30 June 2024

Contract Manufacturing by a Foreign Company

June 30, 2024

BRACE Law Firm ©

Contract manufacturing is often a technologically complex and expensive process, requiring compliance with a significant number of regulatory acts governing the production of specific goods.

Typically, establishing production requires finding facilities, purchasing or leasing equipment, hiring personnel to manage the technological process, and purchasing consumables. However, business interactions continue to evolve; in modern conditions, entrepreneurs can outsource the production of goods. This type of cooperation is known as contract manufacturing. Implementing this model allows a business to delegate the manufacturing process, reduce organizational costs, comply with legal requirements for goods production, and mitigate numerous manufacturing-related risks.

Under Russian law, the concept of contract manufacturing refers to the production of goods by a third-party manufacturer based on an agreement with a trade participant using a trademark registered to that participant (the trademark holder) or a third-party trademark for which the trade participant has a right of use. This concept is reflected in the following regulatory documents:

Government Decree No. 886 dated May 31, 2023, On Approving the Rules for Labeling Dietary Supplements with Identification Means and the Specifics of Implementing a State Information System for Monitoring the Circulation of Goods Subject to Mandatory Labeling with Identification Means with Respect to Dietary Supplements;
Government Decree No. 870 dated May 30, 2023, On Approving the Rules for Labeling Perfumery and Cosmetic Products Intended for Hand Hygiene with a Declared Antimicrobial Effect, as Well as Skin Antiseptics – Disinfectants, with Identification Means and the Specifics of Implementing a State Information System for Monitoring the Circulation of Goods Subject to Mandatory Labeling with Identification Means with Respect to Perfumery and Cosmetic Products Intended for Hand Hygiene with a Declared Antimicrobial Effect, as Well as Skin Antiseptics – Disinfectants.

The process of outsourcing product manufacturing can be divided into the following stages:

Selecting a contractor for contract manufacturing;
Discussing the technical specifications for production;
Concluding a contract;
Supplying raw materials (if necessary);
The actual manufacturing of the goods;
Executing accompanying documents, including both accounting and quality-related documentation;
Packaging, labeling, and storing finished products;
Delivering the goods;
Paying for the contractor's services.

Pricing policy and product quality are critical aspects of any outsourced production process. These factors usually depend on who manufactures the goods and where. Consequently, many entrepreneurs choose contract manufacturing by a foreign company based on these criteria.

Outsourced production may operate under the following manufacturing schemes:

Working exclusively according to the factory's existing patterns, formulas, and recipes;
Manufacturing products according to the customer's technological chart, with the ability to modify the technological chain to meet the specific customer's needs.

Selecting a Country for Contract Manufacturing

The primary criteria for choosing a contract manufacturing site include:

The availability of necessary equipment, production capacities, and technological chains;
Qualified personnel with the required experience and education;
The ability to manufacture the ordered products and issue accompanying documentation;
Experience working with foreign customers.

To select a foreign outsourced production facility, a business must inspect the factory or plant to ensure it meets the criteria for manufacturing a specific product. The primary countries for outsourced production include:

Turkey;
China;
Vietnam;
India, etc.

Each country offers various manufacturing specializations: some focus on apparel, others on cosmetics, others on medicinal products, etc. The choice of country also determines the specifics of interacting with the factory. Each foreign manufacturer may have unique cultural business practices and a different legislative framework. Furthermore, in the current political climate, choosing a country for contract manufacturing requires calculating risks associated with international partnerships under sanctions restrictions. Risks may include the inability to fulfill contractual obligations due to a lack of cooperation with unfriendly countries.

Russian law does not contain a single regulatory document governing contract manufacturing. Therefore, when drafting a contract manufacturing agreement, parties are guided by the provisions of Chapter 37 of the Civil Code of the Russian Federation (Civil Code), which regulates work contracts and identifies:

The Customer, who provides raw materials or materials for processing;
The Performer/Contractor, who receives the materials and manufactures products according to the Customer's technical specifications.

The parties conclude a work contract for the manufacture or processing of an item or for the performance of other work with the transfer of the result to the Customer.[1] Furthermore, the Civil Code stipulates that the Contractor must use the materials provided by the Customer economically and prudently. Upon completion, the Contractor must provide the Customer with a report on material consumption and return any remaining balance or, with the Customer's consent, reduce the work price by the cost of the unused material remaining with the Contractor.[2] If the Contractor fails to achieve the result or if the result contains defects rendering it unfit for the use specified in the contract (or unfit for ordinary use if not specified) due to defects in the materials provided by the Customer, the Contractor may demand payment for the work performed. Depending on the product, the parties may include provisions for product expert examination, including stage-by-stage inspections at each production site.

The Contractor is liable for the failure to preserve materials, equipment, items transferred for processing, or other property in the Contractor's possession due to the execution of the work contract.[3] Additionally, the Contractor must immediately warn the Customer and suspend work until further instructions if it discovers:

Unsuitability or poor quality of the materials, equipment, technical documentation, or items transferred for processing provided by the Customer;
Potential adverse consequences for the Customer if the Contractor follows the Customer's instructions regarding the method of performance;
Other circumstances beyond the Contractor's control that threaten the quality or durability of the work results or make it impossible to complete the work on time.

The contract manufacturing agreement must include all these provisions, clearly defining the procedures for the transfer of materials, manufacturing formulas, and product sketches, as these parameters determine the final product.

The Contract Manufacturing Agreement with a Foreign Company

Cooperation for production by a foreign company is formalized through a contract manufacturing agreement that covers all essential aspects of production and contract execution. In addition to standard sections such as the preamble, scope, manufacturing deadlines, payment terms, duration, and parties' details, a contract manufacturing agreement with a foreign company must include the following:

The Contractor's liability for timely performance and the production of defective goods, including liquidated damages/penalties;
Applicable law and jurisdiction for dispute resolution;
Compliance with Russian legislation regarding manufacturing standards (GOST, technical regulations, Technical Specifications (TS), SanPiN, etc.) and product quality;
Compliance of the goods with technical documents, layouts, recipes, formulas, etc.;
Ownership of intellectual property (IP) rights, conditions for transferring the production formula, and other essential sections for contract performance.

Depending on the product and the technological chain, the parties may supplement the contract with clauses reflecting specific rights, obligations, and liabilities. When interacting with foreign partners, it is vital to consider the specifics of the Contractor's jurisdiction and the local laws. The contract must explicitly state which regulatory documents apply to production, contract performance, and dispute resolution.

Since contract manufacturing is often located abroad, the foreign trade agreement must consider both Russian regulations for the specific product and the laws of the foreign partner's country. In some cases, foreign law may differ significantly from Russian law, which could lead to inconsistencies if not addressed. Furthermore, since Russian law does not define a specific "contract manufacturing agreement", such contracts are often "mixed contracts" containing elements of various legal arrangements. The parties must account for this when drafting the foreign trade agreement, as the foreign partner's law may regulate specific activities differently. Additionally, governing law provisions in the contract can apply to both the overall technological process and specific partner interactions.

Detailed drafting of every section and clause allows foreign trade participants to clearly understand their obligations and reduces risks associated with the misinterpretation of manufacturing and performance requirements.

Tolling Transactions (Production from Foreign Customer-Supplied Raw Materials)

Current Russian regulations do not strictly define "customer-supplied raw materials" (or "toll materials"), despite its use in various acts. In practice, these are materials transferred by the Customer to the Contractor for processing or manufacturing without the Contractor paying for them. The Contractor undertakes to manufacture a pre-agreed product from these materials. If raw materials remain after production, the parties may agree to return them, use them for additional production, or allow the Contractor to keep them in exchange for payment to the Customer.

Russian law does not classify a "tolling transaction" as a separate contract type. However, given the principle of freedom of contract provided by Russian civil law, parties may enter into any agreements not prohibited by law, including mixed and unnamed contracts.[4] Typically, the provisions of the Civil Code on work contracts apply to tolling transactions, whereby the Contractor undertakes to perform specific work at the Customer's request and deliver the result, while the Customer undertakes to accept and pay for it.[5]

A tolling agreement requires the Customer to transfer the raw materials and the Contractor to manufacture and deliver the specific products. The transfer of raw materials must be properly documented for accounting purposes. Documents used for receiving raw materials may include:

An act of transfer and acceptance of raw materials to the Contractor;
A bill of lading for the transfer of inventory;
An intake voucher.[6]

Every business transaction of a legal entity must be documented with a primary accounting document. The mandatory details of such a document are:[7]

The name of the document;
The date of preparation;
The name of the economic entity that prepared the document;
The description of the business transaction;
The natural or monetary measurement of the transaction, including units of measurement;
The titles of the persons who performed the transaction and are responsible for its documentation;
The signatures of the persons, including their surnames and initials or other identification details.

Primary accounting documents may be prepared in hard copy or as an electronic document signed with an electronic signature.

The lack of evidence regarding the transfer of raw materials can lead to adverse consequences for the Customer, including the loss of materials and the failure to receive finished products.[8] To prevent such situations, businesses must choose reliable manufacturers and properly execute all accompanying documents, including the contract, transfer acts, acceptance acts, certificates, and other performance-related documents. Notably, specifying the amount of initial material and the quantity of finished products in the acceptance act constitutes a sufficient report by the Contractor on material usage.[9]

When concluding a tolling agreement, the parties must ensure that the quality of the manufactured products matches the parameters in the technical specifications, as product certification is typically required. Failure by the Contractor to meet tolling agreement conditions, resulting in substandard products, may lead to the denial of a safety certificate and, consequently, the inability to sell the goods.[10]

Quality Documentation in Contract Manufacturing

Product quality is a paramount component of manufacturing. When outsourcing production, the Customer must provide the Contractor with quality documentation that must be strictly followed along with the production formula. Under Russian law, product quality may be confirmed through certification—a form of compliance confirmation by a certification body ensuring that objects meet technical regulations, standardization documents, or contractual terms.[11] Certification results in a Marketing Authorization (MA) or Registration Certificate, which attests that the object complies with the required standards. A Registration Certificate includes:

The name and location of the applicant;
The name and location of the manufacturer;
The name and location of the certification body that issued the certificate;
Information identifying the object of certification;
The name of the technical regulation used for certification;
Information on the research, testing, and measurements conducted;
Information on the documents provided by the applicant as evidence of compliance;
The certificate's expiration date;
Information on the applicant's use (or non-use) of Russian national standards included in the list of standardization documents for voluntary compliance with technical regulations.

Registration Certificates are issued for mass-produced products, specific batches, or single units.[12]

Since work contract provisions apply to manufacturing, the quality of the Contractor's work must comply with the contract or, if not specified, with the requirements usually applied to such work. Unless otherwise provided by law or contract, the result of the work must possess the properties specified in the contract or determined by standard requirements at the time of transfer. It must remain fit for the contractually specified use (or ordinary use) for a reasonable period.[13] If the Contractor performs work with deviations from the contract that impair the result or with other defects rendering it unfit for use, the Customer may, unless otherwise provided by law or contract, choose to demand from the Contractor:[14]

The free rectification of defects within a reasonable timeframe;
A proportionate reduction in the price of the work;
Reimbursement of the Customer's expenses for rectifying the defects, provided the contract grants the Customer the right to do so.

Alternatively, the Contractor may perform the work again for free and compensate the Customer for any losses caused by the delay. In this case, the Customer must return the previous result if possible. If the deviations or defects are not rectified within a reasonable time or are substantial and irreparable, the Customer may terminate the contract and demand compensation for damages.

Regarding the timeframe for discovering quality issues, if no warranty period is established, the Customer may file claims for defects discovered within a reasonable time, but no later than two years from the date of transfer, unless other deadlines are set by law, contract, or business custom.[15]

When outsourcing, the Customer must meticulously define not only the formula but also other indicators affecting quality, such as:

The use of specific raw materials or those provided by the Customer;
Technological manufacturing charts, including mandatory temperature controls;
Product packaging, which can affect the shelf life.

It is also vital to specify the criteria the goods must meet to be sold in a particular country. Regardless of where they are manufactured, products must comply with the quality requirements of the destination country. For example, quality parameters in India may not match those in Russia for the same product. Therefore, when outsourcing to India, the contract must reflect the quality criteria for the intended market.

The statute of limitations for claims related to defects in work performed under a work contract is one year.[16] Since this is shorter than the standard period, the Customer must thoroughly inspect the products upon acceptance.

Information Confidentiality and Copyright in Manufacturing

When ordering production from a foreign company, the Customer transfers the production formula (recipe, sketch, industrial design, etc.). Consequently, the contract manufacturing agreement must include clauses prohibiting the copying or disclosure of this formula to third parties.

Article 727 of the Civil Code stipulates that if a party, through the performance of its obligations under a work contract, receives information from the other party regarding new solutions or technical knowledge (including those not protected by law) or information subject to a commercial secrecy regime, the receiving party may not disclose it to third parties without consent.

Some products are manufactured using unique parameters that are both commercial secrets and protected by intellectual property law. The contract must reflect this, providing for liability (fines and Lost Profits) for violating IP rights or disclosing commercial secrets.

The results of intellectual activity and equated means of individualization subject to legal protection (intellectual property) include:[17]

Works of science, literature, and art;
Computer programs;
Databases;
Performances;
Phonograms;
Broadcasting or cable transmissions of radio or television programs;
Inventions;
Utility models;
Industrial designs;
Selection achievements;
Topologies of integrated circuits;
Production secrets (know-how);
Company names;
Trademarks and service marks;
Geographical indications;
Appellations of origin of goods;
Commercial designations.

Given the wide range of IP objects, the contract must specify what is being transferred and what is protected, including protection under international law.[18] Because IP laws in the manufacturing country may differ from Russian law, the contract must include a section on applicable law and IP protection.

Advantages and Disadvantages of Contract Manufacturing by a Foreign Company

Like any business model, contract manufacturing has pros and cons that must be considered during legal formalization, especially when working with foreign companies.

Advantages include:

The factory remains operational, and employees remain employed;
The Customer avoids the costs of building facilities, buying equipment, and hiring specialized staff;
The Contractor's staff can handle the creation of the technological chart;
The manufacturer does not need to worry about product marketing.

Disadvantages include:

Risks of information leakage or the transfer of unique formulas to third parties;
Difficulties in exercising quality control, particularly with foreign companies;
The risk of the Contractor substituting high-quality ingredients with inferior ones without the Customer's knowledge.

Despite these issues, many entrepreneurs choose the manufacturing option that best fits their specific situation and financial capabilities. When entering these transactions, especially with foreign partners, it is essential to anticipate all potential scenarios, define all aspects affecting the final product in the contract, and ensure compliance with both Russian and foreign regulations. Proper documentation minimizes risks of substandard quality, reduces disputes, and increases product competitiveness.

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References

[1] Clause 1 of Article 703 of the Civil Code of the Russian Federation.

[2] Article 713 of the Civil Code of the Russian Federation.

[3] Article 714 of the Civil Code of the Russian Federation.

[4] Article 421 of the Civil Code of the Russian Federation.

[5] Clause 1 of Article 702 of the Civil Code of the Russian Federation.

[6] Decree of the State Statistics Committee of the Russian Federation No. 71a dated October 30, 1997, On Approving Unified Forms of Primary Accounting Documentation for Labor and Its Payment, Fixed Assets and Intangible Assets, Materials, Low-Value and Rapidly Wearing Items, and Work in Capital Construction.

[7] Article 9 of Federal Law No. 402-FZ dated December 6, 2011, On Accounting.

[8] Decree of the Arbitration Court of the Volga-Vyatka District No. F01-10373/2020 dated May 28, 2020, in Case No. A79-15148/2018. The claim sought the recovery of unjust enrichment in the amount of the value of unreasonably withheld toll materials. The parties entered into an agreement to manufacture items from raw materials. A copy of the acceptance act was presented without the original. The Contractor alleged the document was falsified. The court dismissed the claim due to lack of evidence of the transfer.

[9] Decree of the Federal Antimonopoly Service (FAS) of the Moscow District No. KA-A40/8214-08 dated September 3, 2008, in Case No. A40-67911/07-129-404.

[10] Decree of the Arbitration Court of the Central District No. F10-5953/2016 dated March 9, 2017, in Case No. A23-3388/2015 On the Recovery of Actual Damage and Lost Profits. The tolling agreement resulted in substandard products, making safety certification impossible. The court partially granted the damages due to the defendant's fault in causing the plaintiff's losses.

[11] Article 2 of Federal Law No. 184-FZ dated December 27, 2002, On Technical Regulation.

[12] Article 25 of Federal Law No. 184-FZ dated December 27, 2002, On Technical Regulation.

[13] Clause 1 of Article 721 of the Civil Code of the Russian Federation.

[14] Clause 1 of Article 723 of the Civil Code of the Russian Federation.

[15] Clause 2 of Article 724 of the Civil Code of the Russian Federation.

[16] Clause 1 of Article 725 of the Civil Code of the Russian Federation.

[17] Clause 1 of Article 1225 of the Civil Code of the Russian Federation.

[18] Convention for the Protection of Industrial Property, signed in Paris on March 20, 1883. The document entered into force for the USSR on July 1, 1965. The Stockholm Act of July 14, 1967, was ratified by the USSR by the Decree of the Presidium of the Supreme Soviet of the USSR No. 3104-VII dated September 19, 1968.