Machinery and Equipment Supply Contracts

This does not stop many customers from proposing terms and conditions that ask their suppliers not only to provide equipment, but also to be, in effect, their liability insurer, their business interruption insurer, and their general security blanket for anything bad that might happen.

Particularly in an economy recovering from weak demand, it may be tempting to machinery and equipment sellers to avoid the cost of legal review of sales contracts, or, worse yet, to sign whatever terms the buyer provides. Needless to say, this is not a good idea. Having negotiated and drafted supply contracts throughout the United States and Canada, as well as other parts of the world (with the help of local counsel), I have observed that the key legal issues are usually the same. Four of the most fundamental are: 1) getting paid; 2) warranties; 3) indemnities; and 4) limitations of remedies.

This article considers these issues, but with two important caveats: First, this article is written from the seller's point of view. Second, this article deals with general U.S. legal principles, and I am a lawyer licensed in Georgia. One should always consider the legal issues in the particular jurisdiction and should consult with local counsel as necessary.

General Considerations

Equipment sales in the United States are almost always governed by Article 2 of the Uniform Commercial Code (“UCC”). The UCC was first published in the 1950s and has since been adopted by almost all states. The basic philosophy of the UCC is to provide a general framework for commercial transactions. In the area of the sale of goods, the default provisions of Article 2 are quite buyer-oriented.

Another basic philosophy of the UCC, however, is freedom of contract. Particularly when sales are between merchants (commercial parties, as opposed to consumer parties), as almost all machinery and equipment sales are, the buyer and the seller are free to vary the default provisions of Article 2 by agreement.

A prudent seller of machinery and equipment, therefore, will not want to rely on the default provisions of the UCC, and should make sure that the contract of sale contains terms and conditions that appropriately limit and define the seller's responsibility.

Getting Paid

Machinery and equipment orders often involve expensive goods that are customized for the customer. Thus, if the buyer defaults on payment, the seller may be left with expensive goods that are not easily re-sold, likely leading to a large economic loss. Here are some of the basic steps that can help avoid such a scenario:

• Know your buyer and keep your knowledge current. Having a buyer with known financial resources and a good track record of payment is one of the best practical means to ensure payment. Many substantial companies and formerly proven buyers, however, may have fallen on hard times and are no longer creditworthy, or as creditworthy as they have been in the past. Make sure your knowledge is current.
• Get a large down payment and make sure the financial terms provide protection. Machinery and equipment sellers should insist on financial terms where, at the least, their out-of-pocket and labor costs will be covered. This is best accomplished by a substantial down payment and other financial milestones that will make sure that the seller's anticipated costs are covered. In most instances, the substantial majority of the purchase price should be due upon delivery.
• Consider requiring a letter of credit. Letters of credit are probably the “gold standard” for protecting a seller against the risk of non-payment. Buyers prefer not to provide them because of the cost involved and because they limit credit resources. In large or potentially risky transactions, however, a letter of credit may be a practical necessity.
• Taking a security interest in the goods may not be enough. Although taking a security interest may provide adequate assurance of payment in many transactions, it may not be enough for machinery and equipment sales. Without getting into other potential pitfalls, enforcing a security interest in the event of non-payment usually involves repossessing the goods, with the right to then resell them. This is often not practical for customized machinery, particularly after it has been installed at the buyer's plant.

Warranty Issues

Negotiating the warranty for a machinery sale is usually one of the more involved and complicated issues. The buyer, obviously, wants the longest warranty possible with the widest possible protection. Most machinery sellers readily stand behind their equipment, but cannot afford to offer the more generous warranties often provided for consumer goods, where, for example, it is not so difficult to change out a malfunctioning camera or television. It is not feasible to change out machinery that has been bolted to a specially made foundation and that may occupy half a football field or more. Here are some of the key points:

• Warranty period. The standard warranty period may vary in different industries, but it should be clearly defined. If the warranty period is to run from start-up or acceptance of the machinery, the seller should insist on an outside limit from delivery, because buyers will sometimes delay installation or start-up of the machinery for business reasons, or start-up may be delayed for other reasons not attributable to the seller. For example, a warranty period could be stated to be 12 months from start-up or 18 months from delivery, whichever is earlier.
• Limited remedy. The UCC allows the parties to agree to remedy limitations. Most machinery sellers will want to limit remedies to repair or replacement of defective components at the seller's option and at the seller's expense. This remedy is usually fair to both parties for several reasons. First, the buyer's interest is in getting the machinery up and running as quickly as possible. Fixing the problem is usually the fastest way to accomplish this. Second, the seller almost certainly has the most expertise regarding fixing its own equipment. Third, during the warranty period, the seller should bear the cost of the repair or replacement.
• Disclaimer of implied warranties. Under the UCC, there are two implied warranties that potentially come into issue: 1) the implied warranty of merchantability, and 2) the implied warranty of fitness for a particular purpose. The implied warranty of merchantability essentially provides that the goods are to be of fair and average quality, and pass without objection in the trade. The problem with the implied warranty of merchantability is that it is very vaguely defined, and thus a plaintiff's attorney can characterize pretty much any way that is advantageous in the event of a lawsuit. In general, the warranty can be disclaimed by language that is conspicuous and that specifically mentions merchantability.

The implied warranty of fitness for a particular purpose may well come into play in machinery sales. This implied warranty arises when the seller has reason to know of the buyer's purpose for the goods, and provides that, in such circumstances, there is an implied warranty that the goods will be suitable for the buyer's purposes. Because the sales process for machinery is complex and may last for several months or longer, the seller's sales personnel may well have knowledge of the buyer's purpose. Again, the problem with the implied warranty is that it is very vague, and, in litigation, the buyer's attorney can use 20/20 hindsight to “define” the buyer's purpose after a problem has arisen. Again, this implied warranty can be disclaimed through language that is conspicuous.

Note: It is especially important to check the particular state law regarding the disclaimer; i.e., that state's version of the UCC.

• Limitations on coverage of the warranty. Warranties are meant to cover problems with the machinery and equipment that are properly the responsibility of the seller. For these reasons, it is common to limit warranty coverage for issues caused by: 1) failure of the buyer to follow the manufacturer's operating or maintenance instructions, 2) use of improper or out-of-specification raw materials, 3) damages caused by the buyer's unauthorized efforts to repair the machinery, 4) use of the equipment for unintended purposes, or 5) the buyer's other abuse of the equipment. It is also common to preclude warranty coverage for wear parts, meaning parts that are designed to wear out during normal operation and that must be periodically replaced as part of standard maintenance procedures.

Indemnities

Indemnity provisions are often contentious and highly negotiated. In general, an indemnity provision, also known as a hold harmless provision, provides that one party will pay for any loss sustained by the other party under specified circumstances. Such clauses are risk-shifting provisions and should be approached by a seller with great care.

Unfortunately, it has become quite common for buyers to propose standard indemnity provisions that essentially provide that the seller will indemnify the buyer for anything bad that happens once the seller (or its equipment) comes on to the buyer's property, regardless if the seller was in any way at fault.

Essentially, the buyer proposing such clauses is asking the seller to become an insurer, except without any limitations on the scope of liability. Most buyers proposing these terms would never accept them if they were on the receiving end, and sellers should reject them out of hand. It is important to remember that most large buyers have (or should have) sophisticated risk management and insurance programs. It is fair to ask buyers, for the most part, to insure their own risks.

Here are some additional points about indemnity provisions.

• Indemnity provisions should be limited to third-party claims. A reasonable indemnity provision should generally be limited to third-party claims. Indemnity clauses should not cover claims between the parties, which should be addressed by warranties or other contractual covenants. Thus, for example, if a seller's employee drives onto the buyer's premises and negligently runs into a visitor's automobile, resulting in a claim against the buyer by the visitor, then the buyer can fairly expect to be held harmless against any loss from the claim.
• Indemnity provisions should be insurable. A seller will want to make sure that any indemnity it gives is backed by its liability insurance. In very broad terms, liability that is based on an insured's negligent conduct is likely to be insurable. For these reasons, sellers should seek to limit indemnity obligations to claims arising from the seller's negligence or fault. In any event, a seller should ask its insurance broker to review any indemnity provision ' as well as any insurance requirements specified in the contract ' to make sure that they are covered by the seller's insurance coverage.
• Indemnities should be mutual. Often, the work of installing and commissioning equipment involves a mutual effort by the buyer and seller. As such, the seller has a risk of claims arising from the buyer's conduct, just as the buyer has a risk of claims arising from the seller's conduct. Therefore, it is certainly reasonable for a seller that is asked to provide an indemnity to ask the buyer to provide a mutual indemnity protecting the seller from claims arising from the buyer's fault. In any event, a request that the indemnity be mutual will often cause the buyer to be much more reasonable with respect to the other terms of the indemnity.
• Indemnities should not be unlimited. Indemnities should be subject to a reasonable time limit. Indemnities should also be capped in terms of total potential liability.

General Remedy Limitations

Unless limited by contract, the UCC provides for some fairly generous remedies or potential remedies for buyers. Some of these remedies, most of which are likely uninsurable, could potentially put an equipment supplier out of business. It is important, therefore, that the parties agree to appropriate general remedy limitations.

• Consequential, incidental and punitive damages disclaimer. Consequential damages are a huge potential liability for a machinery seller. Consequential damages may include, depending on the circumstances, lost profits or loss of production, increased labor costs, increased material costs and the like. Incidental damages may include costs incurred by a buyer in dealing with a breach. In many instances, the lost profits associated with a few days' worth of the buyer's production may equal a substantial portion of the cost of the equipment. As a result, it has become standard and accepted practice to include a disclaimer of consequential and incidental damages in supply contracts. Even the most stubborn buyers understand the need for such provisions.

Punitive damages are awarded not as compensation, but to punish and deter future bad conduct. Punitive damages typically require a showing of intentional or at least reckless conduct, and are often not permitted in breach-of-contract cases. In order to avoid any prospect of punitive damages, it is a good idea to exclude them specifically in the contract.

• Cap on total liability. It is common in supply contracts to have an aggregate total cap on liability. The reason for a cap is to limit the seller's exposure so that one project will not expose the seller to financial ruin. The liability is often limited to the purchase price, although in some circumstances the cap can be less, or perhaps slightly more.
• Mutual remedy limitations. Remedy limitations are often made mutual, meaning they apply to both the buyer and the seller. This is often appropriate, and also tends to limit the buyer's objections to these important contractual terms.

Conclusion

Machinery and equipment sales will, it is hoped, rebound in 2011. As sales rebound, it is important for sellers to remember the basics in negotiating and drafting their sales contracts. Equipment sales contracts, by their nature, involve unique risks and issues that are not present in the sale of consumer goods or commodity products. Sellers need to pay as much attention to the commercial terms and conditions and legal risks as they do to the technical specifications and other issues that surround industrial projects.

John L. Watkins is a partner in the Atlanta office of Barnes & Thornburg LLP and a member of the firm's Litigation Department. He may be reached at [email protected].

Machinery and equipment suppliers manufacture and sell the machinery that other manufacturers use to produce all manner of manufactured goods. The “Great Recession” has been, in general, a very bad time for machinery and equipment suppliers in North America. However, there is reason for optimism in 2011.

The tax package recently enacted into law includes a provision allowing customers to write off many machinery purchases immediately. Machinery and equipment orders in Germany (a major supplier of machinery and machine tools) surged in 2010. Many international companies are recognizing that it is economically viable (if not economically superior) to establish manufacturing operations in the United States rather than manufacturing goods overseas and then transporting and importing them to the United States and Canada.

Machinery sellers typically sell equipment with a long expected-useful-life that will allow the customers to manufacture and sell their own products ' and hence make a lot of money ' for many years. Machinery and equipment sellers are often smaller than their customers and operate at modest profit margins.

This does not stop many customers from proposing terms and conditions that ask their suppliers not only to provide equipment, but also to be, in effect, their liability insurer, their business interruption insurer, and their general security blanket for anything bad that might happen.

Particularly in an economy recovering from weak demand, it may be tempting to machinery and equipment sellers to avoid the cost of legal review of sales contracts, or, worse yet, to sign whatever terms the buyer provides. Needless to say, this is not a good idea. Having negotiated and drafted supply contracts throughout the United States and Canada, as well as other parts of the world (with the help of local counsel), I have observed that the key legal issues are usually the same. Four of the most fundamental are: 1) getting paid; 2) warranties; 3) indemnities; and 4) limitations of remedies.

This article considers these issues, but with two important caveats: First, this article is written from the seller's point of view. Second, this article deals with general U.S. legal principles, and I am a lawyer licensed in Georgia. One should always consider the legal issues in the particular jurisdiction and should consult with local counsel as necessary.

General Considerations

Equipment sales in the United States are almost always governed by Article 2 of the Uniform Commercial Code (“UCC”). The UCC was first published in the 1950s and has since been adopted by almost all states. The basic philosophy of the UCC is to provide a general framework for commercial transactions. In the area of the sale of goods, the default provisions of Article 2 are quite buyer-oriented.

Another basic philosophy of the UCC, however, is freedom of contract. Particularly when sales are between merchants (commercial parties, as opposed to consumer parties), as almost all machinery and equipment sales are, the buyer and the seller are free to vary the default provisions of Article 2 by agreement.

A prudent seller of machinery and equipment, therefore, will not want to rely on the default provisions of the UCC, and should make sure that the contract of sale contains terms and conditions that appropriately limit and define the seller's responsibility.

Getting Paid

Machinery and equipment orders often involve expensive goods that are customized for the customer. Thus, if the buyer defaults on payment, the seller may be left with expensive goods that are not easily re-sold, likely leading to a large economic loss. Here are some of the basic steps that can help avoid such a scenario:

• Know your buyer and keep your knowledge current. Having a buyer with known financial resources and a good track record of payment is one of the best practical means to ensure payment. Many substantial companies and formerly proven buyers, however, may have fallen on hard times and are no longer creditworthy, or as creditworthy as they have been in the past. Make sure your knowledge is current.
• Get a large down payment and make sure the financial terms provide protection. Machinery and equipment sellers should insist on financial terms where, at the least, their out-of-pocket and labor costs will be covered. This is best accomplished by a substantial down payment and other financial milestones that will make sure that the seller's anticipated costs are covered. In most instances, the substantial majority of the purchase price should be due upon delivery.
• Consider requiring a letter of credit. Letters of credit are probably the “gold standard” for protecting a seller against the risk of non-payment. Buyers prefer not to provide them because of the cost involved and because they limit credit resources. In large or potentially risky transactions, however, a letter of credit may be a practical necessity.
• Taking a security interest in the goods may not be enough. Although taking a security interest may provide adequate assurance of payment in many transactions, it may not be enough for machinery and equipment sales. Without getting into other potential pitfalls, enforcing a security interest in the event of non-payment usually involves repossessing the goods, with the right to then resell them. This is often not practical for customized machinery, particularly after it has been installed at the buyer's plant.

Warranty Issues

Negotiating the warranty for a machinery sale is usually one of the more involved and complicated issues. The buyer, obviously, wants the longest warranty possible with the widest possible protection. Most machinery sellers readily stand behind their equipment, but cannot afford to offer the more generous warranties often provided for consumer goods, where, for example, it is not so difficult to change out a malfunctioning camera or television. It is not feasible to change out machinery that has been bolted to a specially made foundation and that may occupy half a football field or more. Here are some of the key points:

• Warranty period. The standard warranty period may vary in different industries, but it should be clearly defined. If the warranty period is to run from start-up or acceptance of the machinery, the seller should insist on an outside limit from delivery, because buyers will sometimes delay installation or start-up of the machinery for business reasons, or start-up may be delayed for other reasons not attributable to the seller. For example, a warranty period could be stated to be 12 months from start-up or 18 months from delivery, whichever is earlier.
• Limited remedy. The UCC allows the parties to agree to remedy limitations. Most machinery sellers will want to limit remedies to repair or replacement of defective components at the seller's option and at the seller's expense. This remedy is usually fair to both parties for several reasons. First, the buyer's interest is in getting the machinery up and running as quickly as possible. Fixing the problem is usually the fastest way to accomplish this. Second, the seller almost certainly has the most expertise regarding fixing its own equipment. Third, during the warranty period, the seller should bear the cost of the repair or replacement.
• Disclaimer of implied warranties. Under the UCC, there are two implied warranties that potentially come into issue: 1) the implied warranty of merchantability, and 2) the implied warranty of fitness for a particular purpose. The implied warranty of merchantability essentially provides that the goods are to be of fair and average quality, and pass without objection in the trade. The problem with the implied warranty of merchantability is that it is very vaguely defined, and thus a plaintiff's attorney can characterize pretty much any way that is advantageous in the event of a lawsuit. In general, the warranty can be disclaimed by language that is conspicuous and that specifically mentions merchantability.

The implied warranty of fitness for a particular purpose may well come into play in machinery sales. This implied warranty arises when the seller has reason to know of the buyer's purpose for the goods, and provides that, in such circumstances, there is an implied warranty that the goods will be suitable for the buyer's purposes. Because the sales process for machinery is complex and may last for several months or longer, the seller's sales personnel may well have knowledge of the buyer's purpose. Again, the problem with the implied warranty is that it is very vague, and, in litigation, the buyer's attorney can use 20/20 hindsight to “define” the buyer's purpose after a problem has arisen. Again, this implied warranty can be disclaimed through language that is conspicuous.

Note: It is especially important to check the particular state law regarding the disclaimer; i.e., that state's version of the UCC.

• Limitations on coverage of the warranty. Warranties are meant to cover problems with the machinery and equipment that are properly the responsibility of the seller. For these reasons, it is common to limit warranty coverage for issues caused by: 1) failure of the buyer to follow the manufacturer's operating or maintenance instructions, 2) use of improper or out-of-specification raw materials, 3) damages caused by the buyer's unauthorized efforts to repair the machinery, 4) use of the equipment for unintended purposes, or 5) the buyer's other abuse of the equipment. It is also common to preclude warranty coverage for wear parts, meaning parts that are designed to wear out during normal operation and that must be periodically replaced as part of standard maintenance procedures.

Indemnities

Indemnity provisions are often contentious and highly negotiated. In general, an indemnity provision, also known as a hold harmless provision, provides that one party will pay for any loss sustained by the other party under specified circumstances. Such clauses are risk-shifting provisions and should be approached by a seller with great care.

Unfortunately, it has become quite common for buyers to propose standard indemnity provisions that essentially provide that the seller will indemnify the buyer for anything bad that happens once the seller (or its equipment) comes on to the buyer's property, regardless if the seller was in any way at fault.

Essentially, the buyer proposing such clauses is asking the seller to become an insurer, except without any limitations on the scope of liability. Most buyers proposing these terms would never accept them if they were on the receiving end, and sellers should reject them out of hand. It is important to remember that most large buyers have (or should have) sophisticated risk management and insurance programs. It is fair to ask buyers, for the most part, to insure their own risks.

Here are some additional points about indemnity provisions.

• Indemnity provisions should be limited to third-party claims. A reasonable indemnity provision should generally be limited to third-party claims. Indemnity clauses should not cover claims between the parties, which should be addressed by warranties or other contractual covenants. Thus, for example, if a seller's employee drives onto the buyer's premises and negligently runs into a visitor's automobile, resulting in a claim against the buyer by the visitor, then the buyer can fairly expect to be held harmless against any loss from the claim.
• Indemnity provisions should be insurable. A seller will want to make sure that any indemnity it gives is backed by its liability insurance. In very broad terms, liability that is based on an insured's negligent conduct is likely to be insurable. For these reasons, sellers should seek to limit indemnity obligations to claims arising from the seller's negligence or fault. In any event, a seller should ask its insurance broker to review any indemnity provision ' as well as any insurance requirements specified in the contract ' to make sure that they are covered by the seller's insurance coverage.
• Indemnities should be mutual. Often, the work of installing and commissioning equipment involves a mutual effort by the buyer and seller. As such, the seller has a risk of claims arising from the buyer's conduct, just as the buyer has a risk of claims arising from the seller's conduct. Therefore, it is certainly reasonable for a seller that is asked to provide an indemnity to ask the buyer to provide a mutual indemnity protecting the seller from claims arising from the buyer's fault. In any event, a request that the indemnity be mutual will often cause the buyer to be much more reasonable with respect to the other terms of the indemnity.
• Indemnities should not be unlimited. Indemnities should be subject to a reasonable time limit. Indemnities should also be capped in terms of total potential liability.

General Remedy Limitations

Unless limited by contract, the UCC provides for some fairly generous remedies or potential remedies for buyers. Some of these remedies, most of which are likely uninsurable, could potentially put an equipment supplier out of business. It is important, therefore, that the parties agree to appropriate general remedy limitations.

• Consequential, incidental and punitive damages disclaimer. Consequential damages are a huge potential liability for a machinery seller. Consequential damages may include, depending on the circumstances, lost profits or loss of production, increased labor costs, increased material costs and the like. Incidental damages may include costs incurred by a buyer in dealing with a breach. In many instances, the lost profits associated with a few days' worth of the buyer's production may equal a substantial portion of the cost of the equipment. As a result, it has become standard and accepted practice to include a disclaimer of consequential and incidental damages in supply contracts. Even the most stubborn buyers understand the need for such provisions.

Punitive damages are awarded not as compensation, but to punish and deter future bad conduct. Punitive damages typically require a showing of intentional or at least reckless conduct, and are often not permitted in breach-of-contract cases. In order to avoid any prospect of punitive damages, it is a good idea to exclude them specifically in the contract.

• Cap on total liability. It is common in supply contracts to have an aggregate total cap on liability. The reason for a cap is to limit the seller's exposure so that one project will not expose the seller to financial ruin. The liability is often limited to the purchase price, although in some circumstances the cap can be less, or perhaps slightly more.
• Mutual remedy limitations. Remedy limitations are often made mutual, meaning they apply to both the buyer and the seller. This is often appropriate, and also tends to limit the buyer's objections to these important contractual terms.

Conclusion

Machinery and equipment sales will, it is hoped, rebound in 2011. As sales rebound, it is important for sellers to remember the basics in negotiating and drafting their sales contracts. Equipment sales contracts, by their nature, involve unique risks and issues that are not present in the sale of consumer goods or commodity products. Sellers need to pay as much attention to the commercial terms and conditions and legal risks as they do to the technical specifications and other issues that surround industrial projects.

John L. Watkins is a partner in the Atlanta office of Barnes & Thornburg LLP and a member of the firm's Litigation Department. He may be reached at [email protected].