Outsourcing Product & Regulatory Liability Gains With OEMs
Contract Manufacturers Look to Fulfill Needs, Jump Legal Hurdles
By Andy Teng
As full-service, outsourced manufacturing gains greater inroads in the medical device industry, the relationship between OEMs and their contract manufacturers continues to change as well. Evolving from what has traditionally been a disconnected, vendor-buyer rapport, their roles are transforming in numerous ways as the two sides grow more symbiotic and embedded in each other’s operations.
One clear indicator of this change is how contract manufacturers are shouldering more risks for customers, especially in the area of liabilities—both product and/or regulatory. That’s because as OEMs increasingly look to shed manufacturing burdens, including product liability risks, their outsourced partners are often more than willing to take on these additional risks. By further insinuating themselves in their customer’s operations, vendors sometimes secure long-term relationships, sell value-added services and gain happier clients in the process.
This trend is also fueled by more OEMs outsourcing not just components but entire finished goods. These services may also include ancillary services such as product design, sterilization and packaging—steps in the supply chain with risks. By leveraging the expert knowledge and infrastructure of contract manufacturers who have invested in costly capital equipment and comprehensive quality systems, OEMs through outsourcing can actually reduce their liability exposure while cutting costs.
However, handing important responsibilities to vendors should not be taken lightly. Legal advisors familiar with outsourced liability issues say customers need to ensure that agreements with vendors cover a myriad of contingencies, especially when it comes to regulatory actions. For instance, determining which party is responsible for handling recalls or for maintaining product histories in case of an FDA audit should be clarified prior to products rolling off the line. Failing to do so, legal experts say, could lead to big headaches later.
Additionally, not all vendors are ready to take on greater liability. Many have traditionally operated as component suppliers and competed on price rather than value-added services. As OEMs look to incorporate contract manufacturers into risk management programs—through expanded indemnification provisions, for instance—some vendors are pulling back from taking on more risk, at least not without incentives to do so. Also, some component makers simply don’t want the added exposure.
Another concern for OEMs seeking to shift liability is ensuring that vendors, especially those overseas, are still operating in case of claims. With more outsourcing going to offshore suppliers in developing markets such as China, device makers must be absolutely sure about the solvency of suppliers to protect their interests.
Industry observers say these trends point to a significant change in outsourced medical device manufacturing: the relationship between OEMs and contract manufacturers has become more complex, and as a result the contracts themselves have also become more complicated.
“Five years ago, the customer base was not as defined as it is today. That’s what is driving the change you’re seeing. What’s happening in the market is that finished goods are becoming a bigger and bigger piece of the pie,” said Duncan Simpson, executive vice president and general counsel for Fort Worth, TX-based Avail, a leading single-use medical device outsourcer.
Simpson said with demand for outsourced finished goods significantly outpacing the general contract manufacturing market, many component suppliers are being pulled into a market segment to which they are not accustomed. To provide finished products, component makers must invest in stronger quality programs and be willing to take on more risk for their clients. This can mean indemnifying for faulty products, handling recalls and other liabilities.
While this trend has made little impact on companies such as Avail, whose business model is built on full-service outsourcing, the change will have a much more profound impact for many component providers. To meet customers’ needs, they might have to increase liability insurance coverage, bolster quality systems, invest in regulatory expertise and work more closely with clients in the front and back ends of product development. Another growing practice is the use of joint service agreements, which act as addendums to boilerplate contracts to help further define the role of customers and contractors.
“In the finished goods model, the OEM has no choice to push more obligations onto the contract manufacturers,” Simpson added.
Varying Risk Levels
Of course, liabilities can vary widely depending on the medical device. The contract manufacturer of a critical care product faces markedly greater exposure than a counterpart making a Class I device. So when medical device OEMs outsource, they must be mindful of the risk factor when choosing a partner; the selection criteria should reflect the type of product manufactured and the contractor’s capabilities and skill set, according to Roger Thies, a partner at Hyman, Phelps and McNamara, a Washington, DC-based law firm specializing in healthcare.
Thies, who helps life sciences companies comply with applicable FDA regulations, said outsourcing accords should cover a multitude of issues such as requiring contract manufacturers to comply with the Quality System Regulation (QSR), provide access to device history records, cooperate with the customer in case of recalls or other enforcement actions and additional provisions. Holding contractors accountable for these issues, along with conducting regular audits, are ways OEMs can reduce their risk exposure, he added.
One consideration that medical device companies sometimes overlook is requiring contract manufacturers to communicate any significant change in the manufacturing process, even when the change is perceived as minor. Because some of these changes may require resubmission to the FDA—when substantially substituting a component’s materials, for instance—failure to communicate this to the customer could result in severe consequences, Thies explained.
“Frequently, they (OEMs) don’t have enough control over changes that the vendor might make, and a lot of companies have gotten into trouble,” he said. “I’m aware of companies who have had to make recalls because their supplier thought the change they made was inconsequential, and it wasn’t inconsequential.”
Thies recalled one instance in which a device maker’s supplier made a change in a semiconductor that led to a recall and the eventual demise of that company. The difficulty, he pointed out, is many items are purchased off the shelf, but the manufacturer responsible for the finished device—whether the OEM or the contractor—must ensure that the products meet the appropriate specifications and are appropriate for their medical device. These include computer chips, wiring, plugs and many other common components.
Internal and External Management
Managing risk and liability exposure includes both internal and external management. Making sure off-the-shelf components are compliant requires much more internal vigilance, while outsourcing finished products requires greater faith in the partner. In recent years, OEMs are demonstrating that they have more confidence in the contract manufacturing marketplace by engaging in “scope creep,” in which suppliers are being asked to take on more services and liability beyond their original agreements. This has particular benefits to device manufacturer, said James Ravitz, a partner with Washington, DC-based Arent Fox, a life sciences law firm, and a contributing columnist to Medical Product Outsourcing.
Ravitz said shifting liability to contract manufacturers is a growing practice, particularly as contracts become more specific in assigning liability and product complexity grows. This will require service providers to possibly spend more time and resources on reviewing contracts. This is also being driven in part by the maturing of outsourced manufacturing, which has led to more sophisticated customers paying closer attention to contract terms and demanding stricter quality control.
“You’re going to see product companies ask for full indemnification. Passing on that risk is going to be important,” Ravitz said. “It’s less of an issue when it’s a component but more of an issue when you use full service.”
Ravitz also noted that with more companies outsourcing, the FDA will likely step up enforcement actions against non-compliant contract manufacturers. This could also mean more headaches for OEMs as well, because even though they are outsourcing finished products, as holders of the 510(k) and PMAs, they are ultimately responsible for the safety of their products. Still, having contract partners to help buffer some of the liability is comforting.
For companies such as Avail, the industry’s maturation has resulted in little impact on its business model, said Simpson. He noted that although the company has largely abided by the same contractual terms with its customers during the past several years, clients are asking for slight language changes in the accords to make them even clearer. In addition, deal sizes have grown as well, with some of them now $30 million or $40 million in size, up from just a few million dollars several years ago. This growth in contract size automatically draws more scrutiny from all sides, and, as a result, has led to further dovetailing of contracts. While it may require more work, this shift is indicative of how enthusiastically OEMs have embraced outsourcing.
“There’s no mystique behind drafting agreements; it’s an allocation of risk. The allocation of risk hasn’t changed for us over the past five years, whether it’s a pricing model or supply chain,” Simpson added. “The industry, as I see it, has become more sophisticated. As we deal with the larger OEMs, the language has to reflect their sophistication.”
Indeed, the continued rapid growth of outsourced manufacturing will lead to the refinement of contractual terms, transfer of liability and better management of risk by OEMs. But their gain doesn’t necessarily mean contract manufacturers’ loss. More likely, service providers will gain in other ways—through more lucrative deals, longer contracts and stronger relationships with their customers. This market shift is simply escalating the outsourcing model to another level, one in which vendors prepared to take on the added responsibilities—and the rewards—will come out the winners. Still, the market will remain segmented with component makers expected to retain the largest portion of the outsourcing business for some time. But as medical device makers look for value-added services, these vendors may have to reconsider whether they can retain their market share under the old business model.