August 2, 2005

Warranty Laws:

Though the federal government has been quiet, there are plenty of laws and regulations governing product warranties and service contracts at the state level.


Once upon a time, a reader asked what was the difference between a full and a limited warranty. That one was easy. A full warranty is, well, full, while a limited warranty is -- you guessed it -- limited. A lawyer would probably come up with a more comprehensive definition, but then again we're not lawyers.

Sometimes, however, the urge is strong to act like one, such as when a reader asks for an overview of warranty laws. While we can't document all the nuances of warranty law at the U.S. federal, state, and international level, we can provide a quick high-level tour of the landscape. And again, we're not lawyers, and nothing we say should be construed as providing legal advice.

To non-lawyers like us, there are four basic types of warranties. There are express warranties, which are overtly written or spoken, and there are implied warranties, which are not. The most important forms of the latter are the implied warranty of merchantability and the implied warranty of fitness for a particular purpose. Most of what would be called basic warranties or product warranties or manufacturer's warranties are of the express type.

There are two other types of warranties that need to be mentioned in brief. One is the statutory warranty, which is usually an express warranty of a certain duration as required by law. For instance, the European Union under the authority of Directive 1999/44/EC now mandates that all consumer products sold as new be covered by two-year warranties (or what they call guarantees of conformity). Such a law does not prohibit three-year express warranties, but it would prohibit one-year warranties. Or more precisely, within the 25 EU nations all express warranties with durations under two years would automatically be extended to equal the statutory EU minimum. Used products sold by professionals must be covered by statutory one-year warranties, but products sold at public auction need not be covered at all. Dr. Ekkehard Helmig wrote about this in detail in a June 29, 2004 Warranty Week article.

In the U.S., statutory warranties are seen most often with passenger cars (e.g. Lemon Laws), where the states typically set a minimum duration for used car warranties designed to prevent the sale of clunkers that can't make it over their first hill. Statutory warranties also are now seen with the emissions equipment on both new and used vehicles (e.g. Environmental Protection Agency laws). Some states with particularly bad air pollution problems mandate even more stringent "super warranties" on emissions equipment than does the EPA. Some of these "super warranties" extend to 15 years and pass from one owner to the next -- effectively ensuring that certain emissions-related repairs are always free to the consumer for the life of the vehicle.

"Voluntary" Minimums

In addition, a new crop of somewhat statutory yet somewhat voluntary warranties are cropping up for other products in the name of energy efficiency. For instance, the U.S. Dept. of Energy and EPA now require two-year warranties on fluorescent lamps and one-year warranties on ventilating fans before they can be called energy-efficient. Technically, the sought-after "Energy Star" label is voluntary, and so adherence to these statutory minimums is voluntary as well. But its requirements illustrate how government can leverage the high correlation between warranty and product quality. Manufacturers of shoddy merchandise could never afford the cost of servicing two-year warranties. Therefore, shoddy products are unlikely to carry the Energy Star seal of approval.

The fourth type of warranty may not even be a warranty. What some merchants call extended warranties are called service contracts by others. Almost nobody wants to call them insurance policies, but basically they are contracts that exchange the payment of a premium for the assumption of the risk that a product will need to be repaired. If the product never needs repairs, the seller of the contract books the premiums as revenue. In some cases, the reward for no claims is a partial refund. But if the product does require a repair, the seller must assume the cost.

If only it were so simple. Some extended warranties, and indeed some basic product warranties, provide different durations for coverage of parts and labor. The cost of replacement parts may be covered for a year, while labor may be covered only for 90 days. Or labor may not be covered at all. With some plans, shipping costs in one direction or in both directions must be paid by the consumer. Used cars are sometimes covered by so-called 50/50 warranties, which allegedly split the cost of repairs between the buyer and the seller. The bottom line is that the law allows the seller a great deal of latitude when setting the terms and conditions of a warranty policy.

What are commonly called home warranties are service contracts that cover the major appliances typically found in a home. But some policies require the payment by the homeowner of a $45 service fee per claim, or they include a set deductible per occurrence. In some states, they're called home service agreements. In others, they're called home protection insurance policies. Some policies aren't insurance at all -- they promise only to help a homeowner find a reputable repairman, or to help them buy replacement products at a discount.

However, this is an article about warranty law -- not the many shapes and sizes that the terms and conditions of a warranty can assume. So let's look closer at just the laws that surround the promise made by the seller and/or the manufacturer that a product is free from defects.

Implied Warranties

The implied warranty of merchantability is basically a guarantee made by the seller that the products they sell are fit to be sold. If they sell a washing machine, they must guarantee that the machine can wash clothes. If they sell a television, they must guarantee that the unit will receive and display television images. And so on.

What's important to remember is that this implied warranty applies only in cases where a merchant is selling a product that they are normally in the business of selling. So if an appliance merchant sells a delivery truck, and they do not regularly trade in delivery trucks, the law would not automatically treat them like a used car dealer. They would face the same laws in regards to the sale of the delivery truck as would any private individual.

The implied warranty of fitness for a particular purpose is a guarantee the merchant makes at the time of sale that a product can do what is expected of it. This is more subjective and qualitative than the implied warranty of merchantability, but they do overlap to some extent. For instance, if a washing machine is described as being "heavy duty," or more specifically as "large capacity," it must live up to those attributes, especially if the buyer relied upon those attributes to make their selection.

Unlike an express warranty, an implied warranty normally has no set duration. This is because an implied warranty is designed to protect buyers more from fraud or unscrupulous sales practices at the outset than from poorly-designed or defective products down the road. The old warranty joke was that if the used car you just bought broke in half on the way home, you would own both pieces. Nowadays, an implied warranty of merchantability would protect against that kind of problem. But it would be no help if the car failed after months or years of normal use.

Most states allow a merchant to sell products "as is" or "with all faults," as long as they inform the buyer of this policy in writing. In such a case, the "as is" buyer would indeed own both halves of the useless car, because there would be no implied warranty of merchantability. However, some states simply do not allow a merchant to disclaim these implied warranties, even if they try to do so in writing. Some states have outlawed only "as is" sales of vehicles, and some states have gone a step further by requiring statutory warranties on used cars. In Massachusetts, for instance, dealers must cover used cars sold for $700 or more with 80,000 to 125,000 miles on them at the time of sale with a 30-day/1,250-mile warranty. Used cars with less mileage are covered for up to 90 days or 3,750 miles.

Finally, implied warranties apply to many types of products that are rarely if ever covered by an express warranty. For instance, a restaurant is bound by an implied warranty that its food is edible. It may not be delicious, but it must not be poisonous. A filling station cannot pump gasoline and call it diesel fuel. Even a Web site is bound by an implied warranty that the information it publishes is true. It's always amusing to see a publisher who claim their articles are provided "as is," but in this era of fake news and retractions, perhaps the best policy is to let the buyer beware.

Lemon Laws

There is a very good summary of the Lemon Laws of the 50 states online at http://www.autosafety.org/lemonlaws.php so we won't spend a great deal of time detailing all the variations. But in the opinion of the Center for Auto Safety, California, New Jersey, and Ohio have some of the strongest lemon laws in the country, while Colorado, North Dakota, and Illinois have the weakest. Click on the state name for explanations of their rankings.

Most states use some time- or mileage-based refund formula to compensate the seller for the return of vehicles that have been driven between repairs. Some states require binding arbitration, and others allow lawsuits but require the loser to pay the winner's attorney fees. All specify some minimum threshold for what constitutes a lemon, defined by the number of repair attempts or the number of days out of service. All cover at least passenger cars, and some also cover motorcycles and recreational vehicles. Few cover farm vehicles, trucks, or other commercial or off-road vehicles, although that is changing state by state.

In addition, some statutes outlaw "as is" sales of passenger cars, although only by dealers (private individuals may still sell vehicles without warranties). Some states define anyone selling four or more vehicles in a year as a dealer, thus preventing so-called "curbstoners" from avoiding warranty laws. Other states outlaw 50/50 warranties on used cars for some initial period (forcing the dealer to pay 100%) and still others require sellers and/or manufacturers to inform all buyers when an express warranty is lengthened or strengthened, as is commonly done during a service action or product recall (and with so-called "secret" warranties).

The Center for Auto Safety's state-by-state guide referenced above was last updated in 2003. Since then, the case law regarding warranties on leased vehicles has changed significantly in states such as Wisconsin and New Jersey. In other states, the lemon laws have been completely rewritten. For instance, in California, the Governor recently signed the Car Buyer's Bill of Rights, which takes effect on July 1, 2006.

Most intriguingly, the new California law will allow consumers to return a car valued at less than $40,000 within two days for a full refund, but it also allows car dealers to charge a fee of up to $400 for the privilege. Consumers must not have driven the vehicle more than 250 miles, and they must sign up for the right of return before driving the car off the lot. The law also prohibits dealers from using the tag "certified" when reselling cars bought back under lemon law provisions. And it prohibits dealers from bundling the cost of an extended warranty into the monthly loan premium, in an effort to conceal its true cost. But California already had some of the strictest laws governing the sale of extended warranties, so not much else was changed.

Outside of motor vehicles, lemon laws are less common but not unknown. Again, California is setting the pace. The state's Song-Beverly Consumer Warranty Act outlines mandatory return and refund policies for appliances, electronics, and even hearing aids and wheelchairs. California's current Lemon Law is actually a section within this act, formally known as the Tanner Consumer Protection Act.

Service contracts are further regulated by a section of the state's Business and Professions Code. Section 1718 of the state's Civil Code regulates warranty work done by farm machinery repair shops. Section 1723 outlines a retailer's disclosure requirements for returns and exchanges. In fact, California's Bureau of Electronic and Appliance Repair requires all service contract administrator and sellers, as well as repair firms, to register themselves before conducting business in the state.

Most other states do not have separate lemon laws for appliances, computers, or electronics, but like California they all have laws regarding deceptive trade practices, fraud, grand theft, etc. States such as Pennsylvania have tried to pass lemon laws for computers, but they never get too far. A possible template for bringing a successful lemon-like action against an appliance, computer, or electronics manufacturer or retailer in a state without a non-auto lemon law can probably be found in states that currently have only weak auto lemon laws. In those states, consumers usually disregard the provisions of the weak lemon law and instead file suit demanding a refund or replacement under the Uniform Commercial Code, which governs contracts in general. But those who use the UCC in this fashion will quickly discover that there's no accepted standard for what constitutes a lemon when it comes to a PC, a washing machine, or a television.

Extended Warranties

For sellers of extended warranties, there are two aspects of law that need to be considered. First, of course, is the degree of regulation in a certain state for a certain product. As attorney Timothy Meenan detailed so eloquently at the Warranty Chain Management conference in March, some states have different laws for home warranties, vehicle service contracts, and other types of extended warranties. Some states always treat extended warranties as insurance, though most provide for some alternative to this type of usually heavy regulation. For instance, if the seller maintains a certain level of reserves or follows certain guidelines regarding underwriting, state regulators will not consider the contracts to be insurance.

Sellers who do not comply with these minimums would therefore be considered to be selling insurance. And if they're not complying with these minimums, they're unlikely to be complying with the state's regulations regarding the sale of insurance. Therefore, they may be subject to civil and/or criminal penalties regarding the sale of insurance without a license. Usually, state attorneys general bring these actions to either close down a rogue business or to force compliance from a sloppy merchant.

What's more common is to see local prosecutors pursue merchants for pocketing the premiums they collect through the sale of extended warranties. For instance, an auto dealer might collect $1,000 from a customer on behalf of an extended warranty administrator, but he never passes any of the money to that administrator. Therefore, there's no policy. The dealer could assuage victimized customers by quietly arranging to cover the cost of repairs as they arise, but inevitably somebody complains and a fraud case results.

The point is, no new laws are required to prosecute cases where a dealer pockets extended warranty premiums. It would not be fraudulent for a dealer to sell self-insured policies good only at their facility. It's also not fraudulent for the seller to "split" the cost of repairs, as is common with 50/50 warranties. And in most states it would not be fraudulent for the seller to pay as they go, making no provision for reserves at the time of sale (however, some states require either reserves or insurance, or both). It would not be wise to sell such poorly-backed service contracts, but it would not be criminal. It only crosses over to fraud or theft when the dealer states they are selling a reputable policy and instead pockets the premiums.

Numerous auto dealers have been prosecuted, including Arnold Dreier Sr. of North 95 Auto Sales in Ponderay, Idaho; Lance Swalve of Kneips of Watertown and Kneips GMC of Arlington, South Dakota; and Jeffrey Star and Joe Demarco of the Alpine Auto Group in Illinois. And it's not just auto dealers. In 2004, roofer Joseph Perry of Pottstown, Pennsylvania was charged with numerous felony counts of theft by deception related to extended warranties he sold but did not honor.

Sometimes it's more expedient to go after a company for selling insurance without a license. In one recent case, the Attorney General in Ohio went after an extended warranty company for telemarketing without first having registered with his office. The Attorney General in Texas went after an extended warranty company for sending spam email. Other companies are prosecuted for deceptive advertising or some other seemingly non-warranty-related infraction. But the end result is always the same: their operations cease.

In last week's newsletter, we included a list of links to the complaint forms used by state attorneys general, consumer protection agencies, and departments of insurance. After complaining to the merchant and/or manufacturer, filing such a formal is always a good second step. But in most of the examples cited above, the matter at hand has less to do with whether a given claim is valid and more to do with what ordinary people would consider to be fraud.

Then again, there's always that gray area where administrators avoid paying valid claims by doing their best to make sure no claim is ever valid. The world's expert practitioners of this art are the providers of carpet and furniture rip and stain extended warranties. The fine print in their terms and conditions typically mandates that all warranty claims be made within a specified period, and that all stains be reported individually. Report two stains at once, or report either of them a day past the deadline, and the claim will be denied. Some require periodic follow-up treatments of the surface with the company's own chemicals for the policy to remain in effect. Some overtly exclude stains caused by pets or by certain types of food (such as those known to cause stains). Also, all damage considered to be normal wear and tear is not covered, nor are rips that occur on seams or edges. If all else fails, they can say the product was damaged by improper cleaning methods, because the consumer might have tried using a sponge without calling them first.

Another area of law that affects extended warranties is the collection of sales taxes. But there is no consensus. Some states do and some states don't collect sales tax on the sale of extended warranties. Some states collect sales tax on auto repair bills, but not when the manufacturer is picking up the tab under warranty. Some states that didn't charge sales tax on warranty work recently began to, in an effort to reduce their budget deficits. Interestingly, they bundled these new taxes with increases in tobacco, liquor, and even adult entertainment taxes, so the headline-writers inevitably zeroed in on the "sin tax" angle and buried the warranty news.

Federal Law

The extent of U.S. laws at the federal level as they relate to warranties virtually begin and end with the Magnuson-Moss Warranty Act. The law, passed in 1975, does not actually require retailers or manufacturers to provide express warranties. But it does regulate the disclosure of the terms of written warranties if a retailer or manufacturer decides to provide them.

There are four basic requirements. First, the Act requires all providers of warranties for products selling for $10 or more to describe their warranties as either full or limited. Since the vast majority of warranties are limited in duration or some other aspect, this requirement is the easiest with which to comply. Second, the Act requires a written warranty on a consumer product that costs $15 or more to be clear, easy to read, and contain certain specified items of information about its coverage, such as what is and isn't covered, and how long the coverage lasts. Third, the Act requires that written warranties on consumer products costing $15 or more be available to consumers before they buy. This rule applies whether the retailer operates a storefront, a mail order catalog, or a Web site. And fourth, a consumer must not be required to buy an item or service from a particular company to use with the warranted product in order to be eligible to receive a remedy under the warranty, for instance requiring the use of a certain brand of vacuum bags.

In practice, compliance with the requirement to make copies of written warranties "available" can vary all the way from placing the entire text of the policy a mere click away from a product's spec sheet to inviting the consumer to send in a stamped, self-addressed envelope and wait a few weeks. A few Christmas seasons ago in November 2002, the Federal Trade Commission announced the results of a survey of 23 major Web commerce sites, in which 14 were found to not be in compliance with the disclosure section of the Act. So what happened? Each non-compliant Webmaster received a stern letter from the FTC's Bureau of Consumer Protection informing them of the disclosure rules. And the FTC hasn't used the phrase Magnuson-Moss Warranty Act in a press release since January 2003. Therefore, we can only assume that everybody is now in full compliance with the Act.

There have been other warranty-related enforcement efforts at the federal level. For instance, the U.S. Dept. of Justice and the FTC recently prosecuted KB Home for violating a 1979 consent decree, specifically over its alleged non-adherence to a stipulation that it would not require homeowners to submit to binding arbitration. The FTC made no judgment about whether the practice of binding arbitration is an acceptable industry practice. It simply noted that KB Home agreed to end the practice and did not. That case cost the company $2 million.

In general, however, whether it's product-related, insurance-related, or accounting-related warranty laws, most of the recent action has been at the state level. Take the current prosecution of the American International Group (AIG) by the Attorney General of New York as a template. There are at least two and maybe more federal agencies that should have been there first. Although insurance-related regulation is usually left up to the states, allegedly cooking the books to conceal extended warranty losses could have been dealt with at the federal level.

Accounting Law

National accounting laws also are rather silent when it comes to warranty. In late 2002, following the Enron, Tyco, and WorldCom scandals, the Financial Accounting Standards Board adopted Interpretation Number 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." Basically, FIN 45 requires companies to recognize a liability for the fair value of a guarantee they might make of stock prices, leases, loans, etc. A guarantor also is required to disclose the terms of the guarantee, how it arose, how it is collateralized, and the events or circumstances that would require the guarantor to perform under the guarantee, plus the maximum potential amount of future payments under the guarantee.

Of course none of this applies directly to either product warranties or extended warranties. Yet those are quite obviously two different types of guarantees. However, it would make no sense for warranty issuers to calculate the maximum potential amount of future payments, because this would involve the highly hypothetical assumption that every product turns out to be defective and is returned for a full refund. Instead, FASB mandates that for warranty the issuer of a guarantee must disclose how they finance claims, and if they use a warranty reserve and accrual method, how they calculate the appropriate amount to accrue. FIN 45 also requires manufacturers to disclose the opening and closing balances of that reserve fund, as well as the net amount of additions, subtractions, and other adjustments.

We're paraphrasing here, but we're really not leaving out much. In its entirety, less than a page of FIN 45 is taken up by warranty-related text:

    14. For product warranties ... a guarantor is not required to disclose the maximum potential amount of future payments specified in paragraph 13(d) above. Instead, the guarantor is required to disclose for those product warranties the following information:

      a. The guarantor's accounting policy and methodology used in determining its liability for product warranties (including any liability [such as deferred revenue] associated with extended warranties).

      b. A tabular reconciliation of the charges in the guarantor's aggregate product warranty liability for the reporting period. That reconciliation should present the beginning balance of the aggregate product warranty liability, the aggregate reductions in that liability for payments made (in cash or in kind) under the warranty, the aggregate changes in the liability for accruals related to product warranties issued during the reporting period, the aggregate changes in the liability for accruals related to preexisting warranties (including adjustments related to changes in estimates), and the ending balance of the aggregate product warranty liability.

There really isn't much more to it. To date, FASB has not defined or listed the components of a warranty claim, so one company can theoretically count different components than another. A group of manufacturers who first met at the Warranty Chain Management conference in March have launched an informal effort to detail exactly what is and what isn't a warranty cost component. In addition, the Automotive Industry Action Group may define the components of at least an automotive warranty claim as part of their Early Warning Standards initiative. But as far as we know, nobody is writing either a law or a binding regulation in this regard.

In another 1990 publication called Technical Bulletin No. 90-1, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts," FASB outlined how revenue from the sale of service contracts must be deferred and recognized gradually over the life of the contract. But it too was silent about how much should be set aside to fund future claims.

There are numerous technically prohibited ways to manipulate warranty accruals to a manufacturer's benefit. For instance, a manufacturer could over-accrue when sales are good and under-accrue when sales are slow. Or, they could suddenly "discover" that product quality has recently soared and that it's safe to reduce the balance in the warranty reserve fund. This would have the effect of shifting earnings from the good times to the bad. And it turns the warranty reserve into a kind of rainy day fund to be manipulated so a company can "make its numbers."

Just try to catch a company doing it, however, and try to prove beyond a reasonable doubt that they knew what they were doing when they did it. Unless the chief executive brags about manipulating earnings on CNBC or documents how he did it in an email that later falls into the hands of prosecutors, it's difficult to make the case. Since nobody in authority has defined the appropriate amount of reserves to maintain for a given product with warranties of a given duration, a company has quite a bit of discretion in this regard.





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