Sometimes a breach of contract by a supplier is completely unexpected, but other times you might see it coming weeks or months in advance, and be left wondering about your options.

For this reason, it’s important that purchasing and sales executives be familiar with the Uniform Commercial Code (UCC), which answers this question for most contracts for the domestic purchase of goods. The relevant UCC concepts are known as anticipatory repudiation and adequate assurance of performance.

Imagine that six months ago, you (an employee of Alpha Corp.) signed a contract committing Alpha to purchase all of its widgets from Xero Corp. Xero committed in the contract to supply all of Alpha’s widgets for five years. While reading the news this morning, though, you saw that Xero announced it’s shutting down its business division responsible for manufacturing the widgets. You need the widgets to make your own products, and so you immediately start to wonder: What are your options? Despite the long-term exclusive supply contract, can you immediately start purchasing the widgets from another supplier? Or do you have to keep purchasing from Xero until it actually misses a shipment? The answer often lies in Sections 2‑609 through 2‑611 of the UCC.

Anticipatory Repudiation

Anticipatory repudiation of an agreement occurs when a party indicates that it will be unwilling or unable to fulfill its future contractual obligations. It can be expressly communicated, implied from a party’s actions.

There’s a two-pronged test to determine whether an anticipatory repudiation has occurred. First, the communication or action must either overtly communicate a party’s intention not to perform an obligation under the agreement, render performance of an obligation reasonably impossible, or demonstrate a party’s clear determination not to continue to perform an obligation when performance will be due.

Second, a failure of a party to perform the contractual obligation must substantially impair the value of the contract to the other (non-breaching) party. The drafters of the UCC included a note that, in their view, the most useful test to determine whether substantial impairment exists is whether the aggrieved party would suffer a material inconvenience or injustice if it was required to wait and see whether the other party performs its obligations in full.

Some common examples of anticipatory repudiation include:

• A seller says that goods will not be delivered unless a buyer agrees to a price increase.
• A seller indicates that it is ceasing production of goods that it’s contractually obligated to supply (for instance, because a manufacturing facility has been shut down or a business division has been shuttered).
• A buyer says it won’t pay for previously ordered goods, as required by a contract.
• A seller obtains credible information regarding a buyer’s material adverse change in credit rating or diminishing financial condition (but only if such information would result in a buyer’s inability to timely perform under an agreement).

Responses to Anticipatory Repudiation

Aggrieved Parties. Returning to our example above, because Xero made it clear that they would no longer be producing widgets, and because Xero’s failure to produce widgets would substantially impair the value of the contract to Alpha, it’s very likely that Xero’s announcement of the division shutdown constitutes an anticipatory repudiation of the agreement. Under the UCC, so long as Alpha is not itself is in breach of the contract, Alpha now has the option of (1) waiting a commercially reasonable time for Xero to retract the repudiation and perform its obligations under the agreement, (2) sending a formal demand for adequate assurance, as discussed below, (3) treating the agreement as being breached by Xero and pursuing any available remedies, or (4) notifying Xero that it is treating the agreement as cancelled and the notice of repudiation as being final.  Regardless of which option Alpha elects to pursue, it may also suspend its own performance under the contract if such suspension of performance is commercially reasonable under the circumstances.

Repudiating Parties. Xero can retract its repudiation any time up to the time its performance is due under the contract unless (1) Alpha has materially changed its position in reliance of the repudiation (e.g., Alpha has already signed a contract with a secondary supplier for the widgets) or (2) Alpha has communicated to Xero that it has treated the agreement as cancelled or the notice of repudiation as being final. If the repudiation is retracted then the contract will be reinstated, except that allowances will be made to Alpha for any delay in its performance caused by Xero’s repudiation.

Demands for Adequate Assurance

Sometimes, a party may learn of circumstances that, while not rising to the level of an anticipatory repudiation, raise reasonable doubts that the other party will perform their obligations under a contract. Returning to our example above, imagine that Xero learns from a mutual supplier that Alpha is close to insolvency and has stopped paying its bills. These rumors are substantiated by Xero’s own experience with Alpha, who’s late to pay Xero for the most recent shipment of widgets. Is Xero still obligated to ship widgets to Alpha, even though it has a reasonable belief that Alpha won’t pay it for those widgets?

If reasonable grounds for doubt (or “insecurity”) exist that a party will perform its contractual obligations, the other party may issue a written demand for adequate assurance of due performance and (if commercially reasonable), suspend its own performance under the agreement until such assurance has been provided. There is, however, significant risk in suspending performance when making a demand for adequate assurance because, in doing so, a party risks being in breach of the contract if a court later determines that it didn’t actually have reasonable grounds for insecurity. As a result, it’s common to make a demand for adequate assurance and allow a reasonable amount of time for the other party to respond before suspending performance.

Returning to our example, Xero should carefully tailor its demand letter so that the request for adequate assurances is limited to the performance previously agreed to in the contract (i.e., payment of goods), and should avoid demanding that the contract be modified. For instance, while Xero could likely require that Alpha provide a letter of credit to secure its performance under the agreement, it cannot demand that Alpha agree to new terms of payment or higher prices for the goods. An improper demand from Xero to modify the contract might itself constitute an anticipatory repudiation of the contract, giving Alpha rights and remedies under the UCC.

Once a demand for adequate assurance has been made, Alpha must provide assurances in a reasonable amount of time. How much time is reasonable will depend on the circumstances, but the UCC specifies that the amount of time cannot exceed 30 days. If Alpha fails to provide adequate assurance within a reasonable period of time, Xero may treat the contract as having been repudiated, and respond in any of the manners discussed above.

By becoming familiar with the UCC protections relating to anticipatory repudiation and adequate assurance of performance, purchasing and sales executives may be able to minimize the impact of a future breach of contract in their supply chain.

Patrick Taylor and Brandon Krajewski are partners at Quarles & Brady LLP.