manufacturing agreements

Product manufacturing in China’s coastal regions has become increasingly challenging for manufacturers and buyers alike. Costs such as wages and rent have risen dramatically over the past five years at the same time that the economies of major buyers have suffered severe setbacks. This has put tremendous pressure on the small and medium businesses that make up the manufacturers in the export-oriented belt extending from Jiangsu down to Zhuhai.

There have been many predictions that this process would fundamentally change the structure of manufacturing in China. Since as far back as 2008, it has been confidently predicted that basic manufacturing would move from coastal China either to inland China or to other countries in SE Asia. Even the Chinese government has predicted a shift in the coastal region away from basic manufacturing to high-tech, high value added, high investment manufacturing consolidated in the hands of a few highly capitalized players.

However, this has not happened. Basic level export oriented contract manufacturing in China remains concentrated along the coastal belt. Many businesses that experimented with inland China and SE Asia are now returning to the coast. There are two primary reasons for this. First, the Chinese coast has an in-place manufacturing support base that simply cannot be duplicated anywhere else in China, Asia or probably the world. Ports, rail and road networks are first rate. Electricity is generally available and black outs are rare. Ancillary support is available everywhere. If you are making clothing and you need a new type of button, you can find a supply and have it delivered within 24 hours. If a manufacturing line goes down the repairman arrives in 4 hours with the replacement part in hand.

Second, China has developed the ability to implement complex production plans in way that cannot be matched elsewhere. Foreign buyers have grown accustomed to showing up at a Chinese facility with a mere product sketch which then becomes a marketable product, rolling off the production line in quantity within 9 months. Moreover, the Chinese have become masters at managing production of such new products on a massive scale that simply cannot be duplicated.

As a result, even though prices are rising, foreign buyers are still actively purchasing product in China’s coastal regions. This applies both to purchases of basic non-brand products and to purchases of highly customized OEM products. The reason is simple. The buyers simply have nowhere else to go. Thus, to the surprise of many, the China coast remains the manufacturer to the world. Recent trade statistics bear this out. In the face of enormous headwinds, Chinese exports have increased substantially in 2013: 25% in January, 21.8% in February and 11.7% in March.

Though exports continue at a high rate, we do see a major new trend in purchases by foreign buyers from the manufacturing sector. In the past, foreign buyers were oftentimes content to purchase product from their Chinese manufacturers without using a written contract and with no long-term commitment on the part of the buyer or the manufacturer. We know many foreign companies that have purchased product from the same manufacturer for over ten years on a per purchase order basis.

This approach is changing and more and more foreign buyers are entering into long-term purchase contracts with their suppliers (typically called OEM Agreements, Manufacturing Agreements, Product Supply Agreements, or Product Sourcing Agreements). There are several reasons for this trend.  Probably the most important reason is the drive for standardization on the part of buyers. Chinese product is just one part of a worldwide supply chain. Major retailers have diverse sources of product. All product has to meet a basic standard to fit smoothly into the chain.  Product that is delivered late or that does not meet specifications fouls up the chain. Product that is subject to an intellectual property infringement challenge or that contains pirated, non-standard parts or that contains a non-standard component that raises safety issues disrupts the supply chain.

In the early days of buying product from China, the price was so cheap that these non-compliance issues and their resulting costs were simply absorbed by the foreign buyers at each stage of the purchase chain. However, in the current environment of tight supply chain management, the disruption is normally quite costly and cannot be tolerated by retailers already financially stressed by the current economic environment. As a result, retailers are imposing strict standards on their direct suppliers. The strictness of the controls and the magnitude of potential losses mean that foreign buyers can no longer simply absorb the costs of non-conformance by the Chinese manufacturers.

Foreign buyers now have no choice but to impose the same standards on their Chinese suppliers. Thus foreign buyers must enter into written contracts for product purchases from their Chinese suppliers that mirror their own obligations to their major retailer customers. These contracts must be supplemented with detailed supplier manuals and codes of conduct that seek to regulate the day-to-day business operations of the Chinese manufacturers.

None of this is unusual in North America and Europe, but the approach is very new to most Chinese export oriented manufacturers. The purpose of these agreements is quite simple. The purpose is not to make the situation better but rather to impose liability for non-performance directly on the Chinese manufacturer. That is, the foreign buyer is saying: “I no longer will simply absorb the costs caused by your lack of compliance with the conditions of sale. If you (Chinese manufacturer) do not perform, I will suffer a loss and I am going to pass that loss on to you.”

Chinese manufacturers fully understand that the purpose of these new contracts is to impose liability on them that they have been able to shrug off in the past. As a result, many Chinese manufacturers resist entering into this kind of agreement. They have had a free ride for many years and they want that ride to continue.

Foreign buyers are now more often insisting on contracts that impose liability on their Chinese manufacturers as I have described above. This trend is just part of the process of maturation of the Chinese manufacturing system and there is nothing anyone can do to stop the process. Smart foreign companies are getting accountability or moving on to another factory.  Chinese manufacturers that get the message and enter into and comply with detailed purchasing and manufacturing agreements will survive and those that don’t won’t.  It is that simple. I have discussed these things with many Chinese factory owners and none have disagreed.

Note however that this applies in the same way to foreign buyers. Foreign buyers that continue to absorb the cost of Chinese manufacturer non-compliance will be swept away. The rising cost of Chinese product coupled with the vigilant approach of major retailers means that absorbing these costs is no longer economically feasible. Buyers who do not protect themselves and continue to operate on a per purchase order basis will be looking at an enforced career change in their future. The coffee shop in my neighborhood in Qingdao is advertising for a new barista. Send me your name and I will make an introduction.

For more on the kind of written contract required to hold your China manufacturer responsible for things like bad product or late delivery, check out the following:

 

 

Back when China Law Blog was a young pup, the Wall Street Journal Blog referenced one of our posts and we went all Sally Fields about that. We ran a post, entitled, The Wall Street Journal — They Like Us. They Really Like Us, the sole purpose of which (near as I can tell nearly six years later) was to let everyone know that the Wall Street Journal had noticed us. We are, of course, far too cool/wise/jaded/experienced/old to act that way now.

Or so I thought until I read a post on theContractsGuy Blog, entitled, The Reading List: China Law Blog.

The author of that post, St. Louis business lawyer, Brian Rogers, so totally understands this blog that his post felt like confirmation of what we are seeking to achieve here. In addition to that (or better yet, because of that), Rogers’ post does a phenomenal job listing out what are probably our best (or at least most practical/helpful) posts for 2011.

I am not going to list all the posts Rogers lists because i want to make sure you read his entire post, but I am going to state how delighted I was to learn that his favorite post “by far” was China Manufacturing Agreements. Watching The Sausage Get Made, which he describes as follows:

The post consists simply of a pair of sanitized client emails. One explains the typical contents of a Chinese manufacturing agreement, along with a discussion of important issues to consider. The other email accompanied the initial draft of a manufacturing contract. They’re pieces of commercial transaction art, clearly explaining the significant issues the client should consider and providing salient commercial and legal advice.

I too loved that post because it consisted pretty much entirely of emails co-blogger Steve Dickinson had sent to a client and all I had to do was remove any client identifiers and then post it. In other words, the post was the essence of what we as China lawyers do pretty much every day. Then to have a fellow lawyer appreciate that is — to me — one of the highest compliments we could ever get.

Whenever someone thanks me for highlighting on our blog something they have written elsewhere, I demur by saying that I should be thanking them instead. I say this because we mention and link to other writings not as a favor to their authors, but because we think the writings are interesting and worth reading and we want to bring them to the attention of our readers. So for this reason, I am not going to thank theContractsGuy for highlighting our blog on his blog.

Instead I am going to thank him for making my day. Thank you, thank you, thank you.

One of the hallmarks of a good China OEM Contract is that it provides for very specific penalties if the Chinese manufacturer fails to abide by its crucial terms. These penalties will typically be in the form of a liquidated damages provision, which Wikipedia defines as follows:

Liquidated damages (also referred to as liquidated and ascertained damages) are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach (e.g., late performance).

Chinese courts tend to view contractual liquidated damages provisions very favorably and so long as they are not unreasonable, they will usually be enforced. Most importantly, courts will seize Chinese company assets based on a liquidated damages provision and they will seize these assets before trial. Chinese companies know and fear this.

Liquidated damages provisions make sense in many different types of contracts with Chinese companies and they make particular sense in the context of a product supplier relationship.

We most often put in liquidated damages provisions to “encourage” the Chinese supplier to comply with the following:

1.  Shipping Dates.  If the product our client is having made in China is at all time sensitive, it is our practice to specify the delivery date and a penalty to the Chinese manufacturer for not meeting that date. We sometimes set the penalty at a flat dollar amount and at other times, we make it a percentage of the value of the order. We sometimes set out just one penalty and at other times, we hae the penalty escalate as the lateness increases. The key is to make sure the provision is very clear on the date (or dates) that trigger the penalty.

2. Quailty Specifications. We also often put in a liquidated damages provision if the quality of the product falls short on what was promised by the contract. These provisions make particularly good sense if what you receive can still be sold, but for less money. For example, if you are buying a food product that is industry-rated from A to D and you pay for an A product and half of what you get is B, you will be much better off with a contract that clearly states you get $1 for each level below A the product falls than having to prove up your damages by showing how you could have made X dollars more with the A product than with the B you were provided.

We generally strive to make the penalties reasonable not only because the courts are more likely to enforce such penalties, but because the Chinese manufacturer is more likely to take them seriously as well. The thing to remember about penalities is that the best ones need never be enforced because they were so effective in molding the manufacturer to comply.

For more on what should go into an OEM Agreement, check out the following:

Manufacturing agreements between foreign companies and their Chinese manufacturers typically come with all sorts of clauses dealing with choice of law, indemnification, time of delivery, failure rate, price, payment, and various other contractual provisions. But, it is oftentimes the Bill of Materials that will make or break the success of the manufacturing relationship, but far too often this document is either ignored or given far too short a shrift.

The Bill of Materials is simply a list of the components to be used in fabricating the proposed product. A good Bill of Materials, inserted as an appendix or addendum to an Original Equipment Manufacturing (OEM) agreement, should specify in excruciating detail exactly what the Chinese manufacturer must use in manufacturing the product. A well drafted and precise Bill of Materials minimizes the likelihood of confusion and future mistakes, which in turn saves money. It can help minimize product defects and recalls.

I have seen far too many OEM manufacturing agreements that did not have a Bill of Materials and far too many OEM agreements where the Bill of Materials was not made a part of the contract. Perhaps even worse, I have seen Bills of Materials that were made a part of the contract, but that allowed the Chinese manufacturer to substitute any component in the Bill of Materials whenever it felt like it. There is oftentimes nothing wrong with allowing your Chinese manufacturer to make substitute materials with your knowledge and approval, but there is a lot wrong with a Bill of Materials that gives your Chinese manufacturer complete discretion to substitute in materials.

When a problem arises, you should be able to cross-reference your Bill of Materials with the actual product to see if the correct components are present. When I see Chinese manufactured products with high return or defect rates, the cause is almost invariably the Chinese manufacturer having used cheaper components. But far too often, I also find that there was nothing in the OEM contract or in the Bill of Materials (or in the two of them working together) that contractually prevented the Chinese manufacturer from having done exactly what it did.

If you want to reduce your chances of defective or dangerous product, you cannot just rely on your Chinese manufacturer to do the right thing in terms of your product’s materials or components. It is your responsibility to make sure your Chinese manufacturer is using the correct materials in manufacturing your product. A well drafted Bill of Materials is the first step towards that.

For more on OEM agreements, check out the following: