Checkpoints for Sales Agreements: How to Read Inspection and Acceptance, Risk of Loss and Contractual Non-Conformity Liability

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

The sales agreement is one of the most basic types of contract in business-to-business transactions. It is used in every aspect of daily corporate activity, such as selling products, purchasing equipment, transferring inventory and procuring the various devices a business needs.

Because it is such a familiar and basic contract, reviewing it is often treated lightly as a formality. However, sales agreements contain many issues that readily develop into serious problems in practice, such as identifying the subject matter, delivery, the transfer of risk of loss and the allocation of contractual non-conformity liability, and it is important to carefully examine the contract terms from the perspective of both the buyer and the seller.

Businesses that want lawyers to scrutinize liability for non-conformity and acceptance-inspection terms in sales agreements can see our legal outsourcing, in which outside lawyers handle this work on a continuing basis even when legal staff are short.

The Basic Framework of a Sales Agreement and Identifying the Subject Matter

A sales agreement is a contract in which the seller promises to transfer a property right to the buyer and the buyer promises to pay the price for it. In business-to-business transactions, a wide variety of property is the subject of sale, such as tangible movables, machinery and equipment, and product inventory.

When examining a sales agreement, first check the consistency of the underlying transaction terms. If the parties' understanding of the subject matter or the basic transaction terms differs, the very criteria for the subsequent inspection and acceptance procedure and for determining contractual non-conformity liability become unclear.

A sales agreement may appear simple in structure at first glance, but if the subject matter is not sufficiently identified, "what must be delivered" and "what counts as performance in accordance with the contract" later become matters of dispute. If the contract merely states "a set of products" or "a set of machinery and equipment," the risk that the parties' intended scope will differ after delivery cannot be eliminated. Identify the product model numbers and quantities, accessories and maintenance parts in the contract or an exhibit. Also check whether the performance and quality the buyer expects are included in the agreement, and whether the warranties the seller undertakes are excessively broad.

Careful identification of the subject matter is especially important for purchases of used or display items, matters where the specifications are scattered across proposals and quotations, prototypes and custom-made items, equipment with embedded software or data, products where the scope of accessories and maintenance parts matters, and transactions that include transport and installation work. The more the specifications are spread across multiple documents rather than contained in a single contract, the more likely something will be overlooked.

If the contract is concluded with an ambiguous description of the subject matter, it becomes difficult to determine whether contractual non-conformity liability can be pursued even when defects or malfunctions are found later. Compare the main text of the contract with the attached specifications, and put things in a state where any third party reading them can unambiguously identify what is being sold.

The Timing of Delivery, Inspection and Acceptance, and Transfer of Title

Delivery means the seller handing over the subject matter to the buyer; inspection and acceptance means the buyer inspecting the subject matter and confirming that it conforms to the contract; and transfer of title means ownership of the subject matter passing from the seller to the buyer.

It is entirely common in practice for these to occur at different times, and the difference in timing does not in itself mean the contract is defective. However, it is essential to accurately organize when each event occurs and how it relates to the provisions on accident risk (risk of loss) discussed below. For example, the allocation of risk borne by the seller and the buyer changes significantly depending on whether title transfers upon completion of delivery, upon full payment of the price, or upon passing inspection. It is also essential to sort out whether title transfers before inspection takes place or after the goods pass inspection.

From the buyer's perspective, check whether the terms are such that the obligation to pay the price becomes fixed, or the buyer is made to bear unexpected accident risk, before inspection and acceptance is complete. Note that acquiring title early is not necessarily disadvantageous to the buyer in itself. From the seller's perspective, take measures so that the inspection and acceptance procedure is not unreasonably prolonged due to the buyer's circumstances and receipt of the price is not delayed for a long period. Check one by one the place and method of delivery, the procedure in the event of late delivery, a reasonable inspection period, the procedure for repair or delivery of replacements upon failure, a deemed-acceptance clause for when the buyer fails to give notice, and the link with the payment due date.

Provisions on Risk of Loss, Which Allocate Accident Risk

Risk of loss is the question of which party bears the financial loss when the subject matter is lost or damaged due to causes not attributable to either party. For example, it determines whether, if a product is damaged in an accident during delivery, the seller must redeliver free of charge or the buyer must pay the price.

In practice, the contract sets the timing at which risk of loss transfers by linking it to milestones such as delivery, inspection and acceptance, or transfer of title. On the buyer's side, check whether the contract makes your company bear accident risk arising before the goods pass inspection. On the seller's side, check whether you are taking on the excessive burden of continuing to bear liability for accidents for a long period after delivery is complete.

In particular, where the delivery and installation processes span multiple carriers or contractors, the boundaries of responsibility tend to become unclear in the provisions. Clearly agree on the risk of damage during delivery, the risk of accidents during installation work, loss or damage before inspection, the treatment where the buyer delays in taking delivery, whether casualty insurance is taken out and the agreed scope of coverage, and, in international transactions, the application of Incoterms (trade terms). Note that the transfer of title to the buyer does not necessarily mean that risk of loss also transfers. Because Article 567 of the Civil Code provides for the transfer of risk based on delivery and the like, confirm the timing of the transfer of risk by checking both the special provisions of the contract and the default rules of the Civil Code.

Remedies and Liability Periods Under Contractual Non-Conformity Liability

Where the type, quality or quantity of the delivered subject matter does not conform to the contract, contractual non-conformity liability is considered. The cure of performance that the buyer may demand includes repair, delivery of substitutes and delivery of the shortfall. Price reduction, termination of the contract and damages are also considered, after checking the requirements for each.

The law sets different requirements for each of these remedies, such as whether a demand is required and whether the counterparty is at fault. In reviewing a contract, check the notice period, the statute of limitations and any liability period set as a special contractual provision, distinguishing among them. Where the sale is between merchants, check the provisions of Article 526 of the Commercial Code on inspection after receipt and notice upon discovering a non-conformity. Also check the relationship with the special provisions of the contract, including the timing of notice and the exceptions.

From the buyer's perspective, determine whether the notice period or liability period for non-conformity is too short, whether the conditions on the method of notice are set too strictly, and whether the remedies are limited to demands for cure only. From the seller's perspective, to avoid continuing to bear unlimited liability after the contract ends, set an upper limit on the liability period and provide that the seller is exempt from liability for defects attributable to improper use or storage by the buyer. Note that even if the contract provides for the seller's exemption from or limitation of liability, it is not always effective; keep in mind that under Article 572 of the Civil Code, the seller cannot escape liability in cases such as where it knew of the non-conformity but did not tell the buyer.

Checkpoints by Position and Considerations for Ongoing Transactions

When reviewing a sales agreement, the direction of analysis for the same clause differs greatly depending on whether your company is the buyer or the seller. It is natural for a buyer to think, "Even after passing inspection, I want to be able to demand cure for non-conformities discovered within a reasonable period," and for a seller to think, "After passing inspection, I want to be liable only for serious hidden non-conformities that could not be found through ordinary inspection." For purchases of equipment or systems, keep in mind the connections across the whole sequence of installation, trial operation, handling of initial defects and the maintenance contract.

When examining a sales agreement, check at least the following basic items.

• Whether the subject matter is identified by model number, specifications and the like
• Whether quantity, quality standards and inspection criteria are clearly set out
• Whether the place of delivery, delivery date and allocation of delivery costs are specified
• Whether the criteria for acceptance and the inspection period are appropriately set
• Whether the procedure for repair or delivery of replacements upon failing inspection is set out
• Whether the timing of transfer of title is consistent with the payment terms
• Whether the timing of the transfer of risk of loss matches the realities of the transaction
• Whether the notice period, liability period and remedies under contractual non-conformity liability are reasonable
• Whether the provisions on the payment due date, late payment charges and set-off are in order
• Whether the termination events and damages provisions are commensurate with the size of the transaction

In addition, the perspectives to consider also change depending on whether the sale is a one-off transaction or an ongoing series of repeated sales. In a relationship where sales take place on an ongoing basis, look beyond the sales agreement itself and check the order of precedence with the master transaction agreement. If the master agreement provides for transfer of title and contractual non-conformity liability but an individual sales agreement or purchase order states different terms, the parties' rights will be thrown into confusion when a problem arises. In ongoing transactions, also check issues different from those of a one-off sale, such as a clause providing for consultation on price revisions in response to rising raw material prices, minimum purchase quantities (minimum commitments), and the response when quality claims arise. Also consider the response if the supply of raw materials stops or force majeure occurs. Fees for regularly outsourcing the review of sales agreements and purchase orders can be found at Legal Outsourcing.