By: Steve Dickinson

In my previous post in this series on the end of cheap China, I noted that the risks relating to purchases from Chinese manufacturers are rising in the export sector in China’s Eastern provinces. Given the risks, it surprises me that I still see many buyers who continue to use the worst payment system possible in their dealings with Chinese manufacturers. The standard (terrible) system for payment in most of the export sector is: 30% down payment on signing of contract with the remaining 70% payable prior to shipment.

Why is this a terrible system for the Buyer? Let’s consider the deposit system first. It is common for a Buyer to learn that the manufacturer is not able to make the product, makes the product with excessive defects or substantially delays in delivering the product. If the Buyer has paid a 30% deposit, the Buyer is basically “stuck” with the manufacturer and is not able to go elsewhere even after these problems are discovered. I have seen many Buyers who find themselves trapped in this way.

More important, the need for deposits reveals weakness of the manufacturing sector. Many foreign buyers naively believe the deposit is retained in a special account or is at least reserved for their own project. This is not the case. The 30% deposit is not used as any sort of security. Rather, the deposit is used as a financing tool for the manufacturer. Most raw materials for production are purchased with these deposits without regard to the specific project or buyer. Other costs are paid from the same general deposit fund.

As a result, when there is a problem, the deposit is almost never returned. There are two reasons for this. First, the manufacturer has already spent the money on costs and simply does not have the funds available to pay a refund. Second, the manufacturer knows that the amount of the deposit is so small that there is little risk of the foreign buyer filing suit for a refund. Indeed, normally there is not contract so the basis for requiring a refund is not clear. Thus the Buyer is forced to negotiate a price reduction or an extension or some other make-do remedy with a manufacturer that has already revealed ts clear weaknesses.

Now consider payment of the 70% upon shipment and prior to delivery. Under this approach, if the Buyer does not inspect in China, the Buyer only discovers what has actually been shipped after the payment and after the product has been delivered to the buyer. To consider the risks, consider these stories that have come into my law firm over the years:

  • Buyer purchases carrying cases for its notebook computer. Computer is 8 inches wide. The cases arrive. They are beautiful, except for one “minor” problem: they are all seven inches wide.
  • Buyer purchases jewelry bracelets with clasps that are to be mounted on the left side. The bracelets arrive. They are beautiful, except for one minor problem: the clasps are all mounted on the right side.
  • Buyer purchases hand blown glass Christmas tree ornaments. The ornaments arrive just in time for holiday sales. The are beautiful except for one minor problem: the ornaments do not include a ring on top for mounting on the tree.
  • Buyer purchases candle lamps. Lamp must be made from inflammable safety materials. Buyer pays extra for use of this material. The lamps arrive. They are beautiful except for one minor problem: they are made from normal, flammable paper and plastic and explode into flames at the touch of a match.

In each case, the Buyer received a full container of 100% defective product. The defect was so obvious that it would have been discovered by even the most rudimentary inspection prior to shipment. By failing to inspect, the buyer suffered a total loss. So much for the China price.

Of course, the more common thing is finding a smaller number of defects that result in damages ranging from 10% to 30% of the delivered product. Since the money has been paid, if these defects are discovered only after delivery to the buyer, then the buyer is entirely at the mercy of the manufacturer and is virtually without an effective remedy. The manufacturer knows that the amount at issue is too low to justify a lawsuit on the part of the buyer. If the manufacturer is looking for repeat business, the most common result is that the manufacturer will admit there are defects, refuse to pay a refund or damages and will instead offer a “credit” (typically 5% to 10%) against future purchases.

As with advance deposits, the “credit for defects” system is also a terrible system for the buyer that virtually always ends in failure. Let’s take a look at how this works. In order to obtain the credit, the buyer must purchase from a manufacturer who has already shown that it will make a defective product and not give a refund for having done so. Buyers then get locked in a downward spiral. Each shipment has defects, and the amount of the credit grows. The manufacturer knows that the price for the subsequent shipments will be discounted, so the manufacturer gets even sloppier. So defects increase and delays become common. Finally, the buyer just gives up and writes the whole thing off or simply goes out of business due to the lack of adequate product.

Some buyers have finally understood that making payment prior to inspection is an invitation to disaster. Many buyers now perform inspections in China prior to shipment. This is an excellent trend and is basically required for protection of the buyer. However, this approach is still not as safe as inspection after delivery in the home country of the buyer. The basic reason is that we are aware of many times where Chinese manufacturers deceived inspectors and shipped non-conforming product.

As I mentioned in my previous post, some really bold manufacturers will substitute an entire container of non-conforming product by replacing a sealed container with an alternative. More often, manufacturers will rig the container so that conforming product is easy to find, with non-conforming product hidden deep in the container or in alternative locations on the loading dock. The only way to avoid these deceptive practices is to inspect at the place of delivery in the home country of the buyer and to make payment after that inspection is complete. Most Chinese manufacturers will strenuously resist payment only after inspection upon delivery. Buyers should therefore at a minimum inspect in China prior to shipment and then take into account the inherent risk in this practice. The price the buyer pays is actually substantially higher than its face value since this inherent risk is built into the price.

In part V of this series, I will discuss payment options that can reduce your risks.