Legal considerations for manufacturing contracts

Friday, April 15, 2016

In the manufacturing industry where on-time delivery of products by a supplier to its customers is critical, contracts are too-often referred to as the document that’s signed and filed away to get that “check in the box”.  If anything goes wrong, however, the contract you didn’t take time to read and negotiate can have unintended or surprising consequences.  While each contract requires individual attention, there are several high-risk issues that consistently arise and should be considered before the contract is signed and filed away.  The goal is to make sure your contracts are consistent with your expectations and you’re not surprised by the consequences when things don’t go exactly as planned in your business relationship.

By heeding the considerations below, companies can focus on identifying and addressing high-risk contract issues:

1.    Determine your company’s high-risk points.  There’s no one-size-fits-all for any industry.  Some companies see loss of their intellectual property as their most important risk that needs to be addressed in their contracts.  Others see warranty obligations or raw material cost increases as their highest risk points.  The key question is what’s most important to your business and its success?  Define those important issues and then focus on what language can be included in your contracts to mitigate your risks.  

2.    Understand your warranty obligations.    What promises do you need from your suppliers regarding how the product will perform?  What promises are you willing to give your customer regarding the design, manufacture, function or life of your product?  Is your contract aligned with your answers?   If not, take action and make adjustments to your contract, your product or your business relationships.  

3.    Define ownership of intellectual property. A good contract will spell out who owns the intellectual property (IP) rights that are incorporated into the product or that are used to manufacture the product.  Let’s say, for example, that you’re designing a specific device for a customer’s manufacturing process. Your engineers are creating IP with respect to that design. Who owns that IP? Who gets to exploit it? These questions should be clearly defined within your contract so it’s aligned with each party’s expectations.  The bottom line is that if IP is important to you, make sure your contract gives you the rights and protections you need.

4. Consider dunnage and tooling costs.   Does your product require a special die to manufacture it?  Is the packaging in which the products will be delivered expendable or returnable?  Who will pay for the costs of that die and the packaging?  What if it needs to be refurbished or replaced?  If your contract doesn’t address these and other elements associated with dunnage and tooling, your profit margin could suddenly erode.  Again, make sure your contract addresses these issues if they’re a risk point to your business.

5.  Address engineering, design and testing cost recovery. Despite the parties’ best efforts, consumers sometimes don’t embrace a new product and programs are cancelled early or program volumes get significantly reduced.  Nevertheless, neither party had a crystal ball and both expended significant time and money in the early stages of the program to engineer, design and test (ED&T) the product.  Often, a supplier expects to recover that ED&T cost over time, with each product sold – something purchasing professionals often call “amortizing” ED&T through the piece price.  In the event of an early cancellation or reduced volumes, does either party have a right to recover that ED&T cost against the other?  If so, have you made that clear in your agreement?  

6. Make sure your contract is binding (if that’s your intent).   Manufacturing companies typically develop long-term contracts and are often unaware of specific output quantities when the contract is drafted and signed. In these cases, the contract might serve as an option to purchase your products at a later date or a long-term agreement with an obligation to supply and purchase.   With only an option contract, a supplier might have the ability when the customer asks for a shipment of products to say “not this time.” If the customer, instead, intended a long-term agreement, a dispute can quickly arise.  A good contract will address issues of unknown quantities, and define parameters for missing quantity terms. Each contract is unique, so legal counsel is the best resource to navigate these terms carefully.

7. Address the variables.  Changes in contracts create risk — and in manufacturing, changes are abundant. You’ll often encounter adjustments to product engineering, delivery schedules and pricing based on material economics and fluctuations in currency exchange rates. Suppose you’re in a long-term agreement to manufacture a part, and in year two the price of steel doubles. Your customer is locked into a lower price that could crater your profitability unless your contract gives you the right to re-negotiate prices.

8. Always have an exit plan.  Despite our best efforts, the future is, and always will be, unpredictable. Forecasts are off. Trends change. Suddenly, your products aren’t a priority anymore. Because these things happen every day, it’s important to understand the termination options that exist in your contract. Can either party terminate for good cause, bad cause or no cause at all?  What rights do each of you have in the event of a termination?  No, you can’t predict the future, but your contract can spell out contingencies, such as right to recover obligations and amortized costs, or perhaps some required transition support in the event of an unexpected termination.

9. Determine your service obligations. In many cases, you may have a long-term agreement to provide service parts for products. And these agreements can last as long as 15 or more years. Your contract should appropriately define each party’s responsibilities regarding service parts, including such matters as tooling refurbishment costs, service literature, special packaging obligations and pricing.

10. Look beyond the first document. The life of a business relationship in the manufacturing industry spans many legal documents. It typically begins with a request for information or a quote and may include a purchase order and long-term agreement, among other legal documents. All of these contain legal terms. Often, terms reference other important documents, like manuals, regulations or policies by which manufacturing companies have to abide.  To get it right, you have to understand the obligations in all of those documents, so it’s essential to review all of the elements that make up the terms and conditions and consider those elements in connection with regulations and laws that may apply.

While the contract phase of a long-term relationship can be time-consuming, the goal is a  binding agreement that meets the parties’ expectations and accurately sets out the parties’ business relationship. Without fail, contracts should be reviewed carefully and with your company’s risk points in mind.  When contracts are legally solid from the first clause to the last, manufacturers can reap maximum benefit and shield themselves from legal complications.

M. Kimberly Stagg is an attorney in the Nashville office of Dickinson Wright, PLLC, a North American law firm with offices across the United States and Canada. With a practice focused in manufacturing and contract matters, bankruptcy and global real estate, Stagg has counseled manufacturing clients on significant transactions and regulatory and litigation matters. Reach her at