Reducing Counterparty Risk -- Managing Contracts and Disputes in Today's Markets. Presentation Overview. Topic No. 1 - Know Your Customer

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1 Reducing Counterparty Risk -- Managing Contracts and Disputes in Today's Markets 1 Presentation Overview When considering legal issues associated with commercial contracts, including commodity contracts, there is a tendency to focus on the substantive legal terms of the contract. Comparatively, there is often too little focus on the process of contracting. In an area where contracts are largely standardized, such as commodity contracts, it is often a breakdown in the process that leads to a dispute, not the failure of a substantive term. By strengthening your adherence to proper contracting procedures, you can reduce your risk of a dispute and the legal proceedings that often follow such disputes. This presentation focuses on three procedural issues often associated with legal proceedings: The importance of identifying the contracting party; The significance of a signed contract confirmation; and The importance of identifying the date of default. 2 Topic No. 1 - Know Your Customer Does Not Mean: That you went to high school/college with him/her. That you know his/her mother/uncle/cousin/brother-in-law/etc. That you attend the same church. That you are members at the same golf course. Does Mean: That you know the full legal name of the party you are contracting with. That you know the nature and scope of the person s/entity s business operations. That you are comfortable, after a reasonable inquiry and assessment, with the risk of doing business with the person/entity. 3 1

2 Business Organization Options The Evolution of Limited Liability Entities The first step in knowing who you are contracting with is to understand what types of business organization options are available to the parties you contract with. The options available have expanded over the past years, and many of these new options shield the assets of the business owner from third-party creditors. While there is variation from state to state, the primary options are discussed below. 4 Sole Proprietorship A sole proprietorship is a business that is owned and managed by one person. Often referred to as doing business as or d/b/a ; Owner is inseparable from the business; and Owner is personally liable for the debts of the business. Owner s Name d/b/a Business Name Example: Jacob Bylund d/b/a Bylund Farms Contract is With: Jacob Bylund Liability Runs To: Jacob Bylund 5 General Partnership A general partnership is an association of two or more persons to carry on as co-owners a business for profit. A General Partnership is a legal entity but does not require filing with Secretary of State; Like sole proprietorship but more than one person; and Partners have unlimited liability for debts of partnership, regardless of which partner incurred the liability. Bylund Farms, Jacob Bylund, Partner Contract is With: Bylund Farms Liability Runs To: Bylund Farms, Jacob Bylund, and Larry Bylund (Partner) WARNING THE PARTNERS IN A GENERAL PARTNERSHIP MAY BE LIMITED LIABILITY ENTITIES 6 2

3 Corporation A corporation is a legal entity with powers and liabilities independent of its stockholders (the owners). As a separate entity, the corporation owns the corporate property, owes the corporate debt, and is the debtor that gets sued or the creditor who sues. Is a legal entity and requires a filing with Secretary of State; Complex organization to operate (board of directors, annual meetings, officers, etc.); and Double taxation, meaning a corporation pays a tax on its income when earned, and its shareholders pay a tax on the income when it is distributed to them in the form of dividends. Bylund Farms, Inc., Jacob Bylund, President Contract is With: Bylund Farms, Inc. Liability Runs To: Bylund Farms, Inc. 7 Limited Partnership A limited partnership is an entity having one or more general partners and one or more limited partners. Requires a filing with Secretary of State; General partner(s) have unlimited liability for the debts of the limited partnership; and Limited partner(s) are not liable for the debts of the limited partnership. Bylund Farms, LP, Jacob Bylund, General Partner Contract is With: Bylund Farms, LP Liability Runs To: Bylund Farms, LP and Jacob Bylund WARNING THE GENERAL PARTNER IN A LIMITED PARTNERSHIP MAY BE LIMITED LIABILITY ENTITY 8 Limited Liability Company A limited liability company is an unincorporated association having one or more members. The LLC form combines elements of both a corporation and a partnership. Like a corporation, owners of a LLC are not liable for the obligations of the business. Like a partnership, income and losses of the company flow through the company to the owners avoiding double taxation. Only one member (owner) needed; Requires a filing with Secretary of State; and Members are not liable for debts and obligations. Bylund Farms, LLC, Jacob Bylund, Manager Contract is With: Bylund Farms, LLC Liability Runs To: Bylund Farms, LLC 9 3

4 Limited Liability Partnership The limited liability partnership arose in response to laws authorizing the creation of the limited liability company. In a general partnership, individual partners are liable for the partnership's debts and obligations, whereas the partners in a limited liability partnership are statutorily provided full-shield protection from partnership liabilities, debts and obligations. Requires a filing with Secretary of State, and Partners are not liable for debts and obligations. Bylund Farms, LLP, Jacob Bylund, Partner Contract is With: Bylund Farms, LLP Liability Runs To: Bylund Farms, LLP 10 The Proliferation of Limited Liability Entities Formation of a LLC or LLP is not time consuming; either type of entity can be formed in hours. Formation of a LLC or LLP is not costly; either type of entity can be formed for less than $1,000. The formation of a LLC or LLP does not affect the tax burden of the owners. The formation of a LLC or LLP does not affect a business ability to obtain credit; banks typically require personal guarantees (and may actively support the formation of a limited liability entity). The formation of a LLC or LLP does not affect an owner s liability for a tort committed by the owner (if a LLC member is negligent in causing a car accident while traveling on LLC business, the owner is personally liable). The formation of a LLC or LLP does protect an owner from contract liability to third-parties that contract with the LLC or LLP. STATED DIFFERENTLY, LLCs AND LLPs PROTECT THEIR OWNERS FROM LIABILITY TO YOU!!! 11 What Can/Should You Do? Identify the Contracting Party Consider a master agreement at the start of the business relationship establishing the identity of the contracting party (see example included with materials). Clearly identify the exact person or legal entity you are contracting with from the moment you begin the relationship. In preparing the documentation of the contract (including your company s internal record keeping system), be very precise as to the legal name of the contracting parties. If the seller asks that the contract be in the name of Bylund Farms, confirm that Bylund Farms is a d/b/a for Jacob Bylund. Set up the signature block as Jacob Bylund d/b/a Bylund Farms. If the seller asks that the contract be in the name of Bylund Farms and that it is a partnership with his father, set up the signature block as Bylund Farms, Jacob Bylund, Partner. If the seller asks that the contract be in the name of Bylund Farms, Inc., Bylund Farms, LP, Bylund Farms, LLP, or Bylund Farms, LLC, set up the signature block in the name of the entity with a signature by its authorized representative. 12 4

5 Financial Condition Assessment - Individuals If the contracting party is an individual, consider what information you know about the person and his/her business. If you don t have any information about the person, ask the person about their business. Consider asking for references. Because of personal liability for default, individuals are less likely to breach as compared to limited liability entities. 13 Financial Condition Assessment - Limited Liability Entities If contracting with a limited liability entity, you MUST consider the ENTITY S financial condition and liability in the event of default. Option 1: Obtain personal guarantee with respect to all limited liability entities. This option is the easiest from an administration standpoint but may not be feasible from a business standpoint. For small contracts, the risk of loss may not justify taking a guarantee. For certain limited liability entities, particularly large family farm corporations, a personal guarantee may not be necessary. Option 2: Obtain personal guarantee with respect to all contracts over a certain size. Under this option, your company identifies a certain risk level over which it is not comfortable with a contract in the absence of a personal guarantee. This may be 20,000 bushels or 200,000 bushels, depending upon your company s risk tolerance. Option 3: Obtain financial information with respect to all contracts over a certain size. Under this option, your company identifies a certain risk level over which it is not comfortable with a contract in the absence of detailed financial information. Financial information includes a current financial statement supplied by the contracting party and the most recent financial statement provided by the contracting party to its lender for the purpose of obtaining financing. In addition, request copies of corporate documents (articles of organization, operating agreement, etc.) 14 Limited Liability Entities (Cont.) Option 4: If unwilling to request a personal guarantee or financial information, review and assess publicly available information about the limited liability entity. Check Registration In most states, documents required to create a limited liability entity must be filed with the Secretary of State. States typically make filing information available via internet including: Date of Filing Formed yesterday? Registered Agent Name/Address Does this match the address you were given? Officers Are you dealing with an officer? Check Lien Filings UCC lien filings are maintained by the Secretary of State. Real businesses have real creditors. If you have a contract with a party that has no liens against it, this is not a positive indicator; it takes money to plant a crop. Check Court Records, the Internet, and the Phone Book 15 5

6 Topic No. 2 - The Importance of a Signed Confirmation Most people incorrectly assume that for a contract to exist it must be in writing and be signed by both parties. In fact, a contract may be either written or oral. However, with respect to oral contracts, certain conditions must be met in order for the contract to be enforceable. Agreements to buy and sell grain (and other commodities) are typically entered into via telephone. Because of the oral nature of most agreements to buy or sell grain, issues of enforceability often arise in association with a dispute. As discussed below, procedural deficiencies related to the enforceability of a grain contract are easily avoided. 16 Confirmation of an Oral Agreement NGFA Grain Trade Rules The NGFA Grain Trade Rules state the proper procedure for the entry into an oral agreement and the subsequent issuance of a written confirmation to form an enforceable contract. Rule 3, NGFA Grain Trade Rules, states: (A) Both the Buyer and Seller shall send a written confirmation, each to the other, not later than the close of the business day following the date of trade, or an agreed amendment, setting forth the specifications as agreed upon in the original articles of trade, or an agreed amendment. Upon receipt of said confirmation, the parties shall carefully check all specifications therein and, upon finding any material differences, shall immediately notify the other party to the contract, by telephone and confirm by written communication. In the case of minor differences, notification may be by either telephone or written communication. (B) If either the Buyer or the Seller fails to send a confirmation, the confirmation sent by the other party will be binding upon both parties, unless the confirming party has been immediately notified by the non-confirming party, as described in Rule 3(A), of any disagreement with the confirmation received. 17 Confirmation of an Oral Agreement Uniform Commercial Code NGFA Trade Rule 3 tracks the Uniform Commercial Code (UCC), which is generally applicable to grain contracts. Confirmations are specifically addressed in three sections of the UCC, namely Sections 2-201, 2-202, and Section provides for the inclusion of additional terms in a confirmation as proposals for addition to the terms of the parties contract (e.g., standard terms and conditions stated on the reverse side of the confirmation). Section precludes the introduction of evidence contrary to terms set forth in writing between the parties (if the confirmation states a price of $4.00, seller is prevented from introducing evidence of a promise to pay $5.00). 18 6

7 Section and the Statute of Frauds The Statute of Frauds refers to the legal requirement that certain types of contracts be in writing to be enforceable. With respect to contracts for the sale of goods, which includes contracts for the sale of grain, the Statute of Frauds (UCC 2-201) provides: A contract for the sale of goods for the price of $5,000 or more is not enforceable by way of action or defense unless there is some record sufficient to indicate that a contract for sale has been made between the parties and signed by the party against which enforcement is sought or by the party's authorized agent or broker. However, UCC makes special provision for a certain category of buyer and seller, the merchant, stating: Between merchants if within a reasonable time a record in confirmation of the contract and sufficient against the sender is received and the party receiving it has reason to know its contents, it satisfies the requirements of subsection (1) against the recipient unless notice of objection to its contents is given in a record within 10 days after it is received. 19 Farmer as Merchant Merchant means a person that deals in goods of the kind or otherwise holds itself out by occupation as having knowledge or skill peculiar to the practices or goods involved in the transaction or to which the knowledge or skill may be attributed by the person's employment of an agent or broker or other intermediary that holds itself out by occupation as having the knowledge or skill. UCC (1). In most states, the status of a farmer as a merchant is a question for the trier of fact. The trier of fact may consider evidence regarding: 1. The length of time the farmer has been engaged in the practice of selling his product to the marketers of his product; 2. The degree of business acumen shown by the farmer in his dealings with other parties; 3. The farmer's awareness of the operation and existence of farm markets; and 4. The farmer's past experience with or knowledge of the customs and practices which are unique to the particular marketing of the product which he sells. See Colorado-Kansas Grain Co. v. Reifschneider, 817 P.2d 637, 640 (Colo. Ct. App. 1991). 20 Effect of an Unsigned Confirmation on a NGFA Proceeding Section 5, NGFA Arbitration Rules, sets out the procedure for initiating a NGFA arbitration proceeding. After a complaint is filed with the NGFA, the National Secretary prepares a contract for arbitration, which is then sent to each party. The contract for arbitration is separate from the NGFA arbitration clause that must be stated in your contract confirmation. The contract for arbitration referenced in Section 5 is a contract between the parties and NGFA to administer the resolution of the parties dispute. If the responding party did not sign the confirmation and the party claims that no contract was, in fact, made, the party may also refuse to sign the contract for arbitration with the NGFA and the NGFA may refuse to hear the matter until the respondent has been compelled to participate. 21 7

8 Compelling Arbitration If a party refuses to participate in arbitration, or if the party initiates litigation regarding a contract subject to arbitration, that party can be compelled to participate in arbitration. Proceedings to compel arbitration can be initiated in either state or federal court. If conducted in federal court, the court will typically apply the substantive law of the state in which it is seated. In order to compel arbitration, the compelling party must establish that an agreement to arbitrate before the NGFA exists and is enforceable. If the confirmation is unsigned (and no master agreement exists between the parties), discovery and an evidentiary hearing may be required to determine if the respondent (a farmer) is a merchant. Proceedings to compel arbitration add a layer of cost and litigation risk that can be completely avoided by adherence to proper contracting procedures. 22 Other Possible Ramifications of Unsigned Confirmations In periods of high market volatility, or general economic uncertainty, lenders may employ greater care in the issuance of credit and/or the oversight of existing credit relationships. If sufficient grounds for insecurity exists, a lender may inquire regarding (or more formally audit) debtor s portfolio of grain contracts. If the portfolio contains an excessive number of unsigned confirmations (or an excessive number of contracts with limited liability entities with respect to which the debtor possesses too little information), it could affect the debtor s ability to obtain further credit or continue the existing relationship. 23 Proper Contracting Procedure Consider a master agreement with each party with whom you contract (see example included with materials). Each oral agreement should be documented at the time it is made (e.g., note the name of the contracting party, the name of the caller, the time of the call, the price, and the quantity in a ledger or in your day planner). A contract confirmation should then be sent [n]ot later than the close of the business day following the date of trade, or an agreed amendment... See Rule 3, NGFA Grain Trade Rules. The confirmation should be mailed with a return-stamped envelope to the other party. Retain a copy of the confirmation, and note the date on which it was mailed to the other party. Upon receipt of the confirmation, the other party should carefully check all specifications therein and, upon finding any material differences immediately notify the other party to the contract, by telephone and confirm by written communication. See Rule 3, NGFA Grain Trade Rules. 24 8

9 Proper Contracting Procedure After three (3) business days, call the other party to confirm receipt of the confirmation, answer any questions, and verify the immediate return of a signed copy. Allow three (3) business days to receive the signed confirmation from the other party. If a signed confirmation is not received within five (5) to seven (7) business days of the date the confirmation was mailed to the other party, follow-up with a call to the other party and either (a) request a meeting with them to sign the confirmation, or (b) re-send the confirmation via a confirmed delivery service (e.g., certified mail, UPS, FedEx). The second copy of the confirmation should be accompanied by a notice to the other party that the contract will be cancelled, and that party is responsible for damages, if any, if the confirmation is not signed and returned immediately. If the other party does not sign the confirmation, within five (5) business days of the issuance of the second copy of the confirmation, terminate the agreement, notify the other party of their breach, and close any corresponding hedge positions. 25 Topic 3 - Identifying Default (Repudiation) In many areas of the law, a party s fault is a factor in determining liability for an act or omission. Generally speaking, however, parties to a contract are free to breach their contract and pay the other party its damages. Thus, determining the measure of the non-breaching party s damages, and not fault, is typically a central issue in disputes involving the breach of a contract. In assessing the measure of damages due a non-breaching party, the finder of fact (a jury/court/arbitrator) must separate the damages caused by the breaching party from those which may fairly be attributed to the nonbreaching party. Stated differently, a breaching party is not responsible for the failure of the non-breaching party to mitigate damages caused by the breach. 26 Contract Repudiation When a party, without warning, fails to deliver/accept delivery pursuant to a contract, the fixing of damages is straightforward; damages are generally established as of the close of the delivery period. However, when a party repudiates a contract, damages can be more difficult to ascertain. Repudiation typically occurs when a contracting party notifies the other party prior to the period of performance that it will not perform pursuant to the terms of a contract. Because damages are fixed as of the time of the repudiation, identifying a party s repudiation of a contract is critical to determining the measure of damages. 27 9

10 The Procedure for Default (Repudiation) - UCC The UCC allows a non-breaching buyer to recover damages from a breaching seller based upon either the cost to cover (UCC 2-712) or the market price/contract price difference at the time of the default (UCC 2-713). With respect to repudiation by a seller, UCC states that the measure of damages for repudiation by the seller is the difference between the market price at the expiration of a commercially reasonable time after the buyer learned of the repudiation The Procedure for Default (Repudiation) - NGFA Grain Trade Rules With respect to a default (including repudiation) by a seller, Rule 28 states: If the Seller fails to notify the Buyer of his inability to complete his contract, as provided above, the liability of the Seller shall continue until the Buyer, by the exercise of due diligence, can determine whether the Seller has defaulted. In such case, it shall then be the duty of the Buyer, after giving notice to the Seller to complete the contract, at once to: (1) Agree with the Seller upon an extension of the contract; or (2) Buy-in for the account of the Seller, using due diligence, the defaulted portion of the contract; or (3) Cancel the defaulted portion of the contract at fair market value based on the close of the market the next business day. See Rule 28, Grain Trade Rules (emphasis added). 29 Repudiation Example In April, Buyer and Seller contract for the November delivery of 40,000 bushels of corn, nearly all of Seller s annual production, for the price of $3.00 per bushel. By July, the market price has moved to $3.50 per bushel. At a Fourth of July picnic, Seller tells Buyer that he does not believe the contract was fair and that Buyer should not have encouraged him to enter into the contract. At the State Fair in August, Seller tells Buyer that he may not have enough corn to perform pursuant to the April contract and asks what it would cost to get out of the contract. At the time, the market price was $4.00. While attending a high school football game in October, Nosy Neighbor informs Buyer that Seller is delivering corn to Buyer s competitor. At the time, the market price is $4.50. By November 30, the last date of the delivery period, Seller has failed to deliver any corn. On November 30, the market price was $5.00. The date of repudiation was: (a) The Fourth of July (b) The State Fair (c) The Football Game (d) The Close of the Delivery Period 30 10

11 Right to Adequate Assurance of Performance If a ground for insecurity exists, a party should demand assurances pursuant to UCC 2-609, which states: (1) A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party, the other may in writing demand adequate assurance of due performance and, until he receives such assurance, may if commercially reasonable suspend any performance for which he has not already received the agreed return. (4) After receipt of a justified demand, failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract. 31 What should you do if the other party to a contract indicates it may not perform? Document the statements/actions giving rise to your concern. Inform your supervisor of the situation and discuss a course of action. Consult with counsel, and consider appropriateness of a demand for assurance pursuant to UCC If assurance of performance is not provided, terminate the contract, closeout hedge positions related to the contract, and proceed with settlement discussions/an action for damages against the breaching party. 32 QUESTIONS? 11