China contract lawyersDespite all that you may have read about China’s economy being on the downswing and despite all that you may have read about China factories closing, our China lawyers are starting to see distinctly tougher negotiating by China factories. We attribute this to the following:

  1. To greatly simplify, ten years ago China factories made socks and rubber duckies and with thousands of factories capable of making these things competition was incredibly intense. On top of this, price was oftentimes the foreign buyer’s only real concern. Today, China factories are making incredibly complicated products and oftentimes few or sometimes only one China factory has the capability to make the exact product the foreign buyer wants. Sometimes a China factory even holds a patent for some aspect of the product and so that factory is the only factory that can produce the product with that one aspect. Needless to say, being unique or nearly unique increases pricing power.
  2. To again greatly simplify, ten years ago, there were a number of China factories that knew little to nothing about pricing. It would not be an exaggeration to say that our China lawyers oftentimes dealt with China factories that did not even know their costs, leading us to often joke that they would make up for their selling widgets at a dollar under their costs by selling massive quantities of widgets. Most of those factories either wised up or no longer exist.
  3. Read all you like about factories closing in China, but recognize that there are plenty of profitable China factories these days with very good long term relationships with good stable foreign buyers. Those China factories are in no rush to take on your production on bad terms.

So what we are seeing now is a power shift, with Chinese factories more and more often gaining the upper hand. In subtle ways, this is making our job as China lawyers more difficult, while increasing legal fees for our clients. In the old days, our typical scenario would be that we would draft a manufacturing agreement (a/k/a OEM or ODM contract), send it to the Chinese company and get it back signed within 24 hours. Nowadays, it is far more common for us to receive pushback from the Chinese company on terms, including on terms to which the Chinese company previously agreed with our client. Needless to say, one of the more common push-backs is on price, with the Chinese factory oftentimes saying something like, we quoted $5 per widget with the understanding that we would have 90 days to produce after receiving the PO and now you are asking for 45 days (even though the email trail reveals that our client had made clear it was 45 days all along).

We are also seeing increased toughness even in the pre-quoting stage from China companies. About a month ago, I received an email from a foreign buyer telling me that a potential supplier was saying that it would sign an NNN Agreement with the foreign buyer agreeing not to use any secret information provided by the foreign buyer to compete with the foreign buyer, but if the foreign buyer ended up using another supplier to make its widgets, it would not be bound by the NNN Agreement. In other words, it would be free to use the foreign buyer’s top secret information to compete with it. The foreign buyer asked if something like this would work, to which I replied as follows:

No, this will not work. Not at all. This could be terrible for you. Imagine this scenario. Imagine you get quotes from five other good manufacturers ranging from $5 per widget to $7 per widget, but this one Chinese company is quoting you at $12 per widget. Do you pay the obviously inflated $12 per widget price, because if you do not, that Chinese company can (and likely will, otherwise why is it’s price quote so out of line with everyone else’s) will start making your widgets and competing directly with you. So you can see why this is not acceptable. We have actually never heard of a Chinese company making this sort of proposal so you should not face this situation with any other potential suppliers.

But then yesterday, one of our China lawyers got a similar email from a foreign buyer asking us essentially the same question. I discussed all of this with co-blogger Steve Dickinson and his response was “that’s what’s so cool about Chinese companies. They tell you what they are going to do. These two Chinese companies are saying if you don’t choose us we will steal your product. The choice is up to you. It’s up to our clients to listen”

I guess that is true. To which I can only ask whether you our readers agree that doing business in China and with China is only getting tougher.

For more on China manufacturing pricing, check out China Manufacturing Agreements: Binding Contract or Contract Terms.

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 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 trademark. China Customs.
1. Register your trademark in China. 2. Register your China trademark with China customs.

One of our China lawyers got the following email from a client the other day about an AmCham China IP event:

Just saw that AmCham is putting on this Innovative Approach to Stop Counterfeit Goods and just wanted to congratulate you for having convinced me to institute that approach nearly five years ago.

The “innovative” approach to which both AmCham and the writer of this email are referring is the following, as described by AmCham in its lead-up to this talk:

Many companies with large overseas operations have to deal with lost revenues and reputational damage caused by counterfeit goods. As well as being a large potential market, China is also major manufacturing hub, for both fake as well as genuine products. Despite improvements in the legal framework regarding intellectual property rights, companies are often disappointed by the results of their attempts to prevent the proliferation of counterfeit goods through through the courts, the Ministry of Commerce and local governments.

Now there is a new, innovative approach to stemming the trade of counterfeit products. Based on their experience working with numerous clients, experts … will share details on how the Customs Bureau can help companies in the fight against counterfeits.

Seeing as how none of our China attorneys attended this event, we do not know what was discussed at it. But we can tell you what we have been saying on this blog and to our clients since at least 2013, and that is that not only must you file for a China trademark for your brands and your logos, but you should also then register your granted China trademark with China customs to stem counterfeits of your products from leaving China.

For instance, earlier this year, in China Trademarks: Customs Helps Those Who Help Themselves one of our China IP lawyers, wrote the following regarding the real benefits to be gained by registering your China trademarks with China customs: “For trademark owners, customs seizures can be a valuable part of an anti-infringement strategy. But don’t expect much help from the customs authorities if you can’t be bothered to help yourself.”

But long before that, way back in April, 2013, we wrote a post, Register Your China Trademark Now. Then Register It Again With Customs, where we called for exactly what the title of that post would lead you to expect: that you should not only be sure to file for a trademark in China, you should also be sure to take that China trademark once you get it and register it with China customs. It bears repeating what we said in that post because it so nicely sets out what exactly this will entail and why it is of such importance:

The implication for foreign companies doing business in China is clear: Chinese Customs can help protect your IP from infringement…. What the numbers [of China customs seizures] don’t tell you, however, is that nearly all of the seizures were of goods that infringed registered Chinese trademarks, and that those trademarks had been registered not only with China’s Trademark Office but also with Chinese Customs.

As we have written a number of times — see File Your Trademark In China. Now., China: Do Just One Thing. Trademarks, and China’s Changing Trademark Environment. Why You Need To Register Your Trademark Now. — the essential first step in any China IP strategy is to register your trademarks with China’s Trademark Office. Because China is a first-to-file country, until you register a trademark you have no rights in that trademark. But a trademark registration alone will not limit the spread of counterfeit goods. A trademark registration merely gives you the legal capacity to enforce your rights to that mark, and should properly be seen as one of the pieces in an overall strategy.

For any company concerned about counterfeit goods coming from China, the next step should be registering your trademark with Chinese Customs. This is not a legal requirement but a practical one: though China Customs officials have discretion to check every outgoing shipment for trademark infringement against the Trademark Office database, in reality they only check against the Customs database. No separate registration with Customs means no enforcement by Customs.

If you register your mark with Customs, they will contact you any time they discover a shipment of possibly infringing goods. At that point you have three working days to request seizure of the goods. Assuming you request seizure (and post a bond), Customs will inspect the goods. If Customs subsequently concludes the goods are infringing, they will invariably either donate the goods to charity (if the infringing mark can be removed) or destroy them entirely. The cost of destruction, and of storing the goods during the inspection process, will be deducted from your bond.

Registration with China Customs generally takes three to five months and can only be done after China’s Trademark Office has issued a trademark certificate. The latter currently takes approximately fourteen months, which means that within nineteen months of the date you file your trademark application, Chinese Customs could be helping to stop counterfeit goods from being exported from China.

Nineteen months can be an eternity in the retail world. Whether you’re a toy company producing dolls in Shanghai, a home video company making DVDs in Guangzhou, or a luxury goods company manufacturing high-end purses in Qingdao, there’s only one approach that makes sense. Register your China trademark now. Then register it again.

So though we never saw registering your China trademark with China customs as innovative, we have always viewed it as important, and that really is all that matters in any event.

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.

 

China manufacturing lawyers
China molds. Keep them to yourself.

In working with outsource manufacturing in China, one of our primary goals is to control the molds used in the manufacturing process it is critical to make clear that the foreign buyer owns the physical molds. To accomplish this, our China manufacturing lawyers concentrate on two issues when drafting mold provisions that are part of a larger contract (such as a manufacturing agreement or a product development agreement) or that essentially stand alone as part of a mold ownership contract.

First, we want to make clear that the Chinese factory can use the molds only for producing our client’s product and not for producing for any other party. Second, we want it clear that when our client chooses to move its production to a different factory, it will have the right to take possession of the molds and transport them to the new manufacturing location. Negotiation of these terms is usually quite difficult, since the Chinese manufacturer has a strong incentive to hold molds “hostage” so as to prevent the foreign buyer from moving its manufacturing to a new factory. The only way to succeed is with a stand alone mold ownership agreement or well-crafted mold ownership provisions inserted into a written manufacturing agreement. For why it can be so important to be clear regarding mold ownership in China and some of the specifics on what you should be doing to prevent your Chinese factory from walking away with your molds, check out Product Molds And Tooling In China: Three Things You Must Do to Hang on to Yours and Want Your China-Based Molds? You’re Probably Too Late For That.

As manufacturing in China has become more complex, molds for products have become correspondingly more complex as well. In many cases, the mold embodies most or all of the intellectual property in the product. I can give two examples. First, in some products, the interior mechanism is based entirely on open source hardware. The external enclosure surrounding the mechanism is therefore the primary protectable IP for the product. The IP resides entirely in the molds used to manufacture the product case. The”look and feel” of the enclosure then becomes the identity of the product, and If that “look and feel” is not protected, the foreign designer owns nothing at all in the IP of the product. Without the IP in the molds protected, Chinese factories can freely copy the product.

Second, in some products, the form embodied in the mold is in fact the entire value of the product. Take for example a complex part used in the manufacture of a turbine or jet engine. After all the engineering and testing is complete, what remains? What remains is a single part produced by casting into one or more molds. In this situation, the molds embody the entire intellectual property in that part. and thus the party that owns or controls the intellectual property in the molds is essentially in complete control of the product. More importantly, if no party owns any IP in the molds, the molds are effectively open source, and no one owns any IP in the molds or the product.

Chinese factories have figured this out, making protection of molds much more difficult. In figuring out what to put into our clients’ contractual mold provisions, our China manufacturing attorneys can no longer focus solely on the issue of ownership; we now also must focus on ownership of the intellectual property in the molds as well.

The new mold IP issues frequently arise in two settings. First, in dealing with third party mold fabrication shops in China. Second, in dealing with the Chinese outsource factories themselves. In part 2 of this series, I will address mold IP issues when dealing with third party mold fabricators and in part 3 I will discuss how to approach these issues when dealing with the Chinese factory to which you are outsourcing your manufacturing.

 

Importing from China
Importing from China. Get it right.

Companies importing goods from China into the United States may find themselves in having to respond to a U.S. Customs and Border Protection (“CBP”), Request for Information (CBP Form 28) or what may be worse, a CBP Notice of Action (CBP Form 29). The CBP Form 28 – Request for Information is a tool routinely used by CBP to solicit additional information about a shipment to verify if the goods are properly classified, valued or otherwise meet U.S. import requirements. The CBP Form 29 – Notice of Action can be used to inform an importer of a proposed action, including assessment of additional duties on the goods, or to notify the importer that the action has already been taken by CBP. Both communications may be considered red flags for CBP to investigate prior transactions of an importer and for CBP to initiate a penalty investigation.

Though you as an importer may have an easy response to a CBP inquiry or a valid basis as to why the CBP’s proposed action should not be taken, your response often may require you to provide information from your China (or other) manufacturing supplier. In these situations, it can be critical for your supplier to work with you the importer in the United States, to ensure you have all necessary information for the goods you imported. It is also critical that your communications with the CBP not provide the CBP with information the CBP can use against you. Pulling together a sufficient response together for the CBP within a short time frame can be no small task, but you can almost always ease that task and improve your odds by anticipating and preparing for your customs problems within the framework of import procedures and controls.

It is a common misconception among importing companies that they do not have to be exact on their commercial invoice or other import documentation. But to properly import goods for entry in the United States, a complete product description, accurate country of origin, and correct value in accordance with CBP rules are all key pieces of information which must be accurately provided. These requirements fall under the importer’s legal responsibility to exercise “reasonable care.” If you as an importer fail to attend to these basic legal requirements, you will be greatly increasing (1) your risk of delays in the release of your goods, (2) further scrutiny by CBP through an audit, and (3) penalties.

The import compliance burden shifted to U.S. importers in 1994, when Congress passed the Customs Modernization Act of “Mod Act” as a part of the same legislation package as the North American Free Trade Agreement (“NAFTA”). It is under the Mod Act that CBP expects importers to exercise “reasonable care” when addressing the following, per the CBP Reasonable Care Checklist:

  • Customs documentation for entry;
  • Complete merchandise description for tariff classification and proper duty rates;
  • Valuation of merchandise consistent with specific CBP valuation rules;
  • Country of origin verification, marking, labeling;
  • Free trade agreements; and

Though the above list is not meant to be an exhaustive one, it tracks key compliance components in the reasonable care checklist.

Despite its name, the CBP Reasonable Care Checklist is not a formulaic standard, but rather a list of questions to prompt U.S. importers to create their own internal framework or methodology to meet United States import compliance standards. CBP allows U.S. importers flexibility in how to manage their reasonable care responsibilities based on the importer’s own transactions.

If you import from China, your first step in managing your reasonable care responsibilities so as to minimize your importing compliance risks is to start with the basics and become familiar with the CBP Reasonable Care Checklist. Answering the questions posed by CBP will help you formulate your necessary internal import procedures and controls.

 

 

China manufacturing Lawyer
Photo from our lunch in Shenzhen.

When I was in Shenzhen last month, co-blogger Steve Dickinson and I had a long lunch with China manufacturing guru, Renaud Anjoran of Sofeast. During our lunch, we talked extensively about what we were seeing in China manufacturing these days, particularly in the electronics and Internet of Things sector in China. As we always do, we shared many of the horror stories we were seeing and hearing about as it is from those that lessons get learned.

During that lunch Renaud told us of an American (or was it European?) company that had chosen to pay its Chinese manufacturer in advance, believing that by doing so, it would make for a “great relationship.” Instead, it led the Chinese manufacturer to keep the money and never make a thing. Renaud told us that he knew the manufacturer and he insisted that the manufacturer was not a crook, but that it simply could never prioritize making products for the company that had already paid it over those companies for whom it NEEDED to make product to get paid. The lesson learned from this story is how critical payments terms can be in influencing what gets made and how.

Renaud recently did a terrific post explaining this payment-results connection, entitled,T/T Payment Terms with China Factories: Set the Right Incentives. Renaud starts off this post by noting that “at the end of the day, what the factory really looks at is, ‘how much of the order did we get paid, and how much room for maneuver do we we have right now?’” He goes on to talk about how Chinese factories very much tend to be “focused on the short term” and this means you as the buyer need “to think very carefully about payment terms.” In other words, “you need to make sure your Chinese supplier, who has over-promised to 10 customers and needs to disappoint 5 of them at some point, will think twice before deciding you will be among the unfortunate ones.” I 100% agree.

The article then sets out the following various payment options and the pros and cons of each:

 

100% T/T pre-payment. This is a beginner’s mistake. Renaud remarks on never having seen this sort of payment plan work out well in his 10+ years working in China and neither Steve nor I can recall such payment terms working out well either. Neither can I. I can though recall a number of such companies calling me because they have not received their products. I also recall getting a negative answer to the one question I always ask whenever a foreign company calls me with a China manufacturing problem: Do you have a written Manufacturing Agreement in Chinese that is crystal clear about what your Chinese manufacturer must provide you? I also recall being amazed at how many times the response was something like, “we don’t because we didn’t want to get off on the wrong foot with them” and then my telling them that our China lawyers would not be interested in taking on their case.

Renaud correctly notes that this sort of payment plan gives your manufacturer “zero incentive to perform.”

30% T/T deposit, 70% T/T payment after passed QC inspection. Renaud describes this sort of payment plan as quite common and it is the one we typically see offered by Chinese manufacturers, especially in the electronics industry. Renaud describes these payment terms as being a “generally a balanced and fair deal,” but still with “a number of risks for the buyer” and he recommends negotiating a lower initial deposit, “especially if the products are very standard and could easily be sold to another customer” and payment of the remainder only after the product ships. .

20% T/T deposit, 50% T/T payment after production and after passed QC inspection, 30% after delivery in buyer’s country. These payment terms give you “some leverage until you receive the goods. If the manufacturer played games during the inspection, or ‘salted’ bad products into your order just before shipment, you can still catch it.”

Letter of credit (L/C) at sight. Renaud rightly notes that “only some suppliers accept a payment by L/C.” He then also notes that though these payment instruments favor the buyer, they are expensive. Our China attorneys are generally not big fans of letters of credit. First, it truly is the rare Chinese manufacturer that will accept them. Second, they are really expensive. Third, they have to be done right or they are essentially worthless, and they are rarely done right. Fourth, you need to use a trusted bank for one and Chinese banks do not generally fall into this category if you are a foreign company having your product manufactured in China.

100% T/T payment 2 months after shipment, with no deposit. This is sort of the gold standard for buyers, but even this payment arrangement is not without at least some risk:

However, if you have an ongoing business relationship with a supplier that you pay that way, you are still ‘hooked’ to a certain extent. Above all else, you probably need continuity of supply. If you find quality issues and you act in a way the supplier sees as unfair, they might stop shipping goods to you!

Renaud’s article then discusses how Chinese manufacturers take advantage of foreign buyers (especially in the Internet of Things sector) by not requiring “the foreign company to pay for the non-recurring engineering costs such as tooling, firmware code development, etc.” This is done as part of a strategy “to gain the upper hand in the business relationship in the long term” and “this is extremely dangerous for buyers of highly customized products.” If you want to know how dangerous this can be, check out China and The Internet of Things and How to Destroy Your Own Company or Hardware Co-Development in China: Do it Right, Part 2, from which Renaud quotes extensively:

The foreign designer and the Chinese factory will work together for months or years to develop a commercially viable product and then when the prototype is finally finished, the question then becomes who actually owns the prototype: the foreign developer that came up with the idea or the China factory. The foreign developer says it owns the product while the Chinese factory says it owns it. Who does legally own it? Way more often than not, the Chinese factory does.

How does all this come about? The standard scenario goes something like the following. A foreign product designer comes to China and works with a Chinese factory to commercialize an innovative hardware or IoT product design. In a cooperative co-development setting, the foreign party and the Chinese factory work together to create the prototype of the commercial version of the new product. All the work is done on a purchase order basis, with no written contract or other documentation.

At the end of the development cycle, the Chinese factory announces to the foreign developer that the prototypes are completed. The factory retains the prototypes in anticipation of moving to the manufacturing phase. However when the parties move to the manufacturing phase, it is normal for something to go wrong. This can happen in two ways. First, the Chinese factory surprises the foreign designer by substantially increasing the projected unit price for the product or it announces that it cannot meet the quantity or delivery date requirements for the product. Second, the factory consistently manufactures product with substantial product defect/quality control issues.

Facing these problems, the foreign party confronts the Chinese factory and announces that it is going to take the prototypes and have them manufactured by another factory. The Chinese manufacturer replies: “you cannot do that. We own all the IP contained in the product. We agree that we will manufacture the product for you exclusively for as long as you are willing to order on our terms. But you cannot take that prototype anywhere else. Only our company has the right to manufacture that product. And, if you are not successful in making substantial sales, we will cut you off and market the product ourselves.”

The real problem with this scenario is that in most cases the factory is absolutely correct about the legal situation concerning the intellectual property in the new product. Stated simply, absent a written contract to the contrary, it is generally true in this setting that the factory DOES own the intellectual property in the product.

Renaud then notes how Steve describes the legal consequences, but “from the perspective of the buyer, it is worse”:

In many cases they PHYSICALLY can’t do anything. The mold is in the Chinese factory; developing and fine-tuning a new one would take time and money. Maybe some code was developed for the firmware, but again the supplier (or, often, a sub-supplier) keeps the source code.

In such a case, having a contract that clearly spells out who can do what with the finished product, is extremely important. You will probably have to pay for some/all of the non-recurring engineering work for the supplier to agree to this.

Bottom Line: When outsourcing your product manufacturing to China, your payment terms matter. A lot.

 

Cover_design,_A_Book_of_MythsIn my previous post Three Myths of China Technology Transfers, I focused on the misconceptions Western companies so often have regarding China technology transfer deals. In this post, I focus on two commonly held misconceptions foreign technology owners have regarding “partnering” with Chinese companies.

Due to a partnership relationship, the foreign side often wrongly believes it is somehow better protected against IP theft. The foreign side then lets down its guard, only to learn that its China partner has appropriated its core technology. This sense of partnership is most common with SMEs and technology startups, especially those companies whose owner is directly involved in the relationship with the Chinese entity.

The two primary “we are partners” myths our China lawyers see are the following:

Myth One: Our personal connection will protect us. The Chinese company will not appropriate our technology because I (the owner of the U.S. company) have a close personal relationship with Mr. Zhang (the owner of the Chinese company). Usually this statement is followed with some bit of personal data, such as: “He came to my daughter’s wedding” or “I sponsored his son’s admission to college” or “I helped bring his family to the United States” or “He is my son’s godfather.” Trust me when I say our China attorneys heard them all. This idea that a close personal relationship will somehow insulate your company from China IP theft is probably results in more technology transfer disasters than any other myth about China. It is a myth for two quite different reasons:

On the most basic level, personal relations are not a barrier to committing acts of appropriation or other breaches of trust or contract. For most Chinese business people, personal relations, such as attendance at weddings and other shows of friendship are strategic matters, done to achieve some form of business benefit. When that benefit involves breaching a contract and appropriating technology, the Chinese side will often do it. Of course, this is not always true, but it is certainly true often enough that this possibility cannot and should not be ignored.

When the foreign party points out that this is a breach of trust, the Chinese side will often reply with something like the following: “In China, business is like warfare and contract like a treaty between nations. We will honor the treaty when it benefits us, and we will breach when it benefits us. Personal matters are not relevant. As soon as we see a benefit, we will take it. The situation is really all your fault. You should not have presented me with a situation where I had the opportunity to betray you. By leaving me an opening, you forced my hand, because the rule in China is that when an opportunity presents itself the prudent businessperson must take advantage of it opportunity.”

I have many times heard a Chinese company owner state this sort of argument with a certain amount of bitterness. They actually say: “It’s your fault. You made me do it.” They resent you for having forced them to the friendship in a way that was painful to them. But again, the common Chinese view is that when a foreign company provides an opportunity to seize a benefit, the Chinese company is obligated to seize. Personal feelings do not count; action is required.

In many cases, however, the Chinese company owner has no reason to appropriate your technology, so it is safe not because of an emotional commitment but because there is no benefit from the theft. But, the technology is still stolen. This is because the technology is stolen by an employee of the Chinese entity.

In fact, for technology that requires a small investment to commercialize, theft by a Chinese company employee is probably the most common way foreign technology gets appropriated. This is particularly true of software products, where no large capital investment is required. In these low barrier to entry businesses in China, senior technical employees are constantly on the look out for an opportunity to steal technology and leave their employer to start out on their own.

This is part of the aggressively entrepreneurial mindset of Chinese technical personnel. Appropriating a nice piece of foreign software is often seen as the perfect way to get a head start on forming a new company. In the same way, if an employee can make off with a full set of production molds, he or she can start up a small factory at a very low cost in China. So the opportunities abound and the foreign technology disappears, leaving both the Chinese owner and the foreign entity frustrated as their mutually advantageous business relationship is destroyed by a low cost Chinese competitor.

Myth Two: Our partnership is secure because of investment by the Chinese side. We hear this argument a lot and it is essentially that it is not necessary to formally protect the technology because the Chinese company plans to invest significantly in the foreign company.

This argument has two variants, both of which are false:

Variant Number 1: The Chinese side plans to purchase a majority ownership interest in our company. In effect the Chinese side will own the technology in the end. Since the Chinese side will eventually own it, there is little reason to try to protect it from appropriation by its future owner. In this way, the Chinese side convinces the foreign entity to transfer the important technology to the Chinese entity prior to the date with the investment occurs.

But, then, there are always delays in closing that investment transaction and in many (most?) cases the full (sometimes any) investment never occurs. The Chinese side assures the foreign entity that the investment funds are on the way; the delay is only temporary. In the meantime, the Chinese entity obtains all of the relevant technology. Finally, the Chinese side announces that it sincerely regrets the transaction cannot be concluded. There is always some good reason. Either the bank that was going to finance the investment deal got cold feet or the Chinese government withdrew its approval of the transaction at the last minute. Either way, the deal is off with no liability on the part of the Chinese side. But the Chinese side got what it wanted. It obtained the key intellectual property without having to pay anything approaching market price for it.

Now that Chinese companies are perceived as wealthy, this investment promise has become a standard technique Chinese companies use to convince foreign companies to drop their guard. The way to prevent the unfortunate result is simple. Up until the day the purchase transaction closes and the funds are clearly in your bank account, treat the Chinese entity as a neutral third party. Protect your intellectual property in exactly the same way you should (or at least would) if you were dealing with an unrelated third party. The Chinese side will complain about the expense and inconvenience, and your reply should be: if you do not like it, pay the money now.

Variant Number 2: The Chinese side will purchase a minority interest in your company, just to provide support for developing the technology. In this variant, Western companies believe protection of their intellectual property is not required because: “Why would the Chinese company want to harm the interests of a company in which it is a part owner?”

This argument assumes that the Chinese company sees greater future benefit in the earnings it will get from its minority share of the U.S. entity as compared to walking away with the American company’s technology.  The U.S. side often tells us that “when we go public, the Chinese side’s share will give them a huge profit. Why would they screw things up now and prevent that public offering from ever happening?”

The Chinese side rarely sees it this way. First of all, few Chinese companies focus on the long term. So for many, the promise of a future IPO or other monetary benefit from their minority investment means little or nothing to them. Second, when the Chinese side makes a minority investment, they do not see it as a investment in stock. They are making the payment to hire the foreign entity to do research and development work on their behalf and usually what they pay for such work (via the minority investment) is far less than they would pay for an arm’s length R&D program.

The investment in this R&D work is valuable to the Chinese company, but only to the extent it can take control of the technology. So the Chinese company will invest in the foreign development efforts for only so long as it receives direct benefits in the form of transfer of technology. The Chinese side has no intention of allowing the underfunded foreign start up to commercialize that valuable technology. Instead, the Chinese entity will transfer the technology to one of its many well funded subsidiaries for entry into the market. Normally, the Chinese entity expects the foreign start up to then simply die. They do not see this as a loss of their investment. Instead, they figure they see themselves (usually rightly) as having received an excellent return on their payments. It paid the money and the foreigners did the development work which it (the Chinese company) now owns. That is the end of the analysis.

The solution here is the same as the solution for Variation 1. Treat the Chinese entity like you would any third party entity. Disclose as little as possible to the Chinese entity and thoroughly protect what you disclose. If the Chinese side continues to seek access to your technology, consider carefully why it is  making such requests. A normal investor does not need such information. If the Chinese side is asking you for more than a normal investor would ask, you have to ask why. The answer will almost certainly be that the Chinese company wants access to the intellectual property underlying your technology and it wants  that for its own use.

In this situation, if the Chinese side complains or says something like “Don’t you trust us? We’re your partner.” This is sure sign of trouble. If the Chinese side requests access to your proprietary technical information, you have to ask: why are they making such a request? The real reason is seldom what you will want to hear.

Bottom Line:  Do not be lured into believing that the nature of your relationship with your Chinese counter-party or the structure of your deal will be enough to protect your intellectual property from being appropriated. Or as my co-blogger, Dan Harris, always likes to say: Be careful out there.

China manufacturing contractsIn China Product Development: Focus on Manufacturing Rights, I set out the ideal resolution of product manufacturing rights issues that arise in co-development projects in China. As I noted in that post, in our experience it is often difficult to convince the Chinese side to agree to that ideal option. So what do you do when the Chinese side refuses to agree? You have a number of options, including the following:

Option 1: License the underlying technology from the Chinese side. When the Chinese side takes the position that it will retain the rights to the underlying technology in your product, your next step is to try to negotiate a license to that technology. This kind of license is common around the world, and it can take many forms, including the following:

a. Negotiate a standard license for the underlying technology for which you will pay a license fee. You can pay this fee as a lump sum or as a per unit royalty for each item manufactured in a separate facility. In some settings the license payment is based on purchasing a certain number of units at a premium price. After that amount has been paid, the foreign party then has a license to manufacture elsewhere. This standard license approach is a very common procedure around the world, but it is seldom used in China. As Chinese manufacturers become more sophisticated about monetizing their technology, this type of agreement will become more common, and our China lawyers are already starting to see that happen.

b. Negotiate an agreement with your Chinese manufacturer side that allows you the freedom to manufacture the product in a different facility, but only if your Chinese manufacturer is unable to meet predetermined quantity, delivery date or price terms. Often this license will allow manufacturing in a different facility only for amounts in excess of a predetermined minimum. For example, the Chinese factory may produce 100,000 units per year at a set price and the foreign party is permitted to use a different facility only to manufacture anything in excess of 100,000. The flaw in this approach is that it assumes the Chinese side will be capable of manufacturing the first 100,000 units, both in terms of quantity and quality. Where this is not true, this leaves you as the foreign product developer hostage to the Chinese factory, which can be financially devastating.

Option 2: Walk away. It is surprising to me how many times foreign hardware entrepreneurs fail even to  consider the basic option of refusing to work with a Chinese company that will not cooperate on key manufacturing rights issues.

It is critical to understand what the Chinese side means when it states it will under no circumstances release the manufacturing/IP rights in a co-developed product. What the Chinese side means is: We own the product. We will manufacture the product and we will allow you to sell the product on our behalf in a foreign market. If you succeed, great. If you do not succeed, we will simply refuse to accept your future purchase orders. We will then either market the product ourselves or we will engage some other company to market the product. That “other company” will normally be an established player in the market, and not a mere start-up like you. In other words, you will be reduced to becoming essentially the Chinese company’s sales agent and you will be subject to being terminated even for that at any time. 

Most start ups are looking for new money. Consider how hard it is to raise new money when you are in the situation where you have no control over “your” product. Since the result will be an economic disaster, it is often best to simply walk away when it is clear that the Chinese side is trying to put you in an untenable situation.

Option 3: Turn the tables. Some foreign developers do not walk away because they feel they have no other option; they think they are forced to work with the Chinese manufacturer. Though this situation is dangerous, it can work so long as the foreign entrepreneur is willing to turn the tables and operate how a Chinese company would operate in the same situation.

In the turn the tables approach, the foreign developer basically “writes off” the co-developed product. The product is not treated as the foundation for the start up company. Instead, the co-developed product is treated as a research project that will provide the foundation for an entirely new product. For this new product, the foreign product developer will work to achieve control over the technology and the manufacturing rights. It may take several rounds of development, but the goal of the foreign developer is always to achieve complete product control, using the Chinese manufacturer as a test bed for developing a new technology.

Many foreign product developers are confident that they can pull off this reversal of roles. They tell me that they will not walk away because they have this plan. In my experience, it is quite difficult to turn the tables on Chinese manufacturers. Chinese manufacturers have been using this strategy themselves for many years and they usually can see what is happening in time to take early action to protect themselves. However, if well planned, this strategy can be successful. The key is in the planning. If the plan is not laid out clearly from the very start, there is very little chance of success.