Tuesday, February 15, 2011

Negotiation - Thoughts on Negotiating Epidemic Defects

The concept of epidemic defects is that below a certain threshold, the Supplier’s costs of any defects are limited to their warranty replacement, but once that threshold has been exceeded, the Supplier will assume a share (if not all) of Buyer’s costs associated with the defective products. Buyer’s costs can include the cost of re-work of the product and the cost of replacing failed products that failed in the field so the cost of a defect is substantial and could easily run into hundreds of dollars for a single failure.

In negotiating epidemic defect provisions, aside from getting the Supplier to agree to the concept itself, there five issues that are typically negotiated.
1.     The first rate(s) which sets the threshold.
2.     The basis for measurement.
3.     The period of coverage for the protection.
4.     The extent of the costs that will be reimbursed.
5.     Any cap or limitation on the total liability.

Since many of the costs involved in an epidemic defect would be considered to be incidental in nature, a normal limitation of liability provision might limit the damages to only those costs that are direct.  That would substantially limit the amount of the recovery. If you have a limitation of liability provision, check whether the Epidemic Defects provision is excluded from the limitation or liability, If it doesn’t include it as an exclusion.

Since the potential cost of an epidemic defect is substantial, Suppliers first seek to avoid the risk by pushing for a high failure threshold. In negotiating the threshold one of the things to use is the Supplier’s quality and reliability commitments or specifications. For example, if a Supplier is committed to shipping a product with a quality rate of 50 parts per million (PPM), and wanted a epidemic defect rate of 2 %, you would highlight the fact that a epidemic defect rate of 2% is really 20,000PPM, and when you compare that to the committed quality level of 50 it doesn’t make sense, as what they propose is 400 times above the quality level they agreed to ship. If the quality numbers are real, the threshold for an epidemic defect situation should be much lower.

Another thing that typically gets negotiated is how the rate is established. What makes up the numerator and denominator to establish the percentage? Suppliers will traditionally want to limit the coverage to only the warranty period.  This causes a problem if there is a significant difference between the warranty period and the agreed reliability commitments for the product (usually expressed in terms of MTBF mean time between failures or FITs (power on hours at a certain environment). If you have a product with a 2 year warranty and it’s supposed to last 100,000 hours (about 12 years), if you don’t have epidemic defects coverage and there are significant failures after the 2 years has passed, you wouldn’t be able to recover anything as your warranty would have expired. Always look at the elements of the formula used to establish the rate. For example if you did agree to limit the period of coverage to the warranty period you would want the formula to be based upon defects occurring during the warranty period divided
by the number of products under warranty. Suppliers frequently have the tendency of wanting to have the numerator be tied to a shorted period where the denominator is tied to a longer period or higher amount so while the percentage may be the same the actual number of units required to trigger the epidemic defect is more.
For the costs that will be reimburse, many epidemic defect provisions allow for the collection of all actual and reasonable costs that are incurred. This is to prevent the language from being interpreted as a penalty that would not be enforceable. A common supplier tactic in negotiating costs is to try to require that they be “out of pocket” costs.
The use of “out of pocket” would exclude the Supplier from having to reimburse the Buyer for any internal costs it may incur.  For example if the Buyer used its own service personnel to repair or replace defective items at a customer site, “out of pocket” would prevent the Buyer from collecting for all those expenses.

Limits on the amount that the Supplier may be liable for can be expressed in a number of ways:
·       A per unit limit
·       A per incident limit
·       A per term limit
·       A per life of the agreement limit
·       A combination of multiple such as per unit limit, with a aggregate total amount of liability over the term of the agreement.
What’s best and what a good limit would be is really dependent upon the circumstances. For example the impact of a defective item is far less if the customer can simply return the items, than it would be if the Buyer need to dispatch service personnel to the field to remove and replace the defective item.

My personal opinion on the amount is it needs to be reasonable enough so it isn’t burdening your purchase price but it needs to be big enough so it has the Suppliers attention so the Supplier will make investments to correct problems that have or can cause defects. If all they have is warranty redemption obligations that may not be big enough for them to make the necessary investments. 

Negotiation – Thoughts on Negotiating Force Majeure

A force majeure is an excusable delay to performance.

In negotiating a force majeure there are usually two main considerations.
1) What events constitute a force majeure?
2) What are the obligations of each party during the force majeure and after it has passed?

Suppliers will want the events to be fairly broad to include things like labor problems or problems with their Suppliers. Buyers want the events that will excuse performance to be clearly beyond the control of the Supplier. That would exclude labor problems, and would require delivery problems with Suppliers be based on things such as a worldwide shortage or allocation of parts, not because the Suppliers subcontractors failed to deliver.

In negotiating Force Majeure you argue that the intent of agreeing to a force majeure is to provide excusable delays for acts that are truly outside the control of the parties. In the example of labor problems, lockouts are totally within the Supplier’s control to manage. Strikes are usually not something that happens instantaneously, and the Supplier should be able manage and have a contingency plan not to affect you should a strike occur.

With respect to the party’s obligations, a force majeure provides the party claiming the force majeure situation with an excusable delay to performance.  It does not cancel any obligations. In negotiating a force majeure the Buyer need to consider the potential impact to your business and your needs. For force majeure situations of a short duration having all commitments remain in effect may not be a significant problem. The longer the duration of the force majeure, the greater the impact it may be. You may no longer need or want the delivery as the reason why you were purchasing it may have passed.

Where negotiation of a force majeure responsibility after recovery is critical is when you
have firm purchase commitments such as a commitment to purchase a specific quantity
of product from a Supplier or when you have committed to purchase all or a percentage of your requirements from the Supplier.

If the Supplier is unable to perform many times you will need to find an alternative source of supply in the interim. To do that you may have needed to make certain investments or commitments. You may want to get the return on those investments or may need to meet those commitments to avoid liability with the alternative source.

Things that I would look for are:
·       The right to cancel any open orders without liability should there an extended delay. Suppliers may object to such cancellation rights, but in most cases they would be covered for any losses to the interim business by normal business interruption insurance coverage.
·       For any firm purchase commitments, I would want all the purchases that would have been ordered during the force majeure period to count toward meeting those commitments.
·       For any commitments to purchase a fixed percentage of your requirements, I
would want all the purchases that would have been ordered during the force majeure period to count toward meeting those commitments. Otherwise you could be forced to purchase a much higher quantity from them when they recover to meet the commitment. That would penalize the other Suppliers.
·       For any commitments to purchase all of your requirements from a Supplier, I would want that excused during the force majeure period and I would want to be allowed to purchase from the alternative source whatever quantities are required to meet any commitments that were reasonably made to secure supply.
·       If recovery by the Supplier would be for an extended period, I might try to simply negotiate the right to terminate the agreement without cause and without liability. In significant force majeure situations such as natural disasters or fires, the Supplier should be covered for an damage to products or inventory under their insurance and they should also be covered for loss of sales if they carry business interruption insurance.

A key point in these discussions is you shouldn’t be penalized because they had a force majeure.

Negotiation - Thoughts On Negotiating General Indemnification

General Indemnification addresses personal injury or property damage sustained by third parties that is caused by the Supplier, the Supplier’s personnel or Supplier’s product.

The reason why Buyer’s need general indemnification against those types of claims is:
1.     Buyer’s may ne liable for the actions of the Supplier and Supplier personnel under the theory of agency.
2.     If Buyer is part of the sales chain for Supplier’s product or service, Buyer may be liable if the product or service is defective and injures a third party or causes property damage.  In most injury claims for what called “tort liability” the lawyer for the injured party will sue all parties that were involved in any manner to both look for the “deepest pockets” (the company that has the most money to recover against and to sort out the responsibility for negligence.
3.     Without an indemnification the Buyer would be brought into the lawsuit by the Supplier (if they weren’t already by the Injured party) looking to collect from the Buyer under comparative negligence. All comparative negligence means is determining the percentage that each party is responsible for.  

In negotiating General Indemnifications many Suppliers want to include a cap on their total liability. The problem with that is you can’t cap the amount of potential claims third parties may make against you, especially for things like personal injury. Agreeing to a cap on personal injury liability would leave you with the situation where you could still be liable to the 3rd party, and only being able to recover portion of that amount from the Supplier because of the cap. Never agree to a cap for general indemnification and make sure that any limitation of liability language you include in the Contract specifically excludes general indemnification. That’s because claims made by third parties are not direct damages.

Another thing that Suppliers may want to negotiate is a cap on liability for property damage. A classic example of this is a Supplier of a part that costs $.01 doesn’t want to be liable for the cost of a million dollar computer or a large facility if it catches fire. There is a difference between personal injury liability and property damage liability that you should be aware of. It would be against public policy to have a cap on personal injury liability in your sales terms and such a term wouldn’t be enforceable. Property damage liability does not get the same protection and may be capped. If you are buying products for resale and the issue of capping liability for property damage arises, check your sales terms to see what you commit to your customer. There may be a separate cap or it may be silent and simply be part of a general cap on liability. If there is, you may be able to agree to something that is consistent with your exposure to your customer.

For any changes to a standard general indemnification section, always involve and work with your lawyer.