Contract manufacturing agreements: the key issues to get right

Contract manufacturing arrangements vary from straightforward supply of goods in two crucial ways:

1. The contract manufacturing organisation (CMO) will be reliant on the customer to provide something for the manufacture to take place – it may be the free issue of materials or the provision of a technical package (i.e. the specification for the product or the process to follow).
2. Each party is likely to contribute intellectual property (IP) to the arrangement, so it can be unclear who owns the IP in the end-product, the process and/or the specification.

In this article, commercial partner Lucy Pringle explains what provisions the CMO should put in its standard contract manufacturing terms to protect itself on these two fronts.

Even if you do not view yourself strictly as a CMO, the points in this article will be relevant to you if you collaborate with customers on the design or development of products you supply.

Customer supplies materials or equipment

If the customer free-issues materials or equipment (such as tooling) to use in the manufacture of the product, your contract needs to:

1. Detail what materials/equipment are to be supplied, the quantities, and the delivery dates and terms.
2. Contain a warranty from the customer about the quality of those materials/equipment.

If materials or equipment are delivered late, you could miss a production window and incur wasted labour costs. If the materials do not comply with their specification, you could suffer wasted expenditure for comingled product, and in some cases clean-down costs for your plant.

Therefore, the CMO needs an indemnity from the customer if the materials or equipment are not compliant with their specification, are delivered late, or infringe the IP rights of a third party.

It is also a good idea to set out the conversion efficiencies the CMO is expected to achieve with the free-issue materials, to avoid arguments about loss tolerance.

Customer supplies the technical package

The customer may supply the specification that the end-product needs to be manufactured to. Alternatively, they may supply the process to be followed, or simply some manufacturing know-how.

Your contract needs to set out details of what the customer is obliged to provide, and when it will be supplied. You should obtain an indemnity for any third-party claims which arise from your use of the technical package, so that you are protected if the know-how provided to you does actually not belong to the customer.

Dependencies drafting

It is crucial to include wording in the contract which states that if the customer does not comply with its obligations, the CMO will be released from its obligations correspondingly. For example, if the materials supplied by the customer are defective, then the end-product will not comply with its specification.

This wording avoids the CMO being put in breach of contract by the customer’s failure.

What warranties should the CMO give?

If the CMO is confident that a guaranteed result can be achieved, then the most appropriate warranty is that the end-product will comply with the agreed specification.

If the CMO’s job is simply to follow the process provided by the customer, then that is the warranty that should be given. Beware warranting compliance with the specification and that the process will be followed, unless you are certain that following the process will lead to compliance with the specification.

If development services are experimental in nature and an end result cannot be guaranteed, the contract should make this clear.

Who should own IP rights?

Contract manufacturing often involves the CMO and customer both contributing know-how to the arrangement. However, it is common for parties to fail to discuss who owns the IP in what is developed. Even if the matter is discussed, it can be hard to agree who should own the resulting IP since both parties may have contributed to it.

There is no hard and fast rule. If the CMO wishes to be able to use the manufacturing techniques or specification which have been developed in order to work for other customers, then the CMO will either need to retain ownership of the IP rights, or at least get a licence of them. If the customer wishes to have exclusivity, it may insist on owning the new IP.

There are, however, three absolute rules for CMOs:

1. Never assign ownership of your background IP to the customer, i.e. your know-how which existed before working with the customer. Sometimes a customer’s terms will state that ALL IP transfers to them, which could include your background IP. Watch out for this.
2. Avoid joint ownership of IP – the law does not recognise this and it creates an unclear position.
3. Any generic improvements developed by the CMO as a result of working for a customer (e.g. developing a technique for filling bottles quicker) should always be retained by the CMO, to ensure that this know-how can be used for other customers.

Why is it important to document the IP ownership position?

Whilst a relationship with a customer is working well, it may seem unnecessary to rock the boat by insisting on documenting who owns the IP. The key reasons to do so are:

1. Your customer could try to move their business to your competitor, by giving them the process know-how or specification you have produced. If you cannot demonstrate that you own the IP, you would not be able to prevent this from happening.
2. If you wish to sell your business at some point, a potential purchaser will want to know what IP rights it is buying and whether key customers are ‘sticky’ to the business. This will affect valuation.

It is far better to seek agreement with customers when the relationship is good, than wait until either of the above two circumstances arise before attempting to assert IP ownership.

Always check your standard terms cover the above points. Your customer may seek to apply their own contract terms to your relationship, but they are very unlikely to cover these issues in your favour (or at all).

If you need a review of your own contract manufacturing terms, or help negotiating terms with customers, please contact Lucy Pringle.