China manufacturing lawyersIn a post entitled The 7 Major Risks You Run With Your China Manufacturers, China manufacturing expert Renaud Anjouran outlines the business risks foreign companies face when outsourcing their product manufacturing to Chinese factories. Renaud’s list nicely accords with what our China lawyers tell our clients for whom we draft Chinese contract manufacturing agreements. See China Manufacturing Agreements: Binding Contract or Contract Terms. When we first talk, our manufacturing clients usually want to focus on the following: a) ownership of intellectual property, b) prevention of counterfeiting, c) ownership of molds and tooling and d) after sales warranty service. This is the kind of thing legal agreements are really good at resolving and it is easy to allow the discussion to center on these issues.

But in my 25+ years of working in China, it is rarely these issues that result in bankruptcy of the foreign purchaser. The matters that result in bankruptcy are usually on the list provided by Renaud. That is, the most serious issues are the core business issues tied to outsourced manufacturing: price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping.

Renaud describes the basic issues, but, we should ask at the outset: what is the source of these issues and what can be done to address them. The source of the problems is the pervasive use of the purchase order approach to purchasing contract manufactured product from China. In China Manufacturing Agreements: Binding Contract or Contract Terms, I wrote how there are two basic ways to structure a China contract manufacturing agreement.

Option One is to enter into a binding contract with the China factory that directly confronts all of the basic manufacturing issues in a manner that is legally binding on both the parties. Under this option, the agreement on price binds both the Chinese factory and the foreign buyer. If material costs change, if labor costs change, if production costs change, the parties remain obligated to pay and sell the product at the agreed-upon price, no matter which party benefits or loses from the changes. Both parties are taking the price risk. If the agreement is long term and if the various input costs are likely to change over time, then the parties either take the risk or develop a detailed system for adjusting in response to the change. In most of the world, this is what is done. In China, however, the entire risk tends to be loaded on one side or the other. The same applies to the other key business terms in China manufacturing agreements, such as the terms for payment, quantity, delivery date and quality.

The issue for many foreign buyers is that under Option One, both parties are bound. Foreign buyers who do not want to be bound or who cannot be bound due to lack of resources will follow Option Two. Under Option Two, any form of contract manufacturing agreement is little more than terms and conditions. Such terms and conditions are binding on the parties only after a purchase order is presented by the foreign party and then accepted by the Chinese party. If the Chinese manufacturer does not accept your purchase order, there is no binding agreement you and your Chinese manufacturer. It is this lack of a binding agreement that is the primary cause of the seven manufacturing risks Renaud discusses in his post.

Consider for a second why that is the case from the perspective of the Chinese factory. Under the purchase order approach, the factory has no assurance that its foreign buyer will place even a single order. During a fiscal year, the Chinese factory has no assurance on price, quantity or delivery date. The Chinese factory is expected to develop the product, taking on the risk and expense of commercialization. The Chinese factory is then expected to turn over to its foreign buyer the plans, molds and tooling so the foreign buyer can move production to a lower cost factory down the road. In this type of situation, the factory really has nothing solid in the relationship with the foreign buyer. So the factory acts in the manner described by Renaud. This is perfectly natural and it is to be expected. That is, any foreign buyer that expects a Chinese factory to act differently under the purchase order approach option is living in a dream world.

So what is the solution? The obvious solution is to follow Option 1 by entering into a binding agreement with the Chinese factory that formally commits both parties to the basic business terms for a specific period of time. However, the lure of China for many foreign buyers is that Chinese factories are willing to do small runs on a purchase order basis. The purchase order system is oftentimes the reason why the foreign company is having its product developed and manufactured in China. To tell these buyers to follow Option 1 is unrealistic.

For this reason, our primary task as lawyers is to develop contract manufacturing agreements that recognize that the purchase order approach will be used and deal up front with the risks that come from that. The key here is that the foreign buyer understand the risks and work actively with the Chinese factory to deal with mitigating those risks in a way that is practical and fair.

We can now consider the situation in China in relation to the risks Renaud identifies. In my follow-up post (on Sunday) I will discuss the first four of these risks and how best to mitigate against them. In part 3 of this series, I will conclude by examining how to deal with the last three of these risks.