Monday, February 14, 2011

Negotiation - Thoughts on Negotiating Intellectual Property Infringement Indemnification

Negotiators should involve their law department in any intellectual property infringement clause negotiations.

An Intellectual Property (IP) Infringement Indemnification is intended to provide the Buyer with protection against 3rd party claims that the Supplier’s product or service infringes the intellectual property rights of the 3rd party.  A valid IP infringement claim can:
·       Prevent the Buyer or their customer from using the product or service. That could cause the Buyer to stop production, breach commitments to deliver the product or service to their customer.
·       Subject the Buyer to paying royalties on products already in use.
·       Require the Buyer to recall affected products from their customers.
·       Require the Buyer to Correct the problem at their expense for their customers.
·       Cause the Buyer to have an inventory of products they can’t sell or use or that need to be reworked  

Normal IP Indemnification Provisions are made up of the following:

1. The Supplier’s obligations in the even to a claim which is usually:
1.     To defend against the claim.
2.     To indemnify the Buyer against the claim (including the cost of any legal fees) .
3.     Hold the Buyer harmless on the claim
4.     Pay all costs and damages awarded.
5.     Meet additional obligations of:
a.     Obtain the right the use Procure a license to use the Intellectual Property
b.     Modify their product or service so its non-infringing
c.     Replace the product or service with non-infringing products or service
d.     Allow cancellation of open orders without liability
e.     Refund the amount paid for any all inventories of infringing product

2. Typical Exceptions to the Supplier’s obligation to indemnify the Buyer are normally given for acts where the Buyer was in control.
·       Claims that based on combination of Suppliers product with another product that weren’t reasonably foreseeable.
·       Implementation by the Supplier of a Buyer specified or provided design.
·       Modifications to the Suppliers Product made by Buyer where the Buyer modification is the source of the infringement.

The things that typically get negotiated in an IP Infringement Section are:
1.     When the Supplier is obligated to take action. Is it when the claim is made or is it when there is actual litigation?
2.     Who controls the defense of the claim, the Supplier or Buyer? Something to consider in this is what assets does the Supplier have and will they be able to pay all the costs? If they can’t do you really want them to be defending against what will become your costs if they lose? 
3.     For the additional obligations listed in 1.5 above, who determines which of those is provided. The higher on the list, the more cost there is to the Supplier. The lower you go on the list the more costs there will be for the Buyer. For example, it will cost the Buyer nothing if the Supplier gets the right to use the product or service, but the costs to the Buyer could be substantial if the Supplier can merely refund the price paid and leave the Buyer with the problem. Suppliers traditional want it to be at their option. Buyers want the actions to be the first one that can be done by the Supplier on that list.  For example if the 3rd party won’t provide a right to use the IP, then you would want the product made non-infringing.

Intellectual Property Indemnification Sections need to be carved out of the limitation of liability section for two reasons. First, the nature of the damages you sustain are more incidental or consequential. Second, in many locations if the infringement is willful, laws may allow for special damages. For example under US Patent law a willful infringement can be subject to treble (3X) damages. Normal limitation of liability provisions will exclude special damages.

To set the right expectations with the Supplier, there are two messages you may want to give.  First, if there isn’t protection for IP Claims, we aren’t interested in buying their product. Second, any risk they assume in providing the Buyer IP infringement protection under is something they have the ability to control. They control it by how they manage their IP and their contract relationships with their Suppliers. If they do what they should, the risk is small and it’s a cost of doing business. It doesn’t mean they can’t be sued by 3rd parties even though their product was developed independently. That’s a risk they have by being in the business, it’s not a unique risk associated with your contract.

If the Supplier wants to place a cap on their liability for IP Indemnity the thing to remind them of is the things that you have control over you have already included as exceptions to the indemnification. They are not responsible to those. What remains are items that only they control and they need to have full responsibility for those.    

Negotiation - Thoughts on Negotiating Lead-Time, Cancellation and Rescheduling

You need understand how to negotiate lead-time for two reasons. The obvious reason it to get the shortest possible lead-time to meet your needs and keep the amount of inventory you need to carry down. The second is to be able to negotiate cancellation or rescheduling terms for individual order.
Limitations on cancellation or rescheduling of orders can force you to purchase items you don’t need, or carry larger amounts of inventory. 

The risk to a Supplier associated with change to your order depends upon whether the item is standard or unique to the Buyer.  For a standard product the prime impact is the carrying cost for the inventory that will take longer to consume in sales to the Buyer or other customers.  The larger the Buyer’s demand is to the demand from all customers, the greater the potential cost and impact to the Supplier.  The key in these negotiations is making it clear that what you want to do is mitigate the potential cost of change and that is best done before production starts or before all the value added is provided, not when the item is complete.
Where the negotiation becomes more complex is when the item being order is custom or unique to the Buyer. In this the two most important questions to ask are:
  1. What makes this unique or custom?
  2. At what point in the process does it become unique?
The simple rationale is if you make the change before the item becomes custom to you it has less of a potential impact to the Supplier as they can use it with other customers.

Lead Times will normally consist of the following main elements
  1. Order/Entry Queue time
  2. Raw material lead time
  3. Manufacturing or Production process cycle time.

Order/entry queue time is the period of time required from the receipt of the Buyer’s order before the order is scheduled so materials will be ordered and the production scheduled. Raw material lead-time would be the longest lead-time for all materials that are consumed. Production or Manufacturing process cycle time would include any queue time to prepare for production, any set up time, actual process time, and the applicable times to inspect, test and package the product to make it available for shipment. If you were purchasing a product with delivered terms, the total lead-time would include the total distribution time from the Supplier’s dock to the Buyer’s point of use. For example if you had a product that had:
  1. An order/queue time of three business days
  2. A Bill of materials in which the longest lead time item was 26 weeks
  3. A manufacturing process time of 4 weeks
The total lead-time would be 30 weeks and 3 business days which may be too long for your needs.

To negotiate the lead-time the first thing you would want to understand is the lead-time for all materials in the Bill of Materials. You would also ask which if those materials are
common parts that they use across multiple products and which are unique or custom to this product or activity.  For any that are common you would expect those will be able to be consumed by other demand. To reduce the lead time or provide flexibility you would only want to assume potential liability for those materials that are custom or unique. For example for a very long lead time custom part you may be able to get a reduced lead time and greater flexibility by agreeing to have the Supplier carry an inventory of those long lead-time parts. Suppliers will want the Buyer to assume liability if they are never consumed or may want compensation if they aren’t consumed as planned to cover their cost of carrying the inventory.

Lets assume that one part (a custom Semiconductor) was the item that had the 26 week lead time and the remaining items had a maximum of four weeks lead time.  If you assume certain liability for that one part and have them inventory and replenish it your materials lead time can be 4 weeks instead of 26 and your total lead time with the exception of that part is now under 9 weeks instead of 30 plus.  The only catch is that if you have excess demand that consumes some of the materials from inventory the replenishment of that inventory will take the full lead time. That needs to be considered in the amount of inventory you want the Supplier to hold.

Cancellation and reschedule rights and costs need to look at the impact to the Supplier based upon what is occurring at that point of time in the process.  Using the same example, we would know that during the 4 weeks prior to delivery the item is in the manufacturing stage. In the manufacturing stage is when the questions of what makes the item unique to the Buyer and at what point in the process does that occur becomes important.  If the notice occurs before the item is made unique to the Buyer, the simple argument is the Supplier should be able to take actions so it can be sold to others and at most the Buyer should have some potential liability for inventory carrying costs that creates. If the notice occurs after the Product has been made unique, the alternatives available to the Supplier are limited to 1) scrap it, 2) re-work it to remove the uniqueness  3) suspend additional value added or 4) complete it. If the cancellation or reschedule is significant that decision should be make by the Buyer with inputs from the Supplier on what the potential cost would be for each option. For example, if the Buyer will no longer need it, it makes no sense to add additional value added steps as that only adds cost to something that will be scrapped. If there is still a need, the Buyer should have the right to determine what’s the best action. For example if it’s a process that should not be stopped it may be more inexpensive to complete the production and have it held as inventory by the Supplier with the Buyer paying a carrying cost rather than have to pay to stop and restart production at a later time. If there are process steps that may be delayed, delaying them will reduce the value of the inventory the Supplier needs to hold and keeps the cost down should you later need to cancel the item. Always try narrow down any liability to only those costs that cannot be avoided.  
There are some Suppliers that as soon as you order something they want to consider it sold.  The way to deal with those types of Suppliers is first educate them on the realities of the market you compete in. For example, would a customer want to wait both the Suppliers and Buyers total cycle time combined to get delivery or would they just migrate to another Supplier that can delivery it sooner to meet their needs.  If Customers won’t wait, you need lead times that reflect that if you are going to sell the product. The second point to make is that flexibility that is required to meet the demands of those markets needs to be managed at the most cost effective level, and meeting demand with finished goods inventory is too expensive. Flexibility needs to be managed with less cost and risk at lower tiers. To meet customer demands and make sales, everyone in the Supply Chain needs to take some degree of risk.

The same arguments apply whether you are negotiating rescheduling and cancellation terms or liability planning horizons in vendor managed inventory situations.  The only difference is with VMI programs you have fewer options to manage the potential liability as the Supplier is stocking completed products.  That’s when the issue of whether the product is custom or standard is key.  If its custom, you own the liability up to the planning horizon. If the product is standard and the demand isn’t there, the message should be that as demand changes the Supplier needs to manage the risk by redeploying the inventory rather than expect the Buyer to purchase those products.

The negotiation of lead time, rescheduling, cancellation rights and charges and liability under VMI is best done by questioning and negotiating each element that makes it up the lead time.  For each of materials as a minimum you would ask:
  1. Is the item custom or unique?
  2. Is it common with other Supplier products?
  3. What is the lead-time?
  4. What flexibility does the Supplier have with their suppliers
For the Manufacturing process you would ask for:
  1. A breakdown of all the tasks and durations in the manufacture.
  2. Where they are done.
  3. Any transit times involved
  4. Whether the processes are standard or unique to the product
  5. At what point in the process does a custom or unique product become custom or unique.
  6. Is it possible to stop production and restart it at some point in the future?
    1. At what point or points?
    2. Would there be a production cost impact to do that?
    3. Would there be a quality impact?
    4. What percentage of the Product cost would be involved at those points?   

In negotiating the flexibility for services with is primarily to either suspend or cancel the service that also is best done by questioning and negotiating each element that makes it up the lead-time to complete the service. As a minimum you would ask for:
  1. A listing to the major tasks to be performed and duration.
  2. A critical path schedule for performing the work that shows when each task is scheduled to be performed, what that task is dependent upon and the tasks that are dependent upon the completion of that task.
  3. In services the risk to the Supplier is not inventory, its labor cost. Some questions you may want to ask are:
    1. Are the tasks being performed by their own employees or by contractors
                                               i.     If there is mix, what is the percentage of mix?
                                              ii.     If they are being performed by contractors, what are their obligations regarding cancellation of the work?
    1. For work performed by their employees, is being performed by dedicated staff or by individual assignments from a common support pool  (e.g. redeployment of dedicated staff could take longer)?
    2. If they are dedicated staff, how long would it take to re-deploy them?
                                               i.     Can they be use for other work?
                                              ii.     Can they replace contractors on existing work?