Negotiating a Manufacturing Agreement
What do you need to know?
By Dan O'Korn
There is a general realization in the industry that there is no such thing as a "typical" negotiation of a third party manufacturing agreement. Each transaction has its own nuances. Does the manufacturer have a lot of empty capacity? How much capacity will the client use? Does the client have other manufacturing alternatives? Is the manufacturing process unique? Is the manufacturing process complex? Is the manufacturer's facility "state of the art"? Does the manufacturer have all of the necessary equipment or will it look to the client to supply certain equipment? These are but a few of the issues that will be factors in the negotiation process. As a consequence, the goal of this article is to discuss the topics that will likely be debated as you negotiate the written manufacturing agreement without the representation that any of it is "typical."
Templates and the Battle of the Forms
The first issue is likely to be whose form agreement will be used as a starting point. Every manufacturer should have its own template agreement. The manufacturer should have fresh eyes look it over from time to time. The manufacturer has likely added new faces to the organization since the template was last revised, and those people might add improvements based on their past experiences. The template should also go through a periodic legal review to make sure it is still in compliance with applicable laws, and the internal legal group or external counsel can add any improvements based on learnings from previous negotiations.
A potential issue arises when the client has its own template agreement. Whose template is to be used largely depends, like many issues discussed here, on which party has more leverage. This can be a potential time-and-money issue for the parties in reviewing the initial draft of the agreement. The party whose template is not used for the transaction will be unfamiliar with the terms and structure of the other's template. While the topics are substantially similar to the other party's template, the manner in which the topics are covered, and the sequence in which they are covered, can be quite different. As a consequence, it will take a significant amount of time for the non-drafting party to review and comment on the first draft. In particular, it will take significantly more time to perform a legal review of a template with which your counsel is not familiar. If you are using outside counsel for the review, this translates into a direct increase in legal fees.
Business Term Sheet
The parties should develop a business term sheet prior to going into contract negotiations. The term sheet does not have to be binding, but it is useful and a time-saver if certain business terms are discussed and decided upon in principal in advance. This way, there is at least some common ground on many of the terms that will be incorporated into the first draft of the agreement. It can become overwhelming in negotiating an agreement when the first draft has little upon which the parties agree. How many times have you received a revised draft of the agreement from the other party that was unrecognizable because of the amount of changes? If you can focus on the business terms first, that almost always guarantees that the redlining on the exchange of the first draft of the agreement will be substantially reduced.
Business terms that should be discussed and agreed upon at the outset include price, price adjustments, volumes, payment terms, agreement length and forecasting (including which forecasts are binding).
In terms of pricing, will price be fixed, or will it be based on volume? If pricing is based on volume, will it be a true tiered pricing, or will it be a fixed pricing based on volume, with year-end adjustments made based on the volume purchased during the year? For example, some pricing mechanisms have a fixed price during the year, and then the parties look back to see how much volume was purchased and apply a retroactive discount or premium.
Another issue with respect to pricing is price adjustments. Can the price be adjusted based on an increase (or decrease) in the cost to manufacture the product? If so, how often? Who pays for changes to the manufacturing process and is the purchase price for product adjusted as a result of those changes? Will price adjustments be based on an index such as CPI or PPI? Will the price adjustments be capped by a fixed percentage? These are all questions that should be answered before the parties begin to look at the written agreement.
In the case of payment terms, will payment be due from the client in 30, 45 or 60 days? When does the clock start ticking for payment: date of invoice or date of receipt of invoice?
Forecasting often generates much discussion, and for that reason should be agreed upon early in the process. In all events, there should be a requirement for a non-binding, long-term forecast that is used strictly for planning purposes. Although there are many variations, the following represents a fairly typical resolution to the forecast discussions. The client provides at least a four calendar quarter forecast broken into months. The first quarter is typically binding. Often, the parties will also agree that when that second calendar quarter becomes the first calendar quarter of the next forecast, the quantity must be within a certain range of the quantity forecast when the applicable quarter was the second quarter of the forecast; say, no less than 80% and no greater than 120% of the second quarter forecast. For example, in the first forecast, if the client forecasts 100 units for the second calendar quarter, the first quarter of the next forecast required to be delivered must be for no less than 80 units and can be no greater than 120 units. There of course are many variations to this, including the percentage range and the length of the binding period (i.e., two quarters binding instead of one quarter). If you have a well-defined market, these discussions can be fairly straightforward. However, when the product is still in development and the only thing you really have is market research, these discussions can become more difficult.
Notwithstanding the forecast discussions, the parties need to determine whether there will be a threshold quantity that must be purchased during a calendar quarter or other time period. The economics of the situation can force the manufacturer to require a minimum purchase obligation in order to make sure the project is profitable for them and to justify the reservation of capacity.
The parties should also discuss how long the relationship will last. Is it going to be a three-, five- or seven-year term? Can the agreement be renewed by the parties? If so, what is the mechanism? Will it renew automatically unless a party says otherwise, or must the parties affirmatively elect to extend the agreement? How long will renewal terms be? Other term and termination topics are usually left for the lawyers (e.g., termination for breach, insolvency, etc.), but these basic questions should be answered before getting to that point.
Negotiating the Agreement
Once there is some common ground to some of the more fundamental business terms, the lawyers can drop those terms into the template agreement and the negotiation of the actual written agreement can begin. The remaining topics relate to additional business terms, and legal terms that the business people leave up to the lawyers to finish.
Some of the remaining business terms to be discussed include:
1. Tech Transfer Activities: Who is responsible for conducting and the cost of these activities? How much presence in the facility is the manufacturer going to allow the client? Who pays for the validation lots if they are not able to be commercially used?
2. Exclusivity: Will the manufacturer have the ability to manufacture products that compete with the client's products? This is a hybrid business-and-legal issue, as it can raise some antitrust issues that need to be evaluated.
3. Changes to Specifications or Manufacturing Process: Who pays for the cost of a change? Typically, the party asking for the change pays for it. But what about situations where the change is required by law? Many times the manufacturer takes the position that the client should pay for the change. But what if the change is required in connection with other products being manufactured at the facility. Is it fair to make one client pay for changes that benefit other clients?
4. Regulatory and Quality Issues: Many of these issues are left to be incorporated into a Quality Agreement. The parties often leave the finalization of the Quality Agreement for a later day, which can be an unfortunate decision. The most notable danger in approaching the Quality Agreement in this manner is that it may not be finished in a timely manner, if at all. Once the "Commercial Agreement" is signed, everyone's focus turns on implementing the project, instead of follow-up items such as the Quality Agreement. The worst thing that can happen is for the parties to realize they don't have a Quality Agreement in place the day before an FDA inspection. To avoid this, Best Practice dictates that if you separate these topics into a Quality Agreement, negotiate the Quality Agreement contemporaneously with the Commercial Agreement.
5. Non-Conforming Product: Discussions can become lengthy with respect to non-conforming product. Typically, the product is non-conforming if it does not conform to the agreed-upon specifications. The parties should also consider other measures of conformity. For example, in order for a product to be "conforming," it should be manufactured in compliance with cGMP and not be adulterated (within the meaning of the Federal Food, Drug and Cosmetic Act).
The other issue in this context is length of time the client has to reject the product. Will the parties agree to a time period after delivery in which to discover nonconformity, or will the manufacturer permit the client to reject the product within a reasonable time after discovery of the nonconformity? There is also the question of latent defects, those not reasonably detectible upon inspection. Does the window for rejection apply in these cases?
6. Recalls: What happens if product needs to be recalled? Regardless of where the parties come out on the issue of rejection of product, typically the parties agree that the manufacturer is responsible for the cost of the recall, as long as the recall was caused by nonconforming product. However, the agreement should expressly state this. In some situations, however, the manufacturer may have the business leverage to disclaim responsibility if the client did not reject the product within the applicable rejection window.
The remaining topics to be discussed and agreed upon are thought to be legal in nature. That is not to say that the business input is not welcomed. In fact, it is necessary. The lawyers typically take the negotiation of these topics as far as they can, each representing their client's best interest. At that point, the lawyers will present the issues as tentatively resolved to their respective clients for approval. The parties typically defer to their lawyers on whether there is any more room for negotiation. This is why it is imperative to have legal counsel that is well versed in these issues as they relate to the pharmaceutical industry. These topics include Representations and Warranties, Limitation of Liability, Intellectual Property, Confidentiality, Termination Provisions (including what happens to work in process at termination), Force Majeure, Indemnification, Insurance, and the Miscellaneous Provisions. While these provisions are extremely important, both parties hope that they will never have to refer to them again, since their application would indicate that something had gone wrong in the relationship.
Hopefully, this has provided a backdrop that will help you in your next contract negotiation. Although this article poses many questions, thinking about the answers early will make for smoother negotiations and create an environment for profitable cooperation between all involved parties.