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China OEM Agreements. Ten Things To Consider.

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Yesterday, our post of a slightly revised email on China’s employment law from Steve to one of our clients was a hit in that we received emails thanking us for having run it. So today, we are going to run another Steve to client email on an Original Equipment Manufacturing (OEM) agreement we drafted, first in English and then in Chinese.

Here’s Steve’s email, slightly revised, setting forth some of the important considerations/issues when drafting China OEM agreements:

  • We need to determine whether the agreement with your manufacturer will be exclusive or nonexclusive. It appears you want to give the Chinese Company an exclusive right to manufacture a certain subset of your products, with other Chinese companies having the right to manufacture other of your products. Please confirm my understanding is correct.
  • We need to determine the Chinese Company’s obligation to sell. There are basically two alternatives. Alternative One: The Chinese Company is obligated to produce product under any purchase order you submit and its failure to produce at the agreed price would be a default. On the other hand, you would then be required to purchase a minimum amount of product during a specified time period. This approach is best if you want to guarantee supply and if you want to hold the Chinese Company to its commitment on price. Alternative Two: the Chinese Company is obligated to produce product only for those purchase orders it accepts. The Chinese Company has the right not to accept Purchase Orders, at its discretion. The advantage of this to you is that it will not require you to purchase any specific amount of product. The disadvantage is that there is no guarantee of supply and there is no way to hold the Chinese Company to any price commitment.
  • The agreement as drafted provides for a specific port of delivery. However, if you will have multiple ports and delivery locations, we should revise the agreement to provide that the port/delivery location will be specified in the Purchase Orders and we will remove these references from the agreement itself
  • We have drafted the agreement to have the pricing system set out in a separate exhibit. For this exhibit, note that you will probably need to have separate pricing systems for domestic purchase and export product. Domestic product has different shipping and title transfer rules and is also influenced by the lack of any VAT rebate. Since you have no presence in China, we would also have to consider exactly how a non-export sale would work. Purchases by one of your allied trading companies may be the solution here.
  • Section 3 of the Agreement provides for payment terms. This approach is very favorable to you, since it provides for payment 30 days after inspection, not 30 days after shipment. If you will provide for payment 30 days after shipment, you will need to determine when you will inspect the product. It is best to have inspection before payment, but this is not always practical.
  • Note that we have not specified a warranty period. The normal period is two years from date of shipment. One year from date of sale is not usually used, since there is no way for the Chinese Company to know when a sale is made. Two year warranties are common because the assumption is that the product will be sold sometime in the first year after shipment from China.
  • In the trade secrets/IP protection provisions, we have provided for a monetary penalty for breach. It is customary to provide for $10,000 for the lump sum penalty and 12% for the percentage of sales penalty. The penalty is intended to be large enough to cause concern for the manufacturer, but not so large as to scare them away. The issues raised in this section come up all the time in China, so these provisions must be considered carefully.
  • The tooling provisions provide for a series of lump sum penalties. Tooling disputes are among the most common in manufacturing agreements and we have found these provisions effective in dealing with this issue. Manufacturers commonly refuse to return tooling and the most effective way to control this is to provide for a significant lump sum penalty for such a refusal.
  • This agreement is written to favor you but be fair.
  • This agreement requires preparation of the following exhibits to provide for the variable and technical provisions of the manufacturing arrangement:
  • List of products
  • Performance criteria (specifications)
  • Product pricing method
  • Quality control and inspection procedure
  • A customer no contact list
  • Tooling List
  • Purchase Order

We can assist with drafting these Exhibits as necessary. It is customary NOT to translate these exhibits into Chinese.

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  • Eric Wheldon

    And how do you intend to enforce this agreement? The manufacturer breaks the agreement – which court do you go to in China to enforce the agreement?

  • Shahzad Khan

    No one replied to Eric’s comment. He raised a valid concern.

  • R

    Depends on if there are any clauses regards to the dispute resolution in the agreement, and which country the law applies.
    Should apply for arbitration in Cietac before lodging your case to the People’s Court.

  • http://www.ricetecmilling.com kennadi

    I want to know about contract laws to export from INDIA to china.

  • Mr. Vinod Shah

    I regularly buy plywood from China. In the month of early May we had paid an advance to a company based in SHouguang for the purchase of plywood. The specifications reqd were told to the supplier and the price was accordingly fixed. I then visited China on the 24th May’11 and met this company who was to show me the quality of the plywood I had ordered. I visited the factory but the quality was not acceptable which was told to the supplier. The supplier than told me that they could not supply the plywood at the price agreed and agreed to refund me my advance which was mutually agreed upon. Now after a month the supplier has still not refunded me my advance and every time I call him he promises to send it within two to three days and he never sends. What should I do to recover my advance? Pls advice.

  • James Noter

    This is a great article. I was looking for materials on manufacturing agreements and came across this and from here I spent the next two hours reading your blog. I have never read such a helpful blog. Your explanations for the legal side of China business are so clear. I cannot thank you enough.

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  • mk

    Thanks!