What To Do When Your Contract Manufacturer Becomes Your Competitor

In this blog post, Vivek Chandar, pursuing M.A. in business law from NUJS, Kolkata, describes the concept of contract manufacturing and the legal clauses to be added to a contract manufacturing contract. 

In today’s times to be more competitive, most companies shift their manufacturing activities to vendors, especially in the third world. These Contract Manufacturers manufacture for numerous competitors. This helps in the development of economies and also motivates the contract manufacturer to invest in technology.

What is Contract Manufacturing?

Contract manufacturing is basically outsourcing of part of the manufacturing process to a third-party. More specifically a Company outsources to a third party (Contract Manufacturer) certain production activities that were previously performed by the manufacturer. You may outsource the manufacture of certain components for the product or outsource the assembly of the product. Some Contract Manufacturers also design, produce, assemble and distribute, i.e., they more or less cover the complete gamut of the business.

Disadvantages of Contract Manufacturing

There are disadvantages to this arrangement, some are:

1. Your competitor may get to know your IP / technology edge /designs. Further, you will have to share some of your IP with the Contract Manufacturer.
2. The contract manufacturer may use your designs, IP and confidential information to make their own products and launch the same in the market.

As in both the above cases it can lead to your losing the edge in the market. To protect your IP and competitive edge a multi-pronged strategy may need to be used.

Multi-pronged Strategy for Contract Manufacturing

It is necessary to protect IP by all available means like patents, design registrations, copyrights, Non-Disclosure Agreements (NDA), etc., but these may not be enough.

You need to look at the following aspect also –

• Chosing the right partner. Choosing a fly by wire contract manufacturer who has not much to lose, may be more inclined to steal the IP, etc. that a well-established Contract
• Continuously review what needs to be protected, i.e., What others want that is unique to you? Is it your technology, or customers or the brand to protect IP?
• Structural protections as a minimum are critical.
• What key activities that the OEM would like to perform by itself, rather than handover these to the Contract Manufacturer. These may include R&D, marketing, after sales service, key technologies or key components.
• What kind of arrangement should be made with the Contract Manufacturer ? Will it be a Joint Venture (JV), a long term Contract and licensing IP to the Contractor, etc?

Once the strategy is finalied, you need to finalise the Contract and also as indicated above register IP includingpatents in the country the Contract Manufacturer is based. IP and patent registrations will avoid the Contact Manufacturer and others to use your name/logo and designs.

One thing a Company certainly needs to do is to register the trademark in the Country of the Contract Manufacturer. Before you use any of your trade names (think brands/ logos or product names) or trademarks in that Country, you must register them or someone else almost will and then you will not be able to use your name, even if all you are doing is exporting your product from that Country. Thus Registration of patents, logos, etc., is critical.

One should not opt for Purchase orders to a well-constructed Contract. A Purchase order does not have all the clauses to protect you from IP infringements or non-use.

Depending on the type of work /services that are required to be performed by the Contract Manufacturer, you need to frame the Agreement/Contract. For example, if you are going to work with a manufacturer to develop a new product, you need a specific product development agreement. These should be drafted to ensure that ownership rights of the final product are whose is clearly spelt out.

Contracts for Contract Manufacturing

The Contract should contain the following clauses/definitions clearly (wording would differ from case to case):

1. Confidential Information: This needs to be clear and precise. A sample definition, etc. “Confidential Information” means all data and information whether in written, machine readable or another tangible form, or obtained by recipient through observation or examination of such information and material or disclosed orally, that is of value to the disclosing Party, is not generally known to competitors of the disclosing Party, and which is indicated as such when communicated to the receiving Party. Confidential Information includes, but is not limited to, all information or materials prepared in connection with this or any related subsequent contract and includes, without limitation, all of the following: designs, software, programs, drawings, specifications, techniques, models, data, source code, object code, documentation, diagrams, flow charts, research, development, processes, procedures, ideas, data, “know-how”, new product or new technology information, product prototypes, product copies, manufacturing, development or marketing techniques and materials, development timetables, strategies and development plans, including trade names, trademarks, customer, the Contractor or personal names and other information related to customers, the Contractor or personnel, pricing policies and financial information, and other information of a similar nature, whether or not reduced to writing or other tangible form, and any other trade secrets or non-public business information. Each party acknowledges and agrees that the Confidential Information has been and is being developed by the disclosing Party through the expenditure of substantial time, effort and money and is a valuable proprietary asset of the disclosing party. Each Party represents and warrants that it has the legal right to disclose to the receiving Party any and all information related to the Contract and any additional disclosure of data pursuant to this Contract or any written extensions thereof. The Confidentiality provisions should in principle include the following:

• The Contractor should undertake:
  • That all Confidential Information shall be and shall remain at all times the sole and exclusive property of the Company;
  • That it’s right to use Confidential Information shall wholly cease upon the termination of this Contract; and
  • To return to the Company on termination of this Contract all material embodying Confidential Information (including, without limitation, information stored on computer disks) or any part thereof and all copies thereof.

2. Intellectual Property Right clause: Other than the standard clauses related to background IPRs. These need to be clear and precise. The following protections may be included (wordings are for reference only and needs to be modified including addl. Standard clause to be included):
   • No licence or any other right, related to any Intellectual Property Right of the Company- No licence or any other right, related to any Intellectual Property Right of the Company shall be deemed granted when the Company provides the Specifications, special function requirements for the Product, and design and model of the products to the Contractor. Such Specifications and function requirements provided by the Company shall only be used by the Contractor for the purpose of this Contract and no other purpose.
   • Foreground IPRs: The entire foreground Intellectual Property Rights created, conceived or generated under this Contract by the Contractor in fulfilling the Contractor’s obligation under this Contract shall be jointly owned by the Company. The Contractor shall not use the foreground IPRs and the Company technical specifications, special function requirements and background IPRs for any purpose other than manufacture and supply of the Products to the Company, nor shall the Contractor authorize or knowingly permit them to be used by anyone else for, or in connection with, any purpose other than the manufacture and supply of the Products. On the filing of a patent application for the above mentioned, foreground IPRs, the right to apply for a patent shall be owned by the Company and all the foreground IPRs created will be owned by the Company. The Company shall have the full right to file a patent application independently , and such independently filed patents shall be solely owned by the Company, and the Contractor shall have no right to an interest in the independently owned Company patents.
3. Termination clause: It should include any breach esp. material breach related to IP and confidentiality provisions as one of the reasons for termination.
4. Governing Law and Jurisdiction : Company/you should be careful in choosing the governing law and jurisdiction so as to ensure that it can protect itself in the right court/jurisdiction.
5. Check the language of litigation in the Country of manufacture/ Governing law. Preferably draft the Contract in that language so that all parties (including courts/arbitrators) are clear of the intent of the Contract and its provisions.
6. Arbitration rules, where it will be done should be clearly and precisely stated.
7. Make sure contract explicitly forbids Contract Manufacturer from competing with you or improperly using your IP. n explicit, non-compete clauses to be included in the Contract.
8. Ensure the Contract also explicitly states that the packaging materialis to be used only for the products being manufactured by the Company. The quantity and quality control of packages need to be monitored.
9. Ensure regular visits to the Contract Manufacturer premises and seek regular reports on the inventories, handling of defective products (how these have been disposed of, etc.)
10. Include an NNN Agreement to be signed by the Contractor. A typical NNN agreement covers the following:
    1. Non-disclosure: For a Contract Manufacturer who is manufacturing not only for you but your competitors you may like to cover internal disclosure within a network.
    2. Non- Circumvention: Prevent the Contract Manufacturer from manufacturing or using the product or information sought to be protected. The non-competition provisions are an essential and material part of the total agreement, by which the Contractor needs to agree that it shall not use any advantages derived from Confidential Information in its own business or affairs unless the same is done pursuant to amendment signed by both parties.
    3. Non-Use/ No-competition: Prevent Contract Manufacturer from circumventing you and going directly to your customers or clients. The Contractor needs to agree that they (including officers, etc.) will not, directly or indirectly, contact, deal with or otherwise become involved with any entity or any other entities or parties introduced, directly or indirectly, by or through the other party, for the purpose of avoiding the payment to the Company of profits, fees or otherwise, without the explicit written approval of the Company.

11. It is also recommended that a reasonable period of non-disclosure be agreed between the parties.
12. Further, a clause to restrict sub-contracting can also be included in the Contract. This will avoid the sharing of IP and confidential information to more parties and thus reduce the risk.
13. In addition to registering your IP including brand name/logo and patents in the relevant registration office, also try to register or provide details as applicable to the customs office of the Contract Manufacturer’s Country. This will help them to notice any counterfeits and notify you.
14. The contract should cover aspects of change management.
15. Who owns the IP of new and better method of production brought in by the Contract Manufacturer? Who pays for the new method and machinery if any?
16. The contract should include provisions for mutual agreements before change or inputs while bringing in new product manufacturing. This ensures participation of the Manufacturer and thus a higher stake in its success.
17. Preferably have long-term contracts/relationship rather than a one-off This avoids Contractor from seeking advantage in stealing your IP, etc.

Conclusion

It may be noted that irrespective of a Contract being very robust and thorough, the key to success of the relationship is:

1. The right choice of a Contract
2. Continuous monitoring of the relationship between the parties.
3. Have multiple vendors for the product.
4. Preferably breakdown the equipment and manufacture the parts in different Contract Manufacturer.
5. Good faith between the parties.
6. Ensure that agreements/contracts are enforceable. For the same, you may need to be careful of the wording and provisions and especially the Governing law, Liquidated clauses, arbitration provisions, etc.

Needless to state Legal protections are still probably most important as these act as a deterrent to the parties from breaching the agreement/contract.

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