach that would of itself give the obligee a claim for damages for total breach, or a voluntary affirmative act which renders the obligor unable or apparently unable to perform without such a breach.
Then the Code's answer. The Uniform Commercial Code settled on a mechanism for relieving some of this uncertainty. In theory, the court said, this relief valve recognizes that the essential purpose of a contract between commercial parties is actual performance, and that a continuing sense of reliance and security that the promised performance will be forthcoming when due, is an important feature of the bargain.
The court admitted where New York stood. New York, up to now, has refrained from expanding the right to demand adequate assurance of performance beyond the Uniform Commercial Code. The only other recognized exception is the insolvency setting. And it declined to adopt the doctrine wholesale, as the utility asked. This court's jurisprudence, it said, usually evolves by deciding cases and settling the law more modestly.
But it moved. This court is now persuaded that the policies underlying the two six oh nine counterpart should apply with similar cogency for the resolution of this kind of controversy. The reason was an analogy. If the contract here was in all respects the same, except that it was for the sale of oil or some other tangible commodity instead of the sale of electricity, the parties would unquestionably be governed by the demand for adequate assurance of performance factors in the Code.
The holding was drawn to the case. It should apply to the type of long-term commercial contract between corporate entities entered into by Norcon and Niagara Mohawk here, which is complex and not reasonably susceptible of all security features being anticipated, bargained for and incorporated in the original contract. Norcon's performance, in terms of reimbursing Niagara Mohawk for credits, is still years away. The certified question was answered yes.
Notice what the court did not decide. Whether the utility's grounds were reasonable, whether six hundred and ten million dollars of projected credits was a storm cloud or a mirage, and what assurance would be adequate. Those went back to the federal court. The New York court decided only that the tool exists for contracts of this kind. That is how the doctrine grows. One case says the demand is available. The next says whether this demand was justified.
Now the second case, where the demand was not justified, and it turned the demanding party into the repudiator. Illinois, nineteen sixty eight. A steel fabricator contracts to build a one million gallon water tank for a water company for one hundred and seventy five thousand dollars.
The fabricator's first proposal asked for sixty per cent on receipt of materials. The water company's president would not agree, and the signed contract says the whole price is due thirty days after the tank is tested and accepted.
A month after signing, the fabricator's credit manager hears that the water company is borrowing to pay for the project. He writes to the lender, copying the president. We hereby request a letter assuring that one hundred and seventy five thousand dollars for payment of the referenced project will be held in escrow and fully committed to payment to us upon completion. As a matter of good business we are holding this order in abeyance until receipt of such notification.
The contract says nothing about escrow. In March the fabricator writes again, asking the president to mail us your personal guarantee of payment. The president sends a personal financial statement, not a guarantee. The crew scheduled for April never goes. The water company has already poured a foundation costing eighteen thousand eight hundred and ninety five dollars. The tank is never built. The fabricator sues the water company for repudiation, and the water company counterclaims.
A jury found for the fabricator. The trial judge entered judgment for the water company notwithstanding the verdict, and the Seventh Circuit affirmed, in Pittsburgh Des Moines Steel against Brookhaven Manor Water Company, nineteen seventy six. First, the tank was goods. In the words of the Code this was a movable thing specially manufactured. So section two six oh nine applied. Then the court asked whether the fabricator had used it or abused it.
Abused it. We do not construe section two six oh nine as being a vehicle without more for an implied term being inserted in a contract when a substantially equivalent term was expressly waived in the contract. The fabricator had asked for progress payments and been refused. It could not get them back by calling them assurance.
The contract negates the existence of any basis for insecurity at the time of the contract when the fabricator was willing to wait thirty days beyond completion for payment.
And the grounds were not reasonable. The fact that Brookhaven had not completed its loan negotiations does not constitute reasonable grounds for insecurity when the money in question was not to be needed for some months. Reasonable business men prefer in the absence of some compulsive reason not to commence paying interest on borrowed money until the time for the use for that money is at hand. Some more objective factual basis than a subjective questioning is needed.
Here is the sentence for the board. Section two six oh nine is a protective device when reasonable grounds for insecurity arise. It is not a pen for rewriting a contract in the absence of those reasonable grounds having arisen, particularly when the proposed rewriting involves the very factors which had been waived by the one now attempting to wield the pen.
The fabricator, by holding the order in abeyance, had repudiated. The water company could suspend its own performance and recover its damages, including the cost of removing the useless foundation.
A concurring judge disagreed on one point, and the disagreement is worth knowing. He thought a prudent businessman would have reasonable grounds for insecurity when a loan the parties both expected failed to materialize. But he agreed with the result, because section two six oh nine does not give the alarmed party a right to redraft the contract. A personal guarantee, an escrow, or a share of the company were all more than adequate assurance of the performance promised.
Put the two cases side by side. New York gave a utility with a genuine long-term exposure the right to ask. Illinois took the right away from a fabricator that had no real grounds and asked for what it had bargained away. The doctrine has two gates. Reasonable grounds for insecurity, judged objectively. And a demand for assurance of the performance owed, not for new security. Pass both and silence becomes a repudiation. Fail either and your own demand may be one.
Now let's change one fact. Two months after the tank contract was signed, the water company's bank called its existing loans, a supplier sued it for non-payment, and its president told the fabricator's sales manager that he did not know how he would pay. The fabricator wrote demanding assurance that the price would be paid on completion. Choose an answer before I go on.
Now the demand is justified. Those are objective facts bearing on the buyer's ability to pay when due, exactly what the Seventh Circuit said was missing. The fabricator may suspend fabrication while it waits, and if no adequate assurance comes within thirty days, the water company has repudiated. Adequacy is judged by the circumstances. A letter from the bank confirming a committed facility would do. And note what the fabricator still may not demand. A personal guarantee the contract never provided.
Change one fact again. The producer in New York answered the utility's letter within a week with audited accounts showing reserves and a parent company guarantee covering the projected credits. Choose.
Then the demand has been met, and the tool has done its job without a lawsuit. The New York court said the doctrine may even provide an incentive and tool for parties to resolve their own differences, perhaps without the necessity of judicial intervention. If the utility rejected that assurance and stopped paying for electricity, the utility would be the party in breach. Adequate does not mean everything the demanding party would like. It means enough to restore the reasonable expectation of performance.
Change one fact a third time. The contract in New York was a short one, a year's supply of electricity, and the utility's letter said only that it had heard the producer was in financial difficulty, without saying from whom or what. Choose.
Two problems. The New York holding was drawn for a long-term, complex contract not reasonably susceptible of all security features being anticipated and bargained for. A one year supply contract may fall outside it, and the utility would have to argue that the doctrine should extend. And even under the Code, a rumour is not reasonable grounds. The insecure party must be able to point to something. The demand fails on both gates, and a suspension of payment based on it would be a breach.
Here is what people get wrong here, and why it is tempting. The first mistake is using the demand as leverage, to get security you failed to negotiate. The Seventh Circuit called that a pen for rewriting the contract, and the party who wields it repudiates. The second mistake is thinking the demand needs proof of a coming breach. It needs reasonable grounds for insecurity, not certainty.
The third mistake is forgetting the form. The Code says the demand must be in writing, and the clock is a reasonable time not exceeding thirty days. Courts forgive some informality, as the Seventh Circuit did, but a lawyer who sends an oral demand and suspends performance the next day has handed the other side an argument.
Here is the rule, in one breath. When reasonable grounds for insecurity arise, a party may demand in writing adequate assurance of due performance and, if commercially reasonable, suspend its own performance until it comes, and failure to give adequate assurance within a reasonable time not exceeding thirty days is a repudiation. The demand must rest on objective grounds and may seek only assurance of the performance owed, not new security, or the demand itself may be a repudiation. Now, five questions.