Over the course of the last three years, original equipment manufacturers (OEMs) and suppliers have been rocked by a series of challenges, including shutdowns and restarts due to COVID-19, extreme labor turnover, higher costs, and prolonged shortages requiring the use of substitutions or alternative products.
As the industry slowly emerges from this period of significant turmoil, OEMs are shifting their focus back to more traditional concerns such as warranty, recall, and pricing issues. Litigation concerning these classic disputes between OEMs and their tiered suppliers began to heat up in 2022 and we expect that trend to continue throughout 2023. Suppliers should be prepared for OEMs to start knocking on their door for warranty reimbursement or to request price reductions. Lower tiered suppliers should expect those issues to flow down to them sooner rather than later. In order to help suppliers prepare for the anticipated increase in disputes with OEMs, this article addresses key issues relating to contracts and cost allocation, warranty campaigns and recalls, and pricing disputes.
How OEMs Use Warranties to Allocate Costs to Suppliers
Because of the unmatched bargaining power of OEMs, suppliers often must accept OEM terms and conditions (T&Cs) to win business. As a result, suppliers must be aware of the ways that OEMs use their contracts to their advantage to pass down liability and allocate warranty costs downstream.
Ordinary Warranty Terms
One of the main ways in which OEMs are passing down costs to suppliers is through their ordinary warranty terms (OWT). In most of these policies, the OEM provides a formula for assessing a percentage of ordinary warranty charges against a supplier without having to demonstrate that the supplier’s part was defective. Under the traditional warranties included in OEM T&Cs, if an OEM seeks to impose charges on a supplier for a warranty campaign or recall, it must be able to tie the defect to a breach by the supplier; there needs to be some nexus to the supplier’s warranty obligations. This is not the case under standard OWT language, which instead assigns damages to suppliers via a pre-designated formula without regard to fault. OEMs who may have previously been lax in their enforcement of OWT are now regularly seeking out reimbursement from suppliers for these ordinary warranty costs.
Warranty and Recall Costs
Ordinary warranty costs generally pale in comparison to the costs that OEMs attempt to pass on to suppliers relating to warranty campaigns and recalls. Although a supplier should not expect its own terms of sale to apply to business with an OEM, it still should review all warranties that the supplier is accepting in the OEM’s terms of purchase to ensure that they cover only the product being sold and not more. OEM purchase orders and corresponding T&Cs contain OEM-favorable terms, making exceptions and limitations to supplier warranties difficult to negotiate. Specifications for the applicable components or systems should be clearly set forth in contract documents and efforts should be made to limit or disclaim any inapplicable warranties, including warranties outside the scope of design responsibility. The supplier also should ensure that each party’s responsibilities are clearly spelled out in a roles and responsibilities document (commonly referred to as a RASI or RASIC, which stands for Responsible, Accountable, Support, Informed, Consulted) so there are clear delineations regarding which party is responsible for each category of design, production and implementation.
Beware of OEMs Attempting to Obtain Reimbursement for Stale Claims
In some cases, OEMs may sit on their rights for years before attempting to seek reimbursement for warranty issues, especially when recent world events and supply disruptions took center stage. Suppliers should be wary of OEMs attempting to receive reimbursement for stale warranty charges. As a first step before agreeing to undertake responsibility for warranty claims, suppliers must check the applicable warranty period and statute of limitations. The OEM’s claims must be both warranty eligible (i.e., fall within the agreed-upon warranty period) and not time-barred by the applicable statute of limitations from when the claim accrued. Under the Uniform Commercial Code (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.1 When the claim accrues depends on whether the warranty extends to future performance, which, practically speaking, is almost always the case in the automotive industry. 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.” Identification of the failure tied to the product at issue is likely enough to qualify as “discovery” of the breach and the statute of limitations will begin to run at that time, even though additional failures may not occur until the future.
Passing Down Warranty Liability to Sub-Suppliers
Understanding that a supplier usually cannot negotiate away its warranty obligations with the OEM during the contracting process, it should focus on protecting itself through its contracts with lower-tiered suppliers. When on the buy-side, auto suppliers are more likely to have the ability to disclaim a sub-supplier’s T&Cs, and should do so. Suppliers should demand that their sub-suppliers sign up to the same warranties as the supplier owes the OEM. Including strong warranties (consistent with the division of responsibility between the parties) and indemnity provisions in the supply contract will provide a supplier with recourse in the event that an issue arises with a sub-supplier’s product, and enable the OEM’s warranty costs to be passed down to the sub-supplier.
Preparing to Address OEM Warranty Campaigns/Recall Claims
When a warranty or other quality issue is of sufficient magnitude, or if it poses a threat to health and safety, it may give rise to a recall or other voluntary field action. Such events are among the most costly claims that a supplier can face. Unlike claims processed under ordinary warranty programs, OEMs often will seek to hold a supplier responsible for 100% of the resulting costs, which easily can reach nine figures depending upon the number of platforms and model years at issue, the corrective action, and whether the vehicles are in the field.
As discussed above, unlike ordinary warranty programs, liability for a recall or other field action usually depends on whether or not the supplier met the warranties and other requirements under the contract. Although, from a strictly legal standpoint, an OEM claiming breach has the burden to prove its claims, the commercial considerations involved (including the risk that a supplier may be put on new business hold) and the ability of an OEM to take unilateral debits can shift this calculous and the supplier must be prepared to demonstrate it is not at fault.
Maintain Proper Documentation
To best defend against a warranty or recall campaign, it is important for suppliers to maintain proper documentation at every step of the process. This should begin at the initial engineering and development phase by ensuring clear divisions of responsibility between the OEM and supplier. In particular, suppliers should document their responsibilities (and the limitations of their responsibilities) for testing electrical system components, systems, and networks, as well as clarify the limits of their responsibility for testing and validation at the component, system, and vehicle level. Just as important as documenting these divisions of responsibility in the first instance, suppliers should ensure that they have a robust document management system to ensure that the key documents outlining these divisions are available for use in the future. There can be many years between validation testing and the time that warranty issues actually surface, and potentially years after that before the OEM actually asserts its claim. During this time, the individuals involved in the original validation plan and testing likely have moved on to other projects and may even have left the company. This creates a significant risk that critical documents can be lost or forgotten if they are not properly preserved and accessible.
Conduct Root Cause Investigation and Mitigate Risk
Once warranty issues arise, suppliers should address them promptly to mitigate the risk that a warranty issue may turn into a recall. Among other things, suppliers should identify the root cause(s), implement containment procedures, and establish clean points. Additionally, protocols should be established for handling warranty claims and analyzing the root causes of dealer repair codes that could implicate the product. If a claim involves multiple parties, the supplier should work closely with the OEM to identify and document quality issues early and promptly communicate responsibilities. It is particularly critical for suppliers to be involved in any root cause investigation conducted by the OEM in order to ensure that the investigation is conducted fairly and is not just focused on how the OEM can assign blame to the supplier.
In many cases, investigation of a quality issue is an emergency situation as the parties seek to identify the cause of a problem as quickly as possible to establish a “clean point” that allows them to resume or continue production. However, in addition to identifying and neutralizing the problem, suppliers must clearly document these steps, the parties’ conclusions, and any areas of disagreement. In particular, suppliers should be wary of the risk that a “fix” for a particular problem may improperly be conflated with the root cause and result in claims against the supplier for which it should not be responsible. For example, a defect in component A may cause component B to wear out and fail prematurely, which will result in component B being identified in the dealer warranty claims received by the OEM. Further, reinforcing component B so that it is resistant to the problems caused by component A may prevent future failures. It does not necessarily follow that component B was the root cause of the problem or that it was defective. However, many OEMs will claim that this is the case and pursue recovery from the supplier of component B.
Give Notice to Sub-Suppliers
If a warranty issue or recall claim involves a component that the supplier obtained from a lower-tier supplier, the supplier should take steps to pass through the claims, including giving notice of the warranty claim and notice of a breach of applicable agreements. In addition to documenting the root case and other matters for which the supplier already is documenting to support its discussions with the OEM, suppliers should document evidence supporting the costs and other damages the supplier incurs to support a claim for recovery from its sub-supplier.
Push Back on OEM Damage Claims
Given the potentially devastating costs associated with recalls and other voluntary field actions, suppliers must carefully review, and should be prepared to push back on, the damages demanded by OEMs. While damages involved in recall cases are often focused on parts and labor costs incurred by the OEM, suppliers must scrutinize other factors, anomalies, and improper claims. Among other potential issues, OEMs may seek recovery for the cost of repairing parts that do not actually fall under warranty or are not specifically identified as eligible for recall repair. OEMs could also seek recovery for duplicate repairs or repairs of conditional parts not directly related to the recall repair. Suppliers should also be prepared to review whether the OEMs seek recovery for repair times in excess of the allowable time for repair or if they premise their calculations on labor rates that exceed the standard rate. In cases in which an OEM is seeking damages for projected future claims, suppliers should carefully scrutinize the calculations and assumptions on which such projections are based, as well as the anticipated timing for such payments. Suppliers may want to instead consider pushing to pay a designated percentage of future claims and to pay in the future based on actual claims accrued. If a supplier is paying a lump sum to settle anticipated future claims, it should account for the time value of the accelerated payments – and make sure it receives an air-tight release that prevents the OEM from seeking additional payments if actual costs exceed the OEM’s projections. When confronting recall litigation, suppliers must rely on qualified experts to understand the circumstances giving rise to the recall and identify the flaws in the OEM’s demand for damages.
Ensure Compliance with Government Regulations
Finally, in addition to issues that may arise between suppliers and OEMs, suppliers must consider the role of the government in connection with any recall and, in particular, the National Highway Traffic Safety Administration (NHTSA). Suppliers that manufacture safety-critical products should ensure proper internal safety review procedures are in place. The procedures will guide the reporting of safety defect determinations concerning components or systems to NHTSA. Suppliers also may be required to provide documents to NHTSA, either in response to a direct request made by NHTSA to the supplier or in response to an OEM that has received a request from NHTSA. In such cases, suppliers must be prepared to protect the confidentiality of documents. If NHTSA commences a defect investigation, it is likely the OEM will be asked to submit confidential information relating to design and engineering documents, as well as test data. Suppliers should consider the confidentiality of such documents and request that the OEM seek confidential treatment of the information in accordance with NHTSA’s regulations.
Strategies for Combating Pricing Disputes
In addition to enforcing warranty provisions, many suppliers also are facing price pressures from their OEM customers. Despite the current cost inflation many suppliers have faced, OEMs are (as is usually the case) resistant to price increases. Some OEMs are going a step further and actually attempting to decrease costs, either through requests for price reductions or by enforcing existing productivity/price-downs. There are some strategies and contract terms that suppliers should look to in order to avoid pricing disputes with their customers.
Negotiating Pricing Provisions in New Agreements
When negotiating any new agreements, pricing – and more specifically flexible pricing – is a key concern for suppliers. Allocations under contractual pricing provisions vary depending on negotiation power. To lock in pricing, OEMs traditionally sought to prohibit a supplier from changing or updating prices even in the face of changed circumstances giving rise to inflated costs. Many suppliers are now burdened with these contracts in an environment where their costs are rapidly increasing.
Suppliers negotiating new contracts should be hesitant to sign up to long-term fixed-price contracts that are the source of current problems. Suppliers seeking flexibility (or at least some measure of protection against rising prices) have a number of tools to consider. Many OEMs already use some form of indexing for raw material intensive products. Suppliers may consider expanding the use of such provisions to other major cost items. When possible, suppliers should try to structure their agreements to allow for periodic negotiations for updated prices and take advantage of those opportunities. While more specific language is preferable, any language allowing a supplier to require that the OEM negotiate regarding pricing in the future gives the supplier at least some protection.
Amending Existing Agreements
Suppliers seeking price relief also should review their current contracts to see if they have any opportunity for relief already built into their terms. Even if a contract does not expressly provide for pricing relief, suppliers should consider whether other potential leverage points exist. Any opportunity that a supplier has to exit the contract or otherwise limit its performance represents a potential opportunity for the supplier to raise prices. For example, suppliers should consider whether the applicable contract is expiring in the near future or allows for early termination by the supplier. While admittedly not common, such rights do exist under certain OEM T&Cs. Suppliers also should consider whether the contract lacks an enforceable quantity term, which is required for enforcement under the UCC. Finally, suppliers may want to consider whether the contract lacks a duration provision and, therefore, may be considered a contract of “indefinite duration”, which could be terminated by either party under the UCC.
To the extent suppliers have fixed-price contracts with their customers and do not otherwise have leverage points to force a price increase, they should consider negotiating to adjust these contracts in order to keep the prices they charge in line with their input costs. When entering these discussions, companies that wish to implement a price adjustment, or eliminate fixed pricing entirely, should consider meaningful ways to incentivize their customers to agree to such changes. Would the customer be willing to agree to a price adjustment in order to extend the agreement or adjust the quantity? Any terms that maintain the relationship between the parties while also allocating cost increases in an equitable way should be considered.
Suppliers should be prepared to provide detailed calculations supporting their requested price adjustments. OEMs often also require suppliers to demonstrate how much their costs have increased above expectations with supporting documents. Suppliers might consider offering their customers the opportunity to obtain price-downs in the event there are changes in the pricing environment. Suppliers also could offer to tie pricing arrangements to one or more indices, so that any future price increases are tied to a neutral source. As an additional incentive to negotiating index-based pricing, suppliers may also consider including provisions for both upward and downward movement, ensuring that customers, while risking inflationary costs, could also receive the benefits of deflationary environments.
The extent to which OEMs will attempt to use suppliers as a cost recovery vehicle remains to be seen. At a minimum, certain OEMs have made clear that they are going to use their muscle to recover warranty costs from suppliers and push for pricing relief whenever possible. Suppliers are well-advised to plan and prepare for these risks. The authors of this article work on these issues daily and are available to help auto suppliers negotiate with OEMs where possible and litigate when necessary.
Subscribe to the Auto Trends 2023 Series
1 Under the UCC, a party may not shorten the statute of limitations for a breach or warranty claim to less than one year. UCC 2-725(1).