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.
Friday, September 28, 2012
Friday, September 21, 2012
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.
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.
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.
Tuesday, September 18, 2012
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.
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.
Friday, September 14, 2012
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.
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.
Sunday, September 9, 2012
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?
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?
Monday, September 3, 2012
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.
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.
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