Intellectual Property Infringement Remedies

Frequently there may be a number of remedies for intellectual property infringement that get negotiated in addition to the intellectual property infringement.
a. Obtain the right the use Procure a license to use the Intellectual Property.
b. Modify their product or service so it is 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.

The key issue in negotiating these remedies is cost. For the supplier, the lower the remedy they have to provide on the list normally represent a lower cost to them. As such they may want the right to pick which remedy they want or they may want to limit their potential cost further by placing a limit on their liability or decreasing the amount they have to pay. For example, they may want to pay a refund on a depreciated basis taking into account the buyer’s use of the item. For the buyer the lower the remedy is on the list the higher the buyer’s potential cost. Obtaining the right to use the infringing item costs the buyer nothing. Modifying the product or service, even if the supplier came to the buyer or buyer’s customers location, has a cost in that you will lose the use of the item while it is being modified. If it needed to be returned for rework the costs go up substantially. Replacing a product or service with a non-infringing one can have a cost, especially if you had the item integrated with other products or software which now need to be compatible with the new item. The ability to cancel open orders without liability can have a cost as you purchased the item for a specific need and now that need may not be met or it could take some time and have losses as a result. For example it you had a single sourced item that was determined to be infringing cancellation doesn’t provide you with the product or service you need and it could require you to re-design your product to use another company’s product. Providing you with a full refund of the price you paid may not make you whole, especially if you invested money to integrate that product. For example, if you license a piece of software and then developed additional software to fully integrate it into your systems and have it play with other software, getting a refund of the license price doesn’t compensate you for those other investments.

As a buyer if you weren’t the cause for the infringement, why should you be forced to pay more because of it? As a buyer, you want to either limit the remedies to only those that are acceptable to you or better yet, require the supplier to perform the first remedy they can perform. I’ve seen language that said that the “Supplier shall provide first of the following remedies that is practicable. "Practicable" means able to be done, used or put into practice successfully). In establishing that, the supplier would need to be able to show that what are higher cost remedies for them couldn’t be done before moving down the list to provide another remedy that may have a cost for the buyer.

Certifications

If you purchase items for resale, most of the time you will require certain certifications apply to the item you purchase. Certifications are to show compliance with specific laws or standards such as safety or environmental standards. Laws or standards are enacted by countries and other governmental agencies and will vary based upon the type of product or service being sold. For example, medical products are required to meet more stringent requirements than non-medical. Products intended for use by children have higher safety standard than products for adults. Standards may address the raw materials used, such as RoHS that requires certain material may not be used in products because of the environmental impact of their disposal after the product’s useful life. They may control the processes used, or the materials used in processing that are ultimately are retained on the product. Many standards address the product’s safety. Recently standards have begun to address how the product will react with the environment it operates in. For example telecommunications products have certain standards they must comply with to be used in certain countries telecommunications systems, and there are Bluetooth standards.

For compliance there are a number of organizations that publish standards:
IEC (International Electrotechnical Commission)
ISO (International Standards Organization)
CEN (European Committee for Standardization)
CENELEC (International Standards and Conformity Assessment for all electrical, electronic and related technologies)
AAMI (Association for the Advancement of Medical Instrumentation)
ANSI (American National Standards Institute)
ASTM (American Society for Testing and Materials)
NFPA (National Fire Protection Association)
FCC (Federal Communications Commission)
UL (Underwriters Laboratories)
BSI (British Standards Institute)
CSA (Canadian Standards Association)
JSA (Japanese Standards Association)
SAC (Standards Administration of China)
VDE (German Standards)

The U.S. Department of Commerce also publishes a list of standards by country at the following website:
NIST – Standards & Technical Regulations

UL , CSA, VDE, IECEE CB, TUV SUD (America), and TUV Rheinland all maintain certification databases.

There are a number of different companies and organization that provide listing of certifications. For example, Underwriter’s Laboratory issues standards, does certification testing and maintains a database of both UL listed and UL Certified products. A U.L. Listed product is one that has not gone through certification testing whereas U.L Certified has been tested for compliance. U.L has some 62 logos that are used to identify what they have been listed or tested against.

From a contracts perspective, why are certifications important? First, in many situations the failure to meet the applicable an applicable law or standard will prevent the importation or use of a product that is not in compliance. In some situations a certification may be required to show compliance with other laws. For example U.S. OSHA laws require safe materials and products be used by workers. Certifications are use by Suppliers for marketing purposes showing compliance or meeting certain quality requirements such as ISO Quality standards. Buyers may view them as an indication of potential quality in the supplier’s operation. One of the most important aspect of certifications is the management of potential liability. In the event of personal injury or property damage anyone in the sales chain may be sued. In determining whether a company has been negligent, part of the defense would be what the party has done to manage against the potential risk. That helps identify if they were negligent or the degree of their negligence. If the party did nothing, that inaction may make them liable. If a company relied on a supplier representation or warranty of compliance they may have an action against the supplier, but could still be liable to the third party for not doing enough. If the company required independent certification by an accredited agency, that action may show they took reasonable steps to prevent it the injury or damage and were not negligent. What you get as a logo or commitment can make the difference. For example, buying something that has a “U.L. Listed” code shows you provide a lesser standard of care than if you purchased a product that was “U.L. Certified” meaning it underwent testing for the specific certification.

In situations where the government could levy fines for violating certain requirements such as compliance with RoHS environmental requirements, the fact that you had something certified for compliance may not help you avoid the fine. In those situations your recourse would be to claim those fines as damages you sustained for breach of the contract requirement by supplier.

If you write contracts that commonly include requirements that suppliers must meet certain requirements or certifications, get a copy of those documents and read them so you understand what is being required.

Flow-down clauses

In many contracts where the ultimate customer is the government, there are requirements that the prime contractor flow specific clauses down to lower tier contractors and suppliers. There are three basic approaches to
doing flow-downs:

1. Use an omnibus clause that says that everything that should flow down flows down.
2. Use an omnibus clause, but make changes to those that apply to that subcontractor.
3. Prepare a list of all the specific clauses that must be met and incorporate that by reference into the subcontract.
In each of these approaches you also need to address the subcontractor’s responsibility to flow those requirements down to lower tier subcontractors and suppliers.

Omnibus clauses are much simpler to write and are less time consuming to do, but they basically require disclosure of the prime contract to the sub and lower tiers so they are aware of what they are agreeing to. Omnibus clauses with changes also require disclosure of the prime contract and may become a problem in negotiating where the subcontractor may want more of the subcontract terms to be the same as the prime has. My preference is to only flow down the specific required provisions.

While you have a contractual requirement to flow down clauses, you still need to do what is best for your company. If there is a problem the government doesn’t care who caused the problem, their contract is with the prime contractor. As such, the prime needs to both meet the flow down requirements, but also protect themselves against potential problems with the subcontractors. I don’t want a blanket flow down of provisions as I may have something in the prime contract that I would not want to be disclosed to them and have the subcontractor want those terms to be extended to them. I may also want to impose stricter controls or requirements on the subcontractor than are required by the prime contract as my way of managing against potential risks with the subcontractors. In flowing them down, I may also want to establish the government requirements as minimum requirements that must be met. That allows the subcontractor to be able to establish more stricter controls or requirements with their lower tier suppliers or contractors if that is needed.

When you do a blanket flow down of the prime contract terms, or flow down only specific terms, you need to make sure that you do not have conflicts between your terms and the required flow-down terms and also establish a precedence in the event of a conflict. Since you are required to flow-down the required terms the precedence in the event of a conflict shouldn’t be based on the writer. If you gave precedence to your terms and the conflicting term was less than what was required to be flowed-down you would not have met your prime contract obligation.

If you always gave precedence to the flow-down that would override any stricter requirements you may have in your terms. In this case precedence should be given to the term that has the strictest requirement of the conflicting terms. That way if the flow-down term has the strictest requirement, it applies. If your terms are stricter than the flow-down term, they apply.

Understand the real cost.

Many times in a negotiation you may need to decide either to what level you want to negotiate the final price or when a price change should be effective. When that occurs always consider the real cost. What I mean by the real cost is how much more or less will you pay based upon the amount you agree based upon the volume of purchases that will occur. For example one cent (US$.01) may not seem to be a lot of money until you multiple that times the volume that you will be purchasing. If over the period of the contract the volume will be two million units that one cent difference means 2,000,000 x .01 = $20,000.00. While you may not be concerned about a penny, those pennies can add up to amounts that you should be concerned about. For high volume purchases its not uncommon for a buyer to want to negotiate a price down to the mils (1/100 of a cent) so when it’s extended over the volume you buy, you have the lowest real cost.

I can remember a commodity manager who negotiated a price reduction on an item of one dollar and she thought she did a great job. The problem was she negotiated the cost reduction to take effect one fiscal quarter later and didn’t understand the real cost in agreeing to do that. The manager knew that the quarterly volume was 200,000 units so with the agreement to take effect three months in the future it cost $200,000.

There is a real cost with many other contract terms than just price. For example you want a one year warranty on a piece of software you want to license. The supplier only wants to provide your with ninety days warranty. What’s the real cost of that? In effect what that would do is force you to purchase maintenance after the ninety days or 270 days prior to when you wanted to purchase it. If the cost of maintenance is 15% of the purchase price, the real cost of that change is it adds 11.25% to the cost of you license purchase. (15 divided by 365 x 270).

If you make a concession in a negotiation always make it clear what the real cost is for what you are conceding and expect a concession or price reduction of an equivalent or greater value.

Liability Caps

In contracts most companies seek to put a financial cap on their potential liability. A financial cap is only one way to limit liability. To understand what your potential liability would be, or to understand what the other party’s liability to you may be, you need to look the entire agreement. That is because in addition to financial caps, there are many other ways to effectively limit liability.

For example:
You can place limits on the types of damages that may be recovered such as “Neither party shall be liable for incidental, consequential, special damages, lost revenue or lost profits”. This would limit their liability and your recover to only direct damages.

You can have limits on various types of claims that can be made. For example an exclusion of warranties for merchantability or fitness for a particular purpose excludes liability that could exist under those implied warranties and reduces the potential overall liability.

You can have limits on the types of costs that may be recovered. For example “Supplier shall reimburse buyer’s reasonable out of pocket costs. That language requires a payment of costs and would preclude any of the other party’s internal expenses.

Your can have limits on remedies in individual sections. For example, if a section states a specific remedy followed by the statement “This shall be suppliers sole liability and buyers sole and exclusive remedy." This is limiting potential liability to only the cost of providing that remedy.

There may be limits on the amount of individual costs a party could recover. For example “Supplier shall not be liable for more than one times the price for any cost of re-procurement”. So if the supplier provided a defective product and failed to meet a warranty obligation to repair or replace, the maximum you could claim would be the
purchase price.

I’ve seen companies that, in the event of an Intellectual property infringement claims, want a remedy to be to refund the depreciated value of the product as a way of reducing their potential liability for infringement claims and letting the choose the lowest cost option to them. That may be the highest cost option to you.

There may be limits on periods when claims may be made. For example: “Any legal or other action related to a breach of this contract must be commenced no later than one (1) year from the date on which the cause of action arose”. This cuts of the period for claims to limit liability.

There may be limits on individual charges claimed. For example: “Supplier shall reimburse buyer for its actual and reasonable costs incurred”. This places a responsibility on the buyer to both keep the costs reasonable and to document the actual cost. It also reduces potential liability if the cost isn’t “reasonable” or can’t be proven.

Liquidated damage provisions are a form of limitation of liability for the specific provision that allows collection of the liquidated damage. Once a liquidated damage is agreed, that caps the liability for that breach and the other party cannot recover more than that amount.

Thresholds that must be met before it triggers the right to claim a remedy is a form of limitation of potential liability. “If one percent of the products are defective then supplier shall ….”. That type of language would have the buyer be assuming most of the cost until that threshold is met.

The standard of commitment used to describe the party’s obligation limits what the supplier is responsible for and what they could be potentially be liable for. For example “Supplier shall use reasonable commercial efforts to ___”. Any commitment that is not a firm commitment to do or complete the work is a limit on liability. All the party needs to do is prove they exercised the agreed level of effort. If they did, they would not be liable for damages even though you may not have gotten what you wanted.

Insurance helps reduce a company’s potential exposure for certain liability. For example if you have a financial cap, is the amount of insurance coverage in addition to or party of that cap. If it is included within the cap the supplier has less potential liability as the insurance company is assuming certain risks.

How a financial cap is structured can either limit or expand the potential liability. Caps may be fixed, multiple of sales or percent of business. They can be limits on total liability for the contract term limits on liability for a defined period such as annual limits or limits per occurrence.

What is included or excluded from the financial cap is also important. I want financial caps to only apply to the parties to the agreement and not limit what may be recovered by third party claims.

A supplier’s potential exposure or buyer’s potential recovery will be dependent upon how you manage all of these. I’ve seen buyers negotiate high financial caps with a supplier only to be giving back what they had negotiated through the other contract terms they agreed upon. They had a high cap but all the other limitations
they agreed, it reduced the real amount they could recover to something substantially less.

Fixed amount caps are good when there is a fixed amount to the contract. In negotiating financial for business with the supplier that is expected to grow over the term of the agreement I avoid fixed caps. That is because the potential risk grows as the volume increases and with a fixed cap the protection per item purchased is reduced with the volume. I also don’t like fixed amounts as claims that occur during the term reduce the value of protection you have in the future.

Breach and the right to terminate a contract for cause.

A breach is the non-performance of a contract or a provision in the Contract. There are two types of breaches, minor and material. A minor breach is usually a cause for the collection of damages. A material breach is a failure to perform that goes to the heart of the Contract and may be cause for both termination of the contract and claim damages. In contract drafting how do you establish something as a material breach, which if uncured would give the right to terminate for cause?

If you say nothing in your contract, it would be up to the court to determine whether it was minor or material and whether you would have the right to terminate the agreement. I don’t like to leave issues to chance, nor do I want a court to determine after the fact that I didn’t have the right to terminate the agreement. So within the agreement I want to use language to establish that right when it’s needed. Since termination is a right, not a duty, I want to use that right to drive the behavior I want from the supplier.

Let me give you an example, if you have a supplier who fails to deliver on time, money damages for the late delivery may be sufficient. If you have a supplier who you committed to purchase a high volume from and they are consistently not delivering on time, you probably want the right to terminate the agreement. If the Contract had language that said “time and rate of delivery of Products is of the essence of this Contract, and failure to meet time and rate of delivery shall be a material breach of this contract. You could establish the right to terminate for cause in that section, or more likely you would establish that right in a separate termination for cause section.

For example a termination for cause section could read: “Either party may terminate this Agreement, without any cancellation charge, for a material breach of this Agreement by the other party. Such termination will be effective at the end of a thirty (30) day written notice period if the material breach remains uncured.” In doing that you can spell out the specific sections, where the breach of that section constitutes a material breach.

Should breach of warranties be a material breach of the contract? In my opinion, that depends upon the warranty and the impact of the breach.

For example a contract may have a warranty against defects in material and workmanship.
Should a breach of that be both a material breach and also give rise to the right to terminate the agreement? While money damages might seem sufficient, what if the supplier wasn’t repairing or replacing any defective products? Would you want the right to terminate the agreement.

Standard Contracts also contain a number of legal warranties such as:
The party signing the contract has the right to enter into the contract.
Performance will comply with contract, laws, regulations, etc.
Product or Service doesn’t infringe the Intellectual Property rights of a 3rd party.
The Product or Service conforms to warranties and specifications of the contract.
Free of defects in design and safe for use.
The Product is new, and not re-conditioned.
Which of these would you want the right to terminate?

Always think about the impact of a breach. For the above list of warranties how would you respond?
The party signing the contract has the right to enter into the contract. I would want the right to terminate simply because if the individual didn’t have the authority, it’s not an enforceable agreement against the other party.

Performance will comply with contract, laws, regulations, etc.. Whether I would want the right would depend on the circumstances. If I had on-going purchase obligations I would want the right to terminate.

Product or Service doesn’t infringe the Intellectual Property rights of a 3rd party. If this prevented me from being able to use. Resell, or sublicense the item I would want the right to terminate.

The Product or Service conforms to warranties and specifications of the contract. If I bought it for internal use, money damages might be sufficient. If I was buying it to resell or use in a product that was for sale, I would want the right to terminate.

Free of defects in design and safe for use. I would always want the right to terminate. I don’t want to buy products that aren’t safe simply because of potential liability issues.

The Product is new, and not re-conditioned. . If I bought it for internal use, money damages might be sufficient. If I was buying it to resell or use in a product that was for sale, I would want the right to terminate. The reason for that is if you use a re-conditioned item, you cannot sell a product as new and that reduces the value of the product and customers may not want to purchase products that contain reconditioned parts.

Construction Contract Documents - mutually explanatory of one another or complimentary

In contracts that have both specifications and drawings included as part of the contract documents you will frequently find a statement that documents are to be taken as “mutually explanatory” or “complimentary”. For example, in construction if a document such as a bill of quantities stated the specific amount of soil for excavation and a specification stated the specific size of excavation footings and foundations, what would happen if the amount specified had been consumed, but there was still more excavation required to comply with the specification? Using “mutually explanatory” or “complimentary” is an attempt to have the multiple documents read together to determine the full requirements so not only did the contractor have to excavate the specified quantity, they also had to meet the specification even if that required additional excavation.

In most of those contracts that use “mutually explanatory” or “complimentary” there may be no order of precedence established between the drawings and specification. If there is an Architect or Engineer involved in the design, most of the time they would prefer to not have an order of precedence and have themselves be the decider of the conflict. If they do include an order of precedence it may give precedence to the most costly of the two items in conflict. As a representative of an owner I always preferred to include an order of precedence to deal with these types of potential conflicts. I didn’t want the architect or engineer to be free to spend my company’s money, and that could occur if you gave them full authority to make these decisions. Construction is local, so an Architect or Engineer and a contractor may have had significant prior dealings and relationships so while ethically they should be neutral, they may not always be neutral.

As between drawings and specifications, which should have precedence? Architects or engineers will say neither, they should be considered complimentary or mutually explanatory. Some groups give precedence to the drawings over the specifications and some give precedence to the specifications over the drawings. The keys in deciding the priority should be is 1) what document provides a more detailed description of the requirements and 2) what type of contract are you buying the construction under.

For example, using the soil excavation issue if the contract was based upon measured quantities under a bill of materials system, you have two things in conflict. The quantities listed in the Bill of Materials, and the quantities required by the specification. If the quantity in the bill of materials and didn’t take into account the amount of total excavation required to comply with the specification, the contractor would perform the work to meet specification and bill and be paid for the additional quantities measured. If the soil issue arose under a lump sum contract, there would be no estimated quantities provided, and the contractor should have determined the total amount of excavation required to meet the specifications.

I’ve always recommended against providing quantities in a lump sum contract because of the potential for conflict and claims that can arise if there is a difference between the stated quantity and the actual quantity required. If there is something where the volume could not be reasonably determined, there are other options than providing a specific quantity. For example the amount of soil that would need to be removed and replaced on a specific site because of concerns about the soil quality. In that case the owner would be concerned that the Contractor would include too high of a contingency because of the uncertainty. You can always exclude portions of the work from the lump sum and have that work be done on a unit rate basis that gets measured.

In doing a lump sum contract I would never provide Bills of Quantities. If you do, and your quantities are wrong or inadequate to complete the work, there will be a claim. If you don't provide quantities, it is up to the contractor to determine what quantities are required to meet the design. If you must include quantities, I would always make the document that lists those quantities have the lowest priority. Using the excavation example, I would have the specification that required specific depths for the footings and foundations have priority over the bill of quantities so when the two are in conflict, the specification requirements would have priority in the conflict between the two documents. A second reason to not provide quantities under a lump sum agreement is under lump sum agreements you don’t staff the site to measure quantities. So you wouldn't know if the quantities were or if there were exceeded.

If an order of precedence does not exist, all terms of the contract documents have equal standing. When you include an order of precedence provision all that does is say that in the event there is a conflict between a higher precedence document and a lower precedence document, the term or requirement of the higher precedence document shall prevail.

Each time you have multiple documents that make up a contract, always consider and establish the precedence you want between all of the documents that are incorporated. This is especially important if you will be incorporating any of the supplier or contractor's documents as part of the agreement.

Bills of Lading and Letters of Credit

In Linked in, an individual asked the question about who has the right to the bill of lading when an “F” type delivery term is used and the sale is by a letter of credit. As this question raised a couple of good topics I thought I would share my response.

A bill of lading is a document that may include the following type of information:
1. Name of the shipping company
2. Name of the shipper.
3. Name and address of the importer or consignee.
4. Name and address of the party to be notifies on arrival of the shipment.
5. Name of the vessel or carrier.
6. Whether freight is payable and whether it has been paid.
7. Number of originals in the set of the bill of lading documents.
8. Marks and number identifying the goods and a Brief description of the goods (possibly including weights and dimensions), number of packages.
9. Date on which the goods were received for shipment.
10. Signature of forwarder or carrier where they acknowledge receipt of goods.

Any INCOTERM that begins with an “F” such as FOB, FAS, FCA all place the responsibility on the buyer to arrange and pay for transport from the specified “F” point. The buyer does not need to get a copy of the Bill of Lading to arrange to have the forwarder pick up the goods. It is the forwarder that issues the Bill of Lading as proof of receipt of the goods. Multiple original copies of bills of lading may be produced.

Under a letter of credit situation you have four parties involved. The supplier, the supplier’s collecting bank, the issuing bank of the buyer, and the buyer. One of the standard conditions of a letter of credit is that a bill of lading must be provided to document that the goods have in fact been delivered to the buyer’s selected forwarder or carrier.

The flow goes as follows:
1. The supplier notifies the buyer that the goods are ready for pickup at the agreed “F” point.
2. The buyer contacts the carrier or freight forwarder to pick up the goods.
3. The carrier picks up the goods and provides the bill of lading to the supplier.
4. The supplier provides the bill of lading to the collecting bank showing their proof of delivery in accordance with the terms of the letter of credit.
5. The collecting bank provides a copy of the bill of lading to the issuing bank as part of their collection process under the letter of credit.
6. The buyer can get a copy of the bill of lading from the issuing bank for their records or in the event of a problem (such as a discrepancy between what is listed on the bill and what is actually received).

So the answer is if there was only one original bill of lading the Seller has the initial right to the bill of lading it as part of the letter of credit collection process. They do not keep the bill of lading and have to provide it to the bank to collect payment. The buyer will have the final right to it once payment is collected from the issuing bank as proof that both banks met their obligations under the letter of credit. As multiple original bills of lading may be issued, the forwarder could potentially prepare three. Two for the Supplier of which one they would keep and one they need to provide as part of the letter of credit payment process and one for the buyer’s records.

International Stocking and Sales

In a LinkedIn procurement group an individual asked what markup they should pay for a distributor or reseller to stock and resell products into local markets. In my responses to him it opened up a much broader discussion that I thought would be worthwhile to share with my readers.

In any reseller situation it is the OEM that decides the type of model they want their authorized resellers to follow. Some will sell to the reseller as a percentage off list price where the price the reseller pays is based upon their volumes. In that model the reseller needs to make their margin off the difference between what they buy it for and the price they can sell it to you at. Others OEM’s may have a more price protected model where the reseller is rewarded with discounts the more they stick to the targeted sales price the OEM wants to sell it at. What this means is that before you can get to the issue of what the margin should be, you need to understand what the OEM's sales model is to the reseller. Then you can select the best approach. For example, a cost plus model works well when the reseller is buying it at a discount off list. There the price they pay becomes the cost in your cost plus approach. It would not work if the OEM has the Distributor on a form of price protected model as they are getting compensated by the OEM for maintaining the target price. In a price protected situation neither approach work. The only time you would want to compensate more is if they are incurring additional costs.

The amount or percentage you will need to pay will be determined by two basic factors. The first factor is what services are you asking them to provide. The second is the point of sale that will decide where there profits are made and where they have to pay tax on those profits. In this case the individual wanted the reseller to be reselling into multiple countries. When you ask them to actually sell a product within another country, four things occur. First, the reseller would need to be legally registered to do business there. That can be costly, time consuming and expensive if they aren't already registered to do business there. Second, once they sell within that country they become subject to local laws. Third, the reseller becomes subject to payment of local income and sales taxes based upon those in-country sales. Fourth, since they will be paid in local currency, they can be subject to currency controls in terms of repatriating their profits and currency exchange risks. The combination of these can make the activity either something they don't want to do or very expensive for them, and impact your costs.

My suggestion was if the individual wanted the mark-up to be as small as possible and wanted the reseller to agree to work with them, they should be exploring the use of Bonded Free Trade Zones for each country that they want to sell into. A bonded free trade zone is an area set aside by the government where goods may be shipped into or out of and stored prior to the items clearing customs. If they set up a distribution center or contracted for one in a Bonded Free Trade Zone, they can operate in that location, but not be legally conducting business within that country. That can avoids the four problems that exist when you do business in the country. You do not need to be legally registered to do business in that country, as you are not conducting business in that country. Since you are not conducting business in that country, you aren’t subject to its laws or taxes. Since you are not selling within the country you can require that payment be made in a more stable currency and avoid being subject to currency controls or significant exchange risks. What you would need to do is have sales delivery terms where the customer purchases the goods within the bonded free trade zone and is responsible for import and transportation from that point forward.

There are many activities in procurement where people want suppliers to have local stocking point for pull replenishment programs or may want a distributor or reseller to stock items close to the customer base or point of use. If you want to be successful in establishing those types of programs, you need to always consider the impact and cost the other party will have and come up with a solution where you get close to what you want, and supplier has the ability to effectively manage the costs and risks and do that in a manner where the cost to you will be minimal. A smart supplier who wants to manage taxes could have a subsidiary based in a tax haven that establishes all these stocking areas. They could then have the profits they make on the sales (which won’t be subject to local sales or income tax) flow to the company in the tax haven where as long as the money is held there is also not subject to taxes. If they did that the percentage mark-up they need to charge you would be less.

Severability Clauses

I had a question on my LinkedIN group about when was the best time to add a severability clause. I thought it would be a good topic for the blog.

A severability clause is one that allows an individual clause or section of a clause to be severed from the agreement, if that clause or subsection is subsequently unenforceable at law. It allows the contract to remain in effect and operate without the clause that was severed. An example of a severability clause would be: "If any term in this contract is found by competent judicial authority to be unenforceable in any respect, the validity of the remainder of this contract will be unaffected, provided that such unenforceability does not materially affect the parties’ rights under this contract."

In the above clause several things are required:
1.The decision on enforceability needs to have been made by a competent judicial authority. It doesn’t require the specific language of the contract be reviewed. There could be prior case precedent making the concept included in the clause be unenforceable.
2.It’s severability cannot materially affect the parties rights under the agreement. This means the impact must got to the heart of the agreement and have a material impact on either party’s rights.

The answer to the individual question about when to include the severability clause is when you are initially drafting the contract. In fact many companies have standard boilerplate legal terms and the severability clause is usually one of those standard clauses. The reason why you would include a severability clause in the agreement from the beginning is that without it, if there was a term in the agreement that was found unenforceable, either party could argue that they are excused from performance under the agreement because of the unenforceable term. That would be an easy way to get out of a bad deal.

When you include it, it places a different standard on the parties. Not only does the term need to be unenforceable at law, it also needs to materially affect the party's rights. It it didn't materially affect either party’s rights, the agreement would remain in effect without that term. In the event of a dispute between the parties a court may determine a reasonable, substitute for that term in interpreting the contract.

What are “unenforceable terms”? They may terms requiring illegal or subsequently illegal acts. They can include terms or acts prohibited by statute. They may be terms that would be considered void as against public policy. Finally they can also be terms that would make a contract voidable such as duress, undue influence, or unconscionable.

Open Source Software risks

Open-source software (OSS) is software that is available in source code form. OSS is frequently developed in a collaborative manner, but could be developed by anyone that wants to share the software they developed in source code form. As with any software, the key to the rights a party will have is the specific license grant that is applicable to the software. There are a variety of different types of license grants, but usual ones for open source software will permit users to study, change, improve and distribute the software. The most common, referred to as the General Public License or GPL, grants the recipients of the software the right to free distribution under the condition that further developments and applications are put under the same license.

The first risk is comes from the conditions of the license grant. For example if you used General Public License program in developing a product that you wanted to license, your license to your customer has to be under the terms of the original license. The terms have to be GPL terms. If it were provided to you for free, you would need to license it to your customers for free. If you had the right to change, improve and distribute the software, you would need to provide those same rights to your customer not just on the original OSS code, but for the entire application that contains the OSS code.

When you use OSS code or license software or buy equipment that that uses OSS code, the fact that it is Open Source Code does not protect you against claims that the OSS code may be infringing upon a third party’s intellectual property rights, patents or copyrights. This means you could potentially be sued for infringement or you could have your use of stopped by injunction because it was infringing. If the equipment you buy needs the software program to operate, if you were stopped from using the code it would make your equipment useless.

To protect against these risks the first step is to first require the supplier to disclose whether any third party code (including open source code is used. When open source code is used, you want to understand the source of that code and a copy of the license it was licensed under to review. The source of the code can help identify the potential risk. The license will tell you what rights or limitations you will have with what you can do with that code. For example I was negotiating the purchase of a product that had open source code that was both on a General Public License and was by our evaluation from a risky source. Rather than include that code as part of our code, which would made our code subject to a GPL license, we kept the code separate and had customers, license the GPL code directly. The last way to protect against the risks if to make it clear exactly what the Supplier’s responsibility will be in the event there is an infringement claim against the open source code such as making sure that there is an Intellectual Property Indemnity provision in the agreement where they have the responsibility to license the right to use, make the item non-infringing. Many times a supplier may want the option to provide a refund of the price, or worse a refund of the depreciated value of the item in the event of a claim. Always consider what the impact of not being able to use the software or equipment would be if you could no longer use it.

Ask them to explain what they mean.

In the Linkedin group Contracts Questions and Answers that I manage an individual asked for a plain English explanation for the following language in a section:

"Nothing in this clause shall not confer any right or remedy upon the Customer to which it would not otherwise be legally entitled".

Without seeing the wording used in its actual context it's hard to know what the intent is. For example, is “Customer” a party to the contract or are they a third party defined in the agreement. The general consensus from the parties that responded was whoever wrote it either 1) doesn't understand English very well as the language includes a triple negative, they don't proofread well, or (iii) they were trying to obscure their intent.

In David Munn’s response to the question he viewed the intent of the wording was to say: "No matter what rights the customer is given under this clause, the customer doesn't really get those rights unless the applicable law or something else in the contract gives the customer those rights." In other words, it could potentially negate all the rights and remedies given to the customer in the rest of the clause. That would clearly be an attempt to obscure the intent where the reader could think they are getting certain rights or remedies that they will not get.

Whenever you encounter language that is confusing to read, always ask the drafter what the intent of the language is. What are they trying to accomplish? Then make sure the language is written in clear and simple language that both parties understand. If needed provide an example to further clarify the intent. This is an example of qualifying language. Every time qualifying language is used in section of a contract it may be done to either limit or expand rights. For example:

If the Customer was a third party you could have language in the warranty section such as “Nothing in this Section shall confer any right or remedy to Customer that they would not be entitled under law.” This would prevent the buyer from passing contract rights or remedies in that section down to the customer. The only rights the end customer would have with the supplier would be what they would be entitled to under law.

If the Customer was the buyer you could have language that says something like “In addition to any rights or remedies in this Section, Customer shall have all rights and remedies available at law or in equity.” This creates and expansion of their rights.

If the Supplier was trying to limit the remedies they could say: ”The remedies set forth in this Section shall be the Customer’s sole and exclusive remedies.” This would eliminate any remedies that might have been available at law.

Never let confusing language or language with double or triple negatives into your contracts.

Getting Supplier Information Back in Your Desired Format

As part of the contracting process frequently you go through a process to solicit information from the Supplier. Different locations, and companies may call them different things so I thought I would describe the ones that I am most familiar with. To simply solicit information about potential work you would normally use a RFI which is short for “request for information”. RFI’s are informational and are not intended to be a binding offer to conduct business by either party. The next acronym used is RFQ which stands for “request for quotes”. An RFQ usually solicits minimum information such as the price, lead-time and availability if the buyer were to place an order. RFQ’s are not intended to be a binding offer and usually what occurs is the buyer may issue a purchase order based on what was quoted based using the buyer’s standard purchase terms that the supplier can accept or reject. An RFP, which is an acronym for “request for proposals” may be used in multiple ways depending on the language that is used in the RFP. For example it could include complete terms that the buyer wants to purchase under and advise the supplier that their signing of the proposal is an offer that buyer may accept. An RFP that doesn’t contain those two things normally does not constitute a binding offer as the terms of the agreement have not been established, so there is no meeting of the minds that is required to form a contract. The last document IFB is an acronym for “invitation for bids”. Invitation for bids normally include the buyers standard agreement, and a format that they want the suppliers to complete and sign that constitutes a formal offer to perform the work at those terms at the price(s) quoted. There are a number of other variations or permutations that may exist by geography, by industry and especially where it is a public or commercial activity.

One of the biggest frustrations of the individuals that manage these processes is you request information be provided in your format, so you can do a simple “apples to apples” comparison and what you get from suppliers looks nothing like what you asked them to provide, so you now have to compare “apples to pears, oranges, and pineapples”. The reasons why suppliers do this can be:

1. They have a standard system they use that breaks the information down a different format and don't want to convert that to your format.

2. They may feel that their format makes them look better and if they used the standard format their proposal wouldn't look as good.

3. They may be concerned about your using the information they provide in a further negotiation and are trying to avoid giving you that tool.

4. Unless they will get all of the business, they may do it to avoid having you "cherry pick" (which means to take the best from all of the different bidders).

5. They may also be concerned that any breakdown would be used for deductions to the scope of the work.

Like everything in negotiating a lot depends upon the leverage you have. The bigger you are, the more they want your business, they will listen more. If you have leverage make it expressly clear (Bold and Underline) a statement that only proposals in your format will be honored. Allow them to submit an alternate only if they have responded to your format. In the document you provide them, tell them in advance what the basis is for the award, and that will potentially eliminate some of their concerns and get better responses. If a supplier doesn’t use the format, let them know that it their document was non-responsive to the requirements and was disqualified because they didn’t follow the specified format. When a bid team has to go back to their management and explain that not only did the not win the work, their proposal wasn't even considered because it was considered non-responsive, that sends a message to not do it the next time. That sends a message that will get out to other suppliers.. Once they know that you are serious about having the responses be in your format, suppliers will either respond correctly, or won’t respond at all. The only time you can't do that is when you need them or you don't have sufficient competition. In those cases you probably should be negotiating with them instead of taking in proposals.

I personally always provide a copy of the agreement I want them to sign and require them to identify any assumptions and exceptions in their proposal. That way I can quickly see what they want changed. If you take in their contracts with their wording it creates a much more difficult task that requires detailed evaluation. A change in one word can make something have a significantly different meaning.
A clause may look similar, but if you read and understand the difference in terms of what it means, normally what a supplier wants to offer you is something that transfers a higher percentage of the risk and cost to the buyer.

If you did work off their contract there are three focus to a review:
1. What is different from your proposed agreement or standard, and what is the impact of that different?
2. What is in addition to your proposed agreement of standard agreement, and what is the impact of or those additional items?
3. What is missing in their agreement from your proposed or standard agreement, and what is the impact of those missing items.

“Not to Exceed” versus “Guaranteed Maximum Sum”

In cost plus contracts,either of the above terms may used. What is the difference between the two terms?

When you write a contract that includes a not to exceed amount, the supplier or contractor is required to stop all work once that not to exceed amount has been reached. The problem is that the work itself may not be fully completed and the supplier has no obligation to complete it unless you increase the “not to exceed” amount. A “not to exceed” amount is established by the buyer. Under a not to exceed amount the supplier or contractor has no responsibility to manage the costs as they will get reimbursed for all cost and they aren’t guaranteeing the work will be completed for that amount.

When you include a guaranteed maximum sum in the contract, the supplier or contractor is required to complete the work. The agreement is still a cost plus type of agreement, but the supplier or contractor needs to manage those costs so they can complete the work at no more than the guaranteed maximum sum. Guaranteed maximum sum amounts get negotiated between the parties and may include incentives for the supplier or contractor to deliver the work for less than the guaranteed maximum sum. If the work is not completed and the guaranteed maximum sum amount has been reached, the supplier or contractor has to pay for any additional costs to complete the work.

Since in either case it’s the buyer’s money that is being spend, the decision on which approach you use will impact the amount of time you spend managing the supplier or contractor. If you select a not to exceed approach you need to spend more time managing the supplier or contractor as their performance can cause you to need to spend more money to complete the work. If you select a guaranteed maximum sum approach you can spend less time managing the supplier or contractor as you have established the total amount you will pay and if incentives were build in for a sharing of the savings you will pay less.

In some situations you could potentially use both approaches. For example if the work wasn't fully defined you could start the work on a cost plus basis and include a not to exceed amount. Once the work is fully defined you could then negotiate a guaranteed maximum sum commitment.

Limitation Of Liability - What Should Be Excluded ?

In a recent post on LinkedIn an individual asked whether warranty obligations should be included within the limitation amount, which was the value of the contract. That gave me the idea to discuss what should be excluded from the limitations. Limitation of liability traditionally consist of two limitations. The first limitation is on the types of damages that may be claimed. The second limitation is one that places a financial limit on the amount of agreed type of damages that may claimed. For example if the limitation limited recoveries to only direct damages, any financial limit would be on those direct damages.

I have a simple view of limitation of liability provisions. I believe they should only apply to claims between the parties to the contract for breaches of the contract. Based on this I have always sought to exclude costs or damages associated with any third party claims. There can be third party claims by the government for things such as not complying with applicable laws or failure to pay taxes. There may also be third party claims for personal injury, property damage, and intellectual property infringement. Even thought the buyer may not have caused the injury or damages, or been the party that infringed the third party intellectual property right, they may still be liable under the principal of agency. As a buyer you have no control over what the third party may claim as damages. Further for things like product liability claims any attempt by a seller to limit liability would probably be void as against public policy. As a buyer if you don’t exclude liability for third party claims, such as you would find in indemnifications, you can wind up in the situation where the third party can recover significant amounts from you, and you could only recover what may be remaining under the limitation of liability. That amount may have been reduced by other claims.

I also seek to exclude warranty obligations from the limitations. My argument is the limitation of liability should only apply to claims between the parties to the contract. Meeting the requirements of the warranty is an obligation, not a claim. The price you paid is based upon the commitment of the supplier that they will meet those obligations. If you included warranty obligations as part of the limitation of liability amount you would either need to have a substantially higher amount or you could have the situation where because of prior claims, there is nothing left and they could stop meeting their warranty obligations. My argument is that it’s in the supplier’s best interest to exclude warranty obligations from the limit rather than agree to a higher limit to include them. The reason is if the product has minimal failures or need for warranty repair or replacement, all they are doing is increasing the potential recovery amount for other claims.

If you provided the supplier with loaned material or equipment or shared confidential information with them I would also exclude claims for those from any limitation of liability. For loaned material or equipment the best way to manage those is by a separate agreement that would not be subject to the limitation of liability. As most limitation of liability provisions limit the types of damages that may be recovered and traditionally exclude lost profits, you need to exclude breach of any confidential information. The primary damages you sustain for the breach of a confidentiality obligations is lost profits. It’s better to manage confidential information under a separate agreement where it would not be subject to the limitation of liability provision.

As a buyer, I would never agree to a limitation of liability cap amount at the amount of the contract and have that include everything unless I had one hundred percent certainty that there would be no third party claim and the impact to me of any failure to perform and my cost to recover would be no more than what I paid. There are very few, if any, contracting situations that I’ve run into where that would apply. If you are going to agree to have a financial cap on the limitation of liability, the amount you should require should be dependent on how many things you have been able to exclude from the limitation. The more you can exclude the lower the cap can be and vice versa, Just as with liquidated damages the amount should be a reasonable estimate of what your damages could potentially be. My personal favorite approach to financial limitation is to have a minimum amount that increases as the amount of the business between the parties increases. If you agree upon a set amount and the business grows your potential risks are bigger and a fixed cap amount may not provide adequate protection.

Stopping Work for Non-Payment

In contracts between owners and contractors or between prime contractors and subcontractors delays in payment are frequently a concern. In some jurisdictions, and for specific industries such as construction,a contractor or subcontractor may want to include the right by statute to stop or suspend work if they have not been paid. In jurisdictions where those types of statutes do not exist, the right to stop work for non-payment needs to be included within the agreement. Not paying on time may be a breach of the contract, but in most cases it would be considered a minor breach where only money damages could be claimed unless the delay is unreasonable. As a result a contractor or subcontractor could wind up continuing to invest more in the work and risk having to sue the breaching party to collect the money and damages. Many prime contractors have tried to implement “pay when paid” provisions so they don’t have to pay a subcontractor until the prime contractor receives payment from the buyer (see separate post on “Pay when paid”). That doesn’t do much to protect the subcontractor.

If I were the subcontractor I would want several things to protect me against the unethical owner or prime contractor. First, I would want to be paid interest on late payments so I’m not providing free financing to either the owner or prime contractor. Second, to deal with the issue of disputed amounts invoiced, I would want language in the agreement that in the event of a dispute in the amount of the payment, the other party may withhold only the reasonable value of the actual amount under dispute. That way they cannot withhold payment of an entire invoice. Third, I would want the right to stop work if any undisputed payment was more than thirty days late. Fourth if the work is stopped I would want to be paid any additional costs to start up the work and have the work be extended day for day for each day it was stopped for non-payment. Last, I would want the right to be able to terminate the agreement for cause if payment was more than sixty days late.

From a procedural standpoint I would add a concept that is frequently used in governmental contracts but seldom used in commercial contracts which is a show cause notice. No one likes to be surprised, and simply stopping the work without any advance notice would be just that. A show cause notice is similar to a cure notice and would provide the facts, remind them of your contract rights, and ask them to provide you with a reason why you shouldn’t exercise your rights. For example,

Invoice number 1234 was submitted for payment on October 1, 2012. In accordance with the terms of the contract EXCO was required to make payment on November 1, 2012. That payment was not received. Invoice 1234 remains unpaid as of the date of this notice. In accordance with Section 9.1.5 of the contract, in the event of payment is more than thirty days late (December 1,2012, SUBCO has the right to stop work for non-payment. This notice is to remind you of your payment obligation and put you on notice of our right to stop work if payment is not made by December 1, 2012. Please show cause why work should not be stopped if payment is not made by that date.

If you were not paid you could both stop the work and send a cure notice that they have breach the agreement for non-payment and the other party would have the cure period in which to correct the breach or be terminated and be subject to damages.

The unethical owner or prime contractor may not want to agree to this as it would take away their ability make money at the expense of their contractor or subcontractors. If an owner or prime contractor is ethical, agreeing to this language places no additional burden on them. They would already pay when they are obligated to pay.

Show Cause Notices and Cure Notices

One of the problems with contracting is the same terminology can be used in different settings and have a different meaning. For example a court issued show cause notice requires the recipient to appear before the court and explain why a certain action should not be taken. In business companies may use a form of show cause notice to place employees or other parties on notice that there has been a performance problem or misconduct that needs to be corrected. In government contracting a show cause notice may be a precursor to terminating the agreement where they want the supplier to explain why they should not be terminated.

In most commercial contracts companies seldom use the concept of show cause notices. Instead if a party is in breach of the obligations under the agreement they will issue what’s called a cure notice. Most commercial contract termination for cause provisions requires several things prior to being able to terminate. First there must be a material breach of the agreement. In drafting this clause to avoid any misunderstanding, the parties may agree what specific terms, which breached, would constitute a material breach of the agreement. Second, the non-breaching party needs to provide notice to the breaching of the circumstances of the breach. That notice is called a “cure notice”, Third, the breaching party will have the right to remedy or “cure” the breach within the period of time specified in the termination for cause
section. If the breaching party cures the breach, the non-breaching party cannot terminate the agreement as the breach has been cured. If the breaching party fails to cure the breach, the non-breaching party has the right, but not the obligation, to terminate the agreement for cause.

That doesn’t mean that a show cause notice cannot be used in commercial contracting. In fact is could be a preliminary notice that could be used to notify the other party that is something isn’t corrected within a specific period, that you would take a certain action or exercise a specific right. An example of that will be in my next post called “Stopping Work for Non-Payment”.

Completion Types in Construction Contracts.

In construction contracting you may define and refer to three types of completion: substantial completion, final completion, and completion of the defects liability period. In many construction contracts to owner will retain a portion of each payment as a form of making sure that the contractor completes the work, or having those funds available it they need someone else to complete the work.

Contractors don’t like to have those funds, which may be substantial, to be retained any longer than absolutely necessary. From that the concept of substantial completion was created is used to allow the release of a significant portion of those retained funds. A common definition of substantial completion is the work is complete with the exception of a small “punch list” or “snag list” of items that still need to be corrected or finished. When substantial completion is certified by a third party such as an architect or engineer or agreed, the contractor will invoice for payment of the amount of funds or percentage to be released at substantial completion. The owner retains the remaining amounts as protection that the contractor will complete the remaining work.

Once all the defects have been corrected and all work is completed, if there is an architect or engineer involved they will issue a certificate of final completion. The final completion does two things. First, it allows the contractor to invoice the remaining amounts withheld, except for any amounts withheld for the defects liability period. The second thing it does is serve as the start of the defects liability or warranty period on the work.

The completion of defect liability period ends the buyer ability to make future defect claims. It does not end the contractors responsibility to correct defects that were identified during the defects liability period. If the buyer was retaining monies during the defects liability period, most agreement do not include anything similar to substantial completion for the defect liability period. The owner would have the right to withhold the remaining amount until the correction of all defects listed defects are complete. Depending upon the relationship, amount withheld, and the value of the defects remaining to be corrected, a Buyer may agree to release further funds and still withhold enough to correct the work if the contractor failed to complete the correction of the remaining defects.

The primary alternative to retaining funds is the requirement that the supplier provide bonds or guarantees given by a third party that guarantee performance by the contractor.

Material Representations and Warranties

What’s the difference between the two and when should you use each? A material representation is a statement of fact at the time the agreement is entered into. For example a material representation could be a statement about performance of a product or service. Warranties can be a statement of a future right or duty or a statement of fact at the time the agreement is entered into. You can have warranties that are a statement of fact. You can also have warranties that are both a statement of fact at the time the agreement is signed and also a future duty. For example:
1. A warranty that the party signing the agreement it has the right to enter the contract is a point in time warranty as of the date of signing.
2. Performance will comply with contract, laws, regulations, etc. This is a statement of a future duty.
3. No claims or liens exist. This can be both a statement of an existing fact but also a future duty to make sure liens or claims are not filed.
4. Product or Service doesn’t infringe the IP rights of a 3rd party. This can be both a statement of an existing fact but also a future duty to make sure there is no infringement in the future.
5. The Product or Service conforms to warranties and specifications of the contract. This can be both a statement of an existing fact about a current product of a duty applying to future products.
6. The product is free of defects in design. This can be both a statement of an existing fact about the design of a current product of a duty applying to future products or changes to the existing product.
7. The product is safe for use. This can be both a statement of an existing fact about the current product of a duty applying to future products or changes to the existing product.
8. The Product is new, and not re-conditioned. This can be both a statement of an existing fact about product or a duty applying to future products being sold under the contract.

A warranty is the highest level of commitment. A material representation is next highest. A firm commitment using the words will of shall is next. Based upon the term that you use to express the commitment, you may have different remedies. In most locations the breach of a material representation of an existing fact would allow you to rescind the agreement without liability and recover any monies paid (but not collect damages). The breach of the warranty provides you terminate the agreement for cause and claim damages.

In sales, salespeople frequently do what is called “puffing”, which means exaggerating their product or service’s performance or capabilities. If you are relying upon what they are telling you to make your buying decision, the best way to make sure it’s the truth is to include those supplier representations as either a material representation or as a warranty. If it were a material representation and it turned out to be false you would be able to rescind the agreement and get a refund of all payments. If you made it a warranty and it was false you could start the termination process where the party must cure the breach. If the breaching party fails to cure the breach within the agreed time frame, you then have the right ( but not the duty) to terminate the agreement for cause and claim damages. If the other party desn’t want to agree to either, don’t rely on what they have said as being factual and follow the rule of Caveat Emptor (buyer beware).

Whether you use Warranty or Material Representation really depends upon the impact it would have on you if the statement of fact were not true. If the impact was minor, having it be a material representation may work, as it will place you in the position you were before the contract. If the impact to you of the existing fact not being true would be substantial I would always make it a warranty so I can recover the damages.

Latent Defects

Latent Defects in Products:
A latent defect is a flaw, weakness or imperfection in a product or good that the buyer cannot discover by reasonable inspection. The buyer’s rights for a latent defect will depend upon the circumstances. If the supplier had knowledge of the defect and failed to disclose that to the the buyer, the buyer should be entitled to rescind the deal and get their money back as it failed to meet the implied warranty that the product be of merchantable quality. If the supplier did not know about it, and the buyer had “accepted” delivery of the product or service it still would not have been of merchantable quality and the buyer should be able to have the product repaired or replaced by the supplier at no cost. If it was sold “as is” and the supplier knew of the defect but did not disclose, it the buyer should be entitled to rescind the deal and get their money back. If the product was sold “as is” and the supplier identified the defect, the buyer would not be able to get their money back.

The length of the warranty term you negotiate is your primary protection against latent defects in a product. Terms like epidemic defects are used to help recover a larger share of the buyer’s costs for latent defects when there are a significant number of defects in the product of the same cause. The term, and the supplier’s responsibilities and cost liability you agree upon for epidemic defects liability is a major protection against latent defects in a product. For example I once encountered a situation where a number of a supplier’s components were failing in the field. We determined that the root cause of the problem was material they used for insulation.
The material, when exposed to humidity over a period of time would deteriorate and would cause the product to fail. It was clearly not something that was capable of identification when it was inspected.

Latent Defects In Software
Latent defects may also occur in software. The most common way of finding them is through software test programs that would be used as part of any acceptance testing of the product where if you find them you can refuse to accept the software, return it and seek a full refund of the price paid. Once you have accepted it the terms of your license agreement will identify want the developer’s responsibility is for correcting the problem. Few software developers would warrant that their product is error free, as it simply may not have been tested under all possible uses and conditions. This means that your primary protection against latent defects in the software is your software warranty that will require them to correct the error or provide a work around to correct the defects. The secondary protection is the purchase of maintenance and support that requires them to do the same thing. In fact most software warranties are deliberately short terms in order to force you to purchase maintenance to correct latent defects found after the warranty has expired.

Latent Defects in Firmware and Programmable Logic.
Firmware is software code embedded in a semiconductor chip that cannot be changed. This is different from programmable logic semiconductors that may be changed. A latent defect in the firmware should be treated in the same manner as a latent defect to a product as it cannot be changed, it must be replaced. A latent defect in programmable logic can be changed and should be treated like software. It simply needs to have the code updated and replaced to correct the defect. A good example of a latent defect in firmware occurred in an early version of one of Microsoft’s Pentium chips. When used for certain mathematical equations, there results would be in error. Since it was in firmware they could not simply provide a software fix, It required correction in the design of the chip. As most people didn’t use the functionality it didn’t impact them and they had no desire to return their system. For the individuals that used that functionality, it required correction of the latent defect and replacement of the chip.

Latent or Changed Conditions

In construction contracts a bid or negotiated price is based upon both the information provided about the location or site itself and what is visible. After work commences, the contractor may uncover prior work or in site work to prepare the site for the desired construction and find a different conditions than the information or visual inspection would have indicated. These latent conditions can add significantly to the cost of the work. For example sample borings done at the site in different locations could show soil or a quality that may be used, whereas a latent condition could involve uncovering huge boulders that need to be removed or large areas of soil of a quality that must be removed from the site. It could also involve uncovering of soil that is contaminated and must be disposed of in a costly manner. In a renovation to a building a contractor could uncover a significant amount of electrical wiring that does not meet the current building codes and must be replaced.

Most construction contracts will include a latent of changed conditions provision. In those the additional cost of dealing with the latent condition and additional time required to correct the latent condition is determined between the parties. While traditionally it is the owner that bears the cost, the specific term that gets negotiated in the contract may change that so it’s important for the parties to understand exactly what they are agreeing to. I read about a case in Australia where the latent defect clause specifically excluded contaminated soil. In agreeing to that the contractor gave up their right to make claims for latent conditions involving contaminated soil. Contaminated soil was found on site and that one error cost the contractor over two million dollars to correct it which they were not able to claim as a latent condition.

Once the work is completed, the work itself may have latent defect that the owner could not discover by reasonable inspection. Most warranties are intended to cover the contractor’s responsibility to correct latent defects in the construction as you can’t return the work to the contractor and expect a refund. There may also be latent defect in the design that while not discovered during the construction of the work arise at a later point in time. A great example of that was the John Hancock office building in Boston, Massachusetts. The Hancock building was a sixty-story office tower in which the large window wall windows kept blowing out and crashing to the ground. That required a different design and a complete replacement of the windows to correct the problem. It was a combination of contractor warranties and Architect’s errors and omissions insurance that is used to protect against these forms of latent defects.

How long is an agreement active?

The answer to that question depends upon how you define “active”.

You can have a contract under which you may no longer make purchases or the supplier may no longer need to sell as the purchase term has expired. While the purchase term may have expired, those agreements will remain "active" until all contract obligations are met. If the term of the agreement has expired, that doesn’t excuse the buyer from making any payments that may be due. The supplier may have warranty obligations. The obligation that you want to survive the either the termination or expiration of the purchase term are normally spelled out in what’s called a survival clause. Survival clauses would include things like the responsibility to pay taxes that may be due based on the work performed or products delivered. The obligation to pay any amounts due and payable. The responsibility to repair, replace or correct any defects under the contract warranties. The obligations to defend against certain third party claims as provided for in any indemnification. As there may be law suits that happen after the expiration of the contract, you would also want any limitations of liability, the order of precedence and agreed choice of laws and forum for any disputes or agreed method of arbitration to survive. If the contract had confidentiality obligations included, you would also want those to survive.

Some of those surviving obligations will have a specific term after which they expire. For example warranties may have a specific duration after which the supplier no longer needs to honor the warranty. The obligation to maintain information as confidential usually has a term associated with that. Taxes and indemnifications will normally not include a specific term. So the contract is still “active” until those obligations expire. The thing that will cause the tax obligation to expire is when the applicable government can no longer make a claim for taxes. The thing that will cause the indemnifications to expire is determined by the statute of limitations for the specific jurisdiction. The statute of limitations places a time limitation upon when a suit may be brought and they will vary by jurisdiction. For example in New York the parties to a contract have six years in which to bring a contract claim including a claim for fraud. For claims of personal injury or product liability a third party has three years from the date of the injury in which to bring a claim. A claim of infringement of intellectual property rights normally has three years after the infringement should have been reasonably discovered by the owner in which to make the claim.

Since contracts are “active” until all obligations have been met, most companies will have a formal records retention program to retain the contract files until all potential claims that could be made have expired. They may not be active in terms of needing to manage them, but they still need to be retained. While a contract file in the U.S. may only need to be retained for seven years from a perspective of taxes, as a minimum you should retain it for at least the useful life of the product plus three years, if not longer. I’ve had many times where I had to call our records retention company to pull contracts that hadn’t been used in ten or more years.

Partial Terminations?

In another forum some asked whether the reduction of a portion of the scope of work was a termination for convenience. Like everything else when you have a question about the rights or obligations of a party, the first thing to do is to read the contract. Normally the concept of termination for convenience applies to the entire agreement and would also require compensation if exercised. The right to remove certain portions of the scope of work or add work is usually addressed a different section of the agreement called “changes” or “variations” provision. You could also have a termination for convenience section that provides for both full and partial terminations.

A good buyer contract should have both clauses so that the buyer has the option of either eliminative a portion of the work or ending all of the work. For a buyer your primary focus in negotiating both of those provisions is to have the flexibility to do what is best for your company. Having that flexibility will also have a cost associated with it as there may be work in process, materials that we ordered that are non-cancellable, etc. As such, the buyer’s goal in a negotiation of these is to make the supplier whole for these costs, but to not pay any more than that. Suppliers on the other hand will always concerned about the unscrupulous buyer or owner that may simply want to remove portions of the work or terminating the contract for convenience simply as a way to award the work to another company who may be cheaper in price.

Can you protect each party’s interests in negotiating both of these terms? I think that a supplier would reluctantly agree that if the buyer really doesn’t need the work, they shouldn’t profit from that. I think that buyers might reluctantly agree that the supplier should be able to collect some damages if the work is simply taken away to be given to another company. A possible solution would be to structure the rights as combination of the payment of costs and damages. In all instances the supplier would be reimbursed their actual costs incurred by either the reduction in scope or the termination for convenience. Whether the damages would be applied would depend upon the circumstances. For example it could be written in a manner where if within a specific period the buyer contracted another party or parties to complete the work, then a damages amount would be paid. If the buyer took no such action within the agreed time frame, then there would be no damages for the reduction in scope or termination for convenience. All the supplier would get would be their actual and reasonable expenses they had incurred at the point the termination or reduction in scope occurred.

The key from a supplier's perspective is to make sure that the damages are sufficient enough to deter the buyer from simply replacing them one with another supplier. For the buyer in doing something like this, if the reduction of scope was for a real need and the balance of the work won’t be completed at any time soon, it eliminates having to pay damages. The establishing damages amount for termination for convenience or major reductions in scope needs a simple tool to determine what’s the best approach. Suppliers also would know that most of the time if the buyer needs the work, they will not wait the time to avoid the payment of damages. As changes these type of changes may occur at any time during the course of the work, as a buyer you would want them to not be a fixed amount. Instead a percentage of the remaining value of the work cancelled would reduce the actual amount that a Buyer could be liable for as work progresses.

I’m sure that there are some suppliers or contractors that would argue that once awarded, the buyer should not have a right to terminate the agreement for convenience or reduce a significant portion of the scope. That’s not a realistic expectation to have as in business change is constant and companies need to be able to respond to the change. I’ve had some suppliers or contractors argue that these rights should be mutual. What that would do is have every supplier that made a bad deal would want to use it to walk away from their commitment. What that could also do is make any investments the buyer made to qualify and use the supplier’s product useless. What that could do in a production setting would be to eliminate a source of supply and not be able to produce until you could source and qualify alternative source. The impact to the buyer could be huge and the damages the supplier would need to pay to have that right would also be huge.

Have I ever used a termination for convenience provision simply to replace a supplier? The answer to that is yes, I have. I’ve done it when it was clear the two companies were simply not on the same page over the work or our requirements. I’ve also done it when it was clear that the work was clearly over the supplier’s capability or the capability of their team assigned. No supplier likes to be terminated for convenience but many times they may also know that if they continue they may breach the agreement and then not be able to recover their costs and may be required to pay damages.

Have I ever used a reduction in scope simply to give the work to another supplier or have the work performed by internal resources? Absolutely. It was always when the supplier in question was a problem, like wanting to make huge profits on new or changed work or simply wasn’t being responsive. When a supplier is a problem sometimes it’s worth paying to get rid of them. No supplier likes to have the scope of the work reduced, but most love it when the scope of the work is increased. I tell them two things. You need to take the good with the bad. As a customer I feel that a supplier need to continue to earn my business and my future business ever day. The best way to do that is do good work and maintain a good relationship. If they work with me and help me they shouldn’t have anything to be concerned about.

How would you deal with this?

An individual asked me how I would deal with a situation and I thought readers might like the thought process.

The facts were that a governmental authority loaned a piece of equipment to a supplier. There was a verbal, but unwritten understanding that the supplier could use that equipment for other customers. The government group was audited and came back to the supplier wanting the supplier to pay rent for the non-governmental use of the equipment retroactive to the original loan date. If you were the contract’s person for the supplier how would you manage this?

The first step in any claim or dispute is to always go back to read what the agreement said. In this case it would require reviewing both the purchase agreement and any separate agreement for the loan of the equipment to see if there is anything that either restricted the use of the equipment to the government or whether there is a requirement to pay for any non-governmental use. As this was a government procurement you would need to check and regulations that were incorporated by reference. If there was nothing that either restricted use or required payment you could say no. Before saying no you need to remember they have a problem (an audit write up) that they are trying to solve. So you may need to work with them as part of maintaining a good relationship.

The second thing that I would do is focus on the equity of their request. You should not be punished for their mistakes. That is exactly what a retroactive payment would be. In commercial contracting you don’t get “do overs”, so you would not be able to retroactively recover anything from those other customers.

A third thing I might do is to make an argument that they already had received value for the loan of the equipment without restrictions as the price you charged them for their work took into account the fact that you would be able to use it for other customers. Following that line I would then highlight the fact that if they need a retroactive payment, you would need to retroactively adjust your pricing to them as they are changing the underlying deal upon which the pricing was based. To them what that would do is only solve one problem at the expense of creating another problem.

That could lead you to a point where you can propose a solution. If they give up on the retroactive aspect of the claim, you will be willing to give up any retroactive price adjustment claim. Going forward you will agree to pay a fee on any new customer use. I would suggest that if their goal is to recover a portion of the cost of the loaned equipment the rate needs to be competitive.There has been use and depreciation of the asset. What has already occurred is the proverbial water over the dam for which there is no going back. If they price it too high there is no incentive for the supplier to have their other customers use it. If there is no other customer use, the government recovers nothing.

If they still insisted that it be retroactive based on the acquisition cost you would then need to have management make the business decision on what to do. What they would consider is:
1. What the cost impact is of having to pay it?
2. How strong of a position do you have to just say no, to avoid paying it?
3. Is there additional value to the relationship you can get if you were to pay it?
4. What would be the impact to the relationship if you said no and stood behind that?
5. What is the leverage position of the parties in the relationship?

Escalation versus Equitable Adjustment

In another forum someone asked the difference between escalation and equitable adjustment in contracts so I though it would be good thing to do a blog post about.

Escalation provisions are used when you know that the costs over the term of the contract are going to change and you don't want the contractor including a significant contingency in their price to cover those changes. In doing that you are taking the cost risk if their are any changes in the costs that are subject to the escalation provision. If the contractor took the risk and the costs wind up to be less than the contingency they built in, the difference becomes more profit for the contractor. Escalation provisions can be written to cover changes to individual costs such as labor. For example if a contract was being performed by union labor and the labor contract was set to expire during the term, escalation could address only the exact change in the labor contract rate. They can be written for changes to specific materials in a highly price volatile market. They may also be used to address inflation over the term of the contract. Well-drafted escalation provisions will always establish the basis against which cost escalation will be measured and a method to adjust the price based upon those changes occurring over time. For example if you outsourced the manufacture of an item where there was frequent changes in the cost of the inventory being used to manufacture the product, you could manage the escalation on a monthly basis. You would look at the changes to the inventory value which could either go up (escalate) or down (deflate) and have a methodology for either credits/payments or adjustments to the price of the product for that coming month.

Equitable adjustment denotes that a party will unilaterally make an adjustment that is fair or equitable. The frequent problem is both parties may have different opinions of exactly what would be equitable. I don’t like equitable adjustment to be used in anything that ties cost or cost related items simply because of that fact.
Equitable adjustment tends to be proposed when there is a change or a delay. They will make an equitable adjustment to the price for a change or deletion. They will make an equitable adjustment to the schedule or date for completion. Neither of those tell you what those adjustments will be. My preference has always been to use unit rates or formulas whenever possible rather than use equitable adjustment. For example in a changes provision that allows changes to the scope of work for the cost of the change I might have something that allows for the cost to be either an amount mutually agreed by the parties or the actual cost plus specific percentages for overhead and profit. I would also include language that deductions to the scope of work would be calculated in the same manner as additions. I do that drive the supplier’s initial proposed cost for the change to be reasonable as they know that if I don’t agree with what they propose I can make them prove their actual cost and pay them that plus the agreed percentages. The time impact for delays can be managed with language where you provide a
“day for day” extension. The time impact for changes to the scope is more difficult to establish a formula. I believe that rather than leave it open to an equitable adjustment its better to negotiate any time impact at the same time you negotiate the cost. If I was representing a buyer I would want that to be either a time period mutually agreed by the parties or an equitable adjustment. I want that so the supplier or contractor will propose something that is truly reasonable rather than being subject to an equitable adjustment which they may not view as being equitable. I also don’t want the supplier or contractor to use that to try to drive a higher price.

If you are a supplier or contractor and you agree to equitable adjustment language, it's very important to have strong record keeping and be documenting the cost or time impact. That way when it comes time to get the equitable adjustment you can prove what that adjustment should be. You also have the necessary documentation should the other party not want to give you an equitable adjustment where the matter may need to be resolved in by escalating the issue to their management, arbitration or litigation.

If you are going to use either word in a contract it's best to create a definition for them so it’s clear exactly what it means when you use them.

Bond Amounts

In procurement there are two general types of bonds that you may encounter. One type is a bid bond that is used to ensure that the bidder stands behind their bid amount and executes an agreement at that amount. Bid Bonds should be sufficient enough to cover any excess cost of re-procurement if the low bidder is unwilling to sign the agreement. Performance bonds need to cover the amount you would need to pay to complete the work if the supplier or contractor abandoned the work, or failed to meet certain on-going obligations requiring you to hire another party to complete those obligations. Payment bonds cover any contractor non-payments to subcontractors that the buyer could be liable for under Mechanics or Materialman’s lien statutes where a subcontractor could place a lien on the property where they provided services and were not paid. Many times
Performance and payment bonds are issued as a single bond covering both issues. The cost of a bid bond is usually low, to a regular customer of the bonding company they may be provided at not cost. There is not standard cost for a performance bond and the rates will be affected by a number of factors such as:

• The amount of the bond.
• The type of contract being bonded.
• The location of the work.
• The contractor’s financial standing.
• The past job history of the contractor.
• The contractors current work on hand.

Rates usually start at one percent (1%) for low risk situations with highly qualified contractors that have the right risk factors for the bonding company and go up from there, so a contractor with credit issues or financial deficiencies will pay a significantly higher amount that will be passed on to the buyer in the contract price.

There are several factors that should drive the amount of the bonds that are required. A buyer should consider many of the same factors a bonding company would consider:
• The type of contract being bonded.
• The location of the work.
• The contractor’s financial standing.
• The past job history of the contractor.
• The contractors current work on hand.

In addition they need to consider potential inflation and increases in materials or labor costs that may occur in the interim with respect to bid bonds. For performance and payment bonds they should also consider the cost of those bonds versus the value they will provide.

Since bid bonds usually cover a very small period of time, and cover only the additional cost of re-procurement, the amount of any bid bond may be a small percentage of the bid amount. The longer it would take to re-procure something the higher you would want the percentage to be. If the contractor fails to complete the work you would have the following funds to use to pay for another party to compete the work.
• Any amounts not paid to the contractor of the original contract price.
• Any retainage held until completion of the work
• The bond amount to cover the cost.
• You would also have the right to sue the contractor for damages for any additional costs you incur in completing the work that are over and above these three previous sources.

Many times under a performance bond the bonding company may reserve the right to hire another party to complete the work. Their goal is to ensure that the full amount of the bond does not get used. If its clear that the could not be completed for the bond amount they would not exercise their right and would pay the owner the amount of the bond leaving the owner to complete the work. What this does is include another party into the relationship where their sole goal is to mitigate their costs. If you suffered any greater costs you could sue the original supplier or contractor for breach and seek to recover any added costs as damages. If the supplier or contractor had minimal assets you might recover nothing. Conversely, if you had little a highly capitalized supplier or contractor, you wouldn't need a high bond amount or might not need to require a bond. If they failed to complete the work you could sue them for breach and recover any difference in between the contract price and the actual cost to complete the work as damages. I had times where I would bid work and require a performance bond and also have the supplier identify how much they would deduct if we waived the requirement for the bond.

In private procurement where you can be selective of what companies you will allow to bid and could even control what subcontractors were acceptable or not, the decision on bonds and bond amounts becomes a cost versus risk decision. If you aggressively qualify who you allow to bid and hire only companies that have a strong track record of performance with solid financials, the need for bonds becomes less and if you do require bonds the amounts can be less because the risk is less.

In an on line forum one party commented that they preferred to use a letter of credit to cover both performance and payment risks. That’s an option that an owner may prefer as all that is needed is to show the conditions on the letter of credit have been met so the payment needs to be made. The letter of credit does not have the high cost of a bond. It also eliminates having to deal with the bonding company. Few suppliers would like this option as it ties up that portion of their available credit line for the period and would affect their ability to take on other work and finance their operations. To me it’s an option that could work for a contract of a short duration. It would also require very clear conditions that must exist both in the contract and in the letter of credit for the payment under the Letter of Credit to be paid.