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Careful Contracts Reduce Risk

Date: 3/15/08

Defective products imported from China have caused alarm among US retailers, distributors, importers and consumers. For this reason, a strong contract is essential for sporting goods companies sourcing and procuring products from China. A good contract should result in legal recourse against a financially viable Chinese supplier and the supplier's products liability insurer; address quality standards, testing, warranties; and provide for arbitration as the dispute resolution mechanism.

A few of the essential elements of a thoughtfully crafted supply contract or purchase order are:

The responsible party
From a fairness standpoint, product liability lawsuits and product recall costs that stem from safety and quality defects should be the responsibility of the party that caused the defects. However, a party not the cause of the defect but in the chain of commerce could, nonetheless, be held responsible on a strict liability principle. Hence, the best way to ensure that the consequences of a manufacturing defect flow to the manufacturer is to make this happen contractually. The contract should explicitly state that manufacturing defects are the responsibility of the manufacturer. In some cases, the defect may not have been caused by the manufacturer but by its subcontractor or material supplier. Nonetheless, the US buyer can only look to whoever is the contract party, usually the manufacturer, for legal recourse. Hence, it is important to be in privity of contract with a manufacturer that has a good track record on quality and is financially solvent and strong.

Manufacturing defect
Quality defects usually fall into manufacturing or design defects. If it is a manufacturing defect, the US buyer should have legal recourse against manufacturer for any liability or costs related to such defects. If it is a design defect, the responsibility should fall on whoever was responsible for the design of the product. If a commodity product us purchased by the US retailer, distributor or importer, the manufacturer is likely to have also designed the product. However, if a US retailer, distributor or importer contracted to buy its own private label or branded product, the product is likely to have been designed by the US brand owner and licensor. Depending on who designed the product, the manufacturer should represent, warrant and covenant that the product is free of any defects (in manufacturing, design, or both, as applicable) and complies with the quality standards of the buyer, a designated product or industry certification, or both.

Product liability insurance
US buyers of Chinese products should mandate in the contract that the Chinese supplier deliver a certificate of insurance affirming that the supplier has product liability insurance coverage for products exported and sold in the United States or worldwide. The policy should name the US buyer as an additional insured, include a waiver of subrogation (whereby an insurer relinquishes the right to hold a third party accountable for a loss suffered by an insured), and require that the US buyer receive advance notice of any cancellation or non-renewal. The contract provision should also state that the supplier is responsible for any deficiencies or gaps in coverage or deviations from the specified insurance terms.

Recall insurance coverage
Ideally, recall insurance coverage should also be required of the Chinese supplier. This can be a stand-alone policy or an endorsement to the product liability or general liability policy. Recall insurance coverage can be expensive or unavailable in certain product categories. Nonetheless, the problems and costs that arise from recalls, whether voluntary or mandated, should be discussed with the manufacturer and an agreement on who should bear these risks should be reached and addressed in the contract.

An indemnity obligation
A strong indemnity obligation from the supplier to the US buyer for product defects and other breaches of contract is recommended. Even under ideal circumstances in which the US buyer obtains the insurance coverages it wants from the Chinese supplier, there are likely to be deficiencies and gaps in what the insurance covers and in the scope of the obligations the US buyer wants to impose on the Chinese supplier under the contract. These gaps are best covered by an indemnity obligation from the supplier to the US buyer.

An arbitration clause
Another essential provision in a cross-border US-China supply contract is an arbitration clause. In the event of a dispute with the Chinese supplier, the US buyer may need to pursue the Chinese manufacturer to enforce the contract. It is important that the supply contract or purchase order mandate that disputes be resolved through arbitration governed by US law.

Article By:
Grace Parke Fremlin, Partner
Steptoe & Johnson LLP

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