How Are Commercial Service Contracts Regulated?
Aaron Lunt | December 1, 2022
A service contract covers the breakdown of a tangible good—an automobile, consumer product/electronic device (e.g., television or cellular telephone), appliance (e.g., washing machine or dryer), or system (e.g., HVAC) that consumers frequently use in their daily rhythms of life.
These goods are used from sunup to sundown and help us manage every aspect of life in between; they are ubiquitous. You can find these products in homes, in garages, and on our persons as we roam around. There's a well-established regulatory structure to sell service contracts on these tangible goods that are designed for personal use to manage risk and help absorb losses due to breakdown or wear and tear. But what if the good is used for commercial purposes or is purchased by a business? Does the same regulatory framework exist for these transactions? This article will not discuss how each state independently treats commercial service contracts; rather, it will illuminate a few key considerations that one must take to analyze this issue.
How Do Statutes Position this Issue?
Approximately 38 states have some sort of service contract statute, with most additional states having another statutory or regulatory exemption that lessens the regulatory requirements of service contracts. Arguably, service contracts would be considered insurance, as all the core elements are present: an unintended, fortuitous event (an unforeseen breakdown or damage due to wear and tear), the shifting of liability (to a third-party service contract provider), a fee for the product (insurance would call this the "premium"), and a loss payment that is covered by an administrator.
With insurance regulation, there is rigorous regulatory oversight, including strict financial requirements for insurance companies and detailed rate and form filing requirements that govern the sale and distribution of these products. Without these service contract statutes or exemptions, service contracts would likely be regulated similarly to a traditional insurance contract—much like when purchasing automobile insurance that extends coverage for liability and property damage to your vehicle.
So, the controlling regulatory authority for commercial service contracts is determined by the state's service contract act or exemption and the insurance laws of the state.
The State's Service Contract Act or Exemption
A closer analysis of the legal framework is needed to make the determination of whether a commercial service contract falls under a particular state's service contract act or exemption. Of the states that have a statute or some sort of guidance on the regulation of service contracts, a close analysis of the language is necessary. States typically fall into one of three buckets in their treatment of commercial service contacts.
First Bucket: The Hunt for a Commercial Exemption
Several states explicitly use the word "commercial" and exempt contracts from the purview of the service contract statute, which typically manifests in one of two ways.
Example 1. The National Association of Insurance Commissioners has a model service contract statute that served as the baseline for state adoption of a statute. Within the model act, there is an express commercial exemption that reads as follows.
Example 2. Massachusetts section 149N, pertaining to service contracts, states the following.
… the marketing, sale, offering for sale, issuance, making, proposing to make and administration of service contracts by providers and related service contract sellers, administrators and other persons shall be exempt from all other provisions of [the insurance code], including any non-consumer commercial service contract." [Emphasis added.]
— Mass. Gen. Laws Ann. ch. 175, § 149N(i) (2022).
These explicit exemptions seem to categorically remove commercial transactions (two business entities engaging in commerce) from the purview of the service contract statute. The logic revolves around the fact that a commercial purchaser is more sophisticated than a consumer and has greater negotiating leverage, awareness of the industry, and an overall better position to protect themselves from making an uninformed decision.
Second Bucket: Use of "Consumer" in Key Definition
Most states define service contracts in a way that indicates a consumer is an entity involved in the transaction, thereby focusing on a consumer transaction as the scope of the statute. The method in which the state defines a service contract can be instructive, absent an express commercial exemption. For example, Michigan defines a service contract as follows.
"Service contract" means a written contract that is sold for stated consideration for a specific duration that provides any of the following: (i) To perform or provide reimbursement for the repair, replacement, or maintenance of a consumer product because of the operational or structural failure of the consumer product due to a defect in materials or workmanship; accidental damage from handling, power surge, or interruption; or normal wear and tear, with or without additional provisions for incidental payment of indemnity under limited circumstances, including, but not limited to, towing, rental, and emergency road service. [Emphasis added.]
— MCL 500.125(b) (2022).
The above emphasis is added to show that the very definition of service contract contemplates coverage revolving around a consumer product or transaction, without any explicit reference to a commercial transaction.
Third Bucket: Silence
Several states are silent on the treatment; either there is not an express exemption, or the definition of service contract does not reveal helpful information. To highlight the differentiation in definition, Montana defines a service contract as follows.
A contract or agreement for a separately stated consideration for a specific duration to perform the repair, replacement, or maintenance of property or to indemnify for the repair, replacement, or maintenance of property if an operational or structural failure is due to a defect in materials or manufacturing or to normal wear and tear, with or without an additional provision for incidental payment or indemnity under limited circumstances, including but not limited to towing, rental, and emergency road service. A service contract may provide for the repair, replacement, or maintenance of property for damage resulting from power surges or accidental damage from handling.
— MCA § 33-1-102(10)(b) (2022).
As illustrated in the definition, it makes no reference to a commercial transaction and remains agnostic in the treatment of commercial versus consumer goods. There is no qualifying language indicating it applies to a "consumer product," rather, it discusses the repair, replacement, or maintenance of "property" and does not go further. As discussed below, these states present a unique challenge.
So, Which Is the Right Bucket?
Each provider, administrator, or industry participant must reach its own conclusion on how commercial service contracts are regulated. True, regulators typically take a softer posture on the rigors of regulation surrounding commercial transactions, but that is not certain, and each provider must perform its own legal analysis to reach a sensible conclusion. Regardless, even if a provider is comfortable that commercial service contracts should not be regulated the same as a consumer service contract, there's a separate analysis that must be entertained.
Is It Insurance?
If outside of the service contract act, a provider still must conclude the transaction is not insurance. For most states, service contracts are granted a unique status under the law and are not considered insurance (Florida excepted). Insurance products are heavily regulated, with an intense regulatory framework regarding the sale and distribution of products, including rigorous financial requirements for admitted insurers and extensive parameters dictating the insurance coverage form itself and the rates charged.
Service contracts are granted a lesser form of regulation, which is outside the scope of this article. To highlight one area, many states do not require form filings for service contracts, which is typically not the case for insurance forms. As another example, most states do not require a licensed producer to sell service contracts, which is not the case for insurance transactions. These differences are consequential in the marketplace.
The reason this issue is important is that a service contract would qualify as insurance but for the exemptions or statutory framework that provide a service contract a separate designation that lessens the regulatory oversight. Some states include additional language to their laws that expressly exempt those agreements from the insurance code to ensure the insurance exemption extends to commercial service contracts. For example, Wyoming's service contract act exempts as follows
(b) The following are exempt from [Wyoming's service contract act]:
. . .
(iv) Service contracts sold or offered for sale to persons other than consumers.
(c) The types of agreements referred to in subsection (b) of this section do not have to comply with any provision of the insurance law of this state.
— 26 Wyo. Stat. § 49-101(b)–(c) (2022).
On the other hand, if the service contract law or framework has an express commercial contract exemption without an exemption from the insurance laws, or if the definition of service contract only affords an exemption for a "consumer product," the industry must determine how to treat commercial service contracts.
Is It Nothing?
Possibly. It may be a plausible conclusion to treat commercial service contracts differently than traditional insurance products. That said, is it an unregulated product? Probably not, as everything is regulated in some fashion and could be subject to the insurance commissioner's jurisdiction, and they could exert authority over the sale, distribution, or delivery of the product. It's just a complicating factor and a consideration that must be reconciled.
Next Steps
This article does not provide legal advice; it is written to highlight this unique challenge. Each provider of service contracts must work with their in-house or external legal counsel to determine the best pathway to comply. Several states have provided clarity on this topic beyond what might appear in the legislation or regulation, such as through direct correspondence with individual companies or through other forums.
There are assumptions that commercial purchasers are more sophisticated than individual consumers due to the nature of their business, their negotiating position, and a host of other factors. This may lead to a reasonable conclusion that if a state is not explicit in the treatment of a commercial service contract, it does not necessarily elevate it as an "insurance transaction" and is treated with more scrutiny and regulatory oversight than a consumer service contract. In many ways, this would be irrational.
Final Takeaways
Each provider, administrator, or industry participant must perform its own risk assessment and analysis, the assumption being that each company must perform a risk assessment to determine how best to treat commercial service contracts. There are several best practices that can be deployed to best position a provider in a way to limit regulatory scrutiny, ensure adequate protections are in place, and limit the pain points a regulator may experience due to provider insolvencies, denied claims, customer complaints, and a host of other traps that trigger an inquiry. The best posture is to deploy a strategy that emphasizes fairness and transparency to ensure an arm's-length transaction takes place and to elevate as many "consumer protections" as necessary to the commercial entity.
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