Delivery vs. Installation vs. Successful Acceptance Testing

When should Customer be expected to pay for the new system?  (For this discussion, let's assume the system is a somewhat customized mix of hardware and software.)

When the system is ordered?  Perhaps, particularly if vendor is a reseller who must pay suppliers for the components.  Vendors may balk at fronting lots of money for customers.  The same analysis applies to paying upon delivery.  

But customer is left with a significant exposure.  What if some of the software disks are corrupted, or the hardware contains defective components?  Such deficiencies may not be detected until the system is assembled, installed and turned on.  Let's assume that when the power switch is thrown, something goes ZAP!! and a cloud of smoke rises from the system cabinet.  In an ideal world we would expect vendor to step up, identify the problem and make it right.  But we do not live in an ideal world and vendor may have moved on to the next project.  Requests for assistance might be met with suggestions that the problem resulted from user error, or recommendations to take up the question with the manufacturer.  (In fairness to vendors, we must acknowledge that some errors or failures may indeed be caused by the users.)  If vendor and manufacturers have been paid in full, customer has little leverage, little opportunity to compel them to pay attention. 

Which leads us to payments on the "installment plan": a portion upon order, a portion upon delivery and the bulk upon successful acceptance testing.  If a substantial portion of the contract price is held back until testing is complete, vendor will not lose interest in the project. 

Of course, vendors will not agree to large hold-backs if customer may arbitrarily decide not to pay.  It would not be good business to allow customer to refuse to pay simply because customer doesn't like the final product or now believes it "doesn't work."  As a result, to be successful, hold backs must be tied to testing standards that are mutually agreed and which can be objectively measured.  In that way, vendor and customer are both protected - customer can withhold payment if the system does not "work," while vendor must be paid if it does.

"B" Is For Boilerplate

Lawyers are fond of boilerplate language. It is quick to add, it covers a wide variety of exposures that might otherwise be overlooked and, since many of the phrases have been around for ages, the meaning is not likely to be debated. It is quick, it is easy, but it can also miss the mark.

Non-lawyers are now asking "What is boilerplate?" It is a lawyer-speak for language that is considered more or less standard in all contracts, such as a disclaimer of consequential damages: "Vendor hereby expressly disclaims any and all liability for consequential damages, whether or not foreseeable and whether or not Vendor was advised of the possibility of such damages." Boilerplate is generally found under the heading of "Miscellaneous."

Difficulties arise, however, when boilerplate is cut and pasted without regard for the transaction in question. For instance, this language comes from an agreement for custom programming service:

Each party to this Agreement shall keep in force during the term of this Agreement a policy or policies of insurance providing the following coverages in commercially reasonable amounts from reputable underwriters:...comprehensive automobile liability, covering all owned, hired, and nonowned vehicles of a party or its affiliates.

Setting aside the questions of what are "commercially reasonable amounts" and how to identify a "reputable underwriter," I am still wondering why auto insurance is relevant to this deal. If memory serves, customer and vendor met twice - when customer drove to vendor's offices. That would not create an exposure for vendor. After the work was awarded, all communications were via telephone, Web conference and email. I struck the language (and vendor agreed) because I saw no raise questions as to whether customer was carrying insurance that would contribute nothing to the deal.

Two of my favorite bits of boilerplate:

1. Mask Works

"Vendor claims all right, title and interest in and to, works of authorship, inventions, mask works, discoveries and other intellectual property created in the performance of this Agreement." But what is a mask work?

According to Wikipedia, a mask work is:

A mask work is a two or three-dimensional layout or topography of an integrated circuit (IC or "chip"), i.e. the arrangement on a chip of semiconductor devices such as transistors and passive electronic components such as resistors and interconnections. By extension, it also refers to the copyright-like intellectual property right conferring time-limited exclusivity to reproduction of a particular layout. The layout is called a mask work because, in photolithographic processes, the multiple etched layers within actual ICs are each created using a mask, called the photomask, to permit or block the light at specific locations, sometimes for hundreds of chips on a wafer simultaneously.

Clearly a mask work can be quite valuable, and such works are specifically protected by US law (17 USC Section 904). At the same time, mentioning mask works in a contract for custom database design merely invites question and confusion, without adding to the protections given to either party.

2. All Rights Anywhere In The Known Universe

"Licensor hereby retains all right, title and interest in and to the intellectual property anywhere in the known universe."

Yes, I have seen this language in genuine contracts. I generally reply that, to my knowledge, the Martians have not agreed to recognize American patents and copyrights. According to one of my very senior colleagues, this language started in a New York firm when satellite communications started to become common. The reasoning was that a radio wave continues forever and ever, and that the copyright owners need appropriate protection. Of course, broadcasts do NOT continue forever, but will eventually dissipate into nothing. More importantly, if the Martians ARE watching reruns of "Lucy" and "My Mother The Car," copyright claims would have to be pursued in Martian courts.

There are, as far as we know, no Martians or Martian courts, but the example is a useful illustration. Copyrights and patents granted in the US provide protection in the US, and not necessarily in other countries. If you plan to market your new Killer Application or Better Mouse Trap in the EU, China, and South America, make sure you have enforceable rights in each region or nation. A boilerplate statement that "Vendor reserves all intellectual property rights anywhere in the world," may simply not do the job if you will be doing business in a nation that requires special registrations or which does not recognize US grants of rights.

Boilerplate can be a drafter's friend, if he/she has a collection generally tailored to his/her field of practice. But both parties are best served if they read the boilerplate with the same care as the main business terms. After all, an error in the boilerplate may not be simply "harmless error" that will not disrupt the deal.

A Bit Of International Law

A reader has asked about laws governing international transactions, and particularly what law controls if vendor is in one nation and customer is another. While international transactions are not one of my strengths, I've done a few and can offer some insights.

To begin, the transaction must be legal in each nation. While that would seem obvious in theory, in practice it an yield many surprises. Years ago I ordered some rare earth magnets from a well known and well respected vendor of woodworking supplies located in Canada. Rare earth magnets are very powerful for their size, and woodworkers use them in all sorts of ways. I glue them to the wall of my workshop and hang tools from them. A few days later I received a call from a very nice, but rather embarrassed fellow at vendor, who advised that it was (then, at least) illegal to ship such magnets across the US/Canadian border. He apologized for the inconvenience, the rest of my order arrived in due course, and to this day I wonder why magnets, of all things, should receive such treatment from government. The moral however, is that government restrictions can pop up in the most unexpected locations. IT, of course, often receives special scrutiny from regulators. I sometimes think one could make a career simply dealing with US government controls on the export of technology.

Assuming the transaction is permitted in both nations, the next question is how to enforce the agreement. If I, as an American, hire a German company to build a factory in Mongolia, where do I file suit if something goes wrong? Despite all the progress of globalization, there is no “international commercial court” to hear such disputes. My choices would appear to be the US, Germany or Mongolia.

Although Mongolia has long fascinated me, I have no knowledge of their system of commercial law. Perhaps their courts would not even hear a case between two foreigners over a project that just happened to be located in Mongolia. Indeed, if the money is merely flowing between the US and Germany, the Mongolian courts may not have effective jurisdiction. Even if I were to win in the Mongolian courts, I would still have to locate the bank accounts (or other assets) of my German vendor and persuade a court there to enforce the Mongolian judgment.

If we presume the contract was signed in the US, I would have a good case for filing suit in that nation. Again, even if I were to win, I would have to find assets to satisfy the judgment. That could be difficult if my vendor only has a small sales force. In that case my US judgment would be useful only if I can enforce it in Germany.

There are, of course, treaties between most nations promising to respect the judgments of one another's courts. But that does not guarantee success. The German judge might discover some defect in the American proceedings and refuse to confirm the judgment. That would leave me with one option – filing suit in Germany.

In this case I have made at least three mistakes:

• I did not insist that the contract specify what law would apply;
• I did not insist that the contract specify where any litigation would be filed;
• I did not make certain that vendor had assets where I could reach them easily (assuming I won my case).

As a result, I condemned myself to play hide and seek across the world with my vendor.

A better course would have been to:

• Hire a US attorney skilled in this type of transaction and the applicable government regulations;
• Hire an attorney in Mongolia to ensure compliance with all local laws;
• Reach an agreement with the foreign vendor regarding where any disputes will be heard, and what law should apply;
• Require the vendor to set up assets or other security within my reach (Vendor, of course, will want similar protection in the event they have to bring suit against me.).

Better to plan and agree how disputes will be handled than to leave the question open and creating something additional to argue about.

"R" is for "Remedy"

A “remedy” is a tool used when a contract goes bad. Statutory law provides a set of “default” remedies, but they are far from perfect. They are designed to “make a party whole,” to deliver “the benefit of the bargain.” In most cases that “benefit” is measured in cash, and the definition of “benefit” might seem unduly narrow. In addition, statutory remedies are retroactive, and do little to promote performance of the agreement.

Example:

A contracts with B for 100 widgets, at $1.00 each. B fails to deliver and, after a ten day search, A finds C, who provides the widgets for $1.20 each. Also, because of the delay, A incurs a $20 penalty to D. How much does B owe A?

The first claim would be for the extra $20 for the widgets. A expected to pay only $1.00 each, and bid the work based on that price. A incurred the extra cost only because of B (something B would dispute). A may also want to claim the cost of personnel time and lost productivity incurred in the search for a replacement supplier. In addition, A may feel B is liable for the performance penalty.

A’s claims for personnel time and the performance penalty are problematic. Courts tend to focus on the contract price, and are reluctant to add extra costs not contemplated in the agreement. The claim for personnel time could be dismissed as a cost of doing business, and as something A could have controlled, either by making sure B was ready and able to deliver on time, or by having a backup plan. The same logic could apply to the performance penalty, unless the contract between provided that B would pay for it, or the contract contained a “time is of the essence” clause, which would allow A to argue that B should bear the costs. If A recovers only $20, after spending much time and money on litigation, A is unlikely to feel it was “made whole.”

Statutory remedies are not the only ones available to commercial parties. They are free, within reason, to fashion their own remedies. The statutory remedies exist as a default to serve those parties who do not stop to fashion their own.

In the case of A and B, A might have built in a timetable, with penalties if B failed to deliver on time. In return, B might have insisted that A have a viable backup plan, or B could have bought insurance to cover its own exposure.

The more complex or sophisticated the transaction, the greater the likelihood that statutory remedies will be inadequate. All the more reason for parties to design their own. These should:

• Encourage vendor to perform on time and within budget;
• Provide that timely performance will result in full and prompt payment.

A carefully crafted set of remedies will help keep the project on track. Certain approaches have repeatedly demonstrated their value:

• Tie payment to performance, not merely to the passage of time. Pay when X is completed, not on the 30th day after the contract is signed.
• Define “success” clearly and in terms that can be objectively measured.
• If the project is large or complex, break it into separate phases, permitting customer to call off further work after each phase.

Other Tools:

• Mutually agreed acceptance testing standards and procedures, combined with an opportunity for vendor to correct defects. Customer also may want the right to bring in a third party, at vendor’s expense, if vendor is unable to promptly solve the problem.
• Warranty coverage, beginning on with first productive use, rather than delivery or installation.

Specifications, specifications, specifications.

• What will the product do?
• How will performance be measured?
• When will it be ready?
• What will it cost?
• Who will do the work?

Careful planning can eliminate unreasonable expectations and reduce the chance of unpleasant surprises. As Poor Richard taught us: “An ounce of prevention is worth a pound of cure.”