Risk Management 360: Contracting, Part I: Why Use Contracts?

In their years working with life sciences companies – large and small – Medmarc’s risk managers have evaluated numerous medical devices and pharmaceuticals as well as their manufacturing and distribution operations and FDA compliance histories. From these experiences, our team of risk managers has developed a unique perspective on this innovative and growing industry. Life sciences companies operate in a heavily regulated and litigated environment. Through studying these companies’ successes, and their missteps, the authors of this series have discerned common trends that can influence a company’s products liability exposure. This series will discuss these trends and what companies can do to manage the products liability risks they create.

Contracting, Part I: Why Use Contracts?

Introduction

Contracts are both one of the most effective risk management mechanisms available to life sciences companies for mitigating products liability risk, and one of the most underused. Contracts effectively transfer risk and assure that each party is liable only for eventualities within their control. In this first part of our two-part series on contracts, we will look at why contracts may be underutilized, some of the practical realities that make contracts especially imperative in the drug and device industry, and the difference between contracts and purchase orders. In part two, we will go through the most important terms for life sciences contracts and how to deal with oppressive terms from the other side—evaluating your bargaining power and knowing when to push back.

Why Contract?

One of the reasons a party may elect not to contract is that it assumes that even in the absence of a contract, liability will extend only as far as its fault – or contribution to the plaintiff’s injury. While something called “common law indemnity” applies to make this true to a limited extent, a more important legal doctrine is at play in the commercial sales context: strict liability. The strict liability doctrine, coupled with other practical realities of the life sciences industry that will be discussed in greater detail in this article, can limit the power of common law indemnity to allocate fault and can have adverse results for a party that did not contribute directly to a plaintiff’s injury. In other words, because of certain principles of law, liability can exist regardless of fault.  For this reason, contracts are an essential risk management tool, because they can allocate responsibility among the parties based on a company’s actions (or omissions) rather than simply because the company participated in the supply chain.

Although the importance of the use of contracts should not be underestimated in any industry, there are some practical realities unique to the life sciences industry that further heighten the need for and benefit of contracting.

Strict Liability

Strict liability is a legal doctrine under which a person or entity is legally responsible for the consequences flowing from an activity even in the absence of fault or criminal intent. In the sale of medical products, this means that all parties with involvement in the production or sale of a product—e.g., spec designer, component part supplier, contract manufacturer, distributor—may be held liable for harm (property damage or bodily injury) allegedly caused by that product. Being well-versed in the application of strict liability, in the event of an allegation of harm caused by a product, plaintiffs’ attorneys will often name all involved entities in the lawsuit, regardless of where the actual source of the alleged defect may lie. Strict liability often means that it is then up to the named parties—the defendants—to sort fault and liability out among themselves.

Being named in a suit, even pending a determination that a party bears no responsibility for the alleged harm, can be expensive for a defendant. Legal defense costs can easily be in the hundreds of thousands of dollars. To avoid or minimize these costs, contracts can be extremely effective. Contracts can protect parties against liability for eventualities outside of their control in two ways. First, a solid indemnification clause can mean that the indemnified party doesn’t even have to pay to defend the suit and can immediately transfer responsibility for the defense to the indemnitor. Second, a clear allocation of responsibility can make ascertaining fault much easier, enabling the not-at-fault party to get dismissed from the suit early on, incurring only minimal defense fees.   

Contracts can be immeasurably important in making fault determinations, as they should lay out exactly what activities and documentation each party is responsible for undertaking and keeping. Without such defined roles, ascertaining and assigning responsibility can be a lengthy (and expensive) process.

If, for example, a claim arises over a respirator with a tube that was found to have a poor connection, causing air to leak out, it may be unclear in the absence of contracts whether the fault is with the contract manufacturer of the tubing, the spec developer, or the OEM that ordered the tubes and connected them to its machines. But with a contract with a clear responsibility matrix, the identity of the party responsible for any prospective defect can be easily ascertained, and those non-fault-bearing parties can extricate themselves from the related products liability lawsuit with relative ease.

Moreover, contracts can require notification and transparency from contract manufacturers and suppliers that is usually not demanded by purchase orders. Component parts are frequently the source of product problems, and often, the problems stem from some change made to the component part of which the OEM was unaware and would not have approved, had review and/or approval been required. When asked how well suppliers keep OEMs informed of changes or modifications to the component-part designs, processes, equipment, raw materials, and/or third-tier suppliers, attorneys who defend these cases indicated that most of the time, OEMs are only informed of “very significant” changes. It is important to remember here that the relative significance is subjective and judged by the contract manufacturer, who may not know how the change will ultimately affect the performance of the OEM’s finished product.1 More worrisome still, nearly 15% of defense attorneys indicated that OEMs are generally in the dark about changes made by their suppliers.

Joint and Several Liability

Another legal doctrine that magnifies the importance of the use of contractual indemnity arrangements is joint and several liability. Joint and several liability is the law in some form in a majority of states, and it dictates that when there are multiple defendants—as there so often are in life sciences products liability claims—each party may be solely liable for the entire amount of the damages, sometimes regardless of fault. For example, if an OEM and contract manufacturer are both named in a products liability suit alleging injury from a defective product, and through trial the jury determines that the contract manufacturer is 99% at fault and the OEM is 1% at fault, the strictest application of joint and several liability could mean that the OEM would still be liable for 100% of the damages award in the event, for example, of the inability to pay by the contract manufacturer. This doctrine can yield arguably unfair results, with a not-at-fault or limited-fault party forced to bear the majority of the cost for another party’s mistakes.

Contracts can help avoid the adverse impact of this doctrine by stipulating fault and by requiring the other party to have insurance, thereby minimizing the possibility that they will be unable to pay.

Contracts vs. Purchase Orders

Many companies, particularly in the life sciences industry, rely on purchase orders and order confirmations, sometimes with terms and conditions appended, to conduct business. In fact, in our most recent survey of our defense panel conducted in 2018, 80% of defense panel respondents indicated that some or most of their life sciences clients relied solely on purchase orders to govern the relationships between themselves and their vendors. There is a misunderstanding in the industry that these documents sufficiently protect the parties by including terms important to them. Although such documents can be preferable to operating without any documentation, they are fraught with problems and a poor substitute for a contract governing an entire relationship. They become particularly problematic when the terms appended to the purchase order differ from those issued from the vendor in a receipt or confirmation. This scenario gives way to something called the “battle of the forms,” after which a contract is hobbled together—often judicially through litigation—from the various terms of the different forms. This process can be time-consuming and expensive to litigate and often yields a result that neither is satisfactory to either party nor reflects the subjective intent of the parties in their dealings.

Contracts for the sale of goods are generally governed by the Uniform Commercial Code (UCC) as it has been adopted by the particular state in which the contract is being litigated. The UCC addresses the “battle of the forms” in § 2-207, Additional Terms in Acceptance or Confirmation. This provision stipulates that any different or additional terms appearing in the “acceptance” or receipt will be deemed accepted and become part of the contract unless: the offer expressly limits acceptance to terms of the offer; the additional terms materially alter the agreement; or notification of objection to the additional terms has already been given or is given within a reasonable time after notice of the terms is received. This means that those including terms and conditions in their purchase orders would be wise to include among those terms an express statement that no additional terms will be deemed accepted except by express mutual consent of the parties in writing. Even this method, however, misses many of the benefits and protections of a contract of mutually agreed upon terms which governs not just one transaction but the entire relationship between the parties.

Conclusion

The absence of a contract leaves parties too vulnerable to cost and uncertainty. Conversely, contracts offer drug and device companies the opportunity to contemplate the details of a particular transaction or relationship and memorialize those details to the parties’ mutual satisfaction before a claim arises. In the event of a products liability lawsuit, contracts can and should assist in identifying the responsible party and obtaining the appropriate indemnification from that party.

In the next installment of our Risk Management 360 series, we’ll continue our discussion of contracts by looking term-by-term at the most important parts of a contract and considering what can be done with unfavorable terms from the other side.

Click to Read Part II