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Terminal Terminations

The unclear language governing termination rights is subject to interpretation and extraordinary financial risk.

Fortnightly Magazine - January 2006

present, the insecure party may demand adequate assurances of performance from its counterparty.”

Regarding the rules for acceptance, Chapter 5 states that “if assurances … are not adequate (in the good faith and commercially reasonable opinion of the demanding party), the insecure party may invoke the early termination and close-out netting provisions of the relevant agreement.” Consequently, similar to the WSPPA, the request and acceptance of adequate assurances is dictated by good faith and commercially reasonable behavior, which as the user guide states, has its origins in article 2 of the Uniform Commercial Code.

What the Law Says

The Uniform Commercial Code is the body of laws adopted by most states to help regulate the laws governing commercial transactions. Section 609 of Article 2 governing the “right to adequate assurance of performance” states “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.” It goes on to state that “(2) between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.”

Again, we are left without explicit guidance. However, the requirement of commercial reasonableness again is present, and it is clear that the request and acceptance of adequate assurance should be in line with “commercial standards” or, in other words, standard-market practice.

Although this sounds vague and legalistic, the requirements that such standards impose should not be ignored. But what is standard market practice? What principles should govern the request and acceptance of adequate assurance?

Assurances: What Is Adequate?

An assessment of standard-market practice governing the request and acceptance of adequate assurances must start by truly understanding the sole function of adequate assurances. In plain English, they are a tool to maximize the probability that a contract entered into by two willing counterparties will run its due course. Consider the following chain of events that demonstrate the use of adequate assurance as a tool of contractual performance:

Example 1: Adequate assurance as a tool of performance

a) Second party is downgraded to sub-investment grade by the rating agencies;

b) First party requests adequate assurances to ensure performance of contract;

c) Second party offers assurances deemed sufficient to ensure performance;

d) First party accepts adequate assurance in good faith if it deems that such assurance is sufficient to ensure contract performance; and

e) Contract continues to expiration.

The first party entirely is within its contractual rights to request adequate assurance after the second party’s downgrade as its contract performance has been called into question. If the second party offers sufficient adequate assurance acceptable to the first party (assuming commercial reasonableness and good faith) then the contract is likely to perform and continue until expiration. However, in recent times a dangerous trend has