Reverse Indemnities

I had an interesting discussion in a linkedIn group so I thought I would summarize the discussion. The initial question was about third party liability. That spun into discussions on warranties and indemnities as they relate to third party liability.

In a normal buyer / seller relationship the buyer will frequently require the seller to indemnify the buyer against personal injury or property damage caused by the seller that is related to either their product or service or an injury or property damage caused by the seller while employed by the Buyer. The underlying reason for requiring indemnity is in many locations the Buyer / Seller relationship may also be viewed a principal / agent. Under agency law the buyer is acting as the principal and the seller is acting as the agent performing work on behalf of the buyer. Under agency law the principal can be liable for the acts of the agent, but the agent can’t be liable for the acts of the principal. Under this general type of relationship you seldom would see a supplier request for a reverse indemnification as the normally would not be sued for the buyer’s negligence.

One of the things I discovered was that in the oil and gas industry the indemnity is sometimes reversed where the Buyer (well operator) will indemnify the service provider against the various types of claims that could occur in the event of a major explosion, etc. In that industry since buyer is providing the indemnification, it is common to include a reverse indemnification if the service provider is grossly negligent or acts with willful misconduct. Clearly that makes sense.

The next question was whether the breach of any warranty, or the act that would exclude warranty coverage could require a reverse indemnification. Typically a buyer doesn’t provide any warranties to the seller. There may be certain acts that void warranty coverage. For example:
“These warranties do not extend to, or apply to, any Product which has been (1) subjected to misuse, neglect, accident, improper installation, or to use in violation of instructions furnished by Supplier, (2) repaired or altered outside of Supplier’s factory by persons not expressly approved in writing by Supplier, (3) evaluated, screened, or tested by an outside testing laboratory not previously approved in writing by Supplier, or (4) based on design features provided by Buyer.”

Should one of these acts that would void the warranty substantiate the need for providing a reverse indemnity? They could, but the key is what caused the injury? Before I would agree to provide a reverse indemnity, I would clearly want that act to be the root cause or have directly contributed to the injury or damage.

Similarly in Intellectual Property Indemnification there carve outs or exclusions to the indemnification. A supplier may want to be excused from providing an intellectual property indemnification in several areas and want a reverse indemnification from the buyer. Examples of those are:
Claims that based on combination of Suppliers product with another product.
Implementation by the Supplier of a Buyer specified or provided design.
Modifications to the Suppliers Product made by Buyer.

In negotiating these I would first want the combination exclusion to be something that wasn’t reasonably foreseeable. Many items I’ve purchased had no useful value of their own and only after they are combined with something else do they become useful. I've had suppliers that had products that were designed for and marketed use with a specific product that wanted to be excused from the indemnity and want a reverse indemnity when they were used in that combination. If you tell me that it was designed for use in that combination, why would I ever want to excuse and indemnify that when it was used in that combination?

As to implementation of a buyer provided design there are three ways the resulting product could be infringing. First, the design itself is infringing. Second the process used to make the product is infringing. Third, materials used in the product are infringing. For me to be willing to provide a reverse indemnity, I would want the sole cause of the infringement to be my design. I would also also want the “Buyer’s modification” exclusion and any reverse indemnification to be contingent on the fact that buyer’s modification is the sole source of the infringement. If you ever purchased things like electronic components you would know that almost all require some form of modification to be used.

Indemnifications are important. Before you give one up by giving a reverse indemnification, make sure you significantly narrow down and make clear exactly what act you must do for that to occur.
For example, no form of maintenance will protect against a latent safety defect that exists in a product. For you to accept responsibility make sure that it was really your act that caused it.

Tooling

In manufacturing, tooling means things like cutting tools, dies, fixtures, gauges, jigs, molds or patterns that are for use in producing a specific product creating the specific form of the item. In procurement the most frequent reference to tooling means a metal die that is used in conjunction with an injection molding piece of equipment or metal stamping piece of equipment to produce an item of a specific form and size that will be unique to the item being produced where the buyer’s payment for such tooling may be required. There are also CNC (Computer Numerical Control) tools. CNC tools are used in a machining process where computers are used to control machining tools such as lathes, mills, routers and grinders. Since these tools are not unique to a specific product most of the time they buyer would not be paying for such equipment unless they were required for additional capacity. It is the first type of tooling that this blog is about.

Tools may be described as soft tools or hard tools. Soft tools are usually lower cost. They are good for medium-low volumes with a high mix of production. They lead to a higher piece part cost. They provide faster lead time and response. They are more flexible to change design. They will result in increased product variances over time. Hard tooling is usually higher cost because of the materials and processes used to make the tool. It will produce a lower piece part cost. When you use hard tooling there is no flexibility in the design, a change in design requires a new hard tooling is usually higher cost. There is no flexibility in design. Hard tooling result in a longer lead time because of the time needed to build the hard tool. It provides for repeatability of the product and results in less product variances. It is used for high volumes. The physical difference between hard tooling and soft tooling is the materials used to make the tools. A hard tool is usually made of hardened steel that is machined to the exact size needed. A soft tool is made of other materials such as silicon, epoxy resin, and lower temperature melting materials such as zinc alloys, and aluminum, etc.

Whether its hard tooled or soft tooled, a tool will have a useful life (a certain number of “hits” or stampings) before it will no longer be able to produce within acceptable tolerances. From an accounting perspective for tooling you probably have several ways to depreciate the cost of the tool. Depreciation can be done as:
1. Straight line (cost minus salvage value divided by the number of years of useful life).
2. Unit of production depreciation basis (cost minus salvage value divided by estimated number of production units).
3. Sum of years (cost – salvage value, where the total number of years are added (a five year life would total 15 (1+2+3+4+5) and year 1 would be 5/15ths, year 2 would be 4/15ths, etc).
4. Double declining balance (cost minus salvage value where the useful life (say 5 years) has 2/5ths of the current book value is depreciated each year so as the years go out the depreciation amount decreases as it’s based on that year’s book value that reflects prior depreciation.
5. Another accelerated method may spread the depreciation cost over the term of the contract if the tool cannot be used elsewhere.

As a buyer if you pay for tooling it can affect future sourcing decisions. The tooling you purchase and own may not compatible with a different supplier's equipment. That can potentially lock you into the supplier because to switch to a new supplier you have two costs. The cost to write off any remaining amount to be depreciated on the old tool as it's now obsolete and the cost of the new tool. One way to protect against that without getting locked into long term contracts with the supplier would be to negotiate options to extend the contract with a pre-agreed pricing formula at the same time you sign the initial contract. That allows you to determine what the best option is for you.

If the supplier agrees to pay for tooling and amortize the cost into the purchase price, you need to agree upon the number of units it will be amortized over, the per unit amount being charged and have an automatic price reduction once the cost has been fully amortized. Otherwise you will be paying for tooling cost well after the item has been fully paid for. Doing that also helps establish what your cost would be if you needed to terminate the agreement or let the agreement lapse without having met the amortized quantity agreed.

There are a number of factors to consider with tooling:
Who owns the responsibility to replace the tool if it breaks?
Is the tool for your sole use or can the supplier use it with other customers?
The set-up and tear down cost for the tool are costs that don't affect the tooling cost. They affect your piece part cost. Those along with your run rate affects your piece part cost as those costs apply each time you don't have continuous production. Depending upon what those costs are it may pay to order and inventory more than you need to reduce the number of times you incur those costs.

When you purchase something that requires tooling that you have to purchase you would normally have a separate tooling agreement or tooling purchase order. There are a number of terms that you would want in such an agreement. For example:
1. You want them to insure the tool against normal perils such as theft, and damage or loss due to fire, floods, etc. and have you named as a loss payee.
2. You want the tool to marked with your inventory control sticker showing the fact that your company owns the tool so you could retrieve it in the event the supplier went bankrupt.
3. You want them to perform maintenance and calibration of the tool to keep it in good working order.
4.You want them to be liable for the replacement of tool in the event of negligent set up, operation, or tear down of the tool that damages or destroy the tool.
5.You want the use of the tool restricted solely to your company unless you otherwise agree and are compensated.
6.You want the right to enter their premises if necessary remove the toll that you own.
7.You want language where they agree that they will not financially encumber the tool.
8.You want the tool to not to be moved without your agreement.
9.You want the supplier to not alter or modify the tool.
10. You want the right to inspect the tool.
11.You want the right to remove the tool at any time.
12. In most situations the buyer wants to own both the design of the tool and the tool itself. Owning the design of the tool makes it your intellectual property that the Supplier couldn’t use to have tools made for others without infringing your intellectual property rights. If you own the tool ,unless you have another commitment with the supplier that locks you into using the supplier (like a firm quantity commitment), you have the flexibility to move the tool at any time to another supplier. That helps keep competition in the equation for future negotiations.

Bills of Lading

In a separate blog post I wrote about Incoterms. Since shipments require bills of lading I decided to do a post on them. A bill of lading has multiple functions. The principal use of the bill of lading is as a receipt issued by the carrier to the seller once the goods have been loaded onto the carrier or vessel. The receipt can be used as proof of shipment for customs and insurance purposes. It can also and be proof of completing a contractual obligations such as when Incoterms are CFR (Cost and freight), EXW (Ex-Works), or FOB (Free on Board). The bill of lading can also function as evidence of the contract of carriage. It is not a contract of carriage per se, but can be made one if the Hague-Visby rules were annexed to the Bill of Lading or other terms creating a contract of carriage are printed on the reverse side. Normally there will be a separate agreement between the seller (or buyer) and carrier.

Legally the carrier is a legal consignee of the goods. A bill of lading may also list the buyer of the goods as the consignee. The two are different. Thw freight forwarder is named by the seller (or Buyer depending upon the delivery term) for delivery to a specific point. The take possession or arrange for the carrier to take possession. The freight forwarder is considered to be the owner of the consigned goods for the purpose of filing the customs declaration and for paying any export duties, taxes or fees. The freight forwarder will further consign the shipment to the carrier. The consignee is listed on a Bill of Lading is the Buyer or a third party designated by the Buyer. If you use the FIATA bill of lading the parties to the transaction would be defined as follows:
a. Freight Forwarder is the company that issues the Bill of Lading
b. Merchant is used to identify the shipper
c. Consignor is the seller of the goods.
d. Consignee (is the buyer of the goods

The freight forwarder and the merchant have certain rights and obligations in conjunction with the consignment that are listed on terms on the reverse side of the bill of lading. There are multiple types of bills of lading. An ocean bill of lading is a document required for the transportation of goods overseas. An ocean bill of lading serves as both the carrier's receipt to the shipper and as a collection document if payment by the consignee is required. Ocean bills of lading may be negotiable or non-negotiable. A non-negotiable ocean bill of lading allows the buyer to receive the goods upon showing identification. If the bill is deemed negotiable, then the buyer will be required to pay the shipper for the products and meet any of the seller's other conditions established on the bill of lading. If the goods are to be initially shipped over land, an additional document, known as an "inland bill of lading", will be required. The inland bill only allows the materials to reach the shore, while the ocean bill allows them to be transported overseas.

Bills of lading need to be consistent with the Incoterms rule selected. For example, if the sale was ex-works the seller’s dock, the seller would not create a bill of lading as it is the buyer’s responsibility to arrange for shipment from that point forward. If the sale was FAS or FOB the seller would only complete an inland bill of lading to get it to the port and the buyer would need generate an ocean bill of lading or a multimodal bill of lading. If the delivery point was after the port of export but prior to the port of import the seller needs to complete the ocean bill of lading. Once the goods are at the port of import, the buyer would need to generate an inland bill of lading to get the goods to the point of delivery. The exception to that would be if the seller sold the items DDP wherein the seller would be responsible for generate the inland bill of lading in the export country, the ocean bill of lading, and an inland bill of lading for the import country.

In most international transactions you would use a multimodal bill of lading. The information provided on that bill of lading includes the following.
1. The ship from address
2. The ship to address
3. The bill of lading number and bar code
4. The carrier name, trailer number and serial number
5. Who and third party freight charges are to be billed to.
6. The SCAC (Standard Carrier Alpha Code) that identifies the specific carrier and pro number (a progressive number used to track shipments
7. Any special instructions..
8. Whether the freight is prepaid, collect or will be paid by a third party.
9. Customer order information
a. Customer order number.
b. Number of packages.
c. Weight
d. Whether its in a pallet
e. Any additional shipper information
10. Carrier Information
a. Handling unit quantity and type
b. Package quantity and type
c. Weight
d. Whether the shipment contains HM (Hazardous Materials)
e. Commodities requiring special care
f. NMFC Number and class code that defines the National Motor Freight Code and class for the materials shipped.
g. If the goods are being shipped independent of value, the declared value of the goods.
h. The COD amount is shipped COD.
i. The fee terms (whether prepaid, COD or customer check is acceptable)
11. A limitation of liability on the shipment.
12. A signature of the shipper if they do not want delivery without payment.
13. Shipper and Carrier signatures and dates.
14. Responsibility for loading the goods on the carrier (shipped or carrier)
15. How freight is counted (by shipper, by driver pallets or by driver pieces)

If you used the FIATA negotiable multimodal transport bill of lading there are terms on the reverse side that contain the following sections:
Definitions
e. Freight forwarder who issues the B/L
f. Merchant (the shipper)
g. Consignor (the seller)
h. Consignee (the Buyer
i. Taken in charge (hand over by consignees and accepted by freight forwarder)
j. Goods

Titles of the specific terms are:
Applicability (makes terms apply even if only one mode of transport is used)
Issuance of FBL (Once issued Freight Forwarder assumes responsibility to delivery and liability)
Responsibilities of freight forwarder
Negotiability and Title to Goods (see below)
Dangerous goods and liability (requirement of notice of and liability if not described_
Description of goods and merchant’s packing (Consignor guarantee Goods are as decribed)
Freight forwarders liability (Limitation of Liability)
Paramount Clauses (incorporates laws (the Hague Rules, the US Carriage of Goods by Sea)
Limitation of Freight Forwarders Liability (limits liability to value of the goods)
Applicability of actions in tort (terms of the contract apply whether action under contact or tort)
Liability of servants and other persons (
Method and route of transportation (provides freight forwarder right to make changes to these)
Delivery (delivered when handed over or made available to the consignee)
Freight and charges
Liens (Provides the freight forwarder with a right to place a lien on the goods)
General average (Actually an indemnity the Merchant provides to the freight forwarder)
Notice (Require notice of loss or damage. If no notice prima facie evidence delivered as described)
Time bar (Period in which to bring suit under the BoL
Partial invalidity (the same as severability where if one part is invalid the remaining will apply)
Jurisdiction and applicable law (based upon the Freight Forwarders place of business)

One of the key things within the Multimodal a bill of lading is the negotiability and title section that reads as follows:
3.1 This FBL is issued in negotiable form unless marked non-negotiable. It shall be constitute title to the goods and the holder, by endorsement of this FBL, shall be entitled to receive or transfer the goods herein mentioned,
3.2 The information in this FBI, shall be prima facie evidence of the taking charge by the Freight Forwarder of the goods as described by such information unless contrary indication, such as shippers weight, load, and count, shipper packed container, or similar expressions has been made in the printed text or superimposed on this FBL. However proof to the contrary shall not be admissible when the FBL has been transferred to the consignee for valuable consideration who in good faith acted thereon.

What does that mean with respect to title in the goods. It means is when you use a negotiable bill of lading the freight forwarder is given title to the goods and can transfer title to the consignee as long as the consignee 1) has paid for the goods and 2) acted in good faith. What it would also mean is seller would be prevented from submitting proof under contract that title did not transfer under their contract with the buyer until payment or that a security interest existing in the goods.

If you use a non-negotiable bill of lading, the bill of lading confers what is called a prima facie title over the goods to the named consignee listed on the Bill of Lading. Prima facie means “accepted as correct until proved otherwise”. This means that under the "nemo dat quod non habet" rule the freight forwarder and subsequently the Merchant (carrier) cannot transfer to the consignee better title than the freight forwarder has. This means that the seller may legally retain title until they are paid. The seller could also retain title until a specific point in the delivery process where there is delivery to the buyer in accordance with the agreed Incoterms rule. The seller could also retain a security interest in the goods.

In getting a prima facie title the carrier may place an encumbrance or have security interest against the goods. If the full title is not granted to the freight forwarder who delivers them to the consignee, the consignee has rights but the seller’s rights in the goods have priority over the consignee’s rights. The prima facie title would allow the consignee to have certain rights in the material. For example they would have the right to withhold releasing the goods to the named consignee (buyer) if they are owed monies. The freight forwarder or carrier also can’t simply sell the goods to recover what they are owed as they don’t have full title to make the sale. In many jurisdictions there is a legal process they would need to follow in which they would need to notify the owner of the title to allow them to make payment before selling the goods.

The UCC makes a slight distinction about the title when it comes to creditors rights with respect to the consigned materials. In those situations the consignee is deemed to have rights and title to the goods identical to those the consignor had or had power to transfer. It also goes on to say that if the consignor had perfected a security interest in the goods, that interest has priority over the rights of the consignee.
Negotiable bills of lading may function as negotiable instrument and be traded in much the same way as the cargo, and even borrowed against if desired. A non-negotiable bill of lading can’t be borrowed against because the freight forwarder and Merchant (carrier) only have prima facie title and the Consignor’s title in the product takes precedence over their rights.

One main point to take away from this post is when making a shipment always make it clear whether the Bill of Lading is negotiable or non-negotiable. The way the FIATA multimodal Bill of Lading, the default is that it is negotiable unless you specifically mark it otherwise. If you fail to make what should be non-negotiable, as non-negotiable you will lose the right to introduce evidence to the contrary if you where you could seek to recover the goods for non-payment by the buyer. Personally, I would never sell under credit terms and use a negotiable bill of lading.

Liability versus providing an Indemnity

In a LinkedIN group a participant asked about the difference between someone accepting liability for their negligent acts versus providing an indemnity. I thought my response should be shared with my readers.

In some jurisdictions around the world the buyer / seller relationship is viewed as principal / agent. Under a principal / agent relationship the principal can be sued for the actions of the agent. If those actions are negligent the buyer can be sued under tort law for that negligence. That results in potential liability to the buyer.

If you have language that says that the supplier will be responsible to you for such liability you have a contract commitment that would be enforceable to recover the damages the injured party was awarded. If you have an indemnification, the seller is agreeing to be responsible for that potential liability and you have protection based upon the scope of that indemnification,

If the injured party sued the seller directly and not the buyer there would be no need for an indemnity. What frequently happens is the injured party will either sue the buyer (as the buyer may have more assets (deeper pockets) or they will sue both parties. An indemnification without the obligation of defense simply means that the seller is agreeing to only pay the damages awarded. If the indemnification also included the responsibility to defend, the seller would need to pay for the defense of the claim, or defend against that claim in court with them bearing the costs of the defense or settlement. If you have the obligation to defend and indemnify the seller (indemnitor) has agreed to effectively "stand in your shoes" and manage the process, pay the costs of the defense and pay any damages awarded or settlement amounts.

The value of either language to accept liability or or indemnify is based upon the assets of the party providing that commitment. When you are dealing with small companies it is best to require them to carry certain levels of insurance as additional financial protection such as comprehensive general liability and vehicle liability. Then if there is a claim the insurance company may be involved in the defense and you have the protection of both the insurance amounts and the sellers assets as protection.

The value of either agreeing to accept liability or agreeing to indemnify can be limited by the limitation of liability section as to both the types of damage that may be claimed and the amounts. I would carve either of these commitments out of limitation of liability for that reason. My rationale is simple, if the third party were to sue them directly they would not have a limit on that potential liability.

One last comment from a buyer's perspective you need to be concerned about the language in the section further limiting the value of what they will provide. You see under tort law a third party can sue for negligence. It doesn't require gross negligence or willful misconduct. Ordinary negligence will do. When a seller wants to be liable or indemnify only for "gross negligence or willful misconduct" they are setting a much higher standard that significantly limits the value of their commitment. What that is effectively saying is you need to be responsible for all ordinary negligence claims and I will only be responsible if the claims meet these much higher standards. As a buyer I would want the liability or indemnity to apply to any negligent act, error or omission. Your company didn't cause the injury or damage, they did, so why should you have to be responsible for anything.

Selecting The Right Incoterms Rule (delivery term)

For those individuals who may not be familiar with Incoterms®, they are a set of rules published by the International Chamber of Commerce in which responsibilities of the parties are established based upon the specific rule (delivery term) selected and the delivery point. Each Incoterms® rule (delivery term) addresses which party (the buyer of seller) has the responsibility for certain costs or tasks:
• Loading on truck at origin
• Export Customs declaration form completion
• Carriage to port of export
• Export clearance
• Unloading at port of export
• Loading onto vessel at the port of export
• Carriage to port of import
• Unloading charges at port of import
• Import customs clearance
• Import taxes and duties
• Loading on carrier at port of import
• Carriage to place of destination
• Responsibility for insurance

Incoterms® are silent as to title transfer, and title transfer can be an important consideration in shipment of goods. Normally ownership is directly tied to risk of loss or damage. The party that owns the goods has the risk of loss or damage in the goods. The exception is that when you use Incoterms they define the point where the risk of loss passes from the seller to buyer. If there is no transfer of title or ownership there is no sale. For example the Uniform Commercial Code that has been adopted by all states in the U.S. presumes that title transfers at the specified delivery point unless there is language in the agreement to the contrary. CISG makes no reference to title transfer and looks to the Incoterms® to establish where the risk of loss transfers.

There are two different groups of Incoterms. The following Incoterms apply to any mode of transportation: EXW (Ex Works), FCA (Free Carrier At), CPT (Carriage Paid To). CIP (Carriage and Insurance Paid To), DAT (Delivered at Terminal), DAP (Delivered at Place), DDP (Delivered Duty Paid). Incoterms that only apply to sea and inland waterway transport are: FAS (Free Alongside Ship). FOB (Free on Board), CFR (Cost and Freight), CIF (Cost, Insurance, and Freight).

If you negotiate contracts involving international trade you should own a copy of the Incoterms. They can be ordered at http://www.iccwbo.org/products-and-services/trade-facilitation/incoterms-2010/. For a very good description of all the individual rules (delivery terms) you can also visit: http://www.inhouseblog.com/international-shipping-terms/.

In negotiating contracts deciding which Incoterms® rule to accept there are many things to take into consideration. The first thing to remember is only the owner of the goods or their representative (a customs broker) can apply for an export license and clear export customs. In some locations like the EEU, non-resident companies cannot clear customs. In the U.S. non-resident companies can apply for export licenses and clear export customs. They are responsible for complying with U.S. export regulations. The U.S. export restrictions may limit some classifications of goods to a limited number of countries. There are also countries where restrictions apply to export all goods to those named countries. Similarly, only the owner of the goods or their representative, are able to apply for an import license and clear import customs.

When goods are shipped a Bill of Lading is completed. A bill of lading could is clearly stated transfer ownership. In most cases what the bill of lading does is transfer possession of the goods. The goods are consigned to the carrier or freight forwarder. The carrier or freight forwarder has certain rights with respect to the goods, but they do not have title or ownership in the goods. For a bill of lading to transfer title/ownership in the goods either the contract or bill of lading would need to clearly show the intent to transfer title/ownership. Otherwise the recipient of the goods has only the legal right to possess the goods subject to the terms of the consignment.

The point at which title or ownership transfers is an important consideration and is not controlled by the specific Incoterms® rule selected. Ownership is tied to the risk of loss or damage. If you fail to specify where title / ownership passes in the contract or other document, applicable laws may do that for you. If you had a contract that specified any state in the United States as the applicable law, the Uniform Commercial Code UCC Section 2-401 would apply. Under the UCC title transfers upon delivery at the agreed delivery point that is defined by the delivery term and delivery point selected. For examples Ex-Works Seller’s dock in New York, New York would mean that title transfers at the point the seller makes the goods available for delivery at their loading dock in New York, New York. That means that from that point onward the risk of loss or damage belongs to the buyer. It would also mean that it becomes the the buyer’s responsibility to either assume that risk or purchase insurance to cover that risk from that point forward. There are only two Incoterms rules that require the seller to provide insurance to protect against loss or damage. Those two are CIF (Cost insurance freight) and CIP (Carriage Insurance Paid to). For all other Incoterms® rules the risk of loss is with the owner of the goods.

Some companies watt to retain title / ownership of the goods until they are paid. They do that to allow them to recover the goods if not paid under what is called replevin. One problem with that is unless the specific Incoterms rule selected transfers the risk of loss, by continuing to own the goods they also continue to own the risk of loss or damage. Other companies choose to transfer title (and risk of loss or damage) to the buyer at an earlier point subject to a security interest in the goods (a lien against the title / ownership). Each approach has their advantages or disadvantages. In many sales the goods may be consumed or converted quickly so retaining ownership rights in the goods may not provide any protection. The specific type of Bill of Lading can also impact title. For example, if you used a negotiable intermodal bill of lading you are agreeing that title is transferred to the freight forwarder and are also agreeing that proof to the contrary shall not be admissible when the FBL has been transferred to the consignee for valuable consideration who in good faith acted thereon. For non-negotiable bills of lading the freight forwarder gets prima facie title in which, you could introduce evidence of title (such as retained title conditioned upon payment or a security interest.

Whether the buyer or seller manages the transportation is also a consideration. There are good and bad carriers. Some shipping lanes carry higher risks due to weather and piracy and theft. One question to ask is which is more important for me, getting the goods when I need them or getting compensated for the loss or damage? The more you want or need the products to be delivered when you need them the more you either want to control or approve the carrier and shipping lanes.

In working for large companies with very competitive shipping costs we always felt that our costs would be less than our Sellers so the majority of our purchases were made under delivery terms where the bulk of the transportation expense was under our control. There can be times when it may make sense to buy an item delivered to the destination such as with an DAP term or have delivery be from a Seller’s local subsidiary. That occurs mostly when you are importing it into a country with high duties. If you buy and import a product your duties will be based upon your purchase price and transportation costs. If the Seller subsidiary purchases it, their duty will not be based upon the purchase price. It will be based upon what’s called the “transfer price” or the amount the company sells the product to the subsidiary for which is less than your purchase price. That means the duty they will pay will be less. The same would apply to buying from a distributor as the distributor is buying it less their discount, but then you need to take into consideration that your contract would then be with the distributor and not the Seller. The one thing you never want to do is leave the cost of transportation totally open ended to the Seller. Either get a price that includes all cost or manage the transportation yourself.

Revenue recognition is another consideration. Revenue recognition is when under the accounting rules for the jurisdiction the seller can classify it as a sale. In the U.S. there are strict rules (Sarbanes-Oxley) issued by the Security and Exchange commission that prevents companies from taking credit for a sale if it can be returned to the seller. Most U.S. Sellers will want terms where title transfer is early so they don’t have to wait for deliver at some other location to occur before they can count it as revenue. They also try to avoid any right of the buyer to return the product and want to only be responsible to either repair or replace they product so it can be considered sales revenue. Revenue recognition is important to companies balance sheets and to sales organizations that are measured and compensated based upon meeting sales goals within a financial period.

Another thing you need to consider is the specific delivery point. INCOTERMS® doesn’t establish the actual delivery point and the parties are free to also establish a deliver point that makes sense between them. Even though a product may be made in one location, it may also be stocked in another. For example many company supply chains want the Seller to have stocking points close to the point of use so they can operate under a pull replenishment program. If the Seller has those, you use them. If the Seller doesn’t have local stocking points you could have stocking at different locations such as a third party warehouse or even a stockroom on the buyer’s site. In doing that you need to select the right INCOTERM and delivery point. Pull replenishment types of arrangements require additional terms regarding pull, replenishment and loss or damage to the product while stored. When I talk about selecting the right delivery point you need to take other things into consideration. For example I’ve written contracts where delivery was to a third party warehouse in a free trade zone prior to import customs clearance because the supplier refused to sell the product within the country of import. If the seller wanted to assume all costs and risks to get it to that point they could sell the product ex-works at that point. The could also select CIP, CIF or DAP to that warehouse but have the title and risk of loss transfer at an earlier point When the buyer wanted to make a “pull” that was the location they pulled from. The buyer then had to arrange for import and transportation from that point. An additional advantage for the Seller was if the materials weren’t pulled, they could have them shipped anywhere. Since the goods were never imported into that country they would not need to do any export clearance or get export licenses.

There can be tax and other implications depending upon which rule you select. Except for situations where ownership/title is transferred “on the high seas” or in a free trade zone, the transfer of title/ownership constitutes a sale at the point of delivery. Deliver point that are between the export and import frontiers are considered international sales. Deliveries within a free trade zone are also considered international sales. For international sales the seller does not have to be registered to do business in the country of import. The seller is not subjected to the laws of the country of import. The seller is also not subject to taxes on the sale of the goods. If you were to agree to sell on a DDP basis that means that the seller is responsible for preparation of the import license and import. The seller is responsible for payment of any applicable duties. From a legal perspective doing those actions within that country means that you are conducting business within that country. To conduct business within a country you must be legally registered to do business within that country. The sale within that country becomes a local sale. As a local sale, that subjects the seller to the import country’s laws and income taxes on that sale. Free trade zones are controlled areas prior to import clearance where warehouses are built and materials may be shipped. As part of tax management many companies want to avoid having sales occur within the country of import because of the tax impact.

There can be liability considerations depending upon the term that’s selected. For example in the U.S. the Patriot Act and the Trade Act of 2002, makes the importer liable if the container contains any illicit goods.

The point of sale can subject the party to the laws of the country of sale as the sale is occurring within that location. The exception to that is when delivery occurs and the sale is completed after the export customs frontier and prior to the import customs frontier. In that situation it would become an international sale and the transaction would be governed by only the applicable law and jurisdiction stated in the contract.

The last thing to consider is your knowledge of the laws of the importing country. There are two general types of laws to be concerned with respect to import. One is environmental laws and does the product comply with local environmental laws which will be a condition on import. The second set of laws are homologation laws. Homologation laws deal with compatibility of a product with local systems or networks it may be connected to. For example, a telecommunications product being imported into a country may need to compatible with local communications systems. If you sell on a delivered term within the import country it is your responsibility to ensure compliance so it can be imported. If you sell on a term where the responsibility for import is passed to the buyer before import, it is their responsibility to ensure that what they buy meets both environmental laws and homologation laws.

The advantages of using Incoterms® and specifying the specific Incoterms delivery rule (delivery term) and date of the Incoterms® publication is:

1. In comparing quotes from different Sellers, if they quote a different delivery terms or points, you should take any cost differences into account in deciding who to award the business to as you want the Seller with the lowest landed cost. One thing I also like to do was to have Sellers quote or bid based upon multiple delivery points and have those costs included in their price. That way I can see how competitive their transportation costs would be which may help decide what’s going to create the lowest landed cost for me.

2. From a contracts perspective, when you incorporate them by reference into the contract the responsibilities of each party from the Sellers dock to the buyers dock for all the activities involved such as loading, transport, preparation of paperwork, export, import, customs clearance, payment of duties and insurance are defined for you. If you didn't use them, you would need to address all of the applicable portions of those in your agreement’s delivery section.

3. Each of the responsibilities has a cost involved. Some costs of those costs may be small (such as completing the export declaration). Other responsibilities such as shipping and duties can be significant. When you use the INCOTERM and specify the delivery point it's clear which party is bearing those costs. That way you know what the true cost of the purchase or sale is and who is insuring the shipment against risk of loss or damage while in transit.

I use the 2010 version. When I use them, I do it by including language such as: “The delivery term shall be Ex-Works (as defined in Incoterms 2010) Seller’s Dock in Taipei, Taiwan”. The ICC periodically updates Incoterms and sometimes eliminates or changes definitions as occurred when Incoterms 2010
replaced Incoterms 2000. While Incoterms 2000 is no longer the current Incoterms rule parties to a contract are still free to use whichever version they want. The key in using prior versions or terms that may have been deleted or changed is you need to refer to the specific Incoterms date. For example, "For example delivery shall be DDU as defined in Incoterms 2000" would correctly create a DDU term. If you said DDU Incoterms or DDU Incoterms 2010 you have a problem as DDU (Delivered Duty Unpaid) doesn't exist in Incoterms 2010. New terms of DAP (delivered at place) or DAT (delivered at terminal) exist. In drafting it's best to refer to the specific date of the Incoterms you want to use to eliminate any confusion.

Like anything else, there may be a number of times where a specific INCOTERM does not match your exact needs. INCOTERMS are not fixed in stone so if none of them fit exactly what you need you can still incorporate the closest one to what you need and then modify it to meet your needs. For example:
“The delivery term shall be Ex-Works (as defined in INCOTERMS 2010 except as modified below) Seller’s Dock in Taipei, Taiwan. The modifications to INCOTERMS 2010 shall be ......” An example of a modification is the buyer could agree to pay insurance to a specific point.

There may be times when you are purchasing capital equipment where you want the Seller to manage the installation and start up of the equipment. In those situations you probably need to separate delivery from installation. You can always have title, risk of loss and the delivery point be outside of the country from a sales perspective, and still have the responsibility to install, test and accept be a separate contract. If you did that the sales agreement should have monies retained, a bond or bank guarantee linked to successful installation, test and acceptance.

The selection of the INCOTERM isn’t just about who is responsible for certain actions, you need to consider all the costs and risks in selecting your term and have those and these other factors drive your selection. For example, as a Seller I would never want to agree upon a delivered term at any place other than a free trade zone prior to the import frontier without having title pass far before that. You see I don’t want to be waiting for a product to clear customs before I can invoice and get paid for the product and I don’t want the buyers inability to import the product to impact their obligation to make payment. As a seller if they cannot import a product I might help them sell the product to a customer in another location where it can be imported. As a Buyer, unless I had a legal presence in the country of export that could manage it, I would avoid EXW (ex-works) delivery terms and would want the seller to be responsible for export clearance.

One final comment, your agreement needs to address when title transfers and payment terms as Incoterms does not address those issues.

Contract Term – when do you include a contract term and how to negotiate it.

In a linkedIN group an individual stated that contracts may only be ended by completion or by termination. This is not the case as there are a number of situations where a party is excused from performing under a contract.
•Subsequently illegality such as a change in the law that makes the performance illegal,
•Impossibility, where the work cannot be done.
•Impracticability, where it is not capable of being done
•Frustration, such as one party failing to meet their obligations can frustrate the other party allowing them not to perform
•Rescission, where the parties have agreed to stop it.
•Novation, where the parties agree that another party will complete the work and the original party is excused from performance, and
•Lapse, such as where the contract term may have lapsed without the work being completed.

It is this last item (lapse) that excuses performance that I want to talk about.

In contracting for a specific deliverable, you traditionally do not include a specific contract term as to when it starts and when it ends. What you instead have are required milestones and completion dates. Failing to meet those dates does not excuse performance and those type of contracts do not expire. To end those types of contracts they must be either completed, terminated, or performance must be excused by law.

In many other contracts such as agreements to purchase goods or service there is normally a specific contract term. In those, once the term has expired, both parties obligations to perform are limited to only those obligations that they have agreed will survive the expiration of the agreement. All terms and obligations that aren't specified to survive the expiration of of the contract term can no longer be enforced. For example, you could have language that requires the supplier to accept and delivery all orders placed within the term and obligations for delivery, compliance with the contract terms will apply to those orders. You would also usually have a
“survival” provision where specific terms and obligation will remain in effect after either the expiration of termination of the contract.

When you do intend to include a contract term for your agreement here are my thoughts on negotiating the term.

If you will be dependent upon the Supplier for the products, service or support for a long period, such as occurs when you design a Supplier’s product into your product, you will always want either an extended term, or a combination of other terms, to help you manage the risk of continuity supply in supporting your production or service needs.

Once the term has ended, if you still need to make purchases, the Supplier may have substantial leverage. You always need to think about protecting against potential abuse where they feel you are locked in. That applies to both the price they can charge or the terms they sell under. If you can’t quickly switch sources of supply, you either need a longer term or need to include things in the contract to protect against those risks. End of the term buy options are one way to manage that risk. Another way to provide protection is to include an option to extend the agreement. Options for extensions of the terms should be subject to mutually agreed terms. I would push to establish pre-agreed parameters on what of the agreement is subject to re-negotiation and have parameters on changes to the price.

A lot of negotiating the term of the agreement is common sense. Always think about when is it best for you to have the contract end. For example, if you were dependent on a Product to meet revenue, you would never want the contract to end during a critical revenue period. If there could be any possible interruption in supply or services, always think about when is the best time for that interruption to occur as you transition Suppliers. If they are on-going services always consider the impact of any Supplier transition on the Business the service supports. For example when I negotiated a Debit Card processing agreement for a Major Bank the term was tied to when a transition would have the least impact. That meant that the major shopping period prior to the Christmas holidays could never have and transition occur as there was to much potential business at risk, whereas if you had the contract end in a time like mid February it made more sense. You also would not want a contract term to expire when you had major commitments you needed to fulfill for a customer and were dependent on that Supplier to fulfill those commitments.

A better way would be negotiate an extension of the contract to cover that term or get agreement from the Supplier that the terms of the current agreement will apply on that program until the program is complete.

Your term also needs to take into account the fact that there is a natural lag caused by lead-time that should be taken into account in establishing the term. For example, if you were buying a product with a 16-week lead-time, the first four months of your term would be consumed by lead-time. If you had a one-year contract term from the date you signed the contract, you wouldn’t get delivery for four months, and you would have to stop ordering four months prior to the end of the term because deliveries after that would then extend beyond the term. If you need time to evaluate the Supplier’s performance prior to any extension of another term or before deciding to change Suppliers, make sure the initial term is long enough. If you have a Supplier with the 16-week lead-time and it would take four months to qualify a replacement, you would have only four months of actual performance before you were forced to make a decision.

Your term should take into account the time you need to negotiate a renewal with an eye on how long it would take to source from an alternative source if needed. If it will take you six months to quality an alternative source, you need a term that is long enough so you can both conduct negotiations with the current Supplier and if your aren’t successful still have the six months needed to source from an alternate source, or you need to have the ability to make a last time buy to cover the interim period before you can bring the other Supplier up. If you have ways in which to manage competitiveness of the Supplier and are not obligated to make purchases, a longer term may make sense.

Suppliers will look at the length of the term from several perspectives. If they are making an investment to win the business, or are discounting substantially to win the business they will want a term that is long enough so they get a return on their investment or to protect them from competition. Supplier’s main concerns with the length of the term are either financial risk (e.g. how long do they have to offer the product at the price) or business strategy (e.g. how long are they required to continue to produce the product). The longer the term, the more the Supplier may look for ways to either be able to adjust pricing to cover their exposure for changing costs, or be able to end of life the Product if it no longer is consistent with their business strategy.

Capital Equipment Purchase Contracts

In another forum someone asked me what I would look for in major capital equipment purchases.
Since major capital equipment purchases involve contracts I thought I would share my responses.

Before deciding to purchase I would want to evaluate the total life cycle cost of the equipment. The total life cycle cost of the equipment would include the warranties provided, and the cost of after warranty service, maintenance, spare parts, and repairs. Further it would include the cost of energy consumed, set up and tear down time for changes, number and type of operators required, operating manuals provided, cost to buy more manuals. It would include the availability and cost of training, the cost of required maintenance, service and calibration and the frequency and cost of those.

First you would start with a standard purchase of goods agreement that would standard legal terms and business terms such as identifying the purchase period, delivery, performance, quality, inspection and acceptance warranty and service. I would also want contract terms that manage the cost of all the elements that the supplier controls by establishing either an agreed price to purchase them over the term at a fixed price subject to possible escalation per an agreed formula.

For things like available options I would want to include the option to purchase those in the future also at a pre-established price. I would want a good specification with acceptance and test requirements to ensure that the equipment meets their specifications. If it is something that can’t be fully tested upon delivery because it is not fully loaded or running at capacity, I would want that inspection, test and final acceptance to occur when those operating conditions are met. To ensure that I can get spare parts I would want a commitment that they will continue to produce and sell spare parts at the agreed pricing for the useful life of the equipment. If I can’t get that I might allow them to end of life spare part production if two conditions are met. First I would want the right to be able to make a last time buy. I would like any replacement include in new equipment to be backward compatible so substitution is possible withthe replacement part be sold at the same price as the original or less.

One other very important thing to consider is these days most capital equipment includes licensed software. Whether you are buying heavy equipment, process equipment and most other types of equipment you will find software is included and the seller will require a software license. To manage the cost I would want the contract to include software maintenance and control the cost of future software maintenance and any required upgrades. Another consideration is to protect the resale value of the equipment once it no longer is needed by your company. To do that I would want the right in the contract to assign the software licenses in conjunction with any re-sale of the equipment. You can sell the equipment without it, but the buyer can’t use the software unless they are licensed to use it. Including that right will ensure you get the highest value for it after your company no longer has a need to use it. If they won't agree with assignment of the license, I would want a fixed price option to license it so you can sell it and not leave the supplier open to charge whatever they want. What they probably want is to sell them a new piece of equipment.


What advice or terms (other than normal T&C’s) would you look for in a capital equipment purchase agreement?

Date Codes and Shelf Life

If you ever look at labels on packaged food you will normally see the date code for when it was manufactured. It may also include the lot in which it was manufactured. Further they will include a best before date or a use or freeze before date.

The simple fact is virtually all items have a form of shelf life after which deterioration will occur. For some items that deterioration may be delayed by the manner in which it is stored. For example computer chips are stored in plastic sealed tubes to prevent exposure to the air that can cause deterioration of the materials (mostly metals). Other items may be required to be stored in specific environments to prevent deterioration.

Different companies may establish and classify shelf life of products base upon risk. Some may have non-extendible shelf lifes which if reached must not be used and must be disposed of, and
Less critical uses which may require checking to determine if they may still be used. For example you could have a 4 month shelf life, which may still be used up to 12 months if determine to be fit for use.

You want to buy from suppliers buy from suppliers that manage their inventory on a FIFO basis (First in- first out). You want that so the longest amount of remaining shelf life time available to you. As sometimes they may not have done FIFO management of their inventory, you may include requirements in your contract or specification to manage shelf life.

Once you learn what the reasonable shelf life for a specific product is, you could require that all shipments to you have a date code of no earlier than X period prior to the shipment date to make sure what you receive still has a reasonable shelf life left. The main reason for that is product that has deteriorated may no longer work in its application or use and could cause other problems. It may require you to purchase another one so you are paying twice.

One of the biggest concerns that I always had with individuals buying products from brokers rather than authorized distributors while you can check the date code, you are buying materials that someone else didn’t want. You have no idea how they may have treated or stored those materials and where and how they are stored can have an impact on the shelf life of the product.

Requiring date codes is also important in managing safety and recall of products and their cost.
Production related problems normally are identified down to the specific date(s) or lot(s) in which the problem arose. From a safety perspective if you buy products and use them to manufacture a product, you need to be able to track what materials were used in which of your products. You do that so you can identify who purchased it so you can contract them to have the item fixed or re-called. If you were able to do that you would either fix all or recall all items. If it’s a safety related problem you need to be able to do that quickly, as personal injuries and lawsuits can cost you far more.

While items have shelf lives from a life-cycle cost perspective companies need to also manage the useful life it their equipment, especially all mechanical equipment. Just like exposure to the elements can affect shelf life, it will also affect the useful life of the product. For example, you have to maintain it when you use it. Conversely, if you don’t use equipment the oils and lubricants can turn into a sludge or dry out requiring repair or replacement.

Here’s a personal tip. For those of us dinosaurs that still have and use watches, all of them have a mechanical element. They need to be used and running so the oils and lubricants don’t become a sludge or dry up. If you have an type of quartz watch sitting in a drawer needing battery replacement, you need to replace the battery so it runs. If you have mechanical watches they need to be wound so they run. If you have automatic watches you need to either wear them or have a machine that helps wind them. If you don’t, you run the risk that the mechanical parts in those watches will freeze up and that can cause either expensive cleaning and repair (if its mechanical or automatic) or could require you to replace your quartz movement.

Meeting Minutes

When work is completed many times one of the next step is dealing with contract claims. There are a number of tools that you use. What does the contract say as expressed by the terms of the contractual agreement? If there were changes to the agreement either by amendment, change order or variation, what do those say, what did they change and when were those changes implemented. If you had personnel on site another tool is site reports of what was being done, by whom, and when. Throughout a project there will also be a number of meetings held and for each meeting minutes should identify the status, any issues or problems, action items and action item status. They will also document what was discussed or agreed, and instructions were given. For example if a contractor brought forth a claim, the owner may provide instructions on what they require to process the claim.

Whether it is the supplier, contractor or employer that writes the minutes is not important. What is important is making sure the minutes, as published, are an accurate reflection of the meeting. As meeting minutes can be introduced into court or arbitration, if you are not the one that published them, you need to take the time to read them to ensure they are correct. If they aren’t, you need to reply and specify what portions or statements need to be corrected.

The reason for this is simple. Many times the individual(s) that need to deal with a claim may not have been involved in the work. The individual(s) involved may no longer be with the company or may not be reachable. For the individual managing the claim to do that effectively the contract file needs to provide them with as good of a picture as possible of what actually occurred and what was discussed and agreed. If you allow incorrect meeting minutes to be published and don’t seek to correct them, the individual managing the claim would think they were accurate.

Change Orders.

In many contracts, once you start with a supplier it is either difficult, costly, or impossible to change. Since you are locked into using them, you have little or no leverage to negotiate changes to the scope of the work that may be needed during the term of the contract. To protect against potential supplier abuse, and to make necessary changes quickly, I’ve always include the right to make unilateral changes to the scope of the work and include a price formula for establishing the cost of those changes. Those unilateral changes I refer to as change orders. In change orders the formula I include to price the change is either an amount mutually agreed or the actual cost of the work plus a percentage for contributions to their overhead and profit. The use of the cost plus a percentage approach does two things. First, it is intended to get the supplier to provide a reasonable cost initially, knowing that if they don’t, the buyer can require them to prove their actual cost. It also protects the supplier against the buyer being unreasonable, as they can wait for the actual cost to be determines.

Below is an example of a Change Order clause:

1. A change order is a written order to the CONTRACTOR, signed by the OWNER, authorizing a change in the Work, the Contract Price or the final completion date.

2. The OWNER, without invalidating the Contract Documents, may issue orders making changes by altering, adding to, or deducting from the Scope of Work. A change in the Scope of Work may also necessitate an adjustment in the Contract Price or the final completion date. No change in the Scope of Work shall proceed and no claim for additional monies for such change or for any extra work, so-called, will be valid unless such work is done pursuant to a written order from the OWNER to the CONTRACTOR signed by an OWNER Representative. Advance approval is not necessary for extra work required to protect life or property under emergency conditions. The OWNER shall determine in each case whether the work done without written approval was of an emergency nature and whether it is to be reimbursed and a Change Order issued.

3. The cost of work for any change order shall be either a lump sum agreed to by the OWNER or actual costs and a percentage fee for overhead and profit. Such percentage fee shall not exceed fifteen (15%) percent of actual costs for work performed by a CONTRACTOR alone. For work performed by a Subcontractor, the cost to the OWNER shall be determined by a lump sum agreed to by all parties or the actual costs to the Subcontractor, plus a percentage fee not to exceed ten (10%) percent for the Subcontractor's overhead and profit, plus a fee not exceed five (5%) percent for the CONTRACTOR'S overhead and profit.

4. If deductions are ordered, a credit shall be computed on the same basis as increases for extra Work.

Limited Performance Windows

A reader asked me for suggestions on how to protect against investments that they need to make in the purchase of goods and equipment that needed to be in storage for extended term. She was dealing with a construction project in a location there would be a limited performance window per year of maybe four months out of the year due to weather and extreme cold. This meant that they would need to buy things in advance and either store them at the site or a staging area until they could be used within that window. This also meant that they had to pay the suppliers well in advance of when they may be used and was concerned about protecting that investment. She had already used several tools to protect her company. She selected only highly reputable companies to provide the materials and equipment. She also used bonding and retention of monies as another tool. She was looking for other tools to help protect her company’s investment.

Once the goods or equipment are delivered to the staging site title and risk of loss transferred to her company. Loss or damage caused by normal perils would normally be covered by the company’s insurance policy. One concern that I had was loss or damage to equipment or materials
caused by being subjected extreme temperatures may not be an insurable risk. The first suggestion I made is to protect against storage in extreme environments, I would want the supplier and their equipment manufacturers to specify storage requirements needed to protect the materials or equipment in that environment. The second suggestion I made was to require them to pack, package and crate equipment in a manner that meets those requirements. My assumption was that there no plans of doing and test or acceptance at a consolidation site. Next I suggested adding contract commitment that if her company followed those storage requirements, it is their supplier or equipment manufacturers responsibility to repair or replace any materials or equipment that are damaged in storage other than by normal perils such as fire or flood. If you didn't do that I could see equipment manufacturers arguing that any warranty is voided. I also thought those requirements would help if you need to call upon the performance bond as you were showing that your acts were reasonable and you followed their instructions.

The other major issue with limited performance windows is warranties. You need to ensure that the warranty in place as they provide another protection against the investment in the equipment. A warranty would require the supplier to repair or replace any defective product. If you were let the warranty lapse because of the limited performance window, when you go to start up the equipment and it doesn’t work, it would be your cost to correct or replace the defective item.

The most preferable warranty to protect the investment would start upon installation and acceptance of the equipment at the site so no warranty time is lost because of the limited performance windows. Alternatively you could have the warranty period that is long enough so you will still have the warranty in place after all the delays because of the limited performance windows so it is still in place after start up of the facility and for any period you have to warrant to the customer.

Most warranties include warranty exclusions such as abuse to the product that would void the warranty. You want to avoid the argument that the product or equipment has been abused. Having the supplier specify the storage requirements, and having them pack, package and create products to meet those requirement will help do that. How can you have abused it if you followed their instruction?

Construction Pre-Qualification

HOW DO WE GET THE RIGHT PARTIES?

The key to it all is that we should only deal with Companies who we have pre-qualified. The nature and extent of Pre-qualification will vary based upon the size and complexity of the activity, the risks involved, the critical nature of the schedule, etc. In general, the flow of a Pre-qualification process would occur in stages however, depending upon the criticality of the schedule you may have to skip various stages, compress stages or even take acceptable short cuts to allow you to have some level a pre-qualification accomplished and yet still meet your schedule.

Information Gathering
FIRST, YOU WOULD SOLICIT GENERAL INFORMATION ON THE COMPANY.
The formats for this will vary as each of the different businesses are unique and certain information that deals with the uniqueness is required.
In general, What you are trying to find out is their size, areas of expertise, the types of people they have on staff, the character of their past projects or products, their financial strength, and any other information which will give you insight into their capabilities. In general this information becomes the basis for your own file of Potential Suppliers of Contractors for that particular type of service or product.

Information Screening
Second, usually when a requirement has been identified, you would review the information you have and from the type and size of products or projects
that they list as experience. You use that to try to establish an initial group of companies to screen/or interview. You are trying to MATCH YOUR NEED AGAINST THEIR CAPABILITIES. Big doesn't always mean better, as a small job can easily "get lost" in a large firm and not get the proper attention. Neither would you hire a small firm for a project well beyond their proven capabilities. You would look at it carefully from the type of work they have done.

The Interview
Third, it is strongly suggested that you CONSIDERING INTERVIEWING THE COMPANY to allow you to get a better idea of the company's capabilities and
their management. Its staff, current status, current workload, management structure and philosophy, general personality, etc. represent the Company.
In short, all the information that you can't get from your Pre-qualification form you should get in the interview. An interview will disclose many
things you would not be able to get from the form. First, a trip to their office or manufacturing facility will indicate how busy they are at the time. For example, empty desks during a period where the business is booming can mean underlying problems in the company.

Always ask for a TOUR OF THEIR FACILITY. It will allow you to look around, see what they are doing, how they manage the business, and the tools they
have. It will also give you a better understanding of the character of the company.

In an interview you use the time to probe in detail. For example, if you were dealing with a Company with multiple offices you may need to find out the
Specific capabilities for the particular office that you will be using. This is especially important in service related activities, where you are relying upon the people and capabilities of the local office. Each office may have a different character depending upon their customer base and may be arranged
and organized to deal with that customer base. For example, an office located in a Country or State Capital may specialize in Government work, while another
office of the same firm in another location may specialize in private work.

You should also have them PRESENT A REPRESENTATIVE PROJECT and have them walk through the project explaining how they managed it. That will allow
you to understand their basic capabilities. It will also allow you to probe about who did what. It is possible to discover through the interview that the
individual who was a major factor of the success of a prior project or the the company is no longer with them. That would change their perceived
capabilities. It is also possible for them to identify a management structure or approach which they use that would be incompatible with your requirements
For activities which involve design you should want to see representative samples of the design drawings and technical specifications which they
generate to determine the quality and depth of the product. You may also want to see in detail their management systems for things like scheduling, buying of equipment and materials, material flows, quality processes, field service and support capabilities, lists of equipment they have, etc. One final suggestion for interviews, use the interview to get you information you need to help you make decisions you need on the Project such as: their estimate of what the time for the project, the estimate of equipment and material lead times, their opinion of your schedule, The contract approach they would recommend using to meeting it.

The Interview Team
As you would in most cases not have all the experience needed to be able to qualify a supplier by yourself, you need to form an interview team to address
all of those other areas. Clearly the size and character of the interview team is dependent upon the complexity of the project and the risks foreseen and the long term relationship. For example, if there is a need for long term service you should have someone with service knowledge and experience look at the supplier's capabilities to help understand what you will need from the supplier and what may have to be covered through other resources to develop the overall service strategy.

Reference Checks
Fourth, you would CHECK REFERENCES on the Company. Find out when they worked, what they have sold, the type of job, their role, the type of
contract, etc. Seek to find out everything that a reference would be willing to share with you. You may quickly find that the work they show in their brochure may not have been totally performed by them. Or they may have done the work but with a high level of work performed by or management assistance and guidance from the client. It is important that you both ask them for references and, while you are at the interview make note of the programs that they may be doing or may have just completed. References provided by a Company will always be positive in nature. That is why you should go beyond those provided in your checking.

Key questions to ask in a reference check would be:
• When did they work for you ?
• How large was the project ?
• What was their role in the project ?
• Who managed the project for them ?
• Would they accept that manager again ?
• How well supported were they by the main office ?
• What Contract Approach was used ?
• Were they satisfied with the performance ?
• Would they use them again ?
• What was the frequency of Change Requests or waivers ?
• What was their adherence to the Schedule ?
• How responsive were they to problems which occurred during the project ?
• How responsive were they to problems or warranty issues after delivery ?
• If they were going to do it over again, what would they do differently ?

Financial Evaluations
Fifth, you would PERFORM A FINANCIAL EVALUATION of the Company. In the exhibits we have provided samples of financial analysis guidelines for
various types of businesses. However, from business to business and from location to location the importance of various things will differ and as such it is always recommended that the specific financial norms for evaluation be locally generated in conjunction with your local finance organization. It is important that you get the most current financial information available. Many Businesses can change dramatically from year to year. Suppliers which
can be very sound one year could have sustained substantial losses and be on the verge of bankruptcy the following year.

In some locations, or for certain size projects the Companies which you may wish to use may be privately held. This can present a problems in terms
of getting detained financial information. If you encounter this type of situation there may be ways of getting an assurance of their financial
stability without you needing to get the actual detailed financial information. For example: You could provide a set a financial norms which you require to be met and ask that the individual's Certified Public Accountant certify that they have reviewed the information and that it meets those norms. In some locations you may consider accepting a third party guarantee such as a Bank Guarantee which would protect you for any advances or payments to third parties. You could consider requiring the party to provide Payment and Performance Bonds which are normally issued by insurance companies. However, as bonds cost money you should consider this as a last step as it will add to the cost of your project and you should try to get the needed information elsewhere to determine the risk.

One important note about Bank Guarantees and Insurance Company issued Bonds. It is important to remember that while they may reduce the financial risks
they will not guarantee you any greater degree of success in completion of your project. In fact, their interests (those of the bank or insurance company)
may be contrary to yours when there is a problem. It will bring them in as third party and usually their sole goal is to minimize their potential
loss. They will not be concerned with your needs unless that effects them financially. On-demand bonds allow immediate collection of the bond amount if the trigger for payment of the bond is reached, they will also cost more than a normal surety bond as the on-demand bond does not require any mitigation of the costs, whereas a surety bond the surety has the right to mitigate the cost to complete the work.

Staffing Comments and Concerns
If you have done all of this checking, will you be successful? If you are dealing with work which relies on the personal performance you can encounter the problem that while you can select a very good company it is possible to get one bad performer from amongst the good. At interviews companies will always will always put their best foot forward and you will meet the top level managers and key personnel. THESE ARE NOT THE PEOPLE WHO YOU WILL BE DEALING WITH IN THE LONG RUN. As impressive as their credentials are, most of the key individuals willbe involved in Marketing for the Firm, Operational Management or providing conceptual or high level direction or top level problem solving.
YOU WILL NORMALLY BE DEALING WITH SOMEONE WHO IS MUCH FARTHER DOWN IN THE ORGANIZATION FOR ALL OF YOUR EVERYDAY NEEDS. As such if you are dealing with a business where personal performance of someone on their staff is critical to your success, it is highly recommended at the interview or as a prior condition of the award, that you MEET WITH THE ACTUAL PERSON OR TEAM WHO THEY WILL ASSIGN TO PROGRAM. By doing this you can interview the specific members, make sure that you feel comfortable with their knowledge and abilities and also feel that you can work with them to accomplish the common goal of the successful completion of the Project. If you are not comfortable with the individual or team presented you should feel free to let the company know that they are not acceptable and that you want someone more acceptable. If they promise you someone and you are concerned about the veracity of their promise, you can consider including a provision in your contract which designates them as the person or team and limit the Company's ability to change to only those situations approved by you.

Approval of subcontractors.
In a number of situations you the contract with may not have all of the capabilities necessary to manage the complete project. The will then have
to use subcontractors to assist them in the performance of their activities. YOUR SUPPLIER OR CONTRACTOR WILL ONLY BE AS STRONG AS THE WEAKEST SUBCONTRACTOR.This is especially the case where the flow of the work requires a strong interdependence between the supplier and their subcontractors performing the work.

If you have one Subcontractor that is non-performing or poor performing it can effect the entire flow of the work and the performance by your other
subcontractors. Their resources are planned around the scheduled flow of the work. Commitments for their other projects are made based upon
the projected flow. If your project is delayed, you then may have the problem where their people are already committed to another project
and the will have to back fill when possible or using secondary resources,which won't provide you as good of a job.

As such, many agreements provide for APPROVAL OF ALL SUBCONTRACTORS. If the performance by a third party is critical to your success, make sure that you have control over who is selected. If it is critical to your success, It would be important that you take the time to verify the subcontractor's capabilities. It may be as easy as discussing their capabilities with your Supplier who may have had on-going business with them. It may however require that you jointly check them out in detail if they do not have an on-going relationship.

Good Suppliers are as concerned with not wanting to bring on a subcontractor
who is unknown or which has potential problems as:
•A Bad Subcontractor will affect your perception of them as a Supplier
•A Bad Subcontractor will increase their management time on the project costing them money and resources
•A Bad Subcontractor will be a source for potential claims from other subcontractors for delays and hence will increase the amount of time it
take them to manage all the claims
•A Bad Subcontractor can cause problems with good subcontractors who because of delays will have conflicting commitments.
They should be willing to, as a team, help make all the necessary checks with
you to make you feel comfortable with the total team you have assembled.


FINANCIAL
As a part of the interview you should also ask them to provide you with the most recent Audited Financial Statement, with the Auditor's notes.
In certain instances where there is added concern, you may also request the most recent balance sheet in addition to the prior audited
report. Obtain a copy of a fully audited, unqualified financial statement as of fiscal year-end. CPA prepared, un-audited interim financial statements are acceptable as long as we have a year-end financial statement. The past two or three years of financial statements are helpful in establishing trends. The financial statement should include as a minimum:
Letter from Accountant (Opinion Letter)
Balance Sheet
Income statement (Profit and Loss)
Notes to the financial statement
Source and use of funds Exhibit*
Change in Financial Position Exhibit*
Schedule of jobs in Progress*
The items marked with an asterisk (*) are helpful for analysis purposes, but are not necessary.

References.
You should obtain bank references, major supplier credit references and client
references.

Evaluation of the Financial Statement.
The first thing to understand in the financial statement is the method of
accounting. The notes to the financial statement should include what method
of accounting the company is using to recognize its income. Contractors generally use either of two accepted methods of accounting:
•Percentage of Completion, which recognizes income on work as a contract
Progresses.
•Completed Contract, which recognizes income only when a contract is
complete.

Generally, percentage of completion is most common because it allows contractors to periodically recognize income on a current basis rather than irregularly as contracts are completed. When the completed contract method is used, it does not reflect current performance when the period of the contract extends through more than one accounting period. Contractors may, for tax purposes use the percentage of completion method for financial reporting and the completed contract method for tax purposes.

In your evaluation you would check all of the references as follows:
Bank references - Credit lines, availability, guarantees given
Suppliers - Credit History
Subcontractors - Payment performance

Analysis
The following ratios that are given are generally considered norms for general construction in the U.S.. You should use them as guidelines. If a contractor does not fall within the guidelines there may be circumstances or explanation for the situation. On the other hand, if they do fall within the norms, it
alone does not automatically qualify them to do the job.

1. WORK ON HAND divided by: ADJUSTED WORKING CAPITAL= 20 or less

2. ADJUSTED CURRENT ASSETS divided by: ADJUSTED CURRENT LIABILITIES =1.2 OR MORE

3. CASH & EQUIVALENTS x 360 divided by: ANNUAL REVENUE = 7 DAYS OR MORE

4. WORK ON HAND divided by: ADJUSTED NET WORTH = 20 OR LESS

5. TOTAL LIABILITIES divided by: ADJUSTED NET WORTH = 2 OR LESS

6. ACCOUNTS RECEIVABLE x 360 divided by: ANNUAL REVENUE = 60 DAYS OR LESS

7. ACCOUNTS PAYABLE x 360 divided by: DIRECT JOB COSTS = 30 DAYS OR LESS

8. SINGLE JOB divided by : ADJUSTED WORKING CAPITAL = 10 OR LESS

9. SINGLE JOB divided by : ADJUSTED NET WORTH = 10 OR LESS

DEFINITIONS
WORKING CAPITAL. The working capital is the amount of current assets the contractor has in excess of current liabilities. When determining the
working capital, review carefully what the accountant has classified as current. Generally cash or equivalents, receivables, inventory and
under-billings are considered current assets. Prepaid amounts and cash surrender value of Life Insurance are not considered current. Use your judgment on the current status of notes receivable from sources such as employees, owners,or subsidiaries of the contractor to determine if they can in fact be
converted to cash or consumed in the year. Current liabilities include: accounts payable, over-billings, current portions of notes payable and
other current obligations such as taxes, payroll, etc.

NET WORTH OR EQUITY/ADJUSTED NET WORTH. This is the total of capital stock and retained earnings less treasury stock and dividends. The number as given
on the financial statement must be reviewed to see that the assets which are stated are hard assets. To arrive at adjusted net worth deduct items such
as goodwill from the stated worth.

WORK ON HAND OR BACKLOG. This value represents the estimated cost to complete for the current work that the contractor has on his books at this time. To
determine this number take the total cost of all work and deduct the cost to date.

ADJUSTED CURRENT ASSETS. This equals the current assets as listed by the accountant less items which you do not consider such as Prepaids or cash
surrender value of life insurance. Also review Notes and accounts receivable from the Owner's of the Company or Subsidiaries.

ADJUSTED CURRENT LIABILITIES. This equals the current liabilities as given on the balance sheet by the accountant and adjusted (Up or down) for other
items which should be considered current.

ADJUSTED WORKING CAPITAL. After reviewing the current status of the assets and liabilities to determine the adjusted Current assets and Adjusted Current
Liabilities, subtract the adjusted Current liabilities form the adjusted current assets to find the adjusted working capital.

ANNUAL REVENUE. The accountant will show this on the income statement(profit or Loss) and will be denoted by sales, income, volume or revenues.

DIRECT JOB COSTS. These are the costs of the job exclusive of indirect job overhead and profit.

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.

Does continuing work void a termination?

Sometimes I’m amazed by some of the opinions expressed on on-line contracts forums. They do provide me with subject matter to write about.

In the situation the individual said that the contract had been terminated by the employer but they continued to perform work. In his opinion he felt that the continuing of work voided the termination. That simply does not happen. Once a contract is terminated, it has ended, except for any obligations that were agreed to survive the termination. Once that contract has been terminated if there is continuing work being performed it needs to be done either under a new contract, or the work is being done without no contract in place. Creating that new contract could be as easy as writing a one page agreement that incorporates the terms of the terminated agreement for the remaining scope of work with a new period of performance.

A further concern he had was the employer was seeking to go against some of the guarantees in the terminated document over two years after the agreement was terminated. For the employer to be able to do that you would need to check two things. First, since the agreement was terminated did the guarantees survive that termination.The second thing to be checked is what is the statute of limitations in that jurisdiction for bringing a contract claim. You see in many jurisdictions an action under contract has a two year statute of limitations. If that statute of limitations had passed, they may no longer have the right to make a claim against the guarantee. The guarantee only applied to the contract that was terminated. It did not apply to the additional work where there was no contract. Allowing additional work to be performed outside of the original contract does not extend the statute of limitations period on the terminated contract.