Is a Promise Plus a Right to Win a Lawsuit Enough? How the Right to Demand Adequate Assurance (Under State Law) Attempts to Protect Contract Counterparties

Contributed by Sara Coelho
Contract counterparties living in a difficult commercial relationship with a reorganizing debtor can find the Bankruptcy Code’s provisions governing executory contracts to be quite onerous.  Section 365(b), for example, allows a debtor to assume even defaulted contracts, so long as the debtor cures any defaults, pays for any resulting losses, and provides adequate assurance of future performance.  Counterparties to non-defaulted contracts sometimes have good reason to be skeptical that a debtor’s future performance will be satisfactory, but the Bankruptcy Code does not entitle them to adequate assurance in the absence of a default or a proposal by the debtor to assign the contract to a third party (in which case the assignee’s ability to perform must be demonstrated).  This dichotomy of treatment in the Bankruptcy Code is not altogether consistent with the state law from which the Bankruptcy Code’s adequate assurance concept is derived, however.  Under state law, adequate assurance may be demanded when grounds for insecurity have arisen, before a default, when it is most useful.  This entry explores some of the state law doctrine and purpose of adequate assurance, and subsequent entries will consider issues in the application of the right, particularly in bankruptcy.
The adequate assurance concept adopted in the Bankruptcy Code was adopted from section 2-609 of Article 2 of the Uniform Commercial Code (applicable to the sale of goods).  New York’s version of section 2-609 is consistent with the Uniform Commercial Code adopted by many states and provides that “[w]hen reasonable grounds for insecurity arise with respect to the performance of either party the other may demand in writing adequate assurance of due performance.”  It also authorizes a commercially reasonable suspension of performance for which compensation has not previously been made.  If the transaction is between merchants, it provides that reasonableness of the grounds for insecurity and the adequacy of the assurance are determined “according to commercial standards.”  Finally, it holds that failure to provide adequate assurance after a “justified demand” is a repudiation of the contract.  “Assurance,” also referred to as security, is a flexible concept and can take many forms, depending on the situation.
Article 2 applies only to the sale of goods, but it has common law antecedents, and some states have found its framework so effective that they have developed common law applications of the statute.  This is the argument made by New York’s Court of Appeals in Norcon, which catalogued jurisdictions that have created a common law right to make an assurance demand, before finding a limited common law right under New York law for parties to certain complex commercial contracts to demand assurance in some situations.
The Norcon court found that the adequate assurance device was developed to address the dilemma that a party faces when circumstances indicate that a counterparty may not perform but has not clearly repudiated the contract.  After a clear repudiation by one party, the other is entitled to treat the contract as completely breached, withhold performance and sue for damages, but is also obligated to mitigate damages.  If the contract is not clearly repudiated, however, such an aggrieved party does not know whether to go forward and perform—and risk having failed to mitigate damages from a foreseeable breach—or withhold performance—and risk being in breach if a court later finds that there was no repudiation.  An assurance demand is supposed to give the non-breaching party a way to gain clarity before risking performance in such a situation.
The Official Uniform Comment, a commentary appended to the sections of the official UCC explaining its intent and meaning, provides an additional rational, rooted in the doctrine of reliance.  It say that section 2-609 “rests on the recognition of the fact that the essential purpose of a contract between commercial men [sic] is actual performance and they do not bargain merely for a promise, or for a promise plus the right to win a lawsuit and that a continuing sense of reliance and security that the promised performance will be forthcoming when due, is an important feature of the bargain.”  Being able to rely on the other party is the whole point of having a contract after all.
The commentary goes far, however, when it says that if “the willingness or . . . ability of a party to perform declines materially . . . the other party is threatened with the loss of a substantial part of what he has bargained for” and characterizes the obligation to perform in such circumstances as an “undue hardship.”  This rationale contemplates that parties are injured not upon breach, but, rather, upon the threat of a breach and that additional rights arise upon a mere threat.  Such a logic assumes that a degree of security, even if not bargained for, is fundamental to the contract.
In most contexts, however, the law does not read a security feature into contracts and does not allow rights and remedies to arise based on, in the words of the Norcon court, a “forecast” of the future.  It is somewhat troubling to impose the burden of providing security on one party, when neither party saw fit to include the feature in the contract when it was formed, and the party benefiting from the security did not give anything for the benefit.  There is, therefore, a fundamental tension between viewing a degree of security as inherent in a contract, as the UCC does, and empowering parties to precisely establish the burdens of the contract at the outset.  Statutory and common law on adequate assurance can manage this tension by limiting the assurance demands that are justified, but the scope of the right is bound to present interesting problems when the party subject to the demand is in financial distress.