Susan Scott, C.P.M., CIRM
Susan Scott, C.P.M., CIRM, Sr. Consultant, Harris Consulting, Inc
ABSTRACT: The Uniform Commercial Code governs a majority of the transactions and contracts executed in a manufacturing, retail, or wholesale operation. It is one legal subject matter most buyers have studied and one that many believe they fully understand. Nonetheless, misuse and misunderstandings abound, generating a plethora of court cases in which the Judge must interpret the application of the Code to the situation at hand. In this session we'll review key elements of the UCC as reflected in actual court cases, so that you can test your knowledge against the verdicts.
PROCEEDINGS: When it comes to legal issues, ignorance is no excuse. It therefore behooves every purchasing professional and anyone else spending company money, to become familiar with the laws governing commerce, foremost of which is the Uniform Commercial Code (UCC). The Uniform Commercial Code governs a majority of the transactions and contracts executed in a manufacturing, retail, or wholesale operation. It is one legal subject most buyers have studied and one that many believe they fully understand. Nonetheless, misuse and misunderstandings abound, generating a plethora of court cases in which the Judge must interpret the application of the Code to the situation at hand. More often than not, commercial buyers operate by accepted practice in their organization, rather than by following strict written procedures. This allows them to inadvertently leave themselves vulnerable to violations of the UCC or to omissions that increase their business risk. Since most Business Law courses cover the fundamentals of the Uniform Commercial Code, I will not repeat that content, but will only note that the key elements that confound many buyers are:
Formation of Contracts
Performance specs and demands
Damages and Remedies for Breach
and Risk of Loss.
Payment issues such as negotiability, types of drafts, negotiability, and checks are handled largely by the Finance department and are seldom handled by Procurement alone. In light of that, let's stick to the five (4) topics mentioned above and see how good your knowledge is on these essential regulations. I propose to present a scenario dealing with each topic and ask you to act as jury or judge for the case. I will hear your arguments for or against the defendant's viewpoint then give you the judge's decision along with a very short overview of the UCC rule upon which it was based. These scenarios will may be in the commercial world or the government sector, since Federal Acquisition regulations still don't prevent people from making mistakes or having different opinions on what was contracted. I am not a lawyer, and make no pretensions to it. The cases are actual and the judicial opinions are reported according to recorded proceedings, with occasionally juxtaposed opinions of mine.
Sales are the most common and important of all commercial transactions. Sales transactions are governed by Article Two of the Code, although general contract law continues to apply where the Code has not specifically modified it. Transactions that remain outside the scope of the Code include employment contracts, many service contracts, insurance contracts, some real estate contracts, and transactions for the sale of intangibles, like patents, and bonds.
Often these items overlap with the sale of goods covered by the same contract. In that case the "predominant purpose" prevails in determining the Code's applicability. The major purpose of Article 2 of the Code is to clarify, simplify and provide uniformity to the law of sales across the country. Let's look now at our first case.
First Case: a buyer regularly imports glove parts into NY for assembly in the Philippines. They are not inspected at the warehouse in NY, but sent right on to the factory in the Philippines. During assembly there it is noted that some parts, shipped from NY two months ago, are below standard. The seller refuses to authorize return of the goods due to the delay in inspection. The battle goes to court. Is it reasonable to demand that the buyer inspect the goods in NY prior to moving them to the Philippines? You be the judge.
Ruling: The question becomes "is the time until inspection reasonable?" The delay between arrival in NY and discover of defects in the factory was two months. Is that reasonable? The seller argues, no, it is too long. The judge ruled, yes, it is reasonable. The key to the issue is the fact that the buyer "regularly imports" glove parts in this manner. The seller must therefore be aware that these items are sent elsewhere for assembly. Perhaps the seller has even received some minor complaints from the factory before this. Also, given the nature of the garment business, it is not reasonable to expect the buyer to inspect the gloves 100% in a NY warehouse prior to transport to the factory. A small sampling of parts would not be sufficient to assure that all the gloves are acceptable. Again, the seller is expected to understand this and have accepted it prior to or during the course of doing business. Section 20606 of the Code states that "acceptance of goods occurs when the buyer (a) after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming or that he will take or retain them in spite of their nonconformity;".
The concept of dealing "in good faith" is one of the fundamental principles upon which the Code is predicated. The Court may scrutinize every contract to ensure that it was made in good faith and is not "unconscionable", of bad faith, or created with the intent to defraud the other party. The law permits the courts to resolve issues of unfairness explicitly, without legal fiction or reference to obscure rules. The court checks for evidence that the negotiations were fair, the important terms of the agreement were not deceptively buried in fine print, and the terms were reasonable rather than exorbitant. The intent of contract should not be to take unfair advantage of the other party, but rather to come to mutually beneficial arrangements. In that light, let's look at another case that hinges upon this, Empire Gas vs. American Bakeries (5 U.C.C. Rep.Serv. 2d 545).
Second Case: Empire Gas is a retail distributor of propane gas. It also sells converters to allow gasoline engines to run on propane. American Bakeries is a wholesaler, which serves its bakeries and processing plants with a fleet of over 3,000 vehicles. During the early eighties they proposed converting their fleet from gas to propane to counteract the sharp rise in gasoline prices. They approached Empire Gas to bid on the work. Empire's initial contract specified a fixed number of conversions per month and was rejected by American Bakeries. A revised contract "for approximately three thousand [conversion] units, more or less depending upon requirements of Buyer" at $750 per conversion kit was accepted. It also specified that American Bakeries would purchase its propane fuel "solely from Empire Gas Corp. at all locations where Empire has supplied carburetion...as long as Empire.remains reasonably competitive" with other major suppliers. The contract has a four year term. Yet American Bakeries never ordered any equipment or propane from Empire Gas. Apparently within days of signing the contract, American Bakeries decided not to convert its fleet, allegedly due to budget constraints. No specific reason was given to Empire. Empire Gas sued for breach of contract, requesting damages in the amount of lost profits on 3,000 units. American Bakeries maintains the contract did not obligate them to a fixed quantity. You be the judge. Should Empire receive compensation ?
The verdict: The crux of this case concerns American Bakeries' obligation under the contract. If the agreement was to buy 3,000 units or slightly more or slightly less, it broke the contract by purchasing none. Based on discussions prior to signing the agreement, American planned to convert its entire fleet, so Empire had a reasonable expectation of 3,000 units. As a "requirements contract", this is governed by section 2-306(1) of the Code, which states: "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 ... may be tendered or demanded." The jury may have read the statute literally, because the judge directed a verdict for Empire Gas who was awarded $3,254,963 representing lost profits on 2,242 conversion units, which was the jury's estimate of American Bakeries needs, including the fuel that the vehicles would have consumed. The stated estimate was 3,000 units. American Bakeries took none. If that is not unreasonably disproportionate to the estimate, what shortfall could be? The essential ingredient of good faith in reducing estimates is that the buyer not merely have had second thoughts about the contract. The buyer cannot arbitrarily declare that his requirements are zero. The judgement was affirmed upon appeal.
Many people in a corporation create contracts, with or without purchase orders or signed agreements. It is not unusual these days for engineers or quality personnel, or administrators to talk to suppliers and commit the Company in some manner. Even buyers occasionally create contracts unwittingly or fail to create them despite their intentions to buy.
The UCC has a multiple segments dealing with Offers and Acceptance (2-2204, 2-2205,2-2206, 2-2207) to help us align actions and intentions with the law. Section 2-2204, dealing with contract formation in general stipulates that a contract may be made in "any manner sufficient to show agreement", even though some of its terms are left open or the exact moment it was made is undetermined. If the intent to commit or agree was evident, a contract has been formed. In the absence of specific terms, reasonableness, demonstrated intent, or past usage usually prevails. Section 2-205 states "An offer by a merchant to buy or sell goods in a signed writing which by its terms gives assurance that it will be held open is not revocable for lack of consideration, during the time stated or if not time is stated for reasonable time, but in no event may such period of irrevocability exceed three months; but any such term of assurance on a form supplied by the offeree must be separately signed by the offeror. " In other words, if you as seller send me a written quote as buyer, it is good for three months, unless another termination date is stated, even if I do not agree to accept it. However, you must countersign any proposals I send back to you in response to it to create a contract. These sections apply specifically to our next case.
Pantsmaker Inc. vs. Collins & Aikman Corp. Collins and Aikman are fabric wholesalers who received an unsigned, printed purchase order from Pantsmaker, Inc. for 5000 yards of a certain fabric, the color yet unspecified. The form was interpreted by Collins & Aikman as an intent to buy 5000 yards upon approval of samples, color being determined prior to sampling. Shortly thereafter C&A received an order, again signed only by the typed company name, for 4200 yards of this fabric in a given color.
It should be noted that each form says "the order shall become a contract when signed and returned by buyer and accepted by seller in writing or when buyer has retained it for ten (10) days without objection, or when buyer accepts delivery of any part of the merchandise specified, or otherwise indicates acceptance." Again the seller took no action, awaiting sample approval as agreed verbally in previous transactions. After a period of time without delivery of any fabric, Pantsmaker demanded arbitration for breach of contract. Although Collins & Aikman claim the order was not a proffered contract until sample approval was received, Pantsmaker maintained that the 4200 yards were ordered and expected. Collins and Aikman demanded relief from arbitration for a non-existent contract.
You be the judge. Was a valid, enforceable contract formed?
Verdict: The question here is that of intent. Given the information we have, intent is subject to factual dispute.
The Code allows that a printed but unsigned form may be read as a signature "if it is clear that it was so intended or adopted". There was no delivery or acceptance to seal the contract or prove intent. The buyer obviously retained the offer of fabric at the stated price more than ten days. The conversation about sample approval would be admissible evidence to controvert the existence of a contract, if such a conversation can be substantiated. If sample approval terms had been printed on the purchase order, no doubt would exist. If previous orders requiring sample approval had such text, and this did not, there would be a substantial doubt as to the existence of a valid agreement. The court granted relief from arbitration pending a hearing on the validity of the alleged contract.
When buying offshore, the U.C.C. does not always apply, defaulting to the Convention on the International Sale of Goods (CISG), if one company is foreign-based. Occasionally however, our contracts invoke the U.C.C. in preference to the CISG, or we deal with a U.S. representative as sales front for the offshore entity. In both cases, the U.C.C. governs our contract. It has segments on the use of Letters of Credit, negotiable instruments, Bills of Lading, and Risk of Loss during delivery. The latter is a prominent concern to many buyers of perishable and easily damaged goods.
Risk of Loss is often linked to the title of the goods, and the performance conditions for both parties. If the title to the goods passes to the buyer upon receipt of the goods from the seller by the carrier, then so too the risk passes at that point to the buyer, unless otherwise specified in the contract. However, when the delivery fails to conform to the terms of the contract, such that rejection of the goods is justified, the risk of loss remains with the seller until either a cure or acceptance is effected. Payment for the goods does not constitute acceptance where it is made prior to inspection of the goods [unless otherwise specified in the agreement].
Fourth and final case: J. Stevenson v. 81,193 bags of flour A container-load of flour was ordered by bread manufacturer, X. It was due to be delivered from Brazil to Costa Rica in October. It was shipped C.I.F. Managuas, Costa Rica. Due to difficulties arranging transportation, the seller missed the specified delivery date by two weeks. This caused problems at the port, since his ship had to wait to be rescheduled into the workload for inspection. Another two week delay ensued. The buyer insisted the seller send the ship on to a second port, where inspection could be more easily arranged. Upon inspection at that port later in November, the flour was found to contain weevils. Buyer X refused to pay for the flour upon submission of documents by the seller on the grounds that the goods were defective. Seller argued that the additional detour and delays by the buyer caused the shipment to spoil. Seller sued for payment, maintaining that the delay in inspection was unreasonable and that he held title to the goods only thru Managuas. The buyer maintains of course that if the seller were not late initially, no further transport would have been necessary, and the delay would not have occurred. Who bears the risk of loss if the flour is unmarketable, buyer X, or seller?
Verdict: The court ruled that the seller bears the risk. It was not unreasonable for buyer to divert shipment in order to expedite inspection and delivery. Moreover, by agreeing to proceed to the second port, seller modified the contract. Title would then pass to buyer at the second port. Since the goods were judged defective, buyer has the right of rejection and the risk of loss remains with the seller until he cures the infestation or gains acceptance.
These cases I hope illustrate the tenuous balance between fairness, common sense and the law in the realm of commercial transactions. Although every buyer as customer expects fair value for goods and services purchased in the form of the right stuff at the right price at the right time in the right place, business does not always transpire that way. The seller wants a fair profit for effort expended on behalf of the customer and/or for goods delivered. The U.C.C. attempts to find a common ground between those two desires when they conflict. Aside from learning more about this commercial code, we'd be well advised to aim for prevention of the problems, rather than trust in the cure.