Evolving Liability for Electronic Component Distributors and Manufacturers

Howard A. Miller
L/B/W Insurance & Financial Services

In an effort to protect customers and end users, leadership in the electronic component industry has evolved from putting parts into the supply chain to determining if those components belong in the supply chain or whether they meet correct specifications. From an insurance and legal perspective this has expanded liability exposure for both distributors and manufacturers. As organizations evolve and grow, it is important to note that the risk management process is cyclical in nature. The first and most important step in the risk management process is identification. Taking the time to consider how your organizations operations have changed and where you’re headed needs to be reviewed at certain intervals. Failure to identify emerging exposures can lead to surprise lawsuits, finding out you are not covered by your insurance program and ultimately a financial loss that can destroy your organization.

Professional Exposures

Professionals are held to a higher standard and expected to have advanced knowledge beyond the general public. An error or negligence on the part of the professional in providing services or products can result in lawsuit by a third party for whom reliance upon this expertise causes actual or alleged financial damages. The standard of care involved in providing professional expertise is litigated in courts all over the country and is not limited to medical malpractice or insurance. With the reliance upon technology and the amount of money involved in maintaining continuity of operations even IT service providers and software developers can be sued. A failure to configure a network that causes a disruption of operations is an example. Failure to factor security into the software development life cycle can cause vulnerability in a software component to be used as a source of unauthorized access to confidential data from an organizations network.

Q: Can an organization be sued over an error, omission or negligence in testing electronic components or failure of their technology products perform the function or service intended?

A: Yes.

Electronic Component Distributors and Manufacturers

If an insurance agent is approached to provide ten million dollars in product liability they might provide the customer an insurance company that is recognized in the industry and a premium for the policy. Next step - do you want to buy the policy? What if the agent said something like this: I thought you should know the general liability policy does not have a duty to defend against a suit for bodily injury or property damage for which the insurance does is not apply. Product failure does not always show visible resultant physical damage and a product failure may not have caused anyone to get physically injured. The general liability policy is a named peril policy that is triggered by actual or alleged bodily injury or physical damage to tangible property. If you are concerned about a failed part causing a product recall from the company that incorporated your components or finding out materials involved in the manufacturing process did not meet specifications, you could be facing a lawsuit that is not covered under your general liability policy. Should we look at expanding your insurance program? We now are going from insurance sales to insurance consulting. Does this sound similar to your company as you provide increasingly sophisticated testing, meeting professional standards or collaboration with your clients involved in electronic manufacturing? Providing value can go beyond price and product into professional exposures.

Let's look at some examples discussed at the recent ERAI Executive Conference 2015.

Example 1 - Failure/Counterfeit Parts

Capacitors are sourced from Asia for a client in the communications industry. The parts are tested by both the distributor and in independent testing lab and the parts are delivered to the client. After the end use product is put in the field, it fails and needs to be recalled and repaired. A demand for damages includes the cost to recall, labor, replacement parts and possible loss of future orders amounting to $500,000 in damages for a $50,000 order.

How is your organization protected from a legal standpoint? How would your insurance respond? What if this demand for damages did not materialize for years after the transaction was completed? Note the exclusion on the general liability policy for damage to impaired property or property that is not physically injured.

Example 2 - Used parts sold as new

A distributor represents to a customer that the semiconductors being sold are new when they are, in fact, refurbished. The distributor also represents that it has tested these alleged new parts and they passed testing and inspection. The customer starts to incorporate the refurbished parts into the end product and the end product starts to fail.

What kind of potential liability will the distributor face? Even if the distributor holds insurance, will it be covered against these claims? Note damages could include lost business opportunity. An offshore manufacturer could cause the bulk of responsibility to fall on the domestic distributor. Specialized legal advice is required. What if this is deliberate act by fraudulent salesperson? Language in the insurance policy that provides severability can be important. The differentiation of the payment for the legal defense of a rouge employee pushing bad parts from the company and executives who had no knowledge of the deceptive sale would illustrate this.

Example 3 - Distributor acquires parts from its supplier which turn out to be mismarked

A distributor procures parts from its supplier which it claims to be new and from an authorized distributor. The parts are then sold to another distributor who then sells them to an end user who, during the process of incorporating them into their product, discovers that the parts are mismarked and causing their product to fail.

What kind of potential liability does the distributor have and what kind of claims can the distributor make against its supplier, the chip manufacture and the parties along the supply chain? Determining where you stand from a contractual basis and if you have the correct insurance to back you up financially can be critical in dealing with this type of claim. If the distributor carries insurance, how can the distributor use its insurance coverage to protect themselves from these various claims that it might be asserted against them? Some good long term advice would be to factor the cost of insurance into the cost of your goods and services. Showing a potential customer that you are serious about quality control and service is important. Showing you are backed by an insurance limit as a financial backstop to cover a potential loss described in these examples goes beyond general liability including standard product liability. I believe there are cases where a company is asked to provide a certificate of insurance naming them as additional insured on a general liability policy without realizing they will have no protection under that policy for these types of claims. Whether you are subcontracting out work or providing services and products, correct liability insurance can give piece of mind.

Example 4 - Manufacturer incorporates materials that do not meet specification

A component manufacturer provides parts for a large computer manufacturer. Despite rigorous quality control by both entities, a problem with the computers is discovered after thousands of products have been sold. The root cause of the problem is determined to be the components.

The computer manufacturer seeks payment from the electronics components manufacturer, to replace faulty components, and alleges additional financial injury from damage to their reputation, as evidenced by lost sales. Could damages include the cost incurred to rework, repair or recall product? What about damages for lost income or extra expenses incurred in implementing a work-around or in expediting repairs?

Manufacturing companies that engage in the following activities are at risk and should consider their risk control and insurance:
  • Manufacturing, assembly or installation based on customer specifications
  • Providing design work
  • Selecting raw material for others
  • Providing services, advice or instruction to others for a fee
  • Subcontracting work to third parties
I hope this article helps to illustrate evolving liability risks how putting together the right insurance program and the correct team of expertise provides a significant upside when you look to minimize financial loss over the long term. I welcome any questions/comments and look forward to addressing other areas of risk such as cyber liability, supply chain exposures, trade credit and continuity exposures.

Special thanks to Keith Gregory from Snell & Wilmer for input.

Howard A. Miller, CRM, CIC
Vice President
Director of Tech Secure® Division
L/B/W Insurance & Financial Services, Inc.