China trade duties“Logic clearly dictates that the needs of the many outweigh the needs of the few.”  Spock, from the Wrath of Khan.

In most trade cases, a few domestic producers (or even one) ask the U.S. government to protect them by imposing extra duties or other trade barriers on imports. Usually, larger numbers of U.S. importers, downstream manufacturers or consumers wind up bearing these costs to protect the domestic producers, even though these costs are often arbitrary, excessive and unfair.

The U.S. International Trade Commission (ITC) just wrapped up its part in the latest trade case against imported solar cells and modules. Solar products from China were already hit with antidumping and countervailing (AD/CVD) duties in 2011 and 2014. This was not enough for the two largest remaining U.S. solar producers, Suniva, Inc. and SolarWorld Americas, Inc., who now have asked for a safeguard investigation to determine whether extra tariffs, quotas, and/or floor prices should be imposed on all imported solar cells and modules from any country. Opposing Suniva and SolarWorld is the rest of the $29 billion U.S. solar industry, mainly the U.S. solar energy developers, downstream U.S. solar panel installers and U.S. manufacturers of solar components, such as racking systems and inverters. On the one hand, Suniva and SolarWorld are hoping the safeguard relief measures will save hundreds of workers at their facilities. On the other hand, opponents argue these remedial measures would threaten many thousands of workers at other U.S. companies that have benefitted from the solar energy boom.

Though Suniva blames import competition for its bankrupt condition and its need for this safeguard action, the reality is that Suniva filed this case because it got whacked by the second solar trade case filed by SolarWorld. Previously, Suniva’s business model relied on producing solar cells in the United States that it then shipped to China where they were assembled into solar panels that were shipped back to Suniva’s U.S. customers.

The second solar trade case brought by SolarWorld in 2014, however, targeted any Chinese solar panels, regardless of where the solar cells were made. SolarWorld had complained that the first solar case in 2011 had an enormous loophole because it covered only Chinese solar panels made with Chinese solar cells. After that first case, Chinese module makers quickly switched to use cells from third-countries, mainly Taiwan, which caused SolarWorld to file its second case. Suniva in the second case claimed that any Chinese modules that used its American solar cells should be exempt from AD/CVD duties just because they were American, but the Department of Commerce (DOC) disagreed. The second round of solar duties disrupted Suniva’s supply chain and made using its Chinese module assemblers cost prohibitive. Suniva thus decided its last hope was to file a safeguard action that would artificially create a level playing field whereby all imported solar panels would be subject to the same high duties, quotas or floor prices.

The problem is how high do those trade barriers have to be for Suniva and SolarWorld to have any chance of surviving?

In this ITC safeguard investigation, Suniva and SolarWorld originally asked for extra tariffs to be imposed for four years, starting at 40 cents per watt on imported solar cells and a minimum price floor of 78 cents per watt for solar modules, as well as proposed import quotas to limit the total amount of imported cells (0.22 gigawatts) and modules (5.7 gigawatts). Solar industry analysts feared these measures would at least double the current cost of solar products, slash solar demand by two-thirds, and undermine billions of dollars of pending solar investment projects.

The ITC just released three different remedy packages that recommend far less than what Suniva and SolarWorld requested. The highest of the Commission proposals calls for extra tariffs of 30 to 35 percent on solar modules and cells that would then decrease certain percentage points each year for four years. Given the current forecasts that imported panels would cost around 32 cents per watt, analysts expect the highest Commission proposed remedies would add only an extra cost of 10 to 14 cents per watt.

Suniva and SolarWorld have expressed disappointment with the ITC recommendations and they have asked President Trump to impose stronger measures they claim are necessary to save the domestic U.S. solar manufacturing industry from extinction.

Unlike the more common AD/CVD cases in which the ITC and the DOC decide on whether to impose extra duties, in these rarely used safeguard investigations, the President has the ultimate authority to decide what, if any, remedial measures should be imposed. President Trump will have until January 12, 2018, to decide what remedial measures will be imposed that may affect $8.3 billion of imported solar cells and panels. He can follow any of the Commission’s recommendations or come up with his own remedial measures.

There have been few U.S. safeguard actions (and none since 2001). One reason why safeguard actions fell out of favor was because domestic industries found them less effective than the more commonly used AD/CVD actions. Because safeguard actions permit trade restrictions to be imposed on fairly traded imports, U.S. law specifically limits safeguard measures to a shorter period (usually four years or less) and to a maximum tariff rate of not more than 50% above existing rates.

Most importantly, the safeguard statute gives the President discretion to weigh the costs and benefits of imposing remedial measures. From 1975 to 2001, U.S. Presidents have declined to implement any trade restrictions in slightly more than half of the cases (19 of 40) in which they could have. In those cases where the President did impose trade barriers, they were usually much lighter than what the petitioning domestic industry sought. Past Presidents chose to impose no or much lighter safeguard remedies because they acknowledged the potentially harmful impact the proposed tariffs or quotas might have on downstream users and consumers, as well as the risk of other countries retaliating by imposing their own safeguard measures against U.S. exports to those countries.

But since President Trump has vowed to take strong action against imports, this solar safeguard action (along with another safeguard action on washing machines) is being watched closely as a test of whether President Trump’s actions will match his tough campaign rhetoric. If President Trump imposes remedial measures tougher than what the Commission recommends, we could see a flood of other safeguard petitions from other U.S. industries seeking a quick direct route to import relief from a sympathetic President.

In 2015-16, solar energy-related companies employed 374,000 people in the U.S., which is more than the combined number of workers in the coal, oil, and gas industries. Technological advances and competition have pushed solar installation costs down more the 60 percent since 2011 and solar electricity has in some places become cost competitive with electricity sourced from oil, coal, and gas. If President Trump imposes excessive safeguard remedies he could wipe out all progress solar energy has made in the United States. For the U.S. solar industry to live long and prosper President Trump will need to balance the needs of the many and not just consider the needs of the few.

Here is hoping the President makes a logical choice because a lot is going to be riding on it.

China IP lawyersI had essentially the same call recently involving European IoT start-up companies that might at this point better be termed “wind-down” companies.

Their stories are an old one and one we have covered and warned about at least a dozen times on here, including in a post directed specifically at Internet of Things companies, entitled,  China and The Internet of Things and How to Destroy Your Own Company. These two companies either did not read that post or they failed to take it seriously. To make a long story short, these two companies were working with Chinese companies to produce two internet of things devices and both companies eventually succeeded. Problem is that when they did, the Chinese companies essentially told them “adios” (I am right now in the Madrid airport on my way to Lisbon for a big lawyer conference) and left these two European companies with pretty much nothing at all.

To make a long story short, these two companies were working with Chinese companies to produce IoT devices and both companies eventually succeeded with their products. Sort of. The problem is that when they wrapped up development on the IoT products, the Chinese companies with which they were working essentially told them “adios” and left these two European companies with pretty much nothing at all.

I am going to digress a bit here, so please bear with me. One of my favorite poems is called “beware:” do not read this poem, by Ishmael Reed and that poem nicely encapsulates what happened with these two European companies. Here is that poem and below that, I explain the connections. Enjoy.

tonite, thriller was
abt an ol woman , so vain she
surrounded herself w/
many mirrors
it got so bad that finally she
locked herself indoors & her
whole life became the
mirrors
one day the villagers broke
into her house , but she was too
swift for them . she disappeared
into a mirror
each tenant who bought the house
after that , lost a loved one to
the ol woman in the mirror :
first a little girl
then a young woman
then the young woman/s husband
the hunger of this poem is legendary
it has taken in many victims
back off from this poem
it has drawn in yr feet
back off from this poem
it has drawn in yr legs
back off from this poem
it is a greedy mirror
you are into the poem . from
the waist down
nobody can hear you can they ?
this poem has had you up to here
belch
this poem aint got no manners
you cant call out frm this poem
relax now & go w/ this poem
move & roll on to this poem
do not resist this poem
this poem has yr eyes
this poem has his head
this poem has his arms
this poem has his fingers
this poem has his fingertips
this poem is the reader & the
reader this poem
statistic : the us bureau of missing persons re-
ports that in 1968 over 100,000 people
disappeared leaving no solid clues
nor trace     only
a space     in the lives of their friends
I cite to this poem because I am desperate to get people to stop essentially losing their companies to their Chinese counterparts and I figure listing out a full poem and then analyzing it will help people remember. I will admit to being desperate here and just plain tired of having to pass on horrible news to what once were up-and-coming start-up companies.
Just as the woman in the poem gets so enamored with herself that she loses her existence, these two companies became so enamored with their technology and their work on their technology, they too lost their existence. The woman was swallowed by the poem and the European companies were swallowed by the Chinese companies with which they worked. Neither the woman nor the European companies really think about what they are doing until it is too late. Not until the Chinese company had taken
the European companies figurative head, arms, fingers, and fingertips did it think about what it had done, but by that point they had essentially ceased to exist.
The final paragraph of the poem describes what happens every day to tech companies that go into China unprepared and all willy-nilly. Their attempts to fuel their dreams destroy their reality. They disappear, “leaving no solid clues nor trace only a space in the lives of their friends.”
Let us now return to the facts and discuss some relatively easy solutions.
Both these European companies had what they saw as great ideas and they both started working with Chinese companies to realize those ideas. One company worked with its Chinese “partner” for more than a year. The other for about a year. Both companies seem to be (have been?) made up of 2-4 people who had dedicated the last year or so of their lives to getting their devices off the ground and to market. Yet right before their products became ready to launch, their Chinese factories jettisoned them and chose to go it alone with the European companies’ devices.
The European companies wanted to know whether the China lawyers at my firm could help. I told them that was “both doubtful AND expensive.”

Technology companies dealing with China tend to make more and bigger mistakes than companies in other industries. The ethos of tech companies is to focus on building things (be it software or hardware or some combination of both) as quickly as possible, and not worry much about anything else. In an effort to preserve oftentimes limited funds, tech companies tend to be reluctant to spend money on anything (including legal fees) that does not directly help them develop their product and get it to market. I completely understand this, including how this usually makes sense when operating purely domestically in the United States and in Europe. But this way of doing business can and too often is disastrous when dealing with China, where it is usually impossible to “fill in” a legal foundation later.

Internet of Things companies are the new poster children for how to operate incorrectly when doing business with China.

I say this with regret because our China attorneys LOVE Internet of Things companies. We love IoT companies because we so often love and use their products and because the work we do for them is typically so cutting-edge and interesting. IoT companies looking to manufacture in China often require assistance with the following:

If you need more proof on how much our China lawyers love IoT companies, check out China and the Internet of Things: A Love Story. The best thing (for us anyway) is that just about all IoT products are being made in China — more particularly, in Shenzhen.

But back to the sad part. What is so terrible is that IoT companies seem to relinquish their intellectual property to Chinese companies more often, more wantonly, and more destructively than companies in any other industry I (or any of my firm’s other China lawyers) have seen. Ever, and by a stunningly wide margin. And the thing is, it is not as though these are big companies with a whole host of other products or IP they can turn to in a storm. No. Most of these IoT companies shrivel up and die after their IP goes “poof” in China.

In describing IoT companies and their problems to others, The following interaction, taken from at least a half-dozen real-life examples in just the last few months (and the last few months before that and the last few months before that and the last few….) should be at least somewhat instructive:

IoT Company: We just completed our Kickstarter (sometimes Indiegogo) campaign and we totally killed it and so now we are ready to get serious about protecting our IP in China.

One of our China Lawyers: Great. Where are you right now with China?

IoT Company: We have been working with a great company in Shenzhen. Together we are working on wrapping up the product and it should be ready in a few months.

China Lawyer: Okay. Do you have any sort of agreement with this Chinese company regarding your IP or production costs or anything else?

IoT Company: We have an MOU (Memorandum of Understanding) that talks about how we will cooperate. They’ve really been great. They told us they would enter into a contract with us whenever we are ready.

China Lawyer: Can you please send us the MOU? Have you talked about what your contract with the Chinese company will actually say?

IoT Company: Sure, we can send the MOU. It’s one page. We haven’t really talked much about the contract beyond the obvious and what we need to do to get the product completed.

China Lawyer: Okay, we will look at your MOU and then get back to you with our thoughts.

Then, a few days later a conversation like the following ensues:

China Lawyer: We looked at your “MOU” and we think there is a good chance a Chinese court would view that MOU as a contract. For why we say this, check out Beware Of Being Burned By The China MOU/LOI. And the Chinese language portion of the MOU (which is all a Chinese court will consider) is different from the English language portion. The Chinese language portion says that any IP the two of you develop (the IoT company and the Chinese manufacturer) belongs to the Chinese company. So as things now stand, there is a good chance the Chinese company owns your IP, at least in China. Therefore, there is no point in our writing a Product Development Agreement because your Chinese manufacturer will almost certainly not sign that.

IoT Company: I’m not worried. I think you have it wrong. I’m sure they will sign such an agreement because we orally agreed on this before we even started the project. (We get some sort of variation on this response at least 90 percent of the time).

China Lawyer: That’s fine, but I still think it makes sense for you to first make sure the Chinese company will sign a new contract making clear the IP associated with your product belongs to you, because if they won’t sign something saying that, there is no point in our drafting such a contract and, most importantly, there is no point in your paying us to do so.

So far not a single such IoT company has come back to us saying their Chinese manufacturer will sign such an agreement. Not one.

The situation with the two European companies has also become par for the course. In this situation, the IoT company is farther along in its product development and actually ready to sell what it perceives to be its product. This situation is exemplified by the email below, which is an amalgamation of various emails received by my firm’s China attorneys:I am hoping your firm can help us figure out the best course of action going forward. [A description of their company and their IoT product then follows, along with how they ended up going with a particular Chinese manufacturer and why they failed to seek out the advice of a China lawyer until now. This description too often involves their domestic attorney having said he or she would turn them over to a “China specialist” as soon as that “becomes necessary.”]

I am hoping your firm can help us figure out the best course of action going forward. [A description of their company and their IoT product then follows, along with how they ended up going with a particular Chinese manufacturer and why they failed to seek out the advice of a China lawyer until now. This description too often involves their domestic attorney having said he or she would turn them over to a “China specialist” as soon as that “becomes necessary.”]

We do not have any contracts in place with our current manufacturer. We started our relationship with our current manufacturer a year ago. He told us that POs are contracts in China and our lawyer confirmed that. We sent our Chinese contract our design and we paid for the molds and he shipped us the products. We recently learned that he has been using our product pictures as marketing material on Alibaba and selling our products all over the world. I also just learned that he has filed for a design patent for our design in China.

When I confronted him about this he basically admitted to everything but essentially said he had no intention of changing and if we go to a new factory to try to make our product, he will shut that down.

We’re filing design patents in the US. If we continue to work with him during this period, which agreement would help us get the best protection?

Since he already claimed our designs in China, will that prevent us from working with a new manufacturer? Do you advise we work with a new manufacturer at this point?

Our response is usually something like the following:

A PO is not really a contract in China; it is the placing of an order. Unless your PO speaks to IP (which would be unusual), it probably will not help us much. On top of this, some Chinese courts do not see POs as a contract at all and some Chinese courts will not even look at a document not in Chinese. The ideal is a Chinese language contract sealed by the Chinese company.

Our biggest concern is that this manufacturer has filed for a design patent for your product. This will no doubt pose problems for you and for any new Chinese manufacturer you might seek to use. Depending on how far along your present manufacturer is in the patent process, it may be able to sue you and your Chinese manufacturer for patent infringement damages and to force production of your product to cease. At a minimum, your Chinese manufacturer will be able to cause you all sorts of problems unless you can stop or invalidate his design patent. There is a good chance this Chinese manufacturer “owns” your product in China and it can use that ownership to control what you do there.

If you seek to go to a new manufacturer you can be pretty sure your old manufacturer will NOT give you the molds you think you bought from it and it will use its design patent to try to block your products from leaving China. It also very well may sue you for patent infringement in a Chinese court. In the meantime, making your product in China will be a high-risk proposition.

Did you register your company or brand name or logo as China trademarks? If not, there is a good chance your Chinese manufacturer registered those as well, but for various reasons under the name of what appears to be an unrelated company. If it did that, it will probably be able to stop anyone from making your products in China with “your” company, brand name or logo on them or on its packaging. No matter what else you do, you should consider retaining us right away to see whether it is not too late for us to secure key China trademarks for you. I urge you to read this on China trademarks.

We usually (but certainly not always!) end up advising these IoT companies to seek to do some combination of the following, none of which are great ways to go and some of which do not work at all for some companies:

  1. Leave China entirely and start manufacturing in some other country.
  2. Seek to block or invalidate the Chinese manufacturer’s design patent.
  3. Try to strike some sort of deal with the Chinese manufacturer whereby the Chinese manufacturer assigns the patent(s) and trademarks to our client who in return agrees to keep using that Chinese manufacturer to make x amount of product for x number of years.
  4. Try to get the Chinese manufacturer to sign a contract that makes clear what IP belongs to our client and makes clear the Chinese manufacturer’s limitations on using our client’s IP. We typically do this with a China-centric OEM Agreement.
  5. Go to a new manufacturer in China. If you do this, you almost certainly will not have your molds and there is a good chance your existing manufacturer will cause you a lot of trouble by suing or threatening the new manufacturer.

Don’t let the above happen to you. For more on how you can prevent this, you should, at a minimum, read and heed China NNN Agreements and China Product Development Agreements. NOW!

 

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 factory visits/China lawyers
China factory visits. Get on that plane

One of the things our China lawyers are always telling our clients is that they should visit their China factories. Such a trip is critical for the following four reasons:

  1. Visiting your China factory emphasizes that you care. Why should your China factory care if it doesn’t believe you care?
  2. Visiting your China factory makes you a human being and not just a purchase order. This decreases your chances of getting bad quality products.
  3. Visiting your China factory is a great opportunity to see product quality (or a lack thereof) and to work on product quality.
  4. I guarantee the value of what you learn from such a trip will exceed the cost of taking it.

I believe — based strictly on feel and not hard evidence, and without doing any accounting for other variables — that foreign companies that visit their China factories have 90% fewer factory problems than those that don’t. Now before you challenge this, note that we as China attorneys do not make a penny more from our clients that make these visits. In fact, we make less, and yet here we are making clear how important this is.

I have had countless clients go on and on about how much they learned from visiting their China factories, but nobody has ever told me they regretted having made such a visit — not even those who left China convinced they needed to cut ties with their existing factory.

But what should you do on such a visit? My answer is that above all else you should spend time getting to know your Chinese counterparts as this is what will help you down the road. But this is also a great opportunity for you to see what your China factory can do. Can it make your next generation widget, or should you be looking elsewhere? Does your China factory look efficient, or does it look like it has almost no clue? Does it look and feel financially healthy or should you be concerned about your next order?

For a whole host of specific questions that may make sense for your business, I urge you to check out the following:

What do you find most important about your China factory visits?

China manufacturing contracts
Use your China manufacturing contract to get out

When foreign buyers purchase products from Chinese factories the big issue is usually who owns the design of the product. This issue is often discussed in a theoretical way, based on intellectual property law principles, without getting to the real point. You are having a product made at Chinese Factory A. You decide the price Factory A is charging you for the product has become too high. The fundamental issue is this: can you take that exact product and have it made at factory B?

Say you are using the following procedure. You find a product made and designed by a Chinese factory. Normally, you will not purchase off-the-shelf products in their “as-is” condition. Normally you will customize the product by maybe changing its colors, and/or its surface design and/or small surface features such the number of buttons.

In this situation, the Chinese factory will take the position its own the design and you have no rights to the underlying design. In general terms, the Chinese factory will say:

a. Chinese Factory owns the underlying design and can sell that product anywhere in the world.

b. Chinese Factory agrees to “customize” its product for you by making surface changes such as color, logo, surface design features. Chinese Factory agrees not to manufacture and sell a product using those same features for sale anywhere in the world.

Given this basic position, what happens if you want to go to a different manufacturer for the same product? There are several alternative responses:

i. The normal response is that the Chinese Factory says you can go ahead and customize the product made by a different factory, but you CANNOT have that factory manufacture your product based on our underlying product design.

ii. In the alternative, some factories will say that you can go to a different factory, but you must pay us a royalty.

iii. In the alternative, some factories will agree to give you a license to go to another factory solely to manufacture the product but not to make any adaptation or other “new work” relying on the underlying design.

Where does your Chinese program fit into this system? Most buyers settle on alternative b. This is a type of stand-off. The Chinese factory cannot sell “your” customized product anywhere in the world, but you are stuck with the Chinese factory. If you want to go to a different factory, you have to start over from scratch or pay what is usually a very high royalty. This can be a disaster if there is no readily available alternative source for your product.

Another issue that arises from this situation is the question of exclusivity. If you have worked hard to create a market for a specific product in a certain territory, you will not want virtually the same product to be sold in that territory in direct competition with your product. It is common to provide that your factory is not permitted to sell the customized product to any other buyer. On the other hand, the factory is free to work with a different buyer who customizes the product in a different way. It is that alternative customized product that will then appear as a competitor in your territory.

Obtaining the agreement of your Chinese factory not to sell your customized product to anyone else is relatively easy because no one else really wants that product. It is much more difficult to get your Chinese factory to agree not to sell an alternative product to another foreign buyer. If you are looking for that kind of protection, you must be clear about the rules and you must expect the Chinese factory will only agree to those rules if it receives a substantial benefit for doing so. That benefit is normally your agreement to a specific volume of product purchase for each year of exclusivity. Big companies often get this sort of deal; SMEs, far less often.

China sourcing agentsMany companies start outsourcing their products from China using a broker/sourcing agent. Tomes have been written about the pros and the cons of using a sourcing agent versus dealing directly with a Chinese manufacturer and I have no intention of rehashing all that here. My relatively succinct and simple and mostly unhelpful view is as follows:

About 45 percent of all sourcing agents are corrupt. About 45 percent of all sourcing agents are incompetent/worthless. About 10 percent of all sourcing agents are invaluable.

I cannot tell you how many times a client has retained one of our China lawyers to assist in making the switch from using a sourcing agent to going direct with a brand new and far cheaper factory only to have the old factory tell our client it can now reduce its prices by 30-40 percent because it will no longer need to kickback 30 to 40 percent to the sourcing agent. I also cannot tell you how many times a client or a potential client has given us some completely invalid reason as to why their sourcing agent is so clearly different from the rest. We commonly hear that such and such sourcing agent must be good and honest because it is being used by some competitor or because it has an office in the United States. If only it were that clear-cut.

One of the legal issues we often must resolve is whether our client who is using a sourcing agent would be better off contracting with that sourcing agent for the manufacturing of its product, or contracting directly with the Chinese factory, while still paying the sourcing agent for its services. One of our China lawyers recently explained to a client some of the things the client should consider in determining whether to contract with its sourcing agent or to contract directly with its Chinese manufacturer, as per the below, with any identifiers stripped off:

You raise the usual and standard issues related to this kind of contract. To start, it makes no sense to have essentially the same a contract with two parties. You must choose with whom you are going to contract. Will it be your sourcing agent or will it be the Chinese factory? You must contract with the entity that will issue the invoice for the product and in this case (unless we change things), that is your sourcing agent. But if you contract with your sourcing agent, you can and you should also have a contract with the Chinese factory that deals with issues like ownership of intellectual property, ownership and control of the materials, non-circumvention and non-compete and similar. See China NNN Agreements. However, many Chinese factories are not willing to enter into that kind of contract if they are not the direct seller of the product.

The old way was to enter a contract with the sourcing agent, loading all of the liability on it. Since Sourcing Company X is a U.S. company, operating in this way is pretty much just like making a purchase from any U.S. company that outsources its manufacturing around the world. The question is: can Sourcing Company X perform? Does it have the resources to do the work and the asset base to deal with any problems?

As you have figured out, there can be many problems with the “old way.” If you are purchasing from a huge company like Apple, you don’t really care about who their ultimate suppliers are because you know Apple will do the work and you know Apple will stand behind the products and has the resources to handle pretty much anything that can go wrong. For a small company like Sourcing Company X, your analysis is quite different and is more difficult.

There are two issues: First, what happens when everything goes right? If Sourcing Company X takes care of everything, then using them makes sense. Many companies fail to consider what happens when things go right. If you end up doing all the work in China, why bother with Sourcing Company X.

Second, what happens when things go wrong? As you know, things going wrong is standard operating procedure for China manufacturing. If there is a defect, can you rely on Sourcing Company X to fix things? If there is a late delivery or a short delivery, can you rely on Sourcing Company X to address this in a way that does not require your staff travel to China? Can Sourcing Company X ensure that the fabrics and other materials are properly processed and securely stored and maintained in China in a situation where you have no direct contract with the China factory? What if the China factory goes bankrupt: what happens to the materials then? Will Sourcing Company X remain liable in that situation?  Can Sourcing Company X ensure all payments will be made to the factory and to the suppliers of the factory? Can Sourcing Company X ensure that the Chinese factory and its suppliers and the suppliers to its suppliers will not steal your IP or circumvent you by going directly to your customers? If circumvention happens, will Sourcing Company X aggressively take care of the issue and does it have the financial resources to cover for liability?

On these issues, if you conclude that the answer is yes in each case, then you should contract with Sourcing Company X. The more difficult situation is if you conclude that Sourcing Company X may not be fully able to deal with these issues. In that situation, you then have to consider whether you are better off with a contract with a Chinese company that will require you to litigate in a Chinese court to deal with the issues or better off with Sourcing Company X here in the U.S. and insured here as well. See also China Contracts, But With Whom?

As you can see, the matter is complex. In my experience, I find large companies with a presence in China prefer to contract directly with the Chinese factories. And this is the modern trend. However, smaller companies that do not have the time or the people on the ground in China still often use companies like Sourcing Company X to secure their products from China. The problem with companies like Sourcing Company X is they often refuse to enter into a reasonable contract. If Sourcing Company X is willing to enter into a reasonable contract, that is one matter resolved in its favor.

 

We have to assess two issues: a) can Sourcing Company X really perform and b) if you contract with a single Chinese factory, does that really put you into a better position if something goes wrong. You will need to make this decision based on your own business judgment, since you are the one with direct contact with the players. We can help you with this by conducting due diligence/background checks on the two companies.

Please let me know if you need more information from me on this matter.

 

 

In both my speeches on product outsourcing and in my discussions with clients, I always emphasize the importance of visiting your Chinese manufacturer. In my speeches I do it by first showing a Powerpoint slide of what looks like a great facility, maybe something like this:

Top tier China factoryI label that slide “China factory per its website. I then show them a picture of the following, labelled, “China factory in real life”:

China factory

I then stress the importance of visiting your factory, preferably before making your first product order. I then discuss how it seems like 95 percent of the time when our clients have major problems with a factory, it is one they have never seen. And if you are not going to visit your potential product suppliers (which is usually best), pay someone qualified and trustworthy to do so.

There are a lot of reasons to visit your China product supplier(s), and not just before you start with one. I for one am convinced that the mere fact that you the buyer make the trip (and not just someone you pay, though this is definitely a lot better than no visit at all) turns you into a human being who cares and that makes it less likely the factory will try to mess with you.

I also frequently emphasize the value of visiting your China suppliers periodically after you have established a relationship with them. We have one client who sends someone to visit the factory a few days to a week after placing every order. This client pays this visit because it is convinced that these trips serve to make sure that the product is of high quality and delivered on time.

A few weeks ago, Bloomberg BNA did a story entitled, China Waging ‘Unprecedented’ Pollution Crackdown. A few days ago, the South China Morning Post did a story entitled, China vows big winter air pollution cuts in northern cities. But what is really happening on the ground in China and what relevance might all of this have to you?

China sourcing agent Jacob Young tells us in his post China Factory Closures for Pollution Review:

Whilst they’re under [environmental] review, they are closed.

No business going in or out.

Out to lunch, gon’ fishin’.

That’s what I’m hearing on the streets. Well not the streets but from my network there, suppliers and wife who’s constantly on WeChat getting the scoop.

If anybody has the dirt on what exactly’s going on with these closures, please comment or DM me.

One of our RFQ’s from this week…

Went forward just fine. Then after discussing with the vendor, they THEN let me know they’re under review. Good thing I asked, right?

Factory closures are all around them too.

Yes this is happening. One of our China lawyers got the following email yesterday (modified to hide any identifiers):

I just learned that my factory in China has been shut down for environmental reasons. They have no idea how long this shutdown will last. Just my luck but I need to get a very large order to me in the next three weeks or I will owe a downstream customer a lot of money for late delivery on my part. What can I do? Can I get all of my damages from my supplier? Should I start looking for another factory?

Our response was somewhat along the following lines:

Much will depend on what your contract says with your current supplier and whether or not it is an effective contract. If it makes clear (in Chinese) that your supplier is liable for any delays and if it also does not have a force majeure provision that would apply to a shutdown like this (and it shouldn’t, because it is your supplier that is polluting, not anyone else and a shutdown for excessive pollution could have been anticipated) and your supplier has enough assets to pay on any judgment you might receive against it, then you have a chance of getting damages from your supplier. But the mere fact that you have written our firm out of the blue makes me think you either did not use a qualified China attorney to draft your agreement with your supplier or you do not have any such contract at all. And if that is the case, your chances of ever collecting against your China supplier have probably just gone way down.

What can you do now to make sure that what happened to the company that emailed us does not happen to you? Two things, above all else. One, find out what is going on with your China factory(ies). Are they in one of the many areas the Chinese government is targeting for pollution closures? Two, go and visit your China factory as soon as possible to see exactly how it operates. Is it a high tech low pollutant or is it a low tech high pollutant? If it is the latter, consider lining up another factory instead of or in addition to your existing one. Three, use good manufacturing contracts with your suppliers going forward. These can both help prevent problems and better position you for resolving them if they occur.

How can a contract help you from your Chinese supplier being shut down for pollution reasons? It can’t. But what it can do is prevent you from doing business with a Chinese factory likely to be shut down for pollution reasons. It can do this because the factory worried about being shut down will be less likely to agree to work with you if your contract will put it on the financial hook for a pollution shutdown and it can also mean that if your Chinese supplier has multiple factories, it will produce your products in the one least likely to be shut down.

But really, the key here is to know your factory.

What are you seeing out there?

 

China contract lawyerJust was cc’ed on an email between one of our senior China lawyers and one of our more junior lawyers. The email was in response to the junior lawyer asking for “the initial questionnaire we use with our clients for whom we are drafting China manufacturing contracts.”

With a few small modifications, here is the response email from the senior China attorney:

We used to send our China manufacturing clients a very long list of questions (it had reached seven pages!). But we were finding many of them were getting overwhelmed by their heft (I don’t blame them) and no matter how much we would try to tailor them to the client’s specific situation, there were also a fairly large chunk of them that proved irrelevant. So now what we do is break up our questions into stages, starting from general matters to more specific, with the “more specific” depending on the responses we get to the general matters. By doing it this way, we end up asking far fewer questions and this in turn relieves the onus we formerly put on the client.

The first stage questions usually consist of the following:

  1. Is the purchase from the actual manufacturer or is it from a trading company?
  2. Who owns the technology for what is being purchased? Note that there are a number of options:
    1. IP/design is 100% owned by the foreign buyer and the Chinese side will make no modification.
    2. IP/design is owned by the foreign buyer, but the Chinese side will make some modifications.
    3. The product is an “off the shelf” item from the Chinese manufacturer.
    4. The product is based on off the shelf from the manufacturer, but is customized in some way for the foreign buyer: new colors, logo, added features.

Often the U.S. buyer will purchase a mix from the same manufacturer.

The second stage, usually involves our trying to figure out the following:

  1. What is the structure of the basic business relationship?
    1. Will the parties agree on a set amount of purchases per year at a set price? or
    2. Will the parties work on a per PO arrangement?
    3. If it is per PO, what is the agreement on price, if any?
    4. If it is per PO, what is the agreement on quantity and delivery date, if any?

At the next stage, I work to figure out the following:

  1. Is tooling/molding involved? If yes, what is the system?
  2. Are other special materials involved? For example, in the clothing business, the buyer often purchases fabric separately and then provides this fabric to the factory.

At the next stage I work to figure out the following:

  1. What is the plan for quality control and inspections?
  2. What is the plan for warranty and dealing with defects that show up in the U.S. or in Europe after delivery?
  3. What is the policy for late or short delivery? Some companies use the 1% a day approach and leave it at that. Other companies have an elaborate “charge-back” system where they impose a penalty for short and late delivery.

As you can see, the whole process now has become more complex than just sending out a single set of questions. Each set of issues discussed above depends in part on the answer to the previous questions. You have to go step by step, adapting your questions to the previous responses. You also have to adapt your questions to what you already know about the client and its business. If you don’t know much or anything at all, a good start is to ask the client to briefly describe their program and their history with that program and their chief concerns.

Sorry not to be able to give a quick and easy answer, but this how China contract manufacturing work has evolved.

China attorneys One of our China lawyers got a weird call a few weeks from a somewhat distraught clothing manufacturer who had just learned that products his company was having made in China may in fact have been made in North Korea. This person wanted to know whether if that were the case whether he might go to jail. When we told him we didn’t know whether it would be illegal or not and that much would likely depend on how much his company knew about the North Korea connection and when, he very quickly lost his ardor for hiring us.

I thought of that call today while reading an article entitled, North Korea factories humming with ‘Made in China’ clothes, traders say. The article essentially says that some clothes that bear a “Made in China” label are actually being made in North Korea. And some are being made in China by North Korean “guest” workers. The degree of culpability for this sort of thing usually ranges roughly along the following spectrum:

  • Those who know and approve of their products being made in North Korea yet labelled “Made in China.” These companies no doubt like the cost savings.
  • Those who don’t want to know where their products are made and make zero effort to prohibit their products being made in North Korea and make zero effort to monitor where their products are being made.. These companies no doubt also like the cost savings and courts tend to categorize them as “having known or should have known.”
  • Those who are actually making a reasonable effort to make sure the products they are sourcing from China are not being made in North Korea.

Now without even discussing whether having your products made in North Korea, funding (albeit indirectly North Korea), and receiving products made in North Korea is legal or not — and this will vary by country — how do you want to be viewed if you are ever before a judge or a jury in your home country? Do you want to be seen as the person/company that tried to stop your products from being made in North Korea, the company that affirmatively didn’t care or the company that encouraged? Now before you answer that, ask any lawyer (no matter what the law is) which category of client he or she would rather defend. The answer to that is obvious. When facing a judge or a jury, the company/person that looks the best is the one most likely to prevail.

Just imagine if opposing counsel gets into evidence some of the things from this article, including how “In North Korea, factory workers can’t just go to the toilet whenever they feel like, otherwise they think it slows down the whole assembly line.” Or that the workers get to keep only ⅓ of their wages, which are only half those in China to begin with, and yet work from 7:30 a.m. until 10 p.m., or 14.5 hours. If facing a jury with those facts doesn’t scare you, I do not know what will.

So when it comes to North Korea how can you be good to look good? It’s like just about everything else with China and with manufacturing: you put how you want your Chinese counter-party to act in your contract (and if you want that contract to actually work, you do these things as well) and you monitor as best you can whether your Chinese counter-party is actually abiding by the terms in your contract.

Simple yet not so simple. But really important.

Your thoughts?

 

China lawyersOne of the joys of blogging is finding gems in unlikely places (pun intended). The gem is a post entitled Jewels Plating Problems: Can You Trust Chinese Factories? I say unlikely because neither (nor I would bet, most of our readers) have much interest in jewels plating problems. Heck, I am not even sure what those are and I wonder whether the writer (who I presume to be French) mistranslated. But I looked at the post because it is a truly excellent blog and the post is actually highly relevant for anyone doing any sort of manufacturing in China. The blog is written by a Shenzhen-based factory auditing company with whom our China lawyers have worked on many China manufacturing matters, and rest assured — for jewels plating or whatever — these people know whereof they speak when it comes to China manufacturing. And this post is no exception.

The post ostensibly deals with how relatively inexpensive jewels (jewelry?) made of brass and plated with gold so often have quality problems. The post then does a great job digging into why this just keeps happening in this industry. This is an industry our China lawyers know well because much of it is based in Qingdao or thereabouts and our firm has long-standing connections to that city. This is also an industry with low profit margins (for just about everybody) and — as President Trump might stupidly put it — a lot of bad hombres.

The post starts out asking “what is happening in this industry? Are they [the Chinese manufacturers] cheating the buyers, or are they simply careless?” It then gives the following three part explanation:

  • Profit maximization with a “calculated risk” approach — what is sometimes referred to as “quality fade.”
  • Reliance on so-called experience — not on facts and objective data.
  • Buyers who don’t define their quality expectations clearly enough.

To which I say, yup.

The post then analyzes/explains each of these three things.

1. Profit maximization with a “calculated risk” approach. Once a Chinese supplier ships its goods, the shipment has usually been approved and paid for and the transaction is fully completed. There are a few reasons for that:

  • High logistics costs
  • The process to return jewels is a nightmare
  • Customs clearance (cost and time) at both the supplier and buyer sides

The above means that China manufacturers try to ship products “as cheap to produce as possible, and yet are likely to be accepted by the buyer. For example, if a buyer is asking for 1um gold plating, the jewels might only have a gold layer of 0.5um.”

2. Reliance on so-called experience — not on facts or objective experiments. According to the post, most buyers are surprised by this. “Chinese factories in general barely have an R&D team. Their expertise is based entirely on their intuition (which they call their “experience”), and unfortunately it can’t be fully trusted.”

Again, I can only assent.

When buyers bring a new case to their Chinese supplier, the supplier tries to remember similar cases. This might work in a factory that has been in business for many years with a stable staff and good problem solving abilities, but it doesn’t work in a small workshop started recently.

3. Buyers who don’t define their quality expectations clearly enough.

The post does not free buyers from at least partial blame. I personally see the foreign buyer as at least partially at fault most of the time. Not saying the Chinese manufacturer is not also at fault, because it usually is, but most of the time had the foreign buyer taken action before the problem arose, there would have been no problem. I wrote extensively on this in China Factory Problems: Always YOUR Fault?

The title is somewhat of a stab at humor. It stems from my blaming most (but certainly not all) China factory problems on the foreign buyer. We have written countless times of what is required to secure good product from Chinese factories:

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.

We have also written how our China lawyers constantly get calls or emails from American and European companies that have received bad product from their Chinese factory suppliers and how there is nothing we can do for them. We wrote about this just last week in How To Get Bad Product From China With No Legal Recourse. To a certain extent, we like being able to blame the victim in these situations because that way we as lawyers can comfortably sit back and tell ourselves that had they only contacted us BEFORE they started having problems, we could have prevented all of their problems.

But what about where the Chinese company just up and suddenly shuts down. How can the American or European buyer be blamed for that? Well guess what, they can and in Doing Business In China Safely. The Due Diligence Basics, I explain the following situations where blaming the victim is really pretty easy.

This post rightly blames buyers for not explaining their quality and manufacturing standards clearly enough to their Chinese manufacturers:

In some cases, the buyer asked for the plating to last for at least 6 months or 1 year. That’s better than nothing. But some factories see this requirement, confirm the need for 1um (or sometimes for 0.5um) gold plating, offer a competitive price, and are likely the get the customer’s business.

For a case of greenish effect on the skin, I called and discussed with tens of Chinese factories. The result was surprising. A few (yes only a few) provided real expert feedback. Most of them provided different requirements (some of them scientifically ridiculous) and said “do not worry, we will provide great quality if your client buys from us”.

Plating, be it on jewels or other products, is an expertise area that most factories haven’t mastered. If plating is critical on your product, you might have to acquire the knowledge to guide (or force) your suppliers to be compliant with clear quality standards.

The post then goes on to explain how to be clear with your plating standards.

What this post does not do though is explain the various ways you as a buyer of manufactured goods from China can avoid quality problems. For that, I suggest you read Five Keys To Getting Good Quality Products From China. In that post, I assure our readers that if they consistently do the following five things, they will get good quality products from China:

  1. Use a Good Company.  Sounds rather basic, but we constantly see this rule violated. If you do nothing else that we suggest in this post, do this one thing as it matters as much as all the other things put together. For how to learn more about “your” China company, check out Basic China Due Diligence. Is This Chinese Company Legitimate?
  2. Use a Good Manufacturing Agreement. Good contracts ensure that your Chinese company knows what is required of it and what will happen if it fails to provide it. For what constitutes a good Manufacturing Agreements herehere  here, and here. Most China contracts we see are completely worthless, with a good chunk of those being even worse than having no contract at all. See Why Your NDA is WORSE Than Nothing for China and Is Your China Contract Worthless?
  3. Use Detailed Documents. Chinese factories tend to do exactly what you tell them to do. This means that what you tell them to do needs to be clearly conveyed and that means your instructions and specifications should be detailed and in. Be specific.
  4. Visit the Factory. Either your own people or a third party QC company should pay regular visits to your factory. Doing this allows you to make sure it understands what you want and lets them know that you are serious about making sure you get it.
  5. Inspect. Perform regular product inspections appropriate to the product you are having made.
Do the above and your odds of getting good product go way up. Don’t do the above and they go way down.Your thoughts?