Best Practices for Customers Structuring Directed-Buy Arrangements

30 January 2019 Manufacturing Industry Advisor Blog
Authors: Kathleen E. Wegrzyn

This article explores the following topics: (1) What is a directed-buy arrangement? (2) What significant issues exist for a customer in a directed-buy arrangement? and (3) What are the best practices for a customer entering into a directed-buy arrangement?

1. What is a Directed-Buy Arrangement?

A directed-buy arrangement (also referred to as a directed-supply arrangement) is one in which the customer requires that its direct supplier (the “Tier 1 Supplier”) purchase from a specific sub-supplier (the “Tier 2 Supplier”) certain raw materials, parts or components (the “Directed Parts”) for integration into the product that the Tier 1 Supplier sells to the customer (the “Integrated Product”).

Customers like the directed-buy arrangement because it provides control over multiple levels of the upstream supply chain. A well-designed directed-buy arrangement may decrease upfront costs, increase quality control, and limit subsequent liabilities for defects. However, customers should structure directed-buy arrangements with caution, particularly regarding the allocation of risk between the parties, or the customer may find itself in a protracted dispute where neither the Tier 1 Supplier nor the Tier 2 Supplier (either, a “Supplier”) clearly bears liability for downstream product defects.

2. Overview of Issues for a Customer in a Directed-Buy Arrangement.

While benefits exist to a customer in a directed-buy arrangement, many issues also arise as a result of such an arrangement. Below is a list of some of the significant issues a customer may face when entering into a directed-buy arrangement:

a. Gap in Coverage. Whether because of lack of customer leverage or other reasons, if a directed-buy arrangement is not structured according to the best practices described in Part 4 below, the customer may find itself with a warranty from the Tier 1 Supplier for that portion of the Integrated Product that is manufactured by the Tier 1 Supplier or otherwise obtained by the Tier 1 Supplier outside of the directed-buy arrangement (the “Tier 1 Component”), and perhaps a warranty from the Tier 2 Supplier for the Directed Parts, but not a warranty for the Integrated Product as a whole. When a defect or other warranty issue arises, particularly where that warranty issue relates to the interaction between the Directed Part and the Tier 1 Component, each Supplier will likely place the blame for the defect on the other Supplier, or on the customer itself, leaving the customer to answer to its downstream purchaser for any warranty obligations to which the customer has committed.

b. Incomplete Remedies. If the customer has warranties only on the Directed Parts and the Tier 1 Components but not on the Integrated Product itself, careful consideration must be given to ensure the warranty remedies are broad enough to make the customer whole. Warranty remedies are often limited to repair or replacement of the defective product or refund of the purchase price. Assuming it is determined (by agreement of the parties, dispute resolution, or otherwise) that a defect arose from the Directed Part, those limited warranty remedies will not account for the service fees paid by the customer to the Tier 1 Supplier to assemble the Directed Part with the Tier 1 Component, or the price paid by the customer for the Tier 1 Component if the defect in the Directed Part makes the Tier 1 Component unusable or requires the integration services of the Tier 1 Supplier to be re-performed.

c. Antitrust Concerns. There could be antitrust issues where a customer steps in to arrange a relationship between two Suppliers if those Suppliers are competitors, particularly where the customer is dictating pricing terms. These issues would need careful consideration by antitrust counsel in connection with each directed-buy arrangement that the client is considering.

d. Relationship Administration. A Tier 1 Supplier that is directed to use a Tier 2 Supplier often feels forced to interact with a sub-supplier it would not otherwise have chosen to use. Because the relationship is mandated, the Tier 1 Supplier may feel restricted in terms of negotiating leverage and its ability to get the best prices from the Tier 2 Supplier, because the Tier 2 Supplier knows the Tier 1 Supplier is required by the customer to enter into the relationship with the Tier 2 Supplier. As a result of these considerations, where stalemates in negotiation occur, the Tier 1 Supplier may expect the customer to get involved. In a traditional arrangement, the customer would not be expected to be involved with its Tier 1 Supplier’s upstream sub-suppliers.

e. Quality or Supply Issues. If the Tier 1 Supplier feels it is experiencing quality or other supply issues with the Tier 2 Supplier (such as the Tier 2 Supplier being habitually late in delivering or producing suboptimal, but perhaps still conforming, Directed Parts), the Tier 1 Supplier will often, again, expect the customer to intervene. The Tier 1 Supplier’s ability to find alternative sources where supply issues arise is, by the nature of the directed-buy arrangement, limited, and, as such, the Tier 1 Supplier will look to the customer to alleviate the bottleneck that may arise as a result of the directed-buy arrangement.

f. Payment. Another common issue arises when the Tier 1 Supplier does not pay the Tier 2 Supplier for the Directed Parts (whether as a result of bankruptcy or otherwise). The Tier 2 Supplier may attempt to recover the unpaid amounts from the customer.

3. Potential Directed-Buy Arrangement Structures.

There are three ways directed-buy arrangements are typically structured:

a. No Direct Contractual Relationship Between Customer and Tier 2 Supplier. Where no direct relationship exists between the customer and the Tier 2 Supplier, the Tier 1 Supplier and Tier 2 Supplier typically contract independently. The customer then enters into a contractual relationship with the Tier 1 Supplier, in which the Tier 1 Supplier is usually required to warrant the entire Integrated Product, notwithstanding the mandated nature of the upstream relationship.

b. Direct Contractual Relationship Between Customer and Tier 2 Supplier. A second directed-buy arrangement structure is one in which the customer enters into a direct contractual relationship with the Tier 2 Supplier to impose on the Tier 2 Supplier warranty responsibilities directly to the customer. The customer also then contracts with the Tier 1 Supplier for the Integrated Product. Even where such a direct relationship exists between the customer and the Tier 2 Supplier, the customer may require the Tier 1 Supplier to handle the warranty claims process with respect to the Tier 2 Supplier and warrant to customer the entire Integrated Product.

c. Three-Party Agreement. A third alternative is a three-party agreement among the Tier 2 Supplier, the Tier 1 Supplier, and the customer, through which the parties allocate the Suppliers’ respective warranty obligations in respect of the Integrated Product. The parties may, among other options, fashion a general warranty such that the Tier 2 Supplier is directly liable to the customer for the functionality of the Directed Parts, while the Tier 1 Supplier warrants not just the Tier 1 Component, but also the assembly and “interface” of the Tier 1 Components with the Directed Parts. While not as favorable from the customer’s perspective as having the Tier 1 Supplier warrant the entire Integrated Product, this approach does give the customer some protection relating to the combination of the Suppliers’ respective products.

Whatever the arrangement, the customer typically, though not always, holds the most leverage to mandate terms, including warranty responsibility, while leverage commonly decreases up the supply chain. While a Tier 1 Supplier may protest being held responsible for a sub-supplier it did not choose (i.e., the Tier 2 Supplier), the Tier 1 Supplier held custody of the Directed Parts, assembled the Directed Parts with the Tier 1 Components, sold the Integrated Product at a mark-up, and chose to enter into a directed-buy arrangement in order to continue doing business with the customer. From the customer’s perspective, the Tier 1 Supplier should protect itself in the warranty it receives from the Tier 2 Supplier. Ultimately, market realities and leverage may dictate the warranty irrespective of which party selects the Tier 2 Supplier.

4. Best Practice for the Customer.

Where leverage permits, the best practice for a customer entering into a directed-buy arrangement is to require the Tier 1 Supplier to warrant the Integrated Product as a whole. In an abundance of caution, particularly where the Tier 2 Supplier is the more financially sound company, the customer may also want to have a separate warranty agreement in place with the Tier 2 Supplier, to provide another potential avenue for recovery for the customer, though it should be made clear in the customer’s agreement with the Tier 1 Supplier that, notwithstanding any such agreement between the customer and the Tier 2 Supplier, the customer has no obligation to pursue remedies against the Tier 2 Supplier. Likewise, the Tier 2 Agreement would need to be clear that it only creates warranty obligations on the Tier 2 Supplier and does not create any obligations (payment or otherwise) on the customer. In addition, again subject to leverage between the parties, the warranty remedies from each of the Tier 1 Supplier and Tier 2 Supplier would ideally not be subject to limitations or caps

Conclusion.

While many benefits exist for a customer requiring a directed-buy arrangement, a typical directed-buy arrangement may expose a customer to unnecessary risk due to the possibility of costly disputes regarding which supplier is responsible for a given defect, the lack of supplier responsibility for “interfacing” of upstream products, and the possible incapacity of smaller suppliers to pay, among others. To minimize this risk, a customer should carefully consider how it structures the directed-buy arrangement and may want to consider: (i) if possible based on negotiating leverage, requiring Tier 1 Suppliers to warrant the Integrated Product as a whole to the customer, or (ii) if the goal in subsection (i) cannot be achieved, ensuring that Tier 1 Suppliers warrant the “interfacing” and interaction of upstream products in the Integrated Product delivered to the customer.

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