As economic uncertainty increases so too does the likelihood of a breach of contract in your supply chain. As these breaches become more common, businesspersons often find themselves seeking to understand requirements regarding mitigation of damages.
Sellers' Mitigation
Picture this: As an employee of Alpha Corp., you signed a contract to sell widgets to Xero Corp. Unfortunately, Xero sent you an email indicating it no longer needs the widgets. You wonder, is Xero still required to pay for these widgets? If not, how does Alpha recover its money? You’ve heard the term “mitigation” before, but what does that really mean?
To mitigate damages means to reduce the damages that you suffer due to another party’s breach. While the Uniform Commercial Code (UCC) does not explicitly require that a seller mitigate its damages, it does implicitly impose this obligation, even if the seller has done nothing wrong. In addition, common law imposes a duty to mitigate on sellers.
A seller’s damages typically are calculated by (i) taking the difference in the original contract price and the resale price (or, if the seller is unable to successfully resell the products, the difference in the original contract price and market value), plus (ii) any incidental damages the seller may have, less (iii) any cost savings a seller might have from expenses related to the breach.
For a seller, the duty to mitigate might mean seeking an alternate buyer, even at a lower price than agreed to in the contract. If a buyer fails to meet purchase requirements, the UCC only allows the seller to recover the cost of the goods “if the seller is unable after reasonable effort to resell them at a reasonable price or the circumstances reasonably indicate that such effort will be unavailing.”
A seller may not be able to resell the products to mitigate its damages when the buyer has possession or control of the products. In this situation, the UCC permits the seller to seek a claim against the buyer for the entire purchase price. Similarly, if a seller is not able to resell custom-made products, the seller could also seek a claim for the entire purchase price.
If the seller has not manufactured all of the products identified under the contract, it must execute “reasonable commercial judgment” as to the best loss mitigation strategy: (i) finish manufacturing the products for the contract to resell them or (ii) stop manufacturing the products and resell any parts for scrap value.
A seller may also recover incidental damages for any commercially reasonable expenses incurred because of a buyer’s breach of contract. If a seller receives cost savings from the buyer’s breach (such as lower storage costs), those savings must be netted against the seller’s other damages.
Under our example above, let’s say that Xero Corp. was going to purchase 25,000 widgets, and Alpha Corp. has already made 10,000 of the widgets. Alpha could not find a buyer at the original price, so it sold the completed widgets to another buyer at a discount, with expedited shipping.
In this situation, Alpha could seek damages for the difference between the original contract price and the resale price for the completed widgets. For the widgets that were never produced, Alpha could recover its expected profit on the sale of those widgets to Xero. Additionally, Alpha could seek incidental damages, including the costs for expedited shipping. However, Alpha’s damages would be reduced by any savings on warehousing costs realized by Alpha due to the earlier ship date.
Buyers' Mitigation
On the opposite side of a transaction, a buyer may also have a duty to mitigate damages caused by a seller’s breach of contract. Let’s say Alpha has a contract to purchase widgets from Omega Corp. Unfortunately, Omega notified you that it will not make the widgets for another year, even though it is required to ship the widgets next month. Is it possible to get your money back related to the contract? What if you have to purchase the widgets from another company (also known as “covering”) at an increased cost?
The UCC does not explicitly require a buyer to mitigate its damages if a seller breaches a contract. However, it does encourage the buyer to do so, and failure to do so may impact the damages that the buyer can recover. In addition, common law once again imposes a duty to mitigate on a buyer in the event of a seller’s breach.
A buyer’s damages typically are calculated by (i) taking the difference in the cost of the substitute products and the original contract price (or, if the buyer does not cover with substitute products, the difference in the original contract price and market value), plus (ii) any incidental and consequential damages the buyer may have (other than damages that could have been reasonably prevented by covering), less (iii) any cost savings a buyer might have related to the breach.
If a buyer covers by purchasing substitute products, it can recover the difference between the cost of those substitute products and the price that the buyer would have paid under the breached contract. However, the substitute products must be reasonable and purchased “without unreasonable delay.” If the buyer does not cover, the buyer can instead seek damages based on the difference between the original contract price and the market price of the products (rather than the actual cost of the substitute products).
A buyer can also recover incidental damages and, in some cases, consequential damages. Incidental damages can include reasonable expenses arising from the seller’s breach. If the buyer covers, then damages can include costs of covering. Consequential damages can include any loss resulting from the seller’s breach that the seller should have been able to reasonably foresee at the time of contract and that the buyer could not reasonably have prevented by covering. However, parties often include a waiver of incidental and consequential damages in the contract, which limits the buyer’s right to recover damages.
Finally, if a buyer receives cost savings from the seller’s breach, those savings must be netted against the buyer’s other damages.
Returning to our example above, let’s say that Alpha Corp. needs the widgets within the next three months, so it has to purchase the widgets from another vendor at twice the cost. Additionally, because the replacement supplier is located in a different country there are additional expenses to import the widgets. Because of the delay in obtaining the replacements, Alpha is not able to deliver its final product to its customer on time.
In this situation, Alpha could seek damages for the difference between the original contract price and the replacement cost, and for any incidental damages related to Omega’s breach of contract, including the increased costs for shipping and import expenses. Alpha could also seek consequential damages for any lost profits it suffers by not being able to fulfill its customer’s order.
By becoming familiar with the requirements and protections provided to a non-breaching party, purchasing and sales executives will be better equipped to respond quickly when a supply chain breach arises.
