China factory due diligence

Many Chinese factories are hurting right now. Badly. This should come as no surprise. First they went through months of closures due to the coronavirus, and just when they opened they faced massively reduced demand. Chinese factories are closing left and right and many of those that are open are facing reduced demand and falling prices. See China’s factory deflation deepens as pandemic hits demand. 

Whenever China’s factories are hurting your risk as a product buyer soars. Way back in 2011, in  China. Smells Like 2008, Gloom And Doom Edition, we wrote how factory risks rise during China economic downturns:

Chinese companies that are going out of business or believe they are going out of business have an annoying tendency to ship bad or fake or no product at all. In 2008, pretty much every week we were getting calls from companies saying that the product they had ordered just was not coming. We handled one case where a company had bought about a million dollars of fish and received containers of cheap bricks surrounded by fish. That fake shipment was the dying gasp of a company that ceased to exist. We have started to get those same sort of calls in large numbers again.

Nothing has changed since then. A bad economy directly translates to factory problems. Conversely, it also translates to buying opportunities as Chinese factories all of a sudden become willing to negotiate a lot more on prices and payment terms. Our international manufacturing lawyers have been seeing a lot of both good and bad things happening for foreign buyers of Chinese products.  There is an old saying about how lawyers do well when times are good and when times are bad, just not when things are staying flat. For foreign buyers of Chinese products, times are one part good, one part bad, with no part flat. That has meant the manufacturing side of our law firm has been keeping really busy of late helping some of our clients avoid problems while helping others secure better pricing and payment terms. Oftentimes we do both for the same client.

Most quality and compliance problems arising with goods made in China can be greatly reduced  by factory visits and product inspections prior to packing for shipping. This point applies to PPE as well as everything else made in China. Access to Chinese factories is becoming possible again as the pandemic abates in China, so now is a good time to look at how to manage your China manufacturing process.

  • Know your factory like never before. For most of the last decade, our recommendation to clients purchasing relatively small amounts of product was just to have one of our China lawyers make sure that the Chinese company from which they would be buying the product actually existed and was licensed to make and sell it. See Basic China Due Diligence. Is This Chinese Company Legitimate? We are now recommending to our clients that we engage in a much more substantial due diligence of any new factory supplier and of their existing factory supplier. This more substantial due diligence investigation typically consists of our reviewing various Chinese government databases to confirm that the Chinese company from which the products will be bought actually exists and is licensed to sell what it is proposing to sell. These investigations also seek to determine whether the Chinese company is well capitalized, is in good standing with the Chinese government regarding fines and taxes, and not involved in lawsuits that would make one doubt its reliability. We also look at the company’s ownership because that sometimes gives us additional good insight about the company. After we search the Chinese government databases, we do an internet search on the company in Chinese and in English to try to get information about its overall reputation. We then draft a 5-8 page report along with recommendations. Sometimes these reports give our clients great comfort and other times they lead them to search out new suppliers. I cannot quantify how many times one of our due diligence investigations has prevented a client from sending money that would have disappeared, but I am certain that we’ve saved foreign buyers tens of millions of dollars.
  • Make friends with your factory manager Factory visits, product inspections, and other forms of due diligence are essential but a good relationship with your Chinese factory manager is key. They are the most important person of all. They can fast-track your order or slow it down. They can give you faulty materials and defective stock or put that stuff in someone else’s order. Despite their critical importance, few foreigners know how to keep their factory manager happy. Most foreigners are unaware of an underlying cultural expectation that serious buyers will befriend the factory manager as a natural part of doing business. This can’t be achieved by occasional site visits or video calls. It takes regular, personal visits with time devoted to eating and drinking together. Visits should become prestigious events during which the factory manager is shown “face” and given an opportunity to show hospitality. Local dignitaries can even be invited so that the power and influence of the manager may be on display. When handled correctly, these visits empower and motivate Chinese factory managers.
  • Get a brand ambassador Another important, and often overlooked, cultural reality is that Chinese businesspeople tend to dislike middlemen and distrust agents and intermediaries — Chinese or foreign. They will often drive a wedge between the foreign customer and the third parties representing the customer in the field. This is because kickbacks or undisclosed benefits are routinely sought by intermediaries, particularly when these intermediaries are locals. In fact, such payments are often the real source of income for the low-paid local intermediaries sent into the field by big companies claiming to protect the interests of their foreign clients. For these reasons, a good QC rep should be seconded to, or embedded in, the buyer’s businesses. When they are presented as part of the buyer’s team (not some third-party helper) the problems associated with intermediaries are reduced. They are more than a mere agent — they become your brand ambassador.
  • Consider a foreign QC rep The assumption is often made that locals are naturally better suited for this kind of work. It may therefore come as a surprise that the leading consultants in this space are usually foreigners fluent in Chinese. Such people have unique advantages, especially when it is routinely assumed they are not following everything that is said during an inspection, a meeting or a banquet. Key insights are gained in this way. A foreigner is also much less likely to be offered kickbacks or to be exploited by the Chinese side during negotiations. There’s also the prestige — it’s a big deal when a Chinese-speaking foreigner bothers to come to one of the small towns where a factory is usually located.

As Chinese factories slowly re-open they need to allocate limited resources among a bunch of outstanding orders and demanding, worried customers. Just by having someone show up as your company’s representative, you can show that you care and that you aren’t frightened to work in and with China. This kind of support is not easily forgotten by factory managers on the front line. Their payback is to greatly increase the chance of timely delivery of product in compliance with your requirements.