contract negotiationsRegardless of whether you are a supplier or purchaser, it is imperative to know whether your contract with your purchaser or supplier is a “requirements contract.” Potentially conflicting terms and conditions in purchase orders and invoices exchanged between parties may result in the formation of a “requirements contract” or preclude the formation of such an agreement. And whether you are a supplier or purchaser, a requirements contract will have a material impact on your rights and obligations.

So, what is a requirements contract? A requirements contract obligates a buyer to buy all of its requirements of particular goods or materials from a seller for a specified period. Exclusivity is an essential element of a requirements contract. A contract that does not expressly obligate a buyer to buy all or a specified quantity of the particular goods or materials from the seller is not a requirements contract.

With a requirements contract, the buyer and the seller share risk. The buyer assumes the risk of less urgent changes in its economic circumstances, and the seller assumes the risk of a change in the buyer’s business that may make the cost associated with the continuation of a requirements contract unduly costly. While the buyer gets the benefit of steady supply and the seller obtains a predictable demand, each incurs risk associated with the potential fluctuation of price beyond what either anticipated.

What constitutes a breach?

The obligations owed under a requirements contract are not inherently absolute. So under what circumstances can a buyer reduce the quantities of goods or materials it purchases under the contract or stop purchasing goods under the contract without breaching its obligations?

Inherent to a requirements contracts is the notion that both the buyer and seller have a duty to conduct their business in good faith. Unfortunately, there is no bright line test for what constitutes “bad faith” in the termination of a requirements contract.

For example, when a buyer reduces or eliminates its “requirements,” to evaluate whether it is in breach, an essential inquiry turns on whether the buyer had a legitimate business reason for doing so as opposed to merely having second thoughts about the contract. And there are circumstances in which a supplier may be excused from its obligations under a requirements contract.

By way of example, a company entered into a five-year requirements contract to buy all of the prepress art services it required to print trading cards. One year into the five-year contract, the buyer sold substantially all of its assets to another company, effectively ending its need for the prepress art services. The vendor filed suit alleging that the company breached its duty of good faith by failing to continue to purchase prepress services. The court held that the company acted in good faith in its termination because it was in economic duress and had a legitimate business reason to sell its business.

Where a seller has made extraordinary expenditures and investments in reliance on a requirements contract, a buyer might find itself duty bound to remain in business (or at least pay an amount covering the damages resulting from its termination) until the term of the requirements contract has expired. The duty has been found in situations where a seller spent significant money to expand its manufacturing operations to meet the demand of the requirements contract, where a seller built a new plant to meet the demand of the requirements contract and where the seller incurred substantial debt on the expectation of the requirements contract. However, these are exceptions to the general rule that a seller assumes the risk to all good-faith variations in a buyer’s requirements, even to the extent of a determination to liquidate or discontinue its business.

Building protection into your contract

With the above in mind, buyers and sellers can take steps to contractually protect themselves by reallocating some of the risks inherent in requirements contracts. For example, a seller may choose to reallocate some of the risk that a change in the buyer’s business might pose by specifying some minimum purchase requirement in the contract. The buyer and seller may reallocate some of the risk of price fluctuations by including clauses that provide for price or supply adjustments.

Fundamental to the risk transfer inherent in the supply agreement is an understanding of whether the terms and conditions exchanged between the parties have given rise to a “requirements” contract. Manufacturers and suppliers should consider reviewing their existing contracts to determine if they have any requirements to gain a better understanding of what their obligations and rights are under those agreements.