OEM Agreement Review Checklist: Practical Issues for the Ordering Party and the Manufacturer

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

In corporate legal practice, we review OEM agreements in a wide range of fields, including manufacturing, food, cosmetics and household goods. It is a form in which products under your own brand are manufactured by an outside factory, but it goes beyond simple outsourcing of manufacturing and includes many issues that go to the core of the business, such as who decides specifications, quality control and ownership of intellectual property.

In new businesses and startups, companies sometimes prioritize speed to market and sign the counterparty's contract template as it is. However, if the contract was not worked through carefully, it can lead to major losses when defects arise after delivery, when labeling errors come to light, or when the manufacturer starts producing a very similar product for a competitor.

Types of OEM Agreements by Transaction Reality and Applicable Regulations

An OEM agreement is a contract form in which the ordering party determines the concept, specifications and brand, and the manufacturer produces the product according to those instructions. Because the finished product is distributed under the ordering party's brand name, consumers recognize it as the ordering party's product.

Actual transaction forms vary. In some cases the ordering party provides detailed design drawings and the manufacturer handles purely the manufacturing; in others, the manufacturer uses its existing formulas, parts or manufacturing know-how and customizes part of them; and in others, the two companies cooperate to develop a new product in something close to joint development. If the manufacturer simply makes the product to the ordering party's specifications, the focus is on conformity to specifications, delivery dates and acceptance inspection; but if the manufacturer's technology is used, it is necessary to carefully separate existing technology from improvements and to set restrictions on manufacturing competing products.

Attention to related regulations is also essential. In addition to checking whether the Act on Ensuring Proper Transactions with Small and Medium-sized Entrustees applies depending on capital, number of employees and the content of the transaction, check the applicable laws for the product field, such as regulations under the Pharmaceuticals and Medical Devices Act relating to cosmetics, and regulations on the safety and labeling of food and electrical products. Even if the procedure for putting things in writing is delayed, agreements exchanged on the ground do not all immediately become invalid, but preparing written contracts is the basis for preventing later disputes.

Identifying the Product and Arrangements on Order Quantities and Price Revisions

The starting point for reviewing the contract is identifying the product covered. In addition to the product name, identify its content through specifications and formula sheets. Where there are quality standards documents or approved samples, also make clear what standard conformity will be judged against. If the specifications remain vague, disputes such as "this is not the finish we expected" are likely to arise after delivery.

As for order quantities, agree on the minimum order quantity (MOQ), forecasts, the timing of firm orders and the conditions for cancellation. Balance the interests of the ordering party, which wants to order flexibly in line with fluctuations in its sales plans, and the manufacturer, which arranges raw materials and secures production lines, and agree on at what point an order becomes firm and cancellation fees or an obligation to buy dedicated inventory arise.

In the price clause, in addition to the unit price of the product and the allocation of initial costs such as mold costs, include a clause for consultation on price revisions when raw material prices, energy costs or logistics costs rise sharply. If the unit price remains fixed, there is a risk that over a long-term transaction an unfair burden will fall on one side.

Allocation of Responsibility for Quality Assurance, Acceptance Inspection and Recalls

Set the method of acceptance inspection and the criteria for pass/fail decisions, and decide how rejected products will be handled. Also check the notice period and scope of responsibility where defects that could not be discovered immediately are found later. A clause under which passing inspection after delivery fully releases the manufacturer is high-risk for the ordering party, while the manufacturer, for its part, wants to avoid a situation in which it can be held responsible indefinitely.

For quality assurance, agree on the warranty period, conformity to standards, whether prior consent (or prior notice) is required for changes to raw materials, manufacturing sites or manufacturing methods, and, where necessary, a right to audit the factory.

For recalls (voluntary recalls) or dealing with authorities should the worst happen, set out the communication structure when an incident occurs, the procedure for investigating the cause, and the allocation of recall costs and the supply of replacement products. When products are sold under the ordering party's brand, the ordering party may be in the position of a "manufacturer by labeling" under the Product Liability Act and bear direct liability for damages to consumers. On the other hand, even where the cause of an accident lies in the design or labeling instructions given by the ordering party, the manufacturer does not automatically escape all liability. By setting out in advance in the contract the flow of incident response and the criteria for allocating costs, the risk of delayed response in an emergency can be reduced. The contractual allocation of costs and the statutory liability each party bears toward victims and authorities should be checked separately. Also check that the contract does not have the manufacturer uniformly assume losses arising from the ordering party's advertising, demand forecasts or contracts with its customers.

Ownership of Intellectual Property, Non-Compete Restrictions and Arrangements on Termination

In the intellectual property clause, distinguish among the trademarks, designs, product concepts and sales data provided by the ordering party; the manufacturing methods, molds and general-purpose know-how the manufacturer has had from before; and the improvements newly created in the development process. Because exclusive intellectual property rights do not uniformly arise in data or know-how, set out statutory rights separately from contractual terms on use and confidentiality. Excessive clauses that transfer even the manufacturer's existing technology to the ordering party are hard for the manufacturer to accept, while the ordering party also needs to secure the rights necessary for continued sale of its branded products and for transferring production in the future.

Restrictions on manufacturing and selling competing or similar products are also an issue debated in practice. The ordering party's intention to prevent the manufacturer from supplying similar products to competitors is understandable, but a comprehensive non-compete that does not limit the products covered, the period or the territory excessively restricts the manufacturer's business activities. When requesting exclusive supply, design it together with achievement of a minimum order quantity, a set period and conditions for termination if targets are not met.

With termination in mind, set out who owns molds and dedicated jigs, the storage period, the taking over of dedicated inventory, and the procedures for returning or destroying drawings and confidential information. The ordering party should check the transfer procedure to ensure supply is not interrupted, and the manufacturer should check the settlement of unrecovered costs such as equipment costs. Leaving the rights to molds and jigs vague becomes a major obstacle when switching production to another company's factory.

Generative AI is useful for identifying commonly missing clauses in a contract. However, the individual regulations for each product field, such as food, cosmetics and electrical products, and the boundary between the concepts and data the ordering party wants to protect and the proprietary manufacturing methods and know-how the manufacturer wants to protect, cannot be judged from the wording of the contract alone. It is important for people to make adjustments that fit the actual situation, taking into account the product's development history and the balance of power in the transaction.