Trust in an outsourcing relationship is key, but a well-designed co-packing or co-manufacturing service agreement can help in reducing risk and defining obligations and requirements for both parties.
Once a company outgrows its in-house facility or wants to focus more on selling and marketing its products, outsourcing the production to a third-party co-packer can be a viable solution. A good relationship with the co-packer is important and should be based on mutual trust, but it’s still recommended to have a written agreement in place.
A co-packing service agreement should define terms, obligations and requirements for both parties as well as co-packing services and performance levels. However, an agreement shouldn’t be too detailed or rigid, especially for a fast-growing company, otherwise the agreement can exacerbate the very problems it is supposed to prevent.
Here are some areas that should be addressed in a co-packing service agreement (in alphabetical order):
Applicable law and jurisdiction
The agreement should define by which set of laws the agreement is governed (i.e. by which state or country). The parties can mutually agree on a state’s law, which doesn’t necessarily have to be the state where either of the parties is incorporated or doing business. However, in case of a dispute, the “choice of law” might be challenged by the court as they normally look for some connections between the agreed state and either the transaction or the parties.
The jurisdiction defines where a dispute will be resolved. In an agreement, the governing law can be different from the jurisdiction; for example, the governing law could be Delaware, but the parties agree that any dispute will be decided under the jurisdiction of the court of San Francisco.
Code of conduct
The code of conduct defines the expectations and requirements how the co-packer should conduct its business in terms of compliance with laws and regulations, ethical standards, social and working conditions as well as the protection of the environment. Some of the principals addressed in the code of conduct can include the compliance with local and international laws and regulations, corruption, bribery, free competition, child labor, fair compensation and working hours, non-discrimination, harassment, health & safety, working conditions, the use of natural resources as well as waste and emissions.
Confidentiality
While entering into a business relationship, both parties may be exposed to certain non-public, confidential information, like sales numbers, technical data, product specifications, business plans and financial data. The provisions in the agreement should state that the confidential information should not be used or disclosed to any other party, unless otherwise agreed.
Co-packing services
Maybe the most important part of a co-packing agreement is the description of the services that the co-packer is performing. The scope of work should be defined as clearly and specifically as possible. For some co-packing services, it might make sense to also state what is not included in the scope of work.
The agreement should state who is ordering ingredients, labels, packing material, and shipping boxes. The paragraph needs to specify what lot or batch code method should be used and what date format is required.
Dispute resolution
Even a strong and long-lasting business partnership is not immune to disputes. No one wants to talk about differences that might arise in the future, especially at the beginning of a new partnership. However, defining in an agreement how potential disputes shall be resolved can save a lot of money and time if a dispute does arise.
It is recommended to define various levels of dispute resolution in an agreement, starting with an escalation procedure. For example, if the parties are unable to resolve a dispute after good faith negotiations within a predefined time, such a dispute should be escalated to the executive team of both parties. Other common dispute resolution processes are mediation between the two parties (non-binding) or arbitration (binding). In mediation or arbitration, an independent third party tries to mediate or arbitrate between the two parties. If there is no mediation or arbitration clause in the service agreement and the parties have exhausted their attempts to negotiate a resolution, the dispute might have to be resolved by litigation. This common legal process refers to the resolution of disputes through the court system.
Fees and expenses
There are different ways co-packers are charging for services; it could be a fixed price per unit (volume based), a time related flat fee (hourly, weekly, monthly), or a combination of fixed and variable fees. The agreement should reflect the price structure that is most appropriate for the type of service provided and the products co-packed. It’s always good to have a clause in the agreement that defines when fees can be adjusted (for example once a year) and what can trigger a price increase (for example minimum wage increase, inflation, or increase of raw material costs).
The agreement needs to state how often the co-packer is invoicing for the services, by when an invoice has to be paid and how payment should be made.
Furthermore, the agreement should clarify which party is responsible for expenses related to additional services, for example extra storage, pallet rentals, rush orders, handling of waste, and receiving of products.
Intellectual property rights and ownership
A proprietary rights provision is a very important clause in the agreement and defines that intellectual property related to anything produced by the co-packer for the customer belongs to the customer. The agreement needs to state that the co-packer is not allowed to use or register any intellectual property rights or trademarks of the customer. In addition, it should clarify if a co-packer can use the name or logo of the customer on their website or any marketing materials.
The agreement needs to state that the title of the products and any supplied materials and documents provided by the customer in connection with the co-packing of the products shall always remain with the customer.
Liability and Indemnification
While negotiating a co-packing agreement, liability and indemnification clauses can become a highly contested topic, since there can be a lot of money at stake for both parties. The customer normally requests that it will not be responsible for any liabilities out of any acts or omissions of the co-packer in connection with the co-packing service.
An indemnification provision (or hold harmless provision) states that the co-packer will compensate the customer for any loss, damage or cost suffered as a result of the co-packer’s acts or omissions. Examples are damaged or lost products during packing, storage or transportation while under the custody of the co-packer.
The customer may ask the co-packer to take out and maintain an adequate and proper insurance that provides coverage against potential risks in connection with the agreement.
Obligation of both parties
The agreement needs to list the obligations of the co-packer. For example that the co-packer agrees to co-pack the products in strict conformity with the specifications and quality requirements provided by the customer, or that it only co-packs the products in a specified location, or ensures the traceability of all co-packed products in all stages.
The agreement should also list the obligations of the customer. For example that the customer provides a monthly rolling forecast for the quantities that should be produced, or all products delivered to the facility of the co-packer are properly marked and packaged, or that the customer is responsible for ensuring that the products comply with all applicable laws and regulations with respect to safety and labeling, or that the customer will be dealing with the regulatory agencies regarding the safety of the products and potential product recalls.
Product specifications
It is recommended to define the product specifications and instructions in the co-packing agreement. The specifications should include information about design, packing and labeling instructions, complete list of bill of materials (BOM) as well as case and pallet configuration. The information can be specified in technical data sheets and attached to the agreement as an exhibit.
It should also specify in what format work instructions or work orders will be sent by the customer to the co-packer and what information it should contain.
Quality control and inspection
The agreement needs to specify who is responsible for quality control and how often product inspections should be performed and recorded. As a minimum, the co-packer should inspect all co-packed products prior its release to ensure that the product conform to the specifications. The agreement should also define what factors will render a product defective or non-conforming and who will cover disposal or rework costs of rejected products.
Furthermore, the agreement should specify if the customer is allowed to enter the premises of the co-packer to inspect co-packing methods and conditions as well as the quality of the co-packed products. It may also be defined in the agreement that the customer or an external audit company is performing an annual audit of the co-packer.
Relationship and status of parties
It’s important that the parties (customer and co-packer) are correctly defined in the agreement. This includes indicating the state and country of formation and entity type of the companies (for example corporation, limited liability company, or partnership).
The agreement needs to state that the co-packer is acting as an independent contractor and that all employees of the co-packer engaged in providing co-packing services for the customer are considered as employees of the co-packer. It should also include a clause stating that the co-packer is responsible for paying its own taxes for the fees received in connection with the service agreement.
Service performance level
It is recommended to define performance levels in the service agreement. This can include key performance indicators (KPIs) like adherence to the co-packing production plan, time needed to complete a co-packing work order, value of co-packing inventory adjustments (wastage), or number of defects, and co-packing quality.
The parties may also define how performance levels are monitored and reviewed, and what happens in case of deviations to the KPIs and non-conformity.
Term and termination
The service agreement should clearly state when the agreements starts and when it ends (term of the agreement) and might also include a renewal provision. It needs to clarify which party can terminate an agreement before the end of the term, under what circumstances, in what form, and with how much notice period. Reasons for an early termination could be if either party commits a material breach, becomes insolvent, enters into liquidation, or bankruptcy.
Other reasons for a customer to terminate an agreement early is if the co-packer does not achieve an agreed performance level during a defined period or fails to initiate adequate corrective actions. A product recall caused by actions or omissions by the co-packer can be another reason for early termination.
Conclusion
The above list is not exhaustive and only includes the most important agreement terms. Depending on the complexity, range and volume of the co-packing services to be provided, additional terms might have to be added.
It is always recommended to get the advice of an attorney while drafting a co-packing service agreement, although for smaller companies the cost can be prohibitive. As a base and good starting point for drafting an agreement, companies can also use standard templates that are available online on various legal websites.
About the Author
Rene Jacquat is the principal of LogiChain Solutions, LLC, based in San Francisco, United States. His experience includes operations, supply chain management and logistics in the consumer goods industry. Rene supports food & beverage companies in supply chain strategy, supply chain & distribution network design, supply chain diagnostics & risk management, sustainability and outsourcing logistics services.