Careful Drafting Pays off in Contracts

Flint Hills Resources, LP  v. Jag Energy, Inc., 559 F.3d 373 (5th Cir. 2009) doesn’t establish any particularly important principle of law. Instead it’s being mentioned because it illustrates the value of good drafting.

Flint Hills, a refiner of crude oil products, agreed to purchase “[a]pproximately 1,000 barrels per day” of “Mexican Condensate” from JAG, a broker in such products. The agreement permitted either party to cancel the arrangement with one month’s notice.

After the contract began, a Flint Hills employee, Rhonda Schlatter, attended a business lunch with Rodrigo Aranda of PMI Trading, the marketing arm of Pemex, the Mexican national oil company and the only authorized seller of freshly extracted Mexican condensate. At this lunch meeting, Aranda allegedly told Schlatter that PMI/Pemex had been experiencing thefts of condensate in Mexico and warned that other companies might be selling this stolen condensate in the United States. Aranda did not name JAG or any other specific company as a suspected seller of the stolen condensate.

Schlatter reported this information to her supervisors, and Flint Hills immediately engaged aWashington,D.C., law firm and a Mexico City law firm to advise Flint Hills about its rights and obligations. The Mexican law firm confirmed that there was an ongoing investigation into thefts of condensate in Mexico, but offered no specific information. The D.C. law firm advised Flint Hills that continuing to purchase condensate from JAG could subject Flint Hills to criminal liability if the product was in fact stolen. Flint Hills did not attempt to contact Aranda or anyone at PMI/Pemex for further investigation.

On March 24, Flint Hills informed JAG that they refused to accept further deliveries due to a legal issue. On March 26, Flint Hills clarified that it was suspending payments until JAG provided title evidence demonstrating that JAG’s condensate was purchased from PMI/Pemex at some point downstream. JAG responded by identifying two of its immediate suppliers and promising to forward documents showing that Pemex was “the first link in one of these chains.” No such documents were ever produced by JAG. After several more weeks of discussion on this title issue, Flint Hills sent a letter cancelling the agreement on May 16. JAG subsequently brought a contract claim in the district court, alleging that Flint Hills breached the parties’ agreement by withholding payment.

The district court held a bench trial and applied Texas contract law. After considering the evidence and the parties’ contract, the court determined that Flint Hills had overreacted to a vague rumor and acted unreasonably in suspending payment. The district court also determined that JAG acted reasonably in refusing to provide a chain of title linking the condensate back to Pemex, as it was industry practice to conceal suppliers for competitive reasons. Accordingly, the district court held that Flint Hills had breached the agreement and awarded JAG damages for the period between March 25 and July 1. Flint Hills appealed this determination of breach.

The court of appeals held that the district court erred and reversed.

In relevant part, the contract provided as follows (emphasis added):

[Paragraph 5]:  In the event of any adverse claim, lien, dispute or lack of information affecting or concerning title to the property or to the crude oil proceeds from lands described in this agreement, Buyer may withhold payment for the crude oil until the claim, lien, dispute or lack of information is settled or resolved, without liability for interest. If requested, Seller agrees to furnish evidence of title satisfactory to Buyer.

[Paragraph 14]:  In the event that either party shall default in any payment or other performance under this or any other agreement existing by and between the parties hereto, . . . [then] the other party, at its option, shall have the right to withhold any payments or any deliveries of crude oil and/or condensate due under this or any other such agreement . . . .

The district court interpreted this language to create a limited right to withhold payment–one available where a third-party brings an adverse claim of ownership or where there is objective evidence of bad title. In evaluating Flint Hills’s decision to withhold payment, the district court repeatedly emphasized that Flint Hills had “overreacted” to a vague rumor and inadequately investigated the general allegations of theft. On this basis, the district court held that Flint Hills breached the contract by withholding payment.

The district court’s focus on the reasonableness of Flint Hills’ own investigation was inconsistent with the contract language. Under the plain terms of the agreement, Flint Hills could suspend payment upon any “dispute or lack of information affecting” title. This right to suspend payment based on a lack of information was not conditioned on the presence of an adverse claim, verifiable proof of theft, or objective evidence of wrongdoing. Furthermore, the contract unconditionally provided that “[i]f requested, [JAG] agrees to furnish evidence of title satisfactory to [Flint Hills].”

Applying these terms to the undisputed facts, the court of appeals found that Flint Hills did not commit breach. Flint Hills was concerned about the source of JAG’s product. Exercising its contractual rights, Flint Hills requested evidence of title tying JAG’s condensate back to Pemex and suspended its purchases until this “lack of information” was resolved. JAG was then obligated to provide “satisfactory” evidence of title. After initially promising to do so, JAG ultimately failed to provide any reliable evidence that its condensate was purchased through Pemex at some point downstream. When it became clear that JAG could not or would not provide this requested evidence, Flint Hills cancelled the arrangement.

Thus, the “lack of information” regarding title was never resolved. Regardless of whether Flint Hills’ initial suspicious were objectively reasonable, its subsequent conduct was at all times authorized under paragraphs 5 and 14 of the contract.

The court of appeals held that the district court committed error by improperly imposing extra-contractual requirements of commercial reasonableness and verifiable proof on Flint Hills.

The district court might have been correct in its imposition of commercial reasonableness on Flint Hills if there were not such an explicit clause in the agreement and Flint Hills had instead relied on the Texas equivalent of California Commercial Code 2609, which allows a party who has “reasonable grounds for insecurity” to demand adequate assurance of due performance. Vague assertions of possible impropriety might not give rise to “reasonable grounds for insecurity” on the part of a buyer. But where the contract expressly provides that a buyer can withhold payment until the seller can provide evidence of good title to the goods being sold, the seller can not escape the consequences of his agreement by alleging that industry custom does not require it or that the buyer’s demand for such evidence was unreasonable.

Lessons Learned

The outcome of this case turned on the text of the agreement, and the draftsman is the unsung hero. The draftsman was probably aware that it was “industry practice” for a broker to conceal its suppliers and that there are sometimes dealings in stolen oil products. By drafting broadly, and expressly including a “lack of information” about title, the draftsman undercut the argument adopted by the district court.

This case was not won on appeal; it was won when the contract was drafted.

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