Microsoft Goes Bespoke: Risks and Rewards in Custom Manufacturing Agreements

Practical Law Legal Update w-002-9471 (Approx. 5 pages)

Microsoft Goes Bespoke: Risks and Rewards in Custom Manufacturing Agreements

by Practical Law Commercial Transactions

Microsoft's Surface Customization Plans

Initially, Microsoft's customization offerings for the Surface will focus on software. The company plans to develop software options for the retail, consumer goods, healthcare, and the public sectors. Additionally, Microsoft plans to offer more tailored buying options to enterprise customers that wish to incorporate the Surface into their technology platforms.

Though the current focus is on software, Microsoft is also open to customizing the Surface's hardware to meet customer needs for increased memory, storage capacity, and security.

Custom manufacturing offers a myriad of benefits for Microsoft. Custom goods can attract new customers that are not being fully served by current off-the-shelf options. Buyers of custom goods are more likely to be repeat customers as they come to rely on a product tailored to their business needs. Microsoft is counting on these benefits to justify the time and expense of customization. However, tailored manufacturing also comes with significant risks.

Risk in Custom Manufacturing Contracts

When a company offers custom-made goods, the contractual relationship with clients increases in complexity. Both parties must carefully consider how the product specifications will impact issues like risk, intellectual property rights, quality control, and termination rights, among others.

This update highlights two important contract considerations for custom manufacturing -- risk allocation and early termination. For a longer discussion of custom manufacturing agreements in the US, see Practice Note, Manufacturing Custom-Made Goods in the United States.

Risk Allocation

Allocation of risk between the parties is a central function of a commercial contract, particularly in a custom manufacturing agreement where the risks are higher than they would be in a standard sale of goods. Parties in a custom manufacturing contract should therefore pay particular attention to contract features that help to allocate risk.

There are a number of contract provisions that help to allocate risk, but three of the most powerful are:

Warranties. Parties can protect against defects in quality and fitness, intellectual property infringement, and environmental liabilities, among other potential issues. For more information on warranties, see Practice Note, UCC Article 2 Express Warranties and Practice Note, UCC Article 2 Implied Warranties.
Indemnification. Contractual indemnity is an express agreement by one party to compensate another party for certain agreed costs and expenses, and is therefore an important tool in managing risk in a custom manufacturing agreement. For more information on indemnification and risk allocation, see Practice Note, Risk Allocation in Commercial Contracts: Indemnification as Risk Allocation Tool.
Insurance. Parties can also allocate risk through covenants requiring one or more parties to maintain specific levels of insurance coverage. For more information on insurance and risk allocation, see Practice Note, Risk Allocation in Commercial Contracts: Insurance Coverage as Risk Allocation Tool.

Other risk allocation provisions include:

Limitations on liability.
Termination rights.
Force majeure.
Contractual remedies.
Payment terms.
Guaranties.

For more information on risk allocation in commercial contracts, see Checklist, Avoiding Key Risk Allocation Pitfalls Under Commercial Contracts and Practice Note, Risk Allocation in Commercial Contracts.

Early Termination

In a custom-goods agreement, the manufacturer is expending extra resources to create a product that may only be useful to the intended customer. Therefore, manufacturers should strive to properly limit the customers' ability to terminate a manufacturing agreement without due compensation.

One way for manufacturers to mitigate risk is to take a purchase-money security interest (PMSI) in the goods sold to the buyer. A PMSI is a security interest that enables a seller who sells a good on credit to obtain a superpriority security interest in the goods to secure the buyer's obligation to pay. For more information on PMSIs, see Practice Note, Purchase-Money Security Interests (PMSI) and Standard Clauses, General Contract Clauses: Payment Terms, Purchase-Money Security Interest (PMSI).

Customers can also insulate themselves from the risk of early termination. One way to accomplish this is to make the manufacturer's termination rights contingent on the customer meeting the manufacturer's demand for adequate assurances. For more on adequate assurances, see Practice Note, Anticipatory Repudiation and Adequate Assurances of Future Performance.

There are additional tools available to the parties in mitigating the risk of expiration or early termination, including:

Including a liquidated damages clause.
Obtaining cash in advance or an evergreen retainer.
Including a right to terminate for convenience or expansive conditions or events of termination.
Including expansive termination-related rights.

For more information on mitigating for expiration or early termination in a custom manufacturing contract, see Practice Note, Manufacturing Custom-Made Goods in the United States: Termination-Related Concerns.

Other Risk Considerations

See Practice Note, Manufacturing Custom-Made Goods in the United States for discussion of additional considerations, including:

Price, timing, and quantity terms.
Intellectual property ownership and confidentiality.
Inputs, quality control, and inspection.
Changes to and compliance with product specifications.
Shipping and delivery terms.

Parties to a custom manufacturing contract may also want to consult:

Microsoft Goes Bespoke: Risks and Rewards in Custom Manufacturing Agreements | Practical Law