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Lincoln Chen's article on the "Commercial Reasonableness" Standard
Chasing “Commercial Reasonableness” in Contract Wonderland
By Lincoln Chen
You may have seen this in a contract before—“Parties shall use commercially reasonable efforts”—and thought nothing of it. After all, if “all is fair” in the world of business, what does it mean for commerce to be “reasonable”? Is it not reasonable to expect businesses to act in their own self-interest, or perhaps, do contractual counterparties owe each other something more than empty words?
That was the critical question proffered to the Honorable Patti Saris, Chief Judge of the U.S. District Court of Massachusetts. In Skyview Finance Co. v. Kearsarge Trading, LLC, a civil dispute considered by the Court in the fall of 2022, this seemingly innocuous but pervasive contract term led to a judgment awarding all damages sought by Skyview and a full recovery of its legal fees and costs against Kearsarge.
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Whether you are a lender evaluating an investment opportunity or a contractor budgeting for a project, you may be subject to market whims. You may not be responsible for how the market moves, but you are responsible for how you react when the market turns against you.
In the Skyview matter, Skyview and Kearsarge were traders and consolidators of environmental commodities known as SRECs. Skyview and Kearsarge entered into four long-term contracts for Skyview to purchase and Kearsarge to deliver SRECs at a future date. By entering into long-term “futures contracts,” Skyview would profit if SREC prices rose, and Kearsarge would benefit if SREC prices fell. The price of SRECs in fact rose, and when the market moved in Skyview’s favor, Kearsarge sought a way to terminate the contracts. Specifically, Kearsarge, in reliance upon the contracts’ “Adequate Assurance” clause, demanded that Skyview post cash collateral for anticipated trades. The relevant portion of the Adequate Assurance clause stated as follows:
Should either Party have reasonable grounds to believe that the (sic.) either the creditworthiness of the other Party has become unsatisfactory or the ability of the other Party to perform its obligations under this Agreement has become impaired then the dissatisfied Party (the “Requesting Party”) may demand that the other Party... provide assurance of its ability to perform its obligations in an amount determined by the Requesting Party in its commercially reasonable discretion… Such assurance includes… posting cash collateral with the Requesting Party…
Skyview Fin. Co., LLC v. Kearsarge Trading, LLC, 651 F. Supp. 3d 353, 356-357.
The Adequate Assurance clause can be invoked at the Requesting Party’s commercially reasonable discretion. Why then did the Court find that Kearsarge breached the Adequate Assurance provision by demanding Skyview post cash collateral?
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Under the contracts, each party was required to produce audited financial statements upon the request of the other party. Under the belief that Skyview, a private company, would not have audited financial statements, Kearsarge sought to demand Adequate Assurance when Skyview did not produce audited financials upon request.
However, Kearsarge erroneously requested Skyview produce its “latest financials”—not “audited financials”—and even invoked the wrong section of the contracts. When Skyview produced its “latest financials,” the fact that they were unaudited could not serve as “reasonable grounds” for Kearsarge to complain because Kearsarge never requested audited financials. Nevertheless, Kearsarge’s burden for demanding Adequate Assurance was still low. Certainly, Kearsarge could have pointed to something as its “reasonable grounds to believe” Skyview’s financials were “unsatisfactory.”
At trial, Kearsarge’s president testified that it had good cause to be concerned about Skyview’s creditworthiness based on a review of its “latest financials.” However, at the time of Kearsarge’s demand for Adequate Assurance, Skyview reached out to Kearsarge to discuss its purported concerns. In response, Kearsarge’s president wrote in an email, “…I do not want to have a discussion on this... the complexity here is not something we want nor need to spend the time understanding...” Id. at 359.
The Court found that a “reasonableness” requirement meant that Kearsarge must make its demand for adequate assurance “in accordance with [the] duty of good faith and fair dealing.” Restatement (Second) of Contracts § 251, cmt. d; see id. § 205, cmt. a (referring to good faith as “honesty in fact”). As stated by Chief Judge, Hon. Patti Saris:
"Kearsarge owed Skyview a duty of good faith, which [Kearsarge] conceded includes an obligation to have a discussion with a counterparty when an issue arises. Yet [Kearsarge’s president] never sought a discussion about his credit concerns. In fact, he stated explicitly that he did not wish to discuss his concerns."
Id. at 364-365.
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Ultimately, the Court did not need to address whether Kearsarge had any reason to demand Adequate Assurance. In fact, even if Kearsarge had reasonable grounds to demand a letter of credit, the Court determined Kearsarge’s demand for a letter of credit of $2.1 million dollars “was not commercially reasonable and was in bad faith.” That’s because a “commercially reasonable demand for adequate assurance should not be higher than the risk that a party faces if the counterparty fails to perform, namely, the cost of cover in the open market.” Id. at 364.
At trial, the Court heard testimony that if Skyview could not pay, then Kearsarge would have to sell its residual SRECs at the clearinghouse auction floor price of $285 per SREC. That would amount to a loss for Kearsarge of $142,000. On the other hand, requiring Skyview to post a letter of credit for $2.1 million would reduce its line of credit by $2.1 million until Kearsarge delivered the SRECs, nearly 15 times the maximum risk of loss to Kearsarge.
One can conclude then, that the “commercial reasonableness” standard means that neither Party is entitled to a blank check. On the contrary, a contractual demand conditioned upon “commercial reasonableness” must be proportional to the harm that the contractual right is intended to prevent. Here, Kearsarge’s demand was disproportional to the harm. Thus, the Court found that it breached its obligation to act within its “commercially reasonable discretion.” Id. at 366.
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Just like with futures transactions, in litigation, foresight is paramount to success. Not only can seeking the advice of litigation counsel early, in anticipation of a potential dispute, help you protect your rights, it can also help you gain leverage, and maybe even prevent the need for a lawsuit altogether with a tactical display of force.
If you do not personally have complex commercial litigation experience or acumen, and a nuanced understanding of the law to foresee how your actions in real-time can affect a future legal dispute, it may be prudent to find an attorney who does. After all, “all is fair” in the world of business. Hiring the right counsel when a dispute arises is a business decision, and those who make smart business decisions deserve to win.
Christine Kirchner and Lincoln Chen represented Skyview Finance Co. in Skyview Finance Co. v. Kearsarge Trading, LLC.
Christine Kirchner is a shareholder, the Insurance Law practice chair and the firm’s General Counsel. Her clients range from individuals, private entities and closely held entrepreneurial companies to large national insurance carriers and public companies with large, self-insured retentions. She has successfully represented clients in a variety of complex civil matters.
Lincoln Chen is an experienced trial attorney. He represents a broad range of clients in a variety of complex contract and commercial disputes, with a focus on energy and property issues. He has represented some of the largest energy companies in the world, ensuring that his clients receive not only effective representation but also strategic insights.
This article was featured in the Thomson Reuters Contracts / Commercial Litigation Blog, April 2024.