Consultants design / specification mistakes – Who should pay for them?

That was a question that someone asked on a LinkedIn website. Since I was surprised with the wide variety of responses (many of which were wrong) I decided to write a post as it involves a couple of key points.

First from a common sense perspective you need to ask the question if there was no error and the work cost more to construct, who would have paid the bill? The answer to that is the employer. While one never likes getting a large additional charge to complete the work correctly, you can't expect to get additional value added for free. If you wanted the consultants to pay the added costs required because of their mistake, you probably couldn't afford their services. It probably would also not be enforceable.

From a contracts perspective there is a concept under equity law where “unjust enrichment” is not allowed. Unjust enrichment is an equitable principle that no person should be allowed to profit at another's expense without making restitution for the reasonable value of any property, services, or other benefits that have been unfairly received and retained. In many jurisdictions that principal in equity has carried over to contract law. In those locations unjust enrichment in the form of penalties are not allowed. You can collect damages, but you cannot profit off the others breach and language that would create a penalty would not be enforceable in their jurisdictions.

If there is a mistake by the design consultant, you can't simply expect that you will get all of the cost to correct that mistake for free, especially if the correction of that mistake provides you with additional value. What you can expect is if the mistake causes you an additional cost over and above what it would have cost you if it had been done right, you might have a potential claim against the design consultant. The key in your success on that damages claim because of the mistake or error is what duty do they have to you? Are they obligated to produce an error free design? The answer to that is no. Are they expected to use ordinary and reasonable care for someone of that experience and skill level? The answer to that is yes. If you want to increase the standard of care they must provide you would want to have the designer represent that they are an “expert” and agree that in spite of any knowledge you may have, you are relying upon their expertise. That provides you with a highest standard of care.

If a design consultant is negligent and makes a mistake in locations that do not allow for penalties, the most you could collect are damages you sustained. Damages include the cost of work that needs to be removed, not the cost of what should have been there in the first place if not for the error. Here’s an example. A concrete floor was specified to be 5 inches deep by the design consultant. Based on the loading it is later determined that the floor depth needed to be 6 inches. If you could simply pour that additional inch without any other impact, should the consultant have to pay for that additional inch? In my thinking that would be a penalty and a form of unjust enrichment or penalty, as the owner would have paid for it in the first place if it was designed correctly. Using the same example but in this case the floor had to be demolished and re-poured. In that situation I think that the designer's potential liability could be for the cost of demolishing, the cost of the 5" floor that had been poured and demolished, but not the additional inch. To have the designer pay for that extra inch would constitute a penalty.

There are different standards of care between the designer and employer versus the standard of care that the designer has with respect to third parties. They have the responsibility to design safe buildings and if they don't not only may they be subject to employer claims for damages, they can also be subject to third party claims for personal injury (including death) and property damage sustained as a result of their negligence. As an employer to protect your company against third party claims you want general indemnifications and insurance from both the designer and the contractor. From the contractor you want "all perils" insurance, and from the designer you want errors and omissions coverage.

Have I every asked a design consultant to contribute a portion of the extra cost when their error cost me more than what it would have originally cost me if it had been done right (because work needed to be redone)? Sure, especially when I paid them for site supervision to prevent that. Have I ever had a contractor and designer get together and tell them that there is a problem, but it's not the employer’s problem. Both failed to identify an obvious error or were negligent. Do I look to them to determine how they will pay for the additional cost? Sure. In negligence there is a latin term “res ipsa loquitor”, which means "the thing speaks for itself".) One is presumed to be negligent if they had exclusive control of whatever caused the injury. There needs to no specific evidence of an act of negligence. However without negligence the accident would not have happened. If as the employer I had no involvement, I look to the companies that had control of the site to work to sort out responsibility.

Implied Warranties (Updated)

In the United States and in other jurisdiction, for transactions between businesses there may be implied warranties. For example under the Uniform Commercial Code enacted in the U.S. there are two implied warranties – merchantability, and fitness for a particular purpose. Below are the specific sections from the UCC that define these implied warranties:

§ 2-315 IMPLIED WARRANTY: MERCHANTABILITY; USAGE OF TRADE.
(1) Unless excluded or modified (Section 2-316), a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to goods of that kind. Under this section the serving for value of food or drink to be consumed either on the premises or elsewhere is a sale.
(2) Goods to be merchantable must be at least such as
• (a) pass without objection in the trade under the contract description; and
• (b) in the case of fungible goods, are of fair average quality within the description; and
• (c) are fit for the ordinary purposes for which such goods are used; and
• (d) run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and
• (e) are adequately contained, packaged, and labeled as the agreement may require; and
• (f) conform to the promise or affirmations of fact made on the container or label if any.
(3) Unless excluded or modified (Section 2-316) other implied warranties may arise from course of dealing or usage of trade.

§ 2-316. IMPLIED WARRANTY: FITNESS FOR PARTICULAR PURPOSE.
Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller's skill or judgment to select or furnish suitable goods, there is unless excluded or modified under the next section an implied warranty that the goods shall be fit for such purpose.

The first things to note is that these implied warranties apply to only goods. The sale must be from a merchant that sells those types of goods. If all a supplier wanted to not be responsible for quality, they could simply state that the product is being sold on an as-is basis. In doing that they are making no representations as to the quality of the product. Most suppliers are less concerned with the warranty of merchantability than they are with the warranty of fitness for a particular purpose. That’s usually the implied warranty they want to avoid. They may include a specific disclaimer against implied warranties or may disclaim only the warranty of fitness for a particular purpose.

As you can see from reading the section, for a supplier to be held to the warranty of fitness for a particular purpose the supplier must have reason to know the specific purpose, such as by having the buyer disclose the specific purpose to the supplier. If they did and the warranty of fitness for a particular purpose was not disclaimed, if the product was not fit for that purpose, the buyer would have a breach of that implied warranty. They could insist on the supplier correcting the problem at the supplier’s expense as an alternative to pursuing breach and damages. They could also keep the product and use the fact that it does not meet the implied warranty to collect damages for the diminished value. If the supplier fails to correct it the buyer could follow procedures to terminate the contract for breach of the warranty and pursue damages. Most suppliers simply want to sell products. They want buyers to determine what they need so that becomes buyer’s problem if the product doesn’t meet their needs. What they don’t want is their sales to result in claims, lawsuits or damages if it isn’t fit for the buyer’s specific purpose. That’s why most will want to include the disclaimer against the warranty of fitness for a particular purpose.

There can be a number of purchases where a buyer is definitely relying upon the supplier to provide them with a product or service that does meet a specific requirement or purpose. In those situations you would not want to rely upon an implied warranty. You would want to either make acceptance conditional upon proving that it does meet those requirement, make it an express warranty or both. In the acceptance and test requirement you would specify both the specific purpose it is required to meet and include acceptance terms that require proof that the item does in fact meet that specific purpose. Your obligation to make payment should be conditioned upon that acceptance. That way if it doesn’t meet those requirements you can return the product and not make payment or you can work with the supplier to correct the problem. Including it as a warranty would protect you against the potential that it did meet the requirements at acceptance but later failed to meet those needs.

Without acceptance to prove it works or an implied or express warranty of fitness for a particular the rule “caveat emptor” applies. If there is a problem it’s your problem. What you can do will depend upon what return or restocking rights you have in the agreement or what the supplier decides they will do.
In the end you need to decide whose problem do you want it to be if it isn’t fit for the specific purpose. Since I’m paying I always want it to be the supplier’s problem. Either make it work, give me my money back or let me decide whether I want to keep it at a reduced price.
Even if you get a warranty that the good is of merchantable quality, most sellers will protect themselves by publishing product specifications that have detailed operating parameters and environments for use. In doing that if you use the product outside the parameters you will have breached the agreement or have voided the warranty. Many suppliers will also include use restrictions to avoid the buyer using them high-risk uses. If the Buyer used it in a prohibited manner they would have breached the agreement and when you breach the agreement the supplier no longer needs to honor other commitments in the agreement such as indemnities against personal injury or property damage. For example, they may make a product that could be used in a life support system, but do not want their product used there because of potential liability should it fail.

Responsibility to notify a supplier of a defect.

In linkedIN an individual asked the question whether language that waived responsibility for buyer to provide notice of a defect was common. In my opinion it isn’t and whether you would want to agree to that as a supplier would depend on a number of things. I personally wouldn’t recommend it for suppliers.

The first key issue in notification of a defect is at what point does a defect in the product change from being covered by the right to return the material for a full credit as being defective versus needing to process it as a warranty claim. For suppliers in U.S. that issue is important. The U.S. Securities and Exchange Commission (SEC) has revenue accounting rules to the effect that a company cannot claim a sale as revenue if the buyer has the right to return the product for credit. I think those accounting rules may have been put in place as a result of companies doing what I call phantom shipments at the end of a fiscal quarter to make their revenue look good only to get the materials returned in the next quarter for credit.

If you don’t have a notice period or leave the period open via including an exclusion from providing notice, my belief is the selling company couldn't claim that sale as revenue as the buyer could return it as defective at any time. As a result of the SEC’s revenue accounting rules most U.S, suppliers want to establish a specific time limit a buyer has to return the product for being defective so they can claim it as revenue. If you agree to that your sole recourse after that period has expired is under the product warranty provision.

As a buyer you want that time limit to notify the supplier of the product being defective to be long enough so it may be able to be put in use to discover the defect. That is because many companies no longer do incoming inspection on materials because of the added cost. As a buyer I always want the period to be at least as long as the payment period. That way if I discover that it’s defective I can stop payment rather than pay them and have to chase them for a refund. I also want the warranty obligation to provide me with repair, replacement or full refund in the event the supplier can't repair or replace it. Since my primary right is to get repair or replacement, the supplier can still classify it as a sale and classify it as take revenue. If they need to provide a refund because they couldn’t repair or replace it, that does not impact their claiming it as a sale from a revenue accounting perspective, it just becomes a later adjustment to their sales.

Another simple reason suppliers want to be notified of defects is so they can understand there are problems allowing them to identify the root cause of the defect. That way they can reduce or eliminate it the defect in the future reducing both their qualify and warranty costs. They also don’t want buyers to be collecting a stockpile of defective products for return at sometime in the future. They do that for a number of reasons. Some products have limited shelf lives where even if they could repair the defect no one would buy it because of the shelf life. Another reason is many products simply have a product life. If you were a supplier would you want to receive a large quantity of defective product where the buyer wants their money back because they are defective. Think about the financial impact it would have if they were returned at a point in time where even if they could be repaired there is no longer a demand for them, making them worthless.

Is Negotiation Only About Price and Discount?.

This was a question that someone asked in a LinkedIN forum. The ensuing exchange of posts brought forth an issue that I thought I would share.

My initial response was there are three stages to any major negotiation. The pre-negotiation stage involves qualification of the supplier and preparation for the negotiation. The better prepared you are, the better results you should achieve. The actual negotiation involves not just price but also contract terms. Contract term can either add to or reduce your cost and add to or reduce your risks. Risks that you assume under your contract that materialize add to your costs. You can have a great price and discount with lousy terms that will cost you more in the end. The third stage of negotiation is contract management. Contract management will determine how much of the deal that you negotiated you actually keep. Contracts that are left unmanaged will always cost you more. So my answer to the question was price and discount are never the only factors to negotiate.

Another responder took the approach to segment Suppliers into four categories using an IACCM segmentation:
1) Commodity
2) Developing
3) Legacy
4) Strategic
Their position was that with Commodity Suppliers, it was only about cost and discount but with other suppliers it involved more.

Based upon this I thought I would write about supplier segmentation and what affect that would have on what or how you would negotiate.

Different companies may segment suppliers differently I decided to first identify how I’ve managed this form of segmentation in the past. My view is based upon the computer industry where products, and the materials used in those products had a life cycle. Those life cycles for production can be as short as six months. You have suppliers that are industry technology leaders who are usually first to market with new products and new technology (“leaders”). You also have companies in those commodities that I call "followers". I define "Followers" as usually being late to market with their focus on low cost to capture market share. “Leaders” are usually classified as strategic and get managed as strategic suppliers. “Followers” are usually classified as commodity suppliers. The key is not how they are segmented, the key is the risks involved and the potential future opportunity they bring.

As there can be the same performance risks between strategic suppliers and commodity suppliers, price and discounts are never the entire focus of at least the initial negotiation. Once you have an existing agreement in place with a commodity supplier, future negotiations may be more focused on just price and discount but that is seldom the only thing that gets negotiated. As you move further out in the product’s life cycle the “followers” may become more important. The reason for this is leaders may end of life the current product you have been purchasing moving to their next leadership product and you may be dependent upon the “followers” for product until you end of life your product or can use the “leader’s” new product.

When you segment suppliers and have developing and legacy suppliers, what you negotiate in terms of your contract should be no different. Again the problems they can create and potential risks and costs they can cause really aren’t any different than commodity or strategic suppliers. The difference you have between those two categories is normally the amount of time you spend managing them or the frequency of the negotiations. A true legacy supplier has been working with you so you don’t need to invest the same amount of time in managing them as a developing supplier that may just be starting to learn what is needed to be successful to grow a long term relationship. You may also have less frequent negotiations with legacy suppliers as the opportunity to reduce cost may be less.

The reason less frequent negotiations with legacy suppliers is without outside influences such as increases in demand, most product pricing follows price curves.“Leaders” who are first to market will set the price high. As more competition enters the market the price will be drive down. When there is maximum competition (especially from “followers” joining the market) you reach the lowest price. Leaders may exit the market to introduce their next leading product and that may create a shortage of supply driving the price up. ( see http://knowledgetonegotiate.blogspot.com/2011/09/price-curves.html )

Segmentation of suppliers is more for determining the amount to time and effort you spend with a supplier and can be a tool to prioritize the frequency of negotiations. It’s not a tool to determine what gets negotiated. What gets negotiated should always depend upon the risk. How frequently things get negotiated depends upon the opportunity.