28 July 2009
A contract manufacturing arrangement typically involves a customer engaging a contract manufacturer to manufacture consumer products, which will then be sold by the customer into the market. Several unique risks can arise out of such a relationship, which are distinct from the issues present in other sourcing transactions. In large part, these risks arise from the fact that the customer’s core business is the sale and distribution of these products and that the products are being distributed into the marketplace, which increases the number of persons who could suffer harm from the products and increases product visibility. This article highlights a few key risks unique to contract manufacturing arrangements.
Delivery of the Products.
The purpose of the contract manufacturing agreement is for the supplier to manufacture products for the customer to deliver to the market. The customer’s business and reputation depends on its ability to supply product to meet its contractual obligations and market demands. Thus, the risk that the supplier does not deliver products in a timely way could have substantial consequences to the customer. The customer should give consideration to the remedies and penalties to attach to any such breach by the supplier, and protections for the customer to alleviate the potential consequences.
Regulatory Requirements, Specifications and Quality Measures.
The customer will want to market and distribute products that appeal to consumers and that meet or exceed industry standards for quality. In addition, the customer will want to ensure that its products are safe. Many consumer products are subject to regulatory requirements, which are typically imposed for consumer safety. The customer should build the obligation to meet regulatory requirements into the specifications for the products and include warranties from the supplier that the products will meet all legal requirements (in addition to warranties that the supplier will perform the services and its other contractual obligations in accordance with laws). The supplier should warrant that the products will conform to the specifications and meet or exceed industry quality measures, where appropriate. The customer should have inspection rights to confirm that the supplier is meeting quality standards in the manufacturing process, as well as to confirm the quality of the products themselves.
There is always the risk that the customer will not be able to successfully commercialize the product. This could result from, among other things, the failure of the customer to successfully market the product or a failure of the supplier to timely deliver products meeting contractual requirements. Consideration should be given to how to allocate this risk and the rights and remedies available to the customer where the risk results from supplier’s default.
Product Liability Risks.
One of the paramount risks associated with contract manufacturing relationships is product liability. Product liability claims can arise from the failure of products to meet regulatory requirements, specifications or quality measures or otherwise from defective products that lead to personal injury or death. Because of the potential significant costs associated with these claims, product liability indemnities are particularly important and it is essential that appropriate insurance be mandated by the contract and put in place. It is key for the insurance requirements to be appropriate for the particular industry and product.
Depending upon the type of product to be manufactured, warranties may be extended to the ultimate consumer of the product, and inevitably consumer warranty claims can arise. In addition, the manufacture, sale and distribution of consumer products give rise to the potential for product recalls, both voluntary and mandatory. The contract manufacturing agreement should define the responsibilities of the parties for these costs, and, perhaps as important—where the supplier is to bear the responsibility and liability—include appropriate mechanisms to ensure that the customer can collect from the supplier where it is responsible for these costs.
Intellectual Property Risks.
The distribution of products into the marketplace increases the potential risk for intellectual property claims. Appropriate and customary indemnification provisions should be built into the contract to protect the customer against third-party infringement claims. In addition, the customer will want to assess the ability of the contract manufacturer to bear the costs associated with such risk, and establish contractual protections to ensure that the supplier can fulfill its indemnity obligations.
The ability of the customer to continue to meet market demand and to have a smooth transition of the manufacture of the products post-termination is essential. The contract should contain appropriate post-termination assistance obligations and, in particular, depending upon the industry, should include an obligation for the supplier to continue to supply product for a period of time post-termination and/or to continue to supply service parts for the products to permit the customer to continue to meet its post-termination consumer warranty obligations and consumer demand generally.
Contract manufacturing arrangements relationships are complex. Each contract will raise issues unique to the parties and circumstances involved, and specialty areas of the law will likely be implicated. While parties may decide to allocate risks differently from that suggested above, our goal is to highlight some of the common risks unique to contract manufacturing arrangements in order to generate thoughts on the structure of the relationship.
Linda Rhodes focuses her practice on complex commercial transactions, including mergers, acquisitions and divestitures, contract manufacturing, outsourcing, transition services, strategic alliances, and information technology and telecommunications transactions. She has substantial experience in general corporate representation of clients, which includes advice on structuring and handling contract negotiations.