Negotiating Medical Device Outsourcing Agreements
Understanding the strategies and pitfalls of manufacturing contracts can save time and frustration.
Christopher J. Donovan, Esq., McDermott Will & Emery
Against the backdrop of one of the most significant recessions of all time, medical device manufacturers have placed increased focus on reducing costs through outsourcing key components of
manufacturing. While quality, in all likelihood, has been, is and will be the overall primary screening tool, device manufacturers—particularly publicly traded firms—are looking for new ways to reduce inventory “carry” on their books, retain competent outsourcing firms and outsource major stages of product delivery, and increasingly design with partners they can trust.
Simultaneously, there is a renewed focus by the U.S. Food and Drug Administration (FDA) to counteract a perceived softness in enforcement under prior administrations including, but not limited to, the issuance of warning letters without internal counsel review, post-market surveillance of premarket approval products and the increased issuance of warning letters as to domestic and foreign production capacity. These enforcement efforts will focus on supply chain management, including outsourcing.
Global health reform efforts, especially in the United States, also provide a meaningful backdrop for the current context of medical device outsourcing. Despite the fact that a so-called “public option” of mandatory national, publically paid health insurance is unlikely to occur, the envisioned reform bills pending (as of press time) contemplate insurance “exchanges” where private insurers will compete for government-subsidized insurance.
In return for new covered lives, insurers will need to accept margin controls and lift pre-existing condition controls, all of which will drive the need for greater cost controls. These controls will be pushed down to providers and manufactures of devices, resulting in enhanced focus on cost and quality despite an enlargement of the target patient population. This cost containment for market size expansion tradeoff will result in greater opportunity and need for outsourcing, possible mergers among outsourced firms to provide a broader, one-stop option and reward those with quality and cost systems viewed as superior by manufacturers.
Against this background of cost control, enforcement and reform, this article identifies the major issues in most medical product outsourcing contracts. It attempts to lay out the motivations and goals for both sides with the objective of coming to a mutually advantageous agreement from both the OEM and contract manufacturer standpoints.
Document Structure; Performance Criteria
In the United States, FDA regulations require (21 CFR 820.50) that each OEM maintain detailed protocols on the selection of and quality of each supplier of goods and services to the OEM. Consequently, outsourcing contracts frequently come in several constituent parts consisting of (a) a supply agreement; (b) separate quality standards; and (c) supplier manuals; or other similarly labeled documents. In many cases where a contract manufacturer is working off purchase orders, simply a quality assurance or quality agreement is utilized. However, it is important for both the contract manufacturer and the OEM that there be consistency between these constituent documents.
It is not unusual to have a relationship that starts with a purchase order containing a separate quality agreement to progress to a full supply agreement. So that both sides understand their respective obligations, it is important that inconsistencies between documents be removed, and documents that supersede earlier documents clearly indicate such.
Increasingly, OEMs require contract manufacturers to cooperate to identify the “root” cause of any Medical Device Reports (MDRs), Medical Device Vigilance Reports (MDVRs) and other similar evidence of potential device failure or potential adverse patient experience that the OEM is required to publicly report. Increasingly, this reporting is finding its way into detailed provisions; most OEMs require contract manufacturers to maintain specific record-keeping, including device traceability to assist the OEM in any investigations relating to such issues.
The important distinctions in this area are for the parties to agree that burdens on the contract manufacturer be limited to those devices in which it can be proven that the contract manufacturer’s product has potentially contributed to a malfunction under an agreed standard. The scope of such provisions as well as the costs of compliance (e.g., recall) is an area that requires significant discussion of both the parties with the appropriate balance frequently arrived at through a combination of itemization of specific steps of cooperation, financial limits and/or minimum/ maximum responsibilities.
Most outsourcing agreements require the contract manufacturer to cooperate with all product recalls initiated by the OEM. In cases where the OEM is not sure whether the contract manufacturer’s product contributed to the defect resulting in the recall, cooperation by the contract manufacturer is typically at the OEM’s cost and expense.
OEMs typically design their own medical devices and provide the embedded intellectual property (IP) to the CM for manufacture. IP embedded in the device is warranted as owned by the OEM, and the OEM provides the contract manufacturer with a full indemnification.
One area of oversight in many contracts is the intellectual property developed by the contract manufacturer in processing the part for the OEM, or using tooling associated with or provided by the OEM in connection with such production. Most often, OEMs lay claim to all IP derivatives otherwise associated with the manufacture of their product. Contract manufacturers, however, frequently maintain that process improvements associated with manufacturing the parts, as opposed to design, are retained by them.
Perhaps there is no larger area of potential dispute in the outsourcing agreement than indemnification as it presents a mixture of legal and economic issues for both sides. Normally, OEMs seek the contract manufacturer to provide a warranty that the product is in compliance with specifications and free from defect and suited for the purposes for which it is produced (i.e., medical device). They seek indemnification for any third-party claims in connection with a failure of a component in a device that is sold to the public.
However, in most cases, contract manufacturers are not financially positioned nor are their products priced in such a fashion to accommodate the type of potential product liability exposure that most OEMs price into their products.
Consequently, in most cases a negotiation on the limits associated with such indemnification is discussed between the parties. This negotiation can take several forms including (a) narrowing the scope of the warranty so that the product is in compliance with specifications rather than its suitability for a particular purpose; (b) disclaimers of any liability associated with product design which is typically the domain of the OEM; (c) caps or baskets on the overall liability incurred by both sides; (d) limits on the amount of recall exposure incurred by the contract manufacturer in connection with an OEM recall; (e) disclaimer for so-called indirect or consequential damages such as lost profits; and (f) carve outs from any indemnity for the reckless conduct of a party. Contract manufacturers must be careful in connection with negotiating indemnification to be certain that they either have the financial wherewithal or the insurance to back up any indemnification claims in the product liability arena. In that connection, it is prudent to have insurance experts or counsel to review any contract indemnification language before it is finalized.
An area of frequent dispute is in forecasting inventory demand and whether such forecasting is binding or non-binding together with the associated issue of whether stock that is not purchased based on forecasts is at the risk of the OEM or the contract manufacturer.
Most contracts say forecasting is non-binding, but if specification changes or forecasts deviate by more than a certain percentage, the OEM either has full exposure or exposure up to a certain amount for non-purchased product, work in progress or raw material.
Inventory Management and Consignment
The request for consignment inventory creates a conflict between the parties; the OEM does not necessarily want to purchase the product, consistent with consignment accounting, while on the other hand, the contract manufacturer wants the OEM to buy the consigned product, which is not sold given the custom nature of the production of such components.
Compromises in this area include a cap on the amount of consignment inventory at the OEM, the use of kanbans, safety stock and other contract manufacturer onsite tools to insure the availability of future supply. Additionally, advance notice of consignment obsolescence (to allow remaining product to come off consignment) and similar forecasting tools can help bridge the divide between the OEM and contract manufacturer.
Inspection Compliance Certification
In almost all outsourcing contracts, both parties seek to obtain the other’s consent or certification performance as early as possible after product is shipped. For OEMs , this takes the form of the OEM requiring the contract manufacturer to supply compliance certificates; for contract manufacturers, this takes the shape of the contract manufacturer requiring the OEM to inspect (or approve) a product within a certain number of days of receipt, barring all claims not made.
In fact, FDA regulations (21 CFR 820.8) require that each OEM has an inspection protocol including inspection testing. These types of provisions do not work in all circumstances due to the nature of the product. In most cases, the OEM should be in a position to certify some type of testing of a product within a certain number of days of receipt and CMs are prudent to ask for such provisions. On the other hand, OEMs are entitled to receive some certification that a product upon delivery complies with specification.
Change in Location
Due to the long lead time in re-qualifying a contract manufacturer and its production facility, most OEMs place limits on the ability of a contract manufacturer to relocate the site of product manufacturing. The tension, of course, within growing contract manufacturers is the inability to consolidate locations to generate efficiencies or quality improvement, as needed, especially after a merger or acquisition. Typically, some sort of lead notice, qualified OEM consent and safety stock build-up, with associated risk allocation for ultimate purchase, work in combination to provide a solution both parties can live with.
Governing Law, Forum and Cross Border Issues
Many outsourcing contracts cross borders (both state and international). Therefore, it is critical that the governing law, language of the contract and the forum for any dispute under the contract be agreed to up front. Although it is sometimes viewed as an unnecessary provision, having contracts translated from the local language into English is highly advisable given that translations can differ, resulting in materially different substantive views of a contract.
In addition, American law for the treatment of warranties and indemnifications and associated waivers can be starkly different from the law of other countries, including civil code countries in the European Union (EU). U.S. common law, subject to certain public policy limits, generally allows sophisticated commercial parties to negotiate the terms of their deal, while EU civil code countries generally proscribe the terms of warranty and related terms in regulation. Also, contracts must be carefully reviewed for compliance obligations as in many cases the FDA requires reporting of adverse regulatory actions or adverse product experience even if it occurs outside the United States. Confidentiality, the expertise of a tribunal and relative costs need to be weighed.
The outsourcing of medical products is a phenomenon that is definitely here to stay. Increased pressure from investment sources including private equity to monetize device IP and reduce related startup costs, as well as the increasing focus of larger public companies on the cost of maintaining expensive inventory, capital expenditures and manufacturing facilities, will drive growth in outsourcing of devices. Health reform in the United States, by focusing on costs and increased enforcement efforts, will accelerate this trend.
In order to achieve a successful negotiation of an outsourcing contract, each side must look to what motivates the other side, realize that each side needs to achieve a benefit from the contract (whether in the form of revenue or cost reduction), and that by focusing both sides on the enhancement of value (i.e., lowering costs for high quality product, which provides for a reasonable rate of return by the vendor), both parties stand to benefit.