Archives: manufacturing agreement

Every so often one of our China lawyers will get an email from someone who essentially challenges us to tell them why they should hire us. Our response is to patiently explain why they are wrong to think that they do not need a lawyer and to not so patiently tell them that it would probably not be a good idea for us to represent them. We do this because we long ago learned that taking on a bad client is never a good idea and that trying to convince someone to hire you who believes that do not need to do so never works out.

I got such an email the other day from an American company that seemed downright angry that one of our clients “had insisted” that they contact us:

________ at ________ [our client company] insisted that I contact you about our China manufacturing plans even though I have been doing business with China for more than twenty years.  ______ tells me that you believe that contracts with China manufacturers can be worthwhile but I know that it is the government there that determines everything. I want to stop my Chinese manufacturers from copying my products and selling them to my competitors. I doubt any contract can do this for me but can you lay out for me exactly how your company can help me, how long it will take and what you will charge. They just signed the attached NDA but ________ keeps telling me that I should have you modify it. If you are going to do that, I will need it back by the end of the week.  I also am enclosing a manufacturing agreement my lawyer drafted for me and I would appreciate your point of view as to how realistic it is.  We made it very favorable for my company.  It is approximately 10,000 words and so I also need to know what you will charge to revise it. I need this back by the end of the week as well.

Here was my response:

I hesitate to spend time on this because I do not think that you will retain us both because you have come to us too late for us to fix your NDA (which, quite frankly, does not achieve what you want it to achieve) and because you are neither going to believe nor like what I have to say. So I instead urge you to read  How To Stop Your Chinese Supplier From Becoming Your Competitor and China Contracts. Why Even Bother? and all of the links contained in these.

What you have done so far is unlikely to help you in dealing with Chinese manufacturers. It just does not sound like you have received good advice so far and I have to wonder whether that is because you have been hiring the wrong China attorneys (or no attorneys at all) or if it is because you are not interested in changing how you do business with China.

An American NDA with jurisdiction in Chicago is not likely to have any impact on a Chinese company. What you need is not really a China NDA at all, but an NNN (Non-Disclosure, Non-Use, Non-Circumvention) Agreement that protects you before you have actually chosen a particular manufacturer for your product.  This sort of agreement can go a long way towards preventing potential or future manufacturers from stealing your design.

The ability to sue in Chicago is not likely to give you any power over a Chinese manufacturer. The bottom line is that Chinese manufacturers do not fear foreign litigation as much as they fear being hauled into a Chinese court and hit with liquidated damages (or even worse, a pre-judgment seizure of their assets). The goal with our NNN agreements (and of all our China contracts) is to prevent the Chinese company from doing what you don’t want them to do, not so much to beat them if you end up having to sue.

There is no point in our using your existing NDA as a template because it would take us more time to do that than for us to use our own template and then modify that to suit your current needs. More importantly, non-disclosure isn’t really the risk you face; it’s non compete that really matters and your NDA is completely silent on that. Your biggest risk isn’t your Chinese manufacturer disclosing your product to someone else; your biggest risk is your Chinese manufacturer making your product.

I spent five minutes reviewing your manufacturing agreement and that was enough time for me to determine that too also isn’t close to what you need for China. Honestly, it isn’t close for what you would need in the United States either. It does not mention any penalties for bad quality nor does it set forth any sort of timeline. These two things are the most basic provisions one expects to see in such an agreement. It reads as though a non-lawyer cobbled it together from various contracts on the internet. You probably would be better off with no contract at all.

And there is no way that we can promise you anything by the end of the week because we do not even have a good idea yet of exactly what it is you really need. You are going to need to determine whether you are prepared to spend money to do things right in China contractually or just continue muddling through. You know what I would recommend, but of course it is entirely up to you.

I never heard from him again.

One of the themes we have been addressing for the last year or so is how the relationship between foreign companies and their Chinese product suppliers is maturing. A few months ago, in The New Role Of Written Contracts For Product Purchases In China we wrote of how rising product prices have increased the need for good contracts between foreign companies and their China product supplier and of how such contracts are becoming far more common.

There is an old saying that “good contracts make good partners” and that is even more true in a cross-cultural context, as we noted in China Contracts Make Sense:

A contract is the best way to make sure that you and the Chinese company with which you are contracting are on the same page. For example, if you ask your Chinese supplier if it can get you your product in 30 days, it will say “yes” almost every time. But if you then put in your contract that the Chinese company must pay you a penalty if it fails to ship your product within 30 days, there is a very good chance the Chinese company will tell you that 30 days is impossible. At that point, you and the Chinese company should figure out realistic shipment dates and put that in the contract. You then know what is actually realistic to expect by way of shipment dates and you can act accordingly with your own customers. Spending the time to negotiate a contract with your Chinese counter-party, especially if that contract is in Chinese is the best way I know to achieve clarity before you lock yourself into a relationship.

With this increase in contracts between foreign companies and their Chinese product suppliers has come an increase in what I would describe as good relations between these two sides. Though I do not ascribe the increased use of contracts as the sole factor in the rising level of the supplier-purchaser relationship, I do see that as a factor.  But whatever is causing it, I am convinced it is happening because I am more and more hearing from foreign companies that rightly describe their relationship with their Chinese manufacturer as a partnership.  Foreign companies are becoming more experienced at dealing with Chinese factories and Chinese factories are becoming more experienced at dealing with foreign companies.

And with these real partnerships comes a desire from both the Chinese manufacturer and the foreign product buyer to “take the business to a higher level.”  This desire typically manifests itself with the two companies wanting to sell their “mutual” product in China (and sometimes elsewhere in Asia) together or to develop new and better products together. Neither of these things are particularly legally complicated but both of these things call for new contracts.

If you are going to have your Chinese manufacturer selling your product in China, you should, at minimum, enter into a distribution and/or licensing contract with your Chinese manufacturer. Your manufacturing agreement is not going to cover even close to the various important matters that are involved with using another party to market and sell your product.

For what is involved in a distribution contract with a Chinese company, check out the following:

If someone else is going to be using your trade name or logo in China or elsewhere, either through a distribution or a licensing arrangement, you are almost certainly going to want to register that trade name/logo as a trademark to make sure you and nobody else have ownership of those trademark rights. Here’s some information on that: China: Do Just One Thing. Trademarks.

If you are going to work extensively with a Chinese manufacturer to develop a new product, you need a specific product development agreement. These agreements cover the cost and procedure for development and ownership of the developed product. Many companies fail to enter into this kind of agreement and then discover that the Chinese side owns “their” product and/or molds at the end of the process.

What are you seeing out there?

Renaud Anjoran over at the Quality Inspection Tips blog recently wrote on “How your Chinese suppliers might become your competitors.”  Anjoran provides some excellent suggestions for preventing your China supplier from competing with you, based on his notes from a talk by Paul Melkebeke, Vice President Supply Asia for Samsonite.

Melkebeke talked of how building a brand and a distribution network is a long-term investment.  No doubt about that.

He then noted how Samsonite protects its IP by all available means — patents, design registrations, copyrights, Non Disclosure Agreements (NDA), etc, but these things are “not enough.”  I completely agree.  Companies must do everything they can to protect their IP from China and from elsewhere and doing this requires more than just registrations and contracts, as we noted in our post, How To Protect Your IP From China. Part 2:

Though there are, of course, particular protections you can and should employ depending on what you are doing in China, it will almost always make sense for you do to do the following four things.

  • Do business with the right people in China. Companies with nothing to lose are far more likely to take your IP than those with established businesses and reputations and incentives for not getting sued.
  • Think about what you have that needs protecting. What do you have that others want? What do you have that your competitors would love to get their hands on? Is it your technology?  Your customers?  Your brand?
  • Figure out how you (not your lawyer) can protect what needs protecting. Can you break into subparts whatever it is that you want to protect so that nobody in China gets access to the full thing? Can you get away with sending an older version to China? Can you lock it down in your building in China or on one computer such that your employees cannot leave with it? Can you keep the key portions on a server in the US?  These sorts of protections are usually called structural protections and they can be absolutely critical.

Melkebeke noted how Samsonite helps its suppliers improve on efficiency and quality, knowing that the supplier’s other customers (Samsonite’s competitors) will also benefit from these efforts. This is a really important issue and one that is difficult to address. One way to handle this is to become the exclusive buyer from your supplier. But if you are not Wal-Mart, the odds of your being able to achieve that are incredibly slim.  We have had clients that have purchased equipment for their Chinese suppliers with the proviso that equipment can be used only to make our client’s product. This too is pretty rare though.

Melkebeke noted how “many suppliers compare their FOB price to Samsonite’s retail price, and think it is all profit. Many of them start their own brand and push for distribution. But retail space is not cheap in China, and these companies are not expert at this game, so they end up losing money. So far, none has been successful.”  This is something we often discuss with our manufacturing clients that outsource product to China, especially when they claim that “there is no chance our Chinese manufacturer will ever be able to compete with us.” I often give the following example:

We had an outdoor equipment manufacturer (“USA Company”) come to us after its Chinese manufacturer (“China Manufacturer”) had stopped making outdoor equipment for USA Company. China Manufacturer had not only stopped making outdoor equipment for USA Company, but it had also registered USA Company’s brand name as a China trademark in over a dozen different categories/classes (this was before China prohibited this sort of thing by agents).  China Manufacturer’s plans were to sell the outdoor equipment to the two large hardware store chains to whom USA Company had been making the overwhelming bulk of its sales.

China Manufacturer completely struck out in its efforts to sell its own products to the two large hardware store chains. China Manufacturer went to those chains and offered to sell its product for about half the price of what USA Company had been selling them, but both hardware chains basically threw it out because China Manufacturer had no plans and no ability to maintain constant stocking of the products and no plans and no ability to repair the products and no plan and no ability to handle returns and other customer service needs. China Manufacturer’s plans to sell directly into the US market were essentially a joke.

Nonetheless, China Manufacturer had done huge harm to USA Company’s business.  USA Company had to scramble to find a new supplier (it succeeded) and it also had to figure out how to get its products manufactured and shipped out of China without violating China Manufacturer’s trademarks (it did, by securing a trademark for small engines and then prominently plastering its name on the small engines of all of its outdoor products).

The moral of the above story is that you cannot count on your Chinese manufacturer not trying to compete with you even if doing so makes no sense at all.

Melkebeke went on to note how the internet has broken down selling barriers and OEM manufacturers can sell their products online, but only at “a very low price” and “this is not the way to build a brand.”  China is Samsonite’s second largest market after the US. According to Melkebeke, Chinese consumers are willing to pay a premium price for Samsonite product and are “as picky as Japanese consumers.”  Because of this, despite helping its manufacturers improve, Samsonite is not really hurt by suppliers that try to compete with Samsonite because Samsonite prevails because of its quality and brand recognition.  But, Melkebeke rightly notes that companies with a weak brand, and in certain categories (e.g., electronics, where components and specifications are easily compared) are at much higher risk of losing business to a China supplier that seeks to compete with them.  I completely agree.

Anjoran then wrote about how Melkebeke advocated for employing legal methods to keep suppliers in their place, “even if they are not 100% effective.”

The first comment to Anjoran’s post stated that “legal contracts are next to useless in most cases unless you are a Samsonite or an Apple. For SMEs, the only sustainable strategy is relentless innovation.”  I completely disagree.  

From the legal side, there is a lot that can be done to protect yourself from your China supplier, even though, like anything else, these things will not work 100% of the time.  But really, legal protections are probably more important for small and mid-sized companies than for a massive company like Apple!

Let me explain.

First, I would urge everyone to read a post we did last week, entitled, The New Role Of Written Contracts For Product Purchases In China, in which we talked about how the importance of having real contracts with Chinese suppliers has increased and of how American companies are reacting to that:

This approach is changing and more and more foreign buyers are entering into long-term purchase contracts with their suppliers (typically called OEM Agreements, Manufacturing Agreements, Product Supply Agreements, or Product Sourcing Agreements). There are several reasons for this trend.  Probably the most important reason is the drive for standardization on the part of buyers. Chinese product is just one part of a worldwide supply chain. Major retailers have diverse sources of product. All product has to meet a basic standard to fit smoothly into the chain.  Product that is delivered late or that does not meet specifications fouls up the chain. Product that is subject to an intellectual property infringement challenge or that contains pirated, non-standard parts or that contains a non-standard component that raises safety issues disrupts the supply chain.

In the early days of buying product from China, the price was so cheap that these non-compliance issues and their resulting costs were simply absorbed by the foreign buyers at each stage of the purchase chain. However, in the current environment of tight supply chain management, the disruption is normally quite costly and cannot be tolerated by retailers already financially stressed by the current economic environment. As a result, retailers are imposing strict standards on their direct suppliers. The strictness of the controls and the magnitude of potential losses mean that foreign buyers can no longer simply absorb the costs of non-conformance by the Chinese manufacturers.

Foreign buyers now have no choice but to impose the same standards on their Chinese suppliers. Thus foreign buyers must enter into written contracts for product purchases from their Chinese suppliers that mirror their own obligations to their major retailer customers. These contracts must be supplemented with detailed supplier manuals and codes of conduct that seek to regulate the day-to-day business operations of the Chinese manufacturers.

None of this is unusual in North America and Europe, but the approach is very new to most Chinese export oriented manufacturers. The purpose of these agreements is quite simple. The purpose is not to make the situation better but rather to impose liability for non-performance directly on the Chinese manufacturer. That is, the foreign buyer is saying: “I no longer will simply absorb the costs caused by your lack of compliance with the conditions of sale. If you (Chinese manufacturer) do not perform, I will suffer a loss and I am going to pass that loss on to you.”

Second, check out our post from 2011, entitled, Getting Started On Manufacturing In China. The Legal Basics.  In that post we set out the legal basics for manufacturing product in China, in the form of a response to a typical email from a US company seeking to have its products manufactured in China:
The first two things you will likely need are a Non Disclosure Agreement (NDA) and a registered trademark in China. We prefer to do what we call an NNN Agreement — non-disclosure, non-use and non-circumvention. This is an agreement that you use when you are trying to find manufacturers for a product. You have the manufacturer sign the agreement before you show them the product. It prevents manufacturers from stealing your design for themselves and from going around you to sell the product to your US customers.

Here is some more information on NDAs/NNNs:

If you are not concerned about manufacturers in China copying your designs, you do not need an NDA/NNN Agreement.

The one thing you will almost certainly need to do (but maybe not right away) is to register your trademark in China. Before you use any of your trade names (think brands or product names) or trademarks in China (think logos), you absolutely must register them in China or someone else almost certainly will and then you will not be able to use your name in China, even if all you are doing is exporting your product from China. Here’s some info on that: China: Do Just One Thing. Trademarks.

Depending on your situation, you may also want/need a Product Development Agreement. If you are going to work extensively with a Chinese manufacturer to develop a new product, you need a specific product development agreement. These agreements cover the cost and procedure for development and ownership of the developed product. Many companies fail to enter into this kind of agreement and then discover the Chinese side owns “their” product and/or molds at the end of the process.

Once you have chosen the manufacturer for your widget, the next thing you will need is a Manufacturing Agreement (these are also called supplier agreements and OEM Agreements). Many US companies do all their manufacturing in China based on purchase orders. This is very bad for the US side. A good manufacturing agreement covers IP, quality control, NNN issues, warranty, ownership of molds, tooling, supplies, diversion, dispute resolution, and all the other various issues that arise in a manufacturing relationship.

Here is some more information on Manufacturing Agreements:

But what is a small company to do?  The above.  But what about the idea that contracts are “useless” for small companies?  I am not sure why this commenter said this, but I do know that small companies often ask me whether it is worth having a contract if they cannot afford to sue to enforce it.  I often respond by saying that if they cannot afford to sue on a breached contract, they also cannot afford bad product and that is all the more reason they need a contract.  There are many reasons to have a good contract with your Chinese supplier and suing on a breach is but one of them.

As anyone who has been involved in litigation anywhere in the world will tell you, it is a horrible thing. It is expensive, time consuming, and imperfect. Litigation signifies the end of discussion between parties and, as such, it should only be undertaken after all other avenues have been exhausted. As I am constantly telling clients, “if you have to sue, you have already lost. You can win the litigation, but even so, you will have lost.”

Litigation virtually never brings anyone a complete remedy.  If you are owed $250,000 and you sue and the court awards you $250,000 and the other side pays you in fairly prompt order, you still have not achieved a complete remedy.  What about the time you spent trying to settle the case before suing? What about what you might have done with the $250,000 had you received it sooner? What about your attorneys’ fees in dealing with the problem? What about all the time you and your employees had to spend on the case?  Litigation is not a complete remedy, which just underscores point number 1 on how it should always be a last resort.

There is huge value in having a contract with your Chinese counterpart that has little to nothing to do with winning a lawsuit. Even if you never intend to sue anyone in China, it makes sense to have a good contract, preferably in Chinese.  There are three main reasons to have a good contract, and suing and winning on it is only one of them.

One of the main reasons for having a good contract with your Chinese product supplier is to make sure that the two of you are on the same page. We wrote about this reason in Chinese Manufacturing. Delivery Date? What Delivery Date?:

One of the most common problems we see between American companies and their Chinese manufacturers is “late” delivery.  I put late in quotes because many times I think the problem is not so much that the Chinese manufacturer was late, but rather that the contract and the American buyer were unclear on the actual delivery date requirements.

Let me explain.

When we draft an OEM Agreement (a/k/a Manufacturing Agreement or Supplier Agreement), we are always very careful regarding delivery times.  Most of the time, our clients come to us with a term sheet or an oral agreement with their Chinese manufacturer dictating something like 30 days for delivery.  We like strictly tying the Chinese manufacturer to the “agreed-upon” delivery time and we usually do that with a liquidated damages provision tied to late delivery.  Just by way of example, we might put into the OEM Agreement a provision saying something along the lines of delivery shall be within 30 days and for every day beyond thirty the Chinese manufacturer shall be required to pay US Company 1% of the purchase order price within ten days.

Perhaps more than any other contract provision, we tend to get blow-back on the delivery time provision from the Chinese manufacturer. Oftentimes when faced with the reality of having to pay a set amount for late delivery, the Chinese manufacturer gets really serious about delivery times and tells us that they simply cannot promise delivery within the previously “agreed” time frame.  Our client usually realizes it is better to get real agreement (even if longer than originally anticipated) before ordering, rather than getting late delivery after ordering.

The other, somewhat related issue we face on delivery times is that when our client comes to us and says it has agreed with its Chinese manufacturer to a 30 day delivery schedule, we then have to figure out 30 days from what.  We typically go with 30 days from the issuance of the purchase order, but oftentimes the Chinese company pushes for it to be 30 days from its receipt of payment or 30 days from its receiving proof of payment.

Bottom Line:  Certainty is important with respect to delivery dates and, without a doubt, the best way to achieve that certainty is a written contract, in Chinese (so that there is no doubt the manufacturer understands what is on the paper) clearing setting forth the delivery date.

In my view though, the main reason to have a good contract is to prevent problems on which you might need to sue:  We wrote about this way back in 2006, in China OEM the Smart Way:

The best solution for this is to prevent it from happening in the first place and the best way to do that is to choose the right supplier and use a good OEM contract.  When we draft OEM contracts for our clients, we always put in a provision precluding the Chinese manufacturer from subcontracting out production. Without exception, the Chinese manufacturers have agreed to this provision and, again without exception (at least as far as we know), they have always abided by it.  The reason for this is simple.  The manufacturer may have twenty some companies for whom it produces goods, but probably less than half of them forbid subcontracting.  When the Chinese manufacturer is so busy as to require subcontracting, it makes sense for it to first subcontract out work for those foreign companies for whom it is NOT prohibited by contract from doing so.  I am always analogizing this to bike locks.  Even the best bike lock cannot prevent all thefts, but its efficacy comes from the fact that bike thieves generally find it easier to steal a bike with a poor quality lock or none at all than one that is difficult to break.

Any contract that makes your Chinese counter-party think twice about messing with you has at least some value.  My law firm has settled a number of matters with Chinese companies based on well-written contracts, but we decline to take on cases without contracts.  Having a well written contract does not mean you will always win your lawsuit if you are forced to sue on it. But it does mean you will have some leverage if things go wrong and it does mean you will at least have a chance. Having no contract means no chance.

How do you stop your Chinese supplier from becoming your competitor?

  1. Choose the right Chinese supplier.  A company that is thriving has a lot more to lose than one that is tanking.
  2. Register your intellectual property (trademarks, copyrights and patents).
  3. Make sure your supplier signs well-written (preferably in Chinese) contracts that forbid it from competing with you or improperly using your IP.

It is that simple.

What do you think?

Every December, we get an even greater than normal number of phone calls from companies that have received bad product or no product at all and the past two weeks have been no exception.  And as is almost always the case, I blame the “victim.”

I blame the victim because without exception, in every single case where we have gotten such a call, the non-Chinese buyer has done a lot of things wrong in its sourcing of product from China and now it is, to put it somewhat harshly, paying the price for that.

But what so often really drives me nuts about these people is that after I tell them exactly why my law firm has zero interest in their case, some of them say something like “I knew you can’t trust Chinese companies” or “I knew they had no law there” and then they usually say something like “I’m never going to do business there again. The risks are just too high.”

Wrong. Wrong. Wrong.

What I always want to tell them, but pretty much never do, is the following:

What are you talking about?  You did NOTHING to try to protect yourself.  You didn’t research the Chinese company before sending them money.  You didn’t use anyone to monitor quality control.  You didn’t use anyone to write you a contract that would actually work in a Chinese Court.  So really, what did you expect? I hate to tell you this, but we have hundreds of clients who buy from China all the time and they almost never experience anything close to what you are going through.

It reminds me of a relative I have (not on my side of the family, I might add), who during the tech boom would brag about how he had gotten so good at the market he would be earning 20% a year forever.  Yes, he actually said that.  But what is even more interesting is that after the market crashed and he lost a ton of money, he then started preaching how the market was rigged and he would never buy stocks again, not once even referencing his prior claims.  As my older brother the stockbroker is always saying, “genius is a rising market.”  But the corrollary to that for this relative is that a falling market is a rigged market to be avoided by everyone.

Wrong. Wrong. Wrong.

Just like there are ways to do well in the stock market (over time), there are ways to do well in the China product sourcing market.  The way to increase your odds of getting the product for which you paid is to do the following:

1. Make your product purchases from China under a well-drafted contract that is enforceable in China. Purchases under informal purchase orders simply do not work for China.  For more on China OEM Agreements, check out the following:

2. The contract with the Chinese manufacturer must provide for a mechanism where the foreign buyer can exercise constant control over the quality of the Chinese product. Liability for defect must be made clear and it must fall hard on the Chinese side. If possible, no defective product should ever be permitted to even leave the Chinese factory. If defective product is discovered outside of China, the Chinese side must be absolutely liable for dealing with the problem. The standard procedure (in China, anyway) for dealing with defects through a discount on future purchases must not be used.

3. The foreign buyer must actually follow through and constantly monitor the quality of the product. The best contract with the best procedure is no good if the foreign side does not follow through by rigorously implementing the procedures outlined in it. As I mentioned above, this is an expensive and tiresome process. Parties that do not follow through are almost guaranteed to experience problems in China. These problems are an irritant to the Chinese side but can be fatal to the foreign side. For this reason, the only side that has any incentive to follow through is the foreign side.

Is China product quality getting  better?  Yes and no. Chinese manufacturers are not doing a better job on their own at maintaining quality. In fact, if left on their own, much evidence suggests they are doing worse. But yes, the legal system and quality control systems have progressed to the point where aware and active foreign companies can force Chinese manufacturers to operate in a reasonably acceptable manner. “Forcing” means doing things right.

What do you think?

Renaud Anjoran at the always on the money Quality Inspection Tips Blog has a post, entitled, “The 10 components of a good quality assurance strategy in China,” that very nicely lays out what it takes to get good product from China. The post breaks out the ten components of effective China product sourcing into the following four “themes”:

  1. Qualification of new suppliers
  2. Purchasing method
  3. Quality control
  4. Buyer-supplier relationship

Renaud calls for buyers to do the following (my comments are in italics):

  1. Conduct a background check on your potential supplier. Make sure they really are the factory, and not just an intermediary entity.  Agreed
  2. Audit your factory.  Agreed.
  3. Make sure the factory is the right fit for you, particularly in terms of size.  Agreed. 
  4. Avoid paying 100% upfront and use a good OEM Agreement.  Agreed.
  5. Make sure your own company follows its buying procedures.  Agreed.
  6. Define very clearly what you want from your Chinese factory and make sure that the factory understands what you want.  Agreed.
  7. Regularly perform quality control inspections, as appropriate.  Agreed.  A good Manufacturing Agreement is important, but it is not sufficient.
  8. Stay with the same supplier as long as the relationship is good, rather than abandoning them to save a few pennies somewhere else. Completely agree.
  9. Visit your factory on occasion to meet with their people face to face.  Agreed.  I am convinced that those factories that “know” their buyers and have real relationships with them are much less likely to provide them with bad product. 
  10. Contribute to your factory’s improving its operations.  Interesting idea. 

If you are buying product from China or planning to have your product manufactured in China, I suggest you read Renaud’s entire post.

What do you think?  Anything else that should be done to ensure you receive a quality product from your China manufacturer?

We generally think the best way for us to draft China OEM Agreements is for our clients to reach oral or “term sheet” agreement wtih their Chinese manufacturer and then come back to us with the tersm. We then draft the OEM contract based on those terms (and many more) and our client then presents the agreement to its supplier. At that point, the Chinese product supplier either signs or additional negotiations ensue.

A few weeks ago, a regular client of ours was heading to China to negotiate a supplier agreement (OEM Agreement/Manufacturing Agreement) with a new supplier. This client sent us an email a few hours before it was to meet with its soon to be new manufacturer The email listed out the following “deal points” and asked us what more they should get clear with their new factory:

  • payment 50% by LC, 50% net 45
  • tooling amortized over 30,000 [widgets], with remainder due after 3 years if 30,000 [widgets] is not met.
  • sales samples charged at 1.5x confirmed FOB pricing.

The client’s email noted that the following still needed to be discussed:

  • agreement and process in case of defective pairs;
  • agreement in case of late shipment.

We responded by suggesting our client at least consider the following as well:

  • Identify the entity that you will be paying; it may not be the factory itself but rather a holding company in Hong Kong/Singapore/Taiwan/etc. In general, unless this entity is acting as an import/export agent for the factory, the contract will be with the entity you are paying, and if things go South, your recourse will also be against that entity.
  • Think about more than just shipping terms. Think also about packaging terms (for each [widget], for each box, etc.)
  • You ABSOLUTELY want an inspection clause. Quality control is extremely important. In an ideal world, you would inspect after delivery and before you pay a dime. But few contracts are ideal. Think about when you want to inspect (probably both before and after delivery).
  • What will happen with defective product? The inspection process is closely linked to what you do with defective product. The worst outcome for you would be for the factory to sell your defective [widgets] on the grey market. Do you want to witness the destruction of defective product? Require a certification of destruction? Have the defective [widgets] shipped to you so you can destroy them? Something else? Also, think not just about when to inspect, but of what an inspection will consist. Will you inspect every [widget]? A statistically significant number?
  • What will constitute “epidemic failure”? Five percent of a shipment? Three percent?
  • Think about warranty provisions, and how they will be implemented. How long will the warranty last? Who will pay for you having to ship back the returns?
  • Think about timing — late shipments are obviously bad, but early shipments can be bad too, especially for seasonal items.
  • How and when will prices be determined? If the factory wants to change prices, how much notice must they give you? Are there built-in volume discounts?
  • What happens if you submit a purchase order and the factory doesn’t accept it? How long do they have to accept or reject a purchase order?
  • How much lead time must you give between a purchase order and the delivery date for that order?
  • Will you be selling the [widgets] all over the world? Will you be selling them in China?
  • Will the factory be using subcontractors? Do you care?
  • Do you want to restrict the factory from working with and/or contacting any of your competitors?

You do not need to answer all of these questions for a term sheet, but you should at least start thinking about them.

What do you think?

For more on China OEM Agreements, check out the following:

Yesterday, I did a post, entitled, “Drafting A China Manufacturing Agreement. Watching The Sausage Get Made,” seting out many of the questions we typically ask our clients before we begin drafting their OEM agreements. A reader, Phil,  left us the following comment to that post:

Can I ask about the wording of your agreements in Chinese? A deal I’m involved with has been running into a lot of trouble because the American law firm who wrote our contracts have written them in highly complex legalese, very different to the language of Chinese law and standard Chinese contracts. In the third tier city where we are trying to operate, our partner and potential collaborators are having real trouble just reading and understanding the documents. (I’m a translator, and I’m reasonably sure that both sides are right on this – the contracts are correct, but they really are very difficult to read.)
How does your firm walk the line between the conventions of English (American) legal drafting and Chinese drafting?

Great question.

We write our contracts the modern way. By that I mean that we eschew legalese (and using strange words like “eschew“) and we strive to avoid unnecessary boilerplate. This is true of our contracts in both English and in Chinese. Most importantly though, we do not really need to “walk the line between the conventions of English (American) legal drafting and Chinese because of how we draw “the connection” between our English version of a contract and its Chinese version.

When we draft a contract for a client, we first draft it in English. We do this for the benefit of the client and we work with the client using the English language contract. Once we have finished the contract in English, we then move on to re-writing it in Chinese. Notice how I did not say “we then translate it into Chinese.” We use lawyers and only lawyers to take the English and re-write it into Chinese and the re-write is not a direct translation. 

Just the other day, in an effort to save a few bucks, a potential client asked me if we would reduce our flat fee on a contract by $300 if he had his own people translate our English version into Chinese. My response was that if we gave such discounts, it would be greater than $300, but that my firm will not do a China contract unless we do both the English and the Chinese. As I wrote in “No China Translation. What Were You Thinking?” and in “Dual Language China Contracts Double Your Chance Of Disaster,” we do not write dual-language contracts. The contracts we write have one official language and that language is nearly always Chinese. 

I love it when a blog post just lands in my lap, and one just did. It is a couple of emails from two of my firm’s lawyers to two different clients, both of whom recently retained us to draft OEM Agreements for production of product by factories in China. Both clients are in the process of changing their Chinese manufacturers and this time around they want a strong and enforceable supplier agreement with their new Chinese manufacturer.

I am doing this post to give an idea of some of what should go into a Chinese manufacturing agreement.

Since we have a fairly standard initial questionnaire we send to our clients when we being working on China OEM manufacturing agreements, I have combined the two emails into one, further camouflaging the companies involved. Here are the questions posed by the emails:

  • What is the name and contact information of the Chinese manufacturer?
  • What sort of products will the Chinese manufacturer be making? Do you anticipate that these products will change over time? Will the volume change over time?
  • Where do you anticipate selling your products In particular, will you be selling it in China?
  • What are you expecting regarding shipping terms?
  • Will you be using this OEM agreement only with this specific Chinese manufacturer, or will you be wanting to re-use it with others?
  • What arrangements will be made for packaging prior to shipment?
  • Are you concerned about your manufacturer going around you by directly selling a competing product your customers?
  • Exactly what will you want to be  done with any defective product?
  • Do you have an existing purchase order (PO) that you intend to use for your product orders from this manufacturer? If so, please provide us with a copy.
  • How are you anticipating pricing and other terms will be negotiated? On a purchase order basis? On an annual basis? Some other way?  If you submit a purchase order and is not accepted by the Chinese side, what happens? In other words, is the Chinese side bound for some period to make a certain amount of product at a certain price, or is the Chinese side only obligated to make product for you after it accepts your purchase order?
  • How many of the deal terms have been negotiated at this point? From the documents you have sent us, it appears that only the very basics have been negotiated: 40% down, 60% before delivery/shipping, plus certain quantity discounts. These are not great terms from your standpoint, but fairly typical for deals with manufacturers in Southern China (i.e., Shenzhen, Guangdong, etc.).
  • What sort of arrangements have you made for inspection and quality control, and what sort of warranty terms have you negotiated? This question is particularly important in that many manufacturers in the south of China insist on a no-warranty provision.
  • What are your main concerns in this deal? I ask this both so I can focus on the provisions that matter to you, and because it can help determine the choice of law and the choice of venue. From what I know so far, your main concerns seem to be twofold: (1) getting a high quality product and (2) protecting your intellectual property (i.e., ensuring that the Chinese manufacturer does not sell your product behind your back and/or steal your tooling).
  • What exactly is the tooling for this product? Does the Chinese manufacturer already have all of the tooling in question?
  • Has the Chinese manufacturer already signed an sort of agreement/memorandum of understanding (MOU) with you, even if only in English?
  • Are there any unresolved issues involving your previous manufacturer ? For instance: have you gotten all of the tooling back from the previous factory? Are there any outstanding invoices or payments due?

After we get answers to the above questions, we virtually always write back with a whole slew of follow-ups.

For more on what it takes to have/create a good OEM Agreement, please check out the following:

Someone called KAS just left us the following comment:

We have a pretty blatant patent infringement where the Chinese manufacturing company (with whom we have a contract) has sold the product to Australia. Our goal is to shut down the sales in countries outside of China, e.g. Australia. Under these circumstances, would it make any sense to sue? We are just starting down this path and I do not want to waste my client’s money. Thank you for your informative posts.

For various reasons, we virtually never answer comments seeking legal advise. The main reason we demure is simply because there is usually no way to give a real answer without knowing all of the facts and without going into great depth as to the additional facts needed. And that is definitely true here as well.

This comment raises such an interesting question and it so well highlights the sort of initial analysis that goes into answering these sorts of fairly typical questions, that I am going to venture an email like response (without a “yes” or a “no”) as though this comment had just come to me via email from a potential client.

Dear KAS,

For us to be able to know whether it would “make any sense to sue,” we would need to gather up all sorts of additional information from you and then conduct our own research regarding various aspects of it. At this point, I am going to give you a taste of just some of what more we would need to know and if you wish to continue the discussion, I would urge you to answer the questions below and then we should follow that up over the telephone. 

For us to have any sense at all regarding whether you should sue or not, we would want to know the following:

  1. Is there really a patent infringement?  You say it is pretty blatant, but what do you mean by that? We would first need to see your patent and then see exactly what it is you say is infringing it.
  2. Where do you have this patent? If, for instance, you have this patent in the United States and nowhere else, your case is not looking so good. This is because for you to assert patent infringement against a company that is manufacturing your product in China and selling it in Australia, you almost certainly (note how lawyers always hedge a bit) will need to have a patent in either China or in Australia.
  3. Where do you propose suing this Chinese company? if you propose suing the Chinese company for violating your Australian patent, you probably (yes I know I am hedging again, but without conducting the specific research, I am always hesitant to say that anything too strongly) can only sue in Australia. If this Chinese company does not have any assets in Australia, there will probably be no point in suing it in Australia unless you can then take your Australian court judgment to China and enforce it there. i know that Chinese courts do not enforce US judgments but I do not know whether or not they enforce Australian ones. It is possible that they do and that is something it may end up making sense for us to research.
  4. Alternatively, if you have a Chinese patent, then your best bet may end up being to sue the Chinese company in China.
  5. What are your damages? Patent lawsuits anywhere are expensive and so if this Chinese company is not hurting your profits all that much, it may not be worth suing it. Of course, the fact that it may not be hurting your profits all that much right now does not necessarily mean that things may not get a lot worse and you may determine that it is critical for your business that you sue to stop the infringement. This is something we will need to discuss.
  6. Do you really have a valid patent? I hate to pose this question, but I must. Patent boards are notorious for being easy in granting of patents that courts then hold should never have been granted in the first place. We will certainly need to look at this issue.
  7. You say that the Chinese company infringing on your patent is (or at least was) your own manufacturer. Do you have a contract with that manufacturer?  I can tell you that when my law firm writes a China manufacturing agreement for our clients, we almost always put in provisions forbidding the Chinese company from copying our client’s product for itself or for others. I am very much hoping your contract has something similar and that it also provides for you to be able to sue the Chinese manufacturer in China and to receive liquidated damages for contract breaches. If all those things are true, you may very well have a good case against this Chinese manufacturer in China. Please send me the contract so I can review that. I am also hoping that your contract is in Chinese as that will make things go a lot smoother in any lawsuit in China. 

Once we get answers to the above, we will have a better sense of whether it will make sense for you to pursue litigation (or anything else) against the Chinese company. At that point, we will also be in a much better position to give you suggestions on how best to proceed and the estimated costs of the various options.  In the meantime, please don’t hesitate to contact me if you have any further questions.

The other day I received an email from a college student looking to form a business that would buy product from China and sell it in the United States. The email asked about the steps to take to get such a business going. Here is that email (modified slightly to maintain the anonymity of its sender):

I am an American college student studying International Business and Chinese at ______ University. This past semester while studying abroad at in China a friend of mine, _______ (who met you in Chengdu), turned me on to the China Law Blog.

A few friends and I have decided to start a company soon after graduating next May. The company will produce and sell product X, starting in the U.S. and then moving to China and elsewhere abroad. Right now my friend’s father is developing the prototype product X, which is coming along with great success. In the meantime, we our trying to structure the company and figure out the logistics of the start-up.

I’m seeking your advice because we want to manufacture product X in China but don’t know how to get started. I have often read your articles describing the risks/dangers of manufacturing there, and I want our company to approach the production of our product in a smart, cautious way. Once the prototype is complete, how do we go about finding reliable manufacturers in China for our product? I know about the importance of protecting IP rights and (some of) the differences between contracting in China vs. America, but I want to know: what is the next step after the our prototype is complete and we have buyers? Where should we go from here??

Thanks a lot for your time and consideration! I hope to hear from you soon.

I responded as follows:

Thanks for writing and thanks for the loyal reading.

1.  Form a US company (probably an LLC) and have a good member agreement drawn up among the owners.  Hire a local lawyer for this.

2.  Make sure your IP is protected in your primary selling market (the United States?).  I doubt you will have anything that can be patented, but that should be a consideration.  Patents are very expensive, however.  If you are going to call your product, product X (that sounds good to me), you should trademark that in the United States.

3.  Now find the manufacturer. There are many ways you can go about this. The best and usually the cheapest is to do tons of internet research and then narrow it down to 4-5 and then fly to China and meet with those factories. If you are going to be doing something really different than other people making this product, you should require the factories sign a Non Disclosure (NDA) Agreement (read about these on the blog) before you show them anything.  This should be in Chinese and in English. The alternative is to hire a sourcing company to find the right factory for you and to negotiate on your behalf. If you choose that route, we can give you names of the people we know and trust who do this. These people can also usually help with things like shipping as well.

4.  Then have a really good agreement with the manufacturer and you need to trademark your product name in China and you should be good to go (assuming your product does not call for a China patent). This agreement with the manufacturer is called an OEM Agreement, a Manufacturing Agreement or a Supplier Agreement and this should be in Chinese and in English as well.

I am sure I have left  out a few things, but the above are the basics.

Good luck.

What do you think?