Does your business have customers who, because of the recent economic downturn, have become significant credit risks? This One Minute Memo outlines one option a product or service supplier may have to protect its interests under existing contracts — to “demand assurances” from a distressed customer.  

If there is no contract between a supplier and its distressed customer, payment and contract terms generally can be changed unilaterally by either party. In that case, then, a supplier should be able to protect itself by requiring advance payments or C.O.D. purchases until the customer regains its financial footing.  

If a written contract exists between a supplier and its distressed customer, however, the written contract will govern the terms of the relationship for the duration of the contract. If the written contract specifies payment and credit terms, the supplier will in most cases be bound by those terms and will not be entitled to make unilateral changes to them. The supplier, then, can be put at risk of a credit default by the distressed customer.  

The supplier can, however, “demand assurances” from the distressed customer. This right exists generally under common law and applies to both sales of goods and services.1 In the context of sales of goods, the right is codified in Section 2-609(1) of the Uniform Commercial Code (the “UCC”), as follows:  

“When reasonable grounds for insecurity arise with respect to the performance of either party the other party may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend performance for which he has not already received the agreed return.”  

As one can readily see, the right to demand assurances is a powerful one because it entitles the supplier in certain cases to suspend its performance on the contract — that is, cease its deliveries of product — until the adequate assurances from the distressed customer are provided. Moreover, if such assurances are not provided, then the supplier is ultimately permitted to cancel the contract, refuse to perform, and sue the customer for breach.2  

Unfortunately for the supplier, there is no bright line rule as to what constitutes “reasonable grounds for insecurity” sufficient to trigger the right to demand assurances from a distressed customer and suspend performance. Courts, though, have found the following, among other factors, to constitute reasonable grounds for insecurity: (1) the customer’s falling behind in payments due on the contract at issue or other contracts; (2) expanded or excessive use of credit by the customer; (3) information or rumors circulating in the industry concerning the stability and conduct of the customer; (4) if the customer has proved unreliable in the past (i.e., failed to perform other contracts); and (5) the repetition of conduct that caused insecurity in other transactions. Notwithstanding this list, the determination of whether “reasonable grounds for insecurity” exist is a factspecific one, and requires careful scrutiny of the individual customer, its size, the history of its relationship with the supplier (both under the existing contract and under other or previous contracts), the course of performance, and other factors before a determination can be made as to whether reasonable grounds exist.  

If reasonable grounds for insecurity exist, then a demand for adequate assurances may be made by the supplier. In order to be effective, such a demand must be in writing and must be clear and unequivocal — courts have dismissed cases due to the demand being made either verbally or in a manner that is deemed too “weak” to be treated as legally effective. In particular, the written demand should: (1) state that it is a demand for adequate assurances of performance pursuant to the UCC as enacted in that state; (2) define the sort of which the customer must provide its assurances.  

If the distressed customer attempts to provide assurances, the determination of whether those assurances are sufficient is a test of reasonableness, based upon the commercial standards applicable to that industry and the circumstances of the case. If the customer is highly reputable, a clear statement and explanation as to its continued viability alone may constitute sufficient assurance. In contrast, if the evidence of financial distress is strong, a supplier may be justified in seeking a bond, advance payments or an escrow of funds as assurance.  

If the assurances received are adequate, the supplier is obligated to continue its performance under the contract. If the assurances are inadequate or are not provided within a reasonable time (30 days under the UCC), the supplier is entitled to deem the failure to be a repudiation of the contract by the customer. The supplier is then freed from the contractual obligation to perform, is free to enter into another agreement, and has the right to sue for breach of contract, limited by its own efforts to minimize damages.