China Manufacturing ContractsThis is the third in my series on China manufacturing contracts. Part one was on the three main types of China manufacturing arrangements we are seeing these days: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM) and Original Development Manufacturing (ODM). Part two focused on ODM contracts, which ten years ago were relatively uncommon (back then many of our clients were making clothing or toys or very basic electronics), but now make up well over fifty percent of the manufacturing contracts seen by our China lawyers — largely complicated hardware, internet of things (IoT) devices, and industrial equipment.

This post focuses on the intellectual property (IP) issues surrounding who owns what in a ODM arrangement and on the need for that ownership to be clear before any relationship between the foreign (usually American, European, or Australian) buyer and the Chinese factory company begins. I concluded

The technical question of percentage ownership is critically important for our clients because it determines the answer to a second, oftentimes even more important question: if you as the foreign buyer decide to or need to move your product production to a different factory, can you do it? Yes or no? If you own 100% of the IP, you can move. And if you have a contract that makes this clear and penalizes your existing factory for not allowing you to do so smoothly, you almost certainly will be able to do so without incident. However, if your China factory owns some or all of the IP, then you will not be able to switch your production to a new factory without some sort of license or permission from the factory. This is an issue that you need to resolve at the outset and you should not assume that you already know what the factory will say. Often, the response of the China factory is quite surprising to the foreign buyer.

In our recent experience, the most common position taken by Chinese factories is as follows:

  1. The foreign customer owns the exterior design (design patent) for the product. The customer owns its trademarks and logos.
  1. The Chinese factory owns the core intellectual property for the product.
  1. The Chinese factory agrees to manufacture the product for the customer on an exclusive basis. However, the manufacturer is free to continue to make use of its core intellectual property, including any “new work” developed as part of the product design process, in manufacturing for itself and in manufacturing products for other customers. This includes the Chinese factory manufacturing products that will directly compete with the foreign buyer’s product. The only limitation on the Chinese factory is that it cannot employ its IP to manufacture a product that uses the exterior design, trademark or logo of the foreign customer.
  1. The foreign customer cannot take the product and have it made by any other factory. That is, the customer is stuck with the Chinese factory, no matter what happens.

Assume the factory takes the “you cannot go anywhere else” approach. Then you will have to consider critical issues that will arise at the production stage. Specifically, you will need to consider what will happen in the following common situations:

  1. The Chinese factory raises its price to an unacceptable level.
  1. The Chinese factory cannot meet your quantity or time of delivery requirements.
  1. The quality of the product is not acceptable. There are consistently too many defects.
  1. The Chinese factory just decides to stop manufacturing for you. This can be because it simply decides to quit, or this can be because it decides to manufacture a similar product for themselves or for a larger company that can generate larger and more consistent orders.

All the above happens all the time when working with Chinese factories in China in the OEM and CM settings. In those settings, the remedy is to move to a different factory. The alternative to move is the primary threat that keeps the Chinese factory under control. Now consider the situation where you cannot move your production to a different Chinese factory. This obviously puts you in a very difficult situation. You are at the mercy of the factory. This is a situation you must avoid. For more on why it is so important to avoid this sort of situation, check out, China and The Internet of Things and How to Destroy Your Own Company, where we talk about companies that have come to our law firm too late.

The standard international standard for dealing with these intellectual property manufacturing issues is as follows:

  1. The factory is required to make the product for you for so long as you are interested in the product. If the factory determines on its own to quit making the product for you, then the factory must provide you with a royalty free license to the technology solely for the purpose of your being able to manufacture the product in a different factory. If the factory wants to avoid this result, its solution is simple: it must continue to manufacture the product for the foreign buyer.
  1. The factory is locked into a specific price for a specific period. Assuming that the production arrangement will be long term, it is probable there will be valid reasons for raising or lowering the price. For example, exchange rate fluctuation can be a good reason to go in either direction with the price. To provide for reasonable price changes, your contract should provide for a mechanism for annual price adjustments. This mechanism can range from a simple index to the CPI to a complex formula that takes into account multiple factors.
  1. There are two primary mechanisms for dealing with the quantity/time issue. The first is to develop a production schedule that binds both parties. The second is to provide for the situation when the factory is unable to meet the foreign buyer’s requirements by contractually requiring the factory to license production at an alternative location, but only in the amounts required to meet the excess requirements.
  1. Your manufacturing contract should provide for the situation where the factory consistently violates quality standards by giving you — the foreign buyer — the right to terminate the manufacturing contract for breach. The foreign buyer may have other reasons to terminate the contract for breach by the factory. Your contract should state that if it is terminated because of a breach by the factory, the factory automatically licenses you to manufacture your product in a different factory. Some Chinese factories will claim this rule allows for breach in bad faith simply for the purpose of moving to a new factory. If this is a genuine concern, the agreement should provide for a method of arbitration focused solely on this issue.

Though the above provisions are both fair and standard in the international business of custom design and manufacturing, we find that many Chinese manufacturers either refuse to discuss these matters or refuse to accept a reasonable solution. The Chinese factory knows that its customer will be stuck and stuck is exactly where it wants its foreign buyer to be. Being stuck with a factory what behaves unreasonably is a very unpleasant experience. You should consider carefully whether you want to proceed in that kind of situation.

You do not want to be ambushed by these critical issues after you have spent considerable time and money in developing a product with a factory that will then hold you hostage at the production stage. See China and The Internet of Things and How to Destroy Your Own Company for a taste of what this can look like.

You need to get clear on these design and manufacturing and pricing and production and intellectual property issues from the start; that means you need an ODM agreement that sets forth how they will be resolved.