Archives: China OEM Agreements

How many of you know what “deep six” means? How many of you have used equally difficult to comprehend slang/words when emailing with your Chinese manufacturer?  How many times has your Chinese manufacturer emailed you back to seek clarification of such words or of anything at all?  I am betting not often.

I had a great conversation the other day with one of my law firm’s savviest China clients.  This is a person/company who has been engaged in China OEM manufacturing for nearly twenty years.  I asked him how things were going and he launched into how he was now communicating with his Chinese manufacturers only in Chinese and that doing so had immediately led to all sorts of improvements.  He said that he had made the switch after realizing that so many of the problems he had been having with his suppliers were due to “silly miscommunications.”  He said the last straw (there I go again with the slang) was when his supplier confused “June” for “July” and delivered product a month late.

He now pays a US-based professional translator (the same one every time) to translate everything he sends to his manufacturers, including (and especially) all emails and all Purchase Orders. His OEM contracts were already in Chinese.  For why it makes sense to have your China OEM Agreements in Chinese, check out China OEM Agreements. Why Ours Are In Chinese. Flat Out (there I went again with the slang).

What he kept telling me is how much more often he is now communicating with his manufacturers and how much more often his China manufacturers are writing back seeking clarification. I said that I thought it interesting that his Chinese manufacturers were seeking clarifications more often now that he was communicating with them in Chinese than when he was communicating with them in English.  He responded by saying that they had previously been too embarrassed to seek clarifications because that would be to admit that their English was not very good.  He also thinks (and I agree) that there are a whole slew of mediocre translators in China who will give their bosses a bad translation rather than admit that they do not understand the English.

Interesting idea communicating with Chinese manufacturers in just Chinese.  I like it.  What do you all think?

Just saw an Inc. Magazine article entitled, “How to Partner in China in 2013.”  The article makes a number of good basic points about what it takes to succeed in doing business in China today and I am saying that not just because I contributed two of them.  The article’s premise question is “How can you take advantage of [China’s] lower costs and the prospect of over 1 billion new consumers while minimizing risk? The following were proposed:

Start Small and Tough.  Arie Lewin, professor of International Business and strategy at Fuqua School of Business at Duke University advocates testing your China partner with “a small, low-risk project to set a high bar for quality and timing.”

Get everything in writing. The article quotes me as saying that ten years ago, the “typical entrepreneur would not have had a written contract with their Chinese suppliers” but now “it’s foolish not to have a written contract,” since most Chinese businesses, especially in places “like Shanghai and Shenzhen” are accustomed to them. The article then advocates making sure that the contract is “spelled out in both English and Chinese, and clearly states the product specifications, the quality requirements, the trade secrets policy, and so forth.”  I disagree a bit with this in that we strongly advocate doing China contracts in only one language, usually Chinese.  For our reasoning behind single language contracts, check out Dual Language China Contracts Double Your Chance Of Disaster and China OEM Agreements. Why Ours Are In Chinese. Flat Out.

Realize a contract is just the beginning of the conversation.  Andrew Hupert talks of the importance of Americans realizing that in China a contracts is “an exercise meant to help the two sides understand the dynamics and expectations of the relationship—not to determine a hard and fast set of deliverables.”  I agree with Andrew, but the problem here is that the Chinese side expects to be able to make changes but it also complains when the American side seeks to make changes. In other words, the flexibility goes only one way and it is up to the American side not to allow that, which leads into the next thing….

Don’t let them get away with things—even if you let them get away with things.  Even if you plan to let one bad shipment slide, it’s important to let the partner know you noticed. “Let them know you know what’s going on,” says Harris. “And if it happens again, you’ll need a new agreement on that.”

Get to know them—and their friends.  “There’s an old joke in China,” says Hupert. “If your partner doesn’t have a picture of your family on their computer, then you’re just a transaction. And that doesn’t count for much.” Reach out to local government officials, and make them aware of you and how you’re helping their economy, says Lewin. “If you’re creating employment, they’re very interested.” By gaining importance as a community member, you gain importance as a business partner, too.

What would you add?

One of the hallmarks of a good China OEM Contract is that it provides for very specific penalties if the Chinese manufacturer fails to abide by its crucial terms. These penalties will typically be in the form of a liquidated damages provision, which Wikipedia defines as follows:

Liquidated damages (also referred to as liquidated and ascertained damages) are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach (e.g., late performance).

Chinese courts tend to view contractual liquidated damages provisions very favorably and so long as they are not unreasonable, they will usually be enforced. Most importantly, courts will seize Chinese company assets based on a liquidated damages provision and they will seize these assets before trial. Chinese companies know and fear this.

Liquidated damages provisions make sense in many different types of contracts with Chinese companies and they make particular sense in the context of a product supplier relationship.

We most often put in liquidated damages provisions to “encourage” the Chinese supplier to comply with the following:

1.  Shipping Dates.  If the product our client is having made in China is at all time sensitive, it is our practice to specify the delivery date and a penalty to the Chinese manufacturer for not meeting that date. We sometimes set the penalty at a flat dollar amount and at other times, we make it a percentage of the value of the order. We sometimes set out just one penalty and at other times, we hae the penalty escalate as the lateness increases. The key is to make sure the provision is very clear on the date (or dates) that trigger the penalty.

2. Quailty Specifications. We also often put in a liquidated damages provision if the quality of the product falls short on what was promised by the contract. These provisions make particularly good sense if what you receive can still be sold, but for less money. For example, if you are buying a food product that is industry-rated from A to D and you pay for an A product and half of what you get is B, you will be much better off with a contract that clearly states you get $1 for each level below A the product falls than having to prove up your damages by showing how you could have made X dollars more with the A product than with the B you were provided.

We generally strive to make the penalties reasonable not only because the courts are more likely to enforce such penalties, but because the Chinese manufacturer is more likely to take them seriously as well. The thing to remember about penalities is that the best ones need never be enforced because they were so effective in molding the manufacturer to comply.

For more on what should go into an OEM Agreement, check out the following:

One of the things that drives me nuts is how some businesspeople act as though the laws in China are so unclear that either nobody knows how to do things right or that there is no point in even trying.

But in so many areas of China business, there is a real uniformity of views among lawyers experienced in representing clients in or doing business with China. That is certainly the case when it comes to the legal safeguards one must undertake when outsourcing from China. These legal safeguards will save you money by both reducing the chance of problems and by greatly increasing your chances for a good resolution should problems occur.

I thought of this uniformity of views when I read a post on the Korean Law Blog, entitled, “Korean Outsourcing: The Legal Basics.” It is a very good post on what it takes to do outsourcing to Korea correctly, but it really is a post on how to do outsourcing to anywhere correctly. In fact, all you need do is change the word “Korea” from that post to “China” and you have a great post on China outsourcing.

That post starts out by noting that if you are “just dealing through a purchase order (PO) in Korea you are heading down a path that will invariably lead to a kick in the tail.” The same is true with China. It then talks of how “foreign companies often make the poorest of choices when doing business with Korean companies” and of how “Korea is still far behind the United States and the West in terms of business ethics, protection of intellectual property and legal transparency.” In these sentences, take the word “Korea” and multiply by four and you have China. It then notes how “many risks, not even considered potential risks in the West, are regularly realized in Korea.” Absolutely ditto for China.

The post then gives the following advice (with my comments in italics:

1. Request and obtain the company’s business registration number and perform a credit check on the company. Ditto for China. For more on this, check out “Giving China Due Diligence Its Due, Part II. Don’t Be A Sucker.”

2. Register all your intellectual property rights (copyright, patents, trademarks etc.) in Korea. Registration will help to prevent your competitor, a disgruntled distributor, or your manufacturer from counterfeiting your goods and exporting your product from Korea to your customers and potential customers. Registration in the United States and Europe does not guarantee that your intellectual property rights are protected in Korea. IP treaties only provide you a window of time to register in a member state.  Ditto for China. For more on this, check out “Register Your IP In China. This Is What I’m Talkin ‘Bout.

3. Your Korean license, distribution, OEM agreements and other agreements used in other nations are not adequate for Korea. All “standard” distribution, license, OEM agreements and other agreements should only be used as guides in Korea. Korea has a unique legal system with unique business risks. If you are planning to deal only through a purchase order (PO), you are a goat waiting to be milked. Ditto for China. For more on this, check out China Supply Agreements. “Why The “Perfect” OEM Agreement Should Cost Less.

4. All agreements, to avoid any initial misunderstandings, should be drafted in English and Korean. A well drafted Korean OEM agreement is not complete until it is translated. Even the best English speaking Koreans, are ill prepared to understand agreements of this nature. Clear misunderstandings upfront and avoid legal fees down the road. Ditto for China. Ditto for China. For more on this, check out “China OEM Agreements. Why Ours Are In Chinese. Flat Out.

5. Know-how, trade secrets and the like should be protected through a written agreement. A standard non-disclosure agreement (NDA) is not enough. This agreement should be signed prior to any course of dealing and normally should include confidentiality, non-use, non-circumvention, non-competition clauses with a liquidated damage clause. Ditto for China. For more on this, check out “Why Non Disclosures (NDAs) Alone Are Not Enough For China” and “Why Non Disclosures (NDAs) Alone Are Not Enough For China, Part II.

6. For at least the first few shipments, don’t pay until the goods are inspected. For the first shipment, check the goods at the port yourself. Afterwards, procedures can be put in place that guarantees the quality, quantity and delivery time through local channels. Not quite ditto for China. This is great advice, when it works. Unfortunately, most Chinese suppliers operate on such slim margins that they cannot or will not start production on a contract without at least half of the money upfront.

What do you think?

Twice this week I got calls from companies who were seeking my law firm’s assistance in getting their molds back from their former Chinese manufacturers and in both cases I had to tell them I did not think it worth their while to pursue their claims. My firm has been called about a dozen time on such matters and we have declined all but two of these.  The two we took on we were able to successfully resolve within a week. 

In all of these cases, the U.S. or foreign company has called us because they have ceased to use a particular Chinese manufacturer and now that manufacturer is refusing to turn over the molds or tooling that the U.S. or foreign company had supplied to them. The molding/tooling have typically ranged in value from $20,000 to $100,000.

There is one massive difference between those mold/tooling cases we take and resolve and those that we decline. We take on those where the foreign company has a contract with the Chinese manufacturer that makes clear that the foreign company (not the Chinese manufacturer) owns the molds/tooling and we decline the rest.  We decline the rest because the value of the molds/tooling usually does not warrant having to sue to try to get them back, particularly when the chances of prevailing are probably less than 50-50.  

If you do not take the right steps with your Chinese Original Equipment Manufacturer (OEM)before you ship over your mold or tooling, it is nearly certain you will never get them back. As soon as something goes wrong between you and your Chinese OEM manufacturer, the OEM manufacturer typically will use your mold or tooling for ransom. It is the very rare OEM relationship that lasts forever and if you do not take steps to protect your mold/tooling, it will be the even rarer relationship where your Chinese OEM company does not end up with either your mold/tooling or at least with your having to expend considerable funds securing their return. 

So what are the right steps?

First, get your Chinese OEM manufacturer to agree in writing that the mold or tooling belongs to you. Make this clear and do it in Chinese. Second, if possible, get a deposit for your mold, which deposit you will return when the mold is returned to you. Third, and this becomes particularly important if you do not get a deposit (and you almost certainly will not), put in a liquidated damages provision that applies if your mold is not returned when specified.

Taking these steps will not guarantee that you will see the return of your mold/tooling, but failing to take these steps virtually guarantees that you will not.

If you want to read more on Original Equipment Manufacturing (OEM) Agreements and on what they should be comprised, check out the following:

The other day we did an extremely long post on the legal issues of outsourcing.  That post was based on an hour long speech I had just given at an International Association of Outsourcing Professionals meeting, so it was very, very long. 

Since not everyone is going to read such a long post, I figure it a good idea to put out the basics and for that, I am pulling from an old article written by co-blogger Steve Dickinson, entitled, “Outsourcing in China: Five Basics for Reducing Risk.”  Here is that article:

Many small and medium sized companies that engage in outsourcing to China fail to take the steps necessary to protect themselves. When problems arise, they can do little or nothing to protect themselves because they have no legal basis for protection. The fact is that in most instances outsourcing disputes must be resolved in China, under the Chinese legal system. The Chinese legal system has improved greatly over the past ten years and taking a few basic legal steps can greatly reduce your risk. The cost of such protection is modest compared to the protection it will provide.

The following five basic steps will greatly reduce your problems with the Chinese company you are using for your outsourcing (be that a company a manufacturer or a software coder or whatever), while improving your chances of recovering damages should any problems arise.

1. Create and properly register your intellectual property rights in the United States. Before you go to China, be sure your intellectual property is protected under U.S. law. Protect your brand identity by creating and registering your trademark, slogan or logo with the U.S. Patent and Trademark Office. Register your important copyrights with the U.S. Copyright Office. Carefully identify and protect your trade secrets, proprietary information and know how. Consider filing for any appropriate patents.

2. Register your trademarks in China. Registration can protect your future access to the Chinese market, prevent the export of counterfeit goods from China, and prevent a competitor from registering your mark in China, which would prohibit you from exporting your own product from China. Consider filing for any appropriate copyrights and/or patents. For more on the necessity of registering your trademarks in China, check out “China Trademarks — Do You Feel Lucky? Do You?

3. Use a written agreement to protect your know how and trade secrets in China. Small and medium companies usually do not have an extensive portfolio of patents. Their most valuable intangible assets typically are their know-how and trade secrets, which cannot be protected by formal registration. Chinese law, however, permits companies to contractually protect their know how and trade secrets by contract. Such agreements may also address issues such as non-competition and confidentiality. For more on this, check out “Why Non Disclosures (NDAs) Alone Are Not Enough For China” and “Why Non Disclosures (NDAs) Alone Are Not Enough For China, Part II. At Least Make It Enforceable.’

4. Product Quality and Payment Terms. The rule here is simple. If possible, do not make final payment to your Chinese manufacturer until you are confident you will be getting an on time shipment of the correct items and quantities at the quality standards you require. This usually means you must incur inspection costs in China and provide for a clear procedure for dealing with these problems as they arise. You must take the lead on this. You cannot depend on the OEM manufacturer to do this for you. If you are going to pay anything upfront, you need an agreement protecting you. 

5. Use comprehensive OEM Agreements with each manufacturer. Small and medium sized businesses often enter into OEM manufacturing transactions with a simple purchase order. This is a mistake. The purchase order will protect the Chinese manufacturer, not you. Your protection depends on your securing a written OEM manufacturing agreement with each Chinese manufacturer with which you deal. The ideal OEM agreement will address all of the issues discussed above, while also addressing other basic legal issues such as jurisdiction and dispute resolution. This agreement should be in both Chinese and English, since the Chinese language version will control in China. For more on this, check out “China OEM Agreements. Ten Things To Consider,” “China OEM Agreements. You Are Naked Without A Good Bill Of Materials,” “China OEM Agreements. Yet Another Reason To Have One,” and “OEM Agreements in China: Why Ours Are In Chinese.

What do you think?

I admit it. The more depressing and violent and gritty the movie or the TV show, the more I like it. 

And as a lawyer, I take perverse pleasure in using gruesome stories to scare people straight. At my last speaking event, I told of how my old law firm had lost its insider standing with a Russian province when our paralegal’s father, who up until that time had been a key Vice-Governor in that province, came home to someone who threw acid on him and then killed him with an ax. The moral of that story? Guanxi is usually fleeting.  

But for some unknown reason, I am in a light mood right now (maybe it is because I watched the regular version of Law & Order tonight, rather than my usual Special Victims Unit fare) and so I am going to write not on the perils of outsourcing, but on the successes.  

And for that I am going to rely on a recent post by Clara Muriel Ruano at The Foreign Entrepreneurs in China Blog, entitled, “Sourcing from China: Who are the Happy Buyers?” 

The post starts out referring generally to the litany of China sourcing horror stories and then segues into a conversation with somebody “who is heading a representative office that helps source a number of goods to its headquarter.” Okay, I cannot resist with one downer comment. This person with the Rep Office that sources goods to its headquarters. They are operating on borrowed time because this sort of activity is, unless really limited, not appropriate for rep offices any more and since China is cracking down on this sort of thing…. 

Turns out this Rep Office is doing well with its China outsourcing and that made Ms. Ruono think about the people she has met “that could be (quite simplistically) described as “happy buyers” and realize they share the following characteristics:

1. “Happy Buyers” are into building long term relationships

a) They happen to be genuinely looking for “win-win” situations because they want (and more importantly need) long term suppliers.

b) They focus on strengthening the relationship because they are aware that not having big purchase orders they need to leverage on the relationship — and with that objective in mind, they make sure that they visit their suppliers very often… because in China things don’t get done by fax.

2. “Happy Buyers” approach price negotiation very professionally

a) They understand their supplier’s cost structure (how much goes into labor, materials cost…), and

b) They track commodity prices that are involved in their products

So, when a supplier comes back saying “I need to increase the price” they can:

a) Assess if there is a valid reason behind the request

b) Estimate what would be the fair cost impact

c) Objectively decide if they should give in (in future orders… not for this one!)

… All of which will positively help the long term relationship and both sides satisfaction.

And, of course, there are some other very basic things in common like having the right tools in places (contracts, good quality control…)… but for the purpose of this post I wanted to focus on the two I’ve mentioned above.

I know the above sounds rather simple, but I think it is mostly true. Though the above will not guarantee a happy long term sourcing relationship (free of vendor fade/quality fade), the above usually is in place in most of the long term successful sourcing relationships I have encountered. 

For more on what it takes to be happy sourcing from China, check out the following:

What do you think?

Yesterday, our post of a slightly revised email on China’s employment law from Steve to one of our clients was a hit in that we received emails thanking us for having run it. So today, we are going to run another Steve to client email on an Original Equipment Manufacturing (OEM) agreement we drafted, first in English and then in Chinese.

Here’s Steve’s email, slightly revised, setting forth some of the important considerations/issues when drafting China OEM agreements:

  • We need to determine whether the agreement with your manufacturer will be exclusive or nonexclusive. It appears you want to give the Chinese Company an exclusive right to manufacture a certain subset of your products, with other Chinese companies having the right to manufacture other of your products. Please confirm my understanding is correct.
  • We need to determine the Chinese Company’s obligation to sell. There are basically two alternatives. Alternative One: The Chinese Company is obligated to produce product under any purchase order you submit and its failure to produce at the agreed price would be a default. On the other hand, you would then be required to purchase a minimum amount of product during a specified time period. This approach is best if you want to guarantee supply and if you want to hold the Chinese Company to its commitment on price. Alternative Two: the Chinese Company is obligated to produce product only for those purchase orders it accepts. The Chinese Company has the right not to accept Purchase Orders, at its discretion. The advantage of this to you is that it will not require you to purchase any specific amount of product. The disadvantage is that there is no guarantee of supply and there is no way to hold the Chinese Company to any price commitment.
  • The agreement as drafted provides for a specific port of delivery. However, if you will have multiple ports and delivery locations, we should revise the agreement to provide that the port/delivery location will be specified in the Purchase Orders and we will remove these references from the agreement itself
  • We have drafted the agreement to have the pricing system set out in a separate exhibit. For this exhibit, note that you will probably need to have separate pricing systems for domestic purchase and export product. Domestic product has different shipping and title transfer rules and is also influenced by the lack of any VAT rebate. Since you have no presence in China, we would also have to consider exactly how a non-export sale would work. Purchases by one of your allied trading companies may be the solution here.
  • Section 3 of the Agreement provides for payment terms. This approach is very favorable to you, since it provides for payment 30 days after inspection, not 30 days after shipment. If you will provide for payment 30 days after shipment, you will need to determine when you will inspect the product. It is best to have inspection before payment, but this is not always practical.
  • Note that we have not specified a warranty period. The normal period is two years from date of shipment. One year from date of sale is not usually used, since there is no way for the Chinese Company to know when a sale is made. Two year warranties are common because the assumption is that the product will be sold sometime in the first year after shipment from China.
  • In the trade secrets/IP protection provisions, we have provided for a monetary penalty for breach. It is customary to provide for $10,000 for the lump sum penalty and 12% for the percentage of sales penalty. The penalty is intended to be large enough to cause concern for the manufacturer, but not so large as to scare them away. The issues raised in this section come up all the time in China, so these provisions must be considered carefully.
  • The tooling provisions provide for a series of lump sum penalties. Tooling disputes are among the most common in manufacturing agreements and we have found these provisions effective in dealing with this issue. Manufacturers commonly refuse to return tooling and the most effective way to control this is to provide for a significant lump sum penalty for such a refusal.
  • This agreement is written to favor you but be fair.
  • This agreement requires preparation of the following exhibits to provide for the variable and technical provisions of the manufacturing arrangement:
  • List of products
  • Performance criteria (specifications)
  • Product pricing method
  • Quality control and inspection procedure
  • A customer no contact list
  • Tooling List
  • Purchase Order

We can assist with drafting these Exhibits as necessary. It is customary NOT to translate these exhibits into Chinese.

A couple days ago, we did a post, entitled, Your Mold Done Gone To China And It Ain’t Never Coming Back, stressing how those doing China OEM Agreements need good contracts to protect their production molds and tooling. Earlier today, we did a post, entitled, China Consultant: Protect Thyself, focusing on how China consultants without good contracts with their clients are setting themselves up for legal problems.

I never expected to be proven so right. So soon. And certainly not in the same lawsuit.

The Bowling Green (Kentucky) Daily News just ran a story, entitled, Holley in Midst of Legal Struggle Over China Deal, that goes a long way in proving the importance of having good contracts when doing business in China, particularly when that business involves molds or consultants.

According to the article, about two years ago, Holley Performance Products began securing materials from China. Holley’s website describes itself as “the undisputed leader in fuel systems for over 100 years. Holley carburetors power every NASCAR team and every NHRA Pro’Stock champion. The Holley line also includes performance fuel pumps, fuel injection, intake manifolds, cylinder heads & engine dress’up products for street performance, race and marine applications.”

Seems that in February of this year, Holley was sued by Doug Smith, “an Ohio-based consultant who helped the company [Holley] secure a supplier in China.” Smith sued Holley for allegedly circumventing Smith by “using his supplier in China without his authorization.” Smith claims to be “on the losing end of the deal after spending more than 185 days in China helping Holley.”

Apparently angered about the alleged circumvention by Holley (see our consultant post to avoid this happening to you), Smith decided to”repossess” Holley’s tooling.  Holley did not take too kindly to Smith’s actions and sued for the return of its tooling:

‘In my last trip to China, I went to all the suppliers and repossessed their tooling,’ Smith said. ‘We had a counterproposal on the table on a Thursday night, but by Friday morning, I had a FedEx package on my front porch with a lawsuit to get their tooling back that they didn’t pay for.’

On November 9, 2006, United States District Court Judge Joseph McKinley issued an injunction ordering Smith return the tooling:

‘The judge gave them a temporary restraining order to give the tools back that Holley hasn’t paid for,’ Smith said. ‘And they’re trying to put me in jail right now. It’s absolutely amazing, they’re trying to put me out of business. It’s like legal stealing.’

Attorney Todd Olhms, who represents Holley, said that Judge McKinley issued a contempt order against Smith for not returning the equipment. The judgment ordered Smith pay Holley $10,000 per day until Smith complies with the court’s order to return the equipment.

Oh, and one more bit of advice for consultants and EVERYONE else: when a Federal Court judge issues an order requiring you to do something, you do it, and you do it even if you do not really want to do it and even if you do not think it is fair. Failing to obey a court order constitutes contempt of court and, as Mr. Smith has learned, the penalties for that can be quite severe.