What Stays and Who Pays?
The rights of buyers and sellers pertaining to defective parts
Whether you are a seller or a buyer (or both), it is important to understand when and how a buyer may reject defective goods—and to apply common sense as well as the law in dealing with these situations.
A Tale to Ponder
The Creative Toy Company (Creative) is starting to manufacture one of its most popular toys for the holiday season. This toy is called the Ani-morph, a toy widget that morphs into different animal shapes and makes the appropriate animal sounds when the child either touches the picture of that animal (toddler version) or touches the written name of the animal (pre-school version). Creative purchases the computer chips that control the actions of the Ani-morphs from the Widget Chip Company.
Creative recently signed a contract to provide 3,000 Ani-morphs to the Kid-Widget stores in time for the holiday season. The Kid-Widget Stores want the shipment immediately, and Creative is going to have to require its employees to work overtime to satisfy the contract. Creative has a sufficient supply of chips in storage to make 2,000 Ani-morphs. It accepted these chips from the manufacturer several months ago, although it did not open the packaging or test them at that time. Creative has ordered 1,000 more chips for immediate delivery in order to meet the terms of the contract.
As the Ani-morphs are manufactured, Creative discovers that there is a serious problem with some of the computer chips. One group of about 500 Ani-morphs will only morph into pigs, although they say “moo” or “bow-wow” or sing like a canary as they are supposed to. This problem was discovered during quality control checks by the toy company. Creative notified Widget Chip Company immediately. Most of the toy widgets seem to be fine, however, so Creative wants to send the properly functioning Ani-morphs to the stores to meet the company’s contract.
What should Creative do? What rights does it have? Does it matter whether the defective chips are from the supply that was on hand for several months or from the recent delivery? What about the Kid-Widget Stores and the parents who bought these toys for their children? What are their rights if some of the defective toys are not caught and get delivered to the stores? Is this going to ruin someone’s Christmas?
The Nature of the Problem
Many firms have faced the situation in which they have purchased parts that were defective, or they have encountered buyers who claim that the parts that they were sold were defective even when the Seller was sure they were not. The latter type of situation tends to arise more frequently during difficult economic times. For example, a company will claim that parts are defective in order to avoid finalizing a purchase because the customer to whom the company is selling the parts no longer needs them. Or perhaps a competitor has reduced the price of comparable parts to try to move inventory, and now the original transaction is no longer economically attractive to the buyer.
However, the concern here is with situations in which there may be a legitimate claim that goods are defective. What rights do buyers and sellers have in such situations? To whom can buyers and sellers appeal regarding their respective rights? Do sellers’ rights change depending upon when notice is given that the buyer no longer wants the parts in question?
A buyer of parts has two bites at the apple in deciding whether to ultimately retain possession of goods that the buyer believes are defective after receipt of them from the seller. The rules prescribed by the Uniform Commercial Code (UCC) differ depending upon when the buyer decides not to retain possession of the goods. The Code sets out the rules that a buyer must follow in order to be permitted to return the parts that have been received from the seller. These two basic sets of rules are the doctrine of rejection and the doctrine of revocation. (It should be noted that this article is dealing with U.S. law. Such laws may differ in other countries.)
The Doctrine of Rejection
Uniform Commercial Code (UCC) Section 2-601 provides that if goods fail in any respect to conform to the contract, the buyer has the option to accept or reject all of the goods or to accept a portion of the goods and reject the remainder. Courts have interpreted the language of UCC Section 2601 to mean that if the goods fail in any respect, (that is, if the goods, as delivered to the buyer, do not fully and completely conform to the terms of the contract), they may be rejected. It is important that buyers understand however, that courts have not interpreted this language to mean that a buyer may reject the goods if they do not meet the personal satisfaction of the buyer. Furthermore, the seller still has the right to cure these defects (e.g., provide replacement goods) before the buyer’s right to reject the goods is considered effective.
Section 2602 of the Uniform Commercial Code specifies the manner and effect of a proper rejection of goods. There are some key points to be noted.
- First, notice of rejection must be given in a timely fashion. No absolute time is prescribed by the Code, so courts have concluded that a reasonable time depends on the nature, purpose, and circumstances that led the buyer to notify the seller that the buyer wanted to reject the goods. At the very least, buyers are entitled to enough time before notifying a seller of a decision to reject the goods so that they can inspect the parts, discover the defect, investigate what rights a buyer has, determine a course of action, and take any steps necessary to implement that course of action. However, a buyer must understand that after notifying the seller of the buyer’s intent to reject the parts, the seller will still have the opportunity to cure the defects that have been discovered.
- A buyer who is seeking to reject goods cannot exercise any aspect of ownership of the goods while they are still in the buyer’s possession. For example, a firm that has notified a seller of its intent to reject parts should not incorporate any of the parts in any of its products. On the other hand, a buyer is not prevented from testing the parts to determine whether they are defective, because this type of act does not constitute exercising ownership. Rather, it reflects the buyer’s right to fully inspect the goods before deciding whether it is appropriate to reject them.
The Doctrine of Revocation
Once a buyer accepts the goods, then that buyer can no longer reject them based on the rules for rejection. If the buyer discovers after accepting them that the goods are defective, then the only right to return them is based on the doctrine of revocation, which is set forth in detail in Uniform Commercial Code Section 2-608.
A buyer’s right to revoke the acceptance of the goods is only available if the buyer is able to satisfy numerous conditions and qualifications.
- First, the buyer must establish that the value of the goods is substantially impaired. Courts have interpreted this substantial impairment requirement to mean that the essential purpose of the purchased goods must be frustrated by the non-conformities before this requirement can be satisfied. For example, if chips that were defective were sold, and this defect was not discovered until after acceptance, then a court would most likely find that the substantial impairment requirement was satisfied because the essential purpose for purchasing these components had not been satisfied.
- A buyer must also establish that s/he revoked acceptance of the product within a reasonable time after s/he discovered, or should have discovered, the defect and before any substantial change in the condition of the goods took place. The question of timeliness of notice in order to revoke acceptance is an issue that courts wrestle with frequently, and the courts’ decisions are generally based upon each particular fact pattern.
Courts will consider objective facts in order to determine a buyer’s intent. For example, if a buyer has used the goods for a month, and s/he has not expressed any problems with the goods, a court is most likely to determine that the buyer’s attempted revocation is untimely. On the other hand, if a buyer has the parts in storage and unopened for over a year, then finally discovers upon opening the product packages that the parts are defective, a court will probably determine that the revocation of acceptance is timely. A significant difference between these two fact patterns is that in the first case, not only did the buyer wait for a month before notifying the seller, the buyer also exercised ownership over the goods. The act of exercising ownership is one significant factor in determining whether the doctrine of revocation can be applied. In the second case, even though the buyer had the products for a significantly longer period of time, the buyer did not exercise the same type of ownership and control over the goods. The packages were not even opened during that year. Also, in the latter situation, the buyer notified the seller of the parts’ defects immediately upon discovering the problems.
Finally, a buyer who seeks to revoke his acceptance of goods must be extremely careful about using the goods after notifying the seller that he wants to return them. While in most cases a buyer will be unable to use the defective parts, situations do arise in which the buyer has no choice but to try to use the components in order to fill an order. In those cases, the buyer is cautioned to attempt to pursue other sources for replacement goods before resorting to what should be the last resort, which is for the buyer to try to fix or use the defective goods. Any use of these defective goods will most likely result in the buyer’s being precluded from exercising his or her right to revoke.
The Ani-Morph Example Revisited
Now consider the example that began this article. The Creative Toy Company has learned that in the future it cannot take for granted that the chips that it purchases for its toys are going to be free from defect even if they are new chips. In this example, since Creative did not test the first set of chips until long after it had taken possession of them — and it could be argued that the company exercised ownership over the first set of chips — Creative likely cannot assert the doctrine of rejection if the defective chips were a part of this shipment. It is clear that the toy company accepted those goods.
However, even in this situation, Creative Toy Company can still seek to have the doctrine of revocation apply. Creative placed the Widget Chip Company on notice within a reasonable time after discovering the defects or problems with the chips and gave the Widget Chip Company an opportunity to cure the defect. Creative should not ship those toys that contain the defective chips to its customer because if it does, then the doctrine of revocation cannot be utilized.
If, however, the defective chips were a part of the new rush shipment of chips, Creative Toy Company is in a much better position. It should still be able to have the doctrine of rejection apply because the company tested the parts within a reasonable time. The only problem that Creative might face is if it did not segregate the two sets of chips that it had purchased from its supplier. If the company did not segregate the chips, then it likely will not be able to make a valid claim of rejection because it will not be able to satisfy its burden of proving that it had recently learned that the chips were defective.
The various parties in these transactions are all considered suppliers, whether of the chips or of the toys themselves or whether as manufacturer or retailer. Thus from a practical standpoint and in order to promote customer satisfaction, the various parties should strongly consider taking the defective goods back without question and should either refund the customer’s money or seek to cure the defect by replacing the defective goods.
When businesspeople seek to remedy a problem such as the one facing Creative Toy Company in this case, not only should they seek to apply the Uniform Commercial Code, but they should also use common sense as well.
The doctrines of acceptance, rejection, and revocation describe the rights that buyers and sellers have when buyers claim that they have discovered that parts in their possession are defective. Buyers and sellers can resolve a number of these issues by including specific provisions in their purchase orders and invoices. For example, sellers should include in their invoices that the parties to the transaction understand that they have only a fixed amount of time to exercise the doctrines either of rejection or revocation before waiving their rights to do so. In addition, buyers should include in their purchase orders that sellers warrant that the parts that they are selling to the buyers are free from defects and are not counterfeit parts.
Both buyers and sellers need to act diligently and in good faith in order to benefit from the rules set forth in the Uniform Commercial Code concerning a buyer’s discovery of defective goods. In order to enjoy the full benefits of the right of rejection, Buyers should always inspect parts soon after their receipt and prior to allowing the goods to leave their possession, even if the parts are going to sit on a shelf for an extended period of time. Otherwise, as described above, a buyer will be forced to attempt to utilize the right of revocation, which is far more difficult to enforce than is the right of rejection.
Finally, if both parties to a transaction understand the doctrines of acceptance, rejection, and revocation, that understanding enhances the opportunity for all parties to resolve any disputes without the parties incurring significant legal fees. Therefore, it is recommended that a firm consult with its local counsel and review points such as those made in this article so that the company develops the knowledge that will assist in avoiding more serious problems between buyers and sellers in the future.
 Uniform Commercial Code Section 2-602 holds that: (1) Rejection of goods must be within a reasonable time after their delivery or tender. It is ineffective unless the buyer seasonably notifies the seller. (2) Subject to the provisions of the two following sections on rejected goods (Sections 2-603 and 2-604), (a) after rejection, any exercise of ownership by the buyer with respect to any commercial unit is wrongful as against the seller, and (b) if the buyer has before rejction taken physical possession of goods in which he does not have a security interest under the provision of this Article (subsection (3) of Section 2-711), he is under a duty after rejection to hold them with reasonable care at the seller’s disposition for a time sufficient to permit the sellter to remove them; but (c) the buyer has no further obligations with regard to goods rightfully rejected. (3) The seller’s rights with respect to goods wrongfully rejected are governed by the provisions of this Article on Seller’s remedies in general (Section 2-703).
 Uniform Commercial Code Section 2-608 states: (1) The buyer may revoke his acceptance of a lot or commercial unit whose non-conforming substantially impairs its value to him if he has accepted it (a) on the reasonable assumption that its non-conformity would be cured and it has not been seasonably cured; or (b) without discovery of such non-conformity if his acceptance was reasonably induced either by the difficulty of discovery before acceptance or by the seller’s assurances; (2) Revocation of acceptance must occur within a reasonable time after the buyer discovers or should have discovered the grounds for it and before any substantial change in condition of the goods which is not caused by their own defects. It is not effective until the buyer notifies the seller of it. (3) A buyer who so revokes has the same rights and duties with regard to the goods involved as if he had rejected them.
About the Author(s)
Stephen J. Baumgartner, MSc (Econ), strategy at the Graziadio School of Business and Management and consults at the Encino, California, law firm of Greenberg & Bass, LLP. As a strategic planning and financial analysis specialist, he has extensive expertise in litigation support, forensic analysis, financial modeling, debt restructuring, reorganization plan preparation, new venture start-ups, and project management. Baumgartner has more than 20 years of experience in finance, information systems, manufacturing, real estate, and management in firms including Xerox and Rand.