17-1 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

17-1McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter 17

Contract Formation and

Legal Issues

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Key Concepts• Litigation Prevention

• Dispute Resolution

» Negotiation

» Mediation

» Litigation

» Arbitration

» Courts

• Development of Commercial Law

• Basic Legal Considerations

• The Purchase Contract

• Letters of Intent

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Key Concepts

• Special Legal Considerations

» Inspection Rights

» Rights of Rejection

» Title and Risk of Loss

» Warranties

» Evergreen Contracts

» Order Cancellation and Breach of Contract

» Liquidated Damages Provision

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Key Concepts

• Special Considerations (cont’d)

» JIT Contracts

» Honest Mistakes

» Patent Infringement

» Restraint of Trade Laws

• International Considerations

» Contracts for the International Sale of Goods

» Foreign Corrupt Practices Act

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Litigation Prevention

• The best way to deal with legal disputes is to avoid them in the first place!

• Daily activities of supply managers are subject to two major areas of the law:

» Law of Agency

– Supply professionals act as agents for their firms

» Law of Contracts

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Why Most Business Firms Utilize Litigation Only as a Last Resort

• Contractual disputes are usually resolved more effectively using negotiation

• A lawsuit almost always alienates a good supplier

• The outcome of any court case is usually uncertain

• Litigation is expensive

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Dispute Resolution

• When attempting to resolve a dispute, it pays to keep in mind six considerations:

1. Time

2. Money

3. Complexity/Formality of Method of Dispute Resolution

4. Stress

5. Visibility

6. Damage to the Relationship

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Dispute Resolution

• Five Options exist to resolve a dispute:

» Negotiation

» Mediation

» Litigation

» Arbitration

» Courts

• Most disputes are best resolved through negotiation and compromise

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Mediation• If negotiation fails, the disputants can

consider mediation

• Mediation involves introducing a third-party into the discussion

• The mediator’s role is to listen, sympathize, empathize, coax, cajole and persuade

• One thing the mediator may not do is decide anything

• If the disputants confer decision-making authority on a third-party, we are now talking about arbitration

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Litigation

• Some maintain that if a commercial dispute reaches litigation, the disputants -- regardless of the outcome -- have already lost

• In litigation, costs tend to be maximized

» Recall: time, money, formality of method, stress, visibility, and relationship damage

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Arbitration

• Arbitration vests the decision-making authority with the arbitrator

» Purchase orders often have arbitration clauses

» It is critical to employ an impartial arbitrator

» A good source in the U.S. is the American Arbitration Association

• The arbitrator will hear testimony and study evidence from both sides, then make a decision based on the facts

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Courts

• Litigation may be brought to state or federal court.

» Lawsuits heard by judge or jury.

» Relevant court rules govern procedure.

» Relevant rules of evidence prescribe what may or may not be presented.

• Best to avoid destructive legal disputes whenever possible.

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Development of Commercial Law

• National Conference of Commissioners on Uniform State Law (NCCUSL)

» Uniform Sales Act

» Uniform Commercial Code (UCC)

– Determines rights on basis of fairness and reasonableness in light of accepted business practices

– Topics treated throughout the rest of the chapter reflect the provisions of the UCC where applicable, as well as the provisions of earlier laws not displaced by the code

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Basic Legal Considerations• Status of an Agent

» Agent - a person who, by express or implied agreement, is authorized to act for someone else in business dealings with a third party

» A “purchasing agent” is not a legal party to his or hers business transactions, but rather serves as an intermediary.

» Law requires the agent to be loyal to the employer

» Law permits the employer to hold its purchasing agent(s) personally liable for any secret advantages

» A buyer operates under two types of authority

– actual authority

– apparent authority

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Basic Legal Considerations

• The Purchase Contract

» Agreement

» Consideration, or mutual obligation

» Competent parties

» Lawful purpose

» “The Written and the Spoken Word”

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Offer and Acceptance

• Purchase order constitutes a legal offer

• Supplier’s quotation usually constitutes an offer

» Agreement does not exist until the supplier accepts

– Called a “meeting of the minds”

• Uniform Sales Act law requires acceptance of an offer in terms that were identical with the terms of the offer

» Mirror image concept

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Battle of the Forms

• Occurs when the terms of acceptance differ from the terms of the offer

• Terms of Acceptance are automatically incorporated into the contract, unless one of three conditions exists:

1.They materially alter the intent of the offer

2.The offerer objects in writing

3.The offer explicitly states that no different terms will be accepted

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Consideration

• A valid contract must also contain the element of obligation

• Most purchase contracts are bilateral

• Important point is the “mutuality of obligation”

• Statements regarding material quantity, price, delivery, and so on must be specific enough to bind both the buyer’s firm and the supplier to definable levels of performance

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Competent Parties

• A valid contract must be made by persons having full contractual capacity

• A contract made by a minor, an insane or intoxicated person is usually entirely void or voidable

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Legality of Purpose

• A contract whose purpose is illegal is automatically illegal and void

• A contract whose primary purpose is legal, but whose ancillary terms is illegal, may be either void or valid

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The Written and the Spoken Word• A contract is not a physical thing

• It is a relationship which exists between the parties

• A written document is evidence of the contract

• Oral contracts are more difficult to prove facts

• Law requires some agreements to be in writing

• Written evidence supercedes all prior oral evidence

• All data to be included as part of the contract should appear above the agent’s signature

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Letters of Intent

• Letters of Intent and Memorandums of Understanding – precontracts to cover informal agreements.

• LOI’s can be used as a planning document to order materials with long lead times, special tooling, or unique design work.

• A preliminary agreement with open issues to be resolved.

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Special Legal Considerations

• Inspection rights

• Rights of rejection

• Title

• Warranties

• Order cancellation

• Breach of contract

• JIT contracts

• Honest mistakes

• Patent infringement

• Restraint of trade laws

• Product liability

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Inspection Rights

• The law gives a reasonable period of time to inspect material after it is received

• If the buying firm raises no objection to the material within a reasonable period of time, he or she is deemed to have accepted it

• Industry practice usually sets the standard for “reasonable” time

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Rights of Rejection• A buying firm has the right to reject

material that:» Does not conform with the terms of the contract

» Is an overshipment

• Rejection requirements:» Notification must be sent to the supplier

» The nature of the defect or default must be specified

» The buying firm is not legally bound to return the material

» The buying firm is obligated to protect and care for the material in a reasonable manner

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Title and Risk of Loss• From a legal point of view, the question of

which party has title to purchased materials is normally answered by defining the F.O.B. point of purchase

» F.O.B. origin shipment: buying firm becomes owner when the material is loaded into the carrier’s vehicle

» F.O.B. destination: supplier owns the material until it is off-loaded at the buyer’s receiving dock

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Title and Risk of Loss

• Liability for goods not determined by title passing.

• UCC designates Risk of Loss for conforming goods passes at the FOB point.

• Risk of Loss for nonconforming goods does not pass until seller delivers conforming goods or buyer accepts nonconforming tender.

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Warranties

• The UCC identifies two specific types of warranties:

» Implied warranty – one which is read into the contract as a matter of law.

» Express warranty – a promise or representation that the goods, services, or subject matter of the contract will have certain characteristics or qualities.

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Warranties

• The warranties Implied by the UCC:

» Implied Warranty of Good Title

» Implied Warranty of Non-infringement

» Implied Warranty of Merchantability

» Implied Warranty of Fitness for a Particular Purpose

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Evergreen Contracts

• Orders or contracts with open-ended termination.

• Can be difficult to monitor or amend.

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Order Cancellation and Breach of Contract

• A breach of contract has occurred if a supplier:

» Fails to deliver by agreed delivery date

» Fails to perform in accordance with the contract

• The buying firm has the right to cancel

• Buying firm can also sue for damages

• Liquidated damages provisions are common

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JIT Contracts

• Require higher quality

• On-time deliveries

• The following must be spelled out in such contracts in unequivocal terms:

» Quality levels and controls

» Delivery schedules

» Inventory levels

» etc.

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Honest Mistakes• Honest mistakes can happen in drawing

up a contract

• The conditions surrounding each case weigh heavily in determining whether the contract is valid or void

• However, a mistake usually must be made by both parties for the contract to be voided

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Patent Infringement• The law gives a patent holder the

exclusive right to manufacture, sell, and use the patented device for a specified number of years

• A buying firm who engages in any of these activities during the period of patent protection, without permission from the patent holder, is guilty of patent infringement and can be sued for damages by the patent holder

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Restraint of Trade Laws

• Robinson-Patman Act

» Designed to prevent price discrimination that reduces competition in interstate commerce

• Act prevents a supplier from offering the same quantity of a specific material to competing buyers at different prices, unless:

» One buyer is offered a lower price because his or her purchases entail lower manufacturing or distribution costs for the supplier

» One buyer is offered a lower price in order to meet the legitimate bid of a competing supplier

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International Considerations

• United Nations’ Convention on Contracts for the International Sale of Goods (CISG)

» Stipulate in the purchase order or contract which body of law is acceptable to both buyer and the seller

» Stipulate a mutually acceptable “choice of forum” at which any lawsuit will be heard

• May want an arbitration clause also

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International Considerations

• Contracts for the International Sale of Goods

» Acceptance of an offer

» Revocation of an offer

» Formation of a contract

» Oral contracts

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International Considerations• Foreign Corrupt Practices Act

» Anti-bribery issues

» Record keeping requirements

» Penalty provisions

• Created in reply to American public

• Amendment to the Securities Exchange Act of 1934

• Objective was to curtail U.S. corporate involvement in foreign commercial bribery activities

• Enhance the image of the United States

• Three major sections focusing on:

» Anti-bribery issues

» Record-keeping requirements

» Penalty provisions

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Concluding Remarks• The most powerful tool a supply professional has to

avoid legal problems is skill in selecting sound, reliable suppliers

• A supply manager must understand basic legal concepts well enough to detect potential problems before they become realities

• Finally, this chapter presents only basic legal considerations

» Interpretations of laws may vary significantly

» Supply professionals should seek legal counsel whenever potential legal problems arise or the opportunity to prevent legal problems will be increased