Requirements Contracts 101
Contracts, contracts, contracts are how we bring order to commerce, but they also denote obligations and rules. Sometimes the rules are a bit more complicated than others and requirements contracts are one of those. These rules mean that the contracting parties have agreed to buy and supply a certain amount of goods over the term of the agreement. Everyone wants certainty and contracts satisfy that need. Contracting parties can plan accordingly by estimating how much will be needed and when, adjusting for pricing and fact-loaded into the contract. The parties benefit from predictability and stability from contracting.
Generally, a requirements contract obligates the buyer to obtain all of its needed goods from the supplier. The supplier is obligated to supply these goods as needed on an as ordered basis. A requirements contract functions as a contract for an indefinite quantity . So, whereas a one-for-one contract might be for one widget at one dollar, a requirements contract for widgets is for thousands of widgets over time with price and schedule of deliveries to be agreed to under the contract. This type of contract goes well beyond parties agreeing to supply widgets upon specific orders at a pre-agreed price per widget.
Requirements contracts are often in place as part of government contracts. A government contract requirement contract, or "requirements contract" for short, obligates the Government Entity and a Contractor to obtain all the supplies of a certain type that the Government says it needs during a certain period, from that Contractor. These contracts are not open ended because the Government gets the ability to set limits on the minimum and maximum supply order quantities, delivery schedule(s) and price of individual orders under the contract. It is possible to negotiate the term of the contract, or its duration.
The Parties have discretion to agree to just about any type of tailor-made term that they want.
Essential Features of Requirements Contracts
Requirements contracts are unique types of supply contracts that characterize many business transactions. Here are a few of the key features of a requirements contract:
Requirements Contracts are One-Sided
A classic requirements contract imposes a contractual obligation on the Buyer only. The Buyer is required to buy all of its inventory needs for the contract term from the Seller. The Seller, on the other hand is obligated to supply the Buyer, while retaining the flexibility to sell any of the goods anywhere else, and at any time.
Contract Sets Quantities
A Requirements contract sets only an "estimated" maximum. Under UCC 2-306(1), a requirements contract can state that the contract is for "all of the requirements for a particular good that the Buyer may require…and there is implied a covenant by the Buyer to order in good faith." Whereas, a Requirements contract does not define the minimum quantity, "a proper essence of the requirements contract…is a failure generally to acquire from some other source."
Buyers Promise to Buy in Good-Faith
What does it mean for the Buyer to buy in "good faith?" UCC section 2-306(1) provides:
"The actual output will determine the scale of the actual performance required under a requirements contract, but a quantity which either is "exclusive" dealing or which operates as if a "requirements" contract . . . is not, except as provided in subsection (3), enforceable by either party beyond good faith operations on the part of the party who has the power to determine the actual output."
Negotiation of Demand and Supply Terms
Typically, a buyer and seller will reasonably negotiate the estimated maximum demand and the minimum supply requirements of the contract. A Requirements contract gives the Seller the ability to negotiate the supply terms.
Good Faith Negotiation
UCC section 2-306(1) states that the parties will negotiate demand and supply terms in "good faith." In other words, both parties are encouraged to negotiate supply terms that ensure stability and performance. This provision may be an implied term of a Requirements Contract, and requires the parties to cooperate with one another to maintain the course of performance.
Benefits of Requirements Contracts
For the buyer, a significant advantage of a requirements contract is the potential for more efficient planning and cost predictability. The supplier will know the buyer’s procurement needs over the duration of the contract. For the supplier, knowing a buyer’s capacity need over a long period of time encourages the supplier to invest in its ability to meet the buyer’s needs over the term of the requirements contract. In the long term, both parties have price and resource commitment and predictability.
A requirements contract may result in a relationship with a supplier that is superior to that which exists under a one-off purchase order transaction. The obligations imposed on the seller are generally important to the seller’s business, and its obligations under the contract may enable the seller to profit or, conversely, commit significant resources while taking the risk that the buyer will decide not to "consume" the product or service. If the buyer does not consume as expected, the seller not only has an unprofitable contract, but it has lost the opportunity to profit from a sale of product or provision of services to third parties. The committed resources, price commitment and priority obligation to that buyer may not be available to the seller in the open market. In such circumstances, the parties’ relationship may be one of mutual reliance and support. The seller is a long term supplier even if neither party is committed for the long term. The buyer gets a qualified supplier who has paid close attention to product quality, price and the ability to perform consistently over the long term.
Common Issues and Limitations
Challenges and Drawbacks
While requirements contracts offer flexibility to the seller and the buyer in certain circumstances, they can also pose challenges to both parties and become subject to costly disputes. Because the contract incorporates an open price term, misunderstandings about the price to be paid by the buyer or received by the seller are common. This can happen particularly in the context of long-running contracts, which in turn require modifications over time. When such modifications are not made in writing, or when the parties fail to agree on the price to be paid going forward, a clear dispute can result from the lack of a specific contractual provision for pricing.
The forecast required under a requirements contract can be both a blessing and a curse. For sellers, a forecast can provide a baseline for sales and help operations and production plan for the future. But if the forecast is inaccurate, it can lead to supply chain issues for the seller, which can result in a breach of the contract.
For buyers, a forecast has similar risks. A forecast can provide a guidepost for purchasing and inventory planning. But as with the seller, if the parties’ expectations are not properly accounted for in the forecast, it can result in a disproportionate of supply and demand at certain times, with the same consequences as stated above. As such, both parties must work together to accurately assess the need for products and the timing for the delivery of such products.
A requirements contract also invites lawsuit challenges by competitors who could allege that the contract has been entered into and is being implemented in an anticompetitive manner. Often, this is done in a predatory manner where one party (which may itself be a competitor) engages in an exclusionary practice that hurts the other party’s competitors by monopolizing existing demand, and then using its monopoly power to stifle new market entrants from filling in the gap. The courts require a three-part test to analyze the claim: (1) whether the contract at issue as entered into will lead to the monopolization of the relevant market; (2) whether that monopolization will lead to exclusionary conduct; and (3) if the conduct will have anticompetitive effects.
Enforceability and Legal Implications
The legal framework for imposing enforceable requirements contracts is set forth by the Uniform Commercial Code, 810 ILCS 5/2-301-318. Under such contracts, a buyer or seller agrees to a "contractual commitment to obtain all of its needs for a particular product from one source." (See Central Illinois Public Service Co. v. Consolidated Communications, Inc. (2004). Illinois courts enforce such contracts, presuming that the intention of the parties is that the buyer will purchase in accordance with its requirements even if the contract does not explicitly state such. This is done by reading the agreement as subject to an implied term limiting the quantity to "no quantity unreasonably disproportionate to stated estimate" if the agreement does not make an express estimate. In order to avoid a finding that so much discretion renders a requirements contract illusory, however, the discretion must be limited in some manner. Some courts in Illinois have also required requiring both parties to act in good faith, which is also necessary in order for the agreement to be enforceable .
If one party cannot satisfactorily demonstrate that the agreement is illusory, it will be enforceable only if actual consideration was tendered and accepted or is set forth in the agreement. Consideration that is based on estimation figures or based on market price at the time of delivery may be adequate to ensure enforceability. For requirements contracts for the sale of goods, however, the UCC allows for the fulfillment of the contract by part performance, which could conceivably be shown by a customer’s continued purchase of goods from the supplier each time the customer should reasonably have needed to procure goods. On the other hand, some courts have held the mere issuing of purchase orders does not impose any obligation on the part of the buyer.
The doctrine of good faith and fair dealing is also important in requirements contracts since it requires that the party with discretion to perform the contract do so in a manner that is consistent with the intention of the parties. This duty is so powerful that some courts have held that party waives the right to assert rights permitted by the contract in order to protect the other party’s interest.
Requirements Contract Examples
Requirements contracts are regularly applied across a variety of industries that span many sectors of the global economy. For example, those in the agriculture, energy, automotive, consumer products, and chemical manufacturing industries use standard forms of requirements contracts to achieve the efficiency of purchasing product through a single supplier. Oftentimes, when a business is dissatisfied with only the price term of their supply contract, they enter into some type of requirements contract with the supplier to satisfy their buying needs.
But what about the real world? Well-known companies such as Caterpillar, Ford Motor Company, and Nestle all utilize requirements contracts within their supply relationships. Caterpillar supplies its dealers with equipment on a requirements contract basis, instead of requiring the dealer to order a specified dollar amount of equipment at one time. This allows the dealer to balance supply against customer demand. Similarly, Ford and Nestle use supply contracts with their various suppliers either on a requirements contract, standing order, or annual reopener basis. These arrangements allow Ford and Nestle to only purchase a contractually agreed amount or quantity of products each year.
To maximize the benefits of entering into a requirements contract with a supplier, companies should strive to: (1) obtain adequate assurance from the supplier to make the necessary purchase requirements; and (2) maintain a track record of purchasing a minimum or eligible share of the supplier’s amount available.
Drafting a Requirements Contract
A requirements contract is a contract for the sale of goods which obligates a buyer to obtain all of its requirements of a particular kind of goods from the seller. Frequently, the buyer agrees to order a specific minimum quantity of goods from the seller, or simply to buy all of the goods "that are needed" or "from time-to-time." Under the UCC, such a contract "imposes an obligation on the buyer to order and on the seller to sell an agreed portion or the total requirements of the buyer."
For a requirements contract to be valid, there must be something that the parties have at least implicitly agreed would serve as a basis for determining the actual quantity of goods to be demanded under the contract. This requirement is necessary to prevent indefinitely indefinite contracts. That is, where the contract is silent as to quantity, the contract would not be enforceable because a court could not determine the quantity of goods the buyer is entitled to demand under the contract.
Some examples of such determinate terms in requirements contracts include:
• "up to a stated maximum" (e.g., 10,000 units/month)
• "minimum" quantity of goods (e.g., 5,000 units/month) and a maximum quantity (e.g., not more than 15,000 units/month)
• "minimum" quantity of goods (e.g., "X") plus "all other goods that the buyer requires or the volume of goods that the buyer may require" (e.g., a business "requires 530,000 gallons for 2011")
• "current" levels or amounts are de facto minimums (e.g., monthly purchase levels for the past three months are the minimums)
It is also important to factor in good faith under a requirements contract. A buyer cannot demand less than a good faith amount, while a seller cannot exploit the requirements contract by demanding more than it reasonably estimates the buyer would need under the type of contract involved.
In determining damages under a requirements contract where the goods ordered are unavailable, the UCC provides a specific formula for calculating damages. However, should the parties wish to displace the UCC’s damages provision, they may do so by specifically stating in their contract how the damages will be calculated.
On its face, drafting a requirements contract—a staple in commercial transactions—may appear straightforward. However, such contracts must be carefully considered to ensure that all requisite elements are incorporated into the contract. Failure to do so can result in an unenforceable contract under certain facts, a finding of bad faith, and/or a failure of remedy.
Conclusion and Tips
In this article we have highlighted some of the requirements for a contract that is based on the buyer’s requirements, and have also touched on the availability of a long-term contract for buyers who do not want to commit to fixed quantities of goods over a 12 month period. We have noted that contracts for future performance that are based on what the buyer "reasonably" needs are harder to breach, while contracts that base the required quantities on what the buyer "may" need creates a contract that is very easy for the buyer to breach.
We have also pointed to the buyer’s duty to deal fairly and in good faith in performing its obligations under a requirements contract , and noted that the seller may well have some relief against a suspension or termination if the change to its business’s future for the items under a requirements contract is substantial.
There are several best practices for requirements contracts that all businesses should consider before entering into or even negotiating such a contract: Like any contract, a requirements contract that is designed to last for 2 years or less should be reviewed every 6 to 12 months to ensure that it continues to meet both parties’ needs. On the seller’s side, it should be counseled that a long term contract must involve consultation with a sales rep prior to cancelling, protesting, or declaring force majeure.