Managing Warranty Disputes in the Age of COVID-19

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Foley & Lardner LLPWhile nearly every facet of the economy has been affected by COVID-19, the automotive industry remains one of the sectors most affected.  The industry continues to face the double impact of declining sales and increasing costs, which has resulted in financial pain for both OEMs and suppliers.  As so often is the case, many automotive OEMs are seeking to offset their own declining performance on the backs of their suppliers.  One tactic commonly employed by OEMs is to take a more aggressive approach in pursuing suppliers for historical, or otherwise questionable, warranty claims.  Going forward, it also remains to be seen whether the scramble by OEMs and suppliers to maintain production in the face of supply chain disruptions, labor shortages, and new safety measures may result in a rise in additional warranty issues in the coming months/years.   

Managing warranty claims, including both defending such claims and pursuing recovery from responsible sub-suppliers, always has been a critical task for automotive suppliers.  This perhaps has never been truer than it is today.  This article provides an overview regarding some of the most critical issues that both buyers and sellers should consider when addressing warranty claims, as well as a number of specific issues arising from the impact of COVID-19. 

Key Considerations for All Warranty Disputes

While COVID-19 has changed much of the landscape in the automotive industry, many of the fundamental issues that suppliers must address in connection with any warranty claim remains the same. 

What Does The Warranty Require?

Contrary to the position commonly taken by most automotive OEMs, the fact that a part may have “failed” is not always per se proof that the supplier is liable for a defect.  Warranties in automotive contracts often are broad and impose significant responsibility on suppliers.  However, they are not unlimited.  Warranties must be understood and applied in light of the interactions among the various components that make up an automobile, as well as the complex set specifications, testing, and validation that go into the vehicle design.  

There are numerous situations in which a part may fail in the field even though it complies with the specifications.  It is not uncommon for automotive OEMs to provide detailed specifications and test criteria that a component must satisfy, only to discover later that the part is failing in the field because the OEM specifications provided do not adequately represent the stresses to which the component will be subjected.   Failures also can be caused by damage or wear resulting from a defect in one of the thousands of other components that make up an automobile, in which case it may be another supplier that is at fault.  In some cases, failures also may be a result of changes to the vehicle environment made by the OEM itself, without involvement of the supplier.  

Depending on the contractual terms and assignments of responsibility under the contract, the fact that a part met specifications is not always a guaranteed defense.  However, a supplier that can show its product met all specifications will be in a much stronger position.  When faced with a warranty claim, one of the first steps any supplier should take is to make sure it fully understands what specifications apply to the part and whether those specifications have been met. 

Are The Parts Warranty Eligible?

In addition to considering what the warranty requires, it is often necessary to consider the time period for which the warranty applies.  Some warranties apply to a product only at the time of delivery.  Other warranties, particularly in the automotive industry, apply for an extended period of time.  For example, a supplier or sub-supplier might offer a warranty for an extended period by warranting that a product will be “free from defects for two years.”  However, this can raise questions about what happens if a product fails after the warranty period has expired, but the defect was present, though latent, during the warranty period?  

To determine whether a breach has occurred, the parties must consider the terms of the warranty at issue and what constitutes the breach.  If the seller warranted that the product will “perform” or “last” for a specified period, it may be valid to argue that no breach has occurred as long as the product continued to function until the end of that period.  However, if a seller gave a warranty that the product “will be free from defects” for a specified period, the breach of the warranty arguably occurs at the time the defect is present, even if the defect does not manifest in a failure until after the specified warranty period.  

Does The Statute Of Limitations Potentially Apply?

Assuming that a breach of warranty exists and the breach occurs within the warranty period, the parties still must determine whether the statute of limitations has expired.  Under the UCC, any claim for breach of warranty must be brought within four years after the claim accrues (unless the parties have agreed by contract to a shorter period).  Depending on when a particular claim accrues and the length of the warranty period, it is possible in some cases that a part may be warranty eligible, but still fall outside the statute of limitations.  

When the claim accrues depends on whether the warranty extends to future performance.  If a warranty explicitly extends to future performance of the goods and discovery of the breach must await the time of performance, the cause of action accrues when the breach “is or should have been discovered.”  If not, the breach occurs, and the statute of limitations begins to run, when tender of delivery is made, regardless of buyer’s knowledge of the breach.  While sounding simple in concept, application of the rule is not always straightforward.  In the context of an automotive supply relationship, the buyer usually purchases thousands of parts over a period of years.  If the parties identify a failure mode and determine that the root cause is a systemic design or manufacturing defect, that point, the buyer’s claim for breach arguably has accrued, and the statute of limitations has begun to run, even though additional failures may not occur until the future. 

Preserving Recovery Against Third-Parties

Modern manufacturing, particularly in the automotive industry, involves complex supply chains with different levels of suppliers and sub-suppliers.  Absent a specific contractual—carve-out, a seller’s warranty to its buyer covers the entire product sold, including components manufactured by sub-suppliers.  However, where the ultimate fault lies with a sub-supplier, the supplier may be able to pursue its own contractual remedies against its sub-supplier.

While the appropriate strategy and timing for pursuing recovery from a sub-supplier may vary depending on the relationship and the circumstances, there is one requirement that is universal in any cases where the claims are governed by US law – the requirement to give notice.  Under Section 2-607(3)(a) of the Uniform Commercial Code (the “UCC”), which has been enacted in all 50 states, “the buyer must, within a reasonable time after he discovers or should have discovered any breach, notify the seller of breach or be barred from any remedy.”  

What constitutes a “reasonable time” to provide notice usually is a fact-intensive inquiry that depends on the circumstances in question.  However, suppliers faced with a warranty claim from their automotive OEM customer is best served to put its sub-suppliers on notice of the claim quickly once it becomes aware of the sub-suppliers potential involvement in order to avoid even the suggestion that they failed to provide reasonable notice.  Such notice need not (and often should not) concede the accuracy of claims by the OEM.  The key in providing such notice is to make the sub-supplier aware of the claim and to provide notice that, if proven, the supplier considers it a breach of the sub-supplier’s contractual obligations. 

A supplier may also formally tender the defense of the claim to a sub-supplier, particularly if the supplier intends to assert a claim for indemnity.  Under Section 2-607(5)(a) of the UCC, a supplier that has been sued for a breach of warranty that is the responsibility of a sub-supplier, may provide the sub-supplier with notice and an opportunity to take over defense of the claim.  If the sub-supplier declines, the sub-supplier will be bound by any determination in the first lawsuit of common factual issues if the supplier later brings a claim of its own against the sub-supplier in a future proceeding. 

COVID-19 Considerations

While many of the most critical issues involved in navigating a warranty claim remain unchanged, the impact of COVID-19 presents additional unique challenges and (in some cases) opportunities. 

Impact on Courts and Litigation Timing

While litigation with a customer is not the preferred outcome in most disputes, suppliers should consider the impact of COVID-19 on the timing for any litigation.  While courts in most jurisdictions are open and functioning, whether in person or via remote technology, many courts are still working through a backlog of cases and/or may not be operating at full capacity.  This can add up to further delays in what often is already a long and drawn out legal process if parties are required to litigate their claims.  

Motives and Implications for Resolution

If an automotive OEM’s primary motivation for asserting a warranty claim appears to be based on an effort to improve financial performance, suppliers should take note of this fact.  If the customer’s primary motivation is to “get cash in the door,” this can have a significant impact on negotiations.  For example, the OEM may be less willing to consider accepting payment through future price reductions.  On the other hand, the OEM may be more open to taking a deeper discount on the claim if paid quickly.

Availability of Witnesses and Information

While always a concern, particularly in the case of older warranty claims, the impact of COVID-19 may exacerbate issues relating to the availability of witnesses and information.  Any staff reductions by the supplier may result in critical witnesses no longer being available to the company or, even worse, becoming hostile to the company.  Employees still with the company, but working remotely, may have more limited access to files and may be limited in their ability to conduct additional testing.   

Existence of Additional Claims and Counterclaims

Warranty disputes do not take place in a vacuum and must be addressed with a view to the overall relationship between the parties.  As a result of COVID-19, many companies in the automotive industry have incurred significant costs for expedited freight, overtime, safety equipment, and other expenses as they strive to maintain production.  Some companies also may have incurred damages for downtime where production was interrupted.  In many cases, companies have issued force majeure notices and other reservations of rights, but are not yet actively pursuing recovery on potential claims related to these issues.  

Suppliers must consider how the existence of other potential claims may impact the resolution of a warranty dispute.  For example, a supplier pursuing its sub-supplier for reimbursement on a warranty claim should consider leveraging any potential claims for expedited freight or downtime that the supplier may have incurred over the last six months in order to apply additional pressure.  Conversely, a supplier that wishes to settle warranty claims by its customer can consider requiring its customer to waive any such claims as part of a global resolution. 

Financial Health and Ability to Pay

Although the current situation may be less dire than some of the earlier predictions, many companies in the automotive industry continue to face financial challenges.  Suppliers facing significant warranty claims from their OEM customers may have greater difficulty than usual pushing such charges down to their sub-suppliers if the smaller sub-suppliers simply are unable to absorb the cost without being forced out of business.  Attempting to push through a recovery against financially troubled companies through the use of unilateral debits presents a significant risk.  Desperate companies often will see themselves as having “nothing to lose,” and are far more likely to stop shipments.  There also is risk that, in the worst-case scenario, the threat of unilateral debits may trigger a bankruptcy filing, or efforts by a lender to step in and foreclose on the sub-supplier’s assets.  

Conclusion 

As the automotive industry continues to work through the challenges posed by COVID-19, suppliers are likely to continue seeing increased warranty claims from their customers.  Effective management and response to such claims will be a key factor for supplier performance going forward. 

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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