Expanding on our recent discussion about how your shipping terms can affect risk of loss in the product you sell, let’s turn to other contract provisions that implicate the same issue: sales on approval or return.  Under both a “sale on approval” and a “sale or return,” the buyer retains the right to return the goods to the seller, even if they conform to the sale contract.  The difference is that a “sale on approval” arises when the goods are delivered to the buyer primarily for use, whereas a “sale or return” arises when the goods are delivered to the buyer primarily for resale.[1]

These are peculiar contract terms and, frankly, I don’t suggest you use them.  However, they are fairly common in manufacturing (both on the procurement side and the sales side), so it is worth addressing them so (a) you can recognize them when you see them, and (b) you understand what they mean and how to use them correctly.

The underlying purpose of these types of contracts, of course, is to induce a sale that a buyer may not otherwise agree to, by giving the buyer an option on whether it will keep the goods or return them.  But, unless the written agreement[2] specifies otherwise, the two types of contracts can pose special risks to the buyer and seller.

First, in a sale on approval, the goods are not subject to claims by the buyer’s creditors unless and until the buyer accepts them.[3]  Conversely, in a sale or return, the goods are subject to claims by the buyer’s creditors.  Accordingly, if you are the seller in a sale or return, you should strongly consider taking and perfecting a purchase money security interest in the goods to minimize the risk that a creditor of your buyer leaves you without the goods or the payment.

Second, in a sale on approval, risk of loss remains with the seller unless and until the buyer accepts the goods.  This means that, if the buyer elects to return the goods, the seller continues to bear the risk of loss during the return (and also the expense of the return).  In a sale or return, however, the buyer bears the risk of loss and expense of return should it elect to return the goods.  If you are the seller in a sale on approval, you should consider incorporating return instructions into the contract, to ensure that due care is taken in effecting the return.[4]

Third, the contract must be crystal clear as to the arrangement contemplated.  Where there is ambiguity in the contract documents, courts will (correctly) presume that the contract did not intend a sale on approval or sale or return.  Further, where issues of risk of loss or the rights of third-party creditors arise, courts will not hesitate to look to the parties’ conduct to determine whether an ambiguous contract was intended to be a sale on approval or sale or return.  For instance, in one Wisconsin case,[5] the court examined whether wood sold to the buyer and incorporated made into cabinets for resale was provided for “use” (indicating a sale on approval) or for “resale” (indicating a return or sale).  The distinction was critical, because one of the buyer’s creditors had seized and resold some of the wood, and whether the creditor had the right to do that was entirely contingent on whether the sale was made on a sale or return basis.

These types of contracts are fraught with peril and, again, I advise against using them.  But if you choose to do so anyway (or a critical customer insists on it), keep these issues in mind and be sure that you take appropriate steps to mitigate the risks, including providing contract terms that alter the default rules imposed by the UCC.