Warranty against defects in material and workmanship

What affects the warranty against defects in material and workmanship?

1. For the supplier it’s the product’s reliability. As a buyer there should be a relationship between the warranty period and the stated reliability of the product. If the supplier is pushing for a short warranty when they promise a long reliability period that should make you suspicious. If they are confident in the reliability of the product, the cost of a longer warranty period should be minimal.

2. When does the warranty start? Does it start when the supplier ships the product? If it does you need a longer warranty period to take into account the in transit time and the length of time before the product is used.

3. What's covered by warranty? Does it include parts only, when the real cost of correcting the problem will be the labor?

4. Where will the warranty correction be performed? Will the supplier come to your location to provide the service or does it require return to a supplier location.? If the warranty requires the buyer to return the product to a supplier location, which party is paying the cost to ship it in both directions? If you are paying for any of that, in addition to your cost of handling, that’s adding those costs to the relationship.

5. Are you losing the time you don’t have the product while it is being repaired or replaced? Should the time that you don’t have use of it be added to the period? For any repaired or replaced product do you have a minimum period of time that it will be warranted?

6. For a defective product what inspection or test does the supplier want you to perform prior to sending the product back to them? If you have to perform any inspection or test, that is adding to your costs. If the supplier wants to charge a fee for no defect found or no problem found, tell them that you expected them to ship good product so if they want to pay you the same fee for every time they ship you bad product you’ll consider that. I’ve yet to find a supplier that will agree to that.

7. Product Changes. Unless every change is backward compatible with the prior product, you can run into situations where you may not be able to repair a defective product and you cannot use a current product to replace it.

8. Exclusions. Most warranty exclusions proposed by suppliers are far too broad. Exclusions prevent you from enforcing the warranty so exclusions can significantly add to your cost. If you allow broad exclusions your options are to either try to have the product repaired out of warranty for an additional charge or purchase a replacement at full price.There are three separate posts on warranty exclusions.

What warranty affects

1. Life cycle cost / profit. If the supplier’s warranty is less than the warranty you offer your customers on your product sales that includes the supplier’s product that is an uncovered risk. If the product fails after the supplier’s warranty has expired but before your warranty has expired you will bear the full cost of repairing or replacing that item.

2. Product or spare parts inventory. The period of time that you give a supplier to repair of replace a product means one of two things. Either you do not have use of the item during that period, or you need to carry an inventory of products or spare parts to correct the problem immediately while you wait for the return of the repaired or replaced item. The longer that period is, the larger the inventory you may have. It can also affect product shipments and revenue if you need to pull from manufacturing inventory for use with a customer warranty.

3. Competitiveness of service or maintenance charges. When a service organization knows what they have under warranty and for how long, they can take that into account in pricing their service or maintenance charges. Once the warranty expires, unless they sell “labor only” service or maintenance contracts they would need to include the cost to repair items out of warranty or replace defective items with replacements.One of the keys in service or maintenance is understanding how long they can count on the supplier to provide spare parts our out of warranty repairs that may be needed. Once you get to the point where the supplier will no longer provide the parts or service, the service organization may need to stop offering service or maintenance to its customers or charge the customers substantially more and get what they need from any source including cannibalizing and using parts from products they take in trade for new sales.

What’s most important?
Having a good warranty against defects is not a replacement for having high quality and reliability.A good warranty against defects helps manage against only a portion of the costs you will incur with a defective product. Collecting more of those costs usually requires negotiating an epidemic defects provision. Even that will not cover all your costs. Mort important defective products cause customer satisfaction issues. When a customer buys your product and it fails, they don’t care that it was the supplier’s product that failed. All they know is that they purchased the product from you.


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Joint and several liabilities.

If as a buyer you had a supplier parent company and a supplier subsidiary both sign an agreement, what do you have? The answer is you have a situation where each company is liable for their own performance and their own actions, Neither is liable for the other company’s performance or actions. As those two companies are legally separate, you would need to determine if the supplier subsidiary could meet all the obligations under the agreement on their own. If they can’t, you need to make sure that the parent company also is responsible for their performance and actions..

If they parent company was not a party to the agreement, the way you make them responsible to require them to provide a parent or company guarantee (which is discussed in another post).Since they are also a party to the agreement, you can do that by simply including a statement that the supplier parent and supplier subsidiary are jointly and severally liable under the agreement. By including a statement that they are jointly and severally liable what that means is both may be held individually liable for their own performance or actions. It also means that both would also be liable for the performance or actions of the other company. You might want a subsidiary to be severally liable for a parent company so you could bring an action in the location of the subsidiary rather than the location of the parent company. You want the parent company to be responsible for the performance and actions of the subsidiary as the parent company will have greater assets and resources to stand behind the contract commitments.

Do you always need to have the parties be jointly and severally liable? The answer to that would be the same as do you need to require a parent or company guarantee. If you are dealing with a subsidiary of substantial size with substantial assets where they should be reasonable able to cover any potential damages, you probably don’t need it. Many subsidiaries are just sales or sales and service companies with few assets.If you were going to conduct significant business through them you probably should have it.

A key point to remember is just because a company may be a subsidiary or have a supplier’s company name as part of their name, when you buy from that company and not the supplier parent, you do not have any privity of contract with the supplier. You cannot make any contract claims against the supplier unless you either get them to sign the agreement and they agree to be jointly and severally liable, or you get them to provide a parent or company guarantee.


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Joint Drafting

In many jurisdictions, how a court interprets a contract will follow what is referred to as the rules of contract construction. One of the most common rules is that in the event of an inconsistency in the contract, that inconsistency will be held against the drafter of the agreement.

What happens when an agreement is heavily negotiated with both parties having drafted sections of the agreement? When someone else is also doing the drafting, you don’t want to have any inconsistencies in their language be held against you. To deal with this people include what is called a Joint Drafting provision.

A joint drafting provision is a very brief statement of intent by the parties. It will say that the agreement was jointly drafted by the parties and in the event of a dispute you do not want the court to follow the rule that inconsistencies will be held against the drafter. By inserting such a provision the court would follow the intent of the parties. Rather than find against the drafter, they would determine the intent of the parties and would interpret the contract and any inconsistencies in the contract according to that intent.


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Jury trials

Why do companies include a waiver of jury trials in their contract terms?

In many jurisdictions a legal dispute that is taken to court will allow for a jury trial. The jury will decide upon both the fate of the parties and any damages that must be paid. When a company
includes a term in their agreement that has both parties waive their right to request a jury trial they are doing that for a reason. They want both the decision and the damages allowed to be based upon the facts and the law, not the potential emotions or prejudices of the potential jurors. For example in a suit between a small company and a large company, a jury or individual juror may emotionally want to side with the small business just like jurors like to side with injured individuals in suits against large insurance companies. They may relate more to the small business or even be an owner of a small business. They could have been laid-off or made redundant after a large business acquired the small company the work for.

While judges may have their own prejudices they still have to make the decision based upon the facts of the case and the law. Once the facts are established they need to apply the law in making their ruling. They know that if they make a wrong ruling based upon the law, the case will be appealed and the finding could be overturned. They also know that they should follow precedent in any award of damages.

Should you agree to a waiver of jury trials in your agreement? That’s something your legal people should tell you. In my years of negotiating contracts I only encountered one supplier that simply refused to agree to a waiver of a jury trial and that was at the direction of their president who was also the founder of the company. He felt that if he could testify before a jury he could convince them that his company was right and the other company was wrong.Whether he was right or not I don’t know. What I do know is that trials with juries traditionally take longer and cost more in legal fees.


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Confidential Disclosure Agreements and Indemnities

Can there be an indemnity clause in a Confidential Disclosure Agrement that includes indirect losses.That was a question that was posed on LinkedIN

The first question to ask is whose information is being disclosed? A Non-disclosure Agreement (NDA) or Confidential Disclosure Agreement (CDA) could be for disclosures between the supplier and the customer,.It could also cover the disclosure of a third party’s confidential information that the supplier is authorized to further disclose. To disclose another party’s information the CDA or NDA needs to allow you to share that confidential information. If it doesn't you have no right to share that information even if you were to disclose it under a CDA or NDA. If the party allows further disclosures, it will require that you have an CDA with that Customer that protects the third party's rights in their confidential information.

For information between the customer and the supplier there would be no indemnity used.Indemnities only apply to third party claims. A breach of the CDA or NDA would result in damages that are allowed in the CDA. For third party confidential information that the supplier has that they want to share with the customer,you would include an indemnification in the CDA or NDA with the customer. You want the customer to indemnify you if they breach the CDA from claims by the third party that the breach by thee customer will also be a breach of your agreement with the third party.

One suggestion is to always keep confidentiality obligations separate from any purchase agreement so that the limitation of liability and the damages can be different and so the term of the responsibility to protect the information can be different.The key in establishing limitations of liability is what types of losses will you sustain from the breach and what is reasonable. While in a purchase agreement limiting certain breaches to only direct damages may be reasonable, most of the time you don’t want to limit liability based upon third party claims as you can’t control what those third party claims may be.For a breach of confidentiality obligation the question would be what types of damages would be claimed. Any direct damages would be very small. The major damages that would be claimed would be loss of revenue, loss of profit and any consequential damages such as costs to stop any infringements or actions to enjoin the use of or further disclosure of the information. In confidentiality agreements you don’t want to limit liability for breach of the obligations. You want the information held and protected in a manner where there will not be a disclosure.

With third party information there are multiple options to manage it. You could have a separate agreement with the customer and have the indemnification included in that CDA or NDA. You could have a three way agreement, Lastly you could have a separate CDA or NDA be created between the customer and the third party. Each approach has its own benefits and risks,The separate agreement with the indemnification approach may have the advantage of not having to involve the third party in the discussion or negotiations. When you do a CDA with an indemnity you are still liable to the third party. The customer would has to indemnify you. If they don't or don't have the assets to cover the damages, you would still be liable to the third party. A three-way agreement works provided that the agreement is clear that there is no joint liability and each party is severally liable for their own breaches. That way if the customer breached the CDA or NDA the third party would need to proceed only against the customer and the supplier would not be liable for the customer’s breach. Establishing a separate CDA or NDA between the customer and the third party eliminates the supplier as a party to that transaction. Since they are not a party they would not be liable and they would not need an indemnity as the third party would need to go directly after the customer.

There may be times where you may not want to involve the third party because of the sensitive nature of the discussions between the supplier and the customer. In those cases you want no limits on liability, the indemnity, and you want to make sure that the customer has the assets and resources to stand behind that indemnity. For all other situations I would suggest avoiding the indemnity approach and have a separate agreement between the discloser and the third party.
Indemnities don't absolve you of liability and they are only as good as the company that is making the indemnity commitment,


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Doing business in another country

In belonging to a number of groups on LinkedIN one of the best things is you get to see the opinions and comments from people all over the world. What may be common or workable from a contracts perspective in one country may simply not work in another. The laws or “rules” may be different so if you are going to conduct business in a foreign country that you have never done business in before, one of the thing you need to do is take them time to find out what the “rules of the game” are in that specific country.

In one my positions my role was to establish new procurement centers and new plants in emerging countries. To discover “the rules of the game” I would use a number of resources. There are books about doing business in certain countries and I would read them. Most countries seeking trade will have trade missions where you can solicit significant information about doing business in the country. Groups like the American Chamber of Commerce frequently have representative or affiliate offices called AMChams located in countries. If your company is a member of the Chamber of Commerce, you can go and meet with those representatives to learn about doing business in those locations.Through your tax or accounting functions you can get contacts in Tax and Accounting firm’s affiliates that you can learn from.Your legal function should be able to provide you with a firm where you can find out any differences in the law you need to be aware of. Many times your company may have a sales subsidiary or local distributor that they have done business.They can further provide guidance. The more research you do,the fewer surprises you’ll have.

Periodically I will post a reply or post and have someone tell me that what I’m saying isn’t true in their country. I know this will happen as I have done enough business internationally to know that the rules of the game are different in many locations. For every post there may be exceptions. If a reader knows that there are exceptions to a post that apply to a specific country, I invite them to share that knowledge and leave a comment..


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Duties

Duties are a form of tax that is levied on a product that is imported into a country. All products have a specific classification code that is assigned to them. Duty rates vary based upon a number of factors: Rates may vary based upon the specific classification code that is assigned; the country of origin of the product (see post “Certificate of Origin”); whether the country of origin has a free trade agreement with the importing country; or whether the product and the country of origin of the product is subject to any anti-dumping legislation. Duties are paid by the Importer of Record (see post “Importer of Record”).

If a supplier is importing the product for sale by a local subsidiary, the duty they pay will be based upon the declared value, which will be the transfer price of the product in the sale of the product to the subsidiary (see post on Transfer Price) . If the buyer is importing the product the duty they pay will be based upon the declared value, which will be the purchase price. This means that the amount of the duty paid will usually be different depending upon who imports the product. If the supplier is the importer and is selling to Delivered, Duty Paid at their location they pay duty on the transfer price. If a supplier is selling it through a distributor, that distributor will be buying the product and importing it and they will be paying duty based upon the declared value that will the price less their discount. In negotiating the price, don’t assume the supplier or distributor will have paid the same amount of duty as you would have to pay to import the item.

Where duties become a major issue is with warranty returns or out of warranty repairs. Some countries have high import duties and may charge import duties on repaired or replaced product that have been returned under warranty or returned for repair. They may provide exceptions to that duty if the product has a serial number and you can prove that they product that was exported for repair is the exact same product and serial number that is being re-imported, Manufacturers that have significant business within these types of countries will frequently establish a repair center within that country or contract with a company in that country to perform local repair to manage the cost. For example, if you had a piece of equipment that was defective they only thing you may need to import would be a part rather than the equipment or a subassembly and they high duty would only be paid on that part.


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The importance of Documenting Performance

In my introduction to one job I was handed a letter and told, “Straighten this out”. On reading the letter I found that it was a claim from a supplier of construction site work services for some $500,000 plus demanding payment or threatening to take our company to arbitration. The heart of the claim was for a substantial amount of soil that had to be removed from the site and replaced with other good soil. While we think of soil as soil, there are a number of different types of soil that react in different manners when wet. For example “blue clay” is like a rock when it’s dry and it’s like “silly putty” when it gets wet. The reason why this soil had to be removed it was alleged, was that it was marginal soil from the beginning and due to the excessive amount of rains that had occurred, it was thoroughly soaked and therefore could not be compacted as is and could not be dried out in time to meet the completion schedule. Further the supplier alleged that they had taken steps to dry the soil, were unsuccessful and needed to have the soil removed and replaced. The charges in the claim were for the removal, trucking, dumping, purchase of new and placement.

The fact that there had been excessive rains was undisputed. A quick check with the National Weather Service verified the extent. So that couldn’t be argued. A quick review of our soil samples also confirmed that it was they type of soil that could be un-usable if it became thoroughly soaked. So that couldn’t be argued.

The next check was of the resident engineer’s logs and the architect / engineer’s site visit reports. Those were our primary documents as to the contractor’s performance.

In going through the resident engineer’s reports I discovered that prior to the rainy period in question, the contractor had trucked off the site numerous truck- loads of soil. Each truck going on and coming off the site had to check in. So we knew the exact number of trucks that went off site carrying soil and could from the size of the trucks calculate a quantity. A Building site design will have elevations that the contractor must grade and compact the soil to those elevations. The supplier is usually responsible to provide fill to meet those elevations when required. If there is excess fill the supplier is usually required to remove the excess, which they may then re-sell. We established that the supplier had removed a substantial quantity of good soil that could have been piled on site, protected, and used instead of purchasing new soil.

In the review of the Architect/Engineer’s site visit reports I also discovered that they had warned the contractor several times about stripping as large of area as they were stripping. Leaving this soil exposed would create a problem if there were heavy rains because of the nature of the soil. The practice of leaving a large amount of soil exposed was documented to have occurred immediately before and even during the early stages of the rains.

What I had discovered though the documentation was that while they hadn’t created the problem itself, they had multiplied the effect of the problem because of their practices. They left large amounts exposed, which they had been warned against. They further multiplied the effect of the problem by removing substantial amounts of soil from the site rather than stored it on site until the grading and compaction were completed. There was far more soil removed than they needed to purchase in the end, so if they hadn’t removed it and had protected it they wouldn’t have needed to purchase any.

I then worked with the Architect/Engineer to determine what would have been a reasonable amount of area to strip at any one time. That was to identify what amount of soil would need to be replaced if they had managed it properly. We then prepared an estimate of what the cost would be to remove that amount of soil would be and replace it with soil that should have be retained on site and protected.

My $90,000 offer to the contractor was backed up with our calculations, copies of the site logs, copies of the architect’s site visits. As things go, the contractor was not one to give up easy and noted said that they would take the claim to arbitration where they felt they would at least get half of their claim. I reminded them that there was no provision for arbitration in our agreement, We heard nothing for a while and then were contacted by their law firm. The first question from lawyer was whether we could agree to pay $97,000. As the cost of taking the case to court would have been substantial, I agreed. They had looked at the case, considered the evidence, understood that our offer was fair and the case wasn’t worth pursuing as they wouldn’t win.

In a later discussion with the lawyer in getting a release signed I asked him about the additional $7,000 and he explained that the $7,000 was to cover their fees!

Documenting performance is important. In these days of electronic communications if you communicate regularly with a supplier create a folder and keep that just in case you need it in the future whether its to defend against a claim or make a claim of you own.


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Prompt Payment Discounts

Suppliers may offer buyers prompt payment discounts in the quotes such as 2% 10, Net 30.
The means that if the buyer makes payment in 10 days there is a discount of 2%, otherwise payment is due net thirty days.

When a supplier offers a prompt payment discount that means that they have a cost of money or value of money that is higher than the amount of the discount they offered. In deciding whether to accept a prompt payment discount there are several things buyers need to consider.

The first consideration would be whether the buyer’s company has the available cash to make such a payment. The second is whether from a cost or value of money the buyer’s company has, is it financially worth paying the supplier sooner? Without taking compounding into account, In the example of 2% 10 making payment twenty days early is worth .1% a day (2% divided by 20). On an annualized basis that equates to 36.5%, This should tell you that the supplier has a high need to cash. So if your company’s cost or value of money was less that this, you might consider the prompt payment discount.

The last consideration is the potential impact the prompt payment would have in the event there was a problem with what the supplier delivered. Normally you do not want to make payment before you have the ability to test or inspect what the supplier provided to make sure than it isn’t defective and that it meets the required specifications, scope or work or statement of work.

If making a prompt payment and taking the discount won’t give you the time to do those inspections or tests, the amounts you can lose and the problems that can arise because they already have your money can be substantially more costly that what you may have saved.
The simple fact is you always have more leverage to correct any problems before you make payment rather than after.

This doesn’t mean that I wouldn’t agree to take a prompt payment discount, I would just want to make sure that I trust the supplier to promptly correct any problems. What this also requires is procurement needs to work with your accounts payable group to make sure that they are not automatically take a prompt payment discount without your agreement. You don’t want them creating a problem for you just because a prompt payment discount is on the suppliers invoice and it meets the appropriate rate.


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Is payment terms or price more important to the company?

That was a question that someone posed on Linked In. While I have already written a number of posts that are involved with this, I thought I would post my response to that question as it pulls those prior posts together.

Every company has a "cost of money" and a "value of money". Cost of money is what it would cost the company to borrow money. The “value of money” is the return you could make if you invested it. Money also has a "time value" that is usually expressed as either "Net Present Value" or “Discounted Cash Flow". The "time value of money" takes into account the fact that whoever in the relationship holds the money, gets the compounding benefit of that money just like you would get compounding interest in a savings account.

Payment terms are all about the time value of money. The longer you hold it, the more benefit you get. The sooner you have to pay it or the longer you have to wait for a supplier to pay you, the less the benefit to you.

The simplest example I can give is if your company's value of money was 12%. Each month you were able to hold it, you would save an additional 1% plus the compounding value. Each month sooner that you have to pay, it costs you 1% plus compounding,

Where you use that is in price negotiations. Tell the supplier you are including the time value of money in the total cost of doing business with them. To be competitive with other suppliers, if they are demanding shorter payment terms they will need to be that much cheaper to offset the cost of the payment terms they want. In our example if the supplier wanted 30 days when you want 90 and other suppliers will give ninety, you would tell them that they need to be at least 2.083% less than the other suppliers (1% for 1 month and 1% for month 2, plus 1/12 of 1% for the compounding on that 2nd month).

Both are price and payment terms interrelated so both are of equal importance. What you lose by a shorter payment term, you want to be offset by paying a reduce price. What you gain by a longer payment term you do not want to pay any more in the price than what that time value is worth to your company.

When a Company’s financial group provides an amount of discount that would be needed for a buyer to accept a prompt payment discount, they would go through the same process where they determine whether from a time value of money perspective the discount is worth accepting.


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Building Good Supplier Relationships and Trust.

To building good supplier relationships with trust there are a number of things you should do.

1. Be predictable in your dealings. If you always respond to things the same way the other party knows what to be prepared for. If you are unpredictable they could be surprised. Good relationships have minimal surprises.

2. Communicate frequently. The more you communicate the fewer surprises you will have.

3. Tell them what you want. This is no different than what you do in preparing for the negotiation. People aren’t mind readers. If you tell them what you want that sets expectations that they can be prepared to respond to.

4. Tell them why you want or need it and expect the same from them. A supplier may deal with a number of different customers and what you want or need may be different. If they can understand why, they can help you.

5. Be factual. Forget the fancy presentations, smoke, mirrors and B.S. Keep meetings and calls brief and provide them with the facts and get facts from them.

6. Be accurate. One of the best was to ruin a good relationship is to be consistently inconsistent. Every time you are inaccurate in an order or forecasts that will impact the supplier.If they work to help you it’s probably impacting their relationship with another customer..

7. Provide reasons, explanations and legitimacy to back up what you want. Many times for a supplier to do something different for you, they need to go back to their own company and sell their management why they need to do it. Given them the help they need to make that internal sale.

8. When you have a problem, communicate and tell them about it. Many times perceptions of problems are simply misunderstandings. The other party can’t do anything to correct the problem if they don’t know about it.

9. Explain problems in a manner they can relate to. This ties back to #7. To explain it to their management they need to understand it and be able to communicate it in a way their management will understand.

10. Say what you’ll do and do what you say. Demand they do the same. Trust is earned and the easiest way to start to build that trust is to do this.

11. Don’t hide facts and expect the same from them. It normally won’t take long to discover all the facts and if the supplier knew that you only shared part of the story, they won’t trust what you say in the future as being the complete or accurate picture.

12. Be willing to say no when no is the right answer for both sides. When you simply can’t do something, say no and explain why. That makes sure that you both understood what you were saying no to. Many times a no exists because of a failure to communicate.

13. Work together when either side has a problem. If you help them when they have a problem you should expect them to help you when you have a problem. If you don’t, they won’t trust you to help them.

14. Expect to get what you give. If you operate under the “golden rule” where you have the money so you make the rules, be prepared for the supplier to have their “golden rule” where
I have the supply so I make the rules. Abuse when you have leverage doesn’t lead to trust.

15. Recognize good performance as much as you complain about bad performance. Suppliers love to get recognized for their performance. Sales people and internal sales people love to get recognized by their customers as one of their key measurements is customer satisfaction.
A simple “thank you” can do wonders.

16. Eliminate games by either side. Make sure everyone on your team is aware of the relationship that you have and they behave in a manner that supports that relationship.

17. Have an escalation path for disputes. Many relationship fall apart because the people who are in the day-to-day heat of the battle get into a dispute where neither side wants to give in because it will make them look bad or cause them to not meet their metrics. Escalations allow for people with a different set of goals and metrics to look at the bigger picture

18. When you are wrong admit it. Being wrong and not admitting to it may help your ego but it won’t build trusting relationships.

19. Always remember that both of you are in the relationship because you both have something to offer and you both want to benefit from the relationship. If the other party starts to head in the wrong direction make it clear that relationships need to provide benefits to both parties.

20. If they fail you in any way, let them know that future trust will need to be earned by performance. I think U.S. President Richard Nixon said “trust, but verify”. Once burned by a supplier that advice makes sense.


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What are franchisees and contractually where do they stand?

I had a comment left on a prior post asking be to address franchisees, so here it is.

A franchisee is an independent company that has an agreement with a company (the Franchisor) that will include many things. As a franchisee is licensed to use the Franchisor’s name and logos in the operation of their franchise, the company will have many controls in their agreement about what the franchisee can or can’t do. There can be requirements on the purchase of goods, and services from the Franchisor. They may be required to purchase certain services from the Franchisor or participate in regional or country-wide programs or advertising campaigns run by the Franchisor. The franchisee as part of the agreement may be granted exclusive rights to certain locations, areas, or even countries. The franchisee paid the Franchisor a fee to purchase those franchise rights. They may make additional payment similar to royalty fees based on their performance and sales and they will pay for any products or services the Franchisor requires them to purchase. As long as the franchisee operates their business in accordance with their agreement they get the rights to continue to operate the business and use the Franchisor's name. If they breach their agreement, the Franchisor could stop selling the what they need to operate and seek an injunction against their using the Franchisor’s name or brand in the future.

From a contractual perspective, the Franchisor has no ownership interest in the Franchisee. There could be a financing agreement between the two companies where the Franchisor would be a secured creditor, but any ownership interest in a franchisee by the Franchisor is not common. A franchisor may operate their own locations and when they do those would be subsidiaries. A franchisor could potentially repurchase the franchise rights with the intent of operating it as a subsidiary or reselling the franchise rights to a third party. Any rights to repurchase would either need to be included in the agreement or would require mutual agreement.

Since the franchisee is an independent company, the Franchisor has no liability for the franchisee. If the Franchisor, as part of the sale of goods or services to the franchisee, provided warranties or indemnities that the franchisee could pass on to their customers, a customer could enforce those. Barring that the only liability that a Franchisor could have would be tort liability claims for personal or property damage that was caused by the Franchisor’s product.

This means that a franchisee from a contracts standpoint would be equivalent to a minority owned subsidiary or an affiliate that the company did not have control over with one difference.
In both the minority owned subsidiary or affiliate lacking control the Company would still
lose based upon their ownership share in those companies and that would effect the profits they could return to the company. In a franchisee situation, unless it’s a product liability clam, all losses and damages would be borne by the franchisee.

From a sourcing perspective this means that even though they may have the franchisor’s name on their business, for anything other than product liability you could only look to the franchisee and you should qualify them as a compete separate company before buying from them.


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Step pricing versus bill-backs

Every buyer wants to get the price for a quantity of 100,000 units without making a firm commitment to purchase that quantity. Suppliers that are use to dealing with this will usually counter with a proposal of either step pricing or discounted pricing with bill-backs if quantities are not met.

The concept of step pricing is simple.
The first X units are at _______________
The next X units are at _______________
The following are at _______________
Etc, etc, etc.

Under a bill-back approach the price would be provided at the highest quantity, but is you failed to purchase the entire quantity that the price was based upon, you would be obligated to pay the difference between the price you received and the price that you would have actually earned based upon your actual quantity purchased.

The major advantage of step pricing is there are no bill-backs if you fail to purchase the quantity. You earn the reduced price based upon the quantity of purchases that you have made. The major advantage of the bill-back approach is you get the low price throughout. A second advantage of the bill-back is you have the use of the that money difference in payments until you have to pay the bill-back amount. The major disadvantage is that if you fail to purchase the quantity, while you are not obligated to purchase the remaining quantity you are subject to the bill-back on the difference between the price you actually paid versus what you would have at that quantity.

Both approaches are good in that they are not making firm commitments to purchase the high quantity. The major issue you should be concerned about in negotiating a deal with step pricing or bill-backs is the cash flow and the time value of money. With step pricing scenarios you pay the supplier at a higher rate earlier so in the interim they have the use of the money. With the bill-back approach you have the use of the difference in the amount until you have to make a bill-back payment. Suppliers who are aware of this impact will usually structure the prices as specific
volumes differently depending upon whether its a step price or a bill-back approach. The prices for step pricing would usually be lower than the bill-back prices at the volumes as the supplier is having the use of the money in the interim period.

If you have a supplier propose either method calculate what your unit costs would be at various levels to determine which is the best approach to follow. If you agree to use the bill-back approach you need to be prepared to have to pay the bill-back if you do not meet the required quantities, One way to do that would be to work with your accounting people to establish a reserve where you pay the supplier the estimated quantity price and sell transfer the product to the internal customer at a higher price with the difference being placed in a reserve. If you don’t meet the needed quantity you pay the bill-back out of the reserve, if you do meet the needed quantity the reserve can be paid to the internal customer to reduce their cost.


If you learned from this post, think about how much more you could learn from the book.
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Free Trade Zones

Anyone that negotiates international contracts should know what free trade zones are and how they can be used. A free trade zone is an area designated by the government that exists prior to customs clearance for items being shipped into a country or after customs clearance for items being exported. It’s an physical area that normally consists of a large number of warehouses where access is controlled.Those warehouses may be operated by the government or by a third party. Many countries require that privately run warehouses be “bonded”.You can have goods be stored, have value added operations be performed all without payment of an import duty provided that any privately run warehouse puts up a customs bond.The liability under the bond is cancelled when the item is exported, withdrawn from the warehouse, destroyed, or imported and applicable duties are paid.

Since the free trade zone is technically not located within the country, purchases or sales that occur within those free trade zones are not considered local sales. They are considered international sales. As an international sale, a foreign company that makes a sale there does not have to be legally registered to do business within that country.Further as an international sale the seller is also not subject to that country’s laws or taxes. For exports held in warehouses, the Seller had to clear customs. The exporting seller would still be subject to local laws. How taxes on export sales that occur within a free trade zone may vary by country as to income tax treatment, but export sales that occur in free trade zones would normally not be subject to any sales or value added taxes as the sale is technically occurring outside of the country. Each country has their own rules on Free Trade Zones such as bonding requirements or the period an item may be held in a free trade zone. For example for U.S. free trade zones the maximum length of time the item may be held is five years.

While you can accomplish many o the same things by having sales and title transfer “when the product is on the high seas”, free trade zones can provide significant other advantages. For example, in Just In Time models, a supplier could establish a stocking hub in a free trade zone for pull by the buyer. The materials are being held closer to your point of use and the supplier has more flexibility. They avoid having to be legally registered to do business in that country and avoid being subject to that country’s laws and taxes. They would also be able to ship any excess stored product to other locations. If they imported the product to the stocking hub within the country, they would have to pay a duty that may not be recoverable if they exported it for use by other customers. They would also have to clear customs, By holding it in a free trade zone, no duty is paid until its imported and there is no issue shipping it to another country as it was never legally imported.

In addition to stocking hubs, you can use free trade zones to take advantage of low cost labor to perform things like repairs or value added activities. If you brought the item into the country you would need to have paid an import duty, which can be high in some countries. When you turn around to export it, you may not recover the full value of the duty paid and the recover process can be lengthy. If you have those activities be performed in a free trade zone, you never paid those duties in the first place. For example, you could have a repair operation where bad circuit cards were shipped to a free trade zone located in a low cost labor country and have individuals cannibalize cards to create working cards for spare parts. As long as you ship both the repaired card and the cannibalized card out of the country, you get the benefits of the low cost labor without needing to be registered to do business there.


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The Good, The Bad and The Ugly of Cost Savings Programs

The Good, the Bad and the Ugly of Cost Savings Programs

Most procurement groups have goals or targets they need to meet for cost savings. I thought I would write a post about what I consider to be the advantages and disadvantages of such programs.

Let me start by saying that I’ve worked for companies who year after year would report significant cost savings. In fact over time if you added all the cost savings up the suppliers should have been paying the buyer to take the product. That simply did not happen in fact the suppliers still made a profit. How did this occur? I think it all goes back to the fact that most products have a limited life cycle. During the term of a product’s life most products also have a price curve (see Price Curves post). In the introduction of a new product with new features, functionality or improved performance
where there is little or no competition the price always starts high, is driven down by competition, and usually goes up toward the end of its life as competitors exit that market. Supplier’s end of life products when they have replacement products with those
new features, functionality or performance. This means that the prices that the buyer worked so hard to reduce the cost of are no longer available and they need to start the
process over again with the replacement product.

The Good/
What’s good about cost savings programs? It places a clear focus on reducing cost. It eliminates complacency. I remember a commodity manager who reported to his manager that for that year he couldn’t drive any savings. The manager simply replied
“then what do I need you for.” The message was sent and savings were found. It can drive reductions in price because of that focus. Those savings can also do good things. For the internal customer it can expand their budget or allow them to lower their price or simply make more money. For the company it can generate additional cash to make investments. For procurement the programs can help drive you to find new, lower cost suppliers that can meet your requirements

The Bad
What’s bad about cost savings programs? Any metric that people get measured against
will drive the individual’s behavior. If all you measure is reductions in price the individuals may be assuming more costs or risks in dealing with suppliers, more costs or risks in terms, or more total life cycle costs simply to generate price reductions. I’ve never seen a cost savings program where the results were measured against the total life cycle of a purchase. The second thing that is bad about cost savings programs is suppliers that know about your program will plan for and manage that to their advantages. If a supplier knows that every year you will come back to them seeking to further reduce the price, do you think they will take that into account in their initial product pricing and in any reductions they give? Suppliers manage their pricing (See Pricing - How Suppliers manage their pricing). With the exception of commodities that are highly volatile, suppliers know what their costs will be. They know how much they can save from volume, learning curves, liquidation of investments, etc. If they know you will be back next year for more savings, do you think they are going to give you the best price today? Will they hold some in reserve for next year? I think they do.
The other area where cost savings is bad is when you have multiple suppliers for an item. Assume you have three qualified suppliers. At the time of award all suppliers prices are competitive. Supplier A you have a contract with that meets all your requirements. You plan to give Supplier A 60% of your business as that’s equal to their available capacity Supplier B you have a contract with but it has certain additional costs or risks that Supplier A. You plan to give Supplier B 30%. Supplier C has refused to come to agreement on certain terms but they have a product that is qualified. You need to keep them in the event you have a problem with either A or B. You plan to give Supplier C 10%. During the course of the year either Supplier B or Supplier C approaches you and offers you a price reduction of they get a larger percentage of the business. Do you give them more so you can meet your cost savings goal, or do you stick with the original percentages. If a supplier knows that they can not agree to your terms and increase the amount of business by simply giving you a lower price, what impact does that have on your contract negotiations with them? I’ve seen this happen too many times. Then a problem occurs whatever the savings was pales in comparison to the losses.

The Ugly
What’s ugly about cost savings programs? The ugly occurs when they buyer that is seeking to reduce cost is simply over their head in terms of knowledge and capability that’s needed to effectively manage what is required to drive savings. One of the best examples of this is sourcing in low cost geographies. For every one company that has been successful in sourcing in low cost geographies, there are probably 10 companies that have horror stories to share. They had problems simply because they didn’t know what they were doing, didn’t want to invest in doing it right, or because they hired and trusted someone that simply didn’t warrant that trust. They may not have realized that contract protection in low costs countries is simply not the same as contract protection at home. They may think that suppliers will respond like the supplier down the street when they don’t. A second great example of ugly is when companies use “Independent Distributors” to generate savings (see Independent Distributors and Brokers post). I’ve personally seen a number of situations where people went to independent distributors and brokers to wind up with counterfeit product that failed in their application where the cost was in the millions and the chances of recovery was slim to none.

If you would like to read about any of the referenced posts go to my wen site
knowledgetonegotiate.com click on the tab hot-links to blog and simply scroll down to the title. It;s hot-linked to the blog topic

Subsidiaries and Affiliates & Franchisees

What is the difference between a subsidiary and an an affiliate?

A subsidiary is usually defined by ownership. For example a parent company have wholly owned subsidiaries where they own 100% of all shares in the company. The parent company may also call a company a subsidiary when they own a majority interest in the company. When a company owns less than controlling interest in a company’s shares they company is usually called an affiliate.

In contracts and in dealing with things like company or parent guarantees you should define the term affiliate. In most cases suppliers do not want to be liable for their affiliates as they only have a minority interest in the affiliate. In some cases that may be true, but in other cases you can have situations where the parent company doesn’t have majority interest in a company but they do have control over the affiliate.

Where this was first very common was when you were dealing with Japanese suppliers that were part of a Keiretsu, which is a family of companies that have interlocking ownership. For example you could have five parties 1) Acme Inc, U.S, 2) Acme Ltd, UK, 3) Acme PTE,Singapore, 4) Acme BV
Netherlands, and 5, Acme GMBH Germany.

The Acme Inc. may not own a majority interest in Acme PTE, in fact they may not own any interest directly. They could however have their three subsidiaries have the following ownership in Acme PTE.
Acme LTD = Forty percent (40%)
Acme BV = Thirty percent (30%)
Amen GMBH = Thirty percent (30%)

None of those subsidiaries have controlling interest in Acme PTE. Together they own the company. If there total interest exceeded fifty percent (50%) they would still have controlling interest in Acme PTE..

Since the parent company (Acme Inc,) owned all or had a majority interest in all three subsidiaries that owned or had controlling interest in Acme PTE, it can be argued that Acme Inc.through their ownership of their subsidiaries, and their subsidiaries ownership and control over Acme PTE, Acme Inc has control over the actions of Acme PTE. They control the companies that control that subsidiary. If they have control over the actions of Acme PTE, they should be responsible for the actions of Acme PTE..

Many companies include a definition of an affiliate based upon their ability to exercise control over that affiliate. When you do that, contractually you treat those type of affiliates the same as the supplier’s subsidiaries where you want the same terms and pricing to apply for purchases through those affiliates. You also want the parent company (in our example Acme Inc.) to be responsible for those Affiliates in the same manner they are responsible for their subsidiaries.

If an affiliate company (even one whose name may include the parent company’s name in their company name) doesn’t meet the defined requirements to be an "Affiliate", buyers need to recognize that they are not dealing with the supplier, they are dealing with a completely independent legal entity. If you write a contract with them, the Parent Company is not a parent to them and they will not agree to be responsible for them. That affiliate will be the only company that is standing behind the contract commitments. The sole exception to this would be when the affiliate company is functioning as an authorized reseller of the parent company's products. As with any authorized reseller you should get any warranties or indemnities that the Supplier authorized
them to pass through to the customer.

Someone posted a comment asking me to also address Franchisees. A franchisee is a completely independent legal entity that has a license from the company to operate with the scope of the license grant. The supplier has no legal ownership in the franchisee company. They could have a potential credit relationship with the franchisee. Since they do not have ownership a franchisee
falls into the same class as an affiliate in which the supplier doesn't have control. The supplier will not agree to be responsible for their actions or omissions. Similar to an affiliate, if the franchisees role is strictly as a reseller of the supplier's products the franchisee can only provide you with any warranties or indemnities that the supplier has authorized them to pass through to the customer.

While the supplier may not be contractually responsible for affiliates (meaning companies they do not control) or for franchisees, the supplier would still be potentially liable for any damage or injury caused by their product.


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Independent Distributors, Brokers

In recent year the term independent distributors has arisen. While the name was clearly intended to make them sound like authorized distributors, what they really are is brokers that purchase and carry inventory speculating on future demand or shortages. Whether you call them independent distributors, brokers and grey market sales the terms that all refer to the same type of activity. They are companies that purchase and resell products from unauthorized channels. The source of their materials may be from companies that sell off their excess materials. The source may be:
1. authorized distributors that purchased in excess of their demand to drive a greater discount on their purchases.
2. other independent distributors or brokers.
3. from shipments that were damaged in transit.
4. from irreputable supplier’s who had quality problems with a lot where it would cost too much to screen out the good parts, but don't want to lose the value in what may be good ones. Those sales are strictly as-is.
5. counterfeiters.

The simple fact is when you buy these you don’t know:
a)where they have come from,
b) how they have been handled;
c) how they were stored;
d) or whether they are the real thing or counterfeit.
Counterfeiters have also become so adapt at counterfeiting products that most suppliers can’t determine whether the product is real or not simply from a date or lot code. They would need to do destructive tests.

Since you are not purchasing the product from the supplier or one of their authorized distributors, the original manufacturer of the product has zero obligations to you in the event there is a problem. You have no privity of contract with them and an unauthorized channel has no right to pass through any supplier warranties that an authorized distributor can provide. Any agreement or purchase order that you write is strictly with the specific party you purchased the product from. That company is only a buyer and seller of products. They do not have the capabilities that the original supplier has when it comes to correcting a problem or defect. They may be able to provide you with a replacement if they have one. If they don’t the best you can get is a refund of your money. They also will not have the financial strength that the supplier has in standing behind any contract commitments. Your ability to enforce any terms or recover any monies with a foreign independent distributor or broker would be both difficult and costly.

I would also be very leery when the suggestion to use and independent distributor comes from the contract manufacturer. I’ve run into situations where a contract manufacturer that was having problems getting supply suggested that we use an independent distributor.I did some checking found out that the “independent distributor” was not really independent. The independent distributor that was owned by the contract manufacturer. I then realized that the contract manufacturer may have been purchasing more quantities than we needed under our authorization and contract price and probably was selling those to their distribution company. They were counting on the fact that there would be times when we had inaccurate forecasts and couldn’t get it from the supplier in time or there would be a shortage where in both cases they could sell those products at a premium. That meant we would be losing in two ways. We would not get any warranties or protections from the original supplier and we would also be paying a significant premium price to get the products.

Independent distributors, brokers and grey markets should be a last alternative in sourcing products. They should never be used to try to reduce the cost.I’ve seen people do this and wind up with counterfeit products that failed in their application. The net result was millions of dollars in service calls, rework costs and huge customer satisfaction issues and a claim against a broker that simply didn’t have the assets to get any significant recovery against.

The old Latin saying "caveat emptor" or buyer beware is a must any time you consider dealing with unauthorized product channels.


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Multiple Parties to a Contract

Any contract may have 2 or more parties that sign and agreement. For example in dealing with a partnership all partners would sign the agreement or you would need a resolution from the partners that one of the partners is authorized to sign on behalf of the partnership.You could have a Supplier and their Subsidiaries all sign an agreement.You could have a buyer and all their subsidiaries sing an agreement.You could enter into a three way non-disclosure agreement, etc.

When you have multiple parties to an agreement there are several issues that need to be managed.

The first is managing your potential liability under the agreement. As a Buyer, if you bring a third party into a relationship with a Supplier, you don’t want to become liable for the third party’s actions. To do that you want to disclaim liability for that third party. For example you negotiate an agreement with a supplier for a custom product. You then want a third party to purchase the product. If you make them part of your agreement, unless you disclaimed liability for their actions and purchases, you could potentially be liable for that third party’s actions. Alternatively you could not have them be a party to the agreement.Since the product is proprietary to your company the supplier cannot sell it to the third party without your authorization. One way that I’ve managed this is to have a term in the agreement where the supplier agrees to sell the product to third parties that you authorize by letter at the price you negotiated. You allow the supplier to establish whatever purchase terms they need to protect themselves in their agreement with the third party so its clear that they are not relying upon you. If the third party was financially unacceptable the supplier could refuse to sell to the third party and you would need to purchase and resell the product to them.

The second issue when you have multiple parties to the agreement such as when you have a Supplier and their subsidiaries, in the event of a problem who can you collect from? Even though both parties signed the agreement each would only be liable for their own actions or inactions. If you want all of them to be liable up to the full extent of the potential contract liability you would need to add language in your agreement that the parties are jointly and severally liable. In doing this if the problem arose from one of their small subsidiaries, this would allow you to only go against that subsidiary and the parent company that has “deepest pockets”. Joint and several liability is similar to requiring a parent or company guarantee in the situation where the agreement is with the subsidiary and the parent company is providing a guarantee on the financial performance of the subsidiary.

Most companies should not want to sign an agreement that includes their subsidiaries. The first reason for that is from a tax perspective that want the relationship to be what's called "arms length transactions". Legally they want to keep the companies operating separately so parties dealing with the subsidiary can't make claims against the parent. The last reason is many times a subsidiary may not be wholly owned by the parent company. In some subsidiaries they may only have controlling interest.There are also countries that would not allow a foreign company to own a majority interest in a local company.In this situation them might own 49%, have another company own 40%, and have the remaining 11% owned publicly with restrictions against the local 40% owner from being able to purchase any of the 11% so they could never get controlling interest.Most parent companies simply do not want to be liable for the acts of subsidiaries that are not wholly owned.In situations where they do not have 100% interest they have to share with the other owners the profits that are made by that subsidiary. Since they don't get 100% of the profits why should they want to assume potentially 100% of any losses?


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Damages and Indemnity & How Terms Are Interconected

In a LinkedIN group an individual asked the question “What’s the difference between damages and indemnity? I thought that this would be a good topic to write about and at the same time discuss the inter-relationship between a number of contract terms. 

In contracts "damages" are what you sustain from a breach of the agreement. Damages are also what third parties could claim for damages to their property or for personal injuries. Indemnities provide you with protection against third party claims for injuries or damages they sustained as a result or actions by one of the parties to the agreement.

There are various types of indemnities. General indemnities provide protection against personal injury or property damage. Intellectual property indemnification provides protection against third party claims of infringement of their intellectual property rights. Most indemnities have the supplier indemnifying the buyer against claims caused by the supplier's actions, exceptions to that could be where the buyer is performing acts or providing designs or materials that could create the cause of the injury or damage. In the oil industry there is what’s called a knock-to-knock or mutual indemnity that’s unique and more of a risk sharing approach. In that approach each party is responsible for damage to their own property or injuries to their own employees irrespective of who was at fault.  

There is a link between the indemnification section, the limitation of liability, the warranties, and the insurance sections and all of them need to work together. The protection you get from a general indemnity will depend upon how the clause is written.

Most indemnities would not protect either a contractor or owner against a general breach of the contract they can be written to protect against the breach of a warranty that could also be the source of a third party claim. They usually will cover injuries or death to a third party or property damage caused by the negligence of the party.

The protection you get from an indemnity from the supplier may be limited by any limitation of liability provision unless you specifically carve the indemnity provision out of the limitation of liability. Most limitations of liability are written to exclude all types of damages other than direct damages. That exclusion does not apply to the types of damages a third party could sue for. So unless you carve the general indemnification out of the limitation of liability you would have the situation where you could be liable for all types of damages the third party could sue for, but you would only be able to collect the portion of that claim that was direct damages from the supplier. Most limitation of liability provisions also include a financial cap. Those financial caps do not apply to what a third party could sue for. If you didn’t carve the general indemnification out of the limitation of liability you could be liable for an unlimited amount and you could only recover up to the cap amount in the limitation from the supplier.

The reason why breach of the warranties may be included as part or the indemnification is because many warranties are there to drive a behavior so third party claims can be avoided. For example a warranty that the product is safe is to protect against product liability claims. A warranty that a product complies with all applicable environmental laws is to protect against claims from customers or governments in the event the product is found not to be complaint. When you include breach of warranties as part of the general indemnification it places the defense and cost of any damages that were cause by the breach directly on the supplier. You want that because those damages could be far more than the limitation of liability amount that you would be available to collect for a breach of the warranty. Without including the breach of warranties as part of the indemnification, if the supplier breached the warranty what you could claim against the supplier would first be limited by the types of damages that were allowed in the limitation of liability. Those damages would further be limited by any financial cap on liability.

Limitations of liability are to limit the liability of the parties to the agreement. They do not limit the liability of the insurance company as the insurance company is not a party to the agreement. Their limits on their liability are defined by what they agree in the insurance policy. This means that in claims under general indemnification that apply to insured risks covered by the policy that was required by the agreement, you would have both the supplier’s assets and the insurance company to collect against. For example, if there was a $7,000,000 loss and you had a $5,000,000 comprehensive and general liability policy required and the agreement has a limitation of liability of $1,000,000. The insurance company would pay the first $5,000,000 of the loss, less any deductible. The supplier would be liable for no more than the $1,000,000 and you would be responsible for the remainder.

I recommend that you always carve the general indemnity out of the limitation of liability because of one simple fact. An injured third party is not limited in terms of what they could sue for. If they sued the supplier directly there would be no limitation on the supplier’s liability. Since they would have unlimited liability on their own, why should they have limited liability simply because the injured party sued you rather than the supplier?

In discussing indemnification, the “Indemnitor” is the party that makes the indemnification commitment. The Indemnitee is the party that receives it. Most indemnities are given by suppliers to buyers. The reason for this is because liability follows the principle of agency. In a buyer / supplier relationship the buyer is considered the principal. The supplier is considered the agent. The principal can be liable for the acts of the agent. The agent is not liable for the acts of the principal. So if a Supplier is negligent and injures a third party, that third party could sue the supplier, the buyer or both. It’s those types of claims by third parties that are made against the Buyer for the acts of the supplier is what a general indemnity is designed to protect against, If the Buyer is the one that is negligent, since the indemnity is only for the supplier’s negligence. the buyer cannot ask the supplier to indemnify them on that claim. The supplier would also not be sued by the third party as an agent cannot be sued for the acts of the principal. 

If both parties are negligent you would need to look at what the general indemnification clause says. If it says the supplier is only responsible to indemnify in the event the injury or damage was caused by their sole negligence, and both parties were negligent, the indemnity would not apply. Both parties could be sued and the courts would determine the percentage of liability attributable to both. This is called comparative negligence. If the language did not say sole negligence, the indemnity would still apply even though the buyer was partially at fault. Suppliers may try to water down the general indemnity by adding the concepts of gross negligence or willful misconduct. What both of those attempt to do is add a higher standard for them to the responsibility to indemnify the buyer. Willful misconduct requires that the misconduct must be deliberate. Gross negligence would excuse them from indemnifying for injuries or damages that result from ordinary negligence. As a buyer I wouldn’t accept either gross negligence or willful misconduct. They were the ones that caused the injury or damage, they should be responsible for their acts.

Intellectual property indemnifications are also normally excluded from the limitation of liability. Just as with the general indemnification the buyer has no control over what the third party could sue for, If the supplier was sued directly their potential liability would be unlimited so why should their liability be limited simply because the claim of infringement was made against the buyer rather than the supplier. Another reason for excluding it from the limitation of liability is that many jurisdictions provide for penalties to be assessed in the event of a willful infringement. This is done to discourage infringements. For example in the U.S. under patent law, a party whose patent was willfully infringed upon could be awarded treble (3X) damages. If you didn't carve the intellectual property indemnification out of the limitation of liability clause, you could wind up in the situation where the party whose rights were infringed could collect 3X damages from you and you could only collect 1X from the supplier. Even worse you could not collect any portion of the 1X amount that exceeded the limitation of liability nor could you collect any portion of the claim that wasn’t direct damages. Most Intellectual property claims include claims for lost revenue and lost profits which are both traditionally types of damages that are excluded under a limitation of liability provision.

Contracts are interpreted where the terms are considered to be complimentary. When it comes to the limitation of liability provision, what that means is the limitation of liability will apply to all terms and obligations between the buyer and the supplier unless you specifically exclude those terms from the limitation of liability, Those exclusions can be full exclusions, You could exclude the limit on the types of damages that may be recovered under a specific clause. You could also establish different limits of liability for different sections. For example you could have the indemnities be unlimited, establish individual caps on liability for the breach of specific warranties. You could have a much higher limitation for things like epidemic defects and have the remaining terms be subject to the different liability amounts.

One last point on the topic. When the contract is written with a buyer that has multiple subsidiaries and the intend is that each subsidiary will create a “duplicate agreement” that duplicates the terms of the buyer / supplier agreement, a smart supplier will see that as a risk and will want to address that in the agreement. The reason is that when you create duplicate agreements, you are now creating a new independent agreement between different legal entities. If you had a $10,000,000 limit in the buyer / supplier agreement and six subsidiaries signed duplicate agreements. Instead of having a limit of liability of $10,000,000. the supplier now has a combined potential liability of $70,000,000 with $10,000,000 to the buyer and $10,000,000 to each subsidiary. To protect against that the supplier may require a statement in the buyer / supplier agreement to the effect that their combined liability to the buyer and all its subsidiaries shall not exceed that one stated amount.


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Managing Insurance

On March 10, 2011 I did a blog about Insurance that discussed both the types of insurance and key terms that may be required in insurance provisions. If insurance protection is important, you may not be able to just rely upon the fact that the contract requires the insurance, you may also need to manage it.

What does managng insurance mean?

First, it requires gettng copies of the actual insurance policies to see proof of insurance.

It means checking the insurance company and whether they meet any financial requirements for the insurance company that was specified in the insureance term such as an AM Best or similar financial rating.

It means checking the actual insurance policy to ensure that it is effective, it contains the necessary coverages required and it meets any requirements around deductibles or exclusions.

It means checking to ensure that the policy meets a number of requirements that were specified in the term such as:
Buyer is named as an additional insured
Buyer being named as a loss payee.
It provides coverage for subcontractors.
The insurance is primary and non-contributary
The insurance includes a waiver of subrogation against the buyer;
Severability of interests is addressed so Buyer and Supplier’s interests under the policy are treated separately for purposes of coverage under the policy.

If you’ve never reviewed a policy before I would always suggest that you schedule an appointment with your company's insurance expert to review it. Insurance speaks in a language of its own so you need that first review to be one where you learn what things means and what’s acceptable and what wouldn’t be acceptable. Then unless they want to review all of them you can come to them when you have questions.

It also means getting and retaining copies of all policies, updates, changes or revisions to those insurances and maintaining them in a file for potential future needs. One of the things you need to know is claims against insurances need to go against the insurance company whose policies were in effect at the time of the injury or loss, not at the time the claim is actually made by the injured party. Injured parties can bring claims any time within the applicable statute of limitations. While a supplier may no longer exist, unless the insurance company has gone bankrupt, you still have the insurance protection you can rely upon.

One of most important terms to avoid having removed is the concept of the buyer being named as “an additional insured”. As an additional insured it makes you a party to that insurance agreement. Being a party to the agreement, you would need to be notified of any cancellation or non-renewal of the insurance. In the event the primary insured was fraudulent in their application for the insurance, their insurance may be cancelled, but as an additional insured, and provided that you were not fraudulent, you would remain protected even though the insured would not.

Managing insurance and not relying upon the contract terms alone is very important in a number of situations:
When you are dealing in activities that have high potential risk for injuried and damages.
When you are dealing with small supplier that does not have the assets on their own if they failed to procure and pay for the necessary insurances.
The company you are dealing is not financially stable and may not be around in the future.
When you have low limitations of liability with the supplier and would be limited in terms of what you could recover from the supplier if they breached the agreement and failed to procure the required insurance.


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Firm Commitments

There are a number of ways you can make firm commitments. You can commit to purchase a specific amount, a specific volume, or you can make a form of requirements commitment where you agree to purchase a specific percentage, if not all of your business for a specific item to a specific supplier. If you decide that it makes business sense to make a firm commitment there are three things that always should be addressed.
1. How do you keep the supplier competitive during the term of the commitment?
2. What liability should you have if you fail to meet the firm commitment?
3. What actions or events should excuse you from purchases or reduce the quantities?.

The first issue I addressed in a Blog called Price - Getting Competitive price when locked in that’s dated September 2, 2011. That post talks about a number of tools that should be included in your agreement when you make firm commitments so the supplier either most perform or they run the risk of losing the commitment.

The amount of liability that you should have should be based upon they concept that the supplier should be made whole for the failure to meet the required commitment, but should not profit from the failure to meet the commitment. In this respect its similar to a termination without cause. The real difference between a normal termination for cause under an agreement with no commitments is because you made a firm purchase commitment to the Supplier the supplier may also have made firm purchase commitments to their subcontractors and suppliers. So instead of only being liable for unique inventory on had and on order that they can’t otherwise consume, you now are going to be looked upon to be liable for all those costs. To me the best approach is to negotiate what your maximum liability will be upfront so you establish the maximum amount you will be liable for if you fail to meet the commitment. That does two things. It creates a cap on you liability that you could potentially negotiate down from. More important, it will drive the suppliers behavior with their subcontractors and material suppliers so they don’t make commitments to them that they won’t be able to recover from you. Unless there was a major cost break on materials that was volume sensitive or the firm commitment drove the investment in equipment that would not be fully amortized by the volume you should be able to further manage you potential liability by doing things like require that the items not be built ahead, but there purchases should be based upon your forecasts and your orders,

Whenever I have agreed to make a firm commitment, I’ve also always included actions or events that count toward toward the commitment so that the size of the commitment is reduced when those actions or events occur. Those include:
For any force majeure events claimed by the Supplier I want the volumes that I would have procured from them during that period to count against the commitment. Most suppliers don’t like that, but most also have business interruption insurance that covers them against there casualty losses.
For any periods in which the supplier is selling under allocation where they cannot meet the volumes I ordered. I want all those unfulfilled amounts to count toward the commitment.
If they have delivery or quality problems where I had to make purchases from a distributor to make up for those problems, I want those to be counted towards the commitment.
For any other problems caused by the supplier that limits their ability to meet my needs, when I need them, I want all those volumes counted.
The reason why I want all those volumes committed is I made the firm commitment to purchase them for a specific time frame based upon the needs that my company had during that time frame. I don’t want to be forced to buy product after I no longer want or need it. If they couldn’t meet their commitments I also don’t want to negatively impact a supplier that stepped up to help me when they couldn’t deliver.

Let me give you a simple example. The supplier has a force majeure situation (a fire in their plant). It takes them nine months to recover to where they could produce product. The full production cycle for the supplier is 16 weeks or four months. This means that they have an excusable delay for thirteen months.

When they had the force majeure I still needed the product. I qualified another supplier, I investment in additional equipment and tooling. That supplier met my needs. Now that they have recovered if I didn’t have those volumes in the interim counting as meeting the commitment, I would still have to purchase those 13 months of volumes from them. I may not need 13 months of volumes any more. Even if I did need them volumes, if I wasn’t excused from the commitment, I would need to take that into account in the volumes I give to the supplier that came in to help me. In a worst case I would need to cliff the second supplier (reduce their volumes to zero) and lose unliquidated portions of the investments I made to bring them on. If you do that Suppliers will learn about it and the supplier you cliffed and other suppliers will be reluctant to help you in the future. If the commitment amount was reduced and you needed the product you could probably split the supply.


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Errors and Omissions

Errors and Omissions is a concept that is found most frequently in construction design or building contracts but it can apply to any area that could involve professional liability.

Errors and omissions requires two basic things. First there must be a duty to perform. Second the supplier must fail to have met that duty by either having an error in the performance of that duty or the omission to perform that duty. If either the error or omission causes damage or injury the professional could be found liable for that error or omission.

The duties that the supplier is required to perform could be duties specifically stated in the contract or they could be duties that the party has as a matter of public policy. For example, an architect or engineer has a duty as a part of public policy to design or buildings or structures that are safe. The agreement doesn’t need to require that.

In many agreements that could generate professional liability, buyers may include two elements that set up potential errors or omissions claims. One is a statement that the supplier is an expert. The second is that the buyer is relying on the supplier’s expertise. What those two concepts do is try to include the implied warranty of fitness for a particular purpose. What they are also intended to do is establish a very high standard for the performance of the duty. Instead of being measured against what would be reasonable for a general company, their performance will be measured against what would be reasonable for an expert in that field.The second is to disclaim
any internal knowledge or ability the buyer has about the subject matter by stating that they are relying upon the supplier.

If you purchase services that could involve errors and omissions where the potential damages could be substantial, you should consider requiring the supplier carry errors and omissions (E&O) insurance. Most companies that do business in areas where there could be professional liability should already carry an E&O policy so there should be no additional cost to you unless you are demanding a higher limit.

What E&O insurance coverage provides the buyer is an additional level of financial protection. In the event of a claim against the Supplier the E&O coverage acts like a deductible. For example if you had a $5,000,000 E&O policy and a $10,000,000 limit of liability with the supplier and you sustained a $16,000,000 loss, the payments would be as follows. The first $5,000,000 less any deductible would be paid by the insurance. The next $10.000,000 which would include the amount of the deductible would be paid by the supplier. Any amount over that would not be recovered. Where E&O coverage is particularly important is when the supplier may not have the financial assets on their own to cover the loss.

For errors and omissions to work, the buyer’s team needs to understand that instructions or requirements they give the supplier could impact the ability to collect if those instructions or requirements are in any way connected to the error or omission. One of the ways that I’ve seen that managed contractually is to say that the buyer has the right to make "suggestions". The supplier can either accept or reject those suggestion. If they accept the suggestion it will be treated as if it was their own. That way the supplier will need to use their skill and expertise to determine if the suggestion was appropriate for their use..


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Labor rate changes

Contractually how do you deal with potential labor rate changes? There are two types of wage changes that could occur. There may be government mandated changes such as changes to the minimum allowable labor rate that may be paid. There may also be changes that are part of a union collective bargaining.

I believe that most jurisdictions would allow for claims for contract price adjustments when the labor under the contract was being paid the minimum and the government imposed rate changed what
the must be paid. They must comply with the law. So irrespective of whether your contract provided for them you could still be billed for them,

For any other type of labor rate changes, do you need to have terms in your contract that will address changes in the rates? If you have contracts where the performance will extend past the expiration dates of known labor contracts I think its important to address those changes in the contract.

If you are the subcontractor or supplier, you want to be able to collect those additional costs that will occur. If there is no a provision to adjust the prices when those labor rates change, to protect yourself you would need to include contingencies in the price to cover those future costs.
As the owner or buyer that is paying the price you want to avoid having the supplier carry significant contingencies in their price. Contingencies are normally based upon what they expect will be the change and when the change will occur.They may be based on worst case estimates. If the change happens later or the rates agreed are less than they predicted, the owner / buyer would have paid for costs the contractor or subcontractor never incurred. If you don’t want the supplier to be profiting at your expense in this manner, you need to allow for labor rates and the price to be adjusted, the key is what do you allow them to adjust and how much.

In many agreements you may negotiate specific hourly rates for various classes of labor. Those hourly rates are fully burdened with contributions to benefits, overhead, and profit. If you include a clause that allows for the adjustment of labor rates you also need to agree upon what portion of that stated rate is subject to adjustment. Clearly you would need to adjust the amount that would actually be paid to the employee and for taxes or fringe benefits that are directly tied to the rate. Changes to the rate for other areas that would provide additional contributions to the supplier’s overhead and profit should not happen. You include the adjustment so the supplier doesn’t lose money when they occur, not so they can make more money.

When I negotiated services contracts I used the rule of thumb that the hourly rate quoted was approximately 2.5 times the actual rate being paid to the individual. The 1.5 amount was made up of benefits contributions, contributions to overhead and profit. So if I had an hourly rate of $25.00 per hour, I would assume that the employee was paid $10.00 per hour. I would also take the employers contributions into to mandatory programs (In the US that would be Social Security (6.2%) and Medicare (1.45%) that are based on a percentage of the salary. I would further include any vacation or holiday pay that might be earned and break that down to an hourly rate. For example is an employee earned 3 weeks of vacation and had a average benefits rate of 40%) this amount would be $10.00 + (10.00 x .40) x 40 hours x 3weeks or $1,680 ad divide that by 2080 which equals $.81 an hour. The adjusted rate would be
$10.00 rate
$ .62 social security
$ ,15 medicaid
$ .81 vacation
$ 11.58
That would be the amount I would base the adjustment off. So if there was a ten percent increase I would add $1.16 to the rate making it $26.16. If the mark up was different in the industry I would use that. That would be my starting point for what I would offer to be subject adjustment. I would look to the supplier to prove that other benefits contributions or overhead were tied directly to the rate. If they weren’t I would adjust them.


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Escalation procedures in contracts

Many contracts have two types of escalation procedures. The first is escalation when there is a problem. These types of escalation procedures have the problem be escalated up within the supplier based upon a particular schedule. For example the initial call for help may go to a help desk that has one level of capability. If they are not able to resolve the problem in X hours, they need to escalate it and involve the next higher level of support. If the next higher level of support can’t solve the problem in Y days, they need to escalate it to the original product designers to help discover the source of the problem and fix. If they can’t solve the problem in Z days, it needs to get escalated to the company’s senior management so they can assign their best experts to resolving the problem. In doing this type of escalation as the time increases, the level of expertise involved in helping identify and solve the problem also increases.

The second type of escalation that you also find in contracts is escalation in the event of a dispute between the parties. Many times an item in dispute may become personal. Over the course of a project or over time the representative of the buyer or supplier may take something
personal and simply refuse to budge on an issue. Those individuals may not want to agree to something if it will expose to their management a problem they caused which is the source of the dispute. They may not want to agree as agreement could impact them meeting their goals or metrics. There are a number of reasons why people may not want to agree. You include and use escalation procedures to help resolve problems and avoid potential litigation. The value that an escalation term provides is it takes the issue out of the hands that have been in the heat of the battle. The person that it gets escalated to will usually have different goals and different metrics they manage to so they can look at it differently. They can put it into the perspective of all the business they manage, not just the individual contract. Instead of looking at it from the perspective of someone that’s in the heat of the battle they can look at the issue from a different perspective, such as the relationship you have or the relationship they want to have with your company.

There are a number of ways that you can do escalations. If an issue is important and needs to be resolved immediately you can require an immediate escalation. I would keep the number of those types of escalations at a minimum. For other issues one of the best times to do an escalation is when you have supplier reviews. Have an open issues list that includes all the areas that are open and in dispute. The simple fact is many times the supplier’s management team won’t know about the issue as they haven’t been informed about it. I’ve had many times where the dispute was immediately resolved at the meeting.When your counterpart knows that the issue will come up at the meeting and they will need to explain it, can put pressure on coming to agreement. Escalation won’t guarantee you that you will get the results you want. It does help get around the person that may have been the problem.


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