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Dissatisfaction Guaranteed? The Legal Issues of
Extended Warranties Explored
Christian Twigg-Flesner
LL.B.,
Ph.D.(*)
Lecturer in Law, Institute for Commercial Law Studies,
University of Sheffield
Copyright © Christian Twigg-Flesner 2002
First Published in Web Journal of Current Legal
Issues
Summary
In early July 2002, the Office of Fair Trading (OFT) published its latest
report on extended warranties. On previous occasions (OFT 1994; 1996), it had
concluded that there was a lack of transparency in the pricing of extended warranties,
and that retailers had often adopted pressure selling techniques to persuade
consumers to buy them. In response, the British Retail Consortium (BRC) adopted
a Code of Practice on the sale of extended warranties. However, the OFT had
become concerned about the monitoring of this code and conducted a ’mystery
shopping’ exercise. The results suggested that there were a significant
number of instances of non-compliance with the BRC code, and a full investigation
was launched by the OFT’s new Market Investigations Division. This considered
not only problems for consumers, but also the lack of competition in the sale
of extended warranties. Its findings suggest a significant lack of competition.
In order to get a more detailed picture, the Director-General of Fair Trading
(DGFT) has asked the Competition Commission (CC) to carry out a monopoly investigation
under the Fair Trading Act 1973 (FTA)
(1).
The purpose of this article is to examine the issues raised in the OFT’s
report and to examine the legal and other issues of extended warranties (particularly
those given on domestic electrical appliances). It will also consider how
some of the problems could be remedied if the CC decides that there is a public
interest problem in this sphere. There will first be an examination of extended
warranties and why these may be attractive for consumers. This will be followed
by an analysis of the relationship between extended warranties, manufacturers’
guarantees and the statutory rights of consumers under the Sale of Goods Act
1979. There will then be a consideration of the competition and consumer protection
problems identified by the OFT. The final part will speculate as to the potential
responses to the CC’s report into extended warranties.
Contents
- What are extended warranties?
Why do consumers buy extended warranties?
Are extended warranties necessary?
-
Extent of protection under the Sale of Goods Act 1979
Extent of protection under a manufacturer’s guarantee
-
Alternatives to Extended Warranties
Competition Problems and Extended Warranties
-
Insufficient competition on extended warranties
High cost of Extended Warranties
-
Consumer Protection Problems and Extended Warranties
-
Selling techniques for extended warranties
Terms and Conditions of Extended Warranties
Premiums, Insolvency and Insurance Regulation
-
Next Steps: The Competition Commission Inquiry and Potential Developments
-
Consumer Protection Act: S.26 Order
Other Possibilities
-
Conclusions
Bibliography
What are extended warranties?
An extended warranty is a contract which is purchased by
a consumer and which offers protection in case the product(s) covered by the
warranty break down. Usually, coverage extends beyond defects that existed at
the time the product was supplied to the consumer to include defects that may
arise during the lifetime of the product, such as accidental damage or
break-down due to wear and tear. These are not manufacturing defects and
therefore not normally covered by the manufacturers’ guarantee, nor by the
buyer’s statutory
rights
(2).
Between one-fifth and one-third of all purchasers of electrical goods take out
an extended warranty (OFT, 1994). Extended warranties are more often purchased
when the product is expensive and an irregular purchase (Kelley, Conant and
Brown, 1988). An important aspect of such warranties is that they are generally
deferred, in that they only take effect after the free manufacturer’s
guarantee has expired. Many warranties are therefore misleadingly described as
“three-year’ or ‘five-year’ extended warranties, because
they do not take effect immediately after purchase and therefore only cover two
or four years.
There are four classes of providers of extended
warranties: retailers, manufacturers, specialist extended warranty providers and
credit card companies (for products purchased with their cards). This
multiplicity of providers may confuse consumers. This is especially so in
circumstances where they pay for a product by credit card and are persuaded to
purchase an extended warranty from a retailer. The credit card company may
already offer an extended
warranty
(3).
Furthermore, the OFT (2002) distinguishes between breakdown insurance cover and
service contracts, both of which are described as extended warranties. Most
extended warranties are underwritten by an insurance company, but not all. The
recent failure of the Tempo chain of stores illustrates the problems that may
arise in the case of extended warranties which are not backed by insurance. In
this instance, customers were left without protection after Tempo had gone into
liquidation and, in effect, had to pay twice for repairs (see
Which?,
January 2002, p.5). This issue will be considered in more detail
below.
Top | Contents | Bibliography
Why do consumers buy extended
warranties?
A retailer who offers an extended warranty is sending
mixed messages to a consumer. On the one hand, the provision of extended
warranties may suggest that a particular business is committed to after-sales
service (Kelley, Conant and Brown, 1988). On the other, some consumers may lose
confidence in a product they have chosen if an extended warranty is offered to
them just before completing their purchase (Voss and Ahmed, 1992). Offering an
extended warranty may, in fact, create a bad product image in that it might
suggests a greater chance of the product breaking down soon after purchase
(Kelley, Conant and Brown, 1988). Although retailers generally seem to play on
the risk of product breakdown, the OFT noted that no mention is made of the
difference in reliability between different brands (OFT 2002, para
4.10).
The latest OFT report indicates that 4 per cent of
consumers bought extended warranties because they thought it was a ‘good
idea’, and a further 37 per cent did so for ‘peace of mind’.
It seems that consumers buy extended warranties in order to minimise three types
of risk. First, there is the performance risk - will the product work? It has
been suggested that some consumers are unduly pessimistic about the standard of
reliability they can expect from a new product (OFT, 1994). In such
circumstances, an extended warranty might provide a form of reassurance, to
boost consumer confidence. This might explain the high volume of sales recorded
in 1994 of 5 million extended warranties with a market value of £650
million (OFT, 1994). More recent figures suggest that the market could now be
worth more than £1
billion
(4),
although the OFT (2002) puts the figure more cautiously at ‘well over
£500 million per year’ (para 3.3).The difficulty for consumers is
that they do not have ready access to data on product reliability or repair
costs (para 4.15). Such information can be obtained e.g., through reports
published by the Consumers’ Association, but these are not accessible to
the vast majority of consumers, either. Consumers may therefore be looking to
the retailer to provide such information, but retailers may be unwilling to
provide all the information they have because being aware of the small
likelihood of a product breakdown may dissuade consumers from purchasing
additional protection.
Second, there is the financial risk - how much will it
cost to repair the product if it does not work? A consumer may believe that the
price of an extended warranty will be lower than the cost of potential repairs
and will therefore opt to buy such a warranty. He will have to balance the
potential expenditure on repair over the period covered by the extended warranty
with the cost of the extended warranty. Consumers who are risk averse are likely
to buy an extended warranty (OFT, 1994). Some consumers may previously have
encountered a product failure and may buy an extended warranty to minimise the
potential cost of a further breakdown (Voss and Ahmed, 1992). Others might
purchase an extended warranty because they anticipate that they will subject the
product to heavy use which increases the likelihood of it breaking down
(Padmanabhan, 1995). Moreover, if a product is used frequently by a number of
different users, it might make more sense from the consumer’s perspective
to acquire an extended warranty. In contrast, if only the consumer himself will
use the product, he may decide that by taking adequate care, he can avoid
product breakdowns and thus not need an extended warranty. Those consumers who
believe they will need to rely on an extended warranty have the greatest
incentive to buy it. This is known as ‘adverse selection’ (cf.
Holdych and Mann, 1996, p.797). Consumers who expect a product to break down
because of the way they use it are more likely to take advantage of the extended
warranty if this will protect them against the financial consequences of a
product breakdown.
The third factor is the potential effort that may be
required to effect repairs when the product fails. Extended warranties may help
because the warranty provider will have put in place a mechanism for ensuring
the speedy repair of the product. Consumers may prefer this to having to arrange
for repairs
themselves
(5).
These seem to be the most significant factors that
influence consumers in deciding whether to take out an extended warranty.
However, consumers are already protected against many (although not all) types
of product failure under the Sale of Goods Act 1979 and under any voluntarily
given manufacturers’ and retailers’ guarantees. Furthermore, many
household insurance policies provide some protection against the cost of
repairing faulty items. The desire of consumers to buy extended warranties may
therefore be based on a limited understanding of their existing protection. The
OFT can be criticised for not considering this point in any detail in its
report. The following part will consider the relationship between
consumers’ legal rights and the additional protection offered by extended
warranties.
Top | Contents | Bibliography
Are extended warranties necessary?
The OFT accepts that there are consumers who want to buy
extended warranties, but it does not consider whether consumers should need to
buy extended warranties in the first place:
This investigation does not seek to question the underlying
rationale for extended warranties as a whole. We recognise that many consumers
value the reassurance that they can bring. Our objective was to examine whether
the market is working well for consumers. (OFT, 2002, para
2.6).
The OFT’s assumption therefore is that there is
demand for extended warranties. However, it may be dangerous to make such an
assumption without investigating the underlying causes of consumer demand for
extended warranties. The OFT accepts that consumers buy extended warranties to
get peace of mind, but it does not consider if consumers really need to
buy additional protection. Consumers already enjoy a significant degree of
‘free’ protection, both under the Sale of Goods Act 1979 (SoGA) and
under free guarantees offered by manufacturers. This section will examine the
relationship between the rights under the SoGA, free guarantees and extended
warranties. It will become apparent that extended warranties can be useful, but
probably only for particular categories of consumers. However, these consumers
do not seem to be the main purchasers of extended warranties in practice. The
OFT has failed to identify this mismatch.
Extent of protection under the Sale of Goods Act
1979
The SoGA requires that goods sold by a seller to a
consumer should be of satisfactory quality (the term implied by s.14(2)), and
makes available a range of remedies if goods do not meet this standard (see
Twigg-Flesner and Bradgate, 2000). Compliance with this term is ascertained at
the time that risk passes from seller to consumer, which is usually at the time
of
sale
(6).
In order to assess whether a particular product is of satisfactory quality, it
is necessary to consider the description of the product, its price (if this is
relevant) and all the other relevant circumstances (s 14(2A)). S.14(2B) provides
a list of factors which may be ‘relevant circumstances’ in some
cases. One of these factors is ‘durability’. However, the Act does
not define ‘durability’ further. A useful explanation of what is
meant by ‘durability’ in a non-legal sense is provided by
Jarmin:
Durability [-] Often confused with reliability, this is how
long a product or specific components of the product endure when used both
normally and abnormally. It is about design and use of materials appropriate to
the application and use of the product (Jarmin, 1994,
p.60).
This can be contrasted with
‘reliability’:
Reliability...is the term used to describe the ability of a
product to continue to perform its function or simply to work. It relates to the
operating ‘mechanism’, whatever it may be. Typical mechanisms may be
mechanical, electrical or increasingly electronic to name but three.
(ibid.)
On this basis, a product would not be
‘reliable’ if it failed to perform the function it was designed to
perform, either on a permanent or on a temporary basis. The product would not be
‘durable’ if it required maintenance or repair on a very frequent
basis. For example, a washing machine which does not spin on some occasions may
be regarded as unreliable, whereas a washing machine which fails to work after a
few washes would not be durable. The distinction between these concepts should
not be overstated, although it is nevertheless important to appreciate that they
are not identical.
Although these explanations do not interpret the meaning
of ‘durability’ for the purposes of s.14, they may nevertheless be
of assistance. In the context of the ‘satisfactory quality’ test, an
important factor in considering the durability criterion could be whether a
particular product has ‘endured’ sufficiently. The SoGA does not
require that products have to be durable for a specific period of time. It would
be impossible to specify a suitable period in a statutory standard. Rather, the
durability of a particular product in relation to the durability to be expected
of the type of product generally is considered. For example, it is common for
washing machines to work without problems for five or six years (or even
longer). If a particular washing machine broke down after seven months of normal
use, it would seem probable that there was something wrong with it at the time
of sale. The consumer would therefore have a good chance of claiming
successfully that the washing machine is not of satisfactory
quality
(7).
It is difficult to say with certainty for how long a
particular product should perform without breaking down before durability is no
longer a relevant factor in applying the satisfactory quality test. For example,
in Thain v Anniesland Trade Centre ((1997) SLT 102, Sh Ct.), the court
suggested obiter that a new car could be expected to work trouble-free at
least for the duration of the manufacturer’s guarantee. Although this
comment was not made directly with reference to the durability criterion in
s.14(2B), it could be followed in a subsequent case. There are two points to be
made against this. First, referring to a manufacturer’s guarantee in
applying the satisfactory quality test could result in a reduction in
consumers’ rights. This is because the guarantee period is determined by
the manufacturer, and taking this into account would in effect operate as a
limitation of the scope of the satisfactory quality test. This contradicts the
general policy that consumers’ rights should not be limited or excluded
(see e.g., s.6 of the Unfair Contract Terms Act 1977). At best, it may be
possible to argue that there is a presumption that goods which fail before the
guarantee period has expired were not of satisfactory quality. Secondly, the
court’s suggestion seems to conflict with certain comments of Mustill LJ
in Rogers v Parish (Scarborough) Ltd ([1987] QB 933, CA). Here, the
claimants had bought a Range Rover which cost £14,000. This was defective
but the claimants agreed to a replacement vehicle. However, there were numerous
problems with the replacement car, and the claimants eventually sought to reject
the car and obtain a refund. One of the questions to be considered by the Court
of Appeal was whether the existence of a manufacturer’s guarantee was
relevant in considering whether there had been a breach of the term implied by
s.14(2). The crucial passage is this:
Can it really be right to say that the reasonable buyer would
expect less of his new Ranger Rover with a [guarantee] than without one? Surely
the [guarantee] is an addition to the buyer’s rights, not a subtraction
from them, and, it may be noted, only a circumscribed addition since it lasts
for a limited period and does not compensate the buyer for consequential loss
and inconvenience. If the defendants are right a buyer would be well advised to
leave his guarantee behind in the showroom. This cannot be what the
manufacturers and dealers intend or what their customers reasonably understand.
([1987] QB 933 at 945)
It would therefore be wrong to suggest that a product is
of satisfactory quality if it has not failed during the guarantee period, but
soon after, because this would have the effect of allowing the guarantee to
operate as a limitation clause. It would also conflict with Court of Appeal
authority. In any event,
Thain does not rule out that
‘durability’ would also be a relevant factor if a product failed
outside the guarantee period. Although there is no further guidance available
from court judgments (the scope of ‘durability’ in the context of
the satisfactory quality test has yet to be considered in detail by a higher
court), this must surely be the case. It was suggested above that the durability
factor is only then relevant where a particular product has broken down
significantly sooner than would ordinarily be expected of a product of the same
type
(8).
It may be possible to produce empirical evidence of the average time a product
will give trouble-free use before it is likely to develop a fault. Products
which fail at a point significantly before that average time would then not be
of satisfactory quality.
It is therefore apparent that consumers already enjoy
some protection against latent defects which existed at the time of sale and
caused a product to break down much sooner than could reasonably be expected.
There is, however, a practical difficulty. If a product breaks down soon after
purchase, it will be relatively easy to show that there was something wrong at
the time of delivery. However, the longer the period since delivery, the greater
the burden on the consumer to prove that the product was faulty when he got it.
A consumer may have to go to court and produce detailed evidence to convince a
judge that the product was not of satisfactory quality, and one may suspect that
few consumers will be able, or willing, to do so. An extended warranty would
obviate the need for having to prove this because as long as the product breaks
down during the warranty period, the provider will make available a remedy in
accordance with the terms of the warranty. In effect, an extended warranty could
provide an uncomplicated means of obtaining redress if a product has broken
down.
If a product is not of satisfactory quality, a consumer
is currently entitled to reject it and terminate the contract if he has not yet
‘accepted’ the product (s.11(4) SoGA). Additionally, he can claim
damages for non-delivery (s.51 SoGA). If he is deemed to have accepted the
product, he will only be entitled to bring a claim for damages. In consumer
cases, ‘acceptance’ is most likely to occur after a reasonable
period of time has lapsed. The length of this period will depend on the nature
and complexity of the goods (Bernstein v Pamsons Motors (Golders Green)
Ltd. ([1987] 2 All ER 220), although it is often likely to last for no more
than four to six weeks after sale. Damages are assessed on the basis of the
difference between the value of the goods at the time of delivery, and the value
the goods would have had, had they been in compliance with the implied terms
(s.53(3) SoGA). Usually, this will cover at least the cost of repairing the
product.
In contrast, extended warranties will often promise a
specific remedy of repair if a product covered by the warranty has broken down.
A replacement may be provided if the product cannot be repaired. In this
respect, extended warranties offer an additional benefit to consumers, because
they are given a contractual entitlement to demand repair. This is not something
currently available under the Sale of Goods Act. However, Directive 99/44/EC on
Consumer
Sales
(9)
will be implemented into UK law by the end of 2002. This requires,
inter
alia, the introduction of repair and replacement as remedies under domestic
sale of goods legislation. The current advantage offered by extended warranties
in this respect will therefore become less significant.
Top | Contents
| Bibliography
Extent of protection under a manufacturer’s
guarantee
The preceding discussion has also mentioned that there
may be a manufacturer’s guarantee available. Such guarantees are given
free of charge and promise that a product is free from defects in workmanship
and materials. Should a problem materialise within a specified period of time
after purchase, the guarantor usually undertakes to repair or replace the
product free of charge. An obvious advantage of such guarantees is that they
give consumers an alternative target if something has gone wrong. Under the
SoGA, only the final seller is
liable
(10).
As with the satisfactory quality test, the guarantee
only covers faults which existed at the time of sale. Most guarantees expressly
exclude faults which are the result of misuse by the consumer, accidental damage
or normal wear and tear. Moreover, guarantees are usually only given for a
period which is relatively short if compared to the potential service life of
the corresponding product. Although there can be little doubt that product
quality continues to improve, the most common guarantee period is still twelve
months. There are some products which come with longer guarantees, but these
tend to be products which are less complex and easier to maintain (a good
example being steel bedframes).
It has been suggested in the past that
manufacturer’s guarantees could be an indicator of product quality. In
giving a guarantee, a manufacturer may be viewed as ‘signalling’ to
a consumer that a product meets a certain level of quality (cf. Priest, 1981;
Willett, 1992; Agrawal et.al., 1996). One view is that the decision to offer a
guarantee signals general confidence in the product (Willett, 1992), but since
the giving of a manufacturers’ guarantee has now become common practice,
it would probably be an unwise commercial decision not to offer a guarantee. A
more interesting suggestion is that by offering a guarantee on terms which are
better than those of guarantees given on competing products (such as a longer
duration), a manufacturer may signal that his product is of higher quality than
competing products. The court’s view in Thain v Anniesland Trade
Centre (1997) that goods should perform without trouble at least during the
guarantee period seems to reflect the notion that a guarantee can be a signal of
quality. If this theory is correct, it may be expected that a product which will
give at least four or five years of trouble-free service is accompanied by a
four-year guarantee. Such longer, free guarantees would reduce the need for
additional, purchased protection in the form of an extended warranty.
However, this is usually not the case, and guarantees
tend to have a much shorter duration than the average life-span of the
corresponding product. A significant body of research has since identified
numerous factors that affect the signalling function of guarantees (see in
particular, Agrawal et.al., 1996; Wein, 2001). Moreover, if the guarantee is to
signal product quality to the consumer, it assumes that a consumer will (a) take
the guarantee into account in deciding whether to make a purchase and (b) is
able to examine the guarantee before purchase. As most consumers do not do so,
it seems unlikely that guarantees have a strong signalling function. Moreover,
there are a number of factors at play which further limit the degree to which a
guarantee can be an adequate signal of product quality. These are primarily
relevant in setting the duration of a free guarantee. First, when a faulty
product is returned to the guarantor, the initial difficulty is to establish
whether the fault is a result of poor workmanship or due to consumer misuse. The
longer a consumer has used the goods, the greater the likelihood that a fault
will have been caused by the way the consumer has used the product (Eddy, 1977,
p.844). By restricting the guarantee period to a relatively short term after
purchase, the manufacturer minimises the likelihood of providing a remedy for
faults which were, in fact, caused by the consumer. Secondly, consumers do not
use products in a uniform manner – some take a lot of care whereas others
do not. If high-intensity use will increase the likelihood of a product
breakdown, then a guarantor will set the guarantee period such as to minimise
the number of claims made as a result of such use (Emons, 1989). Thirdly, and
linked to the previous points, there is moral hazard (Lutz, 1988). This is a
concept which, in essence, refers to the fact that the availability of insurance
is likely to reduce the efforts made by the consumer to take care of the product
in order to prevent the occurrence of the event insured against. A guarantee can
be characterised as a form of insurance against latent manufacturing
faults
(11).
If a guarantee is available, it is less likely that a consumer will take as much
care of a particular product compared as he would if the product were not
covered by a guarantee. A guarantor will take into account the likelihood of
claims which are the result of inadequate care and seek to minimise such
instances by reducing the guarantee period.
These important factors offer at least a partial
explanation for the comparatively short duration of manufacturers’
guarantees. They do not, of course, explain why many guarantees are still
restricted to one year. There are only some manufacturer’s guarantees
which last for a longer period (for example, a Japanese car manufacturer has
recently advertised that all their cars are covered by a five year guarantee).
Perhaps this can be explained by the fact that some manufacturers themselves
offer extended warranties to consumers. Such manufacturers target consumers who
have registered their free guarantee with the manufacturer. Such extended
warranties are an additional source of income for manufacturers and may also be
a significant factor in the decision to offer a free guarantee limited to a
relatively short period.
In light of these points, it is now possible to suggest
that extended warranties have an important role to play in providing additional
protection to consumers. For this, it is useful to refer to the theory of the
consumer guarantee put forward by George Priest (1981) in what is still the most
influential theoretical examination of manufacturers’ guarantees. Priest
argued that the substance of guarantees, i.e., the terms and conditions on which
guarantees are provided, is best explained on the basis of his ‘Investment
Theory’ (or ‘Comparative Advantage Theory’ – see
Schwartz and Wilde, 1983, p.1398). In essence, a guarantee divides
responsibility for allocative investments, i.e., preventive actions to minimise
the risk of a product breakdown, between guarantor and consumer. The party who
is in the best position to assume responsibility for a particular problem should
do so. The basis of this theory is therefore the ‘least-cost
avoider’ (Oughton and Lowry, 2000, p.205). Thus, the manufacturer can
improve the design of the product to minimise the probability of the product
needing repairs, but only in so far as this would be economically viable. The
consumer can take sufficient care when using the product to reduce the
likelihood of a product breakdown, and may also ‘invest’ in
prolonging the life of the product by carrying out some minor repairs himself.
Priest’s example is that of a fridge – the consumer can prevent his
children from swinging from the fridge door, and he can replace a shelve inside
the fridge that may have fallen out.
Market insurance would cover those aspects which cannot
be subject to allocative investments. Guarantees offered by manufacturers are
one form of market insurance. Although the consumer does not pay separately for
the guarantee, the price of the product includes a sum for the guarantee.
However, as demonstrated above, the amount and intensity of use of a particular
product vary between consumers, and guarantees are generally limited to reflect
this (Priest, 1981, p.1317). The longer the consumer uses the product, the
greater is the likelihood that a product failure is caused by the
consumer’s way of using the product. The guarantee is therefore limited to
a period of time after purchase during which product breakdowns are more likely
to be the result of a manufacturing defect. The consumer is expected to take
sufficient care to ensure that the product does not break down after that
period
(12).
If the consumer wants further protection, he will have to obtain this through
additional market insurance. Extended warranties provide such additional
insurance.
Moreover, extended warranties offer protection for
problems which are not covered by the SoGA or free guarantees, such as
accidental damage and breakdown due to normal wear and tear. The consumer can be
expected to invest in minimising the risk of accidents, but will not be able to
eliminate it altogether. Thus, for accidental damage and other product
breakdowns, insurance is provided in the form of extended warranties. One aspect
of this function of extended warranties is illustrated by the decision in
Thain v Anniesland Trade Centre (1997). Here, a second-hand car which was
about five years old and had travelled about 80,000 miles had a latent defect
which resulted in a fault in the gear-box within a fortnight of purchase and the
car was put off the road. The court held that the car was still of satisfactory
quality. The defect did not exist at the time of sale but was likely to develop
at any time with a second-hand car. It is significant to note that the court
put some emphasis on the fact that the seller had offered an extended warranty
which would have provided some protection against the risk of expensive repairs.
In declining this offer, the consumer accepted the risk of expensive repair
immediately. This aspect of Thain is interesting. The car met the level
of quality a reasonable person would expect. There was a risk that a defect
might develop, but this did not affect the satisfactory quality of the car and
there was therefore no breach of the implied term. Had the consumer wanted
additional protection against this risk, she would have had to buy additional
insurance in the form of the extended warranty offered to her. Thain
therefore provides an example of how extended warranties and statutory
rights might interact. However, it is debateable whether the decision in this
case is correct. It seems at least arguable that there was a breach of the
implied term because the car failed very soon after purchase. The fact that an
extended warranty might have offered protection seems to have been a significant
factor in the court’s decision. It is not clear whether a similar decision
would have been reached had no extended warranty been offered. The worrying
aspect of this case is the extent to which the availabilty of additional
protection influenced the application of the satisfactory quality
test.
The preceding discussion suggests that there are clear
rationales for the existence of extended warranties. The OFT has accepted the
desire to obtain peace of mind as the reason why most consumers purchase
extended warranties. This discussion suggests that this is too simplistic an
analysis and that there are more complex factors at play. The OFT’s
failure to analyse this point is a major omission. It states that its objective
has been to examine whether the market works well for consumers (para 2.6). It
must be asked how it can do so without considering the relevant legal framework
and come to useful conclusions. A fundamental conclusion arising from the
preceding paragraphs is that extended warranties should generally be purchased
by higher risk consumers. Yet, the OFT found that it is generally low-income
consumers (Class C2DE) who purchase extended warranties (para 4.48). It seems
rather unlikely that all higher-risk consumers are also on low incomes. It is
regrettable that the OFT has not examined this aspect in depth, and
consequently, some doubts may be raised about the value of the report’s
conclusions.
Consumers may value the reassurance that extended
warranties can bring, but one objective for any system of consumer protection is
to ensure that consumers are better informed about the choices they make. The
OFT has identified a number of problems with such warranties, some of which are
classed as ‘competition’ problems, whereas others are regarded as
‘consumer protection’ problems. These will be examined in the
following sections.
Top | Contents
| Bibliography
Alternatives to Extended Warranties
Prior to considering the competition and consumer
protection problems, it is useful to set out the alternatives to extended
warranties. If a consumer does not buy an extended warranty and a product breaks
down outside the manufacturers’ guarantee period, he might be able to ask
the retailer to provide a remedy. However, as explained above, this is only
possible if the cause of the breakdown was inherent in the product at the time
of sale, and only for a limited time after sale. For other faults, consumers
will have to pay to have the product repaired. There are both independent
repairers and repair networks set up by manufacturers, as well as some
retailers, who provide such a service. Although consumers will have to cover
the cost of repairs themselves, the OFT’s report suggests (at para 4.47)
that repairs are generally likely to cost less than an extended warranty,
although the report does not come to a definite conclusion on this
point.
Competition Problems and Extended
Warranties
The OFT examined both competition and consumer
protection problems caused by extended warranties. This section will consider
the competition problems. Although these are dealt with separately, there is a
considerable overlap with consumer protection concerns, and the competition
problems identified by the OFT have an impact on consumers in that they limit
consumers’ choice, which in turn has an impact on the price they pay.
Insufficient competition on extended
warranties
There is considerable variation in the scope of extended
warranties, as noted by the OFT (1994) and the Consumers’ Association
(1994). For example, some domestic appliance warranties offer a replacement of
the faulty product on a ‘new-for-old’ basis. In contrast, others
take account of the depreciation in product value that will have happened over
time. There is further divergence in the way that payment for repairs to a
faulty product are handled. In some cases, the warranty provider will pay for
the service directly whereas in others the consumer will have to pay for the
repair first and then claim back the money from the warranty provider. Finally,
there can be considerable variation in the various terms and conditions, such as
the exclusion of certain items or parts of appliances, or terms dealing with
related service, such as the fixing of appointments.
One would, therefore, expect the market for extended
warranties to be a healthy, competitive one. Yet, there has been a much lamented
absence of any obvious competition (OFT, 1994). Most retailers seem to offer
only one type of extended warranty for the products they sell. Furthermore,
these are offered for products sold by that retailer. Only a few retailers offer
extended warranties on products purchased elsewhere, but this is not widely
advertised (OFT, 2002).
The OFT concluded that retailers have such a strong
position in the sale of extended warranties that extended warranties offered by
manufacturers present only a small challenge to the retailer’s
‘point of sale advantage’ (para 4.26). One explanation for this is
that manufacturers do not make a significant effort to compete with retailers on
the provisions of extended warranties. Retailers are, of course, the main
customer base for manufacturers – few manufacturers sell direct to
customers. Many retailers are of equal or stronger bargaining power with
manufacturers and could decide to cease stocking a particular brand if the
manufacturer also offered an extended warranty to consumers at the point of
sale. Manufacturers therefore often make a conscious decision not to compete at
point of sale and limit their business to consumers who have registered their
free guarantee.
This is an issue which the Competition Commission will
undoubtedly have to investigate further. It must be noted that an understanding
between a retailer and manufacturer that the manufacturer will not offer an
extended warranty that competes with the retailer’s warranty, may breach
the Chapter I prohibition of the Competition Act 1998 (CA). Section 2(1) CA
prohibits agreements or concerted practices which have as their object or effect
the prevention, restriction or distortion of competition within the United
Kingdom. In agreeing not to offer an extended warranty that would compete with a
retailer’s warranty, a manufacturer and retailer are in effect reducing
competition by limiting the choice that is available to
consumers
(13).
A further factor is the variation in the scope of
protection which, whilst positive for competition, may also make it more
difficult for consumers to shop around for the ‘best’ extended
warranty. This is because consumers often find it difficult to understand
exactly what is provided by the various warranties on offer (OFT, 2002, para
4.23).
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High cost of Extended Warranties
The lack of competition is also blamed for the high cost
of extended warranties in relation to the likely cost of repairs. A fundamental
tenet of competition policy is that greater competition will lead to a reduction
in prices. If competition on extended warranties were to intensify, consumers
should have to pay less. However, increased competition may not be the solution
to this problem. It is necessary to examine extended warranty pricing more
closely.
An important question is whether the price of an
extended warranty bears any relation to the likely cost of repairing or
replacing a product under the warranty. It seems that this is often not the
case. The OFT’s initial examination of extended warranties on electronic
goods (OFT, 1994) noted that the cost of repairing a product is usually lower
than the cost of taking out an extended warranty. The estimated repair costs for
selected electrical goods were all lower than the prices of extended warranties
offered for these products. In some instances, the warranty was twice as
expensive. Consequently, consumers pay over the odds to obtain peace-of-mind
protection.
At the same time, the profit margins on extended
warranties appear to be wide - businesses seem to profit substantially from
consumers purchasing extended warranties. Extended warranties are a significant
source of income, particularly for retailers. Indeed, research indicates that
many businesses in the electronics sector rely on the sale of extended
warranties to make a
profit
(14).
In some cases, a retailer can have a profit margin of as much as 80 per cent of
the total price of the extended warranty. Furthermore, it seems that the ratio
of claims under extended warranties is considerably below the average claims
ratio for insurance products generally (para 4.31).
A partial explanation for the high cost of extended
warranties may be that this takes account of the expenditure incurred in
providing a remedy under a free guarantee (Chen and Ross, 1994). By offering
extended warranties with prices exceeding expected costs, manufacturers and
retailers could recover the cost of additional service under normal guarantees.
This may be preferable to including the cost of free guarantees in the original
product price to be more competitive. However, this would probably only be of
relevance for warranties provided by manufacturers, and the proportion of such
warranties is relatively small. This cannot therefore be a sufficient
reason.
Extended warranties are a type of insurance, and the
objective of insurance is to spread the cost of likely losses among a large
number of people to lower the actual cost to any particular individual suffering
loss. Thus, one might reasonably expect the cost of an extended warranty to be
lower than the actual cost of repairing a defective product. The fact that this
is generally not the case warrants a consideration of the factors that may be
relevant in determining a suitable premium for an extended warranty. The
following paragraphs seek to explore this question, but cannot provide a
definitive answer.
There are a number of factors which need to be taken
into account by a warranty provider in setting the price of, or premium
for
(15),
an extended warranty. The basic starting point is to estimate the risk of
occurrence of the event insured against. Thus, an extended warranty provider
needs to consider how many units of a particular product are likely to break
down during the period covered by the warranty. Furthermore, he needs to be
aware of the cost of repairing the product once it has broken down. For example,
it is assumed that around 35 per cent of all Brand X washing machines will
develop a fault during the first five years of use, and the average cost of
repair is £50. In order to cover the cost of providing insurance against
product breakdown, the insurer has to collect sufficient premiums to cover the
anticipated costs. In this example, the basic premium can be established by
multiplying the risk by the cost of repair, and the insurer needs to collect
£17.50 from every insured person (cf. Shavell, 1997).
The insurer needs to be sure that there are sufficient
pooled assets (i.e., the total of all premiums received) to meet all the claims
that may be made. There are a number of factors which affect the calculation of
the insurance premium. As noted previously, with any insurance policy, there is
a moral hazard problem (Lutz, 1989). This is the problem that an insured who
might take greater care to prevent the occurrence of the event insured against
if no insurance were available will be less careful and thereby increase the
likelihood of having to draw on the insurance policy. This may lead to a greater
number of claims than anticipated. Additionally, those who anticipate that they
will have to make a claim are more likely to take out insurance than those who
think that they will not need the insurance (adverse selection - see e.g.
Akerlof, 1970). Both moral hazard and adverse selection are further factors that
may result in a higher premium. Moreover, those consumers who buy extended
warranties are likely to be higher-risk consumers (see also Padmanabhan, 1995).
Priest (1981) suggests that premiums for extended warranties are likely to be
higher because the consumers who take out an extended warranty have a greater
than average risk of needing the insurance (p.1317). It must be remembered that
this is the theoretical position rather than practice – as noted
previously, those who actually buy extended warranties are on low incomes and
often not high risk consumers.
All these factors indicate that the number of claims
made under the extended warranty policies may be greater than the average. In
order to reduce the likelihood of not being able to meet all claims, the insurer
has to increase the ‘risk bearing capacity’ of the pool, i.e., the
amount by which the value of the pool exceeds the average. The simplest way of
doing this is by increasing the premium paid by the insureds to a sum which
exceeds the average expected loss (Purves, 2001, p.634). Moreover, the insurer
will also need to take into account his overheads, such as the cost of
administering the extended warranties, staff costs and maintaining business
premises. At least some of these costs need to be worked into the premium. The
premium will need to be based on more than the risk of loss and the likely
amount of loss. It is not possible within the confines of this paper to provide
specific figures, but it would seem strange if the premium exceeded the actual
loss that may be suffered by an individual insured. Yet, this exactly seems to
be the case with most extended warranties. In respect of this, it is significant
to note that the OFT found that mot providers do not calculate the premium for
an extended warranty on the basis of the actual risk of failure of a particular
model or brand, but instead charge ‘catch-all’ standard fees. The
only variations that were identified were based on the price bands for the
relevant products (OFT 2002, para 4.13). The perception that extended warranties
generally cost too much is reinforced by this fact.
There is therefore reasonable evidence to suggest that
the price of extended warranties is excessive, even when one takes into account
the fact that those consumers who take out extended warranties are likely to be
higher-risk consumers. The Consumers’ Association’s report (1994)
included a table of figures which set out the basic likelihood of product
breakdown and identified a average repair cost for various products. However,
these calculations were not sufficiently detailed to provide an accurate
picture. The Competition Commission should undertake a detailed analysis of this
point and identify a realistic level of premium based on the various factors
that may be taken into account by extended warranty providers. This might make
it possible to consider whether increased competition could have a noticeable
impact on the premiums paid by consumers for extended warranties. Prima
facie, the high profit margin and low number of claims suggests that
premiums are too high, but it is not clear by how much. This needs to be
investigated further.
The lack of competition and the high premiums are often
regarded as inter-linked issues. Obviously, this has a detrimental impact on
consumers in that they have to pay more for extended warranties compared to a
competitive market. In addition, there are specific consumer protection
problems, which are considered in the next section.
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Consumer Protection Problems and Extended
Warranties
The OFT report identified three aspects of concern to
consumers, in addition to the high cost of extended warranties. First, it seems
that some consumers feel pressured into taking out an extended warranty.
Secondly, some warranties contain terms which may be unfair or could operate
unfairly against consumers. Finally, the fact that not all providers of extended
warranties appear to be subject to regulatory controls means that some consumers
may be left without protection if the warranty provider goes out of business.
These issues will be examined in
turn.
Selling techniques for extended
warranties
Although it was seen above that there are good reasons
why consumer might want to purchase extended warranties, it seems that most
consumers do not set out to buy an extended warranty when they shop for a
particular product. Most extended warranties are purchased as an afterthought
and generally only after the retailer has drawn their availability to the
attention of the consumer (OFT, 2002, para 4.1). Providers of extended
warranties target potential customers at two stages - at the point of sale of
the original product and towards the end of the manufacturers’ guarantee
period by direct mail (OFT, 1994). However, retailers seem to be in a
significantly stronger position, with 71 per cent of consumers stating that
extended warranties are available from retailers, and only 23 per cent
mentioning manufacturers and 14 per cent insurance companies (OFT, 2002, para
4.21).
Particular concern has been expressed with regard to
pressure-selling techniques for extended warranties adopted by retailers at the
point of sale. Some retailers market extended warranties quite aggressively at
point of sale, whilst others sell these in a passive manner (Day and Fox, 1985).
The second OFT report (OFT, 1996) discovered that many retailers did not
volunteer information about manufacturers’ extended warranties, or claimed
that these were not available because the retailer himself offered an extended
warranty. This practice obviously prevented consumers from being able to make an
informed decision when they contemplate buying an extended warranty. Salespeople
are often encouraged to market extended warranties because they are paid a
commission on warranty sales. In response to the OFT reports, the BRC code of
practice for extended warranties requires retailers to provide information about
extended warranties and not to push the sale of their extended warranties.
However, a recent mystery shopping exercise (Taylor Nelson Sofres, 2001) still
showed significant problems, which resulted in the latest OFT investigation into
the provision of extended warranties (OFT, 2002). The BRC code appears to have
been unsuccessful, and it is interesting to see that there is no intention to
apply for recognition of the code under the OFT’s new criteria (OFT, 2002,
para 2.3). Consequently, the limited degree of control offered through the
current self-regulatory regime would be lost and there would be no regulatory
framework for extended warranties at all.
The code was aimed at promoting transparency in the sale
of extended warranties and at allowing consumers to make a choice, rather than
to be pressured into buying a warranty. The OFT’s research suggests that
around 9 per cent of all consumers felt pressured to buy an extended warranty,
and a further 33 per cent were encouraged to purchase one (para 4.5). These
figures are based on all consumers who bought domestic electrical goods.
Extended warranties were not discussed as part of all of these transactions. If
only those transactions where an extended warranty was discussed are taken as a
basis, 15 per cent of consumers felt pressured and almost 60 per cent were
encouraged to buy an extended warranty (OFT 2002, para 4.5). The OFT does not
explain where it has drawn the line between ‘pressure’ and
‘encouragement’, but it does seem that the retailers still take the
lead in offering extended warranties, rather than to respond to consumer
enquiries about such warranty. Often, this is the result of the sales techniques
adopted by retailers, who paint a bleak picture of the reliability of new
products. As consumers are generally not able to establish the likelihood of a
product breakdown before purchase, the retailer’s comments may be very
influential. Moreover, consumers from low-income groups are more likely to buy
an extended warranty (para 4.48). Such consumers may find the prospect of having
the unexpected and unquantifiable cost of repairs or replacement particularly
daunting. This is of concern because consumers who are already financially
stretched are committing themselves to further expenditure which, on balance,
may be unnecessary. This is an aspect which the OFT has failed to give
sufficient attention.
It may be that part of the problem is a lack of
awareness of the existing level of protection under the Sale of Goods Act, both
on the part of consumers and retailers. Greater awareness of their statutory
rights may encourage more consumers to query the need for additional protection,
particularly when faced with claims by a retailer that the product may break
down unexpectedly soon after purchase.
Terms and Conditions of Extended
Warranties
The OFT (2002) noted that most terms and conditions do
not seem to be problematic, although it did raise two features which cause some
concern. First, some extended warranties include a provision by which
depreciation in the value of goods is taken into account. This may, in some
circumstances, result in a product being deemed a write-off and no repair or
replacement being provided under the warranty (para 4.54). Such terms may be
regarded as unfair under the Unfair Terms in Consumer Contracts Regulations
1999. These Regulations implement Directive 93/13/EEC on Unfair Terms in
Consumer Contracts. They apply to contractual terms which have not been
‘individually negotiated’ (Regulation 5(1)). These are terms which
have been drafted in advance and the substance of which the consumer has not
been able to influence (Regulation 5(2)). A pre-drafted term will be regarded
as unfair ‘if, contrary to the requirement of good faith, it causes a
significant imbalance in the parties’ rights and obligations under the
contract, to the detriment of the consumer’ (Regulation 5). In
Director-General of Fair Trading v First National Bank plc [2001] UKHL 52,
[2001] 1 All ER 97,
the House of Lords noted that ‘good
faith’ has procedural and substantive aspects (per Lord Bingham, paragraph
17). With regard to the procedural aspects, good faith requires that a consumer
should be made aware of all the relevant terms, and particular attention should
be drawn to important or onerous terms. As far as the substantive element is
concerned, the House of Lords held that some terms always create a significant
imbalance to the detriment of a consumer (per Lord Steyn, paragraph 37). Such
terms are inherently contrary to the requirement of good faith and therefore
unfair. In assessing whether other terms are unfair, it is necessary to take
into account the nature of the goods or services covered by the contract, to
consider all the circumstances attending the conclusion of the contract and to
the other terms of the contract (Regulation 6(1)). If a term is regarded as
unfair, then it will not be binding on the consumer (Regulation 8(1)). No
assessment will be made of the fairness of a term which defines the main subject
matter of the contract, nor of the adequacy of the consideration provided by the
consumer (Regulation 6(2)). It is still possible to refer to these when
assessing the fairness of other terms in the contract (see Bradgate, 2000,
p.92). The Regulations contain a set of rules for their enforcement by public
authorities and other organisations with a legitimate interest in protecting
consumers (see Twigg-Flesner, 2000). It is possible for such organisations to
challenge terms. This enforcement mechanism is co-ordinated by the OFT, which
also publishes an
Unfair Contract Terms Bulletin that provides details of
terms which have been challenged successfully.
The concern in respect of depreciation clauses is that
consumers may discover that they have paid for an extended warranty, but will
receive little or nothing in return if the warranty provider declares that the
product is a write-off. Such a provision appears to be contrary to the purpose
of an extended warranty, because a consumer would effectively have to pay twice
if the product breaks down – once for the extended warranty which then
does not provide a great deal by way of remedy, and then again to obtain a
replacement product. The 1999 Regulations could be used to control such terms to
ensure that consumers do not suffer unnecessary detriment as a result of such
terms, but to the extent that such terms are regarded as fair, the question
remains whether these are always applied correctly.
A second feature is the ‘cash back’
provision in some extended warranties. These provide that a consumer can obtain
a refund of the premiums paid if no claim is made under the extended warranty.
The procedures for claiming a refund are described as ‘rigid and
complex’ (para 4.55) and require a claim to be made within strict time
limits. The Financial Ombudsman and the OFT have both challenged such terms
under the 1999 Regulations (see para 4.56). If such terms are insufficiently
clear and precise, they may be interpreted in favour of the consumer, but in
individual cases, it may be difficult for a consumer to succeed with his claim
for a refund of the premium.
It may therefore be concluded that there are no obvious
concerns regarding the terms and conditions on which extended warranties are
provided. Those terms which have the potential to be unfair can be controlled
under the 1999 Regulations. All that may be required in this regard is to
step-up the policing of extended warranties to ensure that terms which may be
unfair are no longer used. However, what is not clear is what actually happens
when a consumer claims under an extended warranty. The OFT does not provide any
evidence on the administration of extended warranties, and what looks acceptable
in print may not work in the consumer’s favour in practice. A problem of
much greater concern is how the premiums are used by the extended warranty
provider and what might happen if the provider becomes
insolvent.
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Premiums, Insolvency and Insurance
Regulation
On a number of occasions, providers of extended
warranties have become insolvent and consumers been left without any protection.
If an extended warranty provider becomes insolvent, the very least a consumer
will want is to be able to recover his premiums. However, consumers who have
paid premiums to a provider are likely to be treated as unsecured creditors in
the event of the trader’s insolvency. This means that their claim to any
money still held by the provider will be considered only after those of the
secured
creditors
(16)
have been dealt with. All unsecured creditors are treated equally and they will
have to share any remaining funds rateably between them. Consequently, they will
receive back less than they are owed, if anything at all.
If a consumer is to be able to reclaim the premium, it
is necessary to identify the premium in the hands of the insolvent warranty
provider. In effect, a consumer would have to argue that the premium is held on
trust for the duration of the extended warranty
policy
(17).
This type of trust is know as a
Quistclose trust after the leading case
Barclays Bank Ltd v Quistclose Investments Ltd (
[1970] AC 567). Such a
trust was established in the context of pre-payments made by consumers for goods
ordered by mail-order in
Re Kayford Ltd ([1975] 1 WLR
279).
There are a number of requirements that need to be
fulfilled in order to succeed with such a claim. First, the consumer would have
to prove that there was an intention to create a trust over the premium
payments. It seems that in the normal course of dealings, the presumption is
that a provider should be free to use any payments made by a consumer for his
normal business activities. The provider will not usually keep these payments
separate from other funds needed for his business. It is unlikely that the
presumption would be displaced if the provider kept the premium payments in a
separate account without further evidence of an intention to hold these on
trust. This is well illustrated by
Re Multi Guarantee Co Ltd ([1987]
B.C.L.C. 257, and see Campbell, 1987). Multi Guarantee (MG) was a specialist
provider of extended warranties. These were provided
inter alia to
customers of an electrical appliances retailer. The retailer would collect the
premiums and pay these to MG in return for extended warranty cover. Once the
premiums had been paid to MG, they became part of MG’s assets. The
retailer became concerned about the insurance arrangements made by
MG
(18)
and steps were taken to improve security of the premiums paid by the customers
by setting up a joint bank account to which the premium payments were
transferred. When it had been confirmed that MG’s insurance position was
inadequate, MG petitioned for winding-up. The question arose whether it had
constituted itself as trustee over the funds in the joint account. The Court of
Appeal held that because both MG and the retailer might have a claim to he
money
(19),
it was not clear who had a right to make withdrawals from the fund. There was
insufficient certainty for the creation of a trust. The liquidator was entitled
to claim the funds in the joint account on behalf of MG’s
creditors.
If no separate account for extended warranty premiums is
set up, it may be more difficult to identify the sums in the hands of the
warranty provider. Although it is not impossible for equity to trace the
payments made by a consumer into a mixed bank
account
(20),
this will not be of assistance unless the account has continuously been in
credit (Bradgate and White, forthcoming). As an insolvent provider is unlikely
to have an account which is in credit, and an attempt by a consumer to trace his
premium will fail. The creation of a separate bank account for premium payments
would therefore be a necessary pre-requisite for a
Quistclose trust to be
established. This is unlikely to occur in practice because of the
provider’s need to use the payment for his business
activities.
Even if these hurdles can be overcome successfully,
there may a further problem. As in
Quistclose itself, the
provider’s bank needs to have notice of the trust. It may not be necessary
to notify the bank explicitly, and setting up a separate account with a name
such as ‘active extended warranty policy premium account’ could be
sufficient to give notice to the provider’s bank (cf.
Re
Kayford)(21).
From the point of view of a consumer, the separation of
premium payments and the imposition of a trust would have the advantage of
preventing the use of these payments for general business purposes until the
relevant extended warranty policies have expired. This would ensure that all
consumers could obtain a refund of their premiums if the retailer or
manufacturer became insolvent. However, there would be a number of drawbacks for
the provider. The premiums would be ring-fenced and could not be used for normal
business purposes. For most providers (particularly retailers), the income from
the sale of extended warranties is crucial and it could lead to financial
difficulties for some of them. Moreover, it may be difficult to prove that a
trust has been created.
It is unlikely that a Quistclose trust would be
of assistance in the context of extended warranty premium payments. However,
there is an alternative. It has already been explained that extended warranties
function as a form of insurance against product defects. If they fall within the
legal definition of insurance, protection may be offered to consumers in two
ways. Insurance law requires that insurers maintain a solvency margin to ensure
that all claims can be met. Moreover, insurance companies are regulated by the
Financial Services Authority (FSA). The FSA operates the Financial Services
Compensation Scheme which compensates consumers if an insurance company becomes
insolvent and therefore cannot honour any claims (cf. OFT, 2002, para. 4.59).
Consumers who have obtained their warranties from providers who are authorised
insurers themselves or whose policies are underwritten by an authorised insurer
would therefore be protected.
The question therefore arises whether extended
warranties should be regarded as contracts of insurers and providers of them as
insurers who should comply with the regulatory regime. If this is the case,
future problems could be avoided through improved enforcement of the regulatory
system. However, if this is not the case, then it may be necessary to introduce
specific rules to protect purchasers of extended warranties. Interestingly, this
is a problem which has arisen in other jurisdictions (both in Australia and the
United States). It has been a question of particular concern in Ohio where a
number of cases have tried to discern a boundary between warranties and
contracts of insurance. Interestingly, such cases arose when consumers were left
out of pocket, following the insolvency of a warranty provider (Samini, 1993).
The first point is whether extended warranties should be
treated as contracts of insurance. It is, of course, well-known that there is no
formal definition of ‘contract of insurance’, but it is possible to
identify some key aspects of such contracts (Birds and Hird, 2001, pp 11-17).
These may be summarised as follows. First there has to be a binding contract
which provides that one party will do something for the other party if a
particular event occurs. This event may or may not happen – whether it
will has to be
uncertain
(22).
Furthermore, the person in whose favour the contract will operate (i.e., the
insured) must have an insurable interest in the item(s) insured (see
Prudential Insurance Company v Inland Revenue Commissioners [1904] 2 KB 658). It is not necessary that the insurer pays a sum of money to the insured,
should the event happen, provided that the insurer provides a service (such as
repair) which is clearly worth money (
Re Sentinel Securities [1996] 1
W.L.R. 316). Finally, it seems that the event insured against cannot be within
the control of the party assuming the risk of the uncertain event occurring
(Birds and Hird, 2001). Although there is no case-law authority for the
requirement of control, it seems that this is a factor which the FSA will take
into consideration (Purves, 2001, p.633).
Does the standard extended warranty satisfy these
requirements? There will be a contract between consumer and warranty provider.
The uncertain event is the failure of the product which the consumer has bought.
However, the crucial question is whether the extended warranty provider can be
deemed to be ‘in control’ of the event insured against, i.e., the
breakdown of the product.
This point needs to be examined more closely. A two-fold
distinction can be drawn. First, there are the different parties who might
provide an extended warranty, i.e., the manufacturer, the retailer or a
third-party provider. Secondly, there are the different events which the
extended warranty might cover: defective workmanship and materials, accidental
damage and breakdown due to wear and tear. It seems that only those extended
warranties which cover an event which cannot be said to be within the control of
the warranty provider would be considered contracts of insurance. Out of the
various permutations that can be derived from the distinction set out in this
paragraph, only one combination could be construed as involving an event which
is within the control of the insurer: an extended warranty offered by a
manufacturer which only covers defects in workmanship and materials. It is
arguable that in this case, the manufacturer has ‘constructive
control’ (Twigg-Flesner, 1999) over the defect, because the manufacturer
makes the product and could prevent the occurrence of such defects. In all the
other situations, the person providing the insurance has no control over the
event insured against. Thus, a retailer who provides an extended warranty
against defective workmanship would be providing insurance, as would a
manufacturer who offers a warranty against accidental damage.
What about the types of ‘extended warranty’
which are more like service contracts? A broad distinction may be drawn between
two types of service contract (Twigg-Flesner and Bohling, 1999, p. 195): those
which involve a regular (usually annual) inspection of the relevant product and
those which do not. It seems arguable that the regularity aspect of the first
type of service contract would remove this from the scope of insurance, whereas
the second type is very much like a contract of insurance. The fact that a
regular visit to service the product in question is carried out regardless of
whether there is a fault introduces an element of certainty into the contract
which is unlikely to be compatible with the suggestion that such a contract is
akin to a contract of
insurance
(23).
This view is in line with the decision in
Department of Trade and Industry v
St Christopher Motorists Association [1974] 1 All ER 395. In this case, the
Association undertook to provide its members with a chauffeur service if they
had been disqualified for drink driving. This constituted insurance. It appears
to have been significant that the cost of providing a chauffeur service was an
additional cost for the association, rather than a part of its general running
costs. If the provision of this service had added nothing to the expenses of the
association, it would probably not have been regarded as providing insurance
(per Megarry VC in
Medical Defence Union Ltd v Department of Trade [1979]
2 All ER 421 at 430). In the context of service contracts, it is arguable that
those contracts where no regular visit is included would be insurance, but those
where there is such a visit would not. There could therefore be a thin dividing
line between those service contracts which fall within the understanding of
‘insurance’ and those which do not. Service contracts which do not
include a regular service of the product and the type of extended warranty
discussed above should be treated in the same way, and therefore as contracts of
insurance. This would be in line with the court’s view in
Re Sentinel
Securities, which states that the crucial factor whether a contract is a
contract of insurance is not what it is called but whether the substance of the
obligation undertaken under the contract is to assume the risk of an uncertain
event. There is also no significant qualitative difference between service
contracts with and without regular service of the product, and therefore, they
should also be treated in the same way. It may be concluded from this discussion
that extended warranties and service contracts, no matter what they are called,
should fall within the meaning of ‘contracts of insurance’.
This leads on to the second aspect of this analysis,
i.e., whether extended warranty providers should be subject to the regulatory
regime. Generally, those involved in carrying of the business of insurance have
to comply with specific regulatory requirements: first, they require
authorisation under the Financial Services and Markets Act 2000 to carry on the
regulated activity. The Financial Service and Markets Act (Regulated Activities)
Order 2001 confirms that insurance is a regulated activity. Secondly, the Act
requires insurers to maintain a minimum amount by which their assets exceed
their liabilities. This should protect insureds who have taken out an insurance
policy, and therefore also protect buyers of extended
warranties.
One possible way of analysing the provision of extended
warranties would be to say that all providers, including retailers and
manufacturers, are carrying on the business of providing insurance, and would
therefore have to comply with the regulatory requirements. It is unlikely that
such an analysis would be correct: retailers and manufacturers are primarily
interested in selling their goods, and the provision of extended warranties is
an ancillary part of their business. If extended warranties are contracts as
insurance, and retailers and manufacturers offered these without the backing of
an insurance company, then they would be offering a ‘mixed grill’ of
contracts (per Megarry VC in
Medical Defence Union Ltd v Department of Trade
[1979] 2 All ER 421 at 431). In such circumstances, it seems likely that the
provider would not be regarded as carrying on an insurance business. In the
Medical Defence case, Megarry VC did not have to decide this point, but
his
obiter comments (at 431-432) suggest that the regulatory regime
should only apply to companies who predominantly enter into contracts of
insurance. If the opposite conclusion were reached, then it would be impossible
for the provider to carry on any other business. This would lead to the
paradoxical result that retailers or manufacturers could not carry on their main
activity of making or selling
products
(24).
The concern for consumers is that there have been
spectacular failures of extended warranty providers which have left many
consumers out of pocket and without any protection against product failure. With
the exception of some particular cases, extended warranties fall within the
legal understanding of insurance, but it seems unlikely that manufacturers and
retailers who provide such warranties would be deemed to be carrying on an
insurance business. As a result, they do not have to comply with the strict
solvency requirements imposed by the regulatory regime. However, in order to
prevent the consequences of future failures of non-insurance providers, it may
be desirable to consider two solutions: first, it may be possible to require all
providers of extended warranties to obtain insurance cover to ensure that
consumers will be able to recover their premiums if the retailer or manufacturer
goes out of business. In effect, all retailers and manufacturers wishing to
provide extended warranties would have to enter into an arrangement with an
authorised insurer to underwrite their extended warranty policies. Retailers and
manufacturers will, of course, have to make sure that the insurer has the
appropriate authorisation. In
Re Cavalier Insurance ([1989] 2
Lloyd’s Rep. 430), an insurance company which provided the underwriting of
extended warranties offered by a specialist business (Multi Guarantee Co Ltd)
did not have the appropriate authorisation, and all underwriting contracts were
unenforceable
(25).
In practice, not all providers are authorised insurance
companies or use an insurance company to underwrite their policies. It seems
that a change in Insurance Premium Tax led to a number of retailers to
discontinue their links with insurance companies. Such providers do not have to
comply with the solvency requirement, nor would their customers be covered by
the compensation scheme. Consequently, some consumers would not be protected in
case the provider becomes insolvent. This and the difficulties of establishing a
Quistclose trust may leave some consumers in a precarious position.
An alternative solution may be to introduce specific
provisions into insolvency legislation to give extended warranty purchasers a
preferential status, should a provider of non-insurance backed warranties become
insolvent. This would be so regardless of whether the Quistclose
requirements have been satisfied. However, it unlikely that such changes
would be made if there are alternative means of dealing with this problem. As
suggested above, there is no real difference between extended warranties and
other contracts of insurance. One possible solution for the avoidance of doubt
would be to introduce a general requirement that all extended warranties be
contracts of insurance which must be underwritten by an authorised insurance
company. It is therefore submitted that a rule should be adopted which brings
all types of extended warranty clearly within the scope of insurance
regulation.
Top | Contents | Bibliography
Next Steps: The Competition Commission Inquiry and
Potential Developments
The DGFT has asked the Competition Commission to
investigate the provision of extended warranties under the Fair Trading
Act
(26).
There are two types of monopoly that can be investigated by the CC under the FTA
– scale monopolies and complex monopolies (see Whish, 2001). A scale
monopoly exists where 25% of goods/services of a particular description are
supplied by or to one and the same person. A complex monopoly exists where 25%
of the goods or services are supplied by or to a group of people who, whether
voluntarily or not, and whether by agreement or not, conduct their affairs in
any way to prevent, restrict or distort competition in connection with those
goods or services. This looks at the behaviour of the companies
concerned.
The CC has been asked to carry out what is known as a
‘full public interest reference’ to establish whether a complex
monopoly exists and if so, whether there are adverse implications on the public
interest. The public interest criteria are set out in s.84 of the FTA and
include all matters which appear to the CC to be relevant in the particular
circumstances, and in particular: maintaining and promoting effective
competition, the balanced distribution of employment and industry in the UK, and
competitive activity in markets outside the UK by UK companies, as well as
promoting the interests of consumers, purchasers and other users of goods and
services, and the reduction of costs and development of new techniques. If the
CC concludes that a monopoly situation exists and that it operates against the
public interest, the Secretary of State (SoS) for Trade and Industry has the
power to make orders to remedy the problem. The SoS is under no obligation to
act.
The present investigation into extended warranties may
identify a number of aspects which operate against the public interest, but it
may equally be the case that the CC concludes that there are no adverse
implications for the public interest. If the CC decides that there are adverse
consequences, then a number of options may be available to the SoS for Trade and
Industry. If the CC finds that there is a problem in respect of competition and
that this is the result for the high cost of extended warranties, the SoS may
decide that legislation to promote competition might be the best way forward.
This would need to ensure that consumers are aware not only of the existence of
other warranty providers, but also of the price of such other warranties. In
fact, this was suggested by the OFT in its 1994 enquiry into the provision of
extended warranties. It considered utilising s.26 of the Consumer Protection
Act, 1987 to make an order on pricing of goods or services.
Consumer Protection Act: S.26 Order
This
section
(27)
enables the Secretary of State for Trade and Industry to make an order (by
Regulations) for the purpose of regulating the circumstances and manner in which
any person gives an indication as to the price at which goods or services will
be available, or indicates any other matter in respect of which such an
indication may be misleading. Under s.26(3), such Regulations may, in
particular, require an indication as to a price or other matter is accompanied
by additional information and that such information is accurate. In the context
of extended warranties, the Secretary of State could adopt Regulations in
respect of the way prices for extended warranties are given to consumers. If
there is sufficient evidence that consumers do not receive an adequate amount of
information, Regulations may specify that certain details must be given every
time a person is offering an extended warranty to a consumer. This could be a
statement advising the consumer to consider whether an extended warranty is
needed, bearing in mind the protection under the SoGA and under free guarantees.
It may also include the price and availability of a manufacturer’s
extended warranty, if this is offered. Other relevant details may be the scope
of the warranty, emphasising any important differences between retailer’s
and manufacturer’s extended warranties, as well as the price and
availability of third-party extended warranties. Other matters could also be
deemed relevant. Thus, where reliability data is available, it may be possible
to require that consumers should be given this information before deciding
whether to buy an extended warranty.
Top | Contents | Bibliography
Other Possibilities
A s.26 order may not be appropriate to deal with this
problem, and may not be enough to resolve the competition concerns that exist.
The SoS has the power to introduce Regulations that would address the public
interest concerns raised by the CC’s report, and he does not have to make
use of existing statutory provisions. It may, for example, be necessary to deal
with the pressure selling techniques adopted by some retailers. In this context,
it may be noted that the improved enforcement mechanism in Part 8 of the
Enterprise Bill, which is expected to become law in late 2002, only permits
action by the relevant enforcement authorities if a trader has failed to comply
with relevant civil and criminal law obligations. This does not extend to
behaviour which, although unfair, is not illegal. Although pressure selling
techniques may be regarded as unfair, they are not in themselves contrary to
existing consumer protection rules. Legislation in response to the CC’s
report could therefore seek to deal with this. There would be a number of
possibilities. For example, the SoS could decide to introduce a cooling-off
period for all extended warranties which would allow consumers to cancel their
extended warranties within a specific period. This could be set at seven or 14
days (which seem to be common periods) after purchase, although it may also be
possible to introduce a longer-term cooling off period. Such a longer period
would reflect the fact that most extended warranties do not take effect until
the manufacturer’s guarantee period has expired. More drastically, the SoS
could decide to ban the sale of extended warranties at the time of purchase of
the relevant product. This would not only eradicate the pressure selling
problem, but also allow consumers to compare prices and obtain a better deal.
However, it seems probable that such a response would be treated as
disproportionate. Whatever the outcome of the CC’s investigation (other
than a finding that there are no adverse implications for the public interest),
the SoS will have the opportunity to address the provision of extended
warranties and to introduce rules that could ensure that extended warranties
provide an realistic additional level of protection.
Top | Contents | Bibliography
Conclusions
This article has sought to explore the legal issues
surrounding the provision of extended warranties in the light of the OFT’s
report and the ongoing Competition Commission investigation. Although the
OFT’s report is helpful in putting extended warranties back on the agenda,
it is also disappointing for its lack of rigorous analysis and a failure to
examine the broader context in which extended warranties are provided. The key
problems are understanding the relationship between statutory rights and
extended warranties; the price of extended warranties and the financial
protection of consumers if providers become insolvent; certain terms and
conditions, and sales techniques.
There are some consumers for whom an extended warranty
is clearly attractive because it may reduce the risks associated with the
financial consequences of a product breakdown. Extended warranties offer
protection that goes beyond the level of protection provided under the Sale of
Goods Act 1979 and any voluntarily given manufacturers’ guarantees.
However, there are concerns over the pricing of such warranties and whether
consumers are given adequate choice. It seems that consumers could be better
informed with regard to the durability of particular products, as well as the
likely cost of repairs if a product breaks down. This would enable them to make
a better informed decision about the need for an extended
warranty.
The Competition Commission will need to investigate if
there is a real lack of competition and if competition would result in a
significant lowering of the price of such warranties. It is easy to suggest that
a lack of competition is to blame for high prices, but without a proper
understanding of how extended warranties should be priced, it is difficult to
say what a more realistic pricing level of warranties would be, nor can it be
concluded with confidence that increased competition would inevitably bring
about a lower price. The OFT’s report creates the impression that improved
competition will solve many of the problems with extended warranties, but this
may be doubted. An issue which has not received sufficient consideration is the
fact that extended warranties are purchased disproportionately by lower income
consumers. Surely a lack of competition cannot explain this pattern. Moreover,
there are consumer protection concerns, notably with respect to the selling
techniques adopted by some providers and the financial consequences for
consumers if a provider becomes insolvent. These will need to be addressed and
the CC’s report will hopefully provide the much-needed incentive to
address this issue. The CC has to report by July 2003 and its findings are
awaited with interest.
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Footnotes
(*)
I am grateful to Robert Bradgate and Richard Bragg for their helpful comments
and suggestions.
(1)
Once the Enterprise Bill becomes law, the provisions in the Fair Trading Act
1973 will be repealed and an improved framework for market investigations will
be put in place. However, the current investigation will be carried out within
the framework of the FTA.
(2)
The shorthand “statutory rights” is used in this article to refer to
the terms implied by s.13, s.14(2) and s.14(3) of the Sale of Goods Act 1979 and
the remedies for breach of those terms made available under the
Act.
(3)
Also, credit card providers are jointly liable for contractual claims, including
those arising from a breach of the terms implied by the Sale of Goods Act 1979,
if the goods in question are worth more than £100 (s.75 Consumer Credit Act
1974).
(4)
OFT Press Release PN40/01, 3
rd October 2001.
(5)
Although some extended warranties require a consumer to arrange for repairs
themselves and then claim back the cost subsequently.
(6)
In
Lexmead (Basingstoke) Ltd v Lewis [1982] AC 225, Lord Diplock (at
p.276) suggested that the implied term as to merchantable quality (now
satisfactory quality) was a “continuing term”. The better view seems
to be the one expressed in the main text, i.e., that compliance with the term is
assessed at the time risk passes. Defects which manifest themselves at a later
date are covered if these were latent at the time risk passed.
(7)
Although “reliability” is not a factor expressly mentioned in
s.14(2B), it could nevertheless be a “relevant circumstance” in an
“appropriate case”.
(8)
This comparison may also be made in relation to other factors. A particular
brand may be considerably more durable and its products may generally last for
longer than products made by competing brands.
(9)
Directive 99/44/EC on Certain Aspects of the Sale of Consumer Goods and
Associated Guarantees (1999) O.J. L177/12; 7 July 1999.
(10)
A clear case can be made for extending liability to the manufacturer: see
Bradgate and Twigg-Flesner (2002).
(11)
Whether it is strictly a contract of insurance is considered
below.
(12)
Although this still leaves unresolved the question why most guarantees are
limited to one year. It seems that there is at least some degree of
arbitrariness involved in this.
(13)
It must be noted that such an agreement would be horizontal in nature, rather
than vertical, because manufacturer and retailer would be operating at the same
level of the supply chain and would therefore be actual or potential competitors
in the provision of extended warranties. The distribution agreement between
retailer and manufacturer will be vertical and therefore be excluded from the
Chapter I prohibition by virtue of the Competition Act 1998 (Land and Vertical
Agreements Exclusion) Order 2000, S.I. 2000/310. This Order is currently under
review.
(14)
The Consumers’ Association Report on Extended Warranties (Consumers’
Association, 1994) includes extracts from various annual reports which suggest
that the revenue from the sale of extended warranties makes up a major part of
overall profits.
(15)
The words “price” and “premium” are used interchangeably
to refer to the sum paid by the consumer in return for the extended
warranty.
(16)
“Secured creditors” are those creditors who have obtained a charge
over some or all of the assets of the provider. This entitles them to realise
these assets and keep as much of the proceeds as is owed by the
provider.
(17)
The author is grateful to Robert Bradgate for drawing this point to his
attention. The following paragraphs draw heavily on Bradgate and White
(forthcoming).
(18)
In
Re Cavalier Insurance, mentioned below, it was held that the insurance
company which acted as underwriter for MG’s extended warranties did not
have the requisite authorisation.
(19)
MG may have needed some of the funds to pay for repairs and the retailer may
have needed the funds to obtain alternative cover for their
customers.
(20)
It is likely that the premiums will be paid into the provider’s business
bank account. In that case, the premium payment changes in character and become
a debt due to the provider from the provider’s bank. A consumer would
therefore have to trace his premium into this new asset.
(21)
Even a successful claim under the
Quistclose line of cases may fail if
the premium account is only set up as the provider is approaching insolvency.
The protection given to consumers by the trust device might be regarded as a
preference which could be set aside under s.239 of the Insolvency Act
1986.
(22)
In the context of life assurance, the uncertainty is obviously not whether the
person insured will die, but rather when that person will die.
(23)
In the U.S., it seems that this distinction has become fundamental and is known
as the “service-indemnity distinction”: see Samini
(1993).
(24)
The Court of Appeals of New York reached a different conclusion in
Ollendorf
Watch Co. v Pink (Superintendent of Insurance) (1938) 17 N.E.2d 676. In this
case, a manufacturer had given a “warranty” which offered a
replacement if the original watch was stolen. This was held to be a violation of
the relevant statute prohibiting a “transaction of insurance”
without authorisation. The UK’s authorisation system seems to have set a
higher standard than that which applied in
Ollendorf.
(25)
Thus proving correct the concerns felt by the electrical retailers in the
earlier case involving Multi Guarantee (
Re Multiguarantee Co Ltd [1987]
B.C.L.C. 257.).
(26)
It should be noted that the replacement system under the Enterprise Bill will
have significant differences. This will not affect the present enquiry, which is
carried out under the existing scheme.
(27)
Section 4 of the Prices Act 1974 also empowers the Secretary of State to
make an order on the way prices are indicated to consumers. Under this section,
orders can be made regarding the indication of the price itself as well as the
manner in which prices are given. However, this is limited to indicating prices
and the most recent measure under this section is the Price Marking Order 1999,
requiring an indication of prices per unit. The primary objective of this
measure would be to facilitate price comparison.
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