Thursday, April 24, 2014

Warranty Self-Help and Liquidated Damages on spare parts

Frequently downtime on a product because of a defect is more than just an inconvenience, it can cause significant costs. I had a reader ask about how to manage against those collateral damages that may occur. I thought other readers might enjoy my response.

Normally in a warranty section there will be what the obligations are if something is defective and there will also be warranty exclusions that will relieve the supplier of their obligation to provide the warranty remedies. Many suppliers may also want to have the remedies they provide to be the “sole and exclusive” remedies for a defective product. The “sole and exclusive” language is primarily used to avoid damages being claimed for the defective item. If the sole and exclusive remedies were for repair or replacement, it would also eliminate the ability to claim a refund or credit. When you see “sole and exclusive” the first thing you should check is the scope of that limitation. You do not want it to be written in a way where it will limit your remedies for breach if they fail to honor their warranty obligations.

Warranty exclusions are language voids the warranty. Many suppliers will include very broad exclusions that can impact your ability to manage collateral damage from a defect. One of the most frequent exclusions is if there is damage caused by either self-help or the introduction of alternative parts where either of those actions causes collateral damage. In most contracts any collateral damage would also be consequential damages and may be excluded by the limitation of liability.

How do you protect against the significant cost of down-time? What I might do if facing this situation is carry a small inventory of items that can be expected to fail or wear out. For items that are a large cost or have a lesser incidence of potential failure, I would require the supplier to stock those spare parts for immediate delivery. While there may be some carrying costs to do that, it will be cheaper than having extended downtime. I would also require the supplier to provide you with a list of generic parts that may be substituted in the event there is a failure by them to deliver spare parts on time. Then I performance language in the spare parts section that would include language that if they fail to stock and deliver such parts in a timely manner as needed, the use of those generic parts by you and the performance of self-help will not void your warranty. I would also seek to include an language that if the use of those generic parts causes any collateral damage, the supplier shall have the responsibility to repair or replace the existing product. If the product you have actually requires repair at a supplier location such as a repair depot, you might also require that they inventory a spare, working product that they will loan you while repair is occurring.

He also asked if requiring the supplier to furnish commercial general liability insurance to cover collateral damage would help. Commercial General Liability (CGL) insurance policies cover specific types of perils. Normal CGL policies will not cover willful acts that self-help would be. Would it be possible to have them purchase additional insurance to cover it? While insurance companies issue unique policies they need to be able to price them. . Insurance pricing based on the average cost of the damages that would be sustained and the incidence or probability of the risk. It’s also not clear to me how they would be able to price it as there may be no history. Even if it was possible it might cost more that the other alternatives.

In another forum there was a discussion about a related issue of whether there should be liquidated damages provisions in spare parts agreements. Here is the problem that I see with the rush to seek apply L.D. to spare parts contracts. How predictable is the failure of that part and what is the lead-time for the supplier to produce that part? Ones that require replacement as a result of normal wear and tear can be predictable and the supplier should be able to manage that. However, many times the requirements are not from normal wear and tear. The failure or a part on a piece of equipment may be caused by negligence of the operator or the customer's failure to maintain the piece of equipment. That's not something that's predictable. Is that a risk that the supplier can manage? Then consider how old is the piece of equipment? If the equipment is old it may no longer be in production where you could pull one from the production line to meet the need? If it's old it may need to be produced from scratch. To protect against the liquidated damages it would force the supplier to carry virtually all items in inventory. That of course is going to significantly drive up the cost of all the spare parts.

My solution for that would be similar. The customer should carry an inventory of normal wear and tear parts, so time for replacement isn't critical. I would also require the supplier to carry a dedicated inventory of critical replacement parts, which if they fail would cause the equipment to not operate. For non-critical parts I wouldn't require an inventory as that only would add to the cost and timely delivery isn't needed as they not critical. I probably would agree to pay an inventory carrying charge on those critical parts. I would then seek LD only on their failure to deliver those critical parts. Lastly, as LD clauses will be read together with Limitations of Liability, I would want that LD clause carved out of the LOL, as many or costs you want to recover are not direct, they are consequential and may include lost profits.