Case Study - Nonconformity of Goods

Case Study Key Information

Date: 2002.10.15

Court/Tribunal: Arbitration tribunal, Netherlands

Goods Involved: Rijin Blend condensate (gas-stream liquid product mixed with crude oil)

Key Articles: Arts 35(2)(a), 71, 72, 73 CISG

Summary

The goods involved is known as a commodity with multiple purposes in the oil and gas industry. After years of supply of the goods from S, a group of Dutch companies operating offshore gas fields in North Sea, B, an English oil refining and oil products distribution company, was shocked to discover a containment of high levels of mercury in the latest deliveries of the Rijin Blend. There were no product specifications in the contracts between S and B. B revoked his taking-delivery obligations in relation to both the current lifting and the future contracts unless the mercury problem was resolved. Afterwards, S resold the goods rejected by B to third parties at a loss. The key issues here were whether the Rijin Blend with increased level of mercury were still conforming goods under Art 35 and whether B was entitled to refuse further deliveries.

Facts

In 1993/94 S and B entered 12 contracts for the supply of the Rijin Blend. All the contracts did not contain quality specifications. There were no problems concerning the quality of the Rijin Blend in the initial years. In April or May 1998, B discovered unacceptably high levels of mercury in the Rijin Blend. B discussed the mercury problem with the designated operator at the commingling platform in North Sea without directly notifying S of it. On 1998.06.11, B informed S that he would not take the next mid-June lifting (due to take on 1998.06.13) because the increased mercury levels contained in the Rijin Blend would make further processing and marketing impossible. Several days later, on 1998.06.16, B notified S that he would cease to take any further delivery until a solution of the mercury problem was found. Since no solution was found, B terminated the remaining contracts or led them to expire without renewal. In the intermediate period, S sold the condensate not taken by B to third parties at a loss. S claimed to recover damages from B. B argued that he was entitled to suspend and refuse further deliveries on the ground of the nonconformity of the goods.

Judgment

The Tribunal adjudicated three major issues of the case: First, whether the goods were conforming to the contracts? Secondly, whether B had given a timely defect notice under Art 39(1)? Third, whether B was entitled to suspend and/or refuse further deliveries? On the first issue, Art 35(2)(a) was found applicable, i.e., the Rijin Blend must be fit for the purposes for which goods of the same description would ordinarily be used. Instead of the merchantable and average quality standards used in domestic law, the Tribunal adopted the reasonable quality standard to rule on the conformity issue and decided that the Rijin Blend with the increased mercury levels did not meet the requirements of Art 35(2)(a) for at least two reasons, which were concerned with the contract price and the long-term nature of the sales contracts respectively.

As to price, B had sufficiently proved that when the mercury levels were disclosed to alternate prospective buyers, the contract price could not be obtainable. Since Rijin Blend with increased mercury levels had a significantly lower value than Rijin Blend without increased mercury levels, S should bear the responsibility for removing the mercury or agree to a price reduction, otherwise he would be found delivering nonconforming goods. As to the nature of the contracts, B had sufficiently proved that a pattern had developed, under which B and his customers could expect that the Rijin Blend would have the same quality found in the initial years’ deliveries. The Tribunal considered that the long-term nature of the contracts entitled B to a constant quality level of the Rijin Blend, on which B and his customers could reasonably rely. Therefore, the Rijin Blend with increased mercury levels were not conforming goods.

On the second issue, Art 39(1)’s defect notice requirement was not applicable to the mid-June lifting because that requirement needs to be fulfilled only after a delivery is done. B’s notice of 1998.06.11 was actually a suspension notice. Pursuant to Art 71(3), B was required to give a notice of suspension to S immediately. On the third issue, although B had a right to suspend his taking-delivery obligation under Art 71, his right was forfeited because he had not immediately notified S of the suspension after learning of the mercury problem one month earlier. B was found having failed to send the immediate notice because the designated operator with whom he had discussed the mercury problem in April/May 1998 was not S’s agent, their discussion did not constitute a proper notice given to S. However, the Tribunal considered that B’s notice of 1998.06.16 had been given to S within a reasonable time, he was therefore entitled to cancel the future contracts under Art 73(2).

Comment/Discussion Points

1. Reasonable quality standard

The Tribunal was correct to apply the reasonable quality standard on the ground that reasonableness is a general principle underlying many CISG open-textured provisions. The CISG itself uses reasonableness standards throughout the contractual obligations arising from contract formation and performance. Hence the “reasonableness” approach is a proper method. The CISG does not have a definition of “reasonableness”. According to DCFR (Draft Common Frame of Reference) and CESL (Common European Sales Law), reasonableness is to be objectively ascertained having regard to (i) the nature and purpose of the contract, (ii) the circumstances of the case and (iii) the usages and practices of the trades involved. Any reference to what can be expected is a reference to what can be reasonably be expected. What could be reasonably be expected by B was S to deliver Rijin Blend with reasonable quality. In other words, it was a reasonable expectation of B that the condensate received from S would be up to a reasonable quality standard.

The notion “reasonable expectation” has been elaborated in CISG case law. In a case (also referred to by the Tribunal) decided by the Sweden arbitration tribunal on 1998.06.05, it was held that Arts 35(2)(a) and (b) cover the natural expectations of a buyer if the contract does not contain quality specifications. The buyer’s protection is that he should be entitled to a reasonable expectation of the general and particular purpose of the goods being fulfilled. In another case decided by the German Supreme Court on 2012.09.26, it was held that in order to fulfil user expectations, the goods do not have to be fit for all theoretically perceivable forms and possibilities of use, but only for such uses that suggest themselves in light of the material and technical specificities of the goods and reasonable market expectation.

The two elements in the Court’s reasoning, contract price and the long-term nature of the contracts, can also be elaborated in terms of the notion of “reasonable expectation”. In international wholesale and intermediate trade, a resale of the goods belongs to the ordinary use for which the goods have to be fit, so they must be possible for the traders to resell them. In a case decided by the German Supreme Court on 2005.03.02, the court opined that in intermediary trade, re-sale is to be considered the ‘ordinary use’. In another case decided by the German appeal court on 2006.11.17, the court held that to be fit for commercial purposes, the goods must be possible for resale in view of a reasonable person in the trade sector concerned. B, as a sophisticated distributor in the trade concerned, had proved that the contract price for cover transactions could not have been obtained when the mercury levels were disclosed to alternate prospective buyers. The condensate not taken up by B were resold at a significantly lower price, indicating that they were not fit for commercial purposes. The Rijin Blend with increased mercury levels lacking a resaleability apparently was against B’s reasonable expectation, below the reasonable quality standard, and was therefore not the conforming goods under Art 35(2)(a).

The Tribunal was correct to adjudicate that B was entitled to a constant quality level of the Rijin Blend due to the long-term nature of the sales relationship between S and B. The condensate had been in a stable supply to B for more than five years (1993 to 1998) without major incidents. B sufficiently proved that a quality pattern had developed over this long period. In accordance with the nature and purpose of the contracts between the parties, it was reasonable for B to expect that the Rijin Blend would meet the quality standard it had always been or to claim that he had become used to it over the years. The sudden increase of mercury levels was beyond B’s reasonable expectation, breached the reasonable quality standard, and was therefore not the conforming goods under Art 35(2)(a).

2. Right of suspension and cancellation of future contracts

Art 71 is a self-protection remedy giving the creditor a general right of suspension so that it does not have to perform at the risk of knowingly never receiving a satisfactory performance from the debtor in return. The Tribunal considered that B lost his right to suspend performance under Art 71(3) because he had failed to give S an ‘immediate notice’. An ‘immediate notice’ means the creditor must inform the debtor of the suspension without any avoidable delay. More than one month must have lapsed between B’s notice of 1998.06.11 and the discovery of the mercury problem in April/May 1998, so B did fail to give S an ‘immediate notice’. However, the consequences of such a failure is unclear. Some commentators argue that the obligation to give notice stipulated in Art 71(3) is not a requirement for exercising the right of suspension. If the failure causes any financial loss to the debtor, the creditor is only liable for compensating this loss pursuant to Art 74, but its right to withhold performance is not to be forfeited.

Art 72 provides the right to avoid contract where a fundamental breach is anticipated. The Tribunal seemed to have concluded that S delivering the Rijin Blend with high levels of mercury constituted a fundamental breach of contract. On 1998.06.11, it was legitimate for B to declare an avoidance of the lifting due on 1998.06.13 because it was clear to him the same fundamental breach would occur. Art 72 only requires the creditor to give a reasonable notice if time allows. As the basic requirements of Art 72 were all satisfied, B’s notice of 1998.06.11 might not necessarily be regarded as an Art 71(3) notice, but a simple and plain declaration of contract avoidance under Art 72. In the notice, B seemed to have expressed a refusal to take the mid-June lifting rather than exercising a suspension right. In case of any doubt, the Tribunal should apply Arts 8(2) and (3) to interpret B’s intent or the understanding of a reasonable person in the circumstances. Alternatively, it could be regarded that B had applied Arts 71 and 72 simultaneously by sending one and the same notice.

Art 73(2) allows the innocent party to cancel the future contracts if there are good grounds for it to conclude that a fundamental breach will occur with respect to them. The Tribunal opined that S should be responsible for removing the mercury or agree to a price reduction, indicating that a technical solution of the mercury problem was feasible and the future deliveries might be free of the high levels of mercury. Accordingly, B’s prediction of the occurrence of a fundamental breach with a high degree of probability seemed to be difficult to prove, he therefore might not have the good grounds for cancelling the future contracts under Art 73(2). On the contrary, B should instead be entitled to suspend his obligation to take further deliveries as long as S failed to provide adequate assurance of due performance. In the circumstances, arguably, the future contracts between S and B should be considered as ‘on-hold’. The longer the ‘on-hold’ time, the higher the probability that B would be able to gain the good grounds needed for declaring avoidance of the future contracts under Art 73(2).

In international trade, it seems to be commercially unreasonable to deprive the suspension right of a party like B, who has all the time abided by the contract, just because of a failure to give an immediate notice. By contrast, according to the principle of sanctity of contract, a party like B, who is not able to prove a high degree of probability of the existence of a threatened fundamental breach of the future contracts, should not be allowed to get off the hook. B’s right to withhold taking further deliveries would cease as soon as S could provide adequate assurance that any unacceptable high levels of mercury would be removed from the Rijin Blend before delivery in the future. Arguably, if reading these three articles together, a well-balanced result between the parties’ suspension and cancellation rights should be:

• B’s suspension right was sustained, only liable for paying S the damages in relation to the failure to give notice immediately.