China Manufacturing Agreements: Watching The Sausage Get Made

Strategy

From ChinaLawBlog.com: 

In going through old emails, I came across a couple from co-blogger Steve Dickinson to a client that was going to have its relatively complicated product manufactured in China. This company was engaging in outsourcing for the first time and we were assisting with the contract.

Steve's first email was the following:

Generally, a production agreement (also known as an OEM Agreement or a Manufacturing Agreement) involves the following:

1. U.S. side provides the design.
   
2. Chinese side manufactures the product.
   
3. Chinese side agrees not to manufacture the same product for themselves or for someone else.
   
4. Chinese side agrees not to circumvent and sell directly to U.S. final customers.
   
5. Chinese side agrees not to steal intellectual property.
   
6. U.S. side purchases product and then does whatever it wants to do with product.
   

 

There is generally no talk about anything else. In particular, there is no notion of acting as though the parties are in a joint venture. At its core, the relationship should be viewed as adversarial. You are trying to get the best product at the lowest price and your manufacturer is trying to give you as little as possible at the highest price. I am not saying that the two of you cannot and should not establish a cooperative relationship, because you most certainly should. But I am saying that from a contractual perspective, you need to think of your relationship as essentially adversarial.

Here are some other key issues:

a. Will the agreement be exclusive? If yes, for both sides or for only one side?

b. How will you deal with start up tooling and prototype manufacture expenses?

c. Pricing is always a big issue with these agreements. Normally, the Chinese side ultimately agrees to some price. However, that is just the start. There are two ways to go from there:

i. The Chinese side is absolutely obligated to provide the product during the term of the agreement at the agreement price. Most Chinese manufacturers will only agree to this with two conditions: First, the U.S. side agrees to purchase a minimum amount per year and second, the Chinese side has the right to adjust price if there are significant changes in material costs, exchange rate, labor costs or fixed costs such as utilities. As you can imagine, this all can be extraordinarily complex.

ii. The Chinese side is only obligated to perform on price, quantity and delivery date for accepted purchase orders. This relieves you of a commitment to purchase but it also leaves you with substantial cost risk. The risk is that you will work for a long time with the manufacturer to develop the product, then the manufacturer increases the price or balks on quantity or delivery date. Since the manufacturer has the right to reject any purchase order, you are left with no recourse but to go to find a new manufacturer and start the process all over again.

This is a very difficult issue that must be confronted right from the start. Far too many U.S. companies sourcing from China fail to address this issue in even the most basic way and this usually puts them totally at the mercy of their Chinese manufacturer and the results of this are usually not pretty.

d. Will molds be involved? Will other tooling be involved? If yes, you need to determine how the tooling will be paid for, who will own the tooling, and how the tooling will be dealt with when the production contract is terminated. Our general approach is on this is as follows:

i. U.S. side pays for tooling.

ii. U.S. side owns all of the tooling that it has paid for.

iii. If the Chinese side refuses to return the tooling on contract termination, the Chinese side owes a sum certain. This is what is known as a liquidated damage provision.

iv. I assume you will be able to do whatever you want to do with the product after you purchase it, correct?

v. Do you have any specific plans on quality control? What happens if defective product is discovered? Where will inspection occur?

vi. What are your proposed payment terms? How do those terms link with inspection of product for defects?

vii. How will you work with the Chinese manufacturer in terms of specification for the product? There are generally three ways to proceed:

-- You have done all of the design and production work for the product. You provide the manufacturer with the prototype, CAD drawings and related. You simply tell the manufacturer: make this.

-- You develop the prototype, CAD drawings and related with the manufacturer. You maintain the lead in engineering.

-- You provide a general idea of what you want to the manufacturer and the manufacturer takes the lead in engineering and development of drawings and production technique.

Steve's second email was the following:

Enclosed is our first draft of your China manufacturing agreement. As you will see, there is very much of this agreement that is subject to change depending on the specific situation. I urge you to review this very carefully and then we should set up a time to discuss it. My basic strategy is to push the highly variable, transaction specific items to the exhibits. The things you will never want to change are in the basic agreement. However, the line between the two is never perfectly clear. What I have here is a pretty strict agreement, with much in the agreement that may ultimately be subject to intense negotiation.

1. Note that this does not obligate the manufacturer on price, quantity, etc. That is, the manufacturer is not obligated to perform until after it accepts your purchase order. The alternative is to force the manufacturer to perform upon receipt of a purchase order. This is extremely difficult to pull off in practice. If you want to go this route, you will almost certainly need to commit to purchasing a specific amount of product at a specific price for a specific period of time. If you are willing to do that, we can revise the agreement to work this way. This is how Walmart and Nike and other big buyers operate. They get the very low prices and good payment terms in exchange for agreeing to purchase a specific amount of product during a specific period of time. I find that small buyers are seldom willing to make this kind of commitment. Please consider and let me know how you wish to proceed.

2. Exhibit 3 will include payment terms. This includes: price, delivery terms (free carrier designated port, I suppose), deposit (if any), final payment, inspection and any related terms. This is usually a contentious area of negotiation and I find it is best to put it all into a single exhibit that can change over time.

3. I include several separate exhibits related to manufacturing standards and quality control. These can be combined if you find it too cumbersome. The critical issues are: 1) when and where will you inspect, 2) what happens if the inspection reveals a defect? Many small manufacturers inspect in the U.S. This is fine if you have not paid before the product arrives in the United States, but it can be a big problem if you have paid. Disposition of defective product is always a major issue. Product must be destroyed and not sold to third parties. The Chinese hate to do this. The best approach, of course, is to inspect in China and to catch all obvious defects before shipment. The warranty can apply then to latent defects.

4. For enforcement, the agreement currently contemplates enforcement to occur in the Chinese courts. This is what I prefer, though a number of our clients prefer arbitration. If you would like to discuss the alternatives, please let me know.

Apr 30, 2011