March 01, 2010

Introduction and Background

In industries where complex, tiered supply chains are prominent, product liability cases involving suppliers and Original Equipment Manufacturers (OEMs) are a common risk among all industry participants. In a tiered supply chain, multiple levels of suppliers, often involving hundreds of suppliers each, provide components and assemblies which are ultimately incorporated into an end-product assembled and sold by an OEM. These supply chains make mass production of complex products possible, such as automobiles, airplanes, and construction and telecommunications equipment. However, when costly defects arise relating to these products after being sold to end-consumers, there are often disputes over which party is responsible for the defects and who should bear the costs. For this reason, it is not uncommon for OEMs and suppliers to take legal action to recover warranty and recall-related costs incurred from their suppliers.

By way of a recent example, on January 21, 2010, Toyota recalled approximately 2.3 million cars and trucks due to reported problems with “certain accelerator pedal mechanisms.”1 This initial recall halted production at Toyota plants and stopped sales at Toyota dealerships. The costs to Toyota of such actions could be staggering. Soon after issuing the recall, Toyota pointed to its supplier of throttle-pedal assemblies as the source of the problem. As investigations unfold and costs to Toyota continue to mount in the coming months, legal disputes relating to the causes of the defect and its associated costs are a strong possibility between Toyota and its different tiers of suppliers.

When end-consumers submit warranty claims for products purchased, they typically look to the OEM to complete the repair. In completing the repair, the OEM often incurs costs associated with the replacement of the defective part as well as labor costs associated with time spent performing the repairs (often through a dealer or sales network). The basis for the damages in a warranty case can vary depending on the nature of the product defect and the actions taken by the OEM. While the costs of some repairs may consist primarily of part costs, other repairs may be more labor intensive. Depending on the arrangement between the customer and supplier, the supplier may be liable for certain warranty costs incurred by the OEM in servicing the warranty claims.

In the event a product or part is determined to be unsafe, hazardous, or a known inconvenience for consumers, a product recall may be issued. The decision to issue a recall may be the result of a formal investigation or the result of an internal decision made by the manufacturer. The costs incurred in issuing a recall are similar to those relating to warranty repairs and often include both parts and labor costs. However, recalls may require certain additional administrative procedures and costs associated with the preparation of a customer service notification and standardized recall procedures to be utilized across geographies.

Whether warranty or recall actions (or both) have been initiated, OEMs and suppliers will often look to their sub-tiered suppliers who played a role in the production of the defective part for reimbursement. Due to the complex nature of supply chains in manufacturing-intensive industries, warranty and recall cases involving OEMs and suppliers often require careful consideration of a number of legal and financial factors in estimating damages.

Common Legal Issues to Consider When Evaluating Product Liability Damages

The contract language contained in supply agreements between an OEM and its suppliers may contain provisions which seek to limit, define, or apportion damages differently than what the actual economics indicate. For example, certain contracts may specify that the OEM is responsible for warranty costs under a certain repair threshold, such as an average of two repairs per thousand parts, while the supplier is responsible for any costs associated with additional repairs. In such situations, a damages analysis may require the financial expert to reduce the damages for the costs associated with the “acceptable” number of repairs as defined by the contract. Alternatively, the contract documents may simply apportion damages (for example 80% supplier, 20% OEM), recognizing that the effort to determine root causes may be complex and inconclusive.

Behind the Data

Warranty and recall actions may involve the repair of hundreds of thousands, if not millions, of products. Oftentimes, the individual warranty and recall repair claims are maintained in comprehensive databases or other similar systems. These databases are often the mechanism through which all costs are traced relating to a certain product’s warranty, or to a full-scale product recall. While an analysis of this information is often performed in calculating damages, it is seldom as simple as adding all labor and parts expenses contained in these databases. The magnitude of certain warranty and recall actions may result in unique circumstances and considerations when estimating damages. A damages analysis should consider several common issues that may exist within the data:

  • Non-eligible repairs – Often, repairs are done on products and parts not falling under warranty or specifically identified as eligible for the recall repair. These claims may be entered prior to the official recall date, or may relate to model years which are not covered by the warranty or recall. Further, certain repair claims may be associated with closely related products not falling under warranty or identified in the recall.
  • Duplicate Repairs – In certain cases, a warranty or recall database may contain claims relating to repairs that have been performed on certain products or equipment more than once. It is possible that these duplicate entries may be the result of an error in the repair entry process or relate to repairs that were later credited out of the system. In certain circumstances, multiple repairs may have been done on the same product more than once, especially if the product contains more than one of the parts under warranty or being recalled.
  • Excessive Labor and Parts Costs – Anomalies are often observed relating to both parts and labor costs in which certain claims contain costs that are significantly greater than other repair entries. Claims may have repair times that are in excess of the allowable time for the repair, or may have labor rates in excess of the standard rate. These increased labor times or rates could be the result of a deviation from accepted procedures and time allowances indicated in time studies. Alternatively, it may be possible that the product dealer that performed the repair utilized a higher labor rate than others in the database.
  • Unrelated Conditional Parts – Upon comparison to the OEM part descriptions, it may be found that there are certain conditional parts contained in the repair database which may not be directly related to the warranty or recall repair. For example, it may be found that certain repairs done to replace a faulty brake pedal included the replacement of a cigarette lighter or windshield wiper.

A damages expert will often seek to understand the nature of each of these and other items based on the facts and circumstances of each matter, and confirm that the recorded claims are representative of the actual costs incurred by the OEM. This process will often involve detailed analyses of the product rosters and numerous screens and tests on each of the repair claims. In addition, the expert often will require an intimate understanding of the dynamic nature of the supply chain structure and the contract and pricing practices between its members. While damages involved in a warranty and recall case are often focused on parts and labor costs, there are a multitude of other factors which should be considered.

Common Financial Issues to Consider

The possibility of repairs relating to non-eligible products and parts is an important consideration. In certain cases, recalls may only be issued for certain models or model years and products not meeting certain specifications may not be eligible for repair. However, non-eligible products may be repaired in error or as part of a customer goodwill response. A financial expert will often review detailed product rosters for the purposes of identifying potential non-eligible repairs and the nature of each. This will often include an analysis of product numbers and configurations, model years, as well as repair and claim entry dates. With both warranty and recall repairs, the OEM may allow for the repair or replacement of related parts not falling under warranty or specifically identified in the recall. These “conditional parts” may be necessary to adequately complete the repair for the part under warranty, or they may be included in the repair as part of a customer goodwill response. Conditional parts can often comprise a significant portion of the overall parts costs. For example, exterior products (underbody vehicle components, telecommunications equipment, exterior home products, etc.) may result in significant conditional repair costs due to unforeseen circumstances brought about by weather or corrosion. Depending on the case, certain of the conditional parts may be found to be necessary to make the repairs, while others may be found to be unrelated and not reasonably reimbursable. This distinction is often a point of contention between OEMs and suppliers. Depending on the case, a damages analysis may require an analysis of the nature of these conditional parts and a reduction to damages for unrelated parts.

The process utilized by OEMs in making parts available for repairs often involves complex arrangements whereby individual replacement parts are sold from the OEM to its parts divisions who later sell to product dealers. At each level, parts are often marked up for profit and handling fees. As a result, it may be the case that the warranty and recall parts costs being recorded by the OEM in the claims database may be inflated due to this markup. The markup on parts sold by the OEM to its parts division may be significant, often in the range of 40 to 50% per part. An analysis should consider the markup on replacement parts which may have been applied between the OEM, its parts division, and the product dealers. To the extent the markup includes profit and is not representative of actual handling costs incurred, adjustments to damages may be required.

Further, warranty repairs are often done in the ordinary course before defined recall repair procedures have been prepared and distributed to product dealers or sales outlets. As standard practice in many industries, these repairs often contain a profit markup applied to the parts and labor costs. However, a damages calculation may require that any profit realized by the OEM and its product dealers relating to warranty repairs be accounted for as a reduction to damages.

How Much Is Too Much

Depending on the nature and magnitude of the product defect, there may be a significant warranty repair period prior to the issuance of an official recall. After some period of time, the OEM may have made an independent determination that a product recall was necessary due to continued “excessive” warranty repairs. However, disputes are common between OEMs and suppliers regarding whether a costly recall initiated independently by the OEM was, in fact, necessary. These disputes often involve detailed analyses of the warranty levels prior to the issuance of the recall to determine whether warranty levels were, in fact, “excessive” relative to historical levels.

In evaluating whether excessive warranty levels merited a full-scale recall, a financial expert may be retained to review the warranty database to determine if the observed warranty levels were excessive relative to contract requirements or warranty tolerances. The expert will commonly evaluate the data from multiple perspectives and compare warranty trends across product models and configurations as well as the dates when the products were sold. Further, the expert may consider certain factors, such as the state in which the product was sold or repaired as well as warranty seasonality patterns observed across geographies. These are important considerations in the determination of “excessive” warranty claims, as certain states and geographies may be expected to experience a larger number of warranty claims due to certain climatic effects. Regardless of the facts and issues of the case, expertise in database analysis can assist with the liability arguments of “excessive” warranty claims and aid in justifying the need for a recall.

Conclusion

Warranty and recall cases are often complicated by challenges of sophisticated supply chains, complex databases utilized to gather and maintain information about product sales and repairs, and nuances in the available data. Databases that are utilized in the ordinary course to track warranty or recall repair costs may contain certain items which are not representative of the actual costs incurred by the OEM. These comprehensive databases are further complicated by unique contracting and pricing practices observed between the OEM and its suppliers. At each stage of a warranty and recall case, however, a financial expert can assist in analyzing several common, complex issues that may be encountered in calculating damages associated with warranty and recall actions.

Also a contributing author:

Jacob M. Reed

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1 “Toyota Recall: Gas pedal issue affects more than 2M vehicles,” January 22, 2010, www.usatoday.com

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