China manufacturing contractsI spend much of my time drafting manufacturing agreements between foreign (mostly American, European and Australian) companies and Chinese companies. When doing these manufacturing contracts for China, my first step is determining what kind of relationship the foreign buyer (typically our client) will have with the Chinese factory. We cannot be clear about what kind of manufacturing agreement to draft until after we know what type of manufacturing relationship is intended.

To guide the process, we have found that there are three fundamental types of manufacturing arrangements used in China: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM), and Original Design Manufacturing (ODM). This post is the first in a series of posts I will be writing on how these different arrangements influence the various legal issues inherent in manufacturing in China. Today’s post focuses on the intellectual property issues that can arise when having a product manufactured under each of these three arrangements in China.

Type 1: Original Equipment Manufacturing (OEM). In this arrangement, the foreign buyer purchases a product from the Chinese factory that is already being manufactured by the Chinese factory. The buyer then “packages” this product with its own trademark and logo. The buyer and the factory may also agree to certain cosmetic changes (color, shape, minor added features) that further customize the product for the buyer.

OEM manufacturing was the original standard for custom manufacturing in China. The great trade fairs such as the Canton Fair were designed to introduce standard Chinese factory products for purchase by foreign OEM customers. In the classic OEM arrangement, the ownership of the intellectual property is clear. The factory owns the IP in the product, while the buyer owns the IP in its trademarks and its logos and its packaging. That is, the buyer owns its brand but the factory owns the product.

The difficult issue in an OEM Arrangement is who owns the IP in the changes to the product that involve customization for the buyer? In terms of standard IP analysis, there is no clear answer here. One purpose of a OEM agreement is to clarify this issue. Usually, the buyer seeks to restrict the factory from making use of the customization in sales of the base product to third parties. Stated simply, the factory will usually want to make use of the customization and the buyer will want to prevent this. This can lead to difficult negotiations with no clear outcome.

Type 2: Contract Manufacturing (CM). In this arrangement, the foreign buyer has a fully developed product design. Traditionally, this design was of a product that had been manufactured by the buyer in its home country. More recently, the product is a new design being manufactured for the first time in China.

Contract manufacturing represents the second stage in foreign manufacturing in China. In principle, the design ownership issue is quite simple. The foreign buyer owns all of the IP: the IP in the design and the IP in the brand. The factory owns nothing. However, in actual practice, the division is not so clear. This is especially true when the factory is working with a new design that has not been manufactured previously on a commercial scale.

In this setting, the Chinese factory will often make changes in the product design during the course of “commercializing” the product. Who owns those design changes? What if the factory wants to use those design changes in modifying the factory’s own products that are sold in direct competition with the foreign buyer? What if the foreign buyer wants a different factory to make the product? Is that other factory permitted to make use of the design changes? These are difficult issues that arise in virtually every contract manufacturing project and they can be resolved only by a clear written agreement.

Type 3: Original Design Manufacturing (ODM). As Chinese factories have become more technically competent, foreign buyers have started entering into arrangements where the Chinese factory does some or all of the design work for the product. There are many variations on the ODM approach. For this discussion, we will consider the simplest variant where the design concept and the basic specifications are developed by the foreign buyer, while the commercial design work is done by the factory. In this most fundamental form, the foreign buyer provides drawings and a specification sheet. The Chinese factory does the rest of the work, in consultation with the buyer.

In this setting, the obvious question is who owns the design in the resulting product? In our experience, the foreign buyer will take the position that it owns the design, since it came up with the original concept and then brought that concept to the Chinese factory. However, the Chinese factory will usually take the opposite position, claiming that since the factory did all the R&D and commercialization work, the factory owns the IP in the product design. Often the Chinese factory will agree to make that product on an exclusive basis for the foreign buyer, but the foreign buyer does not have the right to have the product made by a third party factory. This position can come as a bad surprise to the foreign buyer, particularly when the factory suddenly announces it will be doubling the price for manufacturing the product.

These issues can get even more complex when the product developed incorporates or is based on technology clearly owned by the factory. In this setting, the factory will often state that the buyer can go anywhere it wants to manufacture the buyer’s own portion of the product design, but no third party factory can make use of the Chinese factory’s proprietary technology in the manufacturing process. Consider this case for a foreign buyer who has spent considerable time and effort to develop a product design only to learn after one year that the Chinese factory has decided to terminate the manufacturing agreement.

Once again, the only way to resolve this issue to to confront it in advance with a detailed written ODM agreement that sets out a resolution to these issues that is fair to both sides. There is no simple, legal default answer to any of these difficult issues. Or, rather, the legal default favors the position of the Chinese factory. Absent a clear agreement on how to proceed, the foreign buyer will lose pretty much every time.

As you can see, even for the most basic OEM arrangement, a simple purchase order is not sufficient. In every type of manufacturing relationship in China, a formal agreement is required. In the absence of such an agreement, the ambiguity of the situation will always favor the factory that is doing the manufacturing. So forget the POs and join the real world where clearly drafted agreements (in Chinese) are normal practice.