The Perils of Purchase-Order Contracting In Pharmaceutical Transactions

September 5, 2007
Pharmaceutical Technology Editors
PTSM: Pharmaceutical Technology Sourcing and Management
Volume 3, Issue 9

Purchase-order contracting is a commonly used approach to conducting commercial transactions, but it is a risky proposition when applied to pharmaceutical transactions, including the buying and selling of contract services and pharmaceutical ingredients. The authors examine the contract provisions covered in a commercial-supply agreement that are likely to be omitted under purchase-order contracting and the risk-reduction benefits that a commercial-supply agreement can offer in pharmaceutical procurement transactions.

An executed commercial-supply agreement is not a prerequisite for conducting a commercial transaction between a buyer and seller of pharmaceutical products. In fact, most commercial transactions in the pharmaceutical industry take place without any separately executed commercial-supply agreement. Each party typically relies on the business and legal terms contained in its respective purchase order and documentation for order acknowledgement and invoicing. Although such "purchase-order contracting" is an efficient way to conduct commercial transactions, the legal framework governing purchase-order contracting rarely produces a comprehensive set of enforceable legal terms and conditions to govern the transaction.

While this level of legal uncertainty may be acceptable for contracts involving little financial or legal exposure for the parties, the authors believe that purchase-order contracting should be avoided for pharmaceutical transactions, which often include substantial financial and legal risk exposure for the parties. This article will examine three important issues:

  • Rationale of why purchase-order contracting fails to create a reliable legal framework to govern a commercial transaction

  • Identification of the contract provisions that are typically covered in a well-drafted commercial supply agreement but are likely to be omitted under purchase-order contracting

  • Examination of how an executed commercial-supply agreement can lessen the legal risks inherent in pharmaceutical procurement transactions.

Legal framework for pharmaceutical transactions

Pharmaceutical transactions are governed by the Uniform Commercial Code (UCC), a version of which has been adopted by nearly every state in the United States. As there is no single document that both purchaser and supplier sign under purchase-order contracting, the terms of the contract must be largely determined by the legal terms and conditions contained in each party's documentation. The difficulty presented by purchase-order contracting stems from the dramatic differences between the terms and conditions typically contained in each party's documentation. The purchaser typically includes purchaser-friendly terms in its purchase order, such as warranty provisions and requirements for timely delivery. On the other hand, the supplier is likely to include supplier-friendly terms in its documentation for order acknowledgment and invoicing such as disclaimers of implied warranties and exclusions of certain types of damages. And of course, because these "boilerplate" terms are rarely discussed under purchase-order contracting, these inevitable differences are not resolved at the time the contract is formed. Even in the rare circumstances where the discrepancies between the parties' documentation are discussed and resolved orally, there is no mutually executed document in which that agreement is memorialized. This issue has been referred to as "the battle of the forms" because the contract terms are determined by competing legal terms and conditions contained in each party's respective documentation.

Section 2-207 of the UCC was drafted to address this "battle-of-the forms" problem, but it has caused substantial uncertainty in contract law (see sidebar, "Battle of the forms"). Section 2-207 provides as follows:

The battle of the forms

Section 2-207. Additional Terms in Acceptance or Confirmation

(1) A definite and seasonable expression of acceptance or a written confirmation which is sent within a reasonable time operates as an acceptance even though it states terms additional to or different from those offered or agreed upon, unless acceptance is expressly made conditional on assent to the additional or different terms.

(2) The additional terms are to be construed as proposals for addition to the contract. Between merchants such terms become part of the contract unless:

(a) the offer expressly limits acceptance to the terms of the offer; (b) they materially alter it; or (c) notification of objection to them has already been given or is given within a reasonable time after notice of them is received.

(3) Conduct by both parties which recognizes the existence of a contract is sufficient to establish a contract for sale although the writings of the parties do not otherwise establish a contract. In such case the terms of the particular contract consist of those terms on which the writings of the parties agree, together with any supplementary terms incorporated under any other provisions of this Act.

How a contract may be formed. Sections 2-207(1) and 2-207(3) describe how a contract may be formed under purchase-order contracting. Under Section 2-207(1), a contract can thus be formed based on the parties' documentation even where their documentation contains different terms and conditions. In addition, under Section 2-207(3) a contract can be formed by virtue of the parties' conduct if the documentation is insufficient to establish one.

Case law: contract formation

Terms of a contract. Although the rules for contract formation under Section 2-207 are not a model of clarity and have resulted in some inconsistent results (see sidebar, "Case law: contract formation) even greater legal uncertainty exists regarding the terms of that contract. That issue is dealt with under Section 2-207(2) and the last sentence of Section 2-207(3). Parsing through the language of those sections would be neither helpful or instructive here. Suffice it to say that courts have taken different interpretations in analyzing these two provisions, in some instances ignoring terms that are different in the respective parties' documentation, in others permitting the buyer's terms to prevail, and in some instances, permitting the seller's terms to prevail, with gap-filler provisions from the UCC filling in some of the missing terms (see sidebar, "Case law: gap-filler provisions").

Case law: gap-filler provisions

Given this level of legal uncertainty, the authors believe that prudent purchasers and suppliers relying on purchase-order contracting should assume that the contract will comprise only the terms on which their respective documentation is completely consistent. Given that purchaser and seller each generally puts forth documentation skewed in its favor, it is quite likely that the only common terms will be price and quantity. So where does that leave the parties in terms of legal risk?

Likely position of purchaser under purchase-order contracting. There are a number of provisions likely contained in the purchase order (or a commercial-supply agreement) that will likely be excluded from a contract formed under Section 2-207 because they would almost certainly not be included in the seller's documentation. The following is a list of the obvious ones:

  • Warranty by seller to comply with current good manufacturing practices

  • Warranty by seller to produce the product in accordance with written specifications

  • Warranty by seller to comply with other specific laws

  • Consequences of missed delivery dates

  • Restrictions on seller modifying its manufacturing process without obtaining purchaser's consent

  • Product shelf-life requirements

  • Documentation requirements such as labeling and certificates of analysis

  • Supplier obligations with respect to its drug master file or other regulatory documents.

The authors believe that many purchasers would be horrified to know that many of these very important pro-purchaser terms might be excluded in a contract formed by purchase-order contracting. Although it should be noted that the supplier has a legal obligation to comply with certain of the above-noted purchaser-friendly terms, and that certain of these terms may be supplied by gap-filler provisions in the UCC, there is no substitute for having a specific contract provision to address an issue of concern to the purchaser.

Likely position of supplier under purchase-order contracting. Although the supplier is unlikely to forgo as many protections as the purchaser under a contract formed by purchase-order contracting, the protections a supplier is likely to forgo could be extremely important in the event of a dispute. A supplier would not be eager to get involved in a dispute without the following risk-reducing provisions:

  • Exclusion on recovery of consequential damages, including lost profits or dollar limitations on damages

  • Exclusion of remedies other than replacement of products

  • Exclusion of any other express warranties that might be contained in documentation provided by supplier or contained in supplier literature

  • Exclusions of any implied warranties, including the implied warranty of merchantability or fitness for a particular purpose.

Suppliers use the above provisions to lessen the financial exposure from a single contract, and suppliers contend that these provisions enable them to price products affordably. As in the case of the purchaser-friendly terms noted above, the law does mitigate somewhat the impact of not having these terms included in the contract. For example, the law imposes limits on the recovery of consequential damages, making it difficult for a purchaser to recover lost profits even where not expressly excluded. However, having these types of provisions in the contract itself substantially lessens the probability that they could be recovered and may deter purchasers from pursuing legal action against the supplier in the first place.

Neutral terms likely to be omitted under purchase-order contracting. There are a number of contract terms that benefit both parties by providing certainty and predictability to contractual relationships. Some of these terms are helpful in managing contract performance, and others assist the parties in assessing their risk in the event of a dispute. Examples include:

  • Conflict escalation and dispute-resolution procedures

  • Venue and governing law provisions

  • Confidentiality

  • Intellectual property rights

  • Recall procedures

  • Insurance requirements.

Because these issues are important to both the purchaser and the supplier, they are likely to be directly addressed in each party's documentation (and would almost certainly be included in a well-drafted supply agreement). As the parties' documentation would likely clash on a number of these issues, the contract formed under purchase-order contracting would likely exclude some or all of them. In the authors' opinion, both parties lose by having these terms not included in the contract.

Litigation risks in pharma transactions: The case for commercial-supply agreements

The pharmaceutical industry has increasingly gone global and become more complex, with greater risks and rewards, and pharmaceutical transactions are evolving from generic purchase-order exchanges to comprehensive supply agreements. Increases in the number of recalls, mass-tort litigation, regulations and governmental investigations, and a greater focus on supply-chain safety and quality are just some of the factors motivating purchasers and suppliers to enter into comprehensive agreements, including global purchase-order terms and conditions (POTC), which spell out the parties respective rights and obligations. In addition, purchasers and suppliers in the global market place are focusing on risk assessment, risk allocation, and financial predictability when it comes to global transactions. Officers and directors of companies, as well as shareholders, want to know they have contingency plans and recourse against other contracting parties should problems arise due to their performance problems. Well-drafted comprehensive commercial-supply agreements remove considerable uncertainty from the transactional equation and provide protection, especially when things go wrong.

Increased wave of pharmaceutical recalls and financial consequences. Increased wave of pharmaceutical recalls and financial consequences. Despite the most diligent manufacturing, quality assurance, and inspection programs, inevitably things will occasionally go wrong—even for the most careful purchaser and supplier. Between 2001 and 2005, the number of pharmaceutical recalls in the US jumped 63% with 320 total recalls in 2001 [248 prescription and 72 over-the-counter (OTC) products] compared with 502 in 2005 (401 prescription and 101 OTC periods) (1). During this same period, the number of Adverse Event Reports (AERS) in the US jumped from 285,107 to 464,068 (1). It is widely believed that increased worldwide regulatory scrutiny coupled with greater AER system reporting and media attention has led to more pharmaceutical recalls.

Recalls typically cause a material financial impact on the company's finances, often jeopardizing a company's financial viability, subjecting the company to negative publicity, and potentially damaging a company's reputation. In addition, recalls almost always trigger parasitic mass-tort litigation across the globe, financially dogging a company for years and distracting it from bringing other drugs to market or expanding operations. It is no mystery that the plaintiffs bar in the US and around the world has targeted the pharmaceutical industry as a potentially deep-pocket industry.

Recalls are often due to manufacturing and/or distribution of products that present a public health risk. As of 2005, the Center for Drug Evaluation and Research reported that the top 10 reasons for drug recalls involved:

  • Miscellaneous current good manufacturing practices (CGMPs) deviations

  • Failed US Pharmacopeia dissolution-test requirements

  • Microbial contamination on nonsterile products

  • Lack of efficacy

  • Impurities/degradation of products

  • Lack of assurance of sterility

  • Lack of product stability

  • Labeling errors

  • Misbranding

  • Incorrect packaging/container.

Given the inevitability and significant impact of recalls, as well as the predictability of the most common problems triggering recalls, most suppliers and purchasers would be well advised to anticipate these contingencies and to attempt to allocate and manage the risk ahead of time via a commercial-supply agreement. As discussed above, purchasers typically try to negotiate warranty provisions to ensure compliance with product specifications, regulatory requirements, shelf life, and quality standards.

One of the questions contracting and procurement professionals will certainly be asked by company executives during the events leading up to and including a recall is who is responsible for the underlying problem and what are the company's legal rights and obligations vis-à-vis the other contracting party under the supply contract. Assuming the contract does not address the above problems and recall-related expenses, including post-sale remedial costs and financial impact issues, contracting and procurement professionals will likely have some Monday morning explaining to do.

Other risks include False Claims Act investigations and litigation by the federal government permitting potential treble damages. An example of such claims involves situations where drugs have not been manufactured pursuant to GMP, and as such are deemed adulterated, and the manufacturer has received government payments under Medicare or other government programs for the drugs. The federal government has been aggressively pursuing False Claims Act litigation against pharmaceutical companies and has obtained several highly publicized record settlements during the last few years. Allocating responsibility for these matters in a commercial-supply agreement helps the parties manage this ever-increasing risk, which is inherent in pharmaceutical transactions.

Business interruption and market share loss from supply delays. The significant legal risks inherent in pharmaceutical procurement contracts also arise out of the simple fact that pharmaceutical sales are big business and the time and financial investment in bringing drugs to market (even generic drugs) can be substantial. Should problems arise in getting drugs to market and/or keeping them on shelves, the financial consequences in terms of lost profits and investment can be devastating for even the largest pharmaceutical suppliers and buyers. Delays in supplies can occur for a number of reasons and can have similar consequences as product recalls.

Frequently, supply problems occur under single-sourcing and just-in-time arrangements when production disruptions arise. These arrangements often provide suppliers with significant bargaining leverage. As such, purchasers often plan for possible supply-chain disruptions by sourcing their products from numerous suppliers in various geographic locations, and by keeping adequate inventory on hand to cover short-term demand. In situations where significant unexpected increases in materials and labor cause suppliers to lose money under fixed contracts, suppliers often refuse to perform until purchasers agree to new terms. Unless "workout agreements" can be negotiated to ensure profitability, many suppliers in these situations often exert considerable leverage on purchasers by simply refusing to perform. Litigation often arises in these circumstances, which can be expensive and time-consuming, further adding to a party's overall damages. Although having a commercial-supply agreement in place will not ensure continued performance by each party, it will squarely put the non-performing party in the position of having breached a written contract, providing the performing party with a much more secure legal position.

Purchasers and suppliers are advised to ensure their commercial-supply agreements address supply-disruption issues, including provisions possibly entitling purchasers to penalties for late deliveries and/or liquidated-damages provisions triggered by refusals to perform or other defaults. On the flip side, suppliers should consider including late-fee provisions for late payments and/or reimbursement provisions for investments in production facilities where a purchaser decides to discontinue a product or otherwise terminate a contract after a supplier has invested considerable time and effort in production facilities with no ability to obtain reasonably expected profits or to even cover costs.

International contracting and global litigation issues. The pharmaceutical supply industry has been described as an international bazaar with contracts most often entered into between multinational companies located in different corners of the globe. Because of pricing pressures and profitability issues, finish-dosage manufacturers, often based in the US or Europe, are increasingly sourcing product from China, Taiwan, Indonesia, Asia, India, and Mexico. In addition to potential supply-disruption issues related to shipping product across the globe, these international contract arrangements present a myriad of litigation-related issues should a problem arise.

Typically, purchase orders do not contain most, if not all, of the following litigation-related provisions:

  • Choice of law

  • Mandatory forum/jurisdiction

  • Contractual statute of limitations

  • Alternative dispute-resolution procedures

  • Designation of domestic agents for service of process

  • Attorneys' fees and costs

  • Enforcement in foreign countries of potential US judgments

  • Indemnification (including "pass-through" indemnity owed to other entities)

  • Insurance coverage (including additional named insured).

And even if these provisions are included in the purchase order, they are unlikely to survive the "battle-of-the-forms" under UCC Section 2-207.

Unless the above legal issues are specifically addressed in a commercial-supply agreement or global POTC, parties are often left in the precarious position of trying to sort through international law issues and procedures after a breach. To say the least, legal proceedings between foreign entities truly constitute challenging complex litigation, especially when terms are not spelled out. Simple issues that many in-house attorneys take for granted such as service of process can become monumental undertakings that are time-consuming and highly expensive. This situation is often the case when dealing with foreign entities that do not have US agents for service of process or that are located in countries that are not signatories to the Hague Convention. (The Hague Conventions on Private International Law consist of dozens of conventions (agreements) drawn up since the early 1900s aiming to harmonize various aspects of civil law between signatory nations. Among other things, the conventions deal with international service of process in civil actions, and recognition of official documents between signatories). In turn, even if a foreign entity agrees to accept service of process and contractually agrees to a mandatory forum-selection clause requiring litigation to be pursued in US courts, issues arise regarding the enforceability in foreign countries of potential judgments obtained in US proceedings.

Indemnification provisions and related issues also should be analyzed and considered for inclusion in commercial-supply agreements. It should be noted, however, that inclusion of even the broadest indemnity rights in a commercial-supply agreement does not completely eliminate risk and may be of little value if the nonbreaching party realistically cannot pursue litigation against the breaching party to enforce such rights. Similar issues may arise with insurance coverage and additional insured provisions, which typically provide an added level of protection for parties. Nevertheless, including these types of provisions in the commercial-supply agreement is certainly the most prudent course of action.

The time-tested adage of "an ounce of prevention is worth a pound of cure" is well-taken when entering into agreements with foreign-based entities. Parties should complete their due diligence in assessing whether the foreign-based entity (whether supplier or purchaser) is adequately capitalized, insured, has a good reputation and performance track record, and is in compliance with regulatory requirements and good manufacturing practices. International business reports, which are relatively inexpensive, and litigation searches should be obtained in advance of contracting with new companies.

Looking forward

Failing to contractually address well-known "hot-button" issues, and hoping (essentially holding your breath) that contractual disputes will not arise and litigation will be unnecessary is a recipe for disaster. Suppliers and purchasers are well advised to negotiate commercial-supply agreements in advance of problems, spelling out the parties respective rights and obligations. Because of the substantial financial and legal risks, purchase-order contracting in pharmaceutical transactions should generally be avoided.

Stephen D. Sayre is a member of Dykema's corporate finance department and Todd Grant Gattoni* is a member of Dykema with his practice concentrated on products liability, business, and chemical exposure toxic-tort litigation, including pharmaceutical and medical device manufacturers in mass tort and class-action lawsuits involving commercial-supply agreements, 400 Renaissance Center, Detroit, MI 48243, tel. 313.568.5318, fax 313.568.6893, tgattoni@dykema.com.

* To whom correspondence should be directed.

References

1. FDA, The Center for Drug Evaluation and Research's Report to the Nation: 2005 (FDA, Rockville, MD, 2005), http://www.fda.gov/cder/reports/rtn/2005/rtn2005.PDF, accessed Aug. 27, 2007.