Foreign Manufacturing Contracts

— Value of Manufacturing Agreements

Creating a clear manufacturing agreement can alleviate the various legal issues inherent in manufacturing overseas. Before we discuss the key terms for your manufacturing contract, we will briefly address why it is so important to have such a contract at all, even in countries with weak legal systems. There are three reasons why it makes sense to have a contract with your manufacturer and only one of those reasons is enforceability in court:

  1. Clarity. Having a well-written contract in the language of the manufacturing country will ensure that your manufacturer understands exactly what you want. For example, including a clause in your contract that fines the supplier for each day late will let your supplier know that you are serious about your manufacturing deadlines. At least half of the disputes we see between foreign manufacturers and their buyers from different countries stem more from cultural-linguistic misunderstandings as opposed to animus.
  2. Prevention. A well-crafted manufacturing contract with well-crafted damages provisions will convince your manufacturer that it will be better off complying with your contract than violating it. If your contract has clear and strict written deadlines, your manufacturer will give your products priority over its buyers without clear and strict written deadlines when it is facing a production crunch.
  3. Enforceability. Our law firm has written hundreds of manufacturing contracts and yet we have never had to litigate any of them. But when our firm’s international litigators have sued or threatened to sue or arbitrated or threatened to arbitrate on well-written manufacturing contracts drafted by other law firms, we have seen the benefits of having a quality contract, even in countries notoriously bad at contract enforcement.

If your foreign manufacturer believes your manufacturing contract will be enforced it likely will act accordingly. Similarly, if your foreign manufacturer believes no court will enforce your manufacturing contract, it likely will act accordingly.

— OEM, CM, ODM

Most manufacturing contracts we draft involve one of three different types of manufacturing arrangements: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM), and Original Design Manufacturing (ODM). These three different arrangements influence various legal issues inherent to overseas manufacturing.

Type 1: Original Equipment Manufacturing (OEM). In this arrangement, the foreign buyer purchases a product from a foreign country factory that is already being manufactured by that factory. The product buyer then “packages” this product with its own trademark and logo. The buyer and the factory may agree to certain cosmetic changes (color, shape, minor added features) that further customize the product for the buyer.

In this sort of OEM arrangement, intellectual property (IP) is usually clear: the buyer owns its branding (trademarks, logos and packaging) and the factory owns the product. Difficulty arises once the product is customized. Who owns the IP once the buyer has made changes to the product? An OEM agreement can provide clarity here. Usually, the buyer seeks to restrict the factory from using the customization in selling the base product to third parties.

Type 2: Contract Manufacturing (CM). In this arrangement, the foreign buyer has a fully developed product design. Traditionally, this design was of a product that had been manufactured by the buyer in its home country. More recently, the product is a new design being manufactured for the first time overseas. In a CM arrangement, ownership may seem simple: the foreign buyer owns all the IP, both in design and branding, and the factory owns nothing. In practice, however, the division is not always so clear. For example, your factory may change your product’s design and use those design changes to modify its own products it sells in direct competition with your products. Difficulties exist in every contract manufacturing project and they can be resolved with a clear, written agreement.

Type 3: Original Design Manufacturing (ODM). As outsourced factories are becoming more technically competent, foreign buyers have started entering into arrangements in which their overseas factory does some or all the design work for the product. There are many variations on this ODM approach. In its most fundamental form, the foreign buyer provides drawings and a specification sheet and the overseas factory does the rest of the work in consultation with the buyer.

Under this sort of arrangement, the obvious question is who owns the design of the product? Both the foreign buyer and its overseas factory will claim ownership of the design using conflicting arguments. The overseas factory will agree to make the product on an exclusive basis for the foreign buyer, but the foreign buyer does not have the right to have the product made by a third party factory. This position can come as a bad surprise to the foreign buyer, particularly when its overseas factory suddenly announces it will be doubling the price for manufacturing the product. These issues can get even more complex when the product incorporates or is based on technology clearly owned by the overseas factory. In this setting, the factory will often state that the buyer can go anywhere it wants to manufacture the buyer’s own portion of the product design, but no third party factory can make use of the factory’s proprietary technology in the manufacturing process. Consider this case for a foreign buyer who has spent considerable time and effort to develop a product design only to learn after a year that its overseas factory has decided to terminate the manufacturing agreement.

Once again, the only way to resolve these issues is to confront them in advance with a detailed written ODM agreement that sets out a resolution to these issues that is fair to both sides. There is no simple, legal default answer to any of these difficult issues. Or, rather, the legal default in most countries will favor the position of the overseas factory. Absent a clear agreement on how to proceed, the foreign buyer will lose pretty much every time.

Asia has become the main location for start-up companies with an innovative product concept but no manufacturing facility. The most common form of ODM for foreign start-ups in Asia is some form of co-development. Under the old model of co-development, IP ownership was clear: the foreign entity paid the fee and had 100% ownership of the product. The issue our manufacturing lawyers keep encountering is that the legal consciousness of the parties to these transactions is stuck in the old model of straight development for a fee. But the issues that arise under the new, co-development model are quite different from the former “straight” development model.

 

— Product Development.

The basic issues to consider in an overseas co-development project are as follows:

  1. Will your overseas factory do the development work at its own expense or will you pay for the development work?
  2. What is the time schedule for the product development work?
  3. What is the final price goal for the product?
  4. What exactly are the “deliverables” and what is the process for determining whether the deliverables meet your goals?
  5. Who will design and manufacture the molds and tooling? For more on molds check out Overseas Manufacturing: How To Hang On To YOUR Molds

Though these five issues are normally difficult to resolve, they are actually the easy part of the process. The more difficult issue is who owns what with respect to the intellectual property in the product. Determining that your overseas factory owns 50% and you own 50% may be relevant for allocating income from commercialization of the IP, but it does not tell you anything useful on the practical level of manufacturing the product.

A foreign buyer that wishes to move its production to a different factory can legally do so only if it owns 100% of the IP; if the overseas factory owns part of the IP, the foreign buyer cannot legally switch its production to a new factory without a license or permission from its overseas factory.

 

— IP Protection

Overseas factories will usually take the following positions regarding IP:

  • The foreign buyer owns the exterior design (design patent) for the product. The customer owns its trademarks and logos.
  • The overseas factory owns the core intellectual property for the product.
  • The overseas factory agrees to manufacture the product for the foreign buyer on an exclusive basis. However, the overseas factory is free to continue using the core intellectual property in manufacturing for itself and in manufacturing products for other customers. This includes the overseas factory manufacturing products that will directly compete with the foreign buyer’s product. The only limitation on the overseas factory is that it cannot employ its IP to manufacture a product that uses the exterior design, trademark or logo of the foreign customer.
  • The foreign buyer cannot take have its product made by any other factory.

If your overseas factory takes the “you cannot go anywhere else” approach you will need to consider critical issues that arise at the production stage. Specifically, you will need to consider what will happen in the following common situations:

  • The overseas factory raises its price to an unacceptable level.
  • The overseas factory cannot meet your quantity or time of delivery requirements.
  • The quality of the product is not acceptable. There are consistently too many defects.
  • The overseas factory decides to stop manufacturing for you because it decides to manufacture a similar product for itself or for a larger company that generates larger or more consistent orders.

When these things happen, the remedy is to move to a different factory. Your ability to switch to a new overseas factory is what keeps your existing overseas factory “under control.” Now consider the situation where you cannot move your production to a different overseas factory. This puts you at the mercy of the factory and this is a situation you must avoid. For more on why it is so important to avoid this sort of situation, check out China and The Internet of Things and How to Destroy Your Own Company, where we talk about companies that have come to our law firm too late.

The international standard for dealing with the above intellectual property manufacturing issues is as follows:

  • The overseas factory must make your product for you for so long as you are interested in the product. If the factory chooses to stop making your product for you, it must provide you with a royalty free license to the technology necessary for you to be able to manufacture your product in a different factory. If the factory wants to avoid this result it must continue to manufacture your product for you.
  • The overseas factory is locked into a specific price for a specific period. Assuming a long term production arrangement there probably will be valid reasons for the factory raising or lowering the price. For example, exchange rate fluctuation can be a good reason to go in either direction on price. To provide for reasonable price changes, your contract should provide a mechanism for annual price adjustments. This mechanism can range from a simple index to a complex formula that accounts for multiple factors.
  • There are two primary mechanisms for dealing with the quantity/time issue. The first is to develop a production schedule that binds both parties. The second is to provide that if your factory is unable to meet your requirements it is contractually required to license production at an alternative location in the quantity necessary to meet the excess requirements.
  • Your manufacturing contract should provide for the situation where your overseas factory consistently violates your quality standards by giving you the right to terminate the manufacturing contract for breach. Your contract should state that if you terminate your manufacturing contract because of a breach by your overseas factory, your factory automatically licenses you to manufacture your product in a different factory. Some overseas factories will claim this rule allows you to claim breach simply to switch to a new factory. If this is a genuine concern, your agreement can provide for dispute resolution focused solely on this issue.

Though the above provisions are both fair and standard in international custom design and manufacturing, many overseas manufacturers refuse to discuss these matters or to accept a reasonable solution. The overseas factory knows its foreign buyer will be stuck and stuck is exactly where it wants its foreign buyer to be. Being stuck with a factory that behaves unreasonably is an unpleasant and usually very expensive experience. You should consider carefully whether you want to proceed in that kind of situation.

You do not want to be ambushed by these critical issues after you have spent considerable time and money in developing a product with a factory that will then hold you hostage at the production stage. See China and The Internet of Things and How to Destroy Your Own Company for a taste of what this can look like.

You need to get clear on these design and manufacturing and pricing and production and intellectual property issues from the start. This means you need an ODM agreement that sets forth how they will be resolved.

China Manufacturing ContractsAs China and its laws change, the China lawyers at my firm must constantly adjust, usually just ever so slightly. This adjustment can include even how we draft our contracts for China. And oftentimes, with even small changes in how we draft our contracts, we make changes in the questions we ask to gather the information we need to draft a contract that suits both their situation and their goals.

The following is the initial email questionnaire our China manufacturing lawyers are currently using with companies looking to engage in OEM manufacturing in China. Our lawyers send this out and then review the responses, all as a prelude to drafting the  Manufacturing Agreement

 

 

The below is fairly comprehensive, but feel free to provide any additional information that you feel may be relevant. Please answer as much of the below as you can and to the extent any of our questions are irrelevant, please feel free to write N/A, but to the extent it might make sense for you to explain to us why something does not apply to you. Please do so. We will likely have followup questions depending on your responses to the below.

Note that the agreement we will be drafting for you will be intended for use within mainland China with manufacturers based in mainland China. It is not intended to be used with sourcing agents, nor is it intended for use in Hong Kong, Macau, Taiwan, or any other country or administrative region outside China.

1. Basic Information

  1. For each entity that will be executing the agreement, please supply the full legal name, address, phone number, fax number, and URL, as well as the name, title, and email address of the representative who will be signing on behalf of that entity. (In both Chinese and English, as relevant.)
  2. Please identify the state in which your company is incorporated.
  3. Will you be using this OEM agreement only with this specific manufacturer, or are you hoping to be able to reuse it with other manufacturers?
  4. Please provide a copy of your Chinese counter-party’s business license.
  5. To the extent multiple entities will be involved in this agreement on the Chinese side, please identify each of these entities and describe their corporate structure. For instance, many OEM contracts involve one Chinese company that owns a factory and performs all manufacturing and a second company (usually based in Hong Kong) that issues invoices and receives payment.

2. Design Basics

  1. Do you anticipate the Chinese side will be performing any design work or customization as part of the manufacturing process?
  2. If not, are you ordering “off the shelf” products the Chinese side already manufacturers?
  3. If so, have you already entered into a design services agreement? What arrangements have you made regarding ownership of the designs, payment for the designs, milestones, and ordering obligations?

3. Manufacturing Basics

  1. Please describe each product the Chinese side will be manufacturing. Do you anticipate these products will change over time?
  2. What sort of volume are you expecting? Will the volume change over time? Have you have agreed to order a minimum number of products? If so, please provide details.
  3. Do you wish to prohibit subcontracting? Are you aware of any third parties that will be involved in manufacturing, packaging, or shipping your product? This includes any entities that may be owned by or otherwise affiliated with the Chinese contract party.

4. Pricing

  1. Have you determined the prices for the products yet? If so, please include the relevant details.
  2. How will pricing and related terms be negotiated? On a purchase order basis? On an annual basis? Some other way?
  3. Have you negotiated the payment terms? For instance, will you pay by letter of credit? By installments? If by installments, what are the amounts/percentages of those installments, and when are they due?

5. Purchase Orders, Shipments, and Inspections

  1. Do you have an existing purchase order you intend to use for your product orders from these manufacturer(s)? If so, please provide us with a copy.
  2. After receiving a purchase order, how long does the manufacturer have to accept or reject it?
  3. If you submit a purchase order and it 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 only obligated to make product for you after it accepts your purchase order?
  4. What have you negotiated regarding shipping terms? For instance, how long after acceptance of a purchase order will goods be shipped? Will you be using a freight forwarder? From and to which ports will the goods be shipped? Will the goods be shipped FOB or CIF or something else?
  5. What arrangements will be made for packaging prior to shipment?
  6. When your products are shipped from China, what brand names, logos, and/or slogans will appear on the products and packaging? Please distinguish if possible between words and graphic logos.
  7. Where do you anticipate selling your products? In particular, will you be selling them in China?
  8. If you are selling any product in China, what brand names, logos, and/or slogans will appear on the product and on its packaging?
  9. Will any product you manufacture in China have a Chinese name? Does your company have a Chinese name? If so, please provide them.
  10. What sort of arrangements have you made for inspection and quality control during the manufacturing and packaging process (i.e., pre-shipment)? Exactly what should be done with any defective product discovered during the manufacturing process?
  11. What sort of arrangements have you made for inspection and quality control upon receipt (i.e., post-shipment)? Exactly what should be done with any defective product discovered then?

6. IP and other concerns

  1. What are your main concerns in this deal? Are you concerned with ensuring high product quality? Receiving products within the agreed-upon time?  Protecting your intellectual property (i.e., ensuring the Chinese manufacturer does not sell your product behind your back and/or steal your designs)? Pricing?
  2. Do you have any trademark registrations in China or anywhere else in the world (pending or otherwise)? If yes, please list them.
  3. Do you have any patent or copyright registrations in China or anywhere else in the world (pending or otherwise)? If yes, please lis them.
  4. Do you have a list of customers, suppliers, or other third parties you want to prevent the Chinese party from contacting

7. Tooling and Molds

  1. Will the Chinese manufacturer be using any tooling or custom molds to make your products?
  2. If so, does the manufacturer already have all of the tooling in question? Which party owns the tooling?

8. Warranty

  1. What sort of warranty terms have you negotiated or do you expect?

9. Term

  1. Have you determined the length of time this deal will be in place?

10. Other issues

  1. Has the Chinese manufacturer already signed any sort of term sheet, memorandum of understanding, letter of intent, or other document, even if only in English? If so, please provide this document.
  2. Have you previously purchased any products from this manufacturer? If so, please provide an example of the purchase order used.
  3. Are there any unresolved issues involving any previous manufacturers? For instance: have you gotten all of the tooling back from any previous factories? Are there any outstanding invoices or payments due?

China Manufacturing AgreementWith rare exceptions, American and European companies have goods made in China for one reason: because it’s cheaper. Why is it cheaper? Because labor is so much cheaper in China than in the US and Europe, and labor is a significant portion of the production cost. But over the past several years, wages have been steadily rising in China, making Chinese factories progressively less competitive on labor costs. Meanwhile, numerous pundits have made predictions about manufacturing work fleeing China for countries with lower labor costs, and especially Southeast Asian countries like Vietnam or Myanmar. A corollary prediction calls for more reshoring – bringing back manufacturing to the United States.

But the mass exodus from China hasn’t occurred. Thus far most of the manufacturing moving to Southeast Asia has been either redundant manufacturing (i.e., to have an alternate source of production in case something goes awry in China) or manufacturing for goods lower on the value chain. And the reshoring movement is still finding its feet.

China has maintained its competitive advantage in a number of ways. For one thing, it has made enormous investments in infrastructure: raw materials, components, and finished goods travel rapidly and consistently to, from, and within China via a vast web of ports, railways, and highways. None of its competitors come close. Additionally, China’s status as the factory of the world means its factories (and many of its cities) have developed tremendous expertise and specialization. They may have been the cheapest before, but now they’re the most experienced – and sometimes even the most efficient.

A couple weeks ago, Sheelah Kolhatkar wrote an article in The New Yorker about advances in robotics which logically will put a number of factory workers out of a job – no matter where the factories are located. The Chinese factory owners interviewed in the story were almost stereotypically dismissive of concerns about workers rights, and perhaps necessarily so. To them, and arguably as a matter of national economic policy, vast automation is the only way China will remain competitive as a manufacturing base for the rest of the world.

My colleague Grace Yang writes frequently about the challenges companies face when navigating China’s labor laws. Regardless of Chinese factory owners’ attitudes, you’d think they would have a tough time replacing workers with robots. But one of the factory executives quoted in Kolhatkar’s article made a keen insight: up to 80% of factory workers simply don’t come back to work after going home for Chinese New Year. You couldn’t draw it up any better for making a massive and sudden reduction in force.

Of course, US companies that reshore manufacturing with largely automated factories won’t have to contend with disgruntled factory workers, because those workers were laid off years ago. And the better robots get at doing assembly line work, the more it will make sense for goods consumed in the United States to be manufactured in the United States. As Kolhatkar notes, “China was never a particularly convenient place for Western companies to have their sneakers and T-shirts and widgets made.”

But for now, China remains the factory of the world. And the increased shift to automation means there will be an ever-widening divide in China between manufacturers with an eye to the future and manufacturers stuck in the past who can only compete on price but not quality – and won’t be able to compete on price for long. This means that selecting the right manufacturer is more important than ever, and it’s going to be hard to do that without visiting the factory. It also means that a well-written OEM agreement with your Chinese factory is more important than ever. At least, until Skynet becomes self-aware.

China manufacturing contractsI spend much of my time drafting manufacturing agreements between foreign (mostly American, European and Australian) companies and Chinese companies. When doing these manufacturing contracts for China, my first step is determining what kind of relationship the foreign buyer (typically our client) will have with the Chinese factory. We cannot be clear about what kind of manufacturing agreement to draft until after we know what type of manufacturing relationship is intended.

To guide the process, we have found that there are three fundamental types of manufacturing arrangements used in China: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM), and Original Design Manufacturing (ODM). This post is the first in a series of posts I will be writing on how these different arrangements influence the various legal issues inherent in manufacturing in China. Today’s post focuses on the intellectual property issues that can arise when having a product manufactured under each of these three arrangements in China.

Type 1: Original Equipment Manufacturing (OEM). In this arrangement, the foreign buyer purchases a product from the Chinese factory that is already being manufactured by the Chinese factory. The buyer then “packages” this product with its own trademark and logo. The buyer and the factory may also agree to certain cosmetic changes (color, shape, minor added features) that further customize the product for the buyer.

OEM manufacturing was the original standard for custom manufacturing in China. The great trade fairs such as the Canton Fair were designed to introduce standard Chinese factory products for purchase by foreign OEM customers. In the classic OEM arrangement, the ownership of the intellectual property is clear. The factory owns the IP in the product, while the buyer owns the IP in its trademarks and its logos and its packaging. That is, the buyer owns its brand but the factory owns the product.

The difficult issue in an OEM Arrangement is who owns the IP in the changes to the product that involve customization for the buyer? In terms of standard IP analysis, there is no clear answer here. One purpose of a OEM agreement is to clarify this issue. Usually, the buyer seeks to restrict the factory from making use of the customization in sales of the base product to third parties. Stated simply, the factory will usually want to make use of the customization and the buyer will want to prevent this. This can lead to difficult negotiations with no clear outcome.

Type 2: Contract Manufacturing (CM). In this arrangement, the foreign buyer has a fully developed product design. Traditionally, this design was of a product that had been manufactured by the buyer in its home country. More recently, the product is a new design being manufactured for the first time in China.

Contract manufacturing represents the second stage in foreign manufacturing in China. In principle, the design ownership issue is quite simple. The foreign buyer owns all of the IP: the IP in the design and the IP in the brand. The factory owns nothing. However, in actual practice, the division is not so clear. This is especially true when the factory is working with a new design that has not been manufactured previously on a commercial scale.

In this setting, the Chinese factory will often make changes in the product design during the course of “commercializing” the product. Who owns those design changes? What if the factory wants to use those design changes in modifying the factory’s own products that are sold in direct competition with the foreign buyer? What if the foreign buyer wants a different factory to make the product? Is that other factory permitted to make use of the design changes? These are difficult issues that arise in virtually every contract manufacturing project and they can be resolved only by a clear written agreement.

Type 3: Original Design Manufacturing (ODM). As Chinese factories have become more technically competent, foreign buyers have started entering into arrangements where the Chinese factory does some or all of the design work for the product. There are many variations on the ODM approach. For this discussion, we will consider the simplest variant where the design concept and the basic specifications are developed by the foreign buyer, while the commercial design work is done by the factory. In this most fundamental form, the foreign buyer provides drawings and a specification sheet. The Chinese factory does the rest of the work, in consultation with the buyer.

In this setting, the obvious question is who owns the design in the resulting product? In our experience, the foreign buyer will take the position that it owns the design, since it came up with the original concept and then brought that concept to the Chinese factory. However, the Chinese factory will usually take the opposite position, claiming that since the factory did all the R&D and commercialization work, the factory owns the IP in the product design. Often the Chinese factory will agree to make that product on an exclusive basis for the foreign buyer, but the foreign buyer does not have the right to have the product made by a third party factory. This position can come as a bad surprise to the foreign buyer, particularly when the factory suddenly announces it will be doubling the price for manufacturing the product.

These issues can get even more complex when the product developed incorporates or is based on technology clearly owned by the factory. In this setting, the factory will often state that the buyer can go anywhere it wants to manufacture the buyer’s own portion of the product design, but no third party factory can make use of the Chinese factory’s proprietary technology in the manufacturing process. Consider this case for a foreign buyer who has spent considerable time and effort to develop a product design only to learn after one year that the Chinese factory has decided to terminate the manufacturing agreement.

Once again, the only way to resolve this issue to to confront it in advance with a detailed written ODM agreement that sets out a resolution to these issues that is fair to both sides. There is no simple, legal default answer to any of these difficult issues. Or, rather, the legal default favors the position of the Chinese factory. Absent a clear agreement on how to proceed, the foreign buyer will lose pretty much every time.

As you can see, even for the most basic OEM arrangement, a simple purchase order is not sufficient. In every type of manufacturing relationship in China, a formal agreement is required. In the absence of such an agreement, the ambiguity of the situation will always favor the factory that is doing the manufacturing. So forget the POs and join the real world where clearly drafted agreements (in Chinese) are normal practice.

 

Who should sign your China OEM Agreement?
Who should sign your China OEM Agreement?

Got the below great comment/question today:

I would love to see you write about Taiwan / HK being “not” China, but from a different perspective. What advice do you give to a foreign company that plans to engage TW-based (or truly HK-based, e.g. been based in HK for 30-40 years) manufacturer, and said TW/HK company owns (though often, especially in the case of TW companies, via some Cayman/BVI/offshore entity) its own factory in China where the goods will actually be produced.

For many good business and tax reasons, the TW/HK company wants their HQ office to be the supplier of record to the foreign (e.g. US/UK) customer, and for the customer to pay the HQ office for the goods (usually so the factory can keep most profits outside of China and not have the problem of extracting money from China, which you write about so well).

So the US/UK customer will buy goods from (and pay money to) a TW/HK HQ operation, which in turn will sub-contract the manufacturing to their China-mainland subsidiary. In these cases, does your firm typically advise the client to have a contract with the TW/HK HQ, or solely with the China factory (even though they are not paying the China factory directly), or separate contracts with both entities?

You’ve written so much wonderful work on working with “Chinese suppliers” but in so many cases these suppliers are the product of FDI from TW or HK (or Korean, Japanese, US, German, etc) companies. Are the rules of Development Agreements and OEM contracts fundamentally different when a) the china factory has a foreign owner) and b) the customer will pay the foreign owner (rather than factory directly) for the goods?

It is a great question because the situation of a non-Chinese company operating a Chinese factory has become so common and it invariably presents legal problems for the buyer. The issue typically presents itself when the Hong Kong or Taiwan entity wants the OEM agreement (aka the contract manufacturing agreement or  supplier agreement) to be with it and not with the PRC entity that will actually be manufacturing the product. Our China lawyers deal with this issue more than half the time when drafting China OEM agreements, usually in one of the following three situations:

  1. The Hong Kong/Taiwan entity is the parent company of a PRC WFOE, and that WFOE owns and operates the factory that manufactures the product.
  2. The Hong Kong/Taiwan entity has no ownership stake in the PRC entity that owns the factory. Rather, some or all of the owners of Hong Kong/Taiwan entity are also the owners of the PRC entity. Or maybe the owners of the Hong Kong/Taiwan entity and the PRC entity are part of the same extended family.
  3. Neither the Hong Kong/Taiwan entity nor its owners have any financial interest in the PRC entity. The Hong Kong/Taiwan entity is merely a sales agent for the Chinese factory.

Though it is nice to know the real relationship between the Hong Kong or Taiwan entity and the PRC factory, it usually isn’t critical for determining how to write the OEM contract. We generally prefer our clients’ OEM agreements to be with the PRC entity and not with the Hong Kong/Taiwan entity for the following reasons:

  • We know the PRC entity has assets because we know it owns a factory. Oftentimes the Hong Kong or the Taiwan company has no assets beyond a rented office with a few chairs, desks and computers. We would much prefer our client have contract and litigation leverage over a company with a factory than a company with some chairs. Also, a company with a factory is more likely to abide by a contract than a company with some chairs.
  • Our OEM agreements contain non-disclosure, non-compete and non-circumvention provisions. See China NNN Agreements. The PRC entity, not the Hong Kong/Taiwan entity, is by far the most likely entity to manufacture and sell our clients’ products in competition with our client. We therefore very much want that manufacturer to have signed a contract that prevents them from doing such a thing.
  • If the manufactured product is of poor quality or delivered late, it is easier to deal with the entity that actually did the manufacturing.
  • We want the payments to go to the entity that actually does the manufacturing, rather than an interposed Hong Kong or Taiwan entity that receives payment for the manufacturing, and we want the OEM agreement to reflect this. For one thing, the PRC factory could claim it was never paid by the Hong Kong or the Taiwan factory, and use that as a reason not to manufacture for our client. Yes, this problem can be dealt with by contract, but doing so complicates things, not least because it brings another jurisdiction into play.

For more on why it almost always makes sense to contract with your PRC manufacturer, check out China Product Outsourcing. How To Distinguish Between An Agent And A Manufacturer and China Contracts, But With Whom?

manufacturing contracts

Recently we have worked on several matter that involved reviewing multiple contracts and weeks’ worth of emails and WeChat correspondence to piece together how a China manufacturing deal went awry, with the aim to salvage the relationship between the Chinese manufacturer and our client, but mostly with the aim to determine whether we can help our client recover some of its funds that are now in the manufacturer’s Chinese bank account. The funds were paid in exchange for some substandard products. It is important to mention that these clients came to us only after the deals went bad.

Here are some conclusions I have drawn from this process:

Don’t be too eager to make a deal. In the Phase One trade deal between the U.S. and China, one major complaint is that the deal is not really a good deal. In the Trump administration’s haste to make a deal, they put together an agreement that is substandard for a variety of reasons, most notably because it lacks any real enforcement mechanism other than backing out of the deal.

Even good companies with experienced China hands can neglect to incorporate the best China business practices during contract negotiations if they are too focused on signing the contract. This generally happens when companies that are new to China think they cannot afford an attorney to help them conduct due diligence on their Chinese counter-party or draft a solid China contract. These companies typically believe they have enough general business experience not to need an attorney; they have great rapport with their China counter-party and are convinced they will be able to work through any future issues amicably; they have never had an issue in any previous business deal they have done on a handshake or a bare bones contract; their domestic attorney that does not specialize in China matters has looked over it; and/or they are on too tight a timeline to conduct due diligence or negotiate key terms that will matter if the deal starts to fall apart.

Get a good contract now. As a rule, companies need to use strong contracts crafted for enforcement in China unless you are sure you can get the contract enforced in your home country. If you intend to enforce the contract in your home country, then you need a strong contract crafted for your home country. You need a legal expert to confirm to you that you have a strong likelihood of success in a lawsuit.

This is not the same as your gut reaction that because you “know” you’re dealing with a “major Chinese company” that you will have no problem finding a cache of the Chinese company’s assets in your home country. Most of the really big Chinese companies never (and I mean never) do foreign deals with their actual main company. Instead, they set up asset-less shell companies for those deals. By way of one example, our China lawyers have represented parties in at least a dozen deals with one of China’s biggest and best-known companies and every single one of those deals was with a Chinese company formed no more than a month before the contract was signed.

If the Chinese manufacturer’s assets are only in China, you need a law firm that can produce a quality China manufacturing contract for you (see here, here, here, here, here, here, here, and here). Your normal (or top notch) U.S. law firm likely can produce a great U.S. manufacturing contract for you, but they will certainly miss some key elements for a China manufacturing contract.

Stick to your guns during your negotiations. Even if you have a good manufacturing contract, if you or someone in your company with authority decides that one or two provisions are not important (when they actually are), then you are consciously removing your China armor. You should have saved the money you spent on your manufacturing contract because you will need it (and a lot more) to pay your attorney to help you figure out where your negotiations went wrong, why your contract is now substandard, and (hopefully) discerning your best avenue for recovering some of your damages from the substandard products you received and now have no use for.

Make sure your team and your Chinese counter-party know who has authority to bind the company. You need to be clear who in your organization has “actual authority” and who has “apparent authority” to negotiate and contract for the company. Even someone without actual authority can have apparent authority if you do not make clear to your Chinese counterpart that they can only contract with someone who has actual authority. You need to provide this information in writing.

After the contract has been negotiated and signed, and after you have wired your funds and received substandard product, it is not a strong defense to say that you did not approve the prior actions of someone affiliated with your company, whether it is a low-level employee or third party agent.

Good record-keeping only helps if you don’t make a misstep. You may have meticulously documented every exchange with your Chinese manufacturer. And you may believe that you have a good recollection of the events. And you may believe that your employees, co-owners, and other trusted people like your Chinese-based sourcing agent all think and believe and act in lockstep with you. But chances are, you are probably wrong on one or more of these beliefs. Keep good records of all conversations in case you need to fight with your manufacturer at some point down the road. But you also need to prepare yourself for the probability that there will be something less than ideal in your records that you will need to deal with.

China contracting is fraught with dangers even on a good day, and in today’s environment we haven’t had a good day in many years. Remember that making a good deal now does not outweigh the discovery later that your good deal is really a bad deal. The famous Chinese idiom of 同床异梦 (one bed, two dreams) always potentially applies to you and your Chinese manufacturer and to you and everyone else in your organization. Don’t forget to take a step back and review everything before plunging ahead with a seemingly good deal.

Oh, and this review I did. Almost without exception, we ended up having to tell the client that because of its less than stellar contract and its string of various mistakes along the way, we did not think it would make sense for it to pursue their Chinese manufacturer any further. In other words, these companies were now out millions of dollars and we did not think it economical for it to spend a penny more trying to get it back. The client initially complained about our conclusion, to which we essentially said, “Look, if you want to keep paying us to try to recover money for you that we do not believe can be recovered, we will not stop you from doing so, but we do not recommend it.” They ended up taking our advice.

Don’t let this happen to you. Be careful out there.

China contracts

Phone calls from potential clients nearly always start out fun and this economic downturn has brought my law firm a whole slew of new clients and potential clients needing legal help in dealing with the economic downturn.

This post is on three potential clients whose situations were so bad I had to suggest they not hire us. None of them liked what I told them, but two actually hired us anyway. One to try to deal with the matter on which they initially called, one to deal with another matter and to prevent a recurrence of the situation that precipitated their call.

All three calls started out pretty much the same with the nearly obligatory, “I got your name from so and so. She/he tells me you are the right/perfect/best person to solve my problem.” I respond by modestly agreeing that my law firm’s International lawyers are pretty experienced with these sorts of matters. All three phone calls quickly declined from there.

The declines began when the companies started telling me the facts of their situations. Two of the companies had purchased product from their long-time Chinese suppliers and had received — for the first time — totally substandard product. They both felt their  Chinese product suppliers had shortchanged them this time around because they were becoming economically desperate. See China Manufacturing Risks are Sky-High Right Now. Act Accordingly.

Unfortunately, neither company had a written contract with their Chinese supplier; they had both used purchase orders. They both wanted my firm to sue on a contingency fee basis and I immediately refused. My law firm rarely takes on a bad product lawsuit against a Chinese company on a contingency fee basis unless there is a valid contract that sets forth the product specifications and the defect in the product stems from failing to meet a contractual specification. See How to Prevent China Factory Problems and Trademark Theft That is Happening Like Never Before.

Both companies then asked me about how much we would charge them if we were to take their cases on an hourly basis and my response to both was the same: “You are welcome to pay us by the hour but if I were you, I would not spend my money on that and I would instead suggest you retain us to write you a manufacturing contract that actually works for China. That would be money well spent because it will go a long way to prevent this sort of thing from happening again. ” Neither company took too kindly to my suggestion — at least at first. One responded in such a way as to give rise to the title of this post. I totally get it. You have just lost a lot of money and the lawyer you have been told can help you recover it is telling you he does not like your case and instead wants you to pay money to prevent a recurrence.

The third incident was with a company that had supplied its own product to a number of Chinese ships. This company had failed to confirm that the ships to which it was supplying its product were actually owed by the company buying the product and it took our lawyers very little time to discover that they were not. Very roughly, this lack of a link between the company that actually bought the product and the ships to which the product was delivered meant we could not arrest/seize the ships to secure payment and the only way our client could recover on its debt would be to sue the purchasing party directly in an Asian country not exactly known for its rule of law. And the fact that our client had a lousy contract with that buyer did not exactly help.

I suggested to the company that it needed to change its procedures before supplying ships with its product in the future. I was going to tell this company it should in the future always require potential buyers provide a certificate of vessel ownership and then confirm that ownership with the applicable ship registry so there would be no doubt the vessel owner is putting its own ship at risk when it buys the product. But before I could say this, the person with whom I was speaking somewhat angrily told me he knew exactly what he was doing and he had never had this problem before. He made quite clear he did not think he needed any legal advice regarding his future business. In other words, I was to work magic on his problem now and not worry about him making the exact same mistake again.

In all of three of the above cases, these companies had been engaging in risky behavior for many years, apparently without having suffered any real consequences. It seems the old stockbrokers adage that “genius is a rising market” also holds true for China business. Or as I frustratingly put it to a company a few months back: “Look, my grandmother smoked a pack of cigarettes every day of her life since she was 16 years old and she lived to 92, but that just means she was lucky; that does not mean smoking isn’t harmful or dangerous.”

Having a good contract does not guarantee you will never have problems. Nor does it guarantee it will make sense for you to sue if something goes wrong. It does not even guarantee you will prevail if you do sue. But, in our experience (and that of pretty much everyone experienced in cross-border business), having a contract (1) greatly increases the likelihood your Chinese company will choose not to mess with you, (2) greatly increases the likelihood that it will make sense for you to sue the Chinese company if it does mess with you, and most importantly, (3) greatly increases the likelihood you will prevail if you do sue. It is the likelihood of losing at trial that causes companies to want to settle and Chinese companies are no different on this score than companies elsewhere around the world.

We lawyers are trained to think about and prepare for worst case scenarios. The current economic downturn is causing worst case scenarios to happen constantly and those scenarios are exposing those who apparently believed such scenarios could never occur. In other words, we lawyers are being proven to have been right all along. Or to put it more bluntly: We told you so.

We would love to hear from readers who are paying the price for having failed to properly document their China deals and from those readers who are faring relatively well for having done so. If any of you out there are benefiting from not having documented your deal or paying the price of having good documentation, we would love to hear from you, too.

Have at it, people. . . .

 

China manufacturing contractsHardly a week goes by at my law firm where one of our international litigation lawyers does not get a call or an e-mail from a company exploring its options for pursuing its overseas manufacturer for a bad product shipment or for no shipment at all. Each time, we patiently explain the costs and the hassles of litigating in a foreign court (or any court, for that matter), and almost every time, the company that contacted us concludes it does not make sense  to sue.

I find it frustrating that these situations are always occurring when the following can usually so easily prevent them:

  • Know your manufacturer. It is important that you have someone conduct at least basic due diligence on your proposed manufacturer. This basic due diligence ought to tell you whether the manufacturer actually still exists (definitely not a given these days with the economy at such a low point), whether it is properly registered and licensed to do the sort of business for which you will be paying it, and a bit about its financial standing and its reputation. Our international manufacturing lawyers have seen far too many times where companies have ordered and paid for product only to later learn that the “company” from which they bought the product does not really exist or is not licensed to make it or is just a really bad or disreputable company. It is not uncommon for our international litigation team to research a matter and determine that it has been tasked with trying to recoup money for product that was never delivered by a company that never really existed. Do not let this happen to you!
  • Use a good contract. In particular, use a contract that details your product’s quality requirements and clearly sets out how disputes will be resolved. For what constitutes a good overseas manufacturing contract, check out Overseas Manufacturing Contracts (OEM, CM and ODM). In many countries, agreement based on a purchase order and an invoice will not work.
  • Have the product inspected before you pay for it. I realize it is the rare manufacturer that will ship your product before you pay, but if the manufacturer will not let you inspect before the product ships, that is not a manufacturer with which you want to be doing business. There are excellent services around the world that can do this for you very inexpensively on a contract basis.

There are many other things smart companies do to protect themselves when using manufacturers overseas. They protect their intellectual property (IP) with NNN Agreements and/or Product Development Agreements and they protect their brand name by registering their trademarks  early. Companies that conduct due diligence on their manufacturers, use good contracts written for the country from which they are buying, conduct inspections of their product, and do what it takes to protect their IP stand a great chance of never being subjected to a lawyer lecturing them on the difficulties and costs of pursuing international litigation.

What are you seeing out there?

International Manufacturing Contract lawyers

Let me tell you about a European friend of mine in China. Well, he’s not really in China. Right now he’s in Thailand. Like many an expat, he went there for a quick holiday before the border closed and has been stuck for months because of virus travel restrictions.  My friend desires anonymity. We’ll just call him Peter.

Peter has been operating his own factory here in China for the past decade or so. He started up in Jiading, which happens to be where the Tesla factory is now located, just outside of Shanghai. The local government kicked him out of there — on short notice, without cause, and without compensation, he says — and the land on which the factory stood was developed. So now, at considerable expense, Peter has re-located his factory to Wuxi, in Jiangsu Province, where he currently has about 60 workers. He rents the factory space, and hires the workers, through his WFOE.

In the early stages of the US-China trade war, Peter’s company decided to open another factory in California. The American factory was not intended to replace the Chinese one. They are operating in tandem. Peter isn’t giving up on China just yet. One of Peter’s biggest customers just happened to ask him to open his factory in America.  This particular customer now requires half of its products be made in the US, and they wanted to give Peter orders they would not otherwise send him in China. Peter’s American factory employs around 12, with plans to hire more as production increases.

Peter’s factories are both original equipment manufacturers, or OEMs. They produce goods according to their customers’ proprietary requirements, and they typically don’t hold any of the intellectual property rights in the specifications, processes, or finished items. I won’t say precisely what they make, but the finished items are comprised of upholstery, metalwork, woodwork and plastics. They are supplied to, and sold under, major international brands. The American factory serves customers in the US, and the Chinese factory serves customers worldwide.

I asked Peter how the American factory compares to the Chinese one and what tips he has for foreign companies that have their products made in a Chinese factory.

 

China is still better — for now

A major advantage of the American factory was that it would allow shorter lead-times on US orders. Another plus was that customers could apply a label saying “Made in USA with global materials”. These labels are required by many of the government departments that take the goods from Peter’s customers at the very end of the supply chain. Just like in the documentary American Factory, the main challenge has been to get the American factory to reach the same performance benchmarks as the Chinese factory. From his experience in China, he knows precisely how many seconds or minutes each stage of production should take and he expects to achieve this in California, although not overnight.

Even with tariffs of 25% on imports to the US, Peter has found he can still produce and export many components of his products more cheaply and efficiently in China than anywhere else. For Peter, China is still a great place to make complex products. It’s hard to beat the vast infrastructure and supply chain. Power and coiled steel are still cheaper here in China, and his Chinese employees work very hard. Even so, it’s hard for a foreign factory to compete with local Chinese factories on price. Foreigners are under greater scrutiny and they just can’t game the system to achieve a lower cost base like the locals. So, Peter’s competitive advantage is quality — the quality of his products and the quality of his service.

Overall, though, Peter feels that the advantages of China manufacturing are easier to see only if products are being made for the Chinese domestic market, or for markets in nearby Asian countries. China, Peter says, is offering fewer and fewer advantages when products are being made for export to the US or Europe.

And Peter’s tips for foreigners still having their products made in a Chinese factory?

 

Never have a local sourcing team

Peter says the smartest foreign companies have no salaried sourcing employees and no overhead in China. One company he knows, — that just “got smart” — decided to fire its entire local sourcing team. Why? Because the local teams tend to cut themselves into the sourcing deals and thereby create costs that need to be hidden or added on. They partner with the very factories they are supposed to supervise. They often can’t help it. There is simply an expectation that a person placed in a position of power in China should use that power for their own advantage.

 

Never have a local QC team

The local QC has the power to decide whether your products leave the factory. The local QC will ask the factory manager if they want the products approved or not. Everyone knows what that means. Peter goes so far as to say it’s safest to regard local QCs as saboteurs. He wishes he had a dollar for every foreigner who has told him, “We know there are some sharp business practices in China, but our guy is different …” Our China lawyers wish the same thing. As we’ve said before, the leading consultants in this space are usually foreigners fluent in Chinese. For more on this point, see How to manage a Chinese factory.

 

Go for QA, not just QC

Quality control is all very well but it tends to focus on the very end of the production process, by which time it can be too late to change anything or impossible to detect every problem. Proper quality assurance is very different. In Peter’s production lines, there are typically more than 20 quality control points for each product. For complex products, quality needs to be assured at each step, not just controlled at the end. The only way to do this is to focus on QA as an ongoing process.

 

Just because everyone’s out to get you doesn’t make you paranoid

Peter says business practices in China manufacturing are not as bad as you imagine — they’re far worse. The way business is done here is not going to change. It’s not bad or good. It’s just the way it is. So be paranoid. If you’re hyper-vigilant you stand a chance of achieving efficiency.

 

And, no; Peter is not a China-hater. He’s made China his home and he has raised his kids here. He just wishes sometimes that foreigners would take the time to understand the prevailing business culture and work with it properly.

International lawyers for trade law On May 26, 2020, MTD Products Inc. (Petitioner) filed antidumping (AD) and countervailing duty (CVD) petitions against Certain Walk-Behind Lawn Mowers from China and Vietnam.  MTD produces lawn mowers that are sold under the Troy-Bilt, Bolens, Cub Cadet and Craftsman brands.

Under U.S. trade laws, a domestic industry can petition the U.S. Department of Commerce (“DOC”) and U.S. International Trade Commission (“ITC”) to investigate whether the named subject imports are being sold to the United States at less than fair value (“dumping”) or benefit from unfair government subsidies.  For AD/CVD duties to be imposed, the U.S. government must determine not only that dumping or subsidization is occurring, but also that the subject imports are causing “material injury” or “threat of material injury” to the domestic industry.

Before filing these petitions, MTD a few months ago had vigorously opposed the AD/ CVD petitions that were filed by Briggs & Stratton against vertical shaft engines from China in January 2020 and small vertical shaft engines from China two months later.  In those cases, MTD argued that AD/CVD duties should not be imposed on imported Chinese lawn mower engines.  Instead of blaming imports, MTD argued that Briggs & Stratton’s problems were caused by a variety of other issues unrelated to imports.  For example, consumer preferences had shifted away from gas powered mowers to electric/ battery powered mowers. Briggs & Stratton also had to deal with tariffs imposed on steel and Chinese imports which increased its manufacturing costs, making their engines more expensive than foreign engines that did not have to deal with those extra tariff costs.  Moreover, Briggs & Stratton made the dubious business decision to compete with its main customers; instead of focusing on designing, producing and selling engines to U.S. OEM lawn mower producers in the United States such as MTD, Briggs & Stratton decided to acquire a number of small lawn mower producers (Snapper and Murray) and directly compete in that market segment against some of its top customers.

The ITC, however, disagreed with MTD and other respondents and in both vertical shaft engine cases made affirmative preliminary injury determinations.  Seeing how the AD/CVD cases on vertical shaft engines could very well lead to AD/CVD duties being imposed, MTD realized that these AD/CVD duties would increase its lawn mower production costs and would affect its manufacturing supply chain, thus making them less competitive against other foreign lawn mower producers.  So from vigorously opposing AD/CVD duties on vertical shaft engines, MTD now strongly supports AD/CVD duties on imported lawn mowers.  MTD apparently decided it needed to bring its own AD/CVD petitions against lawn mowers from China and Vietnam to protect itself as it deals with the fallout from the vertical shaft engine AD/CVD cases.

This new round of AD/CVD petitions is yet another example of the trickle-down effect of protectionism.  Section 232 tariffs on steel and aluminum imports first begat a wave of AD/CVD cases filed by US producers of products using steel (e.g., steel kegs, vertical metal file cabinets, lawn mower engines).  These AD/CVD cases are now triggering another wave of cases from downstream industries (e.g., lawn mowers) seeking their own import protection.  As the economy reels under the strains of the COVID-19 pandemic, we very likely will see more AD/CVD cases being filed with more U.S. industries desperately trying to survive the economic downturn often by seeking protection from import competition. The cost of protecting each layer of U.S. manufacturers gets added to the cost of the goods ultimately purchased by U.S. consumers.

If you import products from China, be on guard; America’s ever-rising anger at China only increases the odds of more such cases.

The following is the vital information on this new lawnmower case:

— Scope

The petition identifies the merchandise to be covered by this AD/CVD investigation as walk-behind lawn mowers powered by an internal combustion engine with a power rating of less than 3.7 kilowatts which are rotary-powered grass cutting machines.

See here for the proposed scope definition from the petition.

— Alleged AD/CVD Margins.

Petitioner calculated estimated dumping margins ranging between 245.47 to 313.58% for China and from 285.10 to 416.00% for Vietnam. Petitioner did not provide any specific Chinese subsidy margin calculations.

— Named Exporters/ Producers

Petitioner included a list of companies it believes are producers and exporters of the subject merchandise.  See attached list of these companies here.

— Named U.S. Importers

Petitioner included a list of companies it believes are U.S. importers of the subject merchandise.  See attached list of these companies here.

–Estimated Schedule of Investigations.

May 26, 2020 – Petitions filed

June 15, 2020 – DOC initiates investigation

June 16, 2020 – ITC Staff Conference

July 10, 2020 – ITC preliminary determination

October 23, 2020 – DOC CVD preliminary determination (assuming extended deadline) (8/19/20 – unextended)

December 22, 2020 – DOC AD preliminary determination (assuming extended deadline) (11/2/20 – unextended)

May 6, 2021 – DOC final determination (extended and AD/CVD aligned)

June 20, 2021 – ITC final determination (extended)

June 27, 2021 – DOC AD/CVD orders issued (extended)