Tuesday, December 14, 2010

Warranties - Contract Warranties

A warranty is the highest level of a commitment that a Party can make. The failure to meet that commitment makes the breaching party subject to potential termination of their agreement and also subject to damages.

Warranties can be:
  • A statement of a future right or duty.
  • A statement of a fact at the time the agreement is entered into.

For example, a warranty for defects in material and workmanship provides the Buyer with the right to return defective product in accordance with the warranty term for potential repair, replacement, credit or refund.  A Supplier may want to provide a warranty to the effect that at the time of execution of the agreement, there are no claims against them.

Warranties can be
·      Express meaning that they are spelled out in the agreement. by a statement of fact which is made about the object of the contract and which forms a basis of the bargain. A warranty that says that the Product will comply with the specifications is an express warranty.
  • Implied – a warranty that is not expressly stated in the Agreement but is recognized or imposed by law based on the nature of the transaction.
    1.  Implied Warranty of fitness for a particular purpose – an implied warranty that the item being sold is fit for the purpose for which  BUYER is purchasing it.
    2. Warranty of merchantability – an implied warranty that the item being sold is merchantable (of the quality that is generally acceptable in the line of trade).
·      Affirmative – a warranty stating that a fact or condition is true.
·      Promissory – a warranty stating that a fact or condition is and will remain true.

Warranties have two main purposes in contracts:
  1. Their breach (such as with a fact not being true) can allow the buyer the right to terminate for cause and sue for damages.
  2. They can be intended to drive the warrantor’s behavior by making warranties of future duties during the course of a contract. The incentive that drives the behavior is the threat of the potential breach, termination and damages.

Some companies are “warranty happy” wanting the Suppliers to provide a number of different types of warranties.  For example, every time there is a new governmental action or program there’s a push to add a warranty. I know, I worked for one of those companies. Many focus their warranties on managing several key things such as ensuring you get value for your purchases and you are protected against government and third party claims that could cause you damages or penalties or impact the right to use the purchases.

For the most part when Buyer’s think about warranties they do so in the context of the right to return the defective material for repair or replacement, and these types of warranties are traditional the warranties against defects in material or workmanship that are provided for a specific term. In negotiating these types of warranties and the duration, the Supplier’s motivation may be one of either managing risk or generating revenue. If the warranties will be provided at Suppliers expense, the shorter the warranty period, the fewer the expected failures and the less the financial risk they have in providing the warranty. For products that have on-going maintenance or service contracts, the Suppliers want to negotiate short warranty terms so they can sell those maintenance or service contracts. If you are negotiating a warranty on a product where the Supplier’s main motivation is management of the financial risk, one of the best tools to help with the negotiation is the Supplier’s own data about their product’s reliability. If a product is marketed to have a mean time between failures of 100,000 hours, that means it shouldn’t fail for over 12 years on average. If the Supplier is trying to offer only a one year warranty, use their reliability figures against them. The argument is simple. If they really have a product with 100,000 hours, the incidence (and resulting cost) of failures that would occur in a year 2 or 3 are minimal, so the two are inconsistent.

Exclusions to warranties are important as they can dramatically impact your coverage or cost. For example, some Suppliers may provide a ‘parts only” warranty when the real cost of a problem is the labor it takes to correct it. Other exclusions can be so broad that almost anything will negate it. When you agree to exclusions, they should be limited to only those damages that have been caused by parties other than the Supplier, such as Buyer or Buyer’s customer’s abuse or mishandling of the product and they should be for damage that occurs outside what would be the ordinary or expected use for the product.

Standard Contracts also contain a number of legal warranties such as:
  • Right to enter the contract
  • Performance will comply with contract, laws, regulations, etc.
  • No claims or liens threatened
  • Product or Service doesn’t infringe the IP rights of a 3rd party
  • The Product or Service conforms to warranties and specifications of the contract
  • Free of defects in design and safe for use
  • The Product is new, and not re-conditioned
All of these warranties are there to create obligations on the part of the Supplier to manage against specific risks which could impact the Buyer or Buyer’s Customer’s ability to use the product. The failure to meet these warranties will provide the Buyer with remedies for breach of the warranties under the Contract in which the Buyer could pursue appropriate damages. Because of the criticality of many of these terms any negotiation should be done with the involvement of your legal counsel.

There are several implied warranties that suppliers traditionally want to exclude/
Warranties of Merchantability the Fitness for a Particular Purpose and the Warranty of Title and Non-infringement.

Under the Uniform Commercial Code (UCC) goods must be of “merchantable” quality meaning they:
  • are of fair average quality within the description or are are fit for the ordinary purposes for which goods of that type are used;
  • are of equal kind, quality, and quantity within each unit and among all units involved;
  • are adequately contained, packaged, and labeled
  • conform to any promises or affirmations of fact made on the container or label.
  • may have other implied warranties from course of dealing or usage of trade.
Also under the UCC an Implied warranty of fitness for a particular purpose will apply If the Seller has reason to know of any particular purpose for which the goods are required and that the Buyer is relying on the Supplier's skill or judgment to select or furnish suitable goods.
To exclude the warranty of merchantability the language must mention "merchantability", be by a writing, and be conspicuous. To exclude or modify any implied warranty of fitness the exclusion must be by a writing and be conspicuous.  Language to exclude all implied warranties of fitness is sufficient if it is in writing, is conspicuous and states, for example, "There is no warranty that the goods will be fit for a particular purpose".
All implied warranties are excluded by expressions like "as is," or "with all faults," or by other language that in common understanding calls the Buyer’s attention to the exclusion of warranties and makes plain that there is no implied warranty.

It is important to understand that these implied warranties are provided to a Buyer under the Uniform Commercial Code which really applies only to the United States, which means that in other locations of you need these warranties they would need to be expressly spelled out in your agreement as they will not be implied.  Other Jurisdictions may have other warranties that are implied by law.

In deciding whether they are required you need to look at the circumstances of the purchase,

The implied warranty of merchantability is a form of quality warranty.  It says that the goods must be of "merchantable" quality or simply of good enough quality to re-sell. If you have an agreement that
Disclaims that warranty the expectation is that the purchases will have higher quality requirements than it just be merchantable and that is managed by both the Specifications for the Product and all the Quality Documents that are made part of the Specifications or agreement.  In that situation a warranty that the Product complies with the Specifications or Agreement provides the same protection. 

The implied warranty of fitness for a particular purpose requires that the Supplier must know the purpose and the product will work under that purpose. This warranty may be disclaimed by Buyers when at the time of the agreement is executed the Buyer either does not know or want to share the specific purpose or the Buyer is not relying upon that Supplier’s skill or judgment.

If your agreement is silent as to the implied warranties and would be subject to interpretation under the UCC most of the time the Supplier will propose that the implied warranties be excluded.  Whether you should agree to that is dependent upon the circumstances of the purchase.

Here’s a few questions to help decide if they apply:
  1. Will the Product being purchased be resold as is?
    1. If yes, you may need the warranty of merchantability. If no you may not.
  2. Does the agreement have specifications and quality documents that clearly describe the required quality and/or workmanship?
    1. If yes, you probably don’t need the warranty of merchantability. If no and the answer to 1 was yes, you should have it.
  3. Do you intend to disclose the purpose for which you are buying the product to the Supplier?
    1. If yes, you may need the warranty of fitness for a particular purpose. If no it would not apply,
  4. If you are disclosing the purpose, have you made it clear to the Supplier that you are relying on them to select a product that meets that specific purpose?
    1. If yes, you need the warranty. If no or you are not relying on their skill or expertise you probably don’t need it.

In negotiating it as part of a standard agreement that will be used for the purchase of multiple items over time, you can have situations where it may not be needed for some products and it may be needed for others.  This means that if you disclaim them in the master agreement that you use, you may need to add them for any product specific document and ensure that has priority because it will conflict with the master or vice versa.

The Warranty of Title and Against Infringement;  Buyer's Obligation Against Infringement provides that “the title conveyed shall be good and its transfer rightful and shall not unreasonably expose the buyer to litigation because of any colorable claim to or interest in the goods; and “the goods shall be delivered free from any security interest or other lien or encumbrance of which the buyer at the time of contracting has no knowledge”.
If further provides that if buyer that furnishes specifications to the seller must hold the seller harmless against any such claim that arises out of compliance with the specifications.

When a Supplier wants to disclaim this implied warranty what they are effectivly saying is they want to sell only the right or title as the seller or a third person may have (which shouldn’t really apply to OEM’s that produce a product, or that the seller is selling subject to any claims of infringement which would greatly reduce the potential value to the Buyer. They may also want to take the position on infringement that all the want to provide is the indemnification. There’s several problems with that. Once you eliminate the warranty, especially if you had these as express warranties, if the provide the remedies under the indemnification you would not be able to terminate the agreement nor would you be able to recover damages. Not all remedies in most Intelllectual Property indemnification sections are not cost neutral to the Buyer, and giving up the warranty can force you into having to continue to purchase from the Supplier with a much more expensive solution.

Warranty Redemption

In negotiating warranty redemption provisions, just as Buyer’s are concerned about the Supplier’s quality checks prior to shipping parts, Suppliers are concerned that Buyers have a similar quality process in managing returns to screen out non-defective items and items that would not be covered under warranty such as out of warranty items or damages excluded from warranty. Since many Suppliers are concerned about this they may want samples of the defects to be provided so they can verify the defect prior to issuing a return material authorization to return a larger quantity. Supplier’s may also want to negotiate in no-defect found or no-problem found charges for those situations where the Buyer returns good Product to cover their costs of checking inspecting and testing those returns. Suppliers may also want for the parties to split the cost of the returns with the Buyer paying for the return to the Supplier and the Supplier paying for the return back to the Buyer. For the Buyer, the primary concern is the speed in which the repair or replacement will be performed, as that impacts inventory levels, and anything that delay the replacement forces an increased inventory or longer downtime. Issues like No-Problem found requests can easily be dealt with by offering the Supplier to agree to pay that, if they pay you for all your costs every time they send you a defective product, which is a proposition I’ve never had a Supplier accept. On the issue of time, the Supplier requests are really cumulative. First they want a time to verify the defect, then they want a time to issue an RMA, then they will want time to provide a replacement of perform the repair, the total of which can be substantial and the impact to you is it drives your investment in inventories up. The higher the value of the product, the greater the investment in inventory and the more quickly you need to have the repair or replacement of the product turned around and can’t wait for a serial process to occur.  Any time the Supplier wants to include a conditional step prior to your return, if you are going to agree to that step, you should include a timeframe they have to perform it. As part of the warranty many provisions will also include a form remedy should the Supplier fail to perform such as being able to procure it elsewhere and charge the Supplier the difference. That may not be practical as other Suppliers may not be able to repair replace it and, you may be better off negotiating different performance such as being able to pull new parts from an existing VMI hub. As to the cost of the shipping, my position has always been that we paid for the Supplier to provide a high quality, high reliability product. We also, in many cases paid to have that product shipped to us. Since we paid once, we shouldn’t have to pay again.   

Out of Warranty Service And Support

If you have on-going support commitments to your customers or you are buying a product that will need to be maintained, serviced, repaired or supported, the best time to negotiate those Supplier obligations is before you agree to make the purchases that will need them. If all you do is buy maintenance agreements to meet those needs, your primary concerns in the negotiation are cost, the length of the support commitment and the scope of the services (what they will do, when, how, the response times, and how problems will be managed and escalated etc).  If you do self maintenance or perform service and support for others, as a minimum you need to be able to purchase Field Replaceable Units (FRU’s) and out of warranty repairs. If you will do lower level support you may need to purchase of spare parts, training, tools, test equipment or programs and possibly back up support. The most important things you negotiate in all of this is the term and the cost. The term is how long you can count of the Supplier to provide what you need. The cost is important because if you don’t have control over that in the future, the Supplier could price the support items where it is cost prohibitive to continue with them thereby avoiding all the other commitments, or they can use the fact that you are locked into them to substantially improve their profit at your cost. Once these two things are locking in, the next most important thing is to negotiate response times and escalation processes to assure you get what you need when you need it and that you get the appropriate response when problems arise. Since out of warranty service and support is a great profit generator for Supplier and provides them with a revenue stream year after year, when you negotiate the cost you need to be aggressive. Back in the 60’s when a car cost $3,000, if you purchased all of the spare parts to make that car it would cost well over $20,000 and I’m sure that the situation hasn’t gotten any better. Spare parts, and FRU’s will cost more than the production piece if for nothing more than the fact that they must be individually tested, inspected and packaged so an old rule of thumb was that there shouldn’t be any more than a 30% price premium. The other thing that you clearly need to be aware of is that Suppliers will probably have the tendency of trying to charge more for the items that will need replacement more frequently and may try to charge less for those that have substantially less of a probability to fail just to make the overall cost look better. Consumable supplies clearly fall into the category of things you need to closely watch the pricing on to make sure it is competitive.

In negotiation of repair pricing you need to remember that repairs are just another manufacturing process in which tasks are performed and materials are consumed, so the cost you pay for repairs should be based on the competitive cost of those elements plus a reasonable contribution to their overhead and profit consistent with the industry.

Maintenance contracts also need to be looked upon as just another service. There are planned maintenance calls which have certain labor and materials associated with them and there are break-fix maintenance calls in which there is labor and in most cases the swap out of FRU’s that may need to be repaired.  In negotiating maintenance agreements the biggest unknown is the frequency of the amount of break fix activity. If you can estimate what the planned maintenance portion of the cost is, it’s then easy to back into what the Supplier has allotted for break fix as part of their annual fee to determine whether it is better to have an all inclusive maintenance agreement or pay on a per call basis. Since most Suppliers don’t want you to buy maintenance on a per call basis, they will usually overprice the per call rates and they may also use a connection between contract status and service call priority to try to drive you to a maintenance agreement where the odds are great that it will be more profitable for them. As long as you negotiate all of this before you make the initial commitment to purchase the product you have the leverage to negotiate a better deal. If the nature of the business is really structured in a way where the Supplier is dependent on the annuity stream that on-going support provides, always use that to 1) get the best deal you can on support, and 2) use any reluctance you have with them on giving you what you want for support is leverage to drive the initial purchase price down further.

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