Contract manufacturing agreements: reducing legal risks

Contract manufacturers and customers should ensure that contract manufacturing agreements adequately protect them against legal risks. This can avoid unpleasant surprises when disputes or special situations arise such as a due diligence review in connection with financing or an acquisition of the contract manufacturer's or customer's business. There are a number of typical legal risks associated with contract manufacturing agreements that the parties should be aware of and that should be addressed during negotiations and reduced on the basis of generally accepted standards.

Preliminary Agreement. Sometimes the parties start implementing their manufacturing and supply relationship before signing a contract manufacturing agreement. This can save time and costs in the short term. However, the resulting uncertainty about the parties' mutual rights and obligations creates a significant risk and can lead to very expensive disputes with unpredictable outcomes. A better approach is to start the initial phase of cooperation on the basis of a letter of intent or similar preliminary agreement containing the most important provisions and to replace this with a comprehensive contract manufacturing agreement once negotiations on such a contract have been concluded. In these cases, the final contract should typically also cover the activities that have been carried out in the meantime before its signature.

Scope of manufacturing and delivery obligations. The importance of precise definitions of the products to be delivered and the services to be provided is often underestimated in contract negotiations. Although the specifications, quality requirements and other relevant details of the products and services are essential provisions for determining the parties' contractual rights and obligations, they are often less in the parties' field of vision during negotiations and when signing the contract. In practice, many disputes in connection with contract manufacturing agreements result from the fact that the parties have not agreed on a clear description of the products to be delivered and services to be provided and have not sufficiently aligned the annexes relating thereto with the main contract. Therefore, the definitions and annexes with the relevant details should be prepared and discussed with the same attention and care as the provisions of the main contract.

Exclusive purchase obligation of the customer. If the parties agree on an exclusive purchase obligation of the customer, its scope and duration must be defined in accordance with the requirements of the applicable competition law. For example, in the European Union, an obligation of the customer to purchase more than 80% of its total requirements from the contract manufacturer may be ineffective if it exceeds a period of five years. However, since 2022, exclusive purchase obligations that can be tacitly extended beyond a period of five years are permitted under EU competition law if the customer can renegotiate or terminate the agreement containing the purchase obligation with a reasonable period of notice and at reasonable costs, so that the customer can effectively change its supplier after the five-year period has expired. Different (initial and further) exclusivity periods in a contract manufacturing agreement are also possible, with different requirements for the purchase obligation for the first five years (total demand) and from the sixth year of the contract (80% of total demand). The parties should clearly describe the cases in which the customer can purchase the products from another supplier. Examples include certain cases of non-delivery or the purchase of products beyond the percentage of total demand relevant for exclusivity or beyond a certain maximum amount per year if the exclusive purchase obligation is limited to such a maximum amount. The contract should also regulate whether and to what extent the contract manufacturer is obliged in these cases to support technology transfer, supply documents and material or license IP to the extent necessary to manufacture the products.

Supply of products to competitors. Another legal issue to be considered in contract manufacturing agreements is whether and to what extent the contract manufacturer's ability to supply the same or comparable products to competitors should be limited. Non-compete clauses to the detriment of the contract manufacturer must, in order to be effective, be designed in accordance with applicable competition law. They may include the development, manufacture and supply of identical and/or competing products during the contract term and for a certain number of years thereafter. Clear definitions of the relevant terms (e.g. "competing products") are important to avoid future disputes.

Supply of defective products. There should be a clear mechanism for accepting and rejecting supplied products in the contract manufacturing agreement. The definition of "conforming products" may, for example, refer to products manufactured in accordance with the specifications, good manufacturing practice (GMP), quality requirements and/or applicable law. There should be a clear procedure for checking whether the products delivered conform to the contract, based on inspections and  rejections of products by the customer within certain time limits and the decision by an independent laboratory if the parties do not agree. Finally, it should be regulated what rights the customer has in the event of delivery of defective products (e.g. replacement delivery or refund of the price) and whether or not further rights should be excluded.

Non-delivery of products. If the contract manufacturer is unable or unlikely to deliver the products on the agreed delivery date, it should be obliged to notify the customer of the reasons for the non-delivery and its expected duration, and to propose and discuss with the customer any remedial measures or alternative solutions. Possible rights of the customer in the event of non-delivery, which may be staggered according to the number and duration of such non-deliveries, include e.g. (i) cancellation of the relevant purchase order, (ii) revocation of an exclusive purchase obligation and (iii) termination of the contract manufacturing agreement for material breach of contract in serious cases of continued non-delivery. Sometimes, in negotiations, the customer can obtain a commitment from the contract manufacturer to produce and store a certain quantity of products (e.g. depending on the quantities of forecast demand) as a safety stock in order to reduce the customer's risk associated with non-delivery.

Termination of the contract. The conditions and consequences of contractual termination rights of the parties should be carefully considered and formulated. In addition to termination rights in the event of a material breach of contract or insolvency of the other party and ordinary termination rights, other termination rights can also be agreed, e.g. in the event of a change of control over the other party, force majeure, revocation or non-granting of regulatory approval for the product or if the customer decides to stop developing and/or commercializing the product. In order to avoid later disputes, it can be helpful to define in the contract manufacturing agreement certain cases that are to be regarded as material breaches of contract, e.g. certain cases of ongoing non-delivery or a breach of the non-competition clause. Depending on the applicable law, there may also be other statutory termination rights (e.g. under German law, the mandatory right to terminate certain contracts for good cause) or the risk that a termination right may not be effective or enforceable under certain circumstances (e.g. under German law, the right of termination in the event of the insolvency of the other party, the effectiveness of which, according to a decision of the Federal Court of Justice in 2022, may depend in particular on whether it pursues an objective justified under insolvency law).

Intellectual property rights. Negotiations on the allocation of new intellectual property rights created by the contract manufacturer during the performance of the contract manufacturing agreement can be difficult. If the customer has paid for the development of the product and its manufacturing process, the parties will often agree that all intellectual property rights arising during the performance of the contract that relate to the product and its manufacturing process should belong solely to the customer. An exception often applies to new intellectual property rights that relate exclusively to previously existing or independently developed intellectual property rights of the contract manufacturer which shall be solely owned by the contract manufacturer. In these cases, the customer should be granted a non-exclusive and free license to use the relevant intellectual property rights of the contract manufacturer for the further development, manufacture and commercialization of the product. In addition, certain contractual provisions may be necessary under the applicable employee invention law (e.g. under German law, the obligation of the contract manufacturer to claim all rights to the employee inventions) to ensure that the customer can become the owner of the new intellectual property rights allocated to him. Co-ownership should be avoided if possible because under some legal systems (e.g. under German law) this requires complicated contractual arrangements to avoid undesirable consequences of the applicable statutory provisions.

 Indemnification obligations. Another issue that is often the subject of difficult negotiations is the scope of mutual indemnification obligations. In principle, each party usually indemnifies the other party against damages and liability based on third party claims as a result of certain actions or circumstances for which the indemnifying party is responsible. Typical cases are a breach of the contract manufacturing agreement and (gross) negligence or intentional conduct of the indemnifying party. Such indemnification obligations may also cover other circumstances, for example the infringement of third party intellectual property rights by certain conduct and the use or sale of a product manufactured under the contract, depending on whether it was conforming or defective at the time of its delivery to the customer. Indemnification obligations should be limited by excluding such damages and liability caused by the (gross) negligent or intentional conduct of the other party or its breach of contract.

Limitation of liability. The total liability of the contract manufacturer under the contract (sometimes excluding liability arising from indemnification obligations) is usually limited in amount, either by a fixed amount or a variable amount, such as a certain percentage of the total fees payable or paid by the customer to the contract manufacturer over a certain period of time under the contract manufacturing agreement. The extent to which such limitations of liability are permissible and enforceable under the applicable law should be carefully examined. For example, under German law it is not possible to (i) exclude or limit liability for willful intent in individual contracts and standard terms and conditions and (ii) exclude or limit liability in various other cases (e.g. for gross negligence, for personal injury and for breach of certain material contractual obligations) in standard terms and conditions. According to the case law of German courts, the requirements for proving that certain contract clauses are not standard terms and conditions but have been individually negotiated are very strict. The significant risk of liability limitation clauses being ineffective under German law can be reduced in a number of ways, for example by clearly documenting the individual negotiation of such clauses.

 The issues raised above are by no means the only legal issues that require attention when negotiating contract manufacturing agreements because they can lead to disputes. However, experience shows that taking these issues into account can help to significantly reduce the legal risks associated with such agreements.