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China manufacturing agreements: Watching the sausage get made

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by Dan Harris in 'China Law Blog'

Co-blogger Steve Dickinson is in the midst of working on a number of unusually complicated OEM (Original Equipment Manufacturing) agreements for American companies seeking to buy product from China. A few minutes ago, I received a cc'ed email from Steve to one of our clients, explaining what he has done so far on the client's OEM Agreement and seeking a bit more information so as to be able to finalize it.

I immediately felt the email would make a great blog post for those wondering what sort of things should go into a contract with a Chinese manufacturer so I thought I would simply remove all client identifiers and post the email.

Please find attached a first draft of the manufacturing agreement. You will note that this agreement provides for a large number of exhibits. Our strategy is to put into exhibits those items that will change from supplier to supplier or that will change over time. This way you can modify exhibits and avoid having to constantly revise the main contract. However, if there are items that I have put in exhibits that you believe will never change, we should move those items to the main contract.

This contract and its exhibits address all of the items you wanted to make sure were in your supplier agreements. As you review the document, please consider the following:

Article 1.2: Note that this provides only a limited obligation for the manufacturer to supply. The manufacturer is only obligated to supply you with product after the manufacturer accepts the PO. This means that a manufacturer can avoid an obligation to maintain a certain price by simply refusing to accept your purchase order. The alternative is for us to provide that the manufacturer MUST accept purchase orders during the term of the agreement. If you wish to follow that approach, most manufacturers will require that you in turn agree to purchase a minimum amount of product per year. Since you have indicated that you would be reluctant to do this, I have followed this "no obligation" approach.

This then moves to the issue of pricing. If the manufacturer is not obligated to supply, there is no reason to negotiate an elaborate price setting procedure. Normally what is done is to agree on a price and then provide that the manufacturer will give notice (60 to 90 days) of price increases together with some justification for price increases.

Exhibit One: This is the place for you to describe the product and provide for specific product specifications. This exhibit will change from product to product.

Exhibit Two: Performance and Measurement Criteria. This is the place for you to specify your procedures for qualifying factories, for factory communication, for product development, for provision of samples, for factory inspection and for related matters. You have provided us with some fragmentary comments on these procedures but we are going to need more so that we can prepare a single, specific list that can be attached as an exhibit. This list can vary from manufacturer to manufacturer, though it need not do so.

Exhibit Three: Pricing and Payment. This is the place to set out the initial price for product and to agree on payment and shipping terms. Your shipping terms will be ex carrier (Not FOB) with a port designated in the PO. You will need to provide for payment terms. The terms you propose are standard: payment of a % deposit with the remainder paid on shipment. Note that these terms favor the Chinese side in two ways. First, you will pay a deposit before you are able to confirm that the manufacturer can perform. Second, you will pay before you have a chance to inspect the product in the United States. Therefore, you must be careful to ensure that you do not pay a deposit before you are comfortable that the Chinese manufacturer can perform and that you do not allow shipment before you have inspected the product in China.

You will also need to consider how to deal with a deposit refund if the manufacturer cannot perform. Note also that most Chinese manufacturers treat the deposit as a design and development fee and that disputes often arise with over design costs. You need to consider how those costs will be allocated on a project by project basis. The pricing exhibit should take those issues into account.

Exhibit Four: Purchase Order. Please provide a copy of your standard purchase order.

Article 3.1: As requested, we have provided a penalty for manufacturer delay. I strongly support including this type of provision because delay is a major problem with Chinese manufacturers. Note that many Chinese manufacturers resist including this provision. This is because they plan to delay, so you should take this into account.

Exhibit 5: Quality Control. This is a critical exhibit. I leave it as an exhibit because I find that quality control procedures evolve over time and because the procedures often vary from project to project. This exhibit should also set out procedures for disposal of defective product. We typically do not advice requiring our clients return defective product to the Chinese manufacturer. Instead, we usually provide for destruction of the defective product with the Chinese manufacturer obligated to repair or replace defective product.

You will need to reach an agreement on what to do about defective product that you discover on inspection in China. One approach is to destroy the product and obligate the manufacturer to replace. The other approach is to destroy the product and reduce the invoice amount by the appropriate amount. Often as you negotiate the repair and replace procedure, the manufacture will offer to provide a credit on the next shipment. Care should be taken in that case because this can lock you into a situation where you are forced to re-order from a bad supplier just to get your credit.

Exhibit 6: No Contact List. This is a list of customers that you are forbidding the Chinese manufacturer from contacting for any reason during the life of the Agreement. If you have no one for the list, just leave it blank.

Article 5.5: Note that we provide for specific monetary damages for a breach of the Non-Disclosure, Non-Compete, Non-Circumvent, obligations. The amounts we provide are typical. You can increase or decrease at your discretion.

Article 6: Tooling and Molds. You can see from this that we have had a lot of experience in dealing with issues related to tooling. Normally, when you change your manufacturer due to a failure to perform, the manufacturer will attempt to take your tooling hostage to prevent your move. Our provisions are designed to prevent that. The main weapon is the requirement that the manufacturer pay a fixed amount if it refuses to return the molds. The penalty we provide is 125% of the mold value. Note that this provision requires you to carefully enter all mold data into Exhibit 7.

Please review and provide me with your questions or comments. After we get clear on how we will proceed, I will work with you to finalize everything and then we will get the contract into Chinese.

Dan Harris is founder of the Harris & Moure law firm, a boutique international law firm focusing on small and medium sized businesses that operate internationally. China is the fastest growing area for the firm. Dan writes as a source of China legal and business information.

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