Commercial Reasonableness

The concept of commercial reasonableness is central to, or at least in the shadow of, most commercial, financial, and other business law disputes. Often, a court’s decision turns in whole or in part on whether parties acted in a commercially reasonable manner. A transaction that is not commercially reasonable may be unenforceable. However, there is rarely a clear line for when courts should apply such a standard or consensus on how that standard should be proved or even what it means. My article, Commercial Reasonableness, available here, attempts to provide the requisite clarity.

What does commercial reasonableness mean? Certain sources, such as the Uniform Commercial Code (‘UCC’), enable or require courts to apply a commercial reasonableness standard. Within the UCC, the terms ‘commercial’ and ‘reasonable’ combine in various ways to create a standard that is intended to be distinct from the much studied, though fundamentally different, notion of reasonableness generally. The Official Comments to the UCC observe that reasonableness should ‘be defined by commercial rather than legal standards.’

In business transactions not governed by the UCC, a commercial reasonableness standard often derives from other statutes, contractual language, or the common law. The existence of these diverse sources compounds the confusion over what commercial reasonableness means. 

Outside of a specific context, the meaning of commercial reasonableness can be vague. Parties sometimes refer to commercial reasonableness in contracts. Because contracts rarely define the term further, its meaning may derive from the context, which may turn on the type of transaction covered by the contract. For example, in contracts to sell goods in the future, parties may agree that the purchase price will be one that is commercially reasonable. 

Even when contracts do not actually refer to commercial reasonableness, the common law imposes a duty of good faith as a basic principle of contract law. In a business context, courts increasingly have been merging a finding of good faith with evidence of commercial reasonableness based on established industry practices, referring to commercial reasonableness as a fact-intensive inquiry guided by expert and industry evidence or as complying with established industry benchmarks or commonly accepted business practice. The statutes and regulations that reference commercial reasonableness also contemplate that its meaning should be assessed from the standpoint of the prevailing business practice in the relevant market.

In short, commercial reasonableness derives its meaning from context, by comparing actual business customs and practices in the relevant industry. Admittedly, this practical definition can be, and at least in a UCC context has been, criticized as lacking normative coherence—that the reasonableness of a particular business practice should not be decided by the existence of the practice itself. My article later responds to that criticism in detail. 

How should commercial reasonableness be used? A finding of commercial reasonableness can signal the presence of good faith, whereas the absence of commercial reasonableness can signal the lack of good faith, making a transaction unenforceable. One state’s Supreme Court has held, for example, that the implied covenant of good faith prevents a landlord from withholding consent to a lease assignment except for ‘commercially reasonable’ objections. A judicial finding that a business party acted, or failed to act, in a commercially reasonable manner can determine liability by establishing good faith or the lack thereof. 

Commercial reasonableness also can be a significant aid to resolving ambiguity by interpreting a contract or a party’s actions. In one case, for instance, a litigant successfully argued that his opponent’s interpretation of a term could not be correct because no commercially reasonable party would have agreed to it. In another case, the court declined to enforce an agreement because it was not commercially reasonable behavior to have a business relationship in the relevant setting. 

Statutory schemes frequently condition compliance or remedies on commercial reasonableness, making the standard a gateway to liability and loss allocation. The UCC, for example, imposes various such commercial reasonableness requirements. Failure to meet those requirements engenders a host of remedial consequences, depending on the context. 

The legitimacy of using business transactions to minimize or avoid federal taxes also can involve commercial reasonableness. At least in the United States, tax legitimacy often turns on the business purpose doctrine: whether the transaction has a genuine business purpose (other than tax avoidance). In assessing compliance with that doctrine, courts generally examine the transaction’s commercial reasonableness.

How should commercial reasonableness be proved? Because the meaning of commercial reasonableness depends on commonly accepted actual business customs and practices in the relevant industry, its existence rarely should be determined as a matter of law. Courts ordinarily need proof of those actual customs and practices. 

Courts often treat the proof inquiry as fact-intensive, taking into account how parties actually behave including such factors as the content and timing of notice, advertising and solicitation channels, the composition of the bid pool, sale venue and method, prevailing liquidity conditions, and whether the price aligns with recognized-market quotations or comparables. Such an inquiry may well require expert testimony.

Reliance on expert testimony nonetheless raises the aforementioned normative criticism: that the existence of an actual business practice does not necessarily confirm that the practice is reasonable. Professors Alan Schwartz and Robert Scott thus argue that ‘the question whether a particular business practice reflects “the observance of reasonable commercial standards of fair dealing in the trade” cannot be answered by the existence of the practice itself. The evaluator must have some moral criteria, derived independently of the practice, by which to decide what practices are “reasonable” and “fair.”’ 

In contrast, others contend that norms are and should be factually based and tethered to reality, particularly in a business context where a principal norm is maximizing profits. Furthermore, ‘shared reality theory’ shows that people appraise experiences and events collectively, from which they construct or verify views about various types of issues that, in turn, forms consensus political, moral, or religious convictions. By fostering consensus, common experience creates and strengthens stable norms. An industry practice among rational, profit-maximizing parties therefore may evidence an underlying, socially verified judgment that the practice reasonably reconciles competing commercial aims and constraints. Moreover, courts may have the discretion to discount or exclude expert testimony if, for example, the opinions expressed are methodologically unsound, lack a reliable foundation, or are otherwise unpersuasive.  

To address any remaining normative criticism, my article proposes a multistep approach in which experts could go beyond showing the mere existence of prevailing business practices. In the first step, a court would hear expert testimony as to the existence of an actual business practice or custom. Testimony proving that existence and the relevant party’s compliance therewith should create a strong presumption that such party acted commercially reasonably. The opposing party nonetheless could try to rebut that presumption by offering expert testimony, based on criteria derived independently of the practice, to convince the court that such compliance should not be considered commercially reasonable behavior in the circumstances. The article also discusses judicial precedents that at least indirectly support such a multistep approach. 

This post is based on the author’s forthcoming article, ‘Commercial Reasonableness,’ available here. A version of this post was originally published in the Columbia Blue Sky Blog, available here.

Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and Senior Fellow, the Centre for International Governance Innovation.