We are always telling our clients that they cannot be too specific with their product requirements when buying product (OEM product or otherwise) from a Chinese manufacturer.  Words like “blue” or “good quality” or “typical in the industry” are meaningless.  There is a wide range of blues and unless you specify the exact blue that you want, your expectation the odds that you will get the one you want or even the one in the sample are incredibly slim.  And what does “good quality” mean in a country where you can buy t-shirts for 25 cents that will fall apart after one wash?  Typical in the industry?  What industry and how do you expect some manufacturer in China to have any clue about safety or fashion or anything else in the United States.

No, what you need to do is set out exactly what you want.  If your product and all of your competitor’s products are always made with 10% copper and everyone knows this, you still make  VERY CLEAR in your spec sheet that you want your product to be made with 10% copper and then in the contract itself you make VERY CLEAR exactly what liquidated damages you will be entitled to if the product has anything less than 10% copper in it.

When I talk on what should go into Chinese contracts, I usually relay something like the following:

Many years ago, I heard a story of an American who was renting an apartment in Shanghai. Now I am not even sure if this story is true or apocryphal, but it is such a good story to illustrate how Chinese judges and arbitrators view contracts it really doesn’t matter whether it happened or not.

It was a nice apartment, that this American was renting, and it had a really nice expensive office chair (high end apartments in China are virtually always rented out fully furnished). One day, the really nice office chair broke and became unusable and the American tenant kept asking his Chinese landlord to replace it. But that wasn’t happening.

The lease on the apartment eventually came up for renewal and the American refused to renew it unless the landlord put in writing that he would replace the really nice office chair. The landlord agreed and after the new lease was signed, he came by and put in a $2 metal folding chair.

What would happen in the United States if this tenant were to sue the landlord over the landlord’s failure to replace the office chair with something pretty comparable? Anyone know?

The tenant would win because the court would essentially write into the lease contract the provision that the replacement chair had to be a good office chair like the one it was replacing. What would happen if the tenant sued the landlord in a Chinese court?

The Landlord would win because if you want something in your contract in China, you had better put it in there.

Why is this chair story even relevant? It’s relevant because American companies time and time again fail to put enough into their contracts with Chinese companies. Instead, they just assume the courts or arbitrators will know what the parties intended and re-write their contracts accordingly. But it doesn’t work that way in China.

We had a company come to us after having received a large shipment of laptop bags that weren’t strong enough to hold a laptop. We called the Chinese company to ask about getting a refund and they told us that if our client had wanted a bag strong enough to hold a laptop, it should have paid 50 cents more per bag for one that could actually do that. This company should have specified in its contract that it wanted a bag that could hold x number of kilograms.

I was reminded of all this today after reading a post by Renaud Anjoran on his always excellent Quality Inspection blog.  Renaud’s post is entitled, “Be ULTRA SPECIFIC with your Chinese Suppliers” and, needless to say, that is the advice it conveys.  What’s cool about his post though is that he shows a couple of examples where Chinese companies (his own hotel) are super specific in conveying their messages.  This got me to thinking that the need to be super specific may stem from China’s hierarchical society and the role each person sees for him or herself.  To grossly summarize, we Americans love to claim to “think outside the box” whereas in China thinking inside the box is oftentimes valued more highly.  Then again, it all just may have to do with how US courts are so willing to infer contractual terms and Chinese courts are not.

But the reason for having to be ultra-specific in your Chinese contract is not what matters; what matters is that you do so because that is THE key in how to get good product from China and to a certain extent, one of the keys to doing business in China or with China.

For more on what should go into your China OEM Agreement and how to succeed in outsourcing product from China, check out the following:

What do you think?

Co-blogger Steve Dickinson and I had a wonderful dinner the other night with Renaud Anjoran. Renaud Anjoran is the founder of Sofeast, a quality assurance firm that assists small- and-medium importers with China quality control. Renaud has been based in Hong Kong and Shenzhen since 2006. He writes the Quality Inspection Tips blog, of which I have been a huge fan for a long time. See e.g.,  the following posts, where I extensively cite from one of Reanud’s posts:

During our dinner, we spent a lot of time talking of how in buying product from China, “everything is tied together.” In other words, a company that is buying product from China is “only as good as” its weakest link among supplier selection, payment terms and penalties, quality control, communication and contract. Therefore, to succeed, one must have an integrated strategy in place from the start. At the end of the dinner, I asked Renaud to write a guest post on the things on which he had been talking.

Here is Renaud’s guest post:

If you import product from China, there are five basic steps you should be taking to maximize your chance of receiving the right products at the right quality. A shipment of defective or dangerous products can almost never be returned to China and your supplier is not likely to re-do your products for “free” either. Taking these five steps will save you time and money.

1. Find a Suitable Supplier.

Many importers find a nice sample at a trade show, get a good quotation from the company believed to have manufactured the sample and then think their supplier search has ended. It is very risky to choose your supplier in this way. Online directories (e.g. Alibaba) and trade shows are only a starting point. Suppliers pay to be listed or to exhibit, and they are not rigorously screened.

If your contact claims to own a factory, you can run a background check on his company to confirm this claim. Then you should go and see the factory or order a capacity audit (around USD$1,000). Try to get some customer references and call them. Make sure the factory is familiar with your market’s regulatory standards.

If your orders are small, it is usually best to avoid very large manufacturers because they will probably quote high prices and not care about your orders. However, smaller factories usually need closer monitoring, especially on the first production run. Be forewarned: showing a nice factory and then subcontracting production to a smaller workshop is very common and the source of many quality problems. Your contract with your supplier should prohibit subcontracting.

2. Clearly Define Your Expected Product.

Some buyers approve a pre-production sample and a pro forma invoice and then wire the deposit. This is not enough. What about your own country’s safety standards? What about your product’s labeling? Will the packaging be strong enough to protect your goods during freight? These are just some of the many things on which you and your supplier should reach written agreement before money changes hands.

I recently worked with an American importer who had told its Chinese supplier that “the quality standard should be the same as that of your other US customers.” Of course when this American importer started experiencing problems, the Chinese supplier replied by claiming that “our other US customers never complain about this, so it is not a problem.”

The key is to write your product expectations into a detailed specification sheet that leaves no room to interpretation. Your methods for measuring and testing these specifications, along with the tolerances, should also be included in this document. And your contract should set forth specific dollar penalties if the specifications are not met.

If you are developing a new product with a Chinese manufacturer, you should be sure to document the resulting product’s characteristics and production processes as you cannot count on your supplier to give you this information if you later choose to switch to another factory.

3. Negotiate Reasonable Payment Terms.

The most common payment method is T/T (Bank Transfer). The standard terms are a 30% deposit before the components are purchased with the remaining 70% to be paid after the supplier faxes the bill of lading to the importer. It can get a bit more complex if a mold or special tooling is necessary during development.

Those vendors who insist on more favorable terms are usually seeking to trap you. I recently worked with a buyer who was so confident he would receive a good product he paid the full price before production. Needless to say, delivery came late and there were quality problems. He had nothing to use to leverage appropriate corrective action.

Another popular method is to pay by irrevocable L/C (Letter of Credit). Most serious exporters accept an L/C if you specify reasonable terms. You can send the draft to your supplier for approval before the letter is formally “opened” by your bank. Bank fees are higher than when you pay via T/T, but you are much better protected. I advise using an L/C for new suppliers or for very large orders.

4. Control Your Product Quality in the Factory.

How do you make sure your supplier met your product specifications? By going to the factory yourself and monitoring for this or by appointing a third party inspection firm to manage this process for you (for most shipments, third party quality control companies charge less than USD$300).

The most common type of quality control is a final random inspection of a statistically valid sample. This statistically valid sample gives professional inspectors enough to quickly and cost effectively draw conclusions about an entire production run.

In some cases, quality control should also take place earlier so as to catch problems before all production is complete. In these cases, an inspection should take place either before the components are embedded in the final goods or when the first finished products just get off the lines. In these cases, some samples can be picked up and sent for lab testing.

To take full advantage of QC inspections you should first have defined the product spec sheet, (see section 2 above), which then becomes your inspector’s checklist. Second, your payments (see section 3 above) should be tied to quality approvals. If you pay by T/T, you should not wire wire the remainder of your payment until your product passes final inspection. If you pay by L/C, the documents required by your bank should include a certificate of quality control issued by your appointed QC firm.

5. Formalizing the Previous Steps

Most importers are not aware of two facts. First, it is possible for an importer to sue a Chinese supplier, but it only makes sense to do it in China — unless that supplier owns assets in another country. Second, your purchase orders will aid in your supplier’s defense; they almost certainly will not help you.

To minimize your risks, you should buy your product pursuant to an OEM agreement (preferably one that is in Chinese). This contract will decrease your chances of problems and give you greater leverage should a problem occur.

My last bit of advice is that you be sure to put this entire system in place before you start negotiating with potential suppliers. Doing this will let them know that you are a professional importer and they will respect you for this. They will be more likely to agree to your requests because they will know that you can easily find another supplier. Perhaps most importantly, it will be much more difficult and much less effective if you start scrambling to put this system in place after you have already placed your order.

Just received a very typical email from someone looking to manufacture product in China:

A bit of background on our company; we are a supplier and installer of _______ and following months of design and development have finally completed a prototype model of ___________ which we now want to manufacture in China. Following two months of research and talks with various Chinese manufacturers we found a company which manufactures ____________ based out of __________.

Before beginning talks with them, we asked for them to sign a confidentiality agreement which we are in receipt of. We are now looking to arrange sending over a prototype for them to reproduce and send back. Before doing so, however, I wanted to make sure we are not leaving ourselves in a vulnerable position.

On your blog you discuss an OEM contract. Could you provide some information on what this is and whether we need to look into this at this early stage?

I responded as follows:

You do not need an OEM Agreement until you are actually ready to start manufacturing. OEM agreements cover the manufacturing relationship and you are not yet at that stage.

At this point, what you probably need is an NNN Agreement as I am virtually certain the Confidentiality Agreement you had the Chinese factory sign provides you with little to no protection. Here is some information on NNN Agreements:

If you are going to be spending a lot of money to have the prototype made and want to be sure that when it is done you will own the prototype and/or the molds used to make the prototype, then you should have us draft what we call a mold agreement. These agreements are usually not necessary unless you are spending so much on the molds or on the prototype that you want to be certain that if something goes wrong between you and the Chinese factory, you will end up with the molds or the prototype.  

The other thing you will need to think about at some point is securing a Chinese trademark for your name. China is a “first to file” country and so if you are not the first to file for your trademark and someone beats you to it they will own “your” name in China. This means they will then be able to stop you from using their name in China and you will not be able to put your name on your products in China. Without being able to put your name on your product in China, you have to export them without your name on there and then add your name only once your product arrives in the United States. 

If you have any patents on your product, we should discuss that too. My firm does not do any patent work, but I would be happy to refer you to qualified attorneys who do.

If you have any additional questions, please let me know.

 

 

My firm virtually always uses flat fee billing for China OEM supply agreements. We have done so many of these that we pretty much know the range of time one of these will take, even allowing for the required customization and the normal back and forth negotiating that will go on between our client and the Chinese supplier. Our time estimates are nearly always dead on, except for those clients who want the “perfect” OEM agreement.

Those take us less time.

Let me explain.

I am always saying it is easy to write the “perfect” contract and it is. The perfect contract does everything possible to protect your client. At least in theory.

By way of example, the “perfect” OEM agreement would contain something along the lines of the following:

  1. The Chinese supplier cannot raise its prices during the three year term, but the Western buyer has no minimum purchase requirement.
  2. Deliveries more than 10 days late, for any reason, result in a $100,000 cost reduction penalty.
  3. Buyer does not pay for 30 days after goods have arrived, been inspected, and been approved. No time limits imposed on buyer to do the inspection. Buyer pays nothing for non-conforming goods and need not return them to supplier.
  4. Chinese supplier is penalized for a defect rate of more than 1%. 
  5. Arbitration shall occur in Topeka, Kansas (buyer’s hometown).
  6. Chinese supplier cannot sell similar product to anyone else. Buyer is free to buy from anyone else.

Okay, you get the picture. This is obviously a great/perfect contact for the buyer.  

Except there is only one problem. Nobody serious is ever going to agree to this and, in fact, in our experience, contracts like this are automatic deal killers. That is why we should charge less for them. Over the years, we have been asked maybe half a dozen times to write OEM agreements not all that dissimilar from that set forth above. Each time, we have counselled our clients against this sort of agreement, but a few times we have been instructed to go ahead. Once (or maybe even twice), the client remarked on how they bet Wal-Mart has this sort of contract. Our response was that we had seen a number of Wal-Mart’s contracts and though they do tend to be pretty favorable for Wal-Mart, they also typically contain massive minimum purchase guarantees that make the contracts worthwhile for the Chinese supplier.

Now usually when we write a normal (as opposed to “perfect”) OEM contract, we hear back from our client within a couple weeks, discussing potential changes to the contract suggested by the Chinese supplier. We then work for another few days to a week on modifying the agreement to suit both sides and then we are none.  

With the perfect contract, we get silence and then we eventually contact the client. Each time, the client has told us that they have been unable to find a Chinese supplier willing to do business “our way” and so they will be looking elsewhere for their supplies. We suggest they allow us to modify the OEM Agreement and they go back out there, but they say no, they do not want to do business under terms that will put them at risk.  We say okay and move on.

The funny thing about the companies seeking the perfect contract is that they almost always are of a particular type: old line, mid-sized (not small) businesses that have been in business for a very long time and have carved out a pretty good niche and strong brand name in their market. They are looking at China not so much because they have to, but because they believe it will allow them to cut costs and thereby increase their margins. 

In any event, the lack of subtlety in the initial OEM Agreement and the subsequent lack of negotiations and back and forth between the Western buyer and the Chinese supplier means these are the agreements that fall short of our estimated time range. So I guess the next time someone wants the “perfect” OEM Agreement from us, we will have to charge less than for one that will actually work.

What do you think?

For more on China OEM Agreements, check out the following:

It has been awhile since we have written on China product quality issues. As regular readers of this blog know, we are of the view that companies outsourcing to China must focus on 1) choosing the right partner, 2) using a good OEM contract, and 3) constantly engaging in quality control monitoring. Renaud Anjoran’s always excellent Quality Inspection Blog (if you are directly or indirectly engaged in manufacturing in China you absolutely should make this blog a regular read) did a post, entitled, “Four Simple Steps for Starting to do Quality Control“, focusing on our third requirement.

1. “Establish clear expectations.” Renaud talks of how choosing a sample, negotiating a price, and then waiting for delivery is rarely good enough to ensure a quality product. In addition to the sample, you should have an agreed-to specification list. I completely agree, not only because such a list is important for quality control reasons, but because it can be critical for legal reasons as well. Without clearly enumerated specifications, it is difficult to impossible to prevail in a product quality lawsuit against a Chinese company. Chinese law typically will not find an implied reasonable quality standard anything near to what a Western company would typical expect and the reason for that is simple. What constitutes reasonable product quality in China is very different from what constitutes reasonable quality in the United States.

2. “Don’t focus on final inspections.” Renaud notes how final random inspections are a good tool for approving all aspects of production (total quantity, product specs, aesthetics, packaging…), but if problems are found, they are too late to fix. Inspections during production are better:

The risks for a factory that gets caught are pretty high: re-work of the goods, re-production, penalties, air freight, order cancellation… Instead of sending inspectors at the end (i.e. using them as policemen), try to send them when the goods are in process. Issues can get caught and corrected early: this is not only an extra safety for the buyer, but also a helping hand for the factory. This is how you should frame the discussion when you tell your suppliers about your QC intentions.

Early inspections (during production) have several positive side effects. They are a way to ensure that production is taking place in the right factory. Samples can be picked up randomly for lab testing. And it can prevent long shipment delays if the factory corrects course immediately after quality issues are noticed.

3. “Inspections are not an option. Renaud calls for the following:

  • You should write “Quality inspection required prior to shipment” on your P/Os.
  • If you pay by letter of credit, you can require a passed inspection report from your nominated QC provider.
  • When you develop new products, ask extra samples for the inspector’s use.
  • Keep track of the final inspection date and the shipment date, not just the shipment date.

4. “Find the right balance between helping and arm-twisting.” Anaud discusses how large buyers have the leverage to play it “tough,” but smaller buyers have to be more creative. True.

For more on enforcing quality control in China manufacturing, check out the following:
— “Why you MUST Have a China OEM Agreement
— “China OEM Agreements. Why Ours Are In Chinese. Flat Out
— “Let Me Tell You About China Due Diligence
— “China Products: Forget Trust, Just Verify

Had a nice conversation with a potential client last week. Company has a great new product it wants made in China. Like many companies starting out in China, this one is in the process of shopping for its China lawyers and my firm was one of four suggested to it by its regular corporate counsel.

Our conversation was interesting because we were the fourth law firm with whom she had spoken. This gave me an opportunity to ask how we differed from the other three firms and, not surprisingly, we really differed, both in how we bill for these things and, more importantly, how we typically handle these contracts.

I told this company that we would almost certainly do their OEM contract in Chinese and I quoted them a flat fee for doing that, along with an English language translation. They told me that the other law firms were saying that the contract would be in English and they would “need to” charge by the hour and it would even be impossible to estimate how long it would take due to the negotiations that would take place between this company and its Chinese manufacturer.
I think one big reason so many US law firms do not write their OEM agreements in Chinese is simply because they do not have any lawyers who can read and write Mandarin fluently. My firm has four lawyers (and various others) who can read and write (and speak) Mandarin fluently and we usually favor putting our clients’ OEM contracts in Chinese for the following reasons.

Because international contracts are so often between parties from different countries, they commonly are written in two or more languages. Nearly all of the contracts we draft for our Western clients doing business in China are in English and Chinese (though about ten percent of the time, we also translate them into German, Spanish, Korean, or French as well). This duality of language can, if not handled properly, pose big problems.

When we do a contract in both English and Chinese, we always call for the contract to specify ONE official language to control if there is a dispute. We do not advise drafting a contract that is silent on the official language, nor do we advise drafting contracts that call for both English and Chinese to apply. Having two official languages pretty much doubles the chances for ambiguity and pretty much doubles the attorney time (and fees) that will be incurred in fighting over the meaning of the two contracts. It is expensive enough litigating on one contract; there is no benefit litigating on two.

So the question for us comes down to whether English or Chinese should be the official language of the contract and the answer to that question requires we first decide where we would most like to see disputes resolved. If we go for arbitration in English (and if the Chinese manufacturer actually agrees to this, which is quite rare), then we almost certainly will want English as the official language. But if we decide the Chinese courts will be the best place to resolve conflicts, then we want Chinese to be the official language.

Now I know most of you think the obvious answer here is to do anything possible to avoid Chinese courts, but you would be wrong. Let me explain.

In determining where best to resolve conflicts on an OEM contract, the analysis has to begin with first trying to determine the most likely and the potentially most damaging disputes and then analyzing where best to handle each sort of dispute. Disputes between foreign companies and Chinese manufacturers most often involve the following:

1. The Chinese company provides poor quality product. To say this is common would be an understatement. The best way to deal with a dispute involving the Chinese company providing poor product is usually to seek to work it out with the Chinese manufacturer. If that proves impossible AND there is enough at stake to warrant suing, arbitration is likely going to be the best course of action. Not to minimize the importance of these cases, but they usually involve only one shipment and they usually involve a finite amount of money.

Litigation outside China against a China based manufacturer usually does not make sense. Because most Chinese companies do not have any meaningful assets outside China and because China does not enforce foreign judgments, getting a judgment outside China against the Chinese company will likely have virtually no value. Therefore, there is no point in having a contract that calls for jurisdiction in a court outside China. For more on the difficulty/impossibility of enforcing foreign judgments in China, check out “Taking Judgments To China (And Korea), Let’s Not Sue Twice.

2. The Chinese company manufactures the foreign company’s product without the foreign company’s permission and in direct violation of the OEM agreement. You have a great product and you have taken it to China for manufacturing there. You are currently selling in just a few countries, but your plans call for you to eventually sell into China and India and maybe even Africa some day. All of a sudden, you learn that your Chinese manufacturer is not making just the 100,000 units you ordered, but, in fact, is making 500,000 units and shipping the extra 400,000 to India, Africa and the rest of Asia, where it is selling them for 1/5 of what you are charging.

If your agreement calls for arbitration in Hong Kong or New York, or even Beijing . . . good luck. What you need, and what you need fast, in these situations, is a court order requiring the Chinese manufacturer to stop making your product and to stop NOW. And guess what, pretty much the only way you are going to get that badly needed court order is from a Chinese court, not that that will be easy. If you did everything right with your contract, it will have liquidated damages provisions that will also allow you to relatively quickly secure a judgment from a Chinese court for damages and will also, in the meantime, give the Chinese court a strong basis for freezing the assets of the Chinese manufacturer before you even secure your judgment. The threat of all of this is oftentimes enough to convince the Chinese manufacturer to cease and desist.

If your contract calls for arbitration and you sue in a Chinese court to get an injunction to stop your manufacturer from breaching your contract by manufacturing and selling your product, you almost certainly will not succeed. The Chinese manufacturer will show the court your arbitration clause and request it decline the case in favor of resolving the dispute in arbitration. Once you are in arbitration, you pretty much will not be able to get an injunction or an asset freeze.

It is possible to write your OEM contract to call for arbitration with a Chinese court “carve out” for injunctive relief or an asset freeze, but many Chinese courts do not to enforce these sorts of provisions.

For these reasons, we usually favor our OEM contracts calling for dispute resolution in the Chinese courts. And if you are going to be in a Chinese court, you do want your contract to be in Chinese. The reason for this is simple. If your contract is in English, the Chinese courts will use their own translator to translate it. Translations can be easily manipulated and it is virtually always better to have your contract translated by your own law firm in advance so you know exactly what it says before you sign it, than to have it translated into Chinese by an unknown translator only after you have sued on it.

3. The Chinese manufacturer refuses to return the foreign company’s molds after the foreign company seeks to terminate its relationship with the Chinese manufacturer. This often happens when the foreign company terminates its relationship with the Chinese supplier. Not surprisingly, the key here is to have a contract in Chinese that makes clear that the mold belongs to you and that there will be hell to pay (in legal terms) if the Chinese manufacturer does not return these to you pronto. But what if the manufacturer does not return your molds? Damages are usually not what is needed. You need the molds immediately because without them you cannot manufacture your products. Again, the best positioned foreign company is the one with a contract in Chinese who can go to a Chinese court for an injunction mandating the manufacturer return the molds. Or at least a large enough asset freeze to convince the Chinese manufacturer to back down.

Lastly, and perhaps most importantly, we have become convinced that most (yes most) problems that arising between foreign companies and their Chinese manufacturers stem from a lack of clarity between them regarding the manufacturing terms. The best way we know to resolve those sort of communication issues upfront is to resolve them before the first widget is made and then to memorialize those agreements in a written form that both parties cannot fail to understand. The best written form for the Chinese manufacturer is obviously going to be a Chinese language document.

We have also learned that we differ from virtually all the other law firms in our pricing structure. We gave this client a flat fee price based on the complexity of what we anticipated doing for it. This price was to draft an OEM agreement in Chinese, with an English language translation for the client.

None of the other law firms were willing to give a similar fee, even when the company went back to them (at my suggestion) and suggested they do so. They all begged out, claiming they had no way of knowing how long it would take and so they would “have to” charge by the hour. This is, of course, complete malarkey. (I wanted to use a much stronger word here, but since I long ago committed to writing a blog that I would not mind my now 11 year old kid reading….). If law firms do not know how long these OEM agreements typically take, who does? Seriously.

My law firm has done enough OEM Agreements that we know, within around 3-4 hours, how long 90 percent of them will take, and we are willing to take the risk on the remaining 10%. The real answer is that law firms are simply resistant to change and resistant to taking on any risk on behalf of their clients. For more on how law firms are so incredibly resistant to changing their billing paradigm, check out this recent study resoundingly confirming this.

What do you think?