Component Parts and Raw Materials, Successors, and Distributor Liability

Kenneth Ross

Introduction

Now that we have discussed the four main theories of liability that can arise when selling a product – manufacturing, design, warnings and instructions, and marketing defects – I wanted to discuss in greater detail some issues of importance when considering potential liability and techniques for minimizing it.

These involve component parts and raw-material suppliers, successor liability and possible liability of other entities in the distribution chain. The focus will be on pre-sale activities and I will save a discussion of most post-sale issues until my next article on post-sale liability.

Component Parts and Raw Materials

One of the more perplexing areas of law deals with the liability of component part and raw material suppliers in product liability litigation. The difficulty arises because these suppliers do not usually make the product that hurt the plaintiff. However, it is possible that they contributed to the injury. The law has had to establish a basis for apportioning or assigning liability to different defendants in the chain of production and distribution.

Cases where liability must be apportioned among multiple parties can become extremely complex and costly for all parties. This is especially true when some of the parties are out of business or not subject to jurisdiction in the court where the lawsuit is filed.

Basic Law

The law says that if the component is itself defective and the defect causes harm, then the supplier is liable. In addition, the supplier is liable if the seller “substantially participates in the integration of the component into the design of the product” and the integration causes the product to be defective and the defect causes the harm.

In both of these situations, it seems fair to hold the supplier responsible. However, many times, the respective responsibility of various suppliers, the final product manufacturer, and possibly the distributor of the component or product, can make a fair apportionment very difficult.

Defective Component

It is difficult enough with final products to determine whether it is defective. With components, it can be even harder. Components can be designed for many applications. Usually, the final product manufacturer selects the product from a catalog or after discussion with personnel from the component manufacturer or their distributor.

The product may be defective for a particular application, but not defective in general. If the final product manufacturer did not consult the component supplier and selected the wrong component for the application, the product is not defective in itself and the component manufacturer is not liable.

The component can have manufacturing and design defects, defects in warnings and instructions and marketing defects in their sales literature. Liability of the manufacturer would be considered under the same law as that for final product manufacturers.

Product components such as raw materials can be defective if they are contaminated or have the wrong formulation. These are manufacturing defects. If the final product manufacturer uses the wrong raw material or fails to warn, it is their responsibility and not the raw material supplier unless the raw material supplier fails to inform, warn or instruct the product manufacturer that incorporates the raw material about any hazards that exist in that particular use of the raw material. And there can also be marketing defects based on representations by the supplier.

Substantial Participation

When the component supplier is substantially involved in the integration of its component into a final product, and the integration causes a defect and harm, the supplier can be liable as well as possibly the final product manufacturer.

Determining substantial participation and what to do about it are very difficult issues. On the one hand, the component supplier has an interest in having its products used safely and correctly. If there is any question by the purchaser, the supplier should provide assistance in selecting the correct part for the application. Unfortunately, by doing that, the component supplier may become more legally involved in the case.

The tendency may be for the component supplier to supply the component part and not ask for information on what it will be used for or to disclaim liability if the use is incorrect. If the contracts contain indemnification provisions protecting the component part supplier, then it is not in the best interest of the supplier to ask a lot of questions.

The law says that merely designing a component to a manufacturer’s specifications does not necessarily constitute substantial participation. Also, providing technical services or advice concerning the use of a component part does not, by itself, constitute substantial participation.

Unfortunately, the concept is vague and if the judge allows the case to go to the jury, the jury gets to decide. If the component part supplier is the only party left, the court or jury will be very sympathetic to an injured party and will not want to see them go away uncompensated. They can hold the component part supplier liable in whole or in part, even if the supplier believes that it did not substantially participate or helped make the product defective.

Preventive Measures

Appropriate preventive actions differ depending on whether you are the component supplier or purchaser of components. Despite that, the fairest approach is to have the most responsible party be the one to defend the case and be liable to the degree that they caused the problem.

If the component part supplier knows how the product will be used and is asked for advice on what component to buy, they should be the party mostly liable if the wrong component was used. If the final product manufacturer made the final decision, they should accept any liability that results unless the part was defectively manufactured.

Unfortunately, many times people’s memories have faded and documentation of the sale or design process is unclear. And, problems usually arise many years after manufacture.

The best way for the respective parties to deal with the potential liability in this area is to have clear and documented communications on what is being supplied or who selected the part. If the component part supplier suggested the part, there should be documentation on what information was provided to the supplier’s personnel on which they made the recommendation. Similarly, if the final product manufacturer makes the final decision, they should clearly document the basis for the decision.

Each party must consider whether their actions and decisions are justified and how big of a problem might arise if there has been a mistake. Selling the wrong shade of paint can be a big financial problem, but no safety issues will result. Selling the wrong plastic, engine, valve, switch, or chemical can, in many situations, create big problems.

For those products that can create safety problems, the seller has to be more careful when giving advice. Also, the catalog information for safety critical parts or raw material should give some guidance for purchasers so that they can make the correct decision.

And, the contracts should contain mutual indemnification provisions which provide that the responsible parties will indemnify the non-responsible parties to the extent they are responsible.

Predecessor and Successor Liability

Difficult legal and product liability issues arise when a manufacturer sells a product line, division, assets or itself to another company. These issues involve both the seller (also called the predecessor) and the buyer (also called the successor). How the seller and buyer deal with these issues is important for their future liability.

General Corporate Law

Traditional corporate law holds that the buyer of assets does not become liable for the liabilities of the seller except in four situations:

  • The buyer expressly or impliedly agrees to assume liability.
  • The transfer of assets is just for the purpose of escaping liability and is fraudulent;
  • The buyer is just merging or consolidating with the seller so it is in reality the same company; or
  • The purchaser is a mere continuation of the seller with the same name, same personnel, same manufacturing facilities and same design.

This law was meant to protect the rights of creditors and dissenting shareholders and was not initially intended to affect the rights of product liability claimants.

California Exception

The California Supreme Court developed an exception to the general rule of non-liability for a successor corporation. In the case being considered, none of the four exceptions applied and the court wanted to find a way to hold the successor corporation liable.

The fifth exception, which has only been adopted in a few states and only applies to claims of strict liability, says that a successor corporation could be liable if they continue to manufacture a product of the business it acquired, regardless of the method of acquisition or any allocation of fault. This “product line exception” applies if the successor:

  • Produces the same product line under a similar name;

  • Acquired substantially all of the predecessor’s assets, leaving no assets from which a judgment for an injured claimant could be satisfied;

  • Holds itself out to the public as a continuation of the predecessor; and

  • Benefits from the goodwill of the predecessor corporation.

The rationale for this exception is that a successor who purchases productive assets should not be allowed to benefit from receiving the goodwill and reputation of the predecessor’s business without the burden of responding in tort to claims for harms caused by products sold by the predecessor prior to transfer. Presumably, this potential liability would reduce the purchase price and thereby increase the incentive on the seller to invest in product safety before the transfer of the business.

This fifth exception has been recognized in California, New Mexico, Pennsylvania, New Jersey, Washington and New York. Most other states that have considered this new exception have rejected it. Despite that, since a successor must consider liability in all 50 states, it must structure the deal and the organization of the new assets assuming that this exception could apply.

Application to Product Liability

The basis of liability under negligence is whether the manufacturer failed to exercise reasonable care. The potentially culpable party under strict liability is “one … who sells or distributes a defective product.” For breach of contract or breach of warranty, it is the parties who entered into the contract or who issued the warranty that are potentially liable.

So, the courts had to consider liability of a buying company that was not at fault and did not issue the warranty. This usually comes up when the seller no longer exists and has no insurance in force to cover incidents occurring before the sale. In this case, the injured party has no recourse against the most potentially culpable party because they have either merged into a new company, dissolved, or are operating as a shell company. And the plaintiff can’t claim against the insurance company for the predecessor because the insurance policy is usually cancelled when the acquired company goes out of existence.

The courts will do their best, hopefully within the confines of the facts, to hold that a successor corporation “stands in the shoes” of the predecessor company when there is no one else to sue or be held liable. They would rather allow a claimant to prosecute a claim against a company that didn’t make or sell the product rather than allow the claimant to not have a claim. In other words, the courts would prefer to hold an “innocent” company liable instead of having a blameless plaintiff walk away empty handed.

In the sale of all medical products, there are intermediaries such as dealers, distributors and health care professionals. The law is fairly clear that when the manufacturer no longer exists or can’t be sued in the state where the case is pending, claimants can sue the intermediaries who must defend the case as if they were the manufacturer. In that case, it would be unlikely for the court to hold the successor corporation liable unless one of the exceptions applied.

When Buying and Selling Assets

Any company that is buying and selling assets must retain competent legal counsel that is familiar with the rules stated above in all 50 states. Since future product liability actions can occur in any jurisdiction, counsel must assist the buyer and seller in structuring the deal so that it meets the expectations of the parties.

Since it is unclear where an action will be brought, if the seller will go out of existence after the transfer, it is a good idea to have a trust fund established which could be used to defend and resolve post-transfer product liability claims. Another way to deal with the liability issue is to require the seller to maintain an insurance policy for a specified period of time that covers either all claims that occurred prior to the transfer of assets or covers claims involving all products manufactured prior to the closing of the deal.

Some sellers insist that the buyer assume all liability and that the potential liability be reflected in the purchase price, or the purchase price can be adjusted later based on the post-transfer claims experience.

There are many different ways to structure a deal and allocate risk and potential liability. Using competent legal counsel that understands product liability will be very helpful in preventing surprises on either side.

Auditing Company to be Acquired

Many of the preventive techniques discussed in my articles should be considered when a buyer is evaluating a selling company’s assets. Auditing the company’s design, manufacturing procedures, warnings and instructions, the potential for future recalls and other post-sale problems, and potential liability for breach of warranty and breach of contract are all important areas that many times are ignored because counsel are not knowledgeable in these areas or there is no time to perform the audit.

Other things to consider are what will happen to the seller’s documents and personnel necessary to defend cases. If the buyer assumes liability for just new cases, and the documents and personnel are transferred to the buyer, will the buyer provide liberal access to the documents and people to assist in the defense of their current cases? There have been many disputes where responsibility for the defense of cases is split but the resources to defend the cases are transferred to the buyer.

Another interesting problem arises out of the inconsistent treatment of products in the field. Let’s assume that the seller will defend and be liable for cases pending at the time of transfer. And, the buyer decides to change the product’s design or even recall the product that the seller made and sold. This could have a devastating effect on the defense of these pending product liability cases, yet the seller has no control over what the buyer does with its newly purchased assets. Clarifying the rights of each party may prevent significant problems that could affect the liability of the buyer and the seller in the future.

Distributor Liability

Any entity in the chain of distribution can be held liable for selling a defective product, even if it did nothing wrong. But, if the manufacturer is a viable company, is subject to jurisdiction in the lawsuit, can respond to damages and no one else did anything wrong, the manufacturer will usually be fully responsible for the defense and any damages resulting from the claim.

However, dealers and distributors and, of course, health care professionals can be independently liable if their actions caused or contributed to the injury, damage or loss. And plaintiff’s attorneys are increasingly suing downstream product sellers to find other potential sources of settlement dollars.

Even if the manufacturer designs and manufactures a reasonably safe product, there are many additional opportunities during sales, installation, service, maintenance, parts sales, training and operation for dealers, distributors and health care workers to create safety problems or somehow minimize the safety that has been built into the product.

Installation

For many products, manufacturers are required to create and disseminate installation instructions. If non-manufacturers are performing the installation, it is important that it be done correctly.

However, especially with products where the installer has been trained and/or is experienced, the installation instructions may not be complete since the manufacturer assumes that the installer knows more than he may actually know. In that case, the installer could incorrectly install the product and not have any indication from the instructions that it is incorrect.

An example is compliance with laws, regulations, state and local standards and codes. A manufacturer may incorrectly assume that the installer has access to and is familiar with such requirements and will comply with them. If the installer doesn’t and the installation is incorrect, then both the installer and the manufacturer may have a problem, especially if there is a personal injury. Therefore, installers must be sure that they are familiar with the manufacturer's instructions and that they obtain additional information where required.

A manufacturer should request that the installer pass along all of the warnings, instructions and warranty information, and possibly obtain the health care facility’s acknowledgment that they received the safety information, have had the safety information explained to them, and that they have received any training or orientation required by the manufacturer. The manufacturer may also request that the facility sign an installation checklist that has been completed by the installer confirming the above. To the extent feasible, the installer should help with these requests.

Installers need to think about how they are going to defend themselves if there is a problem and the patient or health care professional blames them. Having documentation proving that the installation was performed correctly and that safety information was passed along can go a long way to defeating such a claim. The plaintiff will then have to criticize the accuracy and adequacy of the installation, safety information and orientation. But, at least, the installer can prove that it was done.

Service and Maintenance

Manufacturers are required to provide adequate instructions on how to service and maintain their products. But service and maintenance personnel not directly employed by the manufacturer can be held liable if they don’t follow these instructions and injury or damage occur or if they don’t exercise reasonable care when performing these services.

Service personnel are supposed to be knowledgeable in how to work on certain kinds of products. Manufacturers can assume that such people have received some training and have experience in the proper way to service the product. As a result, the maintenance instructions should be understandable to such experienced personnel and personnel who service or maintain products need to receive appropriate training either from the manufacturer or independently so that they can properly work on the product.

In addition to performing adequate service or maintenance, proper documentation must be kept so that everyone knows what has been done and when, as well as what has been recommended and not done. If there are safety issues found during maintenance, the maintenance personnel must point this out to the customer and try to get him to fix the problem. If the customer refuses to have it fixed, the maintenance company needs to clearly document the problem and the customer’s refusal to have it fixed.

While they can’t force the health care facility to fix the problem, they need to adequately and clearly apprise them (and, if possible, their higher level management) of the hazard, the chances of it creating a problem and what could happen if it occurs.

A related problem arises if the maintenance personnel see that the customer has modified the product and made it less safe. An example would be a health care facility removing safety devices from a diagnostic machine. In that case, the maintenance company is in a difficult position. It isn’t the manufacturer and it didn’t remove the safety devices. Also, it doesn’t want the facility to get mad at them for informing them of a safety problem.

If an employee was injured due to the lack of safety guards, could the maintenance company be held liable? How about the manufacturer? It is possible for both to held liable. The manufacturer could be held liable for designing a product that had safety devices that could be easily removed. The maintenance company could be held liable for negligence in not pointing out the safety hazard to the facility. While the maintenance company’s liability is not a sure thing, as a minimum, the injured party could sue them and make that argument.

Other areas of possible liability

There are many other opportunities for downstream product sellers to create legal problems during the sales and marketing process. A distributor can advertise a product inconsistently from the manufacturer’s advertising. A salesperson can say or do something during the sales process that confuses the customer and contributes to a safety hazard. One example involves whether to buy or use certain optional safety equipment. These sales representations can create liability for both the seller and the manufacturer.

If the dealer or distributor is training the customer’s personnel in the proper and safe use of the product, they can create potential liability if they don’t follow the manufacturer’s instructions or if they do the training negligently.

Preventive tips

A number of preventive techniques are mentioned above. Several more should be considered. The duties and responsibilities of manufacturers, dealers, distributors and health care facilities should be governed by contractual agreements. Each of the parties should understand what it should be doing and what others in the chain of distribution are doing to ensure that the product is being used and maintained safely.

Each of the parties should have insurance and it should be clear when the coverage is applicable. Each of the parties should be willing to indemnify the other party if the first party’s conduct primarily caused the injury, damage or loss.

Many times, it is impossible to utilize indemnification provisions during the pendency of the case because it is unclear on what theory the plaintiff will rely or how a jury will rule. And, everyone in the chain of distribution is in the case and they should try hard not to blame each other publicly. That can only help the plaintiff who loves it when the defendants are pointing fingers at each other.

Conclusion

These complex issues complicate any analysis of potential liability and ways to minimize it. The multiple parties and differing relationships that exist in the supply chain make it difficult to completely analyze and control risk.

Thinking carefully about all potential issues and employing personnel experienced in dealing with the consequences will be helpful in heading off problems before they occur.

Kenneth Ross

Kenneth Ross is Of Counsel to the Minneapolis office of Bowman and Brooke LLP where he practices in the areas of product safety and liability prevention and advises manufacturers, product sellers and insurers on ways to identify, evaluate and minimize the risk of products liability and contractual liability. These guides do not constitute legal advice and are very general. You should consult competent legal counsel or Medmarc Loss Control before acting on any of the information in these guides.

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