By Pamela A. Grinter, partner in the Corporate Department of Fox Rothschild LLP
In a contract manufacturing relationship, a manufacturer contracts with a brand owner to produce goods for that brand owner. This relationship can benefit both parties: contract manufacturing allows a brand owner more flexibility in its business model with reduced investment in capital equipment and access to high quality skills and manufacturing processes, and contract manufacturers who produce their own branded products can fill vacant line time with similar products. Some contract manufacturers solely produce products under contract for others.
But a contract manufacturing relationship also has risks to both parties. On the one hand, for a brand owner, a robust confidentiality provision that specifically protects each product’s recipe, specifications, or formula is essential to any contract manufacturing agreement. However, what if the recipe or formula is easily duplicated, or the product itself is easy to replicate without breaching the confidentiality obligations? Similarly, a brand owner may be concerned that a manufacturer, once it has perfected the manufacturing process to produce the brand owner’s products, will look to capitalize on those skills and produce similar products for others if it can do so without violation of its legal obligations. Does the brand owner want to pay the contract manufacturer to develop those production skills if the manufacturer will turn around and use those skills to develop products that compete with the brand owner’s products?
A manufacturer, on the other hand, may be asked to invest significant time and money to develop specialized skills or acquire expensive equipment in order to start producing the brand owner’s products. What happens to that investment if a brand owner is able to find a different manufacturer who is willing to produce the same goods for less? The manufacturer will also benefit from a reliable production schedule over the longer term.
One way that brand owners and manufacturers can address these risks is through an exclusivity clause, which look very different depending on whether they are drafted for the benefit of a brand owner or a manufacturer.
Exclusivity protections for the benefit of brand owners
A typical exclusivity clause that is designed to benefit a brand owner will require the contract manufacturer to limit its production and sale of the same or similar products for some period of time. An exclusivity clause for a brand owner may last for the duration of the contract manufacturing agreement. However, a brand owner will often want the exclusivity period to extend for a period beyond the contract term so that a manufacturer cannot immediately begin to produce competing products when the relationship ends. The scope of this type of exclusivity clause will also ordinarily cover products that are the same or substantially similar to the products that the contract manufacturer has been engaged to produce for the brand owner. Some brand owners may also want to name specific competitors that a manufacturer cannot work with.
A sample exclusivity clause for a brand owner might look like this:
During the term this Agreement [or some shorter or longer period], Manufacturer agrees that it will not, without the prior written consent of Customer, which consent shall not be unreasonably withheld or delayed: (i) manufacture and sell any [add general description of product – the broader it is, the more benefit to the Customer] or substantially similar to the products produced by Manufacturer for Customer under this Agreement, to any other customer, or (ii) manufacture or sell any [category of product] that are the same or substantially similar to the products produced by Manufacturer for Customer under this Agreement, to any other customer.
A manufacturer may have mixed feelings about agreeing to this type of exclusivity clause. A manufacturer will want to ensure that their line time is fully utilized, which may not be possible if a manufacturer cannot produce similar products to those it is producing for the brand owner for others. Similarly, a manufacturer may hesitate to invest in the skills and technology it may need to produce a brand owner’s product if its client base will be limited to the brand owner. Brand owners who ask for a manufacturer to commit to an exclusive relationship should be willing to commit some level of exclusivity on their side of the relationship as well.
Exclusivity protections for the benefit of manufacturers
An exclusivity provision that is designed to benefit a contract manufacturer looks very different. A typical exclusivity provision for a manufacturer will restrict the brand owner from utilizing other manufacturers for some period of time, but could apply to just one product in the brand owner’s product line; could apply to the products being produced and any expansion of that product line; or could apply to all current products of the brand owner along with any product developed by the brand owner in the future. Often, the exclusivity period lasts for the duration of the agreement, and the brand owner may be given a limited right to use other manufacturers if the contracted manufacturer is unable to meet its legal obligations.
A sample provision looks like this:
Customer agrees that Manufacturer shall, during the term of this Agreement [or some shorter or longer time period] be the sole manufacturer of [the products manufactured under this Agreement, or list specific products] for the [specific industry], unless, in any event, (i) this Agreement is terminated by Manufacturer for any reason or by Customer without cause or (ii) Manufacturer is unable to continue to provide the products to be produced under this Agreement as or when ordered and at agreed upon pricing.
Manufacturers should be aware that brand owners may hesitate to agree to an exclusivity provision such as this one. While a brand owner would certainly appreciate reduced pricing for greater volume, a good working relationship with an experienced manufacturer, and the benefit of the manufacturer’s developed expertise, it may also want multiple sources for its products to minimize supply risk – which this type of exclusivity clause would restrict. The parties may need to find some balance between the two exclusivity provisions, as well as a clear carve out for the brand owner if the manufacturer is not performing as required.
Drafting and negotiating the contract manufacturing agreement
An exclusivity clause is just one of many terms that brand owners and manufacturers may want to address in an agreement that governs a contract manufacturing relationship. Other terms the parties should consider addressing include the relevant business terms, quality standards and remedies, confidentiality provisions, which jurisdiction’s law will govern, and the jurisdiction where any litigation over the agreement must occur. Thoughtful and carefully drafted agreements can protect both the manufacturer and the brand owner from unintended results, and give each party a clear understanding of their rights and obligations in the relationship from the start.
Pamela A. Grinter is a partner in the Corporate Department of Fox Rothschild LLP. She represents private, public and nonprofit businesses in the full range of business transactions, including choice of entity and entity formation; shareholder management; mergers and acquisitions; manufacturing, distribution, franchising and commercial agreements; and business terminations. She can be reached at [email protected]