Thursday, June 30, 2011

Warranty Exclusions For Product Damage

Exclusions to warranties are important as they can dramatically impact your coverage and cost. For example, some suppliers may want to 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 the warranty. I have certain rules on warranty exclusions:
1.     Any exclusion needs to be capable of being objectively measured.
2.     Exclusions 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.
3.     Exclusions should be for damage that occurs outside what would be the ordinary or expected use for the product.
4.     The last rule, and this is important, is the only warranties that should be excluded are those that would be directly impacted. For example, if the Buyer improperly installed the product, that may excuse the warranty against defects in material and workmanship. It shouldn’t exclude all other warranties in your warranty section.
The following are some fairly common warranty exclusions that suppliers try to include:
·       Limit the warranty to the Buyer
·       Improper use
·       Operation beyond capabilities
·       Failure to report defect in warranty period
·       Substitution of parts
·       Damage due to misapplication
·       Lack of proper maintenance
·       Abuse
·       Improper installation
·       Abnormal operating conditions – temperature, humidity, corrosive elements
·       Repair by others
·       Improper packaging and shipping.
Let’s look at each is these.

The exclusion limiting the warranty to the buyer may or may not be acceptable. It the goal is to only have the buyer perform warranty redemption rather than all of buyer’s customers that probably is acceptable. If it’s to have the warranty end if there is a transfer of ownership that probably isn’t acceptable as it would dramatically reduce the value of the product. Many products are purchased with the intent of reselling them as part of another product. If you purchased a major piece of capital equipment, the exclusion of the warranty transferring to the new buyer would reduce the value of the sale adding to your life cycle cost of the purchase.

The exclusion of “improper use” is an entirely subjective measurement. I would want the supplier to either define what proper use is in their specifications or would want them to specifically identify what constitutes improper use. Without either of those a supplier could determine almost anything to be improper use.

The exclusion of operation beyond capabilities would be acceptable if those capabilities are spelled out in the supplier’s specifications that are made part of the contract. If not the measure is entirely subjective and open to abuse.

I wouldn’t agree to the exclusion for the failure to report the defect during the warranty period. That presumes that there would be instantaneous action of notifying the supplier of a defect. Many times a customer will return the defective product to a buyer service depot. The service depot will then investigate the cause of the defect. If they determine the cause is supplier’s product, only then will they seek to return it to the supplier under warranty redemption. As suppliers want buyers to perform that screening type of activity, the time it takes to do that shouldn’t reduce the effective warranty period. As a minimum I would want a reasonable period after the end of the warranty period for any returns to make their way to the supplier.

The exclusion for substitution of parts on its own wouldn’t be acceptable. The key is whether the substitution of parts caused the defect. If it didn’t, why should the supplier be excused from providing the warranty?

The exclusion for damage due to misapplication is subjective.  Before agreeing to this I would want the supplier to show me where and how the correct application is defined if we need to manage against misapplication.

The exclusion for improper maintenance is also subjective. Before agreeing to this I would want the supplier to show me where and how proper maintenance is specified in their specification.

The exclusion for abuse is totally subjective.  In the example below the supplier attempts to describe visual conditions noted to the product that would void warranty rather than simply have the open ended “abuse” measurement. If a supplier wants to exclude warranty obligations for “abuse” have them define what constitutes abuse.

The exclusion for “improper Installation’ is subjective. Before agreeing to this I would want the supplier to show me where instructions on correct installation are defined in their specification. I would also want to make sure that improper installation was the cause of the defective product.

For the exclusions of “abnormal operating conditions” I would ask to see where the operating parameters are spelled out in their specification. I would also want to ensure that the abnormal operating conditions caused or contributed to the defect.

Repair by others should not automatically void a warranty. Many buyers or buyer’s customers may routinely do self-maintenance. The key is whether the repair caused or contributed to the defect. If it didn’t why would you excuse the supplier from the warranty obligation?

The exclusion for improper packaging or shipping is a funny one.  I could potentially see it applying if the improper packaging caused additional damage to the product, but the reason you were returning it in the first place was because it was defective. Improper packaging and shipping shouldn’t excuse them from their responsibility for the original defect. Have them provide you with what they consider proper packaging. Only agree to that where the cause of the defect was the improper packaging or where it caused additional damage to the product. I would never agree to exclusions for improper shipping.  If they were concerned about shipping I would have them specify and pay for the carrier to return the product.

The best way to narrow down discussions on warranty exclusions is to use the “show me” tactic. Everywhere they want to be excused for something they consider wrong, ask them to show you where in their specification it describes how to do it correctly. Everywhere they want to be excused for any form of misuse, ask them to show you where proper use is described in their specification. So they don’t use things as an excuse to avoid their warranty obligation, when you agree to something that would excuse warranty obligations, always require that whatever action you may have taken was either the cause of the defect or contributed to the defect. Never let an exclusion be based on a subjective opinion of the supplier. 

Example from the Internet:
Here’s an example of a simple set of warranty exclusions along with the supplier’s attempt to define circumstances that constitutes the exclusions. 
SUPPLIER does not warranty Products that have been received in any of the following conditions:
  • Improperly packaged and shipped
  • Altered
  • Physically damaged
Upon receipt of product, the SUPPLIER Repair Center will use the following criteria in determining warranty eligibility. If a product as received exhibits any of the following, the warranty will be voided and product returned at Customers expense.
Product received was not packaged and shipped per SUPPLIER packaging and shipping guidelines.
  • Labels are missing.
  • Labels exhibit tampering such as being lifted or reseated.
  • Counterfeit labels.
  • Labels that have been switched and do not match the Product.
    Examples include, but not limited to:
    • supplier label on non-supplier product.
    • supplier label for model placed on a different model.
  • Labels exhibiting damage beyond that caused by normal wear and tear.
    Examples include, but not limited to:
    • Labels that have been defaced such that the model number, serial number, part number, or manufacture date is not readable.
    • Labels with bar codes that cannot be scanned.
    • Seal labels (commonly called pivot seals) that are torn, punctured, lifted or otherwise modified such that the item being sealed is or has been exposed.
Examples of a Product being altered of physically damaged are:
  • There are deep scratches inconsistent with normal wear or tear.
  • There are nicks, dents, bends, or other damage to the cover or base.
  • There are indications that the Product has been exposed to liquid or other foreign substance.
  • There is rust or corrosion on the product.
  • Screws are missing, loose, or cross-threaded.
  • Mounting holes contain broken screws or show thread damage.
  • There have been unauthorized alterations made to the cover or base.
    Examples include, but not limited to:
    • Extra holes drilled
    • Cut-outs added
    • Extra pieces attached
  • Parts of the Product are missing. 
  • Alterations or unauthorized repairs have been made to the PRODUCT.
  • Missing or damaged connector.
    Examples include, but is not limited to:
      • Cracked or broken plastic parts
      • Broken solder joints
      • Pushed pins
      • Broken or bent pins
  • The PRODUCT exhibits damage that is not considered to be a result of component failure or normal wear and tear.
    • Examples include, but is not limited to:
      • Damaged, broken, or missing components
      • Cuts, breaks, gouges to the PRODUCT
      • Scorched or burned PRODUCT
      • The flexible printed circuits are not connected to their respective connectors or are missing/damaged.

In looking through this some of these are good examples of conditions that should probably excuse the supplier from its warranty obligation.  For example a scorched or burned product is probably a good example.  The Buyer may not have caused some of the conditions. For example, a missing label could have been caused by a defect in the adhesive used by the supplier. Just because they supplier can’t scan a bar code may not mean that they can’t identify the product. The key is the condition really a sign of abuse by the buyer that should void the warranty?

Want to learn more? The companion book "Negotiating Procurement Contracts - The Knowledge to Negotiate" is now available on

Wednesday, June 29, 2011

Amendments versus Addendums

In a recent forum an individual asked the difference between amendments and addendums.
When there is a contract that is in existence when you change it, you amend the agreement.  A contract amendment is a bi-lateral agreement to change the agreement. There can be several types of addendums. The first type of addendum is when you need to change a request for bid or request for proposals. That type of addendum is unilateral and does not require agreement by the parties. You could also have addendums included in the agreement when it is signed. Since the agreement requires mutual agreement the inclusion of those addendums requires mutual agreement.

Why would you include addendums in the agreement? 

If you use the bid or proposal requests to establish the scope of work and specifications and you have issued addendums during the process, you have two ways to identify the final scope of work or final specifications. You could re-write the initial documents to incorporate all the changes or additions that were made by the addendums. If you have the time, that is the cleanest approach.  The alternative is to include the original bid or request for proposal document and all addendums that were issued as attachments to the contract.  To eliminate conflicts between the documents you then need to establish the priority between the addendums and the original document they changed. This approach is not the cleanest approach but it’s the fastest as it avoids having to do the re-write.

For example if you had a Request for Proposals dated July 1, 2011 and issued
Addendum 1 on July 10, 2011 and Addendum 2 on July 20,2011, the order of precedence would be:
First to Addendum 2 dated July 20, 2011
Then to Addendum 1 dated July 10, 2011 and
Finally the Request for Proposals Dated July 1, 2011

That would establish the priority between those documents and your agreement also needs to address the priority between those documents and the agreement and other documents that are incorporated into the agreement.

Alternative Dispute Resolution

In negotiating contracts one of the things that must be decided is how potential disputes between the parties will be resolved. Without defining anything else, the primary approach is to try to resolve the problem between the parties and if that fails one of the parties must then decide to pursue the matter in court

As legal fees have increased and the period for trials to be heard has lengthened, parties have looked for alternative ways to resolve disputes such as mediation or arbitration. Clearly mediation and arbitration may be faster, less expensive ways of resolving the disputes, but they also provide an easy way to take the matter to a third party rather than exhausting all efforts between the parties.  In arbitration, the mediators have certain rules of conduct that they must follow, but they are not subject to the rules of contract construction that courts will follow.

If you represent a large company and the other party to the arbitration is a smaller firm, they may expect some sympathy from the mediator or arbitrator who may be similarly situated. Mediators are expected to be experts in the subject matter being arbitrated.  This means that many times the mediator will have worked in the industry of the Supplier or will have had frequent involvement with Suppliers in that industry.  While they are expected to be totally impartial, it’s hard not to form certain opinions or prejudices when you work in or closely with the industry.  If the party that wants arbitration regularly practices in a business from which the arbitrator or mediator would most likely come, and you are only making a periodic buy, the arbitrator or mediator may favor them because they are in the business. In general the odds are usually against the Buyer. I consider a proposal to resolve disputes by arbitration or mediation in the same light as someone proposing that you “split the difference”. The party who proposes it is usually the one who would have the most to benefit.

I’ve also seen individuals recommend referring disputes to an impartial board for decision.  That can have the same problems as arbitration. The difference is instead of having to convince one individual you now have to convince the entire board.

An alternative to arbitration is to propose a formal escalation process for the dispute to be managed within both companies. A dispute may exist only because one party has dug in and refuses to move. It may have become a personal issue for them. There may be no rational or logical reason for their actions. When that occurs it is best to have the matter reviewed at higher levels where the matter is no longer personal. The review of the facts in the escalation becomes strictly of business. The fact that either party can request that the matter be reviewed by a higher level within the other’s organization adds a subtle pressure to come to agreement or have all their facts in order as subordinates don’t want to look bad in the eye of their management.

This escalation process is effectively the same approach you would use to getting past those people whose job it is to tell you no or to place roadblocks in the way of you getting what you want. In business everyone has metrics that they are measured on. If you can escalate the problem to someone who is not measured on the same metrics and can look at the matter from a broader perspective, you have a better chance of reaching agreement. The item will have less of an impact to what they are measured on and as such it is easier for them to reach agreement if agreement is warranted.

If they parties continue to disagree then the complaining parties still would have to decide if they wanted to invest the time and expense to proceed to court. If they feel that they have had their matter heard and have been treated reasonably, they are less likely to sue.

As a Buyer the escalation process may buy you critical time you need to complete the work, or to identify alternative sources and plans in the event that the dispute is not able to be settled in a reasonable manner. 

Tuesday, June 28, 2011

Do Penalties, Liquidated Damages and Remedies Drive Performance

In a recent discussion on someone asked the question of whether or not penalties drive performance.  The responses were varied but I would like to share mine and summarize an observation made of the responses.
Many people kept putting penalties and liquidated damages into the same bucket when they are different. A penalty is an amount that is over and above the actual loss of the party. In many locations penalties are not enforceable.  Liquidated damages can be viewed several ways. A supplier may look upon liquidated damages as a form of limitation of their liability not a form of penalty. If a supplier breaches their agreement the buyer could sue and recover all actual damages they incur as a result of the breach. That amount could be much more than the liquidated damages amount. In that case a liquidated damages provision represents a sharing of the risk.
A buyer should look upon liquidated damages as a way to recover some but maybe not all of losses they sustain from the suppliers non-performance. Remedies are an obligation of a breaching party for failing to meet a specific term.
Whether penalties, liquidated damages or remedies will improve performance will depend the investment trade-off the supplier will make. They will weigh what they would need to invest to perform as agreed against what it will cost them in penalties, liquidated damages, or remedies. If it will cost less to correct the problem they will make the investment and you will get performance. If it would cost them more to correct the problem than to pay the penalty, damages or provide the remedy, it won’t drive performance. If whatever the penalty, liquidated damages or remedy is based upon isn’t realistic, they will drive cost. For a material breach of a contract since you could recover the actual costs you incur, the only thing a liquidated damages provision does is avoid the need to go to court to prove the damages, as the damages were agreed in advance. Some people expressed concern about whether liquidated damages would affect the relationship.  The point I made is that liquidated are a contract right, not a duty. That means the buyer doesn’t have to enforce them or can choose when to enforce them. How they impact a relationship will depend upon how you enforce them. If every time there is even the slightest problem you bring a claim that will clearly impact the relationship. If you enforce them only when there is a significant problem it probably won’t impact the relationship. What they do is allow you to recover incremental costs that the buyer incurs as a result of the suppliers substandard performance that they could also recover as damages in court for breach of the agreement.
The key in structuring penalties, liquidated damaged or other remedies is you never want to provide a supplier with a cheap way to walk away from a problem or to allow problems to continue where you are bearing the majority of the cost of the problems they create.

Liquidated Damages

Liquidated Damages is an amount that is pre-agreed by the parties to the contract on the amount of damages that will be paid in the event there is a specific type of default. Normally liquidated damages are applied when a party fails to perform within the contract period and the amount is established on a time measurement – it could be an amount per hour, per day, etc. 

Depending upon the law is applied to the contract, what you include in the liquidated damage amount could be different.  Under non-English Law based legal systems, the law may allow a damages amount that includes both the expected damages and a penalty.  Under English Law based legal systems, the law of equity was a main principal in the creation of common law. Under the principle of equity you would not be allowed to make a profit on someone’s shortcomings. As such amounts that would exceed the actual damages would be considered penalties and would not be recoverable.  Recovery would be limited to a reasonable approximation of what your damages would be.

Even if there is language in an agreement that said that the amount was liquidated damages and not a penalty, a Court may still look at the amount to determine whether that amount reasonably approximated the damages that would be sustained.  If the court determines that the amount was excessive, that excess amount would not be awarded. Depending upon whether you are the buyer or supplier/contractor you will have a different view of liquidated damages. 

As a supplier you view liquidated damages is another form of limitation of liability in the event of a breach.  Where it’s extremely important for suppliers to want to include liquidated damages would be when the potential for direct damages could that could be recovered without and liquidated damages specified could be substantial. In that case you would want either liquidated damages or a cap on overall contract liability for certain breaches.

If the limitation of liability either had a cap on liability or limited recovery on certain breaches to only direct damages, the contractor might not need a liquidated damages provision for their protection.

Buyers may include liquidated damages provisions for several reasons.

Help drive the supplier to perform on time so as to avoid the payment of those damages.

With liquidated damages the amount is fixed and would be deducted from final payments. Without liquidated damages you would need to go to court to prove you actual damages, which is both time consuming and costly.

Since liquidated damages clauses would be read with any limitation of liability provision, before a Buyer would want to insert a liquidated damages clause into their agreement or agree to a supplier or contractor proposed clause, you should consider it in conjunction with the limitation of liability provision.
What type of damages does the limitation of liability allow you to collect?
If the supplier or contractor failed to perform, what would be the potential amounts and types of damages you will sustain?
What, if any, cap is there on the supplier’s liability?
You would then compare the potential recovery under the liquidated damages versus what you could recover without it to determine if the amount is reasonable.

When I did construction contracting I would ask suppliers to give me two prices, one with liquidated damages and one without. It would do two things. First I could see if a premium was included and second it would provide a good gauge about how confident the contractor was in being able to meet the schedule. If there was a substantial difference between the two prices, I would divide that by the per day liquidated damages amount and that would tell when the contractor really thought the work would be completed.  As schedule or need may be flexible with that information you could work with the business team and identify any premium costs that are associated with the schedule. With that you could potentially negotiate the lower price based upon an extended schedule and still have liquidated damages apply or you could take the deduct and remove the liquidated damages provision. Removing the liquidated damages provision doesn’t mean that you couldn’t claim damages if they were late, it only means that you would have to prove your damages
in court to collect them.

Many people don’t like liquidated damages and argue that they make the relationship adversarial.  I like to deal with suppliers that have a high confidence that they will meet the schedule.  When a supplier strongly pushes back on the inclusion of a liquidated damages amount that is fair and reasonable it shows me that they don’t have the confidence they will meet the schedule and if the schedule is critical I may select a different supplier as a result.