Negotiating Medical Device Outsourcing Agreements

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.
 

Regulatory Reporting

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.
 

Recall Obligations

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.

Intellectual Property

Indemnification

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.

Forecasting

Inventory Management and Consignment

Inspection Compliance Certification

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.
 

Christopher J. Donovan is a partner in the international law firm of McDermott Will& Emery LLP and is based in the firm’s Boston office. He focuses his practice on advising companies, equity investors and financial institutions in mergers and acquisitions, recapitalizations, buyouts and restructurings in the medical device and life sciences arenas. He has experience representing both strategics and investors involved in medical product licensing, joint ventures and outsourcing both within the U.S. market and cross border on behalf of U.S. and international clients.