No one wants to lose business in a contract disagreement, but a forger (or any manufacturer) must determine how important each customer is, against the possibility of liability arising from unfavorable terms of a supply agreement.

10 Red Flags in Customer-Supply Agreements

Jan. 9, 2015
When you’re the supplier, you have to be careful once a customer invites you to enter into a contract … Understand the framework One size doesn’t fit all Know your rights, obligations

You have developed a great relationship with a large customer. The customer asks you to enter into a “Supply Agreement” to cement your relationship. Or maybe it was your idea? Next thing you know, you are asked to sign the customer’s form “Master” or “Framework” or “Preferred Supplier” purchasing or supply agreement. This document is likely to be very one sided (favorable to the customer.)

What to watch for? Here are 10 problematic (from the supplier’s perspective) provisions common to these agreements. For purposes of this article, the customer’s “master” (or “framework”, or “preferred supplier”) purchase or supply agreement will be referred to as the “Master Form.”

1. Who is bound and who is not? It is typical for a Master Form to require a supplier to supply specified parts at stated prices for the term of the agreement, but rarely will a Master Form provide a corresponding obligation for the customer to purchase any parts. So, if left unchanged, the agreement imposes a one-sided supply obligation on the supplier and gives the customer merely an option to buy.

Of course, Master Forms vary.  Some give each side an option, or even oblige the customer to purchase a stated percentage of its requirements from the supplier.

It is important to analyze carefully and understand the purchase and sale commitments. Each situation is different.  If the customer is unwilling to be obligated to purchase from you, you might at least convince the customer to let you off the hook, too -- so that the contract is mutually non-binding regarding purchase and sale obligations. Otherwise, if the agreement gives the customer an option, you will have to reserve capacity, without knowing whether or how much the customer will purchase.

2. Boilerplate terms and conditions. Many Master Forms automatically incorporate the customer’s standard terms and conditions; typically, these are attached to the Master Form and likely are skewed to the customer’s advantage (e.g., a broad unlimited warranty, very long payment terms, one-sided indemnification, late delivery penalties, and/or a customer’s right to terminate for convenience, — which negates any purchase commitment you might have negotiated, among other things.)  So, boilerplate terms and conditions attached to the Master Form have to be read and negotiated, too.

3. Focus on the term. Whether a proposed duration set forth in the Master Form is acceptable or not depends upon the commitments imposed on each party. For example, if the customer has committed to purchase 80% of its requirements for a certain part from you, perhaps you will want a longer term, particularly if you have to make capital investments to meet this demand.  If it is a one-sided commitment to supply (binding only on you), a very short term is probably better.

You might suggest an “evergreen” term, one that renews automatically. For example, the agreement might be for two years, but after the first year another year is automatically added, and so on, so that on each anniversary there are exactly two years remaining.

Some Master Forms provide the customer a perpetual unilateral right to renew the agreement, whether or not the supplier agrees. This could be disastrous for a supplier if it is coupled with an obligation to supply parts at a fixed price. Never agree to give a customer a unilateral right to renew, unless the agreement in question imposes no obligation on you.

4. Don’t agree to a One-Size-Fits-All warranty. Whether the customer includes a warranty in the body of the Master Form or in attached boilerplate terms and conditions (or both), it is likely that the warranty will be overbroad.  Typically the customer will demand that the supplier warrant that parts supplied are “of merchantable quality,” “fit for the purpose intended,” “free from defects in materials, performance, and workmanship,” and in conformity with drawings, specifications, and other requirements referenced or provided by the customer.

A forging company manufacturing parts to a customer’s specifications can (and should) warrant that the parts conform to the specifications. However, you should avoid warranting “merchantability” or “workmanship,” or especially “fitness for purpose”: The first two terms impose vaguely defined industry standards. Agreeing to such warranties will give the customer an argument that the supplier is liable for any trouble that arises, whether the supplier met the specification or not. It would be safer to compromise with an ASTM or other more specific industry standard.

As to the warranty of “fitness for purpose” -- unless you design a part, it is inappropriate to warrant its “fitness for purpose.” You have not been hired to design the part, so you cannot know if it is suitable for the customer’s application, so do not guarantee that it is.

The warranty that you deliver should be limited to a period of time (e.g., 12 or 24 months) and the Master Form should include a bold “disclaimer” of all other warranties, expressed or implied. If not, you may have inadvertently implied warranties under the relevant state’s version of the Uniform Commercial Code. Also, suppliers should consider asking for a dollar limit on liability if the warranty is breached. 

5. Specify purchase and sale obligations. Purchase commitments usually are either “take or pay” or “requirements.” “Take or pay” means that the customer agrees to purchase a certain quantity during a stated period, irrespective of need.  A “requirements” contract typically requires the customer to purchase a percentage of the customer’s total “buy” from the supplier.  If you enter into a “requirements” contract, it must be clear what “requirements” means: Is it the requirements of only one or all of the customer’s locations? Foreign locations too? If you agree to a 50% requirements obligation, does it mean the customer must purchase 50% of its requirements for each type of part listed, or 50% of the total combined parts? What about parts supplied by a customer affiliate? The words of the agreement should address these types of details. 

Once the purchase and sale commitments are clear, the schedules attached to the agreement (typically including part numbers and prices) must be consistent. Disputes may result if the schedules are not consistent with the body of the agreement.

In general, having a customer who wants more than you can supply is a good problem to have, but not if you contract to supply an unlimited quantity of parts at what turns out to be a below-market price, or the customer’s requirements exceed forecast and you must invest to keep up.  So, the contract should cap the maximum quantity you are obligated to supply in a given period, or at least entitle you more time to “ramp up” quantities. 

Customers' Commitments, Suppliers' Obligations

6. Watch for easy defaults. Even if you get a customer’s firm commitment to purchase, it is illusory if the Master Form is structured so the customer can easily put you into default and terminate the contract if it wishes to stop buying parts from you.

If the customer’s right to terminate is very broad it could be worse than having no commitment at all, because you may have made capital investments, reserved capacity, or built stock in reliance on a customer’s commitment, without realizing the agreement can be terminated under loose “default” language.  Particularly dangerous are very broad clauses that permit termination for any breach, large or small (without the right to correct it in a reasonable period of time), or clauses that permit termination upon any quality defect or late delivery (particularly if late delivery is measured from the date of the customer’s receipt, which is usually out of the supplier’s control.) 

7. Modify the customer’s right to assign. Many Master Forms permit free assignment of the contract to another customer, or permit the customer to require the supplier to take orders from, and ship parts to, other contractors or subsidiaries of the customer. This may result in the supplier unwittingly extending credit to a third party that may be a bad credit risk (particularly dangerous when the third-party is in a jurisdiction where collection could be costly or difficult.) 

8. If you manufacture for “stock,” make sure that the customer is contractually bound to buy it. If you agree to maintain a stock of finished parts or buy material for the customer, the agreement you sign should clearly require the customer to purchase the stock and material upon termination of the agreement.

9. Get a force majeure clause. Many Master Forms lack a force majeure clause that gives the supplier (as opposed to the customer) the right to cease performance during any event beyond supplier’s control that impairs supplier’s performance.   While most customers will add such a force majeure clause if asked, it is important to focus on the words of the clause.  .

For example, many customers will retain the right to terminate the agreement if the force majeure lasts longer than an unrealistically short number of days. Many exclude labor disputes, which puts the supplier in a position of having to choose between capitulating to unreasonable labor demands or incurring large damages for breaching a contract.  Also, be careful that if you agree that the customer has a right to terminate the contract if the force majeure lasts for more than an agreed-upon period of time, termination must be expressly without supplier liability.

10. Beware limits on consequential damages.  Most customers will agree to forego their right to claims against a supplier for “consequential and/or other indirect damages,” and you should ask for such a clause. But what if the customer wants that clause to be reciprocal? Be careful: before agreeing to this, make sure to make a clear exception for the supplier’s lost profits if the customer does not meet its contractual purchase obligation.  Lost profits are the primary measure of damages if the customer does not meet its purchase obligations under a supply contract, so the supplier should be careful not to unwittingly give up the right to claim lost profits under these circumstances. 

If you have ever questioned a customer’s Master Form, you may have been told that you are the only supplier who has tried to change it, and that you must sign it as-is or they’ll find another supplier.  This is a scare tactic: no one wants to lose a customer in a disagreement over the words of a contract.  A supplier in this position must evaluate both leverage on both sides (i.e., how important is the supplier to the customer, due to price, capacity constraints, time pressure, or other factors?) against the likelihood and scope of liability that could result from unfavorable provisions in the agreement.  Be as strategic as you can be to eliminate the biggest risks -- and getting help from a practical lawyer who understands your business wouldn’t hurt, either.

Susan Apel is a partner at K&L Gates LLP in Pittsburgh, and the former general counsel of Ellwood Group Inc. Contact her at [email protected].