Toll Manufacturing Transactions: Trade Secret and IP Protection

BENEFITS AND RISKS OF TOLL MANUFACTURING

In a toll manufacturing arrangement, a company provides its raw

materials or semi-ﬁnished goods to a third-party service provider.

The service provider, who often has specialized equipment or

infrastructure, provides a subset of manufacturing processes on

behalf of the company using those materials or goods for a fee.

To effectively leverage a toll manufacturing relationship, a rights

holder must license a combination of proprietary trade secrets,

know-how, processes, data and materials to the toll manufacturer.

However, this introduces risks of teaching a third party to replicate

proprietary processes and allowing the third party to access

valuable know-how that it may either:

 Use for its own independent beneﬁt.

 Sell to a third party.

 Inadvertently allow others to access through the absence of

effective controls.

The lack of protective laws or effective remedies for

misappropriation in BRIC countries and other emerging market

countries may heighten these risks.

Trade secret protection is a particularly sensitive issue in toll

manufacturing relationships because the manufacturers with the

requisite expertise are typically already engaged in the relevant

business or ﬁeld. Accordingly, they may be well-positioned to

compete with the company during or after the term of the toll

manufacturing agreement.

Importance of Internal Controls

A company’s internal controls may help to ensure proper:

 Vetting and selection of the prospective manufacturer during

the due diligence process.

 Negotiation of the toll manufacturing relationship.

 Management of the toll manufacturing transaction and

relationship with the manufacturer.

In today’s corporate environment, many companies consider

toll manufacturing arrangements in emerging market countries

to reduce costs while maintaining access to a highly educated

and technologically advanced work force. Toll manufacturing

in countries such as Brazil, Russia, India and China (BRIC

countries) can allow a company to realize cost savings by

outsourcing functions to highly specialized service providers in

lower cost jurisdictions.

While toll manufacturing can provide companies with valuable

bottom-line drivers in their production pipelines, it presents

unique risks for the potential loss of trade secrets and the

enablement of a new competitor.

This Note outlines a combination of structural, contractual,

practical and institutional measures companies should use in

toll manufacturing arrangements and agreements to protect

their trade secrets and other valuable intellectual property (IP).

Speciﬁcally, it focuses on:

 The general beneﬁts and risks of a toll manufacturing

arrangement.

 Due diligence measures to carry out before entering into any

toll manufacturing transaction.

 How a company can strategically structure a toll manufacturing

arrangement.

 Practical and contractual protective measures and controls to

secure trade secrets and technological assets.

 An overview of other key contractual provisions to include in a

toll manufacturing agreement.

For a checklist addressing these issues, see Toll Manufacturing:

Protecting Trade Secrets and IP Checklist.

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Toll Manufacturing Transactions: Trade Secret

and IP Protection

Bruce Goldner and Jonathan Hillel, Skadden, Arps, Slate, Meagher & Flom LLP, with

PLC

Intellectual Property & Technology

A Practice Note outlining measures companies can use in toll manufacturing arrangements to protect their

trade secrets and other valuable intellectual property (IP). This Note includes a discussion of the risks and

beneﬁts of toll manufacturing, due diligence considerations, and practical and contractual methods of

protecting trade secrets and technological assets.

This is just one example of the many online resources

Practical Law Company offers.

To access this resource and others, visit practicallaw.com.

Toll Manufacturing Transactions: Trade Secret and IP Protection

Delegating signing authority and supervisory responsibility to one

member or a core team of company management can:

 Improve risk-beneﬁt assessments.

 Help achieve uniform application of the company’s toll

manufacturing protocols.

Centralized oversight may also facilitate:

 Knowledge and data management concerning past and current

toll manufacturing transactions.

 Institutional learning to implement and reﬁne protocols for

future transactions.

DUE DILIGENCE OF THE TOLL MANUFACTURER

Selecting a trustworthy partner is an essential ﬁrst step to a

successful toll manufacturing transaction. A company should

only enter into a deﬁnitive transaction with a prospective toll

manufacturer after ensuring it will be an acceptable partner. This

requires the company to conduct rigorous due diligence, which

may include:

 Background checks of the manufacturer’s principal ofﬁcers

and directors.

 Audits of the manufacturer’s ﬁnancial statements.

 Inspections of the manufacturer’s facilities.

 Investigations of the manufacturer’s supply chain and trading

partners.

In addition, a company should require the prospective

manufacturer to submit:

 Business references from past and current clients.

 References and credentials for key employees.

 An overview of its complete organizational structure, as well as

beneﬁcial ownership documentation.

 A list of all current clients.

As part of the diligence process, a company should assess to what

extent the prospective manufacturer or any of its afﬁliates is or

in the future may become a competitor in the commercial areas

that will be the subject matter of the agreement. This may also

impact the assessment of the potential practical risks raised by

the particular toll manufacturing relationship.

While a company should avoid disclosing any trade secrets or

related information until it enters into a deﬁnitive agreement

with the prospective manufacturer, it should enter into a non-

disclosure agreement with the prospective manufacturer before

beginning its due diligence process. This is to:

 Protect the company if any trade secrets or other business

information are shared.

 If appropriate, prevent disclosure of the potential

manufacturing arrangement itself.

TRANSACTION STRUCTURE

Once the company selects a potential manufacturing partner,

it should design a transaction structure that reinforces its

commercial expectations and the manufacturer’s contractual

obligations. Speciﬁcally, the company should structure the toll

manufacturing transaction in a manner best suited to protect the

company’s key IP. Transaction structure considerations include

both:

 The particular corporate and contractual form of the

relationship.

 How the company will delegate the manufacturing process to

the toll manufacturer.

Joint Venture or Arm’s-Length Contract

The ﬁrst structural decision is the corporate and contractual form

of the relationship itself. The parties can enter into a:

 Joint venture with the proposed manufacturer.

 Simpler contract manufacturing relationship.

Forming a contractual joint venture with the proposed

manufacturer or a legal-entity joint venture, by moving certain

manufacturing assets and personnel of the counterparty into a

new entity in which the company will have an ownership interest,

offers certain beneﬁts. For more on establishing joint ventures,

see Practice Note, Joint Ventures: Overview and PLC Commercial,

Practice Note, Cross-border Contractual JVs in the Manufacturing

Sector.

The beneﬁts of a joint venture may include:

 Greater operational control over the manufacturer.

 Increased transparency on the use and protection of key

manufacturing assets and related know-how.

 An enhanced ability to inﬂuence the manufacturer’s practices

and policies on a go-forward basis.

However, a relationship where the company takes an ownership

stake or the parties otherwise document a collaborative joint

venture relationship involves a:

 Higher level of complexity with respect to diligence and

documentation.

 Greater commitment of time and resources.

 Potentially more difﬁcult exit.

Joint ventures also require additional considerations relating to

the transfer, licensing and ownership of trade secrets and other IP

required for and developed by the joint venture.

Together, these factors may undercut the cost-cutting rationale for

seeking a toll-manufacturing solution.

Companies may therefore prefer a more straightforward contract

manufacturing relationship in most contexts and this relationship

is assumed for this Note.

Segmenting the Manufacturing Process

After deciding on the basic corporate or contractual structure, the

company should decide how best to strategically divide up the

manufacturing process. In the toll manufacturing context, the best

process involves not only efﬁcient manufacture, but also most

effective process to mitigate potential trade secret risks.

To protect its assets, the company must ﬁrst identify which IP has

the greatest value and therefore needs the most structural and

contractual protection.

Because of the inherent difﬁculties in enforcing breach of contract

actions alleging misuse of conﬁdential information, practical and

structural protection measures are also critical. These measures

should be built directly into the toll manufacturing relationship.

Where practicable, the company should divide crucial know-how

in a manner that prevents the manufacturer from having access to

all of the trade secrets necessary to complete the manufacturing

process.

Limiting Access and Use

The strictest form of control over the company’s trade secret and

technological assets is to ensure that any manufacturer personnel

do not access these assets, by either:

 Having the company handle key aspects of the process

internally at facilities outside of those of the manufacturer.

 Where internal treatment cannot be used, having company

personnel themselves work in the manufacturer’s facility.

If possible, it can be beneﬁcial to allocate different phases

of the process to different manufacturers. For example, in

car manufacturing, a company may produce the engine

or technology-intensive parts internally or through multiple

service providers. The division of know-how between different

entities can reduce the ability of, and potential harm caused

by, a manufacturer that attempts to misappropriate valuable

information.

Where the use of different manufacturers is not possible, the

company may beneﬁt from separating the process into different

phases within a single manufacturer’s organization. The company

can require that separate teams of employees and management

personnel work on each phase, and that internal ﬁrewalls prevent

the spread of information between the teams.

To the extent practicable, conﬁdential information should be either

or both:

 Provided on a just-in-time and as-needed basis.

 Expunged from the manufacturer’s systems immediately after

use.

Establishing and Maintaining Oversight

Requiring the manufacturer to maintain a designated facility for

all work involving the transaction can reduce the risk of violations

and simplify the monitoring and protection of the company’s IP. In

all cases, the company should reserve the right to frequently audit

the manufacturer’s facilities. If possible, the scope of these audit

rights should extend enterprise-wide to ensure protection and

containment of critical information.

The company should also consider appointing one or more

company delegates to oversee key steps of the toll manufacturing

process within the manufacturer’s facilities. This is the case even

where the manufacturer’s employees, and not the company’s

delegates, are responsible for the manufacturing activities. The

company’s delegates also can serve in a quality-control capacity.

Control over the Final Product

Finally, if the company can control the distribution and sale of the

products following manufacture, it may be in a position to:

 Better control the continuity of its business.

 Limit the impact of the manufacturer attempting to compete in

the future if the company transitions from the manufacturer to

another service provider or to its own facilities.

CONTRACTUAL TRADE SECRET PROTECTION MEASURES

In addition to using structural and practical protections

(see Segmenting the Manufacturing Process), the company

should include speciﬁc measures for protecting its conﬁdential

information in the toll manufacturing agreement. These should

address:

 The identiﬁcation of the company’s trade secrets

(see Identifying the Company’s Trade Secrets).

 The manufacturer’s obligations concerning its employees and

contractors (see Obligations Concerning the Manufacturer’s

Employees and Contractors).

 The manufacturer’s commitment to establish and enforce:

 physical barriers and electronic ﬁrewalls (see Physical

Barriers and Electronic Firewalls);

 special information technology protocols (see Information

Technology); and

 procedures for the use of conﬁdential information

(see Protocols for Conﬁdential Information).

 A narrowly tailored license of the company’s trade secrets and

other IP (see Licensing of Trade Secrets and IP).

In negotiating the toll manufacturing agreements, the company’s

internal controls play an important role in protecting the

company’s interests and continuity of company practices

(see Importance of Internal Controls).

Identifying the Company’s Trade Secrets

The agreement should ﬁrst identify the type and nature of the

trade secrets and conﬁdential information the company intends to

protect. To maximize protection, the agreement should describe

the information:

Toll Manufacturing Transactions: Trade Secret and IP Protection

 With sufﬁcient detail for the information that the company

wants to protect to be identiﬁed.

 Without being overbroad, because:

 the information might be perceived as being deﬁned too

generally; and

 the obligation might be found unenforceable.

The company should consider reviewing and updating the

description periodically or as necessary to ensure that the

agreement continues to accurately and completely reﬂect the

information it has shared with the manufacturer.

The agreement should include an acknowledgment by the

manufacturer of this information’s great value and that this value

derives in large part from its secrecy.

Obligations Concerning Manufacturer’s Employees and

Contractors

Access Limitations

The toll manufacturing agreement should require procedures that

limit access to the company’s conﬁdential information to speciﬁc,

identiﬁed manufacturer personnel and solely to the extent they

need to know the information for performing the services.

Employee Contracts

The company should require the manufacturer to amend its

employment contracts with individuals having access to the

company’s conﬁdential information to provide for conﬁdentiality

and non-compete obligations concerning this information. The toll

manufacturing agreement should make the manufacturer directly

liable to the company for any breach of these obligations.

The company should also consider requiring that key employees

with access to company trade secrets execute a conﬁdentiality

agreement directly with the company. As a result, the company

will be in direct privity with the individuals and may not have to

rely on the manufacturer to enforce employee contracts or on

potentially limited third-party beneﬁciary rights.

These employment contracts should provide for the assignment

to the company of all IP derived from and improvements made

to the company’s trade secrets and other IP. Alternatively, the

agreements can require assignment to the manufacturer, who

should in turn be contractually obligated to assign these rights to

the company. This may be particularly important in certain BRIC

countries, such as China, where applicable laws would allow the

manufacturer’s employees to make these improvements despite

any contractual provisions to the contrary.

Employee Training and Education

The company should require that employees be educated on best

practices for protecting conﬁdential information and preventing

disclosure. The toll manufacturing relationship should include

ongoing education and information for employees and managers

covering:

 The importance of protecting commercially sensitive

information.

 The commercial beneﬁts from this protection.

 The economic and legal consequences of failing to properly

safeguard sensitive information.

The toll manufacturing agreement should provide for disclosure

to and consent from the company for any new or substitute

employees that the manufacturer proposes to use in connection

with sensitive employee functions.

Employee Termination

The company should require the manufacture to adopt protocols

to govern termination of the manufacturer’s employees in

a manner that minimizes the risk of the employees taking

conﬁdential information with them when they leave the

manufacturer. These may include:

 Giving employees short notice before termination.

 Automatically disabling access by these employees to secure

areas or systems before giving notice.

 Informing employees of, and requiring them to agree to, the

withholding of their ﬁnal salary or severance payments, or both,

pending the company’s review of their information access and

transmission records.

Use of Independent Contractors and Consultants

The company should take into account the risks of permitting

the manufacturer to use third-party independent contractors or

consultants. To limit the disclosure and use of its conﬁdential

information, the company should consider expressly prohibiting

the manufacturer from using any independent contractors or

consultants.

However, where the company is willing to allow the use of these

individuals, it should ensure that the toll manufacturer:

 Is directly responsible for their actions and obligations.

 Has agreed to conﬁdentiality obligations and practices for

these individuals at least as protective as those used with the

manufacturer’s employees, including the company’s:

 approval of any individuals before any permitted disclosures;

and

 review and, if necessary, revision of relevant agreements.

Security Procedures for Access, Storage and Transmission

Physical Barriers and Electronic Firewalls

The company should contractually require the manufacturer to set

up physical barriers and electronic ﬁrewalls to protect conﬁdential

information, including:

 Implementation of e-mail ﬁlters.

 Download limitations to prevent the transmission of large data

ﬁles.

 Revocable and subject to immediate termination when

appropriate.

 Sublicensable and assignable only to the extent necessary

under the arrangement.

TOLL MANUFACTURING AGREEMENT PROVISIONS

In addition to practical and contractual protections speciﬁc

to trade secrets, the company should address the following

considerations in its toll manufacturing agreement to help

reinforce the manufacturer’s conﬁdentiality obligations and protect

the company:

 Providing for a limited initial term (see Term and Termination).

 Making renewal terms at the company’s discretion (see Term

and Termination).

 Seeking a right to terminate for convenience (see Term and

Termination).

 Addressing transition services after the agreement

(see Transition Services).

 Including adequate trademark protection (see Trademark

Protection).

 Requiring non-compete covenants (see Non-Compete

Covenants).

 Including assignment and change-of-control restrictions

(see Assignment and Change-of-Control Restrictions).

 Specifying means for dispute resolution (see Dispute

Resolution Procedures).

Term and Termination

The company should keep the initial term of the agreement

relatively short. In addition, the company should consider

including either or both of the following:

 Renewal terms at the company’s discretion.

 A termination for convenience provision.

Due to the overhead required for the manufacturer to start the

services, the manufacturer may not agree to short terms with

unilateral renewal rights or the right for the company to terminate

for any or no reason. If so, the company may wish to focus on

more readily exercisable breach and termination triggers with

relatively short cure periods. These features should create strong

incentives for the manufacturer to comply with the agreement’s

conﬁdentiality provisions. For example, the company could

include:

 A termination trigger if the company establishes its own

facilities.

 An option for the company to acquire the manufacturer’s

designated facilities.

The company should ideally require conﬁdential information in

electronic format to be isolated from the manufacturer’s main

computer network and from any computer or network with

internet access.

The manufacturer also should maintain physical security for its

facilities, including:

 Building security guards.

 Internal access restrictions based on clearance levels.

 Surveillance devices.

Information Technology

Because of vulnerabilities in cybersecurity and efforts by

corporate, state and criminal actors, particularly those based in

certain BRIC countries, to access and siphon off economically

and competitively valuable information, the company should

specify special information technology protocols for the

manufacturer. These protocols can include:

 Keeping certain highly sensitive information entirely off of the

manufacturer’s, and perhaps even the company’s, network.

 Performing periodic information technology audits to assess the

networks’ security.

Protocols for Conﬁdential Information

The toll manufacturing agreement should cover generally

applicable measures for the use and transmission of conﬁdential

information. These should include requiring:

 All documents containing trade secrets and similar know-how

to be marked as conﬁdential.

 Encryption for electronic ﬁles.

Transmission of conﬁdential information should also only occur

through secure channels.

Local Law Considerations

The laws of each particular jurisdiction deﬁne what constitutes

a trade secret in that country and the protective measures

that owners must take to be eligible for legal remedies for

misappropriation. Local counsel should therefore be consulted in

each relevant jurisdiction to review the proposed agreement and

to help determine the most effective means under local law to

protect the applicable IP.

Licensing of Trade Secrets and IP

The licensing of the company’s trade secrets and other IP should

be consistent with the company’s identiﬁcation of its trade secrets

and other IP and appropriately limited in scope. Among other

considerations, the license should be:

 Narrowly tailored to cover only the manufacturer’s required use

of the licensed information and IP.

Toll Manufacturing Transactions: Trade Secret and IP Protection

Dispute Resolution Procedures

The dispute resolution procedures of the agreement should

account for difﬁculties that the company may encounter in

enforcing contracts and other legal rights in the manufacturer’s

jurisdiction. For example, China does not give reciprocity to

judgments by US courts, but Chinese courts do enforce decisions

by arbitral tribunals. The company should consider an arbitral

forum that offers established procedures and a large number of

potential arbitrators who are ﬂuent in English and have experience

with toll manufacturing transactions, such as:

 New York or Miami for a Brazil agreement.

 London or Geneva for a Russia agreement.

 London or Singapore for an India agreement.

 Hong Kong or Singapore for a China agreement.

The agreement should be subject to a neutral governing law with

well-established principles and well-developed precedent for trade

secrets, such as Delaware or New York in the US or English law.

As a general matter, parties based in different countries generally

will seek to resolve disputes through arbitral institutions that

principally focus on international disputes. For example, the

International Chamber of Commerce (ICC) has a long history of

providing an arbitral forum for international commercial disputes,

and parties frequently agree on the ICC the appropriate tribunal

for arbitration. In addition, depending on the region in which the

manufacturing is to occur, there may be international arbitration

tribunals with substantial experience in handling international

commercial disputes in that region. For example, for disputes

involving a China agreement, the Singapore International

Arbitration Center or Hong Kong International Arbitration Center

may be preferable among available arbitral institutions on the

basis of:

 Available remedies.

 Predictability.

 Enforceability of award.

Accordingly, the company in each instance should consider the

appropriate arbitral forum based on its own prior experience and

the reputation of the forum in the applicable region.

For more on arbitration in the US, UK, Switzerland, Singapore and

Hong Kong, see PLC Arbitration, Articles:

 Arbitration procedures and practice in United States: overview.

 Arbitration procedures and practice in UK (England and

Wales): overview.

 Arbitration procedures and practice in Switzerland: overview.

 Arbitration procedures and practice in Singapore: overview.

 Arbitration procedures and practice in Hong Kong: overview.

Transition Services

After termination or expiration, the company should require

the manufacturer to provide extensive transition services to the

company. In addition to customary provisions, the agreement

could provide for the transfer to the company of key:

 Equipment.

 Materials.

 Facilities.

The agreement can further require the manufacturer to offer

severance to crucial employees and encourage them to accept

future employment with the company directly.

Trademark Protection

The company should require that the products manufactured by

the toll manufacturer:

 Prominently bear the company’s trademarks.

 Are not offered in association with the name or mark of the

manufacturer or any other third party.

The agreement should also include appropriate quality control

obligations and oversight relating to the use of the marks. This

should help the company create and maintain equity in the

marketplace concerning company-authorized products.

Non-Compete Covenants

The company should consider requiring certain non-compete

covenants from the manufacturer so that the manufacturer

has less incentive to misuse company trade secrets. These can

also be included in modiﬁed employment agreements with the

manufacturer’s employees. These provisions may be limited to a

speciﬁc industry or sector, or in connection with speciﬁc company

competitors.

Assignment and Change-of-Control Restrictions

Change-of-control and anti-assignment restrictions are important

protections in any toll manufacturing agreement. They can

provide the company with assurances that:

 The identity of the manufacturer will not change during the

term of the agreement.

 A competitor will not obtain access to the company’s sensitive

information through corporate afﬁliation with the service

provider.

For more on assignment and change-of-control provisions,

see Practice Note, Restrictions on Assignment and Change of

Control.

For the links to the documents referenced in this note, please visit

our online version at http://us.practicallaw.com/8-525-5209.

Additional Deterrents to Prevent Breach

To help safeguard against the worst case scenario of the

manufacturer’s breach, the company may consider including

additional contractual deterrents. These may include requiring the

manufacturer to:

 Post a bond in escrow.

 Purchase insurance.

 Maintain a letter of credit.

 Grant the company a lien on certain assets.

The company’s rights under these safeguards should be triggered

by either or both of the following:

 The manufacturer’s material or intentional breach of the

agreement.

 Speciﬁc provisions concerning trade secrets.

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Topics

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(http://us.practicallaw.com/topic3-500-0084)

 Conﬁdentiality

(http://us.practicallaw.com/topic7-103-1304)

 General IP

(http://us.practicallaw.com/topic0-103-2076)

 Supply of Goods and Services

(http://us.practicallaw.com/topic0-103-1128)

 Trade Secrets

(http://us.practicallaw.com/topic3-506-0474)

Practice Note: Overview

 Joint Ventures: Overview

(http://us.practicallaw.com/1-107-3580)

Standard Document

 Conﬁdentiality Agreement: International Joint Ventures

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Checklists

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(http://us.practicallaw.com/6-501-7380)

 Protecting Trade Secrets and IP in Toll Manufacturing Agreements

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