A reader directed me to an excellent article in Material Handling & Logistics Magazine, setting out the basics for succeeding at outsourcing product manufacturing to China.  The article is by Michael Zakkour of Technomic and it is called The Ten Rules for Contract Manufacturing in China.

The article starts out by noting that “there are three overarching ‘must haves’ for producing/buying in China: a good supplier, a good contract and good IP protection.”  It goes on to say that if “you pay attention to the tiniest of details on all three you will likely have a profitable experience,” but “small lapses in any of the three could spell disaster.”  I completely agree.

It then maps out ten “simple rules to follow,” of which I will be discussing only the following, which are all legally related.

  • “Register all of your trademarks, copyrights and patents in China. China is first to file, not first to use. If you are not diligent with this, you will at some point lose your IP.”  I 100% agree.  See File Your Trademark In China. Now.

For more on best methods for China product manufacturing, check out the full article here.

It’s become somewhat of a December tradition to write about China payment scams in December because history shows this is the biggest month for those.  Last December, it was Ancient China Business Scam. Back With A Vengeance This Season.  This year, I asked my co-blogger, Steve Dickinson, to report on what he is seeing and hearing on that front these days. The following is his report:

We are frequently contacted to deal with the following issue. A foreign company has been making purchases from a Chinese company for an extended period. Payments are made pursuant to purchase orders that specify the company bank account to which payment should be made. Suddenly, the Chinese company sends an email requesting funds for outstanding POs be made to a new bank account. Often, the name on the bank account is not the same as the name of the Chinese company. Often, the bank account is in a different city or even in a different country. Often it is for Hong Kong.

The question we are asked is whether the request to make payment to a different account should be honored. Our answer always is no. Ignore the request. Make payment as provided in the original PO or don’t make payment at all. In the past, I have made this statement because it is not uncommon for rogue employees in Chinese companies to set up alternative bank accounts using forged company documents. These employees are noted for having stolen substantial sums using these techniques.

It now turns out that foreign criminal gangs have entered the field, making the situation even more dangerous. China Daily reported today on such a foreign operated fraud.  The foreign gang worked with a network of 9 foreign nationals living in China. The scheme worked as follows:

  •  The China team investigated Chinese trading companies making sales to foreign companies operating in 27 foreign jurisdictions.
  • After locating the target Chinese companies, the gang installed Trojan horse software on the computer systems of the Chinese companies. They used the Trojan horse to intercept email communications between the Chinese and foreign companies.
  • The gang then sent out false emails to the foreign buyers, requesting that they send funds to bank accounts different than those provided in the applicable purchase orders. These accounts were opened in China by the China resident members of the gang. The accounts were emptied immediately, leaving only small sums behind to reward the local gang members.
  • Nine local gang members were arrested. However, since the majority of the funds were sent overseas to unknown parties, the stolen funds were not recovered.

How can you avoid getting caught up in this type of fraud:

  • As you can see from this story, the computer networks of many Chinese companies are not secure. The networks are subject to abuse by employees of the Chinese company and by outsiders. This means that you can NEVER trust an email communication from a Chinese company. Email is inherently insecure in China and you never know with whom you are really dealing when engaging in electronic communication with Chinese companies.
  • Chinese companies are very loyal to their bank and so you should view with extreme suspicion any request to make a change in the payment bank. You should not even consider such a request unless the request is made in writing on a revised purchase order stamped with the company seal. Even in that case, it is important to contact someone you know in the company with supervisory authority to ensure that the request is valid. Email requests to make a change should be ignored, but the request should be forwarded to your trusted Chinese company contact for an explanation.
  • Carefully review all bank account information. Monitor both the name of the payee and the location of the bank. Where the payee is even slightly incorrect, do not pay. Where the location of the bank is in the wrong city or country, do not pay. I have seen cases where foreign buyers paid to bank accounts outside of China to payees with no connection to the seller. These cases were all obvious frauds and the buyers lost their entire payment. I have seen millions of dollars vanish into thin air with this sort of scam.  The Chinese parties committing the fraud will explain the need for this irregular payment as part of a plan to hold foreign currency outside of China. This kind of arrangement is no longer required in China. Explanations of this kind are indicia of fraud and should be ignored.

As China opens to world, this kind of international fraud will become even more common. Constant diligence is required to avoid being taken in.

You have been warned.

What are you seeing out there this season?

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:

I love it when a blog post just lands in my lap, and one just did. It is a couple of emails from two of my firm’s lawyers to two different clients, both of whom recently retained us to draft OEM Agreements for production of product by factories in China. Both clients are in the process of changing their Chinese manufacturers and this time around they want a strong and enforceable supplier agreement with their new Chinese manufacturer.

I am doing this post to give an idea of some of what should go into a Chinese manufacturing agreement.

Since we have a fairly standard initial questionnaire we send to our clients when we being working on China OEM manufacturing agreements, I have combined the two emails into one, further camouflaging the companies involved. Here are the questions posed by the emails:

  • What is the name and contact information of the Chinese manufacturer?
  • What sort of products will the Chinese manufacturer be making? Do you anticipate that these products will change over time? Will the volume change over time?
  • Where do you anticipate selling your products In particular, will you be selling it in China?
  • What are you expecting regarding shipping terms?
  • Will you be using this OEM agreement only with this specific Chinese manufacturer, or will you be wanting to re-use it with others?
  • What arrangements will be made for packaging prior to shipment?
  • Are you concerned about your manufacturer going around you by directly selling a competing product your customers?
  • Exactly what will you want to be  done with any defective product?
  • Do you have an existing purchase order (PO) that you intend to use for your product orders from this manufacturer? If so, please provide us with a copy.
  • How are you anticipating pricing and other terms will be negotiated? On a purchase order basis? On an annual basis? Some other way?  If you submit a purchase order and is not accepted by the Chinese side, what happens? In other words, is the Chinese side bound for some period to make a certain amount of product at a certain price, or is the Chinese side only obligated to make product for you after it accepts your purchase order?
  • How many of the deal terms have been negotiated at this point? From the documents you have sent us, it appears that only the very basics have been negotiated: 40% down, 60% before delivery/shipping, plus certain quantity discounts. These are not great terms from your standpoint, but fairly typical for deals with manufacturers in Southern China (i.e., Shenzhen, Guangdong, etc.).
  • What sort of arrangements have you made for inspection and quality control, and what sort of warranty terms have you negotiated? This question is particularly important in that many manufacturers in the south of China insist on a no-warranty provision.
  • What are your main concerns in this deal? I ask this both so I can focus on the provisions that matter to you, and because it can help determine the choice of law and the choice of venue. From what I know so far, your main concerns seem to be twofold: (1) getting a high quality product and (2) protecting your intellectual property (i.e., ensuring that the Chinese manufacturer does not sell your product behind your back and/or steal your tooling).
  • What exactly is the tooling for this product? Does the Chinese manufacturer already have all of the tooling in question?
  • Has the Chinese manufacturer already signed an sort of agreement/memorandum of understanding (MOU) with you, even if only in English?
  • Are there any unresolved issues involving your previous manufacturer ? For instance: have you gotten all of the tooling back from the previous factory? Are there any outstanding invoices or payments due?

After we get answers to the above questions, we virtually always write back with a whole slew of follow-ups.

For more on what it takes to have/create a good OEM Agreement, please check out the following:

Yesterday, our post of a slightly revised email on China’s employment law from Steve to one of our clients was a hit in that we received emails thanking us for having run it. So today, we are going to run another Steve to client email on an Original Equipment Manufacturing (OEM) agreement we drafted, first in English and then in Chinese.

Here’s Steve’s email, slightly revised, setting forth some of the important considerations/issues when drafting China OEM agreements:

  • We need to determine whether the agreement with your manufacturer will be exclusive or nonexclusive. It appears you want to give the Chinese Company an exclusive right to manufacture a certain subset of your products, with other Chinese companies having the right to manufacture other of your products. Please confirm my understanding is correct.
  • We need to determine the Chinese Company’s obligation to sell. There are basically two alternatives. Alternative One: The Chinese Company is obligated to produce product under any purchase order you submit and its failure to produce at the agreed price would be a default. On the other hand, you would then be required to purchase a minimum amount of product during a specified time period. This approach is best if you want to guarantee supply and if you want to hold the Chinese Company to its commitment on price. Alternative Two: the Chinese Company is obligated to produce product only for those purchase orders it accepts. The Chinese Company has the right not to accept Purchase Orders, at its discretion. The advantage of this to you is that it will not require you to purchase any specific amount of product. The disadvantage is that there is no guarantee of supply and there is no way to hold the Chinese Company to any price commitment.
  • The agreement as drafted provides for a specific port of delivery. However, if you will have multiple ports and delivery locations, we should revise the agreement to provide that the port/delivery location will be specified in the Purchase Orders and we will remove these references from the agreement itself
  • We have drafted the agreement to have the pricing system set out in a separate exhibit. For this exhibit, note that you will probably need to have separate pricing systems for domestic purchase and export product. Domestic product has different shipping and title transfer rules and is also influenced by the lack of any VAT rebate. Since you have no presence in China, we would also have to consider exactly how a non-export sale would work. Purchases by one of your allied trading companies may be the solution here.
  • Section 3 of the Agreement provides for payment terms. This approach is very favorable to you, since it provides for payment 30 days after inspection, not 30 days after shipment. If you will provide for payment 30 days after shipment, you will need to determine when you will inspect the product. It is best to have inspection before payment, but this is not always practical.
  • Note that we have not specified a warranty period. The normal period is two years from date of shipment. One year from date of sale is not usually used, since there is no way for the Chinese Company to know when a sale is made. Two year warranties are common because the assumption is that the product will be sold sometime in the first year after shipment from China.
  • In the trade secrets/IP protection provisions, we have provided for a monetary penalty for breach. It is customary to provide for $10,000 for the lump sum penalty and 12% for the percentage of sales penalty. The penalty is intended to be large enough to cause concern for the manufacturer, but not so large as to scare them away. The issues raised in this section come up all the time in China, so these provisions must be considered carefully.
  • The tooling provisions provide for a series of lump sum penalties. Tooling disputes are among the most common in manufacturing agreements and we have found these provisions effective in dealing with this issue. Manufacturers commonly refuse to return tooling and the most effective way to control this is to provide for a significant lump sum penalty for such a refusal.
  • This agreement is written to favor you but be fair.
  • This agreement requires preparation of the following exhibits to provide for the variable and technical provisions of the manufacturing arrangement:
  • List of products
  • Performance criteria (specifications)
  • Product pricing method
  • Quality control and inspection procedure
  • A customer no contact list
  • Tooling List
  • Purchase Order

We can assist with drafting these Exhibits as necessary. It is customary NOT to translate these exhibits into Chinese.