China contract lawyersIn my first post in this series (here), I described the five basic attitudes Chinese companies have regarding advanced equipment being sold into China.  In part 2 (here), I set out two of five tactics high value equipment sellers should follow when selling advanced (and therefore expensive) equipment into China: One, do not discount, and two, get paid before you deliver your equipment to your China buyer.

In this, part 3, I wrap up this series by setting forth the remaining three tactics equipment sellers should employ when selling their equipment to Chinese companies.

3. Do not deliver the equipment until first verifying that the conditions for its installation have been met. Remember that the Chinese side believes your equipment works based on an almost “magic” formula and your rules on how to set up for its installation and the specifications for its use are just a subterfuge you use to “hide the magic.” The detailed set up work is therefore unnecessary. Meeting the specifications is not necessary. So the Chinese side will not do the proper set up and they will ignore the specifications. But then when your equipment does not work as it was supposed to, the Chinese side will blame you for its failures.

The following are two (of many) true stories that illustrate how this typically goes down:

  • A heavy equipment manufacturing company delivers iron pipe casting equipment. The conditions of sale provide that the floor of the casting room must be perfectly level. When the equipment is delivered, the casting room has an uneven dirt floor. The casting machine does not work and the Chinese side does not pay a single penny on the contract. The Chinese bank that guaranteed the payment sides with the Chinese buyer. Why create a level, clean concrete floor for a dirty machine used for metal castings, one of the China company’s engineers asked at one point.
  • A water power equipment manufacturing company delivers a new hydropower generation set of equipment. The specifications provide that the current flow can never exceed 6 knots. When the equipment is delivered, the Chinese side installs it in an unapproved location where it is well known the current exceeds 8.5 knots. Within one year, the entire facility is destroyed. The Chinese side defaults on the last payment and the reputation of the foreign company is destroyed. The foreign company lost money on the project and never did another sale in China.

Foreign equipment sellers cannot rely just on clear contractual specifications and then relying on the specifications when there is a problem. The foreign seller should itself ensure the conditions are met before it delivers the equipment. And if the conditions are not met, the foreign seller should not deliver. If there is a cost in confirming your Chinese buyer has met the specifications (and there usually will be), you should build that cost into the cost for your product. Remember: the failure of the installation is always your fault and the Chinese side will always find a way to make you pay for that failure. We have said this before and it made people mad, but some of our most experienced and sophisticated and successful China essentially charge a premium to Chinese buyers simply to cover themselves in advance against these sorts of problems.

4. Build required training and after sales maintenance and support into the price of the equipment. No matter how much your potential Chinese buyer tries to get you to decouple the pricing for maintenance and support (and then eliminate it entirely) do not make these optional add-ons that are billed for an additional fee. If you make these optional and charge extra for them, the Chinese side will almost always choose not to pay. So you have to force them to accept training and support as part of your sales price.

Why do the Chinese refuse to pay? Your trying to require them to pay for after sales maintenance is just you admitting that your product is somehow defective and why should they buy a defective product. If properly manufactured your equipment should work forever, with no service or maintenance required and your trying to make the Chinese side pay for training and service as an add-on is you unfairly seeking to increase the price of a product that is already unfairly expensive.

There is one exception related to training. If the Chinese side is planning to clone your equipment, they will seek extensive training in how the equipment operates. Their goal though is not training; their goal is to somehow obtain the formula that will allow them to clone your machine. For this reason, you should carefully control your training with Chinese companies.

During training, the Chinese side will ask for more information and more training time than is necessary. They will also insist on visiting the U.S. manufacturing facility and they will expect to spend substantial time in that facility. For this reason, all training obligations must be carefully defined to prevent your costs from skyrocketing out of control. You should carefully limit time, location and access to information. One good way to control this is to require the Chinese pay by the hour for all training provided in excess of the basic training included in the purchase price.

Many foreign equipment suppliers say they will provide whatever training proves “reasonably” necessary. This sort of an approach is nearly always a mistake because neither Chinese companies nor Chinese courts truly understand or employ the concept of reasonable. You therefore should state state with precision the training you will be providing, where you be providing it, who will be providing it, and for how many hours you will be providing it. The same rules apply to provision for after sales support. Chinese companies tend to abuse after sales support obligations. So those obligations should also be spelled out clearly in your contracts as well. Again, I base this not on any “feelings” I have about China, but based on my having represented countless foreign equipment sellers on countless China equipment transactions and on what I have heard from other equipment companies and from other China lawyers who represent them.

5. Protect your IP through with a China-centric contract. Protecting the intellectual property you have in the advanced equipment you sell into China should be a core goal in all of your sales. Understand the basic approach from the Chinese side: your product is too expensive and b) any form of IP protection is just a unfair device you are using to force them to pay the unfair price of the machine. So the goal of the typical Chinese company is to purchase one or two items at a bargain price and then clone them in China at a “fair” price.

The obvious way to protect the intellectual property in your advanced equipment is to register your patents in China. But for various reasons (including time bars) this is often not possible. Where there is no patent registration (and oftentimes even when there is), your best solution is to incorporate basic IP protections into your sales agreement. This is essential for China.

To accomplish this, either your sales contract or a collateral agreement must provide for the buyer agreeing to the following:

  • Buyer will not reverse engineer or manufacture a copy/clone of the product or engage any affiliate or third party to do the same. A complex legal definition is not required. A blunt, simple statement (in Chinese) is what is required.
  • Define confidential information information (such as the information you provide in training and support) and require no confidential information can be used by your buyer or by any affiliate or by any third party to infringe on your product.
  • Provide for monetary damages if these restrictions are violated. Injunctions rarely work in China, so contract damages are required.
  • Impose these restrictions with a written agreement enforceable by litigation in China. This is a key requirement. Your English language sales agreement that is enforceable in the New York or in London or in Geneva is not going to be helpful in protecting your IP and if it makes sense for you to use that sort of agreement on the sell side (and sometimes it does), you should have a separate IP protection agreement in Chinese, subject to Chinese law and enforceable by litigation in China.

China contract lawyersIn my previous post in this series (here), I described the five basic attitudes Chinese companies have regarding advanced equipment being sold into China. Given these attitudes, what should a foreign seller do? In this part 2 post I set out two of five tactics high value equipment sellers should follow when selling advanced (and therefore expensive) equipment into China. In part 3, I will wrap it up with the remaining three tactics.

1. Do not discount. The first mistake most Western companies make when selling their high end equipment to China is to discount its price. The usual explanation my clients give me for doing this is that “we will discount the first equipment sale and then make up for that discount on future sales.” Wrong.

If you offer a discount you are simply confirming the China side’s basic assumption that your price is too high and you will virtually never get the opportunity to make up for the discount. The Chinese side will do one of two things. Some buyers (especially state owned enterprises or SOEs) will treat the initial discounted items as “samples” they will distribute to other enterprises to be cloned in China. For other buyers, the discounted price will treated as a new floor price for the product. If additional purchases are discussed, the Chinese company will then ask for an additional discount against your already discounted price.

It is therefore critical you hold the line on price. You may perhaps offer a very small quantity discount for purchases of multiple units. You may even offer a small “customer loyalty” discount for return purchases. But never offer a major discount for the initial purchase. Hold the line and explain that your price is both fair and the same price you offer to everyone in the world, on the same terms. What reason is there to change this policy for China?

2. Get paid before you deliver. For companies that are successful in selling to China, this is the golden rule. There really is no alternative. In many countries, issues related to payment can be resolved through the use of carefully drafted letters of credit. Chinese buyers, however, will only use Chinese banks for their letters of credit and those banks will always favor their Chinese buyer customers, so the letter of credit approach will not work for China.

For Chinese companies planning to clone your equipment in China, paying you by installments fits perfectly into their plan. The standard approach works as follows. Set up a system with five installment payments. The equipment will be delivered and installed in stages, in accordance with the installments. Then, the Chinese company will delay payment from the very start and then use the payment delay (which it will usually blame on China’s capital controls or some tax issue) to push the foreign side to deliver more than is required for each installment. The Chinese company will then reluctantly make a payment or two, all the while extracting equipment, training and know-how. When the Chinese side thinks it has gained  “enough” from what you have already provided it, the payments stop. The common standard is to make two of five payments in exchange for 50% of the product and expertise. Our China lawyers warn our clients about this all the time and yet it just keeps happening.

Other Chinese companies will use installment payments to force you to discount. The Chinese side will negotiate for a series of installment payments with a major final installment to be paid after installation and approval by the Chinese side. This approach virtually never works well for the foreign seller as Chinese companies are expert at finding problems with the equipment. The Chinese side will raise these problems as excuses for continual payment delays and then use their own delays to seek an after the fact discount in price from you, while holding the installment payments as hostage to achieve this goal.

If the Chinese company is unable to secure its desired discount from you during the basic installment period, it simply will not make the final payment, achieving a 10% to 15% discount by that single refusal to pay. If the foreign side threatens to sue for that final payment, the Chinese side will trot out a list of problems with the product and its installation — normally problems the Chinese company itself caused. However, this will still be enough to convince the foreign side seller that it will need to mount a long and expensive legal battle to get that final payment and that doing so probably will not make sense.

It is important to note that these tactics by Chinese companies are not unusual. Your price is too high, so they do not see themselves as acting unethically; they are just leveling the playing field. I have spent about half of my life in China and I have heard this reasoning about once a month while there.

How to sell to ChinaThis is the first in an eventual series of posts I will do on the business and legal issues related to foreign companies selling high value equipment to Chinese companies. The behavior of Chinese companies in this area is quite uniform, and it is therefore possible for me to present a uniform approach to sales into China. Before moving to a detailed analysis, it will be best to step back and consider how Chinese companies view the process. Once the fundamental viewpoint of the Chinese side is understood, it is then much easier to determine how to craft an effective sales strategy for China.

Chinese companies purchased a fair amount of advanced equipment from foreign companies in the 90s. But these purchases slowed considerably as Chinese companies shifted their focus to manufacturing for the export market. However, these export oriented Chinese companies have recently started showing a renewed interest in purchasing advanced equipment from foreign manufacturers. That China is now Germany’s largest trading partner is good proof of this.

The reason Chinese companies are buying more advanced equipment from overseas is clear to anyone who visits Chinese factories. The simple truth is that much of the production equipment in these factories is old technology nearing the end of its useful life. The Chinese businesses that have made China the factory of the world have  pushed their manpower and outdated tools to the limit and for them to continue to compete in the world manufacturing market, technical upgrades are required. Chinese companies are mostly unable to innovate in this area on their own; so they are reluctantly making purchases from foreign entities.

Though the world has greatly changed since the 90s, the attitude of Chinese companies towards the purchase of foreign equipment has not. There are five basic beliefs that drove Chinese advanced equipment purchases back when I was working on them in the 1990s and those same five basic beliefs drive these purchases today. Once these beliefs are understood, Chinese behavior on these equipment transactions becomes easy to understand. Once you understand the basis for the behavior of your Chinese counterpart on these deals, you can design a program that can be successful in the Chinese market.

In entering into a sales agreement with a Chinese factory interested in buying your high value equipment, you should understand that the Chinese factory owner almost certainly holds the following five fundamental beliefs that will drive its behavior in the sale process:

1. Your price is unfairly high. The important thing to know is that the Chinese side believes your price is both too high and fundamentally unfair. The Chinese side views this as the legacy of foreign imperialism, designed to keep the Chinese down, always under the thumb of the foreign oppressor. This attitude is supported by the general ideology of the PRC government. Under this basic belief, the Chinese factory owner feels morally justified in working to avoid paying you the full price for the equipment.

To achieve this, the basic strategy of the Chinese side will be the following:

a. Insist on paying in installments, then not paying the last installment.

b. Insist on a major discount, in the range of 30% to 40%. This then becomes the new base price for the equipment.

c. After paying the discounted price for the first two units, insist on an additional discount for future purchases.

2. Training is not necessary. Any requirement for training the Chinese side in how to use your equipment is just another way for you to unfairly extract more money from the Chinese side. It is also a way to keep the Chinese side down by showing that the Chinese have something to learn from foreigners. The Chinese believe that operation of the equipment is governed by a simple magic pill. Foreign companies that insist on a training program are withholding access to the magic pill.

3. Proper equipment set-up is not necessary. Your requirement that the Chinese side retain you for proper equipment set-up is a waste of time and designed to shift blame for operational failure onto the Chinese side. The Chinese side believes the equipment should “just work.” For this reason, elaborate site set up and pre-operations testing should not be required. Just turn the key and go.

4. After sale support and maintenance is not required. Requirements from the foreign equipment supplier for such after-sale support is designed to do two things: unfairly extract more money from the Chinese side and keep the Chinese side employees ignorant about the true nature of how the equipment operates. That is, you are unfairly hiding the magic pill from them. In addition, the equipment should “just work,” with no need for after sale maintenance or support. Your requiring a service contract or related after-sale support is either your admitting that your equipment is fundamentally defective or your trying to unfairly milk more money from the Chinese side.

5. Your attempts to protect your IP is foreign oppression. Intellectual property protection that prevents the Chinese side from copying your equipment is just another form of foreign oppression. The Chinese side does not believe the design of your equipment is the result of years of hard work and R&D and it wants to be able to copy it so that it can be manufactured in China at a “fair” price.

This then means the Chinese side’s standard strategy will be to purchase as few units as possible and then use its initial purchase(s) to extract the “magic formula.” The strategy is to abandon future purchases and have clones of your equipment manufactured in China.

Obviously not all Chinese companies subscribe to all five of these beliefs and some Chinese companies do not subscribe to any of them. But most do and I know this from what they have told me (in Chinese), from what I have overheard (in Chinese) and from what I have read (in Chinese). I mention all this because foreign companies find this all hard to believe and even when they do believe it, they find it hard to truly internalize and adjust their selling behavior accordingly. The typical Chinese factory owner will negotiate and implement its purchases of advanced foreign equipment based on these five beliefs. Many foreign suppliers, when faced with the resulting behavior, will conclude that the Chinese are operating in bad faith. However, to deal with the Chinese buyers, the first step is to understand that they believe their approach is fair. They are simply working against the unfair advantage of the foreign seller by making a more level playing field.

The important thing from the standpoint of the foreign seller is to recognize the following:

  1. These basic beliefs are natural and will not be changed.
  2. Since these basic beliefs are pretty much universal among Chinese companies, it is easy to predict how the Chinese buyer will behave at every critical point in the sales process.
  3. Since the approach of the Chinese side can rarely if ever be changed, foreign companies that want to sell their high value equipment to China should design their sales programs based on what the Chinese side will do, with contracts that protect the foreign seller from the negative consequences of near certain Chinese company actions.

In my next post, I will outline a basic program for achieving this.

My first post in this threeChina manufacturing lawyers part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law firm to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

My second post focused on the first four items on Renaud’s China product outsourcing list. In this, my last post in this three-part series on China manufacturing, I focus on the last three items from Renaud’s list.

Risk Five: Subcontracting. Subcontracting of production presents a number of risks often not clearly understood by foreign buyers. Renaud identifies the first and most common risk. The foreign buyer goes to substantial effort to verify that the Chinese factory it has chosen is capable of meeting its quality standards. If the factory then subcontracts the foreign buyer’s product manufacturing to another factory, all of the buyer’s verification work becomes meaningless. This then leads to other issues: How will inspections take place? How will quality control standards be enforced? How will worker safety or worker age rules be enforced? How will anti-bribery and related rules be enforced? Working to the next level, manufacturing by a third party where there is no contractual relationship means that confidential information agreements are automatically breached, and this is a primary way intellectual property gets lost in China. Finally, molds and tooling are often moved to the subcontractor, resulting in loss of control and the inability to retrieve these items when required.

There are three reasons Chinese factories typically subcontract. First, the “factory” is a front for a trading company that actually does no actual manufacturing on its own. This type of trading company will subcontract all of the manufacturing and will limit its involvement to supervising (usually very poorly) the manufacturing process. Second, the factory may be capable of doing the basic manufacturing process, but it requires subcontracting assistance on key elements of the production process. For example, it is normal for Chinese factories to subcontract mold making and electroplating of key components. Finally, the factory may decide that the foreign buyer’s purchases are too small to justify the effort of setting up production and it will subcontract to a factory with the time and the interest. Such a factory is almost guaranteed to be of lower quality, leading to the problems Renaud describes in his post.

Since subcontracting is always an issue when manufacturing in China, it is necessary to confront the issue directly in a formal agreement. The standard approach is to provide that subcontracting is prohibited without notice to and consent by the foreign buyer. The foreign buyer should condition its consent on inspecting the subcontractor and getting the subcontractor to execute a separate manufacturing contract with the same key terms as the foreign buyer has with its original manufacturer.

Though this approach is best, many Chinese factories insist on an absolute right to subcontract. In that situation, if the foreign buyer agrees, then the normal contract provision is to require (a) the Chinese factory at least identify its subcontractor(s) (b) the subcontractor grant the foreign buyer access to its premises for inspection and c) the Chinese factory agree to be directly liable for any violations committed by the subcontractor. Some Chinese factories will not agree to these conditions. When that happens, our China lawyers recommend the foreign buyer refuse to purchase its products from that factory.

Renaud identifies a more difficult problem: undisclosed subcontracting. This situation is unfortunately quite common. It arises most often during the busy season when a factory simply cannot keep up with the orders it has accepted. The best way to prevent this from taking place, the foreign buyer must regularly inspect the factory operations to ensure that the factory is really doing the work on the premises. Since the high season is the most likely time subcontracting will occur, this is the time when appropriate, unannounced inspections should occur. It is also crucial to enter into a formal agreement that prohibits undisclosed subcontracting as described above.

Way back in 2009, in The Six (Not Five) Keys To China Quality, we wrote about the tremendous value of putting a no-subcontracting provision in your China manufacturing agreements:

We typically put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?

In our experience, these no-subcontracting provisions work shockingly well.

Risk Six: Failure to Deal with Defective Product. The problem of defective products raises several issues. First, it is critical to identify a factory that will attain and maintain a reasonable defect rate. If the defect rate during production is over an “epidemic percentage” level, it is almost certain success will not be achieved. As Renaud illustrates in his post, the defects in Chinese factories are often at the cosmetic level. The base product is acceptable, but the finish is defective or scratched; fingerprints show up on glass in an enclosed case; greasy footprints are found on well sewn, elegant handbags.

There are two issues relating to dealing with such defects. The first is how to locate the defect. It is best to locate the defect during the production process. Second best is to locate the defect before shipping. Third best is to locate the defect after your receipt of the product. The worst case is to learn of the defect after delivery to the down stream customer.

As Renaud notes, once defects are found, the parties must have in place a formal plan that clearly deals with what will be done with the defective product. It is critical not to allow the defective product to enter into the retail market. Many Chinese factories will sell defective product “out the back door.” When this product gets into the market, the damage to your reputation can be substantial.

But what should be done with defective product? We usually provide that the defective product must be destroyed. However, this is not always the best alternative. In some cases, the defective product can be repaired or otherwise reworked. This is a common approach for complex and expensive cast metal parts for large equipment. In other cases, the defective product can be disassembled so that valuable components, such as precious metals, can be recovered.

Once you resolve how to handle defective products you receive from your China factory, your next issue is how to get reimbursed for the defects. The Chinese side will usually propose that the value of the defective product be applied as a credit against your future purchases. This is a bad system because the foreign buyer can only obtain credit if it makes another purchase. This forces the buyer into a relationship with a factory that makes defective product. Even worse, the amount paid to the factory is going down for each new purchase, which means the factory has even less incentive to do a good job.

The practical solution is for you to inspect your product before making any payments for its manufacture and reducing the invoice price to account for any short delivery resulting from removal of defective product from any given shipment. If the defect level reaches an epidemic failure rate (this rate must be determined on a product by product basis), your manufacturing contract should provide for you to be able to impose additional penalties. Foreign buyers that delay dealing with quality issues until after they have made full payment for their product are virtually never able to successfully resolve their China product defect issues.

The above discussion shows that a detailed, formal system for dealing with quality control and handling of defects is required and the only way to do this is with a formal, written manufacturing agreement. The common one line statement that the Chinese factory will warrant the quality of its products will never work. Manufacturing in China will ALWAYS result in defects. A workable plan for dealing with those defects is therefore not optional. It is required.

Renaud’s post raises an even more important issue. In some cases, the defect level from the factory will be high and will remain high. In that situation, where a defect rate is over 20%, it is normally impossible to develop a workable solution with the factory. The solution here is to monitor the process from the very beginning. In China, factories do not do better work over time. Their performance almost always only gets worse over time. As soon as an excessive defect rate is identified, you should take immediate action. Usually that immediate action means cutting your losses and moving to a new factory. A good manufacturing agreement will make this transition as easy as possible.

Risk 7. Logistics Cost Increases Due to Factory Error. As Renaud notes, you need to beware of increased shipping costs due to your factory making an error in the size of container required to ship your product. This issue arises from a common mistake make by foreign buyers. Inexperienced foreign buyers often do not understand that in international transactions, “logistics” is an integral factor for success. Shipping costs, shipping timing, method of shipment (air/ground/ocean), port of delivery and a host of other factors can have substantially impact the marketability/pricing of your product.

This then leads to the standard mistake. The foreign buyer looks for the lowest China Price. So the China manufacturer provides a product price that does not include the shipping cost: free carrier or the (erroneous) FOB price. Under these terms, it is the foreign buyer’s responsibility to make arrangements for shipping. The illusory concept is that the foreign buyer will then negotiate the lowest shipping rate, making for an even higher profit.

In fact, however, foreign buyers are normally unable to effectively manage shipping in China. So even though they specify free carrier terms, they in fact end up needing to rely on their Chinese factory to make all the arrangements for shipping. But under this scenario, the foreign buyer has taken on all liability for mistakes and yet it has no effective control to prevent those mistakes. This then is a perfect setting for the kind of disaster that Renaud describes.

From a legal perspective, resolution of this problem is simple. The foreign buyer’s contract with its China factory should reverse impose all of the responsibility and liability for shipping on the China factory. This is done with a manufacturing contract that provides for the product price to include shipping fees. The standard CIF (cost insurance freight) shipping term will achieve this goal. Use of CIF terms does not mean that your China factory will not make mistakes, but it does mean that your factory (not you) will be liable for those mistakes. Your China manufacturing agreement should also include a provision that requires your factory ship by air freight if delivery of your product will be delayed beyond a certain number of days. The only way to ensure that your China factory treats your key business issues as important is for your manufacturing agreement to impose an immediate penalty on your factory that does not require a cross border lawsuit to enforce.

 

China manufacturing contractMy first post in this three part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law frim to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

The source of the problems for Western companies that manufacture in China 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 legally binding contract (in Chinese!) that addresses all of the basic manufacturing issues. The agreement on price binds both the Chinese factory and the foreign buyer, and even if 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. This sort of contract is common in much of the world, but less so in China. 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. 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, the contract 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. It is this lack of a binding agreement that is the primary cause of the seven manufacturing risks Renaud discusses in his post.

The obvious path to contract certainty  is to enter into an Option 1 manufacturing contract 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 made in China. For this reason, our primary task as lawyers is to develop contract manufacturing agreements that deal up front with the risks that come from using the purchase order approach. Our job as China attorneys then is to make sure that our foreign buyer clients understand the risks and then to work on mitigating those risks in a practical way.

I explain below and in Part 3 of this series how our China manufacturing lawyers do that with each of the seven risks Renaud identified.

Risk 1: Lack of “Motivation.” The major risk we see stems from the foreign buyer loading the development costs onto the Chinese side with no incentive for the Chinese side to follow through on development. Renaud calls this risk “loss of motivation” and we see this all the time. The foreign side relies on the Chinese factory to do the product development, normally loading the cost on the Chinese factory. After two years, the development is not completed and the market has moved on, leaving the foreign side high and dry with no marketable product. The Chinese side assures the foreign buyer that they are “working on it,” but in fact the product development project is a low priority as compared to their ongoing manufacturing that pays their bills and so they are “working on it” only when times are slack. It is also common for Chinese factories to agree to take on a development project when they do not actually have the capability to do the work. In this situation, the delay results from the Chinese side being pushed up against the limits of what it can actually do.

The best way to address this lack of motivation risk basic method is to enter into a legally binding product development agreement with the Chinese factory that includes the following:

  • Milestones: hard dates for development of prototypes or samples.
  • Allocation of costs. If all costs are loaded on the Chinese side, the chance of success is dramatically reduced.
  • A real incentive for the Chinese side to succeed. This incentive can be payments for the Chinese factory hitting its milestones or it can be a commitment to purchase reasonable (but predetermined) quantities of the developed product at a fair price.

Few foreign buyers follow this approach, with the predictable results described by Renaud.

Risk Two: Quality Failure at the Production Stage. The Chinese side agrees to manufacture the product at the “China Price.” Initial samples are acceptable in terms of quality, but once production starts, the quality is consistently bad. When pressed, the Chinese side says: “We gave you the China Price and you knew that at that price we would never be able to produce a quality product. It is your fault: you have to choose. If you want the China Price, you don’t get assurance of quality, quantity or delivery date. If you want all those items to be acceptable to you, we need a binding contract that covers all four issues in a manner that works for us too. But if you insist on the China Price and you do not provide us with a binding commitment for orders, you will have to accept what we provide.”

Price is not the only issue; there are four key factors involved in having your products made in China: price, quantity, delivery date and quality and if you fail to hold your Chinese factory legally accountable for all four of these things, you are likely to have problems. If your Chinese supplier takes all four factors seriously, its pricing must increase. Foreign buyers who are not willing to accept such an increase will continually face the Chinese factory failing to comply with the other factors. Quality will suffer, delivery will be short or late, or the factory will suddenly quit accepting orders right at the height of the delivery season.

Risk Three: Low Priority in Production Schedule. The Chinese side accepts your purchase order for a small run of product at a low “China” price. Then another buyer shows up and offers a slightly higher price for a larger quantity of product. The Chinese side then pushes your order down the line for priority and your delivery is delayed. In some cases, the delay extends to the point where delivery never takes place. The Chinese side is not concerned about failing to deliver on the purchase order, since the litigation risks are extremely low because you do not have a Chinese language contract that works. See China Contracts: Make Them Enforceable Or Don’t Bother.

This situation regularly occurs when the relationship is based on “one off” purchase orders. See How To Get Bad Product From China With No Legal Recourse. The way to deal with this issue is to have a contract manufacturing agreement that clearly incorporates your purchase orders into the legally binding contract and that provides specific monetary penalties if your factory accepts a purchase order and then either delays or fails to deliver. When pressed to enter into this sort of agreement, Chinese factories will treat accepted purchase orders seriously and their delay/default rate goes way down. In our experience, factories that intend to take a relaxed view towards their legal obligations under an accepted purchase order will simply refuse to execute a formal contract manufacturing agreement, which is exactly what you want. See How To Write A China Contract. Liquidated Damages.

Risk Four: Sudden and Unpredictable Price Increases. Under the standard scenario, the Chinese side agrees to manufacture your product at a goal price, without ever having undertaken any serious examination of what it will actually take to manufacturer your product. The Chinese side then does the product development and the production implementation. The samples are acceptable and it is time to begin production. The foreign buyer then submits the first purchase order at the goal price. The Chinese side refuses to accept the PO and announces a substantial price increase. If the price increase is not accepted, the factory states that it will not accept any future purchase order.

There are two reasons China factories do this. The first and most common is that the factory never understood the price issue and never planned to meet the proposed price. The factory merely accepted the goal price to prevent you from going to another factory. The Chinese factory assumes you will be compelled to accept a purchase at the “real” price (whatever that price is) because you will be unwilling or unable to spend another 6-12 months (or whatever it will take) to start over with another factory.

The second common reason Chinese factories will take on a product development project with no intention of giving you the product you want at a price and delivery schedule that can make sense is that the factory is treating you as its outsourced R&D center. The idea comes from the foreign side, the implementation comes from the Chinese side. But the ultimate goal is for the Chinese side to make and sell the product on its own. The Chinese factory never planned to make the product for the foreigner. So they offer a very high price. If the foreigner accepts, they make the product for the foreigner at a price higher than they ever imagined. If the foreigner refuses the price, they move on to make and sell the product on their own. This sort of thing is incredibly common and hardly a week goes by without someone calling one of our China lawyers for our help to “require the Chinese factory to get its price in line with the market.” But unless you have a written contract that works for China and made pricing clear, there is nothing we can do to help at that point.

If the foreign buyer is purchasing an off the shelf product that is part of the Chinese factory’s standard inventory, the risk of any price issue is low. If you are engaging the Chinese factory to make minor customization of its standard product (maybe just adding your logo or changing the color), the risk is also low. But if the Chinese factory will be modifying/customizing its existing product, you should have a legally binding contract that the Chinese factory feels compelled to honor. The way to deal with this is under a product development agreement that includes the following three key components:

  • A strict timeline for developing the working prototype.
  • A provision that makes clear you own the prototype and all data, drawings and tooling required to manufacture based on the prototype.
  • A provision that states that if the factory meets the target price, you will purchase exclusively from the factory, but if the factory cannot meet the target price, you are free to take the prototype and have it manufactured at any other factory.

Without an agreement like this, you should expect a price increase as an almost a certain result of the product development process.

In part 3 of this series (coming later this week), I will examine how best to deal with the last three business risks inherent in having your product made in China, including one of my favorites, subcontracting.

 

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.

China lawyers
Do not fall for manufacturing contract illusions

A good China manufacturing agreement must address many issues, including, most importantly, the basic business terms for purchase of the manufactured product. The key business terms are price, quantity and date of delivery. When our China lawyers draft a manufacturing agreement for a China factory, we have to determine at the outset how to address these essential terms in the agreement.

There are two options.

Option One. With respect to the purchase of goods, we make the manufacturing agreement a binding agreement for a specific quantity of product to be delivered within a specific timeframe at a specific price. The foreign buyer is obligated to purchase and the manufacturer is obligated to sell and failure to perform is a breach of contract. This type of agreement is often supported by a letter of credit.

Option Two. The agreement provides the terms and conditions for a purchase of goods contract formed only after a purchase order is submitted by the foreign buyer and only after that purchase order is accepted by the Chinese manufacturer. If the foreign buyer never submits a purchase order to its Chinese manufacturer or if the Chinese manufacturer rejects the purchase order submitted by the foreign buyer, no purchase of goods contract is ever formed. The failure to submit a purchase order is not a breach. In the same way, the rejection of a purchase order is a also not a breach. Since there is no binding contract, this type of agreement is not supported by a letter of credit.

Multinationals that purchase large quantities of product from Chinese manufacturers generally follow Option One. This provides two major benefits. First, the product price is locked for a specific period. The risk of cost changes for materials or exchange rate or anything else is borne by the two parties equally. Second, the delivery date for the product is mostly fixed, allowing the buyer to plan for seasonal variations in demand. The major risk the buyer takes is that its product will not sell and then the buyer will be “stuck” with a substantial quantity of unsold product.

Buyers not willing to take this risk follow Option Two. Option Two is typical for startups and for entities introducing a new product with an uncertain sales market. This arrangement provides the foreign buyer with substantial flexibility. It allows the foreign buyer to test the market for its product and if its product fails, the buyer is not locked into purchase obligations and being stuck with unsold product.

But this flexibility comes at a cost. Many foreign buyers will do not realize that with this sort of agreement, there really is not agreement on business terms. If the Chinese factory decides it does not want to accept the foreign buyers’ terms it can and will simply reject the foreign buyer’s purchase order. If the Chinese factory wants to raise its price, it rejects. If the Chinese factory is unable to meet the required quantity, it rejects. If the Chinese factory is unable to meet the required delivery date, it rejects. Such a rejection is not a contract breach and the buyer has really no choice other than to accept the rejection.

At its simplest level, this situation means it is impossible for the foreign buyer to negotiate best terms with the Chinese factory. Since the foreign buyer has no real leverage, it cannot negotiate effectively on price. The foreign buyer may think it forced its Chinese counterpart to agree to a rock bottom “China price,” but the China manufacturer can easily turn the table by waiting until the foreign buyer has fully committed to the factory and is hard against a time deadline. The Chinese manufacturer then rejects an important purchase order and negotiates a price increase.

Consider what this means for a startup company with a single new product. The company has worked hard on marketing its product for the holiday sales season. After substantial effort, the startup receives enough orders. Those orders require delivery of the new product on a specific date, in specific amounts and at a specific price. The U.S. or EU buyers insist on a binding contract. The startup is obligated to perform.

Only after receipt of these orders does the startup then submit a purchase order to the Chinese manufacturer and then the Chinese manufacturer rejects the purchase order. The Chinese manufacturer may demand a higher price or it may say: “Sorry folks but you waited too long to place your order. We are all booked up and we don’t have the manufacturing capacity to handle your order.”

Consider what this means for the startup. It has fully binding sales obligations to its U.S. or EU retail customers and its failure to deliver on those obligations is a breach of contract that will subject it to a lawsuit in its home country. Its inability to fulfill its contracted for orders is both a financial liability and it also destroys the credibility of the startup as a real player in the retail field. If the startup does not have deep financial backing, it is usually impossible for it to recover from this blow. Usually, this all comes as a complete surprise to the startup, since it was operating under the illusion that it had a binding contract with its Chinese product supplier on all relevant business terms.

Our China attorneys get desperate calls and emails from U.S. and EU retailers who have unknowingly put themselves in this “no business terms” trap, but our phones ring off the hook with these from October to December. And usually all we can tell them is to do it right the next time (all while wondering if they will have a next time).

This business terms issue must be resolved for every manufacturing contract. It extends to other issues too. For example, say your contract provides for your Chinese manufacturer to provide a certain type of packaging which is included in the price of the product. The manufacturer decides to make a change. Under Option Two, the Chinese manufacturer simply rejects the purchase order and negotiates for a change. The original provision was an illusion since the manufacturer was not obligated to perform.

Warren Buffet once sad that “only when the tide goes out do you discover who has been swimming naked. The holiday season is when so many U.S. and EU companies learn that their failure to have a good manufacutring contract with their Chinese manufacturers has left them with no clothes. If you are looking to have your products made in China, the first thing you must decide is which option will apply to your purchases and you then need a contract that reflects and legalizes your decision. An illusion about your real situation with your Chinese manufacturer can and usually will lead to unpleasant consequences.

For more on what you should do to protect yourself when manufacturing in China, check out Having Your Product Made In China: The Basics on Protecting It and You.

China cybersecurity lawsThe PRC government promulgated its Cybersecurity Law on November 7, 2016, with an effective date of June 1, 2017. To say that foreign tech firms are concerned about the impact of this new law on their business in China would be an understatement. In addition to tech firms, our China lawyers have received a steady stream of questions from clients with China WFOEs who are concerned about an entirely different set of issues. Article 35 of the law states that “personal information and other important data gathered or produced by critical information infrastructure network operators during operations within the mainland territory of the People’s Republic of China, shall store it within mainland China.” Our clients keep asking what this will mean for them.

The surprising answer is not much.

Any company that operates a WFOE in China collects personal information about its employees. China’s new cybersecurity law defines personal information as “all kinds of information, recorded electronically or through other means, that taken alone or together with other information, is sufficient to identify a natural person’s identity, including, but not limited to, natural persons’ full names, birth dates, identification numbers, personal biometric information, addresses, telephone numbers, and so forth.” Certainly, the standard information any company maintains on its employees will qualify as personal information under China’s new cybersecurity law.

In the EU and various other jurisdictions, such personal information must be maintained within the jurisdiction and there should be no transfer of such information across borders. This causes many problems for companies that seek to manage an international workforce through a central location.

So what clients keep asking our China attorneys is whether China’s new cybersecurity laws will establish the same sort of protective system within China? The simple answer is that it will not. China does not have a comprehensive law or regulations relating to the collection, processing or transfer of employee data gathered by a WFOE or other business entity in the normal course of its China business operations and China’s new cybersecurity law does not change that situation.

The cybersecurity law specifically provides that its personal data maintenance and collection rules apply only to critical infrastructure network operators. Network operator is defined as “network owners, managers and network service providers.” In more general terms, this means telecom operators and Internet ISPs. The requirements do not apply to the China business operations of normal private businesses with respect to their normal record keeping requirements for their employees.

Even though nothing has legally changed in China, it is still best practice for foreign companies employers in China to follow the basic rules the PRC government imposes more generally in the consumer context on the collection and maintenance of personal information, including the following:

1. Be sure the disclosing party (your employee) is aware that the company maintains personal information. The company should have a written policy (in Chinese and in English) on how long that information is maintained and that policy should be revealed to the employee.

2. You should not collect more personal information than necessary.

3. You should maintain the confidentiality of the personal information you collect and maintain. That means you should limit internal access to that information and you should take proper security measures to prevent a data breach of the company’s online systems.

4. You should not sell or otherwise transfer the personal information to any third party. Stated more bluntly, do not sell employee personal information to marketers or spammers.

China manufacturing lawyersIn Part 1 of this series, I discussed how the increasing complexity of products made in China has led to a corresponding increase in the complexity of the molds for those products, and of how that means our China attorneys increasingly must draft contracts to protect our client’s IP within those molds. I concluded the first part of this series by noting how most mold IP issues arise in two settings: dealing with third party mold fabrication shops in China and dealing with the Chinese outsource factories themselves. In Part 2 of this series, I addressed mold IP issues when dealing with third party mold fabricators, sometimes called mold fabrication shops. In this, Part 3, I will discuss the sorts of issues our China lawyers have been seeing lately with Chinese manufacturers on mold issues.

The Chinese manufacturer has produced a series of molds for a product for its foreign buyer. Now that the product has become commercially successful, we often see the following three basic problems arise:

  • The Chinese manufacturer announces a substantial increase in the price of the product. This is often a surprise to the foreign buyer, who had expected the per unit price of the product to go down as production increased.
  • The Chinese manufacturer is not able to keep up with increased production requirements. This is often a surprise to the foreign buyer, who had been assured by the manufacturer that it has ample capacity for any scale of orders.
  • The stress of increased production demand causes the quality level from the Chinese manufacturer to progressively decline, reaching unacceptable levels. This is often a surprise to the foreign buyer, who had expected quality to improve over time.

In response to these issues, the foreign buyer gives notice to its Chinese manufacturer that it intends to move production to a different manufacturer, often a direct competitor of the current manufacturer. In the past, the issues that arose at this stage mostly focused on ownership of the physical molds. This issue can be resolved by a relatively simple mold ownership agreement. To the extent that a mold ownership agreement resolves the issues, this is old news. See Product Molds And Tooling In China: Three Things You Must Do to Hang on to Yours.

However, in the past year we have seen Chinese factories make arguments (like those below) that render the situation far more complex:

  • The Chinese factory says: “It is true you paid the fabrication fee for the molds. But that fee only covered the material costs and the time involved. However, in addition to that, we at the factory spent a lot of time and money doing the CAD drawings and related specifications required to fabricate the molds and we also spent additional engineering time in integrating the molds into our production process. Before you can take the molds, you have to compensate us for those costs. We won’t even charge you a markup. Just pay us for our out of pocket costs.” Then the factory provides an unreasonably high invoice for those costs and if you do not pay the invoice, the factory will continue to hold your molds hostage. This has become almost standard practice in outsource manufacturing, particularly in southern China. It is therefore essential for foreign designers to make clear in a written contract that all amounts paid for molds include both design and fabrication costs and that no additional payments will be required when the foreign buyer seeks to take possession of the molds.
  • The Chinese factory says: “It is true that you own the molds and you can take them whenever you want. However, we did all the design work on those molds so we own the design embodied by the molds. We will give you a license to use the molds in production in another factory. However, that license is limited. You have no right to copy the molds. We, on the other hand, have the right to copy the molds and we have the right to use the mold design for our own production or to provide copies of the molds to third party factories for their own production. The only thing you own is the physical object. You do not own anything else.”
  • In the more extreme case, the Chinese factory says: “We did all the design work for the molds so we own that design and we already registered a design patent in the molds. Since we did all the work, we are the inventor for patent purposes. It does not matter that you paid us for the molds. We still remain the inventor and our design patent protects us. You can have the physical molds, but if you want to use those molds for production at a different factory, you must pay us a royalty fee.” This royalty is then quoted at a price so hight that you cannot economically have your product produced at a third party facility.\
  • Lately, the more honest Chinese factories make the situation clear. The foreign buyer pays for fabricating the mold, but that payment does not convey any ownership interest in the molds to the foreign buyer. The Chinese factory does the design work and the Chinese factory owns the molds. The Chinese factory will agree to use the molds only for the purpose of producing the product for the foreign buyer, however, the foreign buyer has no right to move the molds to any other factory. In this setting, some Chinese factories will say that you are free to make new molds at your new factory, but some will assert ownership to the mold design and not allow you to have copies made at the new factory. Often Chinese factories will make this contention even when they do not have a registered design patent. To them the situation is obvious. They both designed the mold and arranged for its fabrication and so they own all rights in the mold without any need to register a design patent. Whether this position would be supported by a court is unclear. But since it is unclear, most Chinese factories will refuse to work with the new factory. What is so interesting about this approach is that the Chinese factory is clear about its intent from the beginning. The Chinese factory intends to hold the foreign buyer hostage by guaranteeing that the foreign buyer cannot go to any other factory in China as an alternative manufacturer of the product. By holding the foreign buyer hostage, when the Chinese factory raises its price or delivers the products late or produces defective products, the foreign party is pretty much trapped. It has no place else to go and no real leverage for dealing with the issues. We are getting a call a week from foreign companies in these situations, with little that can be done beyond essentially starting over.

This is where outsource manufacturing is going in China. Foreign product designers need to deal with it. At a first level, the foreign designer can enter into written contracts that provide protection. However, at a second level, if the Chinese factory intends the “hostage” result, it will reject signing a contract that will prevent that. When that happens the foreign designer is forced to face reality and decide whether manufacturing its new and innovative product in a setting where it is hostage to a Chinese factory makes economic sense or not. Or whether it can or should try to find another manufacturer. Our clients often argue that it does make sense. We are not so sure.

China Mold ownership
Control Room

In part 1 of this series, I talked about how the increasing complexity of products being made in China has led to a corresponding increase in the complexity of the molds for those products, and of how that means our China attorneys are increasingly needing to draft contracts to protect our client’s IP within those molds.

I concluded the first part of this series by noting how most mold IP issues arise in two settings: dealing with third party mold fabrication shops in China and dealing with the Chinese outsource factories themselves. In this part 2 of my series, I address mold IP issues when dealing with third party mold fabricators, sometimes called mold fabrication shops. .

The issues that typically arise with mold fabrication shops arise because of a change in procedure that no one has really noticed. It is standard procedure to provide that the Chinese factory that is making your product is responsible for fabricating the molds for the product. In the old days, the same factory almost always made the molds and the product. However, it has now become more common for the factory to outsource mold fabrication to a third party. In many cases, even the design of the molds is outsourced to that third party.

What this means is that a mold agreement with your factory that has been drafted to control the ownership of the molds and to control the IP in the product is compromised or eliminated when all of the specifications and the responsibility for fabrication gets sent off to a third party mold manufacturer. Given the economics of mold fabrication in China, it is not likely that the mold fabricator will use the mold design for its own purposes. Rather, the fundamental risk here is that the mold manufacturer will sell copies of the molds to other Chinese factories who have an interest in cloning your product.

This type of cloning is of course a thriving business in China. Foreign designers often wonder how a terrific copy of their product got to market before they have even gone into full scale production. Well this is how it happens: the mold manufacturers conduct a thriving trade in selling the “latest” molds. Though it is common to blame the factories for this leakage, this blame is often misplaced. Your China factory has an incentive to keep the mold for its own use since once the mold gets out into the world, the molds are then used by your factory’s competitors. When this happens, the Chinese factory is damaged in much the same way as the foreign designer.

Though losing one’s molds via a third party mold fabrication shop is an enormous risk, few foreign designers and virtually no Chinese factories make much to control the mold fabricator. In other words, clearly drafted written contracts dealing with this issue are rarely entered into between the Chinese factory and the mold fabricator. The foreign designer not only hardly ever enters into any sort of contract with the mold fabricator, the foreign designer normally does not even know the identity of the fabricator. This leaves a gigantic hole in IP protection. This hole can and should be closed through a simple set of contracts.

Consider also what this uncontrolled release of the design of the product means in terms of intellectual property in the product. Many products designs are protected primarily as trade secrets. When the design is released to a third party fabrication shop with no written agreement, the secrecy in that product is broken, and this eliminates any trade secrecy protection.

Consider also the issue of patent protection. In acquiring a patent anywhere in the world, one of the first questions that has to be answered is who invented the item. In a case where the design of the mold has been outsourced to a third party fab shop, the question of who is actually the inventor is now unclear. Is it the foreign designer who developed the basic idea? Is it the Chinese factory that did some preliminary drawings? Or is it the mold fabricator that did the detailed drawings and produced the final working model? Or is it all three, each entitled to an uncertain percentage of the patent?

With this sort of tripartite structure, the usual answer is that no one owns any IP in the molds: no patents, no trade secrets. Often that then means that no one owns any IP in the product itself. This obviously then leads to disaster in the commercialization phase for the product.

In part 3 of this series, I will consider how to approach these issues when dealing with the Chinese factory to which you are outsourcing your manufacturing. Note that though the parties differ from the situation I discuss above, the fundamental issue remains the same: when a third party does the design and fabrication work on behalf of a foreign designer, who owns the IP in the resulting design will be at issue. For the product, the question is who owns the design for the product. For the molds, the question is who owns the design in the molds. Where the molds ARE the product, this becomes a core issue that cannot be ignored.