Book Excerpt: Legal Blacksmith: How to Avoid and Defend Supply Chain Disputes.

“Supply chain legal disputes don't start out as legal disputes. They typically start out as badly written contracts, poor communication with supply chain partners, and an inability to resolve conflicts. While legal battles are sometimes inevitable, most of the time, they can be avoided through planning and an informed approach to the supply chain and associated processes.”

So write Rosemary Coates and Sarah Rathke, the authors of Legal Blacksmith: How to Avoid and Defend Supply Chain Disputes, a new book that sets out to teach attorneys about supply chain processes and supply chain professionals about the legal aspects of their day-to-day businesses.

The pair view the problem through a unique lens: Coates is a supply chain consultant with more than 25 years of experience while Rathke is a trial attorney whose practice focuses on supply chain disputes and related litigation involving manufacturing. Together, they look at each chapter from a supply chain and legal point of view.

The following excerpt - New Product Design and Development Contracts - focuses on the legal issues that may arise from new product design and development. To learn more, you can read a Q&A with Coates.

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Any new product, whether it is an improvement on an aging product or something entirely new and different, starts with engineering and product development. Engineering and development groups in manufacturing organizations gather information and input from other internal departments, such as sales, marketing, field service, customer service, and external groups, including customers and competitors. This information about customer preferences and market direction is then used to design and develop new products.

We are accustomed to seeing the words “new” and “improved” on consumer goods and food product packaging. These changes and improvements to products are the result of product development engineering. The same is true of industrial products. Input is gathered from internal and external sources and a product is changed or developed or something brand new is created. The typical goals are increased customer satisfaction, more efficient design, etc.

Sometimes, a customer will ask a supplier to develop a totally new or different product to meet a specific need. The new product may be a part of an overall design change or some new concept. This is where things can get complicated. One of the thorniest problems from a supply chain perspective is dealing with development programs and new product design. Product development engineers work closely with customers to estimate development costs and design products that integrate into overall designs. Ideally, everyone in the supply chain hopes for and works to achieve the success of new programs. But things can and do go wrong.

The design of a highly engineered product, such as an automotive or aerospace part, is likely to go through an “engineering gates” process. This is a common technique where at each major development milestone—from design through first article production—a review process is applied. At each “gate” there is a series of engineering reviews and management sign-offs. Gating enforces design-principle adherence and gives management an opportunity to verify the strategic direction of the development. For example, if a new product is designed for operation underwater versus an old product that was designed for land, the design process may include up to 10 engineering gates that track progress. The first gate may be at the blueprint design completion, the second gate may be at component design completion, the third may be at vendor/supplier selection and pricing, etc., through gate 10, the final sign-off. At each gate, costs may be reviewed internally and reported to the buyer. As the design progresses, supply chain partners may need to renegotiate their contract in the event costs are higher than expected or if there is design delay.

It is often difficult to establish production price, appropriate warranty coverage, and technical parameters for a new product before it is fully developed. Uncertainty as to how new product development will affect later commercial terms is an issue that flows all the way through the supply chain and is exacerbated when components need to be integrated with one another. Although supply chain partners try very hard to follow product development schedules and milestones, perfect compliance is not always possible, especially if the development process spans several years. Business conditions change and so do supply chain partners. Production costs that an engineering department estimated 10 years ago are likely to evolve over time.

Another complication in development programs is that supply chain partners are often uncertain whether the market will accept the new product. Even if the new product is an improvement on existing technology, as long as the existing technology is not failing, there is a risk that customers may reject the new and untested option. Remember Microsoft Zune? Sony's MD Player? Betamax? These new products flopped as innovations because they just did not catch on with customers.

Consequently, development contracts put a high level of stress on supply chain relationships. This stress is amplified when supply chain partners have not worked together before, which is common in development projects that are competitively bid. Other factors increase the degree of difficulty as well, such as when international suppliers are used, when the product is highly technical, and when there are tight project deadlines.

The supply chain is at its best in development programs when supply chain relationships are effectively managed and communications are open. Over the life of a development project, there are going to be iterations and changes. All product changes should be communicated to the supply chain, and supply chain partners should be given an opportunity to respond. If project changes are significant, they should be approved formally by all affected parties via engineering change orders (ECOs). This is critical (and sometimes legally required) in highly regulated industries such as medical devices and aerospace. Project changes often impact production costs, and communication should flow freely about cost changes as well. We have seen development projects that spanned many years undergo no changes to the contract pricing, even though there were significant design changes. When this happens, one or more of the supply chain partners usually ends up losing money.

Project management is also a critical factor. Project managers on a development project sit squarely between product engineering and the customer. They are responsible for satisfying both parties by keeping track of progress and costs, as well as being responsive to customer needs and concerns. The best project managers communicate well and regularly, and follow up promptly on open items. However, project management can also be a failure point in development contracts. There is often high turnover in project management groups, and therefore a constant stream of new project managers going through the learning curve. We have also seen project managers who are good at documenting details, but ineffective at truly managing issues.

Failure Alert: How an Ineffective Project Manager Can Sink a Project
One of our clients manufactured industrial equipment used in oil and gas production around the world. These development contracts typically took longer than five years to perform, and our client's components usually required integration with multiple other components. These programs were not scheduled to become profitable for our client until development was complete and the equipment was operational in the field.

The project manager was great at capturing and distributing the minutes from the weekly status calls, but consistently failed to drill down into the root causes of issues. She did not feel it was her responsibility to address engineering problems or logistics problems inside her own company, so she simply passed information to the product development and logistics staff and hoped for the best. When the product was ready to be delivered to a remote site in Russia, the company discovered that the product was not properly engineered for the harsh winter environment. In addition, the delivery site was so remote that special equipment had to be brought in at great expense to make the final delivery. The relationship between the parties broke down over time because these issues were never fully communicated, managed, or resolved by the project manager and the project ended up in a legal dispute.

The lesson here is twofold: first, communication is key, and second, there is a difference between checking items off a project manager's list, and really attending to issues that the project manager has reason to know will affect the project, the supply chain relationship, and the bottom line.

Legal Overview
In addition to the operational challenges posed by development programs, there are significant legal challenges as well. The biggest legal challenge occurs when supply chain partners attempt to negotiate the legal rights and duties that will govern the production phase of their relationship before development is complete. Until a new product is meaningfully developed, there are often too many operational unknowns for the parties to agree comfortably on final contract terms. Operational unknowns affect price, warranty, reliability, quality, and other technical parameters in the supply chain contract.

Often, the desire to negotiate development and production terms simultaneously is the result of pressure imposed by buyers, customers further up the supply chain, or a sense that “this is how we always do it.” But prematurely committing to production terms before development has occurred can be economically hazardous. Buyers often expect that suppliers' production pricing is set so that the suppliers can recoup their development costs. Consequently, buyers may be unwilling to renegotiate production pricing, even if development turns out to be more costly than the parties expected. Taking this one step further, in some industries like aerospace, many upstream buyers expect that development and original equipment production will occur at a loss, with profits to be made in aftermarket sales only. Betting on this assumption often causes problems.

While we know that negotiating production contract terms before development is complete is common and often the default, in our experience it is not the best practice. We see frequent supply chain disputes during the production phase emerge as the result of festering issues that originated during development. Often, supply chain contract terms do not take into account problems encountered during development. Usually the result is that suppliers are (or feel) undercompensated.

While it may seem like undercompensated suppliers would be a good outcome for buyers, in reality this is usually not the case. Disgruntled suppliers who are not meeting their margins on a program are not likely to dedicate the necessary resources to making the program work, will be inattentive to issues that arise, and will be less accommodating of any necessary changes. The consequences of economically challenged suppliers will inevitably be increased costs for buyers. And, of course, economically challenged suppliers will most likely look for every opportunity to get out of unprofitable or underprofitable programs. Furthermore, buyers may also benefit from deferring the negotiation of production-phase terms until after development, since there may be unanticipated cost savings during development.

Negotiating Development and Production Contract Terms Separately
Supply chain partners who separate development and production contract phases do so using a variety of structures. Some dual-phase supply chain contracts are structured so that if the supplier meets the buyer's specifications by the end of development (and sometimes by a certain date), the buyer is obliged to purchase its requirements of the new product from the supplier, with full production terms to be negotiated at that point. Sometimes supply chain partners agree to negotiate production terms after the first prototype is approved, after beta products are approved, or at some other benchmark.

In other situations, the buyer agrees to pay the supplier on a cost-plus basis upon the achievement of specified milestones (sometimes with incentive bonuses for achieving milestones by a certain date). Or, for new products that require development work by both the buyer and supplier, supply chain partners sometimes use “co-development agreements” in which each party bears its own development expenses. If development is successful, the supply chain contract will then require the parties to enter into a production contract with terms to be negotiated at that point. Some research and development contracts require the buyer to pay the supplier based on time billed by the hour, which can morph into or be combined with a cost-plus development contract as progress is made.

A more complicated development structure that is sometimes used gives the development-phase supplier the first right to bid on and accept the production contract if the development-stage supplier can establish competitive pricing (within 10 percent, for example, of other potential suppliers).

If production terms must be established before development is complete, supply chain partners can still leave themselves an opportunity to renegotiate production terms. In these circumstances, the supply chain contract can be written to allow one or both parties the right to a price or other contract adjustment upon a showing of undue hardship or good cause. The effectiveness of this type of contract provision relies heavily on contract partners' good faith with one another, but in some situations, it does work.

Other Development Contract Considerations
In addition to dividing the development and production phases of the supply chain contract, development programs involve other unique legal considerations as well.

Timing: For some development projects, timing is important. When deadlines are critical, the development contract should provide for project milestones (the more specific the better), with a provision that “time is of the essence.” To accommodate the possibility of changed circumstances, the development supply chain contract can include a provision allowing milestones to be changed upon the mutual agreement of the parties. Supply chain partners can also include a short period (one week to three months) in which a party that encounters delays is allowed to cure any failure to meet contract milestones.

Specification Changes: For some development projects, technical specifications may evolve during development. Even products with tight tolerances, such as medical devices and aerospace components, often allow some deviation from the originally assumed technical parameters. If evolving technical parameters are a possibility, supply chain partners can include a clause in their contract providing that the parties may mutually agree to any specification changes, or, if appropriate, that the buyer can change specifications in its discretion. If the latter approach is chosen, it may be appropriate for the supply chain contract to provide the supplier with the right to an equitable price adjustment in the event that specification changes impact the supplier's costs.
Component Integration Issues: If supply chain partners anticipate that integrating a supplier's product with other components in the end-product will be complicated, the development contract should clearly specify the supply chain partners' respective product integration responsibilities.

Warranties: Suppliers working on development products should be cautious about extending warranties. If a warranty is extended, it likely makes sense to limit the buyer's remedy to repair, replacement of the defective part, or refund of the buyer's purchase price. All implied warranties should be conspicuously disclaimed.
Damages: In addition to warranty considerations, it probably makes sense for development supply chain contracts to bar recovery of consequential damages, which are damages (such as lost profits) that are not the direct and immediate consequence of a breach of the development contract.

Term and Termination: It may be appropriate for development supply chain contracts to include milestone deadlines that, if not met, will cause the agreement to terminate automatically. Alternatively, it may be appropriate for development supply chain contracts to provide for short, automatically renewing terms (such as three or six months) in which the parties can terminate after giving notice. To accommodate the possibility that the market for a development product may not emerge, supply chain partners also might want to allow termination for convenience at any time.

Product Upgrades: If it is possible that the product being developed will require upgrades over time, a development supply chain contract can specify the conditions in which the buyer has the right to demand upgrades, and the circumstances in which the supplier may demand a price adjustment for upgrades.

Intellectual Property: If a development project will produce intellectual property rights, the supply chain contract should specify to whom the intellectual property rights belong and whether the other party has licensing rights or must make royalty payments.

Taking Market Reaction into Consideration
Often, development projects seek to replace existing technology with an unproven technology that supply chain partners hope will be an improvement. In such cases, there is always a possibility that the market will reject the new technology in favor of what has been tried and true. Until the new technology is proven, many customers may prefer to hold onto what has worked in the past. Taking market reaction into account is often vitally important in ensuring the success of a new product.

Supply chain partners facing uncertain market reaction must achieve a careful balance. On the one hand, the supplier has an interest in requiring the buyer to use its product in all of the applications the buyer sells to the market. On the other hand, if the buyer has competitors still using the old technology, and if the market does not accept the new product, then neither supply chain partner sells anything.

One solution may be to include a provision in the supply chain contract obliging the buyer to purchase only as much of the supplier's product as the buyer's customers demand, which in turn may be augmented by objective measures defining customer demand levels. The development contract can also require the buyer to use best efforts or commercially reasonable efforts to promote the new product. The supply chain contract may allow the supplier to sell the newly developed technology to other customers to accelerate its acceptance in the market.

The Law That Governs Development Contracts
Up to this point, this book has been discussing supply chain contracts as being governed by Article 2 of the UCC, which in the United States applies to contracts for the sale of goods over $500. UCC Article 2 may not be the governing law for development contracts, however. Development contracts that primarily involve design, research and development, engineering, or consulting services will be governed by state common law instead of the UCC since they are principally contracts for services rather than contracts for the sale of goods.

There are several meaningful differences between the common law of most states and the UCC. For instance, under the UCC, in the event of a breach, an aggrieved buyer may be entitled to “cover” damages, meaning the buyer's cost of securing substitute goods. But at least some courts have held that cover damages are not available under state common law. In addition, the UCC includes implied warranties of merchantability and of fitness for a particular purpose that provide rights and protections to buyers that the common law does not recognize. Furthermore, the common law of contracts is less uniform between the states than the UCC is. In many states, the statute of limitations is longer for common-law breach of contract claims than it is for breach of contract claims under the UCC. Paradoxically, this means that supply chain partners may have far longer to sue for breaches of development contracts than they do for production phase contracts.

There are factors and indicators that influence whether a development contract is governed by the common law or by the UCC. If a development contract contemplates purchase orders, delivery terms, and defined product characteristics, and especially if the buyer's payments to the supplier are characterized as payments for goods rather than services, courts are more likely to apply the UCC. In contrast, development contracts that contemplate payments in exchange for design work, intellectual property development, engineering services, or achieving development benchmarks are more likely to be governed by the common law.

For international development projects, the CISG is similar to the UCC in that it applies only to contracts for the sale of goods. Much like the UCC, the CISG applies unless “the preponderant part” of the contract is for labor or services. Therefore, as in the United States, international development contracts may fall outside of the CISG and will be governed by the domestic law of whichever country has the most significant relationship with the parties and the project. To avoid unpleasant surprises, it is especially important for international development supply chain contracts to include a choice of law clause specifying the governing law.

Lessons Learned
When working with development projects and new designs, supply chain partners should:

• Extensively research the need for a new product through market research, competitor research, and a thorough internal evaluation of costs and benefits
• Empower project management personnel with the authority to investigate and fully address problems that arise during development, and ensure that the project manager is not simply checking off boxes
• Understand that development is a process, and one that will likely involve changes to the supply chain partners' original plans, timelines, and expectations
• Be fully open about changes in technical parameters, cost, and anything else likely to affect the success of the development program
• Avoid negotiating production contract terms before development is complete—or at least leave room for production contract terms to be renegotiated to address issues encountered during development
• Disclaim warranties in development contracts
• Understand that the UCC may not govern development contracts, and for international developmental contracts especially, include a choice of law provision to avoid unfamiliar foreign law

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