China sourcing agents
Sourcing agent? Yes or no.

As anyone who has ever worked with me knows (and as is true of many lawyers) I am a perfectionist. If a client comes to me for legal help for their China manufacturing, I almost always question them about their potential or actual product supplier(s) and how they found them. I ask these questions because I know from experience how important it is to choose the right manufacturer and I am borderline obsessed with making sure our clients have the right manufacturer for what they will be doing.

My favorite speech is on how to protect your intellectual property from China and I start that speech by talking about how the following three things matter most in this:

  1. Good partner (the Chinese company you choose)
  2. Good contracts with the Chinese company you choose
  3. Good registrations (register your trademarks and your copyrights and your patents in China, when applicable)

If choosing a good Chinese partner is important for protecting your IP, that choice is even more important for ensuring quality product on time.

So we now get to the proverbial question: how do you choose the right Chinese manufacturer? The baseline question then becomes whether you should find that manufacturer yourself or use a third-party sourcing agent to do so. Unfortunately, there is no one answer to this question. About all I can tell you here is that there are many bad sourcing agents and a few great ones and choosing a bad one is virtually always going to be worse than doing it all on your own. So if you do decide you need a sourcing agent, choose a good one.

Today though I am going to pull from an excellent post from the always superb Quality Inspection Blog. The post is aptly named, Sourcing from China 101, Part 1: Do You Need a Sourcing Agent? and if this issue is relevant to your China business, I urge you to go there and read the whole thing.

The post nicely lays out the following four options for companies looking to have their products made in China by a third-party manufacturer:

Options: Sourcing Agent vs. Buy Direct from China

According to the post, 80% of importers go direct and thereby “control the whole process, and avoid paying commissions to any middleman or agent.” It states and I agree that “if you are organized enough to manage suppliers . . . .and if you can satisfy the minimum order quantities (MOQs) of suppliers, this is probably the best option for you.” I would, however, add “knowledgeable enough” to this sentence.

The post then discusses how over 90% of sourcing agents get a hidden commission from the factory and it calls this “normal business” in China and how when things go wrong, sourcing agents “often tend to defend the factory!” I agree with this though the 90 percent figure may be a bit too high. But you get the point. In fact, this post quotes me using that same figure, though I used it more for rhetorical effect than as a hard and fast number:

Dan Harris has a similar view of most agents:

I often describe China sourcing agents with the following: “Ninety percent are crooks or incompetents and most are both of these things. But ten percent are worth more than their weight in gold.”

 

Perhaps most importantly, the post lays out key questions you should ask potential sourcing agents before you engage one:

  • How will they get paid, and by whom?
  • Will you be able to visit the factories before/during production?
  • Can they provide referrals or testimonials from satisfied customers who buy the same type of product as you? Make sure to contact two of them and get confirmations.
  • Do they do quality inspections by themselves? Or do they resort to a specialized third-party? Will you get a report every time?
  • Will you get an update every week on the production status?
  • Can they share their management system with you? You need to make sure they have processes in place. The vast majority of agents don’t follow any established procedures.
  • What guarantee do they offer in case a supplier scams you? If shipments are behind schedule? If you receive junk product in your warehouse?
  • Are they located in the area where your products will be sourced? (Do a quick search on globalsources.com and you will have an idea about the main area for your product category.)
  • If you keep re-ordering the same products from the same sources, will you pay less for the sourcing agent’s services after the first order?

These are all great questions. When our clients ask one of our China lawyers to refer them to “good sourcing agents,” we typically ask them two questions: What is the product for which you will be needing a sourcing agent and how do you want to pay the sourcing agent. Once we have answers to these two questions we can then provide them with a short list of potential sourcing agents.

We ask the first question because a sourcing agent that is great for sourcing clothes is not the right sourcing agent for sourcing medical devices. The good news on this score is that good sourcing agents don’t source products with which they are unfamiliar. So for instance, if we have a client that wants help sourcing an unusual product and we do not know offhand of any sourcing agents involved with that particular product, we will go to the good sourcing agents we do know and ask them for referrals.

We ask the second question because sourcing agents can charge differently and some are less flexible than others. Generally speaking, the more you pay up front, the less you will likely pay in total over time. Some sourcing agents require a large upfront payment to get started and others are willing to work on a percentage basis. Our start-up clients tend to prefer paying a percentage per widget manufactured and our bigger clients tend to prefer paying upfront.

Now you know….

Beware the fake China attorney
Beware the fake China lawyer

American Lawyer Magazine recently did an article, That Law Firm’s Website Might Not Be for a Real Law Firm on “a new white paper [that] examines a growing trend of fraudsters posing as attorneys or legal consultants online to exploit those seeking legal services.”  To which I can only say, well yeah.

To which I can only say, well yeah.

We actually first wrote about the fake lawyer phenomenon way back in 2006, in China: Where Even The “Law Firms” Are Fake (2006). In that post I talked about fake Chinese lawyers taking money from American companies for trademark registrations:

There are those who take money to file trademarks in China and then simply run away. A new client told me he had sent about $750 to what he thought was a legitimate China law firm to have his company’s brand name registered. As soon as the first $750 hit Shanghai, he was asked to send an additional $600 to “cover the filing fees,” which he did.

A week later the website was down and the Shanghai “firm” was gone.

It turns out this scam is actually pretty common and it also turns out that in every case of which I am aware the scammers were neither licensed Chinese lawyers nor licensed Chinese trademark agents. In other words, they are just people who run China trademark registration scams.

Since 2006 I have heard multiple accounts of foreign companies that paid for trademarks or employment contracts or manufacturing contracts  or company registrations or various other things China lawyers typically do for their clients, only to receive nothing in return and only to learn that the “Chinese law firm” or the “Chinese lawyer” they paid for their legal work never even existed. How many foreign companies believe their trademarks are registered in China when in fact they never were? How many think they have registered companies in China when they don’t? I don’t know the numbers, but I do know that the number of these fake law firms is on the rise, fueled in large part by foreign companies seeking to reduce their costs wherever they can.

In addition to fake law firms that simply steal your money, there are also a whole host of companies with no lawyers who advertise their China legal services on the internet. These companies (at least as far as I know) do not flat out steal your money but what they do can in some cases be almost as harmful. These companies lead their clients to believe they are communicating with lawyers when in fact they are not. This means that there is no attorney-client privilege and that the odds of whoever does your legal work knowing your situation and your goals and having the capability to draft a cross-border document that will work for you are about 1,000 to 1. Be careful of these companies as well.

So how can you avoid these things happening to you? Do some due diligence before you pay/hire a China lawyer, especially if you will be paying upfront for something like a China trademark or a China company registration where it may take you years to realize that you have been had. There are, for instance, some fast and easy steps you can take to confirm that your lawyers actually have a law license. I believe every U.S. state lists its licensed practitioners online and avvo.com also lists all or nearly all licensed lawyers. Here is my proof on Avvo that I am a real lawyer, licensed in Alaska, Illinois, and Washington. Most countries have something similar. Check to see how long they claim to have been in business as compared to how long they have had their website. One fake China attorney claimed to have more than 20 years experience but his website appears to have been online for a total of only 5 months.

Anyway, just be careful out there.

 

We are always emphasizing on here how you need a China-centric contract when doing business in China or, in most cases, even with China. See China Contracts: Make Them Enforceable Or Don’t Bother. This holds doubly true for employment contracts with China employees because everything about such agreements is highly local. If you are having someone in China other than a company performing services for you, you need both your own entity in China (See Doing Business in China with Deportation or Worse Hanging Over Your Head) and a China specific written employment contract with each of those individuals.

China employment law
Don’t let your China employment agreement get lost in translation

And though I should not have to say this, translating your existing employment agreements into Chinese is not going to cut it — not even close. Yet just about every month some foreign company (almost invariably an American or Australian company for some reason) or an executive with such a company (again, almost invariably American or Australian) will come to one of our China employment lawyers with a problem involving a foreign country employment agreement that was translated into Chinese.

The below are some of the common examples we see where a foreign contract/foreign mindset does not jibe with the China employment law reality.

  1. The employment agreement makes clear the employee is being hired on an at-will basis, which means he or she may be fired for “good reason, bad reason, or no reason at all.” This generally works in the United States and in a few other countries around the world, but it absolutely positively does not work in China and putting such a provision in your employment contracts can and often is used as evidence to support a wrongful termination claim, so please just skip it. Terminating a China-based employee nearly always requires good cause and far too often companies that put these at-will provisions in their China employment contracts actually believe what they say and end up in big trouble for wrongful firings.
  2. The employee is expected to work whenever needed to get the job done. This can sometimes work for certain China employees provided various specific conditions have been clearly met, but putting this sort of provision in a contract is not a way to meet those conditions — it is yet another red flag for China judges when you get sued by one of your employees. For you to be able to use your China employees after hours without having to deal with overtime provisions, that employee must (1) have been cleared by the appropriate labor bureau authorities as eligible to work under an alternative working hours system, (2) have specifically agreed in his or her employment contract to work under such an arrangement. Note also that clearance for one of your employees being able to work under an alternative working hours system typically lasts for only a year, depending on the locality. Note also that the alternative working hours system cannot be used with most employees and that means they must work under the standard working hours system which requires overtime for anything beyond 8 hours a day and 40 hours a week. Getting an employee to consent to this without government approval does not work.
  3. The employee agrees to adjudicate all employment-related disputes through arbitration. This does not work if you try even to limit your employees to only labor arbitration and it certainly does not work if you try to require your employees to arbitrate disputes against you in your home country or really anywhere outside the jurisdiction where they are employed. I surprisingly often have to tell American companies that putting a provision in a contract with a China employee that United States law will apply and all disputes must be resolved in some U.S. city has the same likelihood of success in China as would a provision requiring an Omaha employee be bound by Chinese law and Chinese jurisdiction, which is exactly zero. Think about it. Is any American jurisdiction going to let you hire someone and pay them pursuant to China’s minimum wage requirements? Of course not, and the reverse is equally true.
  4. The employee agrees to a non-compete that comes into force after termination of employment and the consideration for this non-compete is the promise of employment. This generally works in the United States (though not in California), but in China, if you want one of your employees to be bound by a non-compete provision, you must pay them consideration for their not competing during the entire term of the post-termination non-compete period. For example, a sign-on bonus may not be consideration for a China non-compete; the (former) employee must receive compensation via bank transfer on a monthly basis after termination for your non-compete to hold.

Provisions like the above send strong signals to your employees, to China labor bureau authorities and to China’s courts that you do not understand how China’s employment laws and you are not willing to make the effort to comply with them. This increases both the odds of your having China employment law problems and the odds of your employees suing you when such problems arise. And as mentioned above, having these unenforceable and illegal provisions in your China employment contracts also tends to prejudice judges against you when you are actually sued.

Bottom Line. Use a China-centric employment agreement with all of your China employees.

China Manufacturing Contracts
China Manufacturing Conmtracts: Like a Maze

Our China lawyers have in the last six or so months been getting more than the usual number of manufacturing contracts that involve U.S. based sourcing companies, oftentimes one in a close (ownership connected?) relationship with the China factory(ies) at which the product or products are going to be made. Figuring out the appropriate party(ies) with whom to contract can be quite complicated in these situations, as can the drafting of the contract(s) as well.

The below is an amalgamation of some recent emails we have sent to clients that are working through an American sourcing company with close ties to the China factory. I am running this because it should prove helpful to other companies in similar situations.

Please advise on the below for your relationship with US Sourcing Company A. Keep in mind that US Sourcing Company A is a U.S. company that will be working with Chinese subcontractors. So you must permit a first layer of subcontracting to factories in China. We can call that first layer the Primary China Contractor.

You should require US Sourcing Company A to provide you with the following:

1. The identity of each Primary China Contractor.

2. You will have essentially the following two choices regarding the appointment of the Primary China Contractor:

a. You will have the right (but not the obligation) to inspect the factory of the Primary China Contractor factory and to approve the Primary China Contractor business and its factory chosen by US Sourcing Company A. US Sourcing Company A must also first provide you with notice of any change in Primary China Contractor and this same procedure will apply to that change as well.

b. No Primary China Contractor can be used until you first approve it in writing. If the Primary China Contractor will change its factory location(s), American Sourcing Company A must give you prior notice of this and you must approve this in writing as well.

3. You will have access to the factory(s) of the Primary China Contractor at all times.

4. US Sourcing Company A must provide the NNN Agreement we drafted for you and your company’s Code of Conduct to the Chinese Primary Contractor. No work will begin until after the Primary China Contractor has returned to you a) an executed version of the NNN and b) a written and signed acknowledgement it has received and will comply with your company’s Code of Conduct. We will revise your NNN to apply in this situation and we will also draft a short acknowledgement for the Code of Conduct.

After deciding on the basic policy towards the Primary China Contractor, we must together consider the issue of how to deal with subcontracting done by the Primary China Contractor.

It is common for the Primary China Contractor to further subcontract out part or even all of the manufacturing process. Will you allow such sub-contracting or not? This is a complex issue:

Though this kind of subcontracting is common (and especially so in your industry) this process greatly increases your intellectual property risks. If the subcontracting process gets too extreme, no one really knows who is doing what. I have worked in situations where there were five layers: U.S. sourcing company and Primary China Contractor with three layers of subcontractors under the Primary China Contractor. It was a mess when things went wrong with quality and with control of IP because everyone pointed to everyone else as the source of the problem. On the other hand, without the extensive subcontracting, no product at all would have been produced for this client.

In theory, we will want the subcontractors to abide by your NNN Agreement and your company’s Code of Conduct. You may inspect the Primary China Contractor factory and find all is in compliance. But, if you allow for subcontracting below the Primary China Contractor, the Primary China Contractor may then subcontract work to a different factory(s) that is not compliant in any way. But, if you require the NNN and Code of Conduct from EACH subcontractor below the China Primary Contractor, you could end up with 30 or more executed agreements and the costs to go with that.

You need to decide how to deal with the issue of subcontracting by the primary Chinese contractor. Your options are as follows:

1. The Primary China Contractor is not permitted to subcontract. At all.

2. The Primary China Contractor is permitted to subcontract. The subcontractors are not required to execute the NNN Agreement or your Code of Conduct. The Primary China Contractor and the US Sourcing Company A are liable for violations by the subcontractors.

3. The Primary China Contractor may subcontract, but only on the same terms under which US Sourcing Company A is permitted to subcontract.

In theory, Option 3 provides you with the most protection. However, as discussed above, the logistics of Option 3 can be very difficult. In addition, many Chinese subcontractors will refuse to execute an NNN Agreement (or any other agreement) with a U.S. company with which it has no direct purchase/sale relationship. For this reason, most U.S. companies (especially those without a massive amount of purchasing leverage) usually settle on either Option 1 or Option 2.

Please consider the above and provide me with your initial choices on how to proceed or let’s talk some more about your various choices. You may wish to discuss the above issues with US Sourcing Company A as well. If US Sourcing Company A will not allow its Primary China Contractor to subcontract, the China subcontracting issue disappears for this particular contract.  However, this issue likely will come up in the future, so we should consider your basic company policy on the issue.

China Factory ClosuresChina factory closures are a hot topic. In the last few months, our China lawyers have received multiple emails from companies that were having their products made in Chinese factories that have been shut down due to environmental concerns.

And needless to say, we are not the only ones dealing with this issue. See More Thoughts on China Factory Closures and What if your supplier has to close due to China’s Ministry of Environmental Protection (MEP) cracking down on polluters?

To us though, the big issue isn’t so much what do you do if your factory in China closes, as those situations usually are governed by the actual facts on the ground. No, for us the more interesting question is what can and should you be doing now to avoid a situation where your China factory closes.

Lately, the China attorneys at my firm have been receiving emails like this:

I run a _________ company in __________ and I have come upon my own situation in which I would like to ask for a legal opinion. We were having our [widgets] made by a factory in Guangzhou that is part of a large Chinese company with more than a dozen factories throughout China. Unfortunately, this one factory that was making our [widgets] is the only factory this company has that makes [widgets].

To make a long story short the company is saying that the Chinese government has shut down its [widget] factory for “environmental reasons” and they will not be supplying us with our [widgets]. This is very bad for us because we now have a long line of very unhappy retail customers and many of them have told us they are done with us (even for our other products) because of our failure to deliver them the widgets we promised.

Can we sue this company in China?

Our typical response is usually something like the following:

Certainly you can sue but can you win? Without reviewing your contract with this company, I have no way to know what you can and should do. If you have a good contract (preferably in Chinese and chopped by the Chinese company) that makes clear that the company must provide you with products and that does not have a force majeure provision broad enough to include this factory being closed by the Chinese government for environmental reasons (even if the fault of the Chinese company) then we should consider pursuing litigation.

But what can you do to avoid a similar situation for your company? The following can help.

  • First off recognize that the Chinese government is more concerned with social harmony than with economic numbers and that is why it continues to shut down highly-polluting factories.
  • Many Chinese exporters, particularly those that compete with companies from lower-wage countries like Vietnam and Bangladesh, are suffering — in particular in low-tech, low-wage industries such as manufacturing of textiles, clothing, shoes and low-end electronics and toys. Some of these companies are claiming to have been shut down by the Chinese government when in reality they shut down on their own because they were losing money. Foreign companies that do business with Chinese companies in these industries must keep up their guard.
  • The key to weathering China’s onslaught of factory shutdowns will be for foreign companies to focus on due diligence at a company-to-company level.

Even though China’s low-end companies are suffering both from environmental shutdowns and rising costs, its high-end companies are getting bigger and deeper, as they strive to provide a product or a service (or a product and a service) that can compete anywhere. The existence of such Chinese companies is not new but these sort of companies are proliferating and growing in strength, and more Chinese companies are realizing that stepping up their game is the best way for them to survive. Co-blogger Steve Dickinson hit on this trend in his post The New Role Of Written Contracts For Product Purchases In China. In other words, the importance of choosing your China partner — which was always critical — has become even more so.

Our best advice to protect your financial interests is (1) document all transactions in simple, concise language so that if there is a fight over the failing Chinese company’s assets, it will be clear what actually belongs to you. If your Chinese factory is going to shut down after you have paid for your products and your Chinese factory has made them, you want to be able to walk away with them (2) do your utmost to determine the financial wherewithal of your Chinese counter-parties before you pay anything. These two steps aren’t foolproof, but if you do both you’re a lot less likely to get burned, shutdown or not.

None of these things are foolproof or even close, but if you do all of these things you are a lot less likely to get burned, slowdown or shutdown or not.

China employment law audit
Salary reductions in China

Can an employer in China unilaterally reduce the salary of one or more of its employees? Like so much having to do with China employment law, it depends.

Because labor remuneration is an often-litigated issue in China, employers should be very careful when reducing an employee’s salary and should take that action only when prepared to defend it before an arbitrator or a judge. As with China-based employee terminations, the best way to proceed and avoid employment disputes will usually be to do it via a mutual agreement (in Chinese) structured as an amendment to the existing employment contract. If you as the employer can get your employee to agree in writing to a salary reduction, that will both minimize your risk of later being sued for reducing your employee’s pay and it will increase your chances of prevailing should such a lawsuit occur anyway.

The tricky question though is whether an employer can reduce an employee’s salary without that employee‘s prior written consent. It is possible, but how you can do it will depend on the local employment laws and even to a certain extent on the local employment bureau. But even if allowed where you are, to maintain its legality, you must do a number of things (and document them) to make this work. In the real world, very few employers take the time and effort to do these things and those who don’t virtually all lost in labor disputes.

China’s Labor Contract Law does not explicitly give an employer the right to unilaterally reduce an employee’s wages because the employee is not competent at his or her job. The Labor Contract Law instead speaks to employer’s being allowed to unilaterally adjust an incompetent employee’s position, provided the employer meets all local requirements in making such adjustment. The Labor Contract Law also calls for the employer to provide 30 days’ written notice or an additional month’s salary in lieu of notice, if the employer can prove the employee is incompetent and remains so after training or assignment to another position. The employer may also reduce an employee’s salary in response to an employee’s breach of the employer’s rules and regulations.

The below are a few of the things employers typically (I say typically because these things vary depending on locale) must do for its unilateral salary decision to hold:

First, the employer needs to make sure its employment contract gives it the right to adjust an employee’s position and remuneration. Make sure the employment contract is fully executed by both parties. With China cracking down on employers lately (particularly foreign employers) our China employment lawyers have been doing a ton of employment audits and we are stunned by how many times we are seeing employment contracts signed only by the employee, signed only by the employer, or never signed by either party. Get your employment contracts signed by both parties and retain copies of those signed employment contracts in a safe and accessible place!

The employer then needs to ensure that its Rules and Regulations set forth its salary reduction policies. Forget about unilaterally reducing one of your employee’s salaries if you do not have a China-centric set of employer rules and regulations. And just as our employer audits are revealing a ton of foreign companies that do not have their employment contracts in good order, many do not have their Rules and Regulations in good order either. Some companies either did not know which was their current version or could not find their current version. And far too many had no written proof of ever having given their Rules and Regulations to their employees. Even with your salary reduction policies in writing, if you never obtained the employee’s written acknowledgment of having received a copy of such a policy, you will likely have a hard time getting a Chinese court or arbitrator to allow that to provide the authority for your reducing a salary.

But if you do have a proper set of Rules and Regulations that gives you the right to reduce the employee’s pay for violations of the Rules and Regulations and you can prove employee did in fact violate your Rules and Regulations, you may be able to reduce the employee’s pay on that basis. For this to work (and even then only in some locales), your Rules and Regulations must clearly specify the Rules and Regulations breach that will lead to a salary reduction and, as I wrote before, such provisions in your Rules and Regulations must be reasonable and not violate any Chinese laws.

If you as employer can get past all of the above hurdles, you next need records proving why the employee deserves a salary reduction. Something like written performance evaluations are usually best, and if signed as received by your employee, all the better. Make sure though that your performance evaluations are in Chinese or have been translated into Chinese; do not wait until your employee brings a legal action against you before you put this into Chinese as that will not be viewed as a contemporaneous document and it may be rejected entirely by the court or at least viewed with much less credibility.

Even if you satisfy all of the above requirements you still have another one: reasonableness. Was the adjustment you made for this particular employee reasonable. For example, is the new position suitable for the employee? Is the reduced pay appropriate for the adjusted position? Does it meet local minimum wage standards? Keep in mind the local differences: e.g., what is considered reasonable in Dalian may not be deemed reasonable in Beijing.

Finally, when you notify your employee of your salary reduction decision, you typically will need to provide him or her with an explanation for your doing so, so the employee can understand what led to your adjustment decision. Again, doing so in a writing in Chinese and getting that writing signed by your employee will almost always be the best way to do this.

Reducing a China employee’s salary is like pretty much everything else employment law related in China: it’s local and it’s not so simple, but done right, it’s possible.

China contract lawyersIn my first post in this series (here), I described the five basic attitudes Chinese companies have regarding advanced equipment being sold into China.  In part 2 (here), I set out two of five tactics high value equipment sellers should follow when selling advanced (and therefore expensive) equipment into China: One, do not discount, and two, get paid before you deliver your equipment to your China buyer.

In this, part 3, I wrap up this series by setting forth the remaining three tactics equipment sellers should employ when selling their equipment to Chinese companies.

3. Do not deliver the equipment until first verifying that the conditions for its installation have been met. Remember that the Chinese side believes your equipment works based on an almost “magic” formula and your rules on how to set up for its installation and the specifications for its use are just a subterfuge you use to “hide the magic.” The detailed set up work is therefore unnecessary. Meeting the specifications is not necessary. So the Chinese side will not do the proper set up and they will ignore the specifications. But then when your equipment does not work as it was supposed to, the Chinese side will blame you for its failures.

The following are two (of many) true stories that illustrate how this typically goes down:

  • A heavy equipment manufacturing company delivers iron pipe casting equipment. The conditions of sale provide that the floor of the casting room must be perfectly level. When the equipment is delivered, the casting room has an uneven dirt floor. The casting machine does not work and the Chinese side does not pay a single penny on the contract. The Chinese bank that guaranteed the payment sides with the Chinese buyer. Why create a level, clean concrete floor for a dirty machine used for metal castings, one of the China company’s engineers asked at one point.
  • A water power equipment manufacturing company delivers a new hydropower generation set of equipment. The specifications provide that the current flow can never exceed 6 knots. When the equipment is delivered, the Chinese side installs it in an unapproved location where it is well known the current exceeds 8.5 knots. Within one year, the entire facility is destroyed. The Chinese side defaults on the last payment and the reputation of the foreign company is destroyed. The foreign company lost money on the project and never did another sale in China.

Foreign equipment sellers cannot rely just on clear contractual specifications and then relying on the specifications when there is a problem. The foreign seller should itself ensure the conditions are met before it delivers the equipment. And if the conditions are not met, the foreign seller should not deliver. If there is a cost in confirming your Chinese buyer has met the specifications (and there usually will be), you should build that cost into the cost for your product. Remember: the failure of the installation is always your fault and the Chinese side will always find a way to make you pay for that failure. We have said this before and it made people mad, but some of our most experienced and sophisticated and successful China essentially charge a premium to Chinese buyers simply to cover themselves in advance against these sorts of problems.

4. Build required training and after sales maintenance and support into the price of the equipment. No matter how much your potential Chinese buyer tries to get you to decouple the pricing for maintenance and support (and then eliminate it entirely) do not make these optional add-ons that are billed for an additional fee. If you make these optional and charge extra for them, the Chinese side will almost always choose not to pay. So you have to force them to accept training and support as part of your sales price.

Why do the Chinese refuse to pay? Your trying to require them to pay for after sales maintenance is just you admitting that your product is somehow defective and why should they buy a defective product. If properly manufactured your equipment should work forever, with no service or maintenance required and your trying to make the Chinese side pay for training and service as an add-on is you unfairly seeking to increase the price of a product that is already unfairly expensive.

There is one exception related to training. If the Chinese side is planning to clone your equipment, they will seek extensive training in how the equipment operates. Their goal though is not training; their goal is to somehow obtain the formula that will allow them to clone your machine. For this reason, you should carefully control your training with Chinese companies.

During training, the Chinese side will ask for more information and more training time than is necessary. They will also insist on visiting the U.S. manufacturing facility and they will expect to spend substantial time in that facility. For this reason, all training obligations must be carefully defined to prevent your costs from skyrocketing out of control. You should carefully limit time, location and access to information. One good way to control this is to require the Chinese pay by the hour for all training provided in excess of the basic training included in the purchase price.

Many foreign equipment suppliers say they will provide whatever training proves “reasonably” necessary. This sort of an approach is nearly always a mistake because neither Chinese companies nor Chinese courts truly understand or employ the concept of reasonable. You therefore should state state with precision the training you will be providing, where you be providing it, who will be providing it, and for how many hours you will be providing it. The same rules apply to provision for after sales support. Chinese companies tend to abuse after sales support obligations. So those obligations should also be spelled out clearly in your contracts as well. Again, I base this not on any “feelings” I have about China, but based on my having represented countless foreign equipment sellers on countless China equipment transactions and on what I have heard from other equipment companies and from other China lawyers who represent them.

5. Protect your IP through with a China-centric contract. Protecting the intellectual property you have in the advanced equipment you sell into China should be a core goal in all of your sales. Understand the basic approach from the Chinese side: your product is too expensive and b) any form of IP protection is just a unfair device you are using to force them to pay the unfair price of the machine. So the goal of the typical Chinese company is to purchase one or two items at a bargain price and then clone them in China at a “fair” price.

The obvious way to protect the intellectual property in your advanced equipment is to register your patents in China. But for various reasons (including time bars) this is often not possible. Where there is no patent registration (and oftentimes even when there is), your best solution is to incorporate basic IP protections into your sales agreement. This is essential for China.

To accomplish this, either your sales contract or a collateral agreement must provide for the buyer agreeing to the following:

  • Buyer will not reverse engineer or manufacture a copy/clone of the product or engage any affiliate or third party to do the same. A complex legal definition is not required. A blunt, simple statement (in Chinese) is what is required.
  • Define confidential information information (such as the information you provide in training and support) and require no confidential information can be used by your buyer or by any affiliate or by any third party to infringe on your product.
  • Provide for monetary damages if these restrictions are violated. Injunctions rarely work in China, so contract damages are required.
  • Impose these restrictions with a written agreement enforceable by litigation in China. This is a key requirement. Your English language sales agreement that is enforceable in the New York or in London or in Geneva is not going to be helpful in protecting your IP and if it makes sense for you to use that sort of agreement on the sell side (and sometimes it does), you should have a separate IP protection agreement in Chinese, subject to Chinese law and enforceable by litigation in China.

My first post in this threeChina manufacturing lawyers part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law firm to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

My second post focused on the first four items on Renaud’s China product outsourcing list. In this, my last post in this three-part series on China manufacturing, I focus on the last three items from Renaud’s list.

Risk Five: Subcontracting. Subcontracting of production presents a number of risks often not clearly understood by foreign buyers. Renaud identifies the first and most common risk. The foreign buyer goes to substantial effort to verify that the Chinese factory it has chosen is capable of meeting its quality standards. If the factory then subcontracts the foreign buyer’s product manufacturing to another factory, all of the buyer’s verification work becomes meaningless. This then leads to other issues: How will inspections take place? How will quality control standards be enforced? How will worker safety or worker age rules be enforced? How will anti-bribery and related rules be enforced? Working to the next level, manufacturing by a third party where there is no contractual relationship means that confidential information agreements are automatically breached, and this is a primary way intellectual property gets lost in China. Finally, molds and tooling are often moved to the subcontractor, resulting in loss of control and the inability to retrieve these items when required.

There are three reasons Chinese factories typically subcontract. First, the “factory” is a front for a trading company that actually does no actual manufacturing on its own. This type of trading company will subcontract all of the manufacturing and will limit its involvement to supervising (usually very poorly) the manufacturing process. Second, the factory may be capable of doing the basic manufacturing process, but it requires subcontracting assistance on key elements of the production process. For example, it is normal for Chinese factories to subcontract mold making and electroplating of key components. Finally, the factory may decide that the foreign buyer’s purchases are too small to justify the effort of setting up production and it will subcontract to a factory with the time and the interest. Such a factory is almost guaranteed to be of lower quality, leading to the problems Renaud describes in his post.

Since subcontracting is always an issue when manufacturing in China, it is necessary to confront the issue directly in a formal agreement. The standard approach is to provide that subcontracting is prohibited without notice to and consent by the foreign buyer. The foreign buyer should condition its consent on inspecting the subcontractor and getting the subcontractor to execute a separate manufacturing contract with the same key terms as the foreign buyer has with its original manufacturer.

Though this approach is best, many Chinese factories insist on an absolute right to subcontract. In that situation, if the foreign buyer agrees, then the normal contract provision is to require (a) the Chinese factory at least identify its subcontractor(s) (b) the subcontractor grant the foreign buyer access to its premises for inspection and c) the Chinese factory agree to be directly liable for any violations committed by the subcontractor. Some Chinese factories will not agree to these conditions. When that happens, our China lawyers recommend the foreign buyer refuse to purchase its products from that factory.

Renaud identifies a more difficult problem: undisclosed subcontracting. This situation is unfortunately quite common. It arises most often during the busy season when a factory simply cannot keep up with the orders it has accepted. The best way to prevent this from taking place, the foreign buyer must regularly inspect the factory operations to ensure that the factory is really doing the work on the premises. Since the high season is the most likely time subcontracting will occur, this is the time when appropriate, unannounced inspections should occur. It is also crucial to enter into a formal agreement that prohibits undisclosed subcontracting as described above.

Way back in 2009, in The Six (Not Five) Keys To China Quality, we wrote about the tremendous value of putting a no-subcontracting provision in your China manufacturing agreements:

We typically put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?

In our experience, these no-subcontracting provisions work shockingly well.

Risk Six: Failure to Deal with Defective Product. The problem of defective products raises several issues. First, it is critical to identify a factory that will attain and maintain a reasonable defect rate. If the defect rate during production is over an “epidemic percentage” level, it is almost certain success will not be achieved. As Renaud illustrates in his post, the defects in Chinese factories are often at the cosmetic level. The base product is acceptable, but the finish is defective or scratched; fingerprints show up on glass in an enclosed case; greasy footprints are found on well sewn, elegant handbags.

There are two issues relating to dealing with such defects. The first is how to locate the defect. It is best to locate the defect during the production process. Second best is to locate the defect before shipping. Third best is to locate the defect after your receipt of the product. The worst case is to learn of the defect after delivery to the down stream customer.

As Renaud notes, once defects are found, the parties must have in place a formal plan that clearly deals with what will be done with the defective product. It is critical not to allow the defective product to enter into the retail market. Many Chinese factories will sell defective product “out the back door.” When this product gets into the market, the damage to your reputation can be substantial.

But what should be done with defective product? We usually provide that the defective product must be destroyed. However, this is not always the best alternative. In some cases, the defective product can be repaired or otherwise reworked. This is a common approach for complex and expensive cast metal parts for large equipment. In other cases, the defective product can be disassembled so that valuable components, such as precious metals, can be recovered.

Once you resolve how to handle defective products you receive from your China factory, your next issue is how to get reimbursed for the defects. The Chinese side will usually propose that the value of the defective product be applied as a credit against your future purchases. This is a bad system because the foreign buyer can only obtain credit if it makes another purchase. This forces the buyer into a relationship with a factory that makes defective product. Even worse, the amount paid to the factory is going down for each new purchase, which means the factory has even less incentive to do a good job.

The practical solution is for you to inspect your product before making any payments for its manufacture and reducing the invoice price to account for any short delivery resulting from removal of defective product from any given shipment. If the defect level reaches an epidemic failure rate (this rate must be determined on a product by product basis), your manufacturing contract should provide for you to be able to impose additional penalties. Foreign buyers that delay dealing with quality issues until after they have made full payment for their product are virtually never able to successfully resolve their China product defect issues.

The above discussion shows that a detailed, formal system for dealing with quality control and handling of defects is required and the only way to do this is with a formal, written manufacturing agreement. The common one line statement that the Chinese factory will warrant the quality of its products will never work. Manufacturing in China will ALWAYS result in defects. A workable plan for dealing with those defects is therefore not optional. It is required.

Renaud’s post raises an even more important issue. In some cases, the defect level from the factory will be high and will remain high. In that situation, where a defect rate is over 20%, it is normally impossible to develop a workable solution with the factory. The solution here is to monitor the process from the very beginning. In China, factories do not do better work over time. Their performance almost always only gets worse over time. As soon as an excessive defect rate is identified, you should take immediate action. Usually that immediate action means cutting your losses and moving to a new factory. A good manufacturing agreement will make this transition as easy as possible.

Risk 7. Logistics Cost Increases Due to Factory Error. As Renaud notes, you need to beware of increased shipping costs due to your factory making an error in the size of container required to ship your product. This issue arises from a common mistake make by foreign buyers. Inexperienced foreign buyers often do not understand that in international transactions, “logistics” is an integral factor for success. Shipping costs, shipping timing, method of shipment (air/ground/ocean), port of delivery and a host of other factors can have substantially impact the marketability/pricing of your product.

This then leads to the standard mistake. The foreign buyer looks for the lowest China Price. So the China manufacturer provides a product price that does not include the shipping cost: free carrier or the (erroneous) FOB price. Under these terms, it is the foreign buyer’s responsibility to make arrangements for shipping. The illusory concept is that the foreign buyer will then negotiate the lowest shipping rate, making for an even higher profit.

In fact, however, foreign buyers are normally unable to effectively manage shipping in China. So even though they specify free carrier terms, they in fact end up needing to rely on their Chinese factory to make all the arrangements for shipping. But under this scenario, the foreign buyer has taken on all liability for mistakes and yet it has no effective control to prevent those mistakes. This then is a perfect setting for the kind of disaster that Renaud describes.

From a legal perspective, resolution of this problem is simple. The foreign buyer’s contract with its China factory should reverse impose all of the responsibility and liability for shipping on the China factory. This is done with a manufacturing contract that provides for the product price to include shipping fees. The standard CIF (cost insurance freight) shipping term will achieve this goal. Use of CIF terms does not mean that your China factory will not make mistakes, but it does mean that your factory (not you) will be liable for those mistakes. Your China manufacturing agreement should also include a provision that requires your factory ship by air freight if delivery of your product will be delayed beyond a certain number of days. The only way to ensure that your China factory treats your key business issues as important is for your manufacturing agreement to impose an immediate penalty on your factory that does not require a cross border lawsuit to enforce.

 

China AttorneysBecause of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

Our China attorneys are often asked some version of the following question:

Why are you so concerned about getting the name of the Chinese party on my contract exactly right?

Answer: Because if it is wrong, the Chinese company may at some point argue (perhaps even successfully) that it is not bound by the contract.

We get this question especially often when our clients are dealing with China’s biggest companies like Baidu, Alibaba or JD.com on the other side. Our clients will ask us to draft a contract with Baidu, for example, but Baidu is really more of a brand name than a company. We then have to push our client to get from their Chinese counterparty (at whatever company it is with which they are actually dealing) the Chinese characters for the specific Baidu entity with which they will be contracting.

China Lawyers

Because of this blog, our China lawyers get a fairly steady stream of China law questions from readers, mostly via emails but occasionally via blog comments as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a super fast general answer and, when it is easy to do so, a link or two to a blog post that may provide some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.

I had no idea what question to use for today but the following email (modified slightly to delete anything that might enable tracking) from this morning solved that problem for me:

I am _________ from _______, consulting company located in Spain. First of all, thank you for the informative blog posts. They have been very helpful.

My client company is a high-tech manufacturer (digital __________) and tries to expand the market to China.

Is it possible for you to recommend me some China distributors who supply to Department Stores and Home Convenient Stores?

Best Regards.

My response to these emails is usually somewhat along the following lines:

I’m sorry but because we represent a number of similar companies who have paid us tens of thousands of dollars over the years I just can’t. I do not think it would be fair for me to take what we have learned from getting paid to represent these companies and then turn around and give that information for free to one of their competitors. I hope and trust you will understand.

There you have it. Your thoughts?