Archives: Product outsourcing

During the first 25 years of China’s opening up process, joint ventures were the favored vehicle for FDI in China. In 2005, the favored form of investment shifted away from JVs to direct investment through WOFEs (Wholly Foreign Owned Entities). During the last year, however, foreign SMEs have been shifting away from WFOEs and back to joint ventures. An even more dramatic shift has seen SMEs decide not to have any direct involvement in China at all. For these companies, licensed manufacturing and sales has become an attractive alternative.

The shift away from WFOEs has occurred because of the worsening environment for small private businesses in China.  Consider just the following in terms of the shift that has occurred in the last ten years:

  • Taxes: In 2003, WFOEs operated in China tax-free. WFOEs are now subject to basic income tax, VAT taxes and a host of local taxes and fees.
  • Wages: In 2003, Chinese wages were some of the lowest in the world. Now, the wage for the average worker on the coast is higher than in Mexico. In 2004, a WFOE could hire and fire workers at will and employ them for as many hours a week as the workers would tolerate. Now, employment is subject to a strict employment contract law system that makes firing workers difficult or impossible and that requires overtime for work in excess of 40 hours per week.
  • Benefits: In 2003, foreign employers could safely ignore paying benefits to their workers. Now, foreign employers are required to pay benefits to both foreign and Chinese employees that amount to almost 40% of the employee wage.
  • Rent: In 2003, rent in Chinese cities was low by world standards. Employers who located outside the major cities often negotiated free rent merely by agreeing to locate in a rural or relatively undeveloped area. Now, free rent is unheard of and rents in general are some of the highest in the world.
  • Environmental and safety regulations: In 2003, a foreign manufacturer could operate in China with minimal concern about environmental and safety regulations. Now, in virtually all jurisdictions, the Chinese authorities require compliance with relatively strict standards.

As this list of major changes shows, the business environment for foreign investors in China has changed dramatically in just one decade. However, many foreign companies that are planning operations in China assume the situation is the same as it was in 2003. It is a nasty shock to most when they evaluate their potential China operation under the current conditions.

Stated simply, many small WFOEs simply do not “pencil out.” However, because China remains an absolutely critical market for countless foreign companies, simply abandoning the China market is not feasible for many. Companies that must operate in China are starting to shift their Chinese investment plans. We are seeing two trends along these lines:

First, joint ventures are experiencing a revival. In the most basic situations, what the joint venture means is that the foreign investor is saying to its Chinese partner: we cannot make this project work by ourselves in China. We need your help. We will provide you with funding and expertise. What we want from you is management and guidance to allow the venture to earn a profit in this difficult environment.

In addition, more complex forms of joint venture are being considered. Two variations we have seen lately are:

  • The foreign company has technology but no money and no ability to manufacture or market anywhere in the world. The foreign company seeks to do a Joint Venture with a  Chinese company that will provide both necessary funding and the support needed to commercialize the product based on the technology. The structures for these China Joint Ventures are complex and are made more difficult by the antiquated and inflexible Chinese laws on joint ventures, financing and IP protection.
  • The foreign company has an existing successful product that it wants to manufacture and then market in China. Licensing is one option. The other is a complex joint venture. As above, the Chinese side of the proposed joint venture is seen not just as a source of manufacturing expertise, but also as a source of funding.
Years ago, my law firm developed a reputation for not liking joint ventures and there was some truth to that.  We did not like joint ventures that were mainly based on the Chinese side claiming that was our client’s only option.  We did not like joint ventures for joint ventures’ sake when there were other, better options for our clients.  We fully recognize that Chinese landscape has changed and whereas six or seven years ago eight out of ten joint venture proposals that crossed our desk did not make good sense, that ratio has probably completely flipped today, to the point that in the overwhelming number of instances, we make no effort to talk our clients out of their proposed joint venture.
The second trend we are seeing is companies abandoning the concept of directly investing in China and instead moving to a contractual approach. We are seeing this especially with foreign SMEs that are determining they do not have the resources to do manufacturing WFOEs in China. Basically, they are determining that Chinese owned factories are better/cheaper at manufacturing in China than foreigners. This includes multi-nationals such as Apple and HP.

In response, the current trend is to work towards purely contract manufacturing (product outsourcing), with no JV and no WFOE involved. This often involves complex IP issues and can also involve complex issues of start-up funding for the Chinese manufacturer. In connection with this trend, the foreign parties are finding that they need to work with their manufacturers to bring up their level of product quality to obtain required certifications such as HACCP and GMP.

Non-manufacturing businesses are also following this trend. In the creative industries, foreign companies are licensing their expertise to Chinese companies who then do the work on the ground. The same approach is taken even where a final product will be produced, such as a magazine or website.  I estimate that my law firm is doing at least five times this sort of work as opposed to just a few years ago and I am seeing the same sort of numbers with China joint venture deals.

This approach also requires complex contracting. In 2004, few foreign businesses had any faith in the enforceability of contracts within the Chinese legal system. This (justified) lack of faith meant that these contract-based approaches to doing business in China were not considered feasible. China’s dramatically improving legal system (at least with respect to contract enforcement where it is now ranked 19th in the world) has made it possible to shift to contract-based approaches to doing business in China. As with WFOEs, many foreign SMEs and their lawyers are not aware of this improvement in the legal system and continue to make their decisions about their China investments based on outdated, 2003 conditions.

Just received the following comment to our post, How To Find And Deal With Chinese Manufacturers:

I have a question,
I sent a picture of a unique [product] and they sent back an email saying that they would like to manufacture it and when I said mine they corrected me by stateing ours.
is this normal?
How should I deal with them.
how does something like this work?
Thanks

We get this type of question shockingly often.  Usually, it comes from someone who just returned from China calling to say that they just spent the last week in China, meeting with a whole slew of potential Chinese manufacturers, and they just realized (oftentimes by having read one of our blog posts on the need for a Non Disclosure Agreement) that they should have required the potential manufacturers to sign a Non Disclosure Agreement BEFORE showing them their product or prototype.

So what can be done?  How should this company deal with their manufacturer? How can this company protect its trade secrets now?  With this particular company, all may not be lost. and that is why I struck its specific definition of their product and replaced it with the generic word, “product.”

If this company provided its product to just one manufacturer and is now planning to buy from just this one manufacturer, this company may end up doing just fine.

What this company should have done BEFORE it showed its unique product to anyone in China (or anywhere else in the world for that matter) is to have required that Chinese manufacturer to sign a comprehensive NNN Agreement written in Chinese and tailored for enforceability in China.  But that was not done, and the question is what can this company do now that it has returned without a China NDA of any kind.

This company can and should go to this particular Chinese manufacturer and say something along the following:

We want you to manufacture our product, but for that to happen, we need you to sign this OEM Agreement.

The OEM Agreement this company provides to its chosen Chinese manufacturer should contain each and every trade secret provision that should have gone into the NNN Agreement this company should have required the Chinese manufacturer to have signed before showing the Chinese manufacturer anything.  If the Chinese manufacturer signs the OEM Agreement, the company will have its trade secret protections. If the Chinese manufacturer refuses to sign the OEM Agreement, the company will have a big problem.

In our experience, Chinese manufacturers will virtually always sign a legitimate OEM Agreement containing trade secret protections becuase the Chinese manufacturer wants the manufacturing business.  I would estimate that Chinese manufacturers sign our OEM Agreements around 98% of the time and those few times that they do not it is because they are not a legitimate company and they do not want to be bound by legitimate requirements.  In other words, the Chinese manufacturer that refuses to sign an OEM Agreement does so because they intend to steal trade secrets or fail to deliver on their quality promises and they do not want to sign a contract that could effectively penalize them for doing so.

The much tougher problem is the company that comes back to the United States having shown its unique product to ten Chinese manufacturers.  That company can get a protective OEM Agreement from just one or two of them (i.e. the ones whom it is going to use for manufacutering) and it will then always have a problem with eight or nine of them.

The real solution, however, is not to go to China without an NNN Agreement at the ready.

If you are seeking to have your product manufactured in China, I suggest you scour  the following regarding NNN/NDA Agreements:

And the following regarding China OEM Agreements:

And the following regarding other key issues arising from China product outsourcing:

Brian Wingfield at Forbes Magazine has a story, entitled Toying With China on the recent Senate hearing on toy safety. Wingfield sees the hearing as “having less to do with safety concerns than with ongoing economic disputes with China.” I agree.

Senator Sam Brownback (who not so coincidentally is running for President), told Nancy Nord, the Acting Chairman of the Consumer Products Safety Commission that, “What I want to hear is for you to say ‘These [unsafe] products are not going to enter our shores,’ He went on to say, “I think you have to just pull a heavy club out and say ‘That’s the way it’s going to be.’

While you are at it Senator Brownback, would you please get someone to say that there will be 1) no more crime, 2) no more car accidents, 3) no more war, 4) no more taxes, 5) no more gossip, 6) no more Entertainment Tonight ragging on Brittany, 7) no more demagoguery. All that would certainly make me feel better.

The article then quotes me as saying, “China right now is the current bugaboo.”

Mattel Chairman Robert Eckert spoke at the hearing and “apologized for the recalls but shifted much of the blame to subcontractors in China,” saying, “We wouldn’t be here if a handful of vendors hadn’t violated our rules.”

I close out the article with the following:

The toy issue is likely to be resolved through market solutions. Harris, who is also an author of the China Law Blog says American companies will have to perform better due diligence, including checking out potential suppliers before doing business with them, examining goods before they leave the factory and getting solid contracts in writing.
“Americans are really going to have to lead the charge by not dealing with bad Chinese companies,” he says.

The toy issue is a politician’s dream come true as it involves “our children,” “our safety,” and the “evil Chinese empire,” but the reality is that this is not really a U.S. government issue. I have heard (but cannot verify) that upwards of 50% of the Chinese companies exporting toys from China were either operating illegally or exporting illegally. At minimum, American companies must make sure the companies with whom they do business in China are legal (though this would not have helped Mattel). For more on what American companies can and should be doing to protect themselves from bad Chinese product, check out CYA: China Outsourcer Protect Thyself.

And though I am always skeptical of the Chinese government’s ability to police the quality of its manufacturers, I do note that a client of ours just yesterday reported the following:

The Xinghu area is under the microscope now. We have one vendor there who informed us they cannot ship our goods because they have not passed an inspection the government made without notice. Their shipments are flagged in Ningbo Customs. They told us the area has many toy mfgs and as such the government has moved into it.

We will see.

Business in Vancouver (Vancouver’s leading business weekly) [link to article no longer exists] recently published a piece written by CLB’s own China lawyer Steve Dickinson, setting forth the basics for protecting your China manufacturing business from problems.

Nothing in the article we have not previously covered here on the blog, but it does provide the basics in probably the most succinct form yet:

1. Chinese suppliers. Since Chinese suppliers run the gamut from superb to criminal, you must check out any potential supplier in advance. A basic credit check will reveal whether the Chinese company with whom you have contracted is the factory owner, not just some broker posing as such. A thriving company is less likely to risk its reputation by cutting safety corners than a company on the verge of going under.

2. Quality control. Because most Chinese product arrives already packaged for retail sale, a statistically valid inspection system within China is critical. The Chinese government has its own inspection system for food and drugs, but to reduce costs, many Chinese suppliers intentionally avoid this system. You have to ensure your Chinese supplier is licensed to manufacture the product you’re buying, licensed to export it and follows Chinese government inspection procedures.

3. Contracts. Your contract with your supplier should detail your safety and quality control requirements and your inspection rights. If the contract states you’re responsible for inspection, you must inspect. Your contract with your Chinese manufacturer can either shift liability toward or away from you. Your contract should almost always be in Chinese.

4. History. You know who your problem suppliers are and you need to replace them now before they cause even bigger problems. Ask a product liability defense lawyer whether having to deal with a bunch of e-mails from you to your supplier complaining of “continual quality shortfalls” is going to be good for your product injury lawsuit. Actually, don’t bother, you know the answer.

5. Insurance. Insurance is not a replacement for the above, but it’s your backup. Insurance almost never covers more than your legal fees and out of pocket damages; it will not cover your time spent defending lawsuits, nor will it cover your damaged reputation.

6. Marketing. Don’t make claims about your product you can’t support. Many North American importers claim their Chinese product is manufactured to a standard that simply is not followed in China. Things like this just give the plaintiff’s lawyer more ammunition against you in any legal proceeding.

That’s it, how to outsource your product manufacturing to China, in 343 words.