It happens time and time again that a seller of goods enters into a contract with a buyer and then later finds out that the buyer is in some kind of distress or trouble and may not be able to fulfill its obligations under the contract. In general, contracts involving the sale of goods are governed by the Uniform Commercial Code (UCC). Under UCC Section 2-609, a party to a contract has the right to demand adequate assurance of performance from a distressed counterparty. This demand usually takes the form of a letter known as a demand for adequate assurance letter.
In the case of a seller concerned that a buyer is in trouble, a proper demand letter allows the seller to suspend its own performance under the contract and avoid incurring additional losses until the buyer provides some kind of proof or assurance that it will be able to pay or otherwise perform its obligations under the contract. If the buyer fails to provide adequate assurance within a reasonable time, then the seller can treat the contract as repudiated.
There are, however, certain standards that must be met by a seller that wants to demand adequate assurance from a buyer. If the demand is not done properly, then the party making the demand (the seller) exposes itself as the breaching party to damages for wrongfully suspending its own performance or treating the contract as repudiated.
A demand letter must set forth the basis for the seller’s insecurity about the buyer. This concern must be reasonable and based on a good faith belief that the buyer is in distress and will not be able to meet its obligations under the contract. For example, a seller that finds out its buyer has gone out of business or become insolvent would have a reasonable basis for demanding assurance. Other situations that could reasonably give rise to a seller’s right to demand adequate assurance include if a collection action has been filed against the buyer or if there is a work stoppage at the buyer’s principal place of business.
The reasonableness of the seller’s insecurity doesn’t have to be directly related to the contract in question. For example, a seller that finds out that the buyer is in breach of its agreements with other sellers may have a reasonable basis for seeking adequate assurance regarding its own contract. The seller’s insecurity must be based on an objective standard and not the seller’s subjective belief.
The seller should never over-demand what it needs as assurance from the buyer. Unreasonable requests could be considered a repudiation of the agreement by the seller. What the seller asks for should be sufficient to satisfy its insecurity regarding contract performance and nothing further. For example, requesting some form of proof that the buyer has the money to fulfill its obligations generally is viewed as an acceptable request.
Unjustified or overly burdensome demands that serve to harass a buyer would not be considered good faith demands. In most cases, a demand for adequate assurance should not include additional material terms that are not in the original agreement, such as earlier payment deadlines, or deposit obligations, or letter of credit or bonding obligations. In addition, a seller should not demand more than is required under the original contract coupled with a threat that the contract will be automatically terminated if those demands are not met. Courts have found that type of demand to be an anticipatory repudiation of the contract by the seller. Whatever is requested should be reasonable and in accordance with generally accepted commercial standards and practice.
What type of writing is required for a demand for assurance letter has been liberally construed by courts. Generally, as long as the seller can show that the buyer had a clear understanding that performance would be suspended until adequate assurance was received, then the written requirement under the UCC should be satisfied. Oral demands for assurance have also been considered acceptable in certain circumstances. Nevertheless, there is no point in assuming unnecessary risk, so the best practice always would be to put your demand for assurance in writing.
The seller should give the buyer a deadline for providing the assurance requested. If no deadline is given then the buyer has up to thirty days to provide one. That is the maximum time period a party has to respond to a demand for adequate assurance under the UCC. The seller may demand that adequate assurance be provided in less than thirty days. Whether a shorter timeframe will be considered reasonable will depend on the circumstances, including the assurance requested. If the buyer fails to provide adequate assurance within thirty days or by the deadline provided, then it will be considered a repudiation of the contract by the buyer, allowing the seller to treat the contract as totally breached.