Our clients often ask that we put a provision into their manufacturing agreements prohibiting their Chinese manufacturer from making the same product for anyone else. This naturally leads to a long discussion, that often goes somewhat like the following, using a laptop computer bag as the example:

China Lawyer:  What do you mean by a product like yours?  A laptop bag?

Client: That would be great. Is that possible?

China Lawyer:  Not unless you are planning to commit to buying $800 million worth of bags a year. Your Chinese manufacturer probably makes laptop bags for 40-50 other companies and unless you commit to massive yearly volumes, there is no way it is going to just make bags for you. What we need to do is figure out what makes your laptop bags different from everyone else’s laptop bags and see if we can get your manufacturer to agree not to make laptop bags for others that contain your unique features.

Client:  That makes sense. Well, first off, our name is unique and I certainly don’t want our Chinese manufacturer making bags with our name on it for anyone but us.

China Lawyer: Absolutely. We will put that in there, but also, we are going to need to register your brand name as a trademark in China so that nobody in China (not just your manufacturer) can make bags with your name on it. We also need to register your trademark in China to prevent anyone else from registering your name and then being able to stop you from using your own name  at all in China. What else distinguishes your bags from others?

Client: We use orange stitching and I don’t think anyone else does that.

China Lawyer:  Great, so we ask that this manufacturer not make bags with orange stitching. What else?

Client:  We have a side pocket that perfectly holds a passport. What about something like that? Oh, and we have an orange rubber tab on all of our zippers.

China Lawyer:  Perfect. We will put a provision into your OEM Agreement that prohibits your Chinese manufacturer from making laptop bags with any of this attributes.

Client: Are these provisions enforced?

China Lawyer:  Yes, in both China and the United States.

Client:  The United States?

China Lawyers. Yes, the United States. If one of your US competitors were to go to your Chinese factory and start purchasing laptop bags with stitching or zippers or a side pocket like yours, we would immediately send them a letter, attaching your OEM contract with your Chinese manufacturer. That letter would point out the provision saying that your manufacturer is not allowed to make laptop bags with your specific attributes and then it would say that your competitor’s getting such laptop bags from your Chinese manufacturer constitutes tortious interference with your contractual relation. We would then say that if they do not immediately cease buying such bags, we will have no choice but to sue. These letters generally work because the US company either did not know it was infringing on your contract rights or else because it simply does not want to be sued in a US court, even if it may think it will eventually prevail. These provisions tend to be very effective.

It’s the weekend, which means that I watch the Seattle Seahawks annihilate an opponent (the Tennessee Titans are this week’s victim) while cleaning up my inbox.

In my inbox was an email from one of our China attorneys to a client for whom we are working on an NNN Agreement, but who will likely eventually need a product development agreement and an OEM Agreement, along with China trademark protection.  It does such a good job of setting out the contracts that are usually needed for foreign companies seeking to manufacture in China that I thought it would be helpful to our readers to post on it, so here goes:

Attached please find an English-language draft of an NNN Agreement, as well as an accompanying Acknowledgment of Receipt (to track exactly which information has been shared with the Chinese party, and when).

In your responses to the NNN questionnaire, you note that you will be sending Chinese companies a sample of the product that you want manufactured (i.e., ________), for the sole purpose of determining whether the Chinese entity can make it. This is exactly the situation in which one ought to use an NNN agreement. That said, your responses also anticipate the possibility of having the Chinese company create custom machinery, and also discuss various details regarding the production of your _______ product. These things are not suited for an NNN agreement.

For the sake of clarity, the appropriate way to handle manufacturing in China of unique products is to have three agreements. First, an NNN Agreement, for the situation in which you reveal confidential information about the product to determine, conceptually, if the Chinese party can make the product(s). This is your current stage. Second, a development agreement, to cover the cost/procedure/ownership of rights of product development, and to figure out if the Chinese party can in fact make the product you want at a sufficiently high level of quality, in a suitable timeframe and at an acceptable cost. Third, an OEM contract, to cover the manufacturing and purchase of the product(s). Many vendors (and buyers) want to cram all of the above into one agreement, promising that they can of course manufacture what you want, and any product development will be folded into the contract. It’s an awkward fit. A manufacturing agreement is not a development agreement.

It sounds like you might need at least one more contract, depending on the answers you get from the Chinese manufacturer. It also sounds like you ought to file at least one trademark in China. We can discuss all of this later. For now, please review the attached and let me know your thoughts.

For more on the legal basics of having your product manufactured in China and the China manufacturing agreements that typically go with that, check out Getting Started On Manufacturing In China. The Legal Basics.

We generally think the best way for us to draft China OEM Agreements is for our clients to reach oral or “term sheet” agreement wtih their Chinese manufacturer and then come back to us with the terms. We then draft the OEM contract based on those terms (and many more) and our client then presents the agreement to its supplier. At that point, the Chinese product supplier either signs or additional negotiations ensue.

A few weeks ago, a regular client of ours was heading to China to negotiate a supplier agreement (OEM Agreement/Manufacturing Agreement) with a new supplier. This client sent us an email a few hours before it was to meet with its soon to be new manufacturer The email listed out the following “deal points” and asked us what more they should get clear with their new factory:

  • payment 50% by LC, 50% net 45
  • tooling amortized over 30,000 [widgets], with remainder due after 3 years if 30,000 [widgets] is not met.
  • sales samples charged at 1.5x confirmed FOB pricing.

The client’s email noted that the following still needed to be discussed:

  • agreement and process in case of defective pairs;
  • agreement in case of late shipment.

We responded by suggesting our client at least consider the following as well:

  • Identify the entity that you will be paying; it may not be the factory itself but rather a holding company in Hong Kong/Singapore/Taiwan/etc. In general, unless this entity is acting as an import/export agent for the factory, the contract will be with the entity you are paying, and if things go South, your recourse will also be against that entity.
  • Think about more than just shipping terms. Think also about packaging terms (for each [widget], for each box, etc.)
  • You ABSOLUTELY want an inspection clause. Quality control is extremely important. In an ideal world, you would inspect after delivery and before you pay a dime. But few contracts are ideal. Think about when you want to inspect (probably both before and after delivery).
  • What will happen with defective product? The inspection process is closely linked to what you do with defective product. The worst outcome for you would be for the factory to sell your defective [widgets] on the grey market. Do you want to witness the destruction of defective product? Require a certification of destruction? Have the defective [widgets] shipped to you so you can destroy them? Something else? Also, think not just about when to inspect, but of what an inspection will consist. Will you inspect every [widget]? A statistically significant number?
  • What will constitute “epidemic failure”? Five percent of a shipment? Three percent?
  • Think about warranty provisions, and how they will be implemented. How long will the warranty last? Who will pay for you having to ship back the returns?
  • Think about timing — late shipments are obviously bad, but early shipments can be bad too, especially for seasonal items.
  • How and when will prices be determined? If the factory wants to change prices, how much notice must they give you? Are there built-in volume discounts?
  • What happens if you submit a purchase order and the factory doesn’t accept it? How long do they have to accept or reject a purchase order?
  • How much lead time must you give between a purchase order and the delivery date for that order?
  • Will you be selling the [widgets] all over the world? Will you be selling them in China?
  • Will the factory be using subcontractors? Do you care?
  • Do you want to restrict the factory from working with and/or contacting any of your competitors?

You do not need to answer all of these questions for a term sheet, but you should at least start thinking about them.

What do you think?

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

We are always preaching that if you 1) choose a good manufacturer, 2) use a good OEM contract, 3) engage in good quality control monitoring, and register your trademark, the odds are overwhelming that you will do just fine in outsourcing your product from China.

The odds just went down.

In 2009 and 2010 and the first half of 2011, I estimate that I would receive maybe two emails a month from someone who had sent money to a Chinese manufacturer and received no product. And of those emails, I estimate that pretty much all of them involved a relatively unsophisticated buyer who had done none of the three things listed out above.

In the last three months or so, I have received probably 4-5 emails from buyers who have been burned by Chinese manufacturers but have a very different story to tell. These buyers have been burned by Chinese manufacturers with whom they have been dealing successfully for many years. The following is a fairly typical example:

I did not receive my most recent order from ____________ Chinese manufacturer. I have been dealing with ______________ for six years and we have never had a problem like this. We have had issues with them in the past but we were always able to resolve them. Now they are not even answering their phone. They owe us around $30,000.  Can you help?

I also just received the following email:

On July 21st, you wrote an article entitled “Factory Closings in South China.  All Part of the Plan,” in which rising costs for low value added factories was cited as part of the reason for factory closings.  Lately there has been another string of articles floating around several websites about Guangdong wages increasing another 20% this coming January.  While I do realize the government often puts out feelers to see how people will react, it does seem realistic and inevitable that wages will continue to rise.
 
Two things I would love to get your opinion on:
 
1)  As a director of a company that sources “promotional items” solely in China (assuming the quantity of goods is large enough), where else can we possibly be looking?  If we only did textiles I could set up in Vietnam or in Bangladesh; but we source plastic trinkets, low-end electronics, pens, lanyards, bags, and a variety of other LOW VALUE ADDED goods.  Is our only option to keep taking the price increase until someone finally starts making plastic toys and trinkets in another country?  From my experience these China manufacturers are NOT moving inland to cheaper places in China, but are either taking the increase or shutting down.  Keep in mind 95% of the factories I’m working with are not huge Foxconn-like factories but private owned 100 employee factories.  What have you seen?
 
2)  We work with over 100 factories a year in China. I’m trying to develop a plan on “How Not to Get Caught With Our Pants Down” where a manufacturer closes and takes our deposit.  If a factory goes bankrupt I think the chances of us getting any kind of money back on a deposit no matter how well our written contracts are is low (maybe this is wrong?).  Our current plan is ‘hoping and praying’ on deposits less than $10k that wouldn’t really hurt our company, and making sure we send our QC team to visit the factory even if previously audited, for any deposits over $10k to ensure they have workers there, raw materials in storage, and are producing something. I don’t know that this plan is the most technical.
 
I would imagine many of your readers are facing similar situations.  It’s a scary time to be exporting from China.  I’m shifting my studies and free time to learning more about China consumerism these days because I believe that’s where the money is for the next decade and beyond.  I enjoyed your recommendation of Billions: Selling to the New Chinese.

I responded to this email by professing that I had no great solutions and that I would blog about it.

As for where to go, the answer is “that depends.”

As for how to prevent yourself from getting caught holding a bag when your Chinese manufacturer disappears or what to do about it when that happens, I have the following advice, none of it great:

  1. Redouble your due diligence in choosing a Chinese manufacturer. Check out the factory. Check out its company registration. Check out the rumors about it. Do whatever you can to try to gain a sense as to whether it is a company that is acting like it has a future.
  2. Reduce the size of your orders to the extent that you can. This way whatever bag you end up holding will at least be a smaller one.
  3. To the extent you can, try not to order anything in September, October or November. I have heard from a couple of clients that Chinese companies typically come up for renewal of various licenses in December and January and that they often try to hold on up until the point they are supposed to pay these. That being the case, they stop shipping a few months beforehand and then they are gone. It does seem to me that in prior years (2008 being a prime example), the number of disappearing Chinese companies increased during the end of one year and the beginning of another.
  4. Increase your monitoring of the factory to make sure your product ships.
  5. Do whatever you can to try to reduce the amount you pay upfront for your product. If you have been doing business with the same factory for five years and paying it 70% upfront, go to them and point out that you have always paid and then ask to be able to switch to a 30-70 or 50-50 payment plan.

Any other ideas out there?

Twice this week I got calls from companies who were seeking my law firm’s assistance in getting their molds back from their former Chinese manufacturers and in both cases I had to tell them I did not think it worth their while to pursue their claims. My firm has been called about a dozen time on such matters and we have declined all but two of these.  The two we took on we were able to successfully resolve within a week. 

In all of these cases, the U.S. or foreign company has called us because they have ceased to use a particular Chinese manufacturer and now that manufacturer is refusing to turn over the molds or tooling that the U.S. or foreign company had supplied to them. The molding/tooling have typically ranged in value from $20,000 to $100,000.

There is one massive difference between those mold/tooling cases we take and resolve and those that we decline. We take on those where the foreign company has a contract with the Chinese manufacturer that makes clear that the foreign company (not the Chinese manufacturer) owns the molds/tooling and we decline the rest.  We decline the rest because the value of the molds/tooling usually does not warrant having to sue to try to get them back, particularly when the chances of prevailing are probably less than 50-50.  

If you do not take the right steps with your Chinese Original Equipment Manufacturer (OEM)before you ship over your mold or tooling, it is nearly certain you will never get them back. As soon as something goes wrong between you and your Chinese OEM manufacturer, the OEM manufacturer typically will use your mold or tooling for ransom. It is the very rare OEM relationship that lasts forever and if you do not take steps to protect your mold/tooling, it will be the even rarer relationship where your Chinese OEM company does not end up with either your mold/tooling or at least with your having to expend considerable funds securing their return. 

So what are the right steps?

First, get your Chinese OEM manufacturer to agree in writing that the mold or tooling belongs to you. Make this clear and do it in Chinese. Second, if possible, get a deposit for your mold, which deposit you will return when the mold is returned to you. Third, and this becomes particularly important if you do not get a deposit (and you almost certainly will not), put in a liquidated damages provision that applies if your mold is not returned when specified.

Taking these steps will not guarantee that you will see the return of your mold/tooling, but failing to take these steps virtually guarantees that you will not.

If you want to read more on Original Equipment Manufacturing (OEM) Agreements and on what they should be comprised, check out the following:

China’s recently stepped up effort to root out foreign companies doing business in China without being registered to do so has caused a rash of China consultants to retain the China lawyers in my firm.

From our work in forming China WFOEs for these consultants, we have learned that many China consultants are falling dangerously short in various other legal aspects of their business as well. Indeed, if we were to single out the foreign businesses in China most often guilty of underestimating their legal risks, it would be China consultants. China consultants seem to have been in China so long that they have lost sight of the fact that when push comes to shove (or as we lawyers like to say, when a deep and easy pocket needs to be found) they are the American/European/Australian company that is going to need to answer for what happened. These China hands also fail to recognize how much China has changed in the last decade and that doing business in China today is just not the same as it was five years ago. Not even close. If you are a Western consultant hired by a Western company to assist in China, you must realize that if something goes wrong for your client you will be your client’s first choice for legal redress.

What can go wrong? And what can you as a China Consultant do to prevent or ameliorate it? Overall corporate planning to protect your personal assets is an absolutely necessary first step. Beyond that however, and more specifically to China, you can do a lot to protect your client and thereby protect yourself.

We have seen the biggest problems with sourcing consultants that assist in finding Chinese manufacturers. A typical sourcing project, might go like this:

  1. Western company retains a product sourcing consultant to find the best Chinese widget manufacturer in terms of cost/quality/dependability.
  2. Consultant requests and secures sample widget from manufacturer.
  3. Consultant meets with countless Chinese manufacturers in search of the best one.
  4. Consultant recommends company Z in China to manufacture 100 million widgets.
  5. Consultant is to be paid a percentage of the manufacturing costs.
  6. Company Z starts manufacturing the widgets.

By this point, I am guessing the sourcing consultants reading this are saying, “yes,” while the China attorneys out there are already apoplectic. Let’s deconstruct this hypothetical project and note where the consultant has potentially harmed the client and needlessly taken on huge liabilities for itself.

  • The sourcing consultant agreed to find “the best” widget manufacturer. Is that best in China or best in the world? What if the widget manufacturer charges one hundred dollars a widget for the 100 million widgets, but your client’s competitor finds another widget manufacturer who will do it for ninety dollars. Are you liable for the difference? Even worse, what if your client’s competitor gets the same Chinese widget manufacturer to do 100 million widgets for ten dollars less? Do you really think a US jury is going to believe you were doing your best when your fee was a percentage of the final costs? Are you responsible for the Chinese manufacturer’s late deliveries? For the Chinese manufacturer’s bad product?  Is it clear exactly what your percentage is going to be based and have you set things up so that your client cannot just go around you? The Solution: Use a well-crafted written contract to make clear exactly what you will and will not do. Put in a non-circumvention provision to make sure you get paid.
  • If you take a sample to China and start showing it to potential manufacturers without FIRST putting in place various safeguards, you are courting disaster. The sample could be used for counterfeiting. We had a consultant call one of our China lawyers in a panic after returning from China to learn that one of the manufacturers to which he had shown a sample had already started manufacturing the product for someone else using the consultant client’s trademark which it had gleaned from the Internet. The Solution: Never show a sample or product plan or reveal your trade name(s) without first making the Chinese manufacturer sign a China-centric NNN Agreement (essentially a hopped up NDA that protects against competition, circumvention and disclosure). Chinese manufacturers tend to be quite familiar with NNN agreements and if you give them a simple and reasonable one, in Chinese, they will sign it.
  • You the consultant must do more than simply negotiate the price and delivery dates or you should at least make clear in writing that these are your only tasks. Typically, product sourcing consultants oversee the OEM contract with the manufacturer and by doing so, they face major liability issues if that contract is not up to snuff. You are the “China guy” and your client is counting on you to guide it through China’s business minefields. You are the one who is supposed to know anything and everything about what it takes to do business in China. Equally importantly, with the manufacturing of its product, your client is probably turning over to the manufacturer all sorts of critical intellectual property. Your client probably thinks that its existing patents, trademarks and copyrights will protect it in China, but a court will expect you as the China expert to know better. The Solution: Put in writing with your client that you will not be providing it with legal advice and that it will need to retain its own lawyer to draft the OEM agreement with the Chinese manufacturer. Put in writing that it is your client’s responsibility to protect its intellectual property in China and that to do so, it must register its IP in China, either through a lawyer with whom you connect them or independently).

Just remember that your client sees you as the expert at doing business in China and it is looking to you for help in all areas and if you fall short in any way, you are at risk for a lawsuit.

China consultant, protect thyself.