Companies facing increasing uncertainty about contractual performance have a tool that might bring certainty in uncertain times – a demand of adequate assurance.
Those familiar with the Uniform Commercial Code (U.C.C.) know about Section 2-609’s right to adequate assurance. But, many forget this provision, and even more are surprised to learn that some states, New York included, extend the right to adequate assurance via the common law to non-U.C.C. contracts.
So, those either facing a shaky counterparty, or those who receive a demand with the words “adequate assurance” in it, would be well served to understand the doctrine.
The doctrine of adequate assurance provides parties with a tool to potentially regain certainty – that is the point of the doctrine. It is also a tool that can hasten the end of a contractual relationship, so it is something anyone dealing with an uncertain situation should know about.
What is adequate assurance?
The doctrine of adequate assurance allows a contract party with reasonable grounds to believe that its counterparty will be unable to perform, to demand that the counterparty provide “adequate assurances” that the counterparty will perform its contractual obligations. Until the demanding party receives adequate assurances, it can usually suspend its future performance under contract.[i]
If the counterparty fails to provide adequate assurance, the demanding party may treat this as a repudiation and terminate the contract.[ii] But, if the counterparty does provide adequate assurance of performance, the demanding party must resume performance to avoid its own breach of the contract.
Ultimately, the doctrine of adequate assurance aims at protecting both parties from the possibility of undue hardship when “either the willingness or the ability of a party to perform declines materially between the time of contracting and the time for performance.”[iii]
Scope of application of adequate assurance
Although the doctrine of adequate assurance has its roots in U.C.C. § 2-609, several states have recognized that adequate assurance of performance may be demanded in the context of contracts not governed by the U.C.C.[iv]
Indeed, § 251 of the Second Restatement of Contracts, which has been adopted by many states as the common law of contracts, tracks with the U.C.C. and provides for adequate assurance “without regard to the subject matter of the contract.”[v]
As such, in many states, parties should not view adequate assurance as a remedy available solely under contracts for the purchase and sale of goods, governed by the U.C.C.
Who has the right to demand adequate assurance?
Any party to a contract can request adequate assurances from a counterparty when reasonable grounds for insecurity arise,[vi] and when the U.C.C. or state law allows for parties to that particular type of contract to demand adequate assurances.[vii]
In general, the reasonableness of grounds for insecurity is a question of fact, but in some cases, the issue has been resolved as a matter of law.[viii]
What must the demand include?
A strong demand for adequate assurance will meet several criteria.
- It would specify the grounds for insecurity, presented in such a way that a reviewing court would find these grounds to be reasonable.[ix]
- The demand for adequate assurance must be unequivocal and must request assurance of the performance agreed upon in the contract rather than demanding amendment to the agreement or performance of new obligations.[x]
- The demand must be made in good faith.[xi]
What makes assurance adequate? Does the counterparty have other options?
Whether an assurance of due performance is adequate is a fact intensive inquiry.[xii]
Courts consider several factors when assessing whether a party’s assurance of performance is adequate, including the parties’ relationship and prior dealings, the cause of the uncertainty, the non-performing party’s reputational risk, and the time given to provide assurance.[xiii]
If the counterparty is able to provide adequate assurance, the demanding party must continue to satisfy its contractual obligations. If a counterparty cannot provide adequate assurance of performance, the demanding party will likely claim that the counterparty has repudiated the contract.
In response, the counterparty may be able to argue:
- that the demanding party does not have the right to demand adequate assurance, given the nature of the contract; or
- that the demanding party did not properly demand adequate assurances. Either of these disputes will likely land the parties in litigation.
Potential risks of asserting adequate assurance
Given the universal effects of COVID-19, it is possible that a large number of contractual counterparties will invoke the adequate assurance doctrine. As courts are often protective of contracts and contractually-based expectations, they may seek to narrow this common law doctrine in the interest of equity.
Additionally, there may be divergence between courts as they determine the interaction of adequate assurance demands and excuses of force majeure. Under the U.C.C., for instance, demands for adequate assurances may not be available in certain extenuating circumstances, such as fire or other catastrophe.[xiv]
Furthermore, although there are no negative legal consequences to a party that merely requests adequate assurance prematurely or unnecessarily, if that party then incorrectly deems the assurance it receives from its counterparty inadequate, and terminates, there is a risk that a court will find the assurance to be adequate and the party’s termination to be a breach of the agreement.[xv]
This gives counterparties some protection from frivolous demands of adequate assurance as a pretense for terminating the contract.
Conclusion
Ultimately, parties to contracts that are threatened by COVID-19 and its far-reaching consequences would be wise to consider demanding adequate assurances from its counterparty.
At the same time, counterparties who receive a demand for adequate assurance should be prepared to respond promptly and effectively to avoid termination of the contract.
[i] Hornell Brewing Co. v. Spry, 664 N.Y.S.2d 698, 702 (N.Y. Sup. Ct. 1997).
[ii] Restatement (Second) of Contracts § 251. (Am. Law Inst. 1981).
[iii] U.C.C. § 2-609 cmt. 1 (Am. Law Inst. & Unif. Law Comm’n 2020).
[iv] See Norcon Power Partners, L.P. v. Niagara Mohawk Power Corp., 92 N.Y.2d 458, 468 (N.Y. 1998) citing Lo Re v. Tel-Air Communications, 490 A2d 344 (N.J. 1985); Conference Ctr. Ltd. v. TRC-The Research Corp., 455 A2d 857 (Conn. 1983).
[v] Restatement (Second) of Contracts § 251 cmt. a. (Am. Law Inst. 1981).
[vi] Corporate Counsel Guide to U.C.C. § 10:2.
[vii] See, e.g., River Terrace Assocs., LLC v. Bank of New York, 809 N.Y.S.2d 483 (N.Y. Sup. Ct. 2005) (finding that a party to a short-term Credit Agreement did not have the right to demand adequate assurance from counterparty).
[viii] BAII Banking Corp. v. UPG, Inc., 985 F.2d 685, 702 (2d Cir. 1993).
[ix] See, e.g., Phibro Energy, Inc. v. Empresa De Polimeros De Sines Sarl, 720 F. Supp. 312, 322 (S.D.N.Y. 1989)
[x] See Petroieo Brasileiro S.A., Petrobras v. 1BE Group, Inc., 1995 WL 326502, at *6 (S.D.N.Y. May 31, 1995).
[xi] Restatement (Second) of Contracts § 251 cmt. d. (Am. Law Inst. 1981).
[xii] See, e.g., Hornell Brewing Co. v. Spry, 664 N.Y.S.2d 698, 702 (N.Y. Sup. Ct. 1997) (“What constitutes ‘adequate’ assurance of due performance is subject to the same test of commercial reasonableness and factual conditions. McKinney's Consolidated Laws of NY, Book 62½, UCC § 2–609 Official Comment at 489.”).
[xiii] Restatement (Second) of Contracts § 251 cmt. e. (Am. Law Inst. 1981).
[xiv] Corporate Counsel Guide to U.C.C. § 10:24.
[xv] Corporate Counsel Guide to U.C.C. § 10:2.
