A recent Tenth Circuit ruling in an appeal successfully defended by Brownstein Hyatt Farber Schreck affirmed a lower court judgment arising from a termination for convenience. This decision serves as support to contractors seeking compensation for such terminations.
In Davidson Oil Company v. City of Albuquerque, 108 F.4th 1226 (10th Cir. 2024), Davidson Oil Company of Amarillo, Texas, entered into a contract with the City of Albuquerque (“City”) to fulfill all of the City’s fuel needs at fixed prices. Davidson Oil incurred expenses to secure the fixed prices, but before deliveries began, fuel market prices fell and the City terminated the contract by invoking the termination for convenience clause. The City then purchased its fuel requirements from another vendor at the lower market prices.
Contending that the City’s action amounted to a declaration of “heads I win, tails you lose,” Davidson Oil brought suit against the City in the U.S. District Court for the District of New Mexico for improper termination. It prevailed in that suit and the City appealed to the U.S. Court of Appeals for the Tenth Circuit. The Tenth Circuit affirmed the judgment, finding the termination was a breach of contract.
Although this case applies New Mexico law, the Tenth Circuit’s opinion offers guidance to contractors challenging terminations for convenience under state or federal law. The decision further provides support to sellers of goods that have lost money on hedge contracts due to breach of a supply contract.
Facts
In this case, the facts were undisputed. The City solicited bids from fuel distributors to supply its fleet with diesel and gasoline. Davidson Oil submitted the winning bid, and the parties signed a contract (the “Supply Contract”). Rather than contracting for a set amount of fuel, the City agreed to pay a fixed price for each gallon of diesel and gasoline the City required for at least one year. But the Supply Contract also included within its standard terms and conditions a termination for convenience (TFC) clause, providing that the City could terminate the contract at any time by giving at least 60 days’ written notice to Davidson Oil.
Immediately after entering into the Supply Contract and as the contract anticipated, Davidson Oil purchased 12 one-month hedge contracts. In essence, Davidson Oil paid a third party to swap financial positions with it: Davidson Oil received fixed fuel prices and the third party received the floating market prices. If market prices rose above the fixed prices of the hedge contracts, the third party would pay Davidson Oil the difference between the hedge and market prices. On the other hand, if market prices fell below the fixed prices of the hedge contracts, Davidson Oil would pay the third party the difference between the hedge and market prices. However, if market prices fell, because Davidson Oil had a right to sell fuel to the City at a fixed price under the Supply Contract, the company intended to cover any monthly losses on the hedge contracts with its Supply Contract revenue.
A little more than two weeks after signing the Supply Contract, the City asked Davidson Oil to consider a reduction of pricing under the Supply Contract because market fuel prices had fallen by 7.5% to 12.2% since the parties entered the contract. Davidson Oil declined because due to its purchase of the hedge contracts, a reduction in the fixed prices called for by the Supply Contract would cause it to lose money. Unfortunately, the City responded by invoking the TFC clause, thus terminating the Supply Contract.
Breach of Contract by City
Davidson Oil sued the City for breach of contract and breach of the implied covenant of good faith and fair dealing. The district court denied the breach of contract claim but granted summary judgment for breach of the implied covenant. It awarded Davidson Oil damages for monies lost on the hedge contracts and lost profits. The City appealed to the Tenth Circuit both the finding of breach of the implied covenant and the award of hedge losses. In response to the appeal, Davidson Oil contended that the judgment should be affirmed but on a breach of contract theory and the award of damages upheld.
On appeal, Davidson Oil argued that the Supply Contract had been breached even though the contract included a TFC clause. It contended that the City was not entitled to terminate a fixed price requirements contract solely to obtain a better price. Such a termination rendered the contract illusory; that is, the contract lacked mutual consideration. Davidson Oil was required to prepare to perform the contract by hedging, but the City reserved the right to terminate the contract at will without compensating Davidson Oil for preparation expenses. Unlike the typical federal termination for convenience clause, which allows compensation for “preparations made” to perform a contract, see e.g., FAR 49.201(a), the TFC clause required the City to compensate the vendor only for goods “provided and accepted” prior to termination.
The Tenth Circuit agreed that an illusory contract is unenforceable. It noted that although the TFC clause empowers a party to terminate a contract without cause, New Mexico law recognizes that the clause renders the contract illusory if read literally. To prevent illusory government contracts, a breach of contract will be found where a government agency exercises a TFC clause as an abuse of discretion or in bad faith. These principles of New Mexico law were announced by the New Mexico Court of Appeals in Mb Oil Ltd. Co. v. City of Albuquerque, 382 P.3d 975 (Ct. App. 2016). Mb Oil relied on two of the seminal federal cases concerning limits on enforcing termination for convenience clauses, Torncello v. United States, 681 F.2d 756 (Ct. Cl. 1982) and Krygoski Constr. Co. v. United States, 94 F.3d 1537 (Fed. Cir. 1996).
Based on the facts of this case, the Tenth Circuit concluded that the City exercised the TFC clause in bad faith because it sought only to secure a better bargain. This termination, said the appellate court, constituted a breach of the Supply Contract. According to the Tenth Circuit, a buyer that signs a fixed price requirements contract knows the market price for the commodity will fluctuate but the buyer’s obligation will remain the same. If the market price rises, the fixed price will insulate the buyer from the increase. But if the commodity’s market price falls, the buyer must honor its contract—even though it could attain a better bargain elsewhere.
The City maintained that it did not breach the Supply Contract because its exercise of the TFC clause was due to an alleged “unprecedented decline in oil prices” caused by the COVID-19 pandemic. This argument did not persuade the Tenth Circuit because, in soliciting the Supply Contract, the City acknowledged that the market price of fuel would vary. The solicitation for bids specified that the City would only consider bids with a fixed price, would not entertain bids that allowed for adjustments to the fuel price for “market fluctuation” and would not take into consideration fuel pricing that would change daily. In addition, the appellate court noted, although part of the very purpose of setting a fixed price in a requirements contract is to insulate the parties from market price fluctuation, when the fuel market price changed, the City invoked the TFC clause to seek a better bargain anyway.
The City further argued that its exercise of the TFC clause “rested on more than market fluctuations” because the pandemic depressed purchases of goods and services on which the City levied taxes, causing uncertainty in its revenue. Again, the Tenth Circuit was unpersuaded because as a requirements contract, the Supply Contract was extremely flexible, adapting to changes in the City’s fuel needs. Because the Supply Contract did not mandate a minimum purchase, if the City decreased its fuel usage, the Supply Contract ensured its financial obligation would decrease proportionally. In other words, the City could relieve any budgetary pressure by purchasing only what fuel it needed or could afford.
Although the district court entered judgment in favor of Davidson Oil, it did so on the basis that the City breached the implied covenant of good faith and fair dealing in the Supply Contract, rather than committing a breach of contract by exercising the TFC clause in bad faith. To reach this result, the district court relied heavily on a federal case, Northrop Grumman v. United States, 46 Fed. Cl. 622 (Fed. Cl. 2000).
In Northrop Grumman, the National Aeronautics and Space Administration (NASA) engaged four contractors to jointly construct a space station. But because NASA did not designate a prime contractor to lead the effort, the program operated so inefficiently that NASA began to lose political support for the project. To ensure that the space station would be built, NASA designated one prime contractor and exercised the TFC clause in Northrop Grumman’s contract. Northrop Grumman sued, arguing that NASA had breached the contract by invoking the TFC clause to seek a better bargain. The Court of Federal Claims found otherwise, determining that NASA had not exercised the TFC clause to acquire a better bargain from another source, even if that may have been the result. The appellate court concluded that NASA’s purpose in exercising the TFC clause was to save the space station from inefficient leadership.
Relying on Northrop Grumman, the district court found that the City did not exercise the TFC clause in the Supply Contract to secure a better bargain, but to “revamp its budget” in light of the pandemic. Disagreeing with the district court, the Tenth Circuit found that Northrop Grumman actually supports the finding that the City exercised the TFC clause in bad faith. According to the Tenth Circuit, any bargain NASA received was only an incidental effect of rectifying the inefficient accountability structure impairing the space station’s construction. But here the City sought a better bargain as the central means for revamping its budget.
The Tenth Circuit further concluded that the district court’s reading of Northrop Grumman would create an exception swallowing the rule prohibiting exercise of a TFC clause to secure a better bargain. By swapping one financial explanation—the availability of a better bargain—for another equivalent financial explanation—the quality of a budget—any party could exercise any TFC clause so long as the party says the word “budget,” not “bargain.” Moreover, because any budget will operate more effectively if the budget maker acquires a better bargain, any TFC clause could be exercised in bad faith with no adverse consequences for the agency.
In light of the Tenth Circuit’s holding that the City breached the terms of the Supply Contract by exercising the TFC clause in bad faith to secure a better bargain, it affirmed the district court’s judgment on that alternative ground. The appellate court saw no need to decide whether the City also violated the implied covenant.
Damages Awarded to Davidson Oil
The damages sought by Davidson Oil for the City’s breach of the Supply Contract primarily consisted of losses the company sustained on the hedge contacts it purchased in preparation for performing the Supply Contract. Although the City terminated the Supply Contract, Davidson Oil’s hedge obligations remained in place. In honoring these obligations, Davidson Oil paid to its hedge partner a net of $601,858.99.
The parties agreed that the Supply Contract was governed by the Uniform Commercial Code (UCC). In the proceedings below, the district court found that Davidson Oil was entitled to recover its hedge losses from the City as “incidental damages.” Incidental damages are defined by the New Mexico UCC as “any commercially reasonable charges, expenses or commissions incurred in stopping delivery, in the transportation, care and custody of goods after the buyer’s breach, in connection with return or resale of the goods or otherwise resulting from the breach.” NMSA Section 55-2-710.
On appeal, the City maintained that the district court erroneously found that the hedge losses constitute incidental damages. In analyzing this issue, the Tenth Circuit first concluded the hedge contracts were “commercially reasonable” as required by the UCC because they are a well- established tool by which a commodity seller may insure itself against unfavorable changes in the cost of goods. In addition, the appellate court observed the City acknowledged the commercial reasonableness of Davidson Oil’s hedge contract because the solicitation directed all potential bidders to “have its supplies already hedged ... or the ability to hedge.” Thus, the City expressly contemplated that Davidson Oil would hedge its Supply Contract position.
The Tenth Circuit further concluded that as required by the UCC, the hedge losses resulted from the breach because, among other things, the City terminated the Supply Contract with knowledge that Davidson Oil possessed an outstanding financial obligation to a third party. Incidental damages are intended to put the seller in as good a position as if the contract had been performed.
Based on this reasoning, the Tenth Circuit affirmed the district court’s award of the hedge losses. Moreover, as a result of the Tenth Circuit’s ruling, Davidson Oil was further entitled to an award of $142,715.56 representing the profits it would have realized on fuel sales and transport had the Supply Contract been honored. The City did not challenge lost profits on appeal. Davidson Oil thus obtained a judgment against the City totaling $744,574.55, plus post-judgment interest at 5% from the entry of judgment by the district court. The City satisfied the judgment by paying Davidson Oil the sum of $790,288.81.
Implications of Case
Davidson Oil v. City of Albuquerque is an important case. As precedent, it holds that under a fixed price requirements contract, the exercise of a termination for convenience clause by a purchaser to obtain a better bargain is a breach of contract if the contractor is not compensated for costs incurred in preparing to perform the contract. Although the case is governed by New Mexico law, the Tenth Circuit’s decision may be helpful to contractors in any case, federal or state, where they allege the exercise of a TFC clause by the government is a breach of contract. Particularly noteworthy is the appellate court’s conclusion that regardless of whether other factors may support a termination for convenience, the termination is in breach of the contract if the agency’s central motivation is to secure a better bargain.
Davidson Oil further offers support to sellers of commodities who purchase hedge contracts to ensure their ability to perform the contract. These contractors may cite the Tenth Circuit’s finding that losses incurred on their hedges due to a breach of contract by the buyer are recoverable under the UCC.
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