Friday, May 25, 2012

Customer Supplied Material

A reader asked me about the use of customer supplied material or equipment that would be used in an OEM product and how to deal with it with the customer. The problem this creates is you have no privity of contract with the original supplier of the material or equipment and the customer is requiring certain commitments with respect to the sale of the product which you are not getting in turn from the material or equipment supplier. This creates an uncovered risk for you that needs to be managed in the agreement with the customer.

There are a number of issues that you must deal with in this situation. Those are:
1. Performance of quality problems with the material being supplied.
2. Potential third party claims resulting from the use of that equipment or materials such as claims of personal injury or property damage they cause, claims of infringement of intellectual property rights or claims by governments for the equipment or materials failing to comply with laws.
3. Potential claims against you by the Customer.

There are basically two general ways in which to manage potential third party claims. One is the customer could assign their rights under the contract with the supplier of those items to you so that you have privity of contract. The problems with that is the commitment they had from the supplier may not match what the customer is requesting of you. The second problem is it makes you responsible to collect from that supplier and to pay any costs of litigation as they would be your supplier. If you took this approach you would want two things. The customer should reimburse you for any costs of litigation with that supplier. Second , you would want to limit the recovery from you for any claims the supplier causes to be limited to only those amounts that are recovered by you. For any claims that involve joint liability, in addition to the above you would also want your liability capped based upon your percent of the problem. The goal is to assume no responsibility for their actions over what can be collected and have the customer pay any costs of collecting.

The second approach is to have the supplier not be assigned. While that would excuse you from indemnifying the customer, it doesn’t protect you from potential liability because you sold a product that contains the supplier’s material or equipment. In this situation since you have no privity of contract with the supplier, you would want the customer to indemnify you against any claim that involves the supplier as they should have the indemnity from the supplier to cover that risk.

As to performance or quality problems, irrespective of which approach you use for third party claims, you need to establish a standard for your responsibility in managing the supplier. For example you will use commercially reasonable efforts to manage the supplier’s quality and delivery performance. You then need to look at specific commitments you make to the customer and the impact the supplier’s non-performance will have. For example:
1.For late delivery caused by the supplier, you want to be excused from any remedies or damages for late delivery.
2.For quality or reliability problems you encounter, you may want to establish a threshold of acceptable levels included with you price in managing the supplier, where you are reimbursed by the customer for you actual and reasonable costs associated with quality or reliability problems that exceed that threshold. The customer should assume the cost of repair or replacement of all defective items so your cost on failures that are less than the threshold are only the re-work of your product to replace the defective item. If your product cannot be reworked or is damaged so it can’t be repaired and the cause of that is the supplier’s product, you should have no obligation to provide a repaired or replaced item.
As to potential customer claims for anything other than third party claims and quality and performance claims, you want to be excused from liability for any potential claims the customer may have the right to claim under the contract to the extent cause of the claim was caused in whole or in part by the Supplier. If a customer does not want to excuse you for items in which you were partially at fault, you want to limit your liability on a comparative basis. For example, if the total liability was $100,000.00 and the portion attributable to you is thirty percent (30%) your total liability should be no more than $30,000.00

In these situations it’s important to make it clear that you had no role in the supplier qualification or selection. You had no ability to control the terms of the supplier’s contract and you are not a party to that contract. For that supplier you are providing a simple management service. In providing that management service you cannot assume liability for their actions. You also cannot assume costs their supplier creates above a certain levels (the thresholds you agree upon). What you are agreeing to be responsible for is all the work and materials and services you provide which includes your committed efforts to manage that supplier. You are not committing to be responsible for that supplier.

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