6 Tips for Agreements with Contract Manufacturers in China

by Cooley LLP
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After months of research and vetting, you’ve finally settled on a good contract manufacturer (CM) in China that offers the best quality and price combo and has a solid track record and now it’s time to cement the relationship with a supply agreement.  Thanks to globalization and outsourcing, a lot of CMs in China today are large and sophisticated, but many of them still like to use supply agreements that look like nothing more than a sloppy purchase order.  Perhaps sometimes they do this to save time but frequently they do this on purpose so buyers don’t get the protections they deserve.  You should resist the temptation to get the CM quickly on board with a bare-bone supply agreement and leave many critical issues unaddressed.  Too many U.S. companies have learned the lessons the hard way.

A good supply agreement should include comprehensive business requirements of the buyer and the CM as well as the legal recourse that the buyer has against the CM if there is a breach.  Below are six practical tips on some of the “must-haves” in supply agreements with Chinese CMs.

1. Make sure you contract with the right party.

You should contract with a company that has sufficient financial resource when things go south.  This seemingly simple principle is often overlooked because a lot of U.S. buyers contract with third-party sourcing companies unaffiliated with the CM that owns the factory.  When a product defect is uncovered, the U.S. buyer will only have legal recourse against the contract party and not the actual CM.  Sometimes the contracting party will be the CM’s holding company in Hong Kong, Taiwan or Singapore.  You should do your due diligence and make sure the party you are paying is not a shell entity that has little or no assets.  When the contracting party is the U.S. sales subsidiary of a Chinese CM, you should consider having the Chinese CM co-sign the supply agreement or guarantee the performance of the supply agreement. Note that a lot of Chinese companies do not have an official English name and thus should identify themselves with their legal name in Chinese together with their English name in the supply agreement.

2. Include detailed bill of materials and pricing provisions.

The bill of materials (BOM) is a list of components to be used in fabricating the product.  Including a precise BOM as a part of the supply agreement is a must when you plan to reply on the CM to procure raw materials and product components.  This will help prevent CM from substituting in cheaper materials at its discretion and will reduce product defects and recalls.

After you work out the unit price to be paid to the CM, think about including detailed pricing provisions in the supply agreement—CMs will not be shy telling you about inflation and rising labor cost several months after signing the agreement and asking for a price adjustment.  If you want to have a fixed price for the next two years, a volume discount or a specific cost reduction plan, or if you want to specify the pricing model based on the BOM or any pricing adjustment mechanism, make sure to include the relevant provisions in the supply agreement or a pricing exhibit.  If you plan to sell some of the products in China, you will probably need to have separate pricing regimes for export products and products for the China market because of the impact of VAT and title transfer rules.

3. Spell out the quality requirements and product warranty. 

You should make sure to include detailed product (and packaging) specifications and quality control and inspection procedures as part of the supply agreement.  Given the distance between China and the ultimate delivery location, it’s common to have an inspection both before and after product delivery. Think about what an inspection will entail—every product vs. sampling, parameters for an epidemic failure, etc.—and try to link payment to the CM with the inspection result.

In the past, many CMs in China insisted on no product warranty.  Today, more and more CMs are willing to offer product warranty against product defects for which the CMs are responsible—i.e., design defects for which the U.S. buyer is responsible are not covered—and you should definitely consider asking for one.  The warranty period usually is measured from the date of shipment since it would be difficult for the CMs to know the date of sale.

4. Be clear on the ownership of mold/tooling. 

There is no shortage of horror stories about mold and tooling disputes with Chinese CMs.  The CMs understand that without molds/tooling you or another CM cannot immediately make the products and they can use the molds/tolling to hold you ransom.  So be sure to get the CM agree in the supply agreement that you own the mold/tooling at all times and include a detailed mold/tooling list. If you are transferring existing molds/tooling to the CMs, ask for a deposit and specify the amount in the supply agreement.  Also, consider including a liquidated damage provision, which specifies a pre-determined amount of damages if your mold/tooling is not returned promptly to you when requested.  A reasonable liquidated damage will put you at a strong position to secure a quick judgment from a Chinese court.  It also gives the Chinese court a basis to freeze the CM’s assets before you secure a judgment, the threat of which would almost always result in the return of your molds/tooling.

5. Protect your intellectual property. 

You might have already registered your patents, trademarks or copyrights in your major markets and in China. Such registrations can prevent the export of counterfeit goods from China, and prevent a competitor from registering the same intellectual property in China.  If your core IP is know-how and trade secrets, which cannot be protected by formal registration, the CM should agree in the supply agreement that you own such know-how and trade secrets and any new intellectual property rights, including any new know-how and trade secrets, that are generated in connection with manufacturing your products under the supply agreement belong to you.  Spell out clearly if the CM can work for other customers in a competing field (and the duration of such non-compete period) and if yes, whether and how the production teams and production lines would be segregated.  Also make sure to address any potential product “leakage” problem, including disposal of defective products.  IP protection is another area where a liquidated damage provision can be useful.

6. Be smart about dispute resolution. 

The best way to resolve a dispute under a supply agreement with a Chinese CM differs depending on the type of dispute.  If the CM cannot meet the product specifications or misses delivery deadlines, you may want to work it out with the CM first.  If that proves impossible, you can seek monetary damages and arbitration in a jurisdiction outside of China governed by U.S. law would be your best option.  Because China is a signatory to the New York Convention on Foreign Arbitral Awards, foreign arbitral awards are readily recognized and enforced in China.  In contrast, China has no obligation to recognize and enforce U.S. court judgments.

On the other hand, if you are in a situation where monetary compensation would not solve the problem, you may want to resolve the dispute by litigation in Chinese courts.  For example, if the CM makes and sells your products without your knowledge either directly to consumers or to a competitor in violation of the agreement, or if the CM refuses to return your molds/tooling, you would want an injunction to stop the CM from breaching the supply agreement.  Under those circumstances, having an international arbitration clause might work to your disadvantage.  You should therefore try to anticipate the most likely and damaging dispute under the supply agreement and determine which dispute resolution approach is best for you.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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