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 trademark law firmNobody disputes that Chinese factories that make OEM products for American and European companies are increasingly looking to make their own products for selling directly to consumers. Nobody disputes that online marketplaces have made this much easier.

And yet….

And yet, without fail and probably at least twice a week, we get emails from stunned companies reporting to us that they have just learned that their Chinese factory has registered “my trademark” or “my patent” in China and is selling our product for 25-75% less. We have gotten more such emails/calls in the last year from companies whose China factories are now directly competing with them than in the three years prior combined. And yet we also still get emails from companies that tell us that they “like” or “trust” their China supplier so much that it does not even make sense for them to spend money trying to stop this company from competing with them or that even asking their trusted China partner to sign anything would be viewed as an insult.

WRONG.

When companies tell me no contract is necessary I usually simply wish them the best of luck. When companies tell me that they are worried about asking their Chinese company to sign anything, I tell them that Chinese manufacturers expect to sign contracts these days and they view foreign companies that do not require them to do so as suckers. But what I want to tell the companies that are planning to rely on their good and trusted relationship with their Chinese suppliers is that pretty much all business relationships start with trust because who goes into a relationship with someone they either hate or know to be dishonest? You want a contract to memorialize your good relationship. You want a contract when you are in agreement and therefore have something to put on paper in the form of a contract. Contracts cannot be written if the two sides cannot agree.

With online selling having become so easy for Chinese factories, your product has never been more at risk for competition by the very same factory to whom you provide your molds and your know-how and your technology. Chinese factories know this and many are agreeing to manufacture products at money-losing prices simply to acquire the knowledge that will allow them to sell those same products directly themselves.

Some of these Chinese factories will not create duplicates of your products for their foreign buyers — be they your competitors or your customers. They instead take what they have learned from manufacturing for you and use that information to compete directly with you. Since you will essentially be educating your Chinese manufacturer on how to compete with you, you need contracts and IP registrations that will at least limit what it can do when it does.

Chinese factories are becoming increasingly confident about selling their own products online and therefore more willing to risk losing their foreign OEM product customers to do so. Add to this that nearly all of the online retail platforms are focusing on helping Chinese manufacturers sell directly and you should be able to see exactly where all of this is leading.

What though can you do to stop this? The better question is what can you do to slow down and reduce this sort of competition? I suggest you read the following:

Despite the need to have a contract (or multiple contracts) with your Chinese supplier and despite the need to always be alert to what your Chinese supplier is doing with your product and in your product marketplace, there is still room for a good relationship and having such a relationship is important. Think of the contract as a way to bolster your good relationship with your supplier by reducing the issues on which there will be disagreements.

Trust yet verify.

What are you seeing out there?

China Manufacturing Lawyers. China IP Lawyers

I wrote a four-part series on product development in China, entitled, Hardware Co-Development in China: Do it Right — Part 1 is here, Part 2 here, Part 3 here and Part 4 here. This series helped explain why developing products in China can be so complex and why it is so important to protect your intellectual property during the product development process. In response to those posts a number of people have asked our China lawyers how to structure product development relationships with Chinese companies so the foreign company actually ends up with the rights to the product that gets developed. This post addresses that issue.

The key is to focus on manufacturing rights, rather than on intellectual property rights, especially when the PRC or Taiwan factory presents the foreign product developer with an already prepared manufacturing agreement. Lawyers all over the world have become masters at writing complex and sophisticated intellectual property provisions for product development and manufacturing agreements. Because these IP provisions are written to cover every possible situation, they are usually written at such a high level of abstraction they often have little to no real meaning on the ground in Asia.

Our solution at this point is not to further refine or revise the already highly refined IP language. Instead, we recommend focusing instead on the practical issue of manufacturing rights. At the end of the development process the Chinese factory and its foreign customer (our client) will be looking at a set of prototypes and the sole issue for the foreign party at that point is usually what can I do with those prototypes? If this question is not clearly resolved in an enforceable contract at the start of the development process, the answer will usually be that the foreign party cannot do anything with the prototypes beyond what the Chinese factory allows it to do. For what is required for a contract to be enforceable, check out China Contracts that Work.

To avoid this result, at the inception of the development process the foreign party should secure a written and enforceable contract that includes the following:

  • A clear statement of what will be done, when and by whom. This should include a clear description of the product to be designed and the work to be performed.
  • A clear statement of the costs, the allocation of costs, and the payment dates for the costs. It is important that your contract be written to provide a clear understanding of what will be provided by the Chinese manufacturer in return for the payments. This provision should address molds, tooling, software, design, and a working model.
  • A clear statement that if the design project fails, all the tangible and intangible materials developed during the project will be transferred to the foreign customer with nothing retained by the Chinese factory or designer.
  • A provision stating that if the design project succeeds and prototypes are developed the foreign customer shall have the right to manufacture the product in any factory anywhere in the world. The foreign party should be free to determine what factory will manufacture the prototyped product. Normally, this will mean manufacturing it in the factory of the co-developer, but what if that factory cannot make the product for a satisfactory price, or in satisfactory quantities, or with satisfactory delivery dates or quality? What if the Chinese factory insists on raising its prices six months later? For you to be able to maintain control over your product, you must have the right to move some or all of the manufacturing of your product to the facility of your choice, for any reason at all.

This issue of the right to manufacture should be clearly understood by both sides before the parties start discussing the more abstract issues of intellectual property rights. Every factory owner and every foreign party understands the issue of manufacturing rights and if you negotiate this early on, the real situation will be revealed in a way both parties understand. When the parties reach clear agreement on manufacturing rights, the intellectual property provisions become relatively easy for our China IP lawyers to draft.

If you wait to seek agreement on manufacturing rights with your China factory until product development has concluded you will have relinquished your leverage. If you wait until your Chinese factory completes the prototype, it can deny that you have any manufacturing rights and it can raise its manufacturing prices with near impunity. You need a China appropriate contract making clear you (not your Chinese factory) own the manufacturing rights because without this your Chinese manufacturer will probably be able to stop your product from being made by any other factories in China or from leaving China if it is.

When beginning the product development process in China it will often make sense for you to skip abstract discussions of intellectual property rights and just focus on the key practical issue both parties can understand: when the prototypes are finished, what can you do with those prototypes? It pays to discuss and resolve this issue early on with your Chinese manufacturer. For what should go into a China product development contract, check out China Product Development Agreements.

China sourcing contractsOne of the first things our China lawyers do when working with a company having products made in China is figure out the contracts and IP registrations that will ensure our client’s intellectual property and other rights will be protected as against its Chinese manufacturer and the rest of the world. In doing so, our China attorneys typically choose from the following manufacturing related agreements and IP registrations:

1. NNN Agreement. NNN Agreements are basic agreements that protect the confidentiality of your products and prevent your Chinese manufacturer from competing with you or circumventing you by going directly to your customers (non-disclosure, non-compete and non-circumvent. Their highest and best use is usually before you chose your specific Chinese manufacturer. Oftentimes an NNN Agreement is not needed because it makes better sense to put the substantive provisions from the NNN Agreement into a Product Manufacturing Agreement, described below. NNN Agreements normally are relatively simple agreements but for one to work with China it must be done correctly and using an off-the-shelf American or European NDA Agreements will not work for China. See Why Your NDA is WORSE Than Nothing for China

2. Mold/Tooling Protection Agreement. This agreement makes clear that the molds/tooling you are having made for you will actually belong to you and cannot be used to make products for anyone but you. Without such an agreement, when you seek to move your production to a new manufacturer, your old manufacturer will very likely keep your molds/tooling. Without this agreement there is also a good chance your old (or even your present) manufacturer will use “your” molds/tooling to make “your” products and compete with you. Just as is true with China NNN Agreements, it often makes sense to skip this agreement and put its substantive provisions into the Product Manufacturing Agreement. For more on these agreements, check out Manufacturing in China: Control Your Molds (Part 1), Manufacturing in China: Control Your Molds (Part 2) and Manufacturing in China: Control Your Molds (Part 3).

3. Product Ownership Agreement. This agreement makes clear the product you are co-developing with your Chinese manufacturer or having made by your Chinese manufacturer belongs to you. This makes sure you have something in writing and enforceable in both China and in any other country in which your product is going to be sold. Without this agreement, your Chinese manufacturer may be able to claim ownership to the IP rights in “your” product and register a patent in “your” product in China and in other countries. See China and The Internet of Things and How to Destroy Your Own Company. This agreement is rarely needed because a Product Development Agreement or a Product Manufacturing Agreement usually can cover the product ownership issues.

4. Product Development Agreement. This complicated agreement should set out the terms of your product development relationship with your Chinese manufacturer, In particular, it should specify who will own what of the finished product and who will pay for what to develop the finished product. These agreement should make clear what you will be paying in product development costs and it should set out the various milestones your Chinese product manufacturer must meet to get paid. At minimum it should address (1) the product to be developed, (2) the technology the foreign company and the Chinese manufacturer will contribute to develop the product, (3) who will provide the product specifications and in what form, and (4) who will own the IP rights to the final product.

5. China Manufacturing Agreement. This agreement is often called a Product Sourcing Agreement or OEM Agreement. These complicated agreements should clarify pretty much everything between you and your Chinese manufacturer and unless you are spending small amounts on your product purchases, you need a China Manufacturing Agreement. Among other things, this agreement usually should — at minimum — address the following:

Quality

Timeliness

IP ownership

Mold and/or Tooling ownership

Non-compete, non-circumvention, non disclosure See NNN Agreements above

Sub-supplier/sub-contractors

Liquidated damages for breaches

6. China Trademarks. If you are having your product made in China you should secure a trademark for whatever brand name (and probably whatever logo) you are putting on your product or its packaging. If you don’t do this, someone else probably will and then they will use their trademark to stop your product from leaving China. You also should secure trademarks in the countries in which you will be selling your product because trademarks do NOT cross borders. Getting a China trademark is nearly always essential.  See China: Do Just ONE Thing: Register Your Trademarks.

7. China Patents. If your product is innovative or distinctive in its function or its design you should consider securing a China invention or design patent. These patents can be valuable/necessary to protect your product against copying and to prevent someone else from registering a patent on your product in China and then using that patent to stop you from manufacturing your product in China or from leaving China’s ports. See China: Do Just ONE Thing: Register Your Trademarks AND Your Design Patents.

The thing we as lawyers always need to focus on is maximizing value/protection for our clients will minimizing costs. This involves choosing the right agreement(s) and the right registration(s) at the right time(s) and doing everything correctly. See China Contracts: Make Them Enforceable Or Don’t Bother and China OEM Agreements. Why Ours Are In Chinese. Flat Out.

Easy-peasy, right?

China IP lawyersChina (Shenzhen mostly) is the primary destination for manufacturing of small electronic consumer products. And since Internet of Things (IoT) products are red hot, this means our China lawyers get a steady stream of China IoT legal matters.

The big issue we most often see is this: the IoT product has now reached the mass production stage and is being produced in large quantities. Now that it has a commercial product, the U.S. or European (usually) buyer now seeks financing for its start-up company. The financier (be it angel, VC, private equity, or even someone’s father-in-law) then asks who owns the intellectual property in the product? With the rise of the Internet of Things (IoT), this question is often difficult to answer definitively.

How did we get to this point where the IP rights of a product are so often vague? The process has worked its way through three general stages:

Stage One. In the good old days (roughly 1981 to 1995), the situation was simple. There were two possibilities. In the first, the Chinese manufacturer made a standard consumer product. The foreign buyer purchased that existing product and perhaps required the Chinese manufacturer take the extra step of placing the buyer’s own trademark/logo on the product. In that setting, ownership of the intellectual property was clear: the Chinese manufacturer owned the product design and the foreign buyer owned its trademark/logo. In the second, the product was a long standing, well developed product of the foreign buyer. The foreign buyer brought the completed product to the Chinese manufacturer and contracted with the Chinese manufacturer to make a copy. In that setting, ownership of the intellectual property was clear: the foreign buyer owned all the intellectual property and the Chinese manufacturer owned nothing.

The simplicity of this sort of relationship encouraged the somewhat lazy practice of documenting the entire manufacturing relationship with purchase orders. NNN agreements, product development agreements and OEM agreements were seldom used, since IP ownership was clear and the price and delivery terms were resolved via the purchase orders. This approach would often lead to product defects, but that is for another post.

Stage Two. In stage two (roughly 1995 to 2015), a new form of manufacturer-buyer relationship developed. Foreign buyers began coming to China with no completed project in mind; they instead would come with a product idea or proposal. The foreign buyer would then work with the manufacturer to co-develop a product. In some cases the Chinese manufacturer would simply take a completed prototype and commercialize that prototype for mass production. In these cases, the foreign buyer arrived with little more than a basic idea and the two sides worked to co-develop the product. See China Product Development Agreements, for pretty much everything you need to know about China product development agreements.

The Chinese manufacturer usually would perform the product development work at its own expense, with the implied agreement being that it would be the exclusive manufacturer of the product. This co-development process typically used the same lazy “purchase order only” approach from stage one. This approach then led to the many issues we see today that make answering the “who owns what IP” question so difficult. To do the co-development process properly, the parties must define their relationship with three agreements: 1) an NNN Agreement, 2) a Product Development Agreement and 3) an OEM Agreement.

When these agreements do not exist, a standard set of issues arises: Who owns the product design? Who owns the molds and other tooling? Who owns the manufacturing know-how and similar trade secrets? If the buyer decides has the product made by a different Chinese factory, what compensation is owed to the Chinese manufacturer that co-developed the product? What are the  Chinese manufacturer’s obligations to comply with the foreign buyer’s price and quantity requirements? If the Chinese manufacturer terminates its relationship with the foreign buyer and manufacturers the product under its own trademark/logo, is this a violation of any agreement between the parties? Absent clear written agreements, none of these questions have clear answers. In these unclear situations, the Chinese factory will nearly always be in a much stronger position than the foreign buyer and the Chinese factory will typically prevail in any IP dispute.

Stage Three. In stage three (2015 to today), we arrive at the IoT era. In designing, developing and manufacturing consumer products for the IoT market, the already unclear and problem-filled relationships of the stage two era are now magnified. In the IoT era a whole new set of issues has arisen. In the stage two era, there was at least the simplicity of two entities designing and/or manufacturing a single product. In the IoT era, the situation is considerably more complex. In most of the IoT projects we have done, the development process has expanded to include the following:

1. Product “concept” from the foreign (usually United States or European) buyer.

2. Product external design, from an international design firm.

3. Internal design and function, owned by:

a. The foreign buyer;

b. The Chinese manufacturer;

c. The provider of sensors and other components required to connect the IoT product to an outside network.

4. Design of the IoT product “app” (usually for smart phones). This involves two completely separate sets of software: the communication sending software residing on the IoT product and the communication receiving software residing in the application. In the same manner as the internal design, these software components may be written/designed by multiple parties: the foreign buyer, the Chinese manufacturer and (quite often) third party software design firms.

What happens then when the product is complete, and manufacturing is ready to start and the foreign buyer starts to seek funding: The funding source almost invariably will ask who owns the IoT product? Who owns its underlying IP? What our China lawyers have far too often found when we ask the foreign buyers these questions is that they usually don’t really know.

This “we don’t know” response does not sit well with potential sources of serious financing. Even worse, when the foreign buyer is pushed to answer the question, it becomes clear that it is not clear who owns the new product. Far too often the only ownership issue that is clear is that the one entity that the foreign buyer is the one entity that does NOT own the rights to the product. Even worse, it is usually not possible to fix the situation by this point.

Bottom Line: As manufacturing in China and the IP issues attendant with that become more complex, it becomes even more important that you have clear written agreements that answer the obvious IP questions in advance. It does not make sense for you to devote your time and your energy and your money developing an IoT product for someone else to own.

For more on the issues involving China and the Internet of Things, check out the following:

China sourcing contracts

China sourcing is complicated. And that’s talking strictly about the non-legal side of it. Our China lawyers who draft manufacturing contracts (typically NNN Agreements, Product Development Agreements and Contract Manufacturing Agreements) have seen enough mistakes to write a book. Well someone sort of just did. Renaud Anjouran, of Quality Inspection Blog, essentially just did, in his post, China Sourcing 101: the 15-Part Guide for New Buyers. He describes it as a “15-part series for new buyers who are starting to work with Chinese suppliers (and for more experienced people who want to double-check whether they are working in a smart way)” and it consists of the following 15 articles:

  1. Do You Need a Sourcing Agent?
  2. How to Identify Potential Suppliers?
  3. How to Verify a Manufacturer
  4. Second Choices vs. “Never Again”
  5. Negotiation: The Terms you Need to Discuss
  6. Keep Some Leverage with Suppliers
  7. Pre-Production: Describing What You Want
  8. Project Management of Your Orders
  9. Check Quality Early in the Manufacturing Cycle
  10. Always Verify Quality Before Shipment
  11. Build Good rapport with Suppliers
  12. How Closely Do You Follow Your Productions?
  13. The 5 Steps to Developing a Chinese Supplier
  14. How a Factory Can Improve Quality
  15. How a Factory Can Improve Productivity

If you want help in figuring out how to better source your product from China, I suggest you work your way through this series. And if you want help on the legal side, I suggest you read some or all of the following:

China Factory Problems: Always YOUR Fault?

How To Get Good Product From China; Specificity is THE Key To Your OEM Agreement.

China OEM Agreements. Ten Things To Consider

China OEM Agreements. Yet Another Reason To Have One

China Supply Agreements. Why The “Perfect” OEM Agreement Should Cost Less

OEM Agreements With Your China Supplier. Not Just For The Big Boys

China OEM Agreements. Why Ours Are In Chinese. Flat Out

The Five Steps To Successfully Buying Product From China.

China Manufacturing Agreements. Make Liquidated Damages Your Friend.

How To Get Bad Product From China With No Legal Recourse.

Any questions?

China IP lawyers and artificial intelligenceI have received a number of emails in response to my recent post on China’s artificial intelligence plan. Many who wrote me seek to reduce China’s plan to the following simple, three step process:

  • Catch up in AI by 2020.
  • Learn to make some basic products by 2025.
  • Lead the world by 2030.

This does not accurately summarize the plan, though it is how much of the English language media describe it. The full PRC AI plan is set out in 35 pages of dense, jargon heavy, Chinese bureaucratic prose. I will be doing a series of blog posts seeking to explain the full plan. My first post, China’s Artificial Intelligence Plan — Stage 1, dealt only with stage one, and as you can see from that post, stage one is not written as “catch up.” Stage one is a full-on plan to continue developing technologies with which Chinese companies are already working. I note also that manufacturing automation robotics is not featured. On the robotics side, the emphasis is on service robots.

Note also that the Chinese companies are already way ahead of this plan. They are not waiting around for guidance from the government on their AI projects; they are moving ahead full speed. In general, Chinese companies are succeeding most with the software/network based applications of AI. This is the focus of the Baidu research center in Silicon Valley. They are not doing as well with mechanical devices such as robotics and smart vehicles and sensor based IoT devices. However, they know that and they are making strong efforts to advances in these areas. We touch on this a bit in China IP Challenges for Automotive Suppliers. One of the areas on which many Chinese companies are focusing is on human/AI interaction and they are having good success with that in the field of medical imaging and diagnosis.

There is little doubt that part of China’s AI strategy involves acquiring technology and then selling in back into the developed market from which it came. This has been and still is the strategy of businesses in pretty much every developing country. The U.S. followed this approach during the entire 19th and early 20th centuries. Japan and Korea and Taiwan did it with great success in the post WWII era. China and India are now moving into that phase. That is how technical progress is made and we write about to guard against this sort of IP appropriation nearly every week. See How To Give Away Your IP In China, How to Give Away Your IP in China Without Realizing It and China and the Internet of Things and How to Destroy Your Own Company.

The real question is whether this strategy will work in the AI era  In general, Chinese companies are not good at working on their own to appropriate foreign technology. They prefer to enter into a manufacturing or joint venture arrangement where they convince the foreign entity to teach them how to use the technology. See China Joint Ventures: Keeping Your Friends Close and Your IP Closer. Then, later, they appropriate the technology and sell the cheaper product back into the same market. This is what Chinese companies did with high speed rail and with the Russian designed fighter jet and this is what they are trying to do it now with commercial aircraft. They will undoubtedly seek to do the same thing with AI and robotics. See China-US Trade Wars and the IP Elephant in the Room.

Will China succeed it purloining AI IP? It depends on a couple of factors. First, if the technology is protected by patent and copyright and trade secrecy, then they cannot sell into the markets where those IP protections exist. This would mean that North America and the EU would be closed to them, at least during the period where the IP protections are in place. Second, can Chinese companies master the technology to point where they can really compete? Normally, the Chinese companies simply clone the product and then seek to compete solely on the basis of price. For some products, this works. For more sophisticated IoT, AI, “smart” products, the success rate of the Chinese companies has been low. How many U.S. consumers get excited about the purchase of a Lenovo computer or a Xiaomi cell phone? How many U.S. customers are interested in buying PRC knock offs of virtual reality headsets? Not many. Price is not the significant issue for these more technically sophisticated products. When Chinese companies cannot compete on price, they traditionally don’t know what to do. There are many programs in place in China focused on changing this “price is the only issue” mindset. So far, progress has been sporadic at best.

However, without regard to whether China can succeed with its AI program, it is clear that appropriating foreign AI technology is the goal of most Chinese companies operating in this sector. For that reason, foreign entities that work with Chinese companies need to be aware of the significant risk and take the necessary steps to protect themselves. There are many ways to do this, using a mix of IP registrations and carefully drafted agreements. See China Contracts: Make Them Enforceable or Don’t Bother. This is what the China lawyers at my firm focus on and this is the issue we discuss most often on this blog. Stay tuned.

China IP attorneysIn the old days, purchasing products from China was relatively simple. The product was a basic “off the shelf’ product. The product was a fungible, internationally traded products, such as white t-shirts, underwear, medical gauze, rubber gloves, tableware and similar. For that reason, specifications were set based on an internationally accepted standard. Neither party set the standards; the standards were set by the market. For these types of products, purchases based on standard international purchase orders was the norm. Though the purchase order approach never worked well, at least for outlining the basic quality standards and business terms, purchase orders were adequate.

The first stage in complicating the system was when foreign buyers began requiring their Chinese factories to do some simple customization of the factory’s off the shelf product. This usually involved little more than putting the buyer’s brand name on the item and its packaging. The next stage of complication came when foreign buyers came to China with a completed product and requested their factory copy it. Since there was a physical item as a basis, there was a clear standard for determining specifications and quality. The copy was either good or bad and it was relatively easy to decide. So even in this era, a simple purchase order usually was sufficient to set out the basic terms of the agreement between the parties.

In the current world of contract manufacturing in China, the situation has become far more complex. It is no longer sufficient to simply set out the terms of the agreement in a simple purchase order or a purchase memorandum. One reason for this complexity is that there is no longer a single type of product being purchased. Dealing with the proliferation in product types has made drafting contract manufacturing agreements progressively more challenging.

For example, even in a very basic contract manufacturing relationship, the foreign buyer is typically dealing with four completely different types of product. The China lawyers at my firm call that the “standard mix.” For this set of products, we typically use the following terms:

1. Manufacturer Standard Product (“Standard Product”).

2. Customized Standard Product (“Custom Product”).

3. Buyer Designed Product.

4. Co-Designed Product, where Buyer claims to own the design IP.

We often call call both 3 and 4 “Buyer Designed Product,” since the buyer claims to own the intellectual property in each case, so there is no real need for two different terms. However, one of the first issues we often confront is that in the case of 4, Co-Designed Product, the Chinese factory usually does not agree that the buyer owns all the intellectual property. For this reason, in defining the term, we make clear the entire ownership rests with the buyer, without regard to the participation of the factory in the design process. This forces the factory to make clear at the start whether will it assert that its own the IP.

Working with these four categories of product in a single contract manufacturing agreement is difficult, but there are other types of products where IP ownership is even more difficult to nail down, making drafting (and doing business) even more difficult. Consider the following:

1). Buyer standard product, base product, or “off the shelf” product is often what we can more technically call an “open source” product where specifications are an industry standard. That is, no one owns the design of a white t-shirt or a pair of flip flops or surgical gauze. These products are standard and made all over the world and they are international set specifications. For these products, the specifications are taken from the international industry standard and the factory is held to that standard. An example is thread count for the fabric used to make t-shirts or underwear.

2. There is, however, another type of “off the shelf” product: this is product for which the factory claims that it owns the design of that product. In some cases, the manufacturer did the design and really does own the design. In other cases, the factory “borrowed” or “appropriated” the design from someone else. Often, these are more complex devices like equipment, machines and electronic devices for which the patent has expired and anyone is free to make a copy. However, in other cases, the factory did in fact steal the design from some other entity that claims design ownership.

In the past, we tended to call both 1. and 2. above “manufacturer base product” or “standard product” or “off the shelf product”. But it is important to note that these two types of product are really quite different. For example, for 2, the specifications come from the factory (not industry standard), the warranty is that the factory will meet its own specifications and there should be an additional warranty from the factory that the manufacturer really does own the IP rights in the product.

Since the issue is usually ignored, there has been no good term for identifying product type number 2. That is, buyers tend to treat product type number 2 as if it were the same as number 1, which is a mistake. For clarity, 1 should be called “off-the-shelf” product or “standard product” or “base product” while 2 should be called “manufacturer proprietary product” or something like that. On the ground, these two types of products are often not clearly identified by the factory, making it even more difficult to determine what is going on.

But the fact is the legal situation for these two types of product is entirely different. In some cases, truly fungible product of type number 1 can be purchased using a purchase order or a standard form agreement. This is not true for the type 2 product where a  completely different legal approach is required. But it is not possible to know what to do until the type of product has been properly identified.

3. There then is a third type of product where the factory owns the core technology but the foreign buyer owns the external “shell.” We see this a lot with medical and electronic devices. The factory owns the technical internals and the foreign buyer owns the design in the case and other housing for the technical internals. The normal position of the IP ownership taken by the factory is that the buyer is free to take the shell to another factory, is not free to take the technical internals to any other factory.

Many buyers do not understand this. They come to the factory with the opposite interpretation. The foreign buyer believes they should be free to take the entire unit to another factory for manufacturing. This mistake in interpretation has become quite common in the past three years and it has caused many disputes and eventual failures in production. In every instance seen by the China attorneys at my firm, the foreign buyer wanted to take the entire product to a different factory and just assumed it could do so and actually built its business model on that assumption. In each case, the Chinese factory refused late in the process and basically halted the product commercialization process. No venture capital fund would provide funds for a product where a single Chinese factory controls production.

4. Finally, there is a the truly co-designed product. In this case, both the buyer and the factory developed the product working together. This is the type of product for which a Product Ownership or Co-Development agreement is required. See Hardware Co-Development in China: Do it Right, Part 4 (and the previous three posts in this series). Without such an agreement, the buyer often believes it owns the design, but in fact either a) both parties have equal ownership in the design or even worse b) the Chinese factory owns the entire design because it did the hard creative work. The foreign buyers are usually unaware of the basic legal rules in this area and during the co-design process they lose ownership and control over their key product IP. Usually this happens before the buyer contacts a lawyer with China manufacturing experience. For examples of how companies lose their IP, check out China and The Internet of Things and How to Destroy Your Own Company.

As you can see, the issue of just what type of product is being purchased from a Chinese factory has become complex. The situation will become even more complex as more IoT and related smart products are produced that combine design, hardware and software with inputs from heterogenous sources, many of which are not in the control of either the buyer or the manufacturer. So the days of a bare purchase order are long over. Moreover, the days of a simple, one size fits all purchase agreement are also over. But many buyers still think of the process as being the same as in the old days of purchasing fungible off the shelf products.

China contract lawyersPurchasing products manufactured in China has changed substantially over the past five years. in the old days, foreign buyers usually either purchased generic, off the shelf products or they hired Chinese factories to make products designed by the foreign buyer. The Chinese factories have gradually become more involved in the design process. Most recently, Chinese manufacturers have started to sell their own proprietary designs. This raises a number of contracting issues that are not fully understood by most foreign buyers.

In the early days, the situation was simple. The Chinese factory manufactured a basic consumer product for which no one in the world claimed any ownership of the underlying design. The product specifications were standardized. The task for the Chinese factory was to learn those standards and then manufacture a product that met the standards.

For example, for a simple white t-shirt there are a number of specifications that apply: sizes, fabric material, fabric color, thread count, neck size, ornament, label placement and label content. The foreign buyer provides the specifications and the Chinese factory is required to manufacture this standard item to meet all these specifications.

For this type of “fungible base product,” neither the factory nor the buyer make any claim to ownership of the underlying design of the product. The product is standard and the specifications are part of a product standard that applies to all manufacturers of the product anywhere in the world. If the Chinese factory cannot meet the specifications, the foreign buyer is free to manufacture for itself or purchase from any other factory in the world. On the other hand, the Chinese factory is free to sell these shirts to any buyer.

In today’s world, Chinese factories have become far more sophisticated. The extreme example of that sophistication is the situation where the product being sold is a sophisticated item designed entirely by the Chinese manufacturer. In this case, there is no open-source, standard set of specifications for the product. The manufacturer owns the design and the specifications are set by the manufacturer, not the buyer. The buyer often chooses from a menu of specifications.

The relation between the parties in this setting is quite different though most foreign buyers treat purchasing this type of “manufacturer proprietary product” the same as purchasing a fungible base product. In fact, the issues are quite different and a contract for purchasing this type of product requires a number of different provisions. For example:

a. How will the specifications be determined? What is the standard for failing to meet the specifications? For the manufacturer of a proprietary product, it is the manufacturer itself that sets the standards. So rather than providing that the Chinese factory must manufacture in accordance with industry standards or the specifications of the buyer, the contract must provide that the manufacturer warrants that it will manufacture in accordance with its own specifications. This then requires that those be stated clearly in a way that provides an objective reference point.

b. In many situations, the buyer will require the product meet safety and quality and other regulatory standards established by the law of the buyer’s country. For this situation, since the factory is entirely in control of the design, the factory must warrant that it is knowledgeable about all applicable standards and its product will meet those standards. The buyer cannot instruct the factory on the specifics of what to do. The buyer must rely on the factory to do it right. This then requires a warranty that the factory actually did what was required.

c. How does the foreign buyer know that the Chinese factory actually owns the design of the product? How does the foreign buyer know that the product does not violate the intellectual property rights of some other Chinese factory or some other entity located outside China? The risk that the Chinese factory design violates the rights of a third party is not low. The foreign buyer should understand this and do some basic due diligence to ascertain its risks of being sued for IP violations. As a contactual matter, the purchase contract should — at minimum — provide that the Chinese factory warrants that its product does not infringe on the intellectual property rights of any third party. The contract should further provide that the Chinese factory is required to indemnify the foreign buyer from liability from any infringement claims made by third parties.

d. Since the Chinese manufacturer owns the product design, the manufacturer has the right to sell the product to any buyer. This means that the manufacturer has the right to sell to other buyers who sell in the same market as the buyer. Most buyers of this type of expensive product will not want an identical product to be sold to its direct competitors in the market. For this reason, most foreign buyers will want some form of exclusivity that would not be possible in the case of fungible base product.

Chinese manufacturers will always agree that they will not sell their proprietary product under the trademark and logo of the foreign buyer. But absent a specific agreement, they can and they will sell the bare product to any buyer who shows up at their door. The Chinese manufacturer will only agree to provide exclusive rights to the foreign buyer in a case where the foreign buyer agrees to pay a price for that exclusivity. That price will generally be a hard agreement to purchase a certain number of units at a certain price for a certain time period. Chinese factories generally drive a hard bargain in this area and require a commitment that is often difficult for the foreign buyer to accept.

Many foreign buyers fail to clearly consider the type of product they are purchasing from China and so they end up treating the purchase of a Chinese manufacturer’s proprietary product as no different from the purchase of a fungible base product. This is a mistake. The terms for purchasing these two types of product should be very different and failing to understand the differences often results in the foreign buyer failing at its product purchase negotiations or ending up with a product purchase situation that does not make sense for it.

China lawyers for manufacturing

Having just returned to Qingdao after a fairly long absence, I met over the weekend with a group of expats engaged in various forms of manufacturing in China to get their  take on current conditions and their feelings about the future. The participants in the discussion were from many regions: United States, Canada, England, Germany, Norway, Finland, India, Pakistan, Spain and Italy.

The discussion was interesting because the opinions expressed were very consistent. Every person said that they were having problems with their manufacturing in China and that they were interested in diversifying into other countries. They identified the following issues as causing them problems in China:

a. Rising wages. When productivity is factored into the analysis, China can no longer be considered a low wage country. Many participants stated that on a purely wage basis, Chinese manufacturing is not significantly cheaper than parts of the United States.

b. Rising costs. The main complaints were directed at soaring rental rates and rising utilities costs. Many of these costs were formerly subsidized. These subsidies are being removed and the cost is being reflected in the price of manufactured products.

c. Declining manufacturing quality. All of the participants in the discussion agreed that instead of improving, the rate of manufacturing defects has risen over the past five years. This rise in defects has been coupled with a general decline in service from Chinese manufacturers.

d. Increase in scams. In recent posts (see part 6 here and follow the links to the previous five posts in this “Scam Week” series) we have discussed the rising number of scams our China lawyers are seeing involving both foreign manufacturers and investors. The participants in this discussion have also seen a rise in irregular practices in the manufacturing sector. Swapping out product components for lower quality items was a major complaint and these swaps are happening more now than five years ago.

Given the above complaints, I asked the participants “To what country would you choose to move your manufacturing operations?” Their responses to this question was surprisingly consistent: they all agreed they would move to Malaysia or Indonesia.

Given the above, I assumed that a move for all the participants was imminent. So I asked the natural question: have any of you actually moved your operations out of China to the countries you have identified or to any other countries in the world? The response was surprising to me. In spite of the consistency of their complaints, NONE of the participants had moved their manufacturing operations out of China. Most had tried some other country, with Viet Nam, The Philippines, Malaysia, India and Bangladesh being the most common countries explored. But every person in the group had abandoned these plans and had either kept their operations in China or moved their operations back to China.

The reasons given for the returning to China or just staying here were as follows:

a. Inadequate supply chain. For larger, established companies the primary reason was the lack of a good supply chain. They found it impossible to obtain all of the components required to manufacture on a consistent and price competitive basis.

b. Low productivity. Though wages in the other countries were lower than China, the skill in manufacturing and the quality of factories is low. When calculated by productivity, none of the alternative countries showed any benefit when compared to Chinese manufacturers who have been in the business for 20 or more years.

c. Lack of engineering and design support. Foreign buyers of product from Chinese factories routinely make use of the staff of the Chinese factory to deal with final design and commercialization of product. Molds and tooling are routinely designed and fabricated in China. Production prototypes are designed by the factory engineering staff. When factories in the other countries are approached about these services, the factory staff is eager to learn, but the expertise is simply not there.

d. Small scale production is not available. Many foreign buyers come to China to manufacture small runs of product. One participant said he had just worked with a local Qingdao manufacturer on a limited run of 100 items for a new product produced to test the market. When I asked him if he could have a short run like that done in any country other than China, his immediate answer was: “Of course not. I can get these items made in Viet Nam, but I have to order at least 10,000 items. I also have to provide my own engineers and design staff and it just does not pencil.”

Every participant in our meeting was extremely critical of current manufacturing conditions in Chine. Every participant expressed an almost ardent desire to move out of China. Every participant stated they had made at least one effort to move production to some other country in Asia. But in the end every participant also stated they are currently not able to leave China because no other country offers the conditions required for small and medium sized companies to produce their product.

The general conclusion from the discussion was that it may be possible for large multinationals to move their manufacturing operations out of China to other countries in Asia. But for the “near future,” for start ups and for small and medium businesses, China remains the only practical place to do outsource manufacturing. What does “the near future” mean? The general impression was that this current situation will last for at least five years. Of course, “five years” really means “we just don’t know.” Or to sort of quote Winston Churchill, China is the worst place to manufacture your product except for all the others.