China manufacturing contracts
Use your China manufacturing contract to get out

When foreign buyers purchase products from Chinese factories the big issue is usually who owns the design of the product. This issue is often discussed in a theoretical way, based on intellectual property law principles, without getting to the real point. You are having a product made at Chinese Factory A. You decide the price Factory A is charging you for the product has become too high. The fundamental issue is this: can you take that exact product and have it made at factory B?

Say you are using the following procedure. You find a product made and designed by a Chinese factory. Normally, you will not purchase off-the-shelf products in their “as-is” condition. Normally you will customize the product by maybe changing its colors, and/or its surface design and/or small surface features such the number of buttons.

In this situation, the Chinese factory will take the position its own the design and you have no rights to the underlying design. In general terms, the Chinese factory will say:

a. Chinese Factory owns the underlying design and can sell that product anywhere in the world.

b. Chinese Factory agrees to “customize” its product for you by making surface changes such as color, logo, surface design features. Chinese Factory agrees not to manufacture and sell a product using those same features for sale anywhere in the world.

Given this basic position, what happens if you want to go to a different manufacturer for the same product? There are several alternative responses:

i. The normal response is that the Chinese Factory says you can go ahead and customize the product made by a different factory, but you CANNOT have that factory manufacture your product based on our underlying product design.

ii. In the alternative, some factories will say that you can go to a different factory, but you must pay us a royalty.

iii. In the alternative, some factories will agree to give you a license to go to another factory solely to manufacture the product but not to make any adaptation or other “new work” relying on the underlying design.

Where does your Chinese program fit into this system? Most buyers settle on alternative b. This is a type of stand-off. The Chinese factory cannot sell “your” customized product anywhere in the world, but you are stuck with the Chinese factory. If you want to go to a different factory, you have to start over from scratch or pay what is usually a very high royalty. This can be a disaster if there is no readily available alternative source for your product.

Another issue that arises from this situation is the question of exclusivity. If you have worked hard to create a market for a specific product in a certain territory, you will not want virtually the same product to be sold in that territory in direct competition with your product. It is common to provide that your factory is not permitted to sell the customized product to any other buyer. On the other hand, the factory is free to work with a different buyer who customizes the product in a different way. It is that alternative customized product that will then appear as a competitor in your territory.

Obtaining the agreement of your Chinese factory not to sell your customized product to anyone else is relatively easy because no one else really wants that product. It is much more difficult to get your Chinese factory to agree not to sell an alternative product to another foreign buyer. If you are looking for that kind of protection, you must be clear about the rules and you must expect the Chinese factory will only agree to those rules if it receives a substantial benefit for doing so. That benefit is normally your agreement to a specific volume of product purchase for each year of exclusivity. Big companies often get this sort of deal; SMEs, far less often.

China sourcing agentsMany companies start outsourcing their products from China using a broker/sourcing agent. Tomes have been written about the pros and the cons of using a sourcing agent versus dealing directly with a Chinese manufacturer and I have no intention of rehashing all that here. My relatively succinct and simple and mostly unhelpful view is as follows:

About 45 percent of all sourcing agents are corrupt. About 45 percent of all sourcing agents are incompetent/worthless. About 10 percent of all sourcing agents are invaluable.

I cannot tell you how many times a client has retained one of our China lawyers to assist in making the switch from using a sourcing agent to going direct with a brand new and far cheaper factory only to have the old factory tell our client it can now reduce its prices by 30-40 percent because it will no longer need to kickback 30 to 40 percent to the sourcing agent. I also cannot tell you how many times a client or a potential client has given us some completely invalid reason as to why their sourcing agent is so clearly different from the rest. We commonly hear that such and such sourcing agent must be good and honest because it is being used by some competitor or because it has an office in the United States. If only it were that clear-cut.

One of the legal issues we often must resolve is whether our client who is using a sourcing agent would be better off contracting with that sourcing agent for the manufacturing of its product, or contracting directly with the Chinese factory, while still paying the sourcing agent for its services. One of our China lawyers recently explained to a client some of the things the client should consider in determining whether to contract with its sourcing agent or to contract directly with its Chinese manufacturer, as per the below, with any identifiers stripped off:

You raise the usual and standard issues related to this kind of contract. To start, it makes no sense to have essentially the same a contract with two parties. You must choose with whom you are going to contract. Will it be your sourcing agent or will it be the Chinese factory? You must contract with the entity that will issue the invoice for the product and in this case (unless we change things), that is your sourcing agent. But if you contract with your sourcing agent, you can and you should also have a contract with the Chinese factory that deals with issues like ownership of intellectual property, ownership and control of the materials, non-circumvention and non-compete and similar. See China NNN Agreements. However, many Chinese factories are not willing to enter into that kind of contract if they are not the direct seller of the product.

The old way was to enter a contract with the sourcing agent, loading all of the liability on it. Since Sourcing Company X is a U.S. company, operating in this way is pretty much just like making a purchase from any U.S. company that outsources its manufacturing around the world. The question is: can Sourcing Company X perform? Does it have the resources to do the work and the asset base to deal with any problems?

As you have figured out, there can be many problems with the “old way.” If you are purchasing from a huge company like Apple, you don’t really care about who their ultimate suppliers are because you know Apple will do the work and you know Apple will stand behind the products and has the resources to handle pretty much anything that can go wrong. For a small company like Sourcing Company X, your analysis is quite different and is more difficult.

There are two issues: First, what happens when everything goes right? If Sourcing Company X takes care of everything, then using them makes sense. Many companies fail to consider what happens when things go right. If you end up doing all the work in China, why bother with Sourcing Company X.

Second, what happens when things go wrong? As you know, things going wrong is standard operating procedure for China manufacturing. If there is a defect, can you rely on Sourcing Company X to fix things? If there is a late delivery or a short delivery, can you rely on Sourcing Company X to address this in a way that does not require your staff travel to China? Can Sourcing Company X ensure that the fabrics and other materials are properly processed and securely stored and maintained in China in a situation where you have no direct contract with the China factory? What if the China factory goes bankrupt: what happens to the materials then? Will Sourcing Company X remain liable in that situation?  Can Sourcing Company X ensure all payments will be made to the factory and to the suppliers of the factory? Can Sourcing Company X ensure that the Chinese factory and its suppliers and the suppliers to its suppliers will not steal your IP or circumvent you by going directly to your customers? If circumvention happens, will Sourcing Company X aggressively take care of the issue and does it have the financial resources to cover for liability?

On these issues, if you conclude that the answer is yes in each case, then you should contract with Sourcing Company X. The more difficult situation is if you conclude that Sourcing Company X may not be fully able to deal with these issues. In that situation, you then have to consider whether you are better off with a contract with a Chinese company that will require you to litigate in a Chinese court to deal with the issues or better off with Sourcing Company X here in the U.S. and insured here as well. See also China Contracts, But With Whom?

As you can see, the matter is complex. In my experience, I find large companies with a presence in China prefer to contract directly with the Chinese factories. And this is the modern trend. However, smaller companies that do not have the time or the people on the ground in China still often use companies like Sourcing Company X to secure their products from China. The problem with companies like Sourcing Company X is they often refuse to enter into a reasonable contract. If Sourcing Company X is willing to enter into a reasonable contract, that is one matter resolved in its favor.

 

We have to assess two issues: a) can Sourcing Company X really perform and b) if you contract with a single Chinese factory, does that really put you into a better position if something goes wrong. You will need to make this decision based on your own business judgment, since you are the one with direct contact with the players. We can help you with this by conducting due diligence/background checks on the two companies.

Please let me know if you need more information from me on this matter.

 

 

In both my speeches on product outsourcing and in my discussions with clients, I always emphasize the importance of visiting your Chinese manufacturer. In my speeches I do it by first showing a Powerpoint slide of what looks like a great facility, maybe something like this:

Top tier China factoryI label that slide “China factory per its website. I then show them a picture of the following, labelled, “China factory in real life”:

China factory

I then stress the importance of visiting your factory, preferably before making your first product order. I then discuss how it seems like 95 percent of the time when our clients have major problems with a factory, it is one they have never seen. And if you are not going to visit your potential product suppliers (which is usually best), pay someone qualified and trustworthy to do so.

There are a lot of reasons to visit your China product supplier(s), and not just before you start with one. I for one am convinced that the mere fact that you the buyer make the trip (and not just someone you pay, though this is definitely a lot better than no visit at all) turns you into a human being who cares and that makes it less likely the factory will try to mess with you.

I also frequently emphasize the value of visiting your China suppliers periodically after you have established a relationship with them. We have one client who sends someone to visit the factory a few days to a week after placing every order. This client pays this visit because it is convinced that these trips serve to make sure that the product is of high quality and delivered on time.

A few weeks ago, Bloomberg BNA did a story entitled, China Waging ‘Unprecedented’ Pollution Crackdown. A few days ago, the South China Morning Post did a story entitled, China vows big winter air pollution cuts in northern cities. But what is really happening on the ground in China and what relevance might all of this have to you?

China sourcing agent Jacob Young tells us in his post China Factory Closures for Pollution Review:

Whilst they’re under [environmental] review, they are closed.

No business going in or out.

Out to lunch, gon’ fishin’.

That’s what I’m hearing on the streets. Well not the streets but from my network there, suppliers and wife who’s constantly on WeChat getting the scoop.

If anybody has the dirt on what exactly’s going on with these closures, please comment or DM me.

One of our RFQ’s from this week…

Went forward just fine. Then after discussing with the vendor, they THEN let me know they’re under review. Good thing I asked, right?

Factory closures are all around them too.

Yes this is happening. One of our China lawyers got the following email yesterday (modified to hide any identifiers):

I just learned that my factory in China has been shut down for environmental reasons. They have no idea how long this shutdown will last. Just my luck but I need to get a very large order to me in the next three weeks or I will owe a downstream customer a lot of money for late delivery on my part. What can I do? Can I get all of my damages from my supplier? Should I start looking for another factory?

Our response was somewhat along the following lines:

Much will depend on what your contract says with your current supplier and whether or not it is an effective contract. If it makes clear (in Chinese) that your supplier is liable for any delays and if it also does not have a force majeure provision that would apply to a shutdown like this (and it shouldn’t, because it is your supplier that is polluting, not anyone else and a shutdown for excessive pollution could have been anticipated) and your supplier has enough assets to pay on any judgment you might receive against it, then you have a chance of getting damages from your supplier. But the mere fact that you have written our firm out of the blue makes me think you either did not use a qualified China attorney to draft your agreement with your supplier or you do not have any such contract at all. And if that is the case, your chances of ever collecting against your China supplier have probably just gone way down.

What can you do now to make sure that what happened to the company that emailed us does not happen to you? Two things, above all else. One, find out what is going on with your China factory(ies). Are they in one of the many areas the Chinese government is targeting for pollution closures? Two, go and visit your China factory as soon as possible to see exactly how it operates. Is it a high tech low pollutant or is it a low tech high pollutant? If it is the latter, consider lining up another factory instead of or in addition to your existing one. Three, use good manufacturing contracts with your suppliers going forward. These can both help prevent problems and better position you for resolving them if they occur.

How can a contract help you from your Chinese supplier being shut down for pollution reasons? It can’t. But what it can do is prevent you from doing business with a Chinese factory likely to be shut down for pollution reasons. It can do this because the factory worried about being shut down will be less likely to agree to work with you if your contract will put it on the financial hook for a pollution shutdown and it can also mean that if your Chinese supplier has multiple factories, it will produce your products in the one least likely to be shut down.

But really, the key here is to know your factory.

What are you seeing out there?

 

China contract lawyerJust was cc’ed on an email between one of our senior China lawyers and one of our more junior lawyers. The email was in response to the junior lawyer asking for “the initial questionnaire we use with our clients for whom we are drafting China manufacturing contracts.”

With a few small modifications, here is the response email from the senior China attorney:

We used to send our China manufacturing clients a very long list of questions (it had reached seven pages!). But we were finding many of them were getting overwhelmed by their heft (I don’t blame them) and no matter how much we would try to tailor them to the client’s specific situation, there were also a fairly large chunk of them that proved irrelevant. So now what we do is break up our questions into stages, starting from general matters to more specific, with the “more specific” depending on the responses we get to the general matters. By doing it this way, we end up asking far fewer questions and this in turn relieves the onus we formerly put on the client.

The first stage questions usually consist of the following:

  1. Is the purchase from the actual manufacturer or is it from a trading company?
  2. Who owns the technology for what is being purchased? Note that there are a number of options:
    1. IP/design is 100% owned by the foreign buyer and the Chinese side will make no modification.
    2. IP/design is owned by the foreign buyer, but the Chinese side will make some modifications.
    3. The product is an “off the shelf” item from the Chinese manufacturer.
    4. The product is based on off the shelf from the manufacturer, but is customized in some way for the foreign buyer: new colors, logo, added features.

Often the U.S. buyer will purchase a mix from the same manufacturer.

The second stage, usually involves our trying to figure out the following:

  1. What is the structure of the basic business relationship?
    1. Will the parties agree on a set amount of purchases per year at a set price? or
    2. Will the parties work on a per PO arrangement?
    3. If it is per PO, what is the agreement on price, if any?
    4. If it is per PO, what is the agreement on quantity and delivery date, if any?

At the next stage, I work to figure out the following:

  1. Is tooling/molding involved? If yes, what is the system?
  2. Are other special materials involved? For example, in the clothing business, the buyer often purchases fabric separately and then provides this fabric to the factory.

At the next stage I work to figure out the following:

  1. What is the plan for quality control and inspections?
  2. What is the plan for warranty and dealing with defects that show up in the U.S. or in Europe after delivery?
  3. What is the policy for late or short delivery? Some companies use the 1% a day approach and leave it at that. Other companies have an elaborate “charge-back” system where they impose a penalty for short and late delivery.

As you can see, the whole process now has become more complex than just sending out a single set of questions. Each set of issues discussed above depends in part on the answer to the previous questions. You have to go step by step, adapting your questions to the previous responses. You also have to adapt your questions to what you already know about the client and its business. If you don’t know much or anything at all, a good start is to ask the client to briefly describe their program and their history with that program and their chief concerns.

Sorry not to be able to give a quick and easy answer, but this how China contract manufacturing work has evolved.

China attorneys One of our China lawyers got a weird call a few weeks from a somewhat distraught clothing manufacturer who had just learned that products his company was having made in China may in fact have been made in North Korea. This person wanted to know whether if that were the case whether he might go to jail. When we told him we didn’t know whether it would be illegal or not and that much would likely depend on how much his company knew about the North Korea connection and when, he very quickly lost his ardor for hiring us.

I thought of that call today while reading an article entitled, North Korea factories humming with ‘Made in China’ clothes, traders say. The article essentially says that some clothes that bear a “Made in China” label are actually being made in North Korea. And some are being made in China by North Korean “guest” workers. The degree of culpability for this sort of thing usually ranges roughly along the following spectrum:

  • Those who know and approve of their products being made in North Korea yet labelled “Made in China.” These companies no doubt like the cost savings.
  • Those who don’t want to know where their products are made and make zero effort to prohibit their products being made in North Korea and make zero effort to monitor where their products are being made.. These companies no doubt also like the cost savings and courts tend to categorize them as “having known or should have known.”
  • Those who are actually making a reasonable effort to make sure the products they are sourcing from China are not being made in North Korea.

Now without even discussing whether having your products made in North Korea, funding (albeit indirectly North Korea), and receiving products made in North Korea is legal or not — and this will vary by country — how do you want to be viewed if you are ever before a judge or a jury in your home country? Do you want to be seen as the person/company that tried to stop your products from being made in North Korea, the company that affirmatively didn’t care or the company that encouraged? Now before you answer that, ask any lawyer (no matter what the law is) which category of client he or she would rather defend. The answer to that is obvious. When facing a judge or a jury, the company/person that looks the best is the one most likely to prevail.

Just imagine if opposing counsel gets into evidence some of the things from this article, including how “In North Korea, factory workers can’t just go to the toilet whenever they feel like, otherwise they think it slows down the whole assembly line.” Or that the workers get to keep only ⅓ of their wages, which are only half those in China to begin with, and yet work from 7:30 a.m. until 10 p.m., or 14.5 hours. If facing a jury with those facts doesn’t scare you, I do not know what will.

So when it comes to North Korea how can you be good to look good? It’s like just about everything else with China and with manufacturing: you put how you want your Chinese counter-party to act in your contract (and if you want that contract to actually work, you do these things as well) and you monitor as best you can whether your Chinese counter-party is actually abiding by the terms in your contract.

Simple yet not so simple. But really important.

Your thoughts?

 

China lawyersOne of the joys of blogging is finding gems in unlikely places (pun intended). The gem is a post entitled Jewels Plating Problems: Can You Trust Chinese Factories? I say unlikely because neither (nor I would bet, most of our readers) have much interest in jewels plating problems. Heck, I am not even sure what those are and I wonder whether the writer (who I presume to be French) mistranslated. But I looked at the post because it is a truly excellent blog and the post is actually highly relevant for anyone doing any sort of manufacturing in China. The blog is written by a Shenzhen-based factory auditing company with whom our China lawyers have worked on many China manufacturing matters, and rest assured — for jewels plating or whatever — these people know whereof they speak when it comes to China manufacturing. And this post is no exception.

The post ostensibly deals with how relatively inexpensive jewels (jewelry?) made of brass and plated with gold so often have quality problems. The post then does a great job digging into why this just keeps happening in this industry. This is an industry our China lawyers know well because much of it is based in Qingdao or thereabouts and our firm has long-standing connections to that city. This is also an industry with low profit margins (for just about everybody) and — as President Trump might stupidly put it — a lot of bad hombres.

The post starts out asking “what is happening in this industry? Are they [the Chinese manufacturers] cheating the buyers, or are they simply careless?” It then gives the following three part explanation:

  • Profit maximization with a “calculated risk” approach — what is sometimes referred to as “quality fade.”
  • Reliance on so-called experience — not on facts and objective data.
  • Buyers who don’t define their quality expectations clearly enough.

To which I say, yup.

The post then analyzes/explains each of these three things.

1. Profit maximization with a “calculated risk” approach. Once a Chinese supplier ships its goods, the shipment has usually been approved and paid for and the transaction is fully completed. There are a few reasons for that:

  • High logistics costs
  • The process to return jewels is a nightmare
  • Customs clearance (cost and time) at both the supplier and buyer sides

The above means that China manufacturers try to ship products “as cheap to produce as possible, and yet are likely to be accepted by the buyer. For example, if a buyer is asking for 1um gold plating, the jewels might only have a gold layer of 0.5um.”

2. Reliance on so-called experience — not on facts or objective experiments. According to the post, most buyers are surprised by this. “Chinese factories in general barely have an R&D team. Their expertise is based entirely on their intuition (which they call their “experience”), and unfortunately it can’t be fully trusted.”

Again, I can only assent.

When buyers bring a new case to their Chinese supplier, the supplier tries to remember similar cases. This might work in a factory that has been in business for many years with a stable staff and good problem solving abilities, but it doesn’t work in a small workshop started recently.

3. Buyers who don’t define their quality expectations clearly enough.

The post does not free buyers from at least partial blame. I personally see the foreign buyer as at least partially at fault most of the time. Not saying the Chinese manufacturer is not also at fault, because it usually is, but most of the time had the foreign buyer taken action before the problem arose, there would have been no problem. I wrote extensively on this in China Factory Problems: Always YOUR Fault?

The title is somewhat of a stab at humor. It stems from my blaming most (but certainly not all) China factory problems on the foreign buyer. We have written countless times of what is required to secure good product from Chinese factories:

How To Get Good Product From China; Specificity is THE Key To Your OEM Agreement.

China OEM Agreements. Ten Things To Consider

China OEM Agreements. Yet Another Reason To Have One

China Supply Agreements. Why The “Perfect” OEM Agreement Should Cost Less

OEM Agreements With Your China Supplier. Not Just For The Big Boys

China OEM Agreements. Why Ours Are In Chinese. Flat Out

The Five Steps To Successfully Buying Product From China.]

China Manufacturing Agreements. Make Liquidated Damages Your Friend.

We have also written how our China lawyers constantly get calls or emails from American and European companies that have received bad product from their Chinese factory suppliers and how there is nothing we can do for them. We wrote about this just last week in How To Get Bad Product From China With No Legal Recourse. To a certain extent, we like being able to blame the victim in these situations because that way we as lawyers can comfortably sit back and tell ourselves that had they only contacted us BEFORE they started having problems, we could have prevented all of their problems.

But what about where the Chinese company just up and suddenly shuts down. How can the American or European buyer be blamed for that? Well guess what, they can and in Doing Business In China Safely. The Due Diligence Basics, I explain the following situations where blaming the victim is really pretty easy.

This post rightly blames buyers for not explaining their quality and manufacturing standards clearly enough to their Chinese manufacturers:

In some cases, the buyer asked for the plating to last for at least 6 months or 1 year. That’s better than nothing. But some factories see this requirement, confirm the need for 1um (or sometimes for 0.5um) gold plating, offer a competitive price, and are likely the get the customer’s business.

For a case of greenish effect on the skin, I called and discussed with tens of Chinese factories. The result was surprising. A few (yes only a few) provided real expert feedback. Most of them provided different requirements (some of them scientifically ridiculous) and said “do not worry, we will provide great quality if your client buys from us”.

Plating, be it on jewels or other products, is an expertise area that most factories haven’t mastered. If plating is critical on your product, you might have to acquire the knowledge to guide (or force) your suppliers to be compliant with clear quality standards.

The post then goes on to explain how to be clear with your plating standards.

What this post does not do though is explain the various ways you as a buyer of manufactured goods from China can avoid quality problems. For that, I suggest you read Five Keys To Getting Good Quality Products From China. In that post, I assure our readers that if they consistently do the following five things, they will get good quality products from China:

  1. Use a Good Company.  Sounds rather basic, but we constantly see this rule violated. If you do nothing else that we suggest in this post, do this one thing as it matters as much as all the other things put together. For how to learn more about “your” China company, check out Basic China Due Diligence. Is This Chinese Company Legitimate?
  2. Use a Good Manufacturing Agreement. Good contracts ensure that your Chinese company knows what is required of it and what will happen if it fails to provide it. For what constitutes a good Manufacturing Agreements herehere  here, and here. Most China contracts we see are completely worthless, with a good chunk of those being even worse than having no contract at all. See Why Your NDA is WORSE Than Nothing for China and Is Your China Contract Worthless?
  3. Use Detailed Documents. Chinese factories tend to do exactly what you tell them to do. This means that what you tell them to do needs to be clearly conveyed and that means your instructions and specifications should be detailed and in. Be specific.
  4. Visit the Factory. Either your own people or a third party QC company should pay regular visits to your factory. Doing this allows you to make sure it understands what you want and lets them know that you are serious about making sure you get it.
  5. Inspect. Perform regular product inspections appropriate to the product you are having made.
Do the above and your odds of getting good product go way up. Don’t do the above and they go way down.Your thoughts?

China NDAAmerican and European companies constantly come to one of the China lawyers at my firm seeking to “shore up” their China IP protections. These are mostly companies that have been doing business in China or with China for months or years and have now decided they are doing well enough financially there to start paying to protect what they have. Let me start out by being clear: it is nearly always better to be late than never when it comes to protecting your IP, both regarding China and otherwise. But let me also be clear that it is also nearly always better to take action to protect your IP before you do anything with China at all.

Far too many of the foreign companies that come to my law firm seeking to “shore up” their China IP protections actually have no China IP protections at all in place. But they wrongly believe otherwise.

Many of these companies do not realize that unless they register their brand name as a trademark in China they are at real risk of losing their right to use their own brand name in China, even if just on their own product or packaging made in China for export elsewhere. See China: Do Just ONE Thing: Register Your Trademarks AND Your Design Patents, Part 1. Some of these companies think they’ve already protected their brand name from trademark “theft” in China, but our own trademark search reveals they have not. See China Trademarks. Register Them In China Not Madrid and China Trademark Registration: Keep it Real.

But by far the most common misbelief regarding China IP protection we encounter is the foreign company that believes its United States style NDA protects their IP in China when it most emphatically does not. See Why Your NDA Does Not Work For China. When I tell them that these NDAs do not provide any protection unless the China company that signed it has assets in the United States their response is almost invariably something along the lines of, “well it is at least better than our having nothing. My response to that is silence and then I say something positive and forward thinking, but ultimately noncommittal like, “well, fortunately, we can now start taking substantive action to protect your IP from China.”

But what I am thinking is, “wrong, your NDA is actually WORSE than nothing.” And here is why.

  1. Your China counterpart knows the NDA it signed is worthless and your using that NDA tells it that neither you nor anybody working for you (within or outside your company) has even the most basic knowledge of what it takes to protect IP in China. In other words, you are ripe for the picking.
  2. Your NDA is pretty much a free pass for your China counterpart to steal your IP with impunity and this is true for multiple reasons, though one reason usually stands out. Your NDA no doubt says all disputes will be resolved in an American court under United States law. Now let’s suppose your China counterpart steals your IP and you want to sue. You now must sue in a United States court and that means you have almost certainly cut off any possibility of recovering anything as against your China counterpart. For why this is the case, check out Enforcing Foreign Judgments In China — Let’s Sue TwiceChinese Companies Can Say, “So Sue MeWhy Suing Chinese Companies In The US Is Usually A Waste Of Time, and Enforcing US Judgments in China. Not Yet.
  3. If you had no NDA you could at least threaten to sue or actually sue your China counterpart in China for statutory trade secret or other potential IP violations. But your NDA agreement actually precludes that.

Sorry.

If you want to protect your IP from China you need an appropriate China NNN Agreement. It’s that simple.

China insurance and indemnificationWebster’s Dictionary defines indemnification as “to make compensation for incurred hurt, loss, or damage” and our clients often request indemnity to protect against a product that injures people or infringes on some third party’s intellectual property right. Seeking such indemnification makes complete sense because the last thing you want when you buy $250,000 of some product is to find your own company on the wrong end of a massive lawsuit for personal injuries or patent infringement. If you are going to have a product manufactured for you in the United States or in the European Union, you commonly include one or more indemnification provisions. In addition, it also usually makes sense to require your manufacturer have enough insurance to be able to pay you on any indemnification claim.

Less so when buying products from China.

The issue of products liability insurance is significant for China, yet in our standard manufacturing agreements with Chinese companies we typically do do not reference insurance. The reason for this is because products liability insurance that would cover U.S. or European based products liability/government recall claims is generally not available in China. Most Chinese factories carry no insurance at all for this type of claim. This lack of insurance is a reason for the “China price.” For entities that want to be covered by insurance for U.S. or European based products liability claims, the best solution is usually to purchase such insurance from a U.S. or a European insurer. The cost of such insurance then illustrates why the China price is often not as low as it seems.

Some of our clients insist on including a standard U.S. or European style insurance provision in their manufacturing contracts with Chinese factories. This usually elicits one of the following three responses from the Chinese manufacturer:

  1. The honest Chinese factories usually refuse to agree to this requirement/provision because they know they probably will not be able to secure this insurance.
  2. Some Chinese factories agree to sign but then also state that they will raise the price of their product(s) to account for the added cost of the insurance. In this case, what they usually mean is that they will purchase the insurance from a U.S. or European insurance company and they will pass on the price of the premium to the U.S. or European buyer.
  3. Some factories will sign but then not obtain the insurance.

We have seen Chinese companies provide fake policies to try to trick Western companies into believing they have insurance. If it is going to cost you the same amount to have your Chinese manufacturer secure sufficient insurance coverage to protect you, but you run the added risk of being tricked about the existence of the coverage, you really do need to ask whether this request even makes sense.

And here’s another thing to consider if you think you are going to be protected by your indemnification provision and/or your Chinese counterpart having secured insurance for you. With China cracking down so hard on hard capital leaving the country (See Getting Money Out of China, Part 6 and the five posts that proceeded that), there is a good chance that even if there is someone in China wants to pay you in the United States or in Europe they will be unable to do so.

In a more general way, one of the risks you will face in getting your products from Chinese manufacturers is that Chinese tend to be either underinsured or not insured at all. This imposes significant risks most U.S and European buyers do not take into account. For example, say you pay a 30% deposit/prepayment for your products and then the factory burns down, and your work in progress is lost. In this case, it would be very rare in China for the factory to have insurance that would cover you for this loss. Say you make the mistake of purchasing your product on FOB terms. In this case, your shipping insurance does not cover the product until after it is loaded on the ship. Say the product is lost in a vehicle accident on the way to the port or in an explosion at the port. Again, it is unlikely the Chinese factory will have insurance covering the situation and once again your deposit is lost. In the U.S. or in Europe, the odds are great these sorts of things would be covered by an appropriate insurance provision, naming your company as an additional insured, but this type of insurance is generally not available in China. So the only way to cover the risk is to purchase your own insurance, which again raises the actual cost of purchasing from China. Most smaller companies either do not understand the risks they take or they take the risk intentionally. In either case, they are underestimating the true cost of purchasing products from China.

As you can see, these various insurance/indemnification issue are quite difficult for China and there are no easy answers.

What do you do to minimize these China risks?

China AttorneysBecause of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

One of the most common questions we will get asked will be something like the following:

I paid my supplier in China X dollars for Y product and the quality is so bad I cannot even use it. Do I have a good case against them and what would you charge us to pursue it.

My response is usually something like the following:

Do you have a written contract with this Chinese supplier?

Is it in Chinese?

Is chopped/sealed by your Chinese manufacturer?

Does it provide for disputes to be resolved in China?

Does it clearly specify what you will be buying and its quality requirements?

Does it clearly provides that any failure to satisfy the product requirements will lead to you being entitled to specific monetary damages against the Chinese company?

If your existing contract provides for all of the above (or at least the first four), we can help and we’d be happy to do so. If you do not have at least the first four above, our chances of being able to help you are not so good and it probably will not make sense for you to hire us.

If you want to protect yourself in the future, I would urge you to use an appropriate Manufacturing Agreement (a/k/a OEM agreement or product supply agreement) the next time around. You can find out more about our Manufacturing Agreements hereherehere, and here.

I should also note that we have been dealing with a massive increase in companies that are losing their ability to have their products manufactured in China entirely because their suppliers there are registering their trade names and then preventing their products from leaving China. If you put your company or your brand name on your products (or on their packaging) you should immediately register your brand/product name and logo as a trademark in China, if you have not already done so. As we discuss here, this is true even if you will not be selling your product in China. I mention this because when foreign companies start having problems with their Chinese manufacturers (like what you are having) the Chinese manufacturer often will go off and register the foreign companies brand names as their own trademarks in China so as to gain leverage against the foreign company. Therefore — and I know this will probably surprise you — the one thing I would urge you to do immediately is to make sure your brand names are registered as trademarks in China and if they are not, to do so immediately.

 I hope the above proves helpful to you. If you have any additional questions, please don’t hesitate.

What are you seeing out there?

China manufacturing trademarkLast year, in Your China Factory as your Toughest Competitor, I wrote about how our China lawyers have “gotten more calls in the last year from companies whose China factories are now directly competing with them than in probably the three years before that combined.” I went on to explain how “Chinese factories are more confident now than they have ever been about going out into the world with their own products, and more willing to toss their foreign customers to the curb early. Amazon and Alibaba do not help matters as we are getting roughly a call a week from someone whose product is being sold on Amazon and/or Alibaba by their Chinese factory.”

The other day I secured permission to write about a sourcing company that contacted us regarding this problem for one of its clients that makes IoT (Internet of Things) products in China. The below is our email correspondence (stripped of any possible identifiers):

IoT Product Sourcing Company: I’ve got an interesting story for you which could potentially mean some China contract work for your team. One of our best clients currently has a written contract with its China manufacturer, but it was written for them by their regular attorney who does not know China and it is badly written. We told our client this going in, however it’s tricky telling our client that their contract is not good, or even that their colleagues have no idea what they are doing. I’m sure you can relate but it’s especially tough for us because we are not lawyers and we do not want our clients ever to think that we are providing them with any legal advice, but like I said, we figured from the contract that they would eventually have problems and now they are.

We have a factory producing a products for us. Various kinds of fairly high end IoT industrial products. Quite profitable too. The contract in place details minimum order quantities annually and clauses related to exclusivity for Spain, France and Italy. During the past 16 months our client has failed to meet the minimum order requirements so its exclusivity is now uncertain. The main reason for their not meeting the minimum order requirements is problems the Chinese factory had with packing the products in a way that protects them during shipment and also problems with the products themselves. These issues have been sorted out now and my client is ready to move ahead with large orders every month. There are also molds involved that are worth well over a million RMB in total.

My client received an email from the factory last week saying they will be attending the ____________ trade fair in __________ and they want my client to send a sales person to represent them. Just to be clear, the Chinese factory wants to show my client’s products in Europe, with a focus on selling it in Spain, France and Italy! This email was quite amusing as they also asked my client for some information regarding how to install the products and requested my client send them a technical person to give more details about the whole system. They offered even to pay for this technical help. My client is a concerned but I find it amusing because the Chinese company has no idea what testing or standards are required in Europe as they manufacture almost exclusively domestic products. It would be a bit like a factory in China exhibiting in the US and telling Home Depot (their client) that they were going to help Home Depot sell its own products. But at the same time, I also know that this Chinese company is probably just one technical and marketing person away from being able to sell my clients products all over the world for 30 to 40% less.

I am curious on your thoughts and I was thinking of the below, but would be open to more:

1.  NNN contract. It may be too late for this as I am not sure the Chinese supplier would be keen to sign a new contract at this point. From their point of view, they already have a great contract.

2.  Trademark in China. Just reading a bit on your site it seems to me my client should be doing this, or really should already have done this.

3.  Have you heard of a trade show barring a supplier from attending because they are selling essentially stolen products?

Please let me know what you think when you have some time.

My response was as follows:

My first advice to you would be to stay completely away from ALL of the legal issues and let your client deal with all of these issues itself. Your client should not expect you to give it legal advice and your doing so just increases the odds of your being blamed when things go wrong and of your being sued and losing on the same grounds.

I would need to know more to be able to provide all options but I can say that separate and apart from what has been transpiring between your client and its factory, your client has indeed made a big mistake by not having already registered its trademark(s) in China. That is the one thing above all else that anyone manufacturing in China MUST must do. See Manufacturing in China: Trademark Registration Should be the First Thing You Do.

As for the issue regarding the factory, a trademark will shut down rival sales as the factory could still sell the same products under a different name, but at least it can stop it from selling your client’s products under your client’s name! We also should talk more as patents in China and elsewhere might be possible, and if they are, they might help. [It turned out the company was too late to secure any patents]. You can try to get the fairs to block this China factory, but I do not see how that will happen because near as I can tell, the China factory is acting legally because it is not violating any contract or any registration.

I cannot recommend doing anything with the factory without getting the whole story because I am scared to death of what could happen here. One part of me says your client should tell its Chinese factory to “sign a new (good) contract now or we walk,” but the other part of me says that would be crazy because this will likely cause the Chinese factory to say, “great, and we keep the molds because they belong to us” and we keep making your products and now we add your brand name to them them because there is nothing to stop us from doing so. And what will your client then do? By the time it has new molds made and starts even trying to fight back, it will likely have lost all or nearly all market share to its factory.  I say this because I presume that the contract your client has with its China factory does not make clear that the molds belong to your client nor provide any real incentives to prevent the factory from hanging on to them. But really, the bottom line is that unless your client wants to retain us so we can get all the facts and figure out step by step what it can do there is really nothing we can do but speculate. A

The email address for the sourcing company no longer works and so I have no update on what eventually happened, but I very much doubt any good result.

What should you do to prevent the above? The following three things are key:

  1. Choose your China manufacturer wisely. Due diligence is the answer to this.
  2. Make your China manufacturer sign a contract making clear that you own the molds, that you own the products and that it will not compete with you.
  3. Register your trademarks in China and with China Customs, register your patents in China and register both of these wherever you sell your products.