Sourcing agents increase overseas manufacturing risks (most of the time)

By Dan Harris

When a company comes to one of our international manufacturing lawyers for legal help, we invariably ask them about their potential or actual overseas product supplier(s). We do this because of how critical it is that they choose the right manufacturer for what they will be doing.

I have easily given more than 100 speeches on how to protect your intellectual property when manufacturing overseas and I nearly always start that speech by stating that the following three things matter most for protecting your IP overseas:

1. Choosing a good manufacturer.
2. Having a good (country-specific) contract with that manufacturer. See THE Rules When Manufacturing Overseas.
3. Good IP registrations. Register your trademarks and your copyrights and your patents in the country in which you are having your products made and in the country in which you will be selling them. See Do You Manufacture in Asia? Let’s Talk United States and Canada and Mexico and EU Trademarks.

If choosing a good overseas manufacturer is important for protecting your IP, that choice is even more important for ensuring quality product and on time deliveries.

How do you choose the right overseas manufacturer? Should you 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 a ton of bad sourcing agents and a few great ones and choosing a bad one will nearly always be far worse than choosing your overseas manufacturer yourself. So if you do decide you need a sourcing agent, choose a good one. A really good one.

In Sourcing from China 101, Part 1: Do You Need a Sourcing Agent? the Quality Inspection Blog does a great job in laying out the pros and cons of using a sourcing agent for China and what is said there about China absolutely applies worldwide. I urge you to go to the Quality Inspection Blog and read the whole article. Heck, I urge you to go the Quality Inspection Blog and read the whole blog because there is no better source for overseas manufacturing information anywhere else on the Internet.

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

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” and how when things go wrong, sourcing agents “often tend to defend the factory!” I agree with this too and this post even quotes me for that number (which I still believe to be about right):

Dan Harris has a similar view of most agents:

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 international manufacturing lawyers to refer them to “good sourcing agents,” we typically ask them the following three questions:

1. What is the product for which you will be needing a sourcing agent?
2. How do you want to pay the sourcing agent?
3. Have you decided on a country you think will be best for your product(s)

We ask the first question because a sourcing agent that is great for sourcing clothes in Mexico is not usually the right sourcing agent for sourcing electronic devises in Thailand. 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 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 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.

We ask the third question because most sourcing agents are good with only a few countries.

One of the things you need to beware of with sourcing agents is that many of them want you to believe they are not sourcing agents, but that they themselves own the factory. This is an incredibly common lie and it is common because so many companies fall for it, usually to their detriment. The sourcing agent will talk about “our factories in China or in Vietnam” as though they own them even though they merely work with them. This difference really matters and I will use IP protection as an easy example of why it does.

We are big fans of using NNN agreements with overseas factories). If you don’t know the identity of the factory manufacturing your goods, an NNN agreement with them is out of the question because you can’t enter into a contract with an unknown company.

The arrangement you have with your sourcing agent will determine the agreements you need, and with whom. In an ideal world, if you are dealing with factories directly, you would want NNN agreements with the factories with which you have initial talks, development agreements with the factories that develop products for you, and OEM agreements (a/k/a contract manufacturing agreements) with the factories that actually manufacture products for you. In this situation, the agreement with the sourcing agent would be fairly simple because it isn’t doing very much – it will basically be an NNN agreement with some additional provisions to cover the sourcing agent’s finder’s fee. You don’t want the sourcing agreement to be the only agreement in place, because it offers so little protection.

If you are dealing exclusively with your sourcing agent, then you cannot have any agreements with the factories. This means you will need to look exclusively to your sourcing agent for everything: non-competition, non-circumvention, non-disclosure, quality control, ordering, warranty, delivery timing, etc., This is because you have no contractual privity with the overseas manufacturers that will be making your products and so there is no way you can hold those manufacturers responsible for anything. This can fine if your sourcing agent is based in Chicago or London or Madrid because it is relatively easy to sue and win and collect on your judgment from a U.S., British or Spanish company. But this presupposes that the U.S., British, or Spanish sourcing company has assets and that your agreement with that sourcing company allows you to hold it responsible for the actions of the overseas manufacturers that will be making your product(s). In this situation, the sourcing agreement is all-important and must be carefully drafted, because many sourcing agents will attempt to avoid responsibility for anything from delays to quality issues to IP infringement. Working with these sourcing agents is taking a huge risk because you now have a situation where neither your sourcing agent nor your overseas manufacturer is responsible for anything!

For all of the sourcing agents in between, you’ll want a robust sourcing agreement and at the very least NNN agreements with the factories. Whether the development and manufacturing agreements are with the factories or the sourcing agent will depend on the particulars of how you deal with the various parties, and also your ability to hold them responsible when things go wrong. If the sourcing agent is a well-established company with multiple employees and a real office and sizable assets, it’s reasonable to look to it for everything. But if — as is way more common — your sourcing agent is a tiny company with a virtual office in Chicago or London or Madrid who spends most of his time overseas, you are setting your company up for disaster.

What about just having an NNN agreement “with everyone” involved with your product? Sure, but that will not cover the various other forms of liability – not even close. It will only hold counter-parties liable for misusing your IP. What about bad product? What about late deliveries?

The following are just some of the instances where companies got in trouble by using third-party sourcing agents without contracts to protect them.

• American company pays Vietnames company a couple million dollars to make a toy for it. The Vietnamese company never never makes a single toy. American company hires our firm to explore options for pursuing the Vietnames toy manufacturer. Our international dispute resolution attorneys look at the the manufacturing contract and notice that the signing party is a completely different entity than the Vietnamese toy manufacturer with which our client thought it had the contract. It turns out our client’s contract was with a “sourcing consultant” who operated out of a $600 a month single office in Hong Kong. Skeptical of ever being able to collect from this company, our client (wisely) chooses not to pursue litigation.

• Many years ago, an American company called us after just having learned that its two million dollar order of Christmas tree lights would not be delivered to the United States until December. We called the Chinese factory and they told us they had no idea who our client even was. It turned out that our client had unknowingly been using a sourcing agent (we figured it out by looking at some Chinese language documents) and so it had absolutely no contractual relationship with the factory. To make matters even worse, the Chinese factory was intentionally not producing our clients order because our client’s sourcing agent owed money to the Chinese factory. Our client ended up having to pay millions more to the factory to get it to deliver the lights on time.

• European company gets bad product from its Chinese shoe manufacturer and so refuses to pay the remaining $800,000 or so for the shipment. European company then gets sued in China and retains us to assist. Turns out that the lawsuit in China has been brought by a Chinese sourcing agent whose contract with our client makes clear that it gets paid for brokering each transaction, whether or not the transaction goes well or not. In other words, there would have been a very good chance that this sourcing agent would have prevailed against our client because it had fulfilled all requirements of his deal with our client, and the fact that the manufacturer had provided bad product was irrelevant. These sorts of contracts are disturbingly common. Our client ended up settling.
• American company hires out the alleged best United States manufacturer for a particular type of sporting good. This U.S. manufacturer told American company that it would make the sporting goods product for the American company in China. American company agreed and within about a year it learned that the American company did not have any factories in China; it was outsourcing the manufacturing to an unrelated Chinese company. American company learned this after the Chinese manufacturer started selling the American company’s sporting good as its own. American company also learned that the Chinese manufacturer had secured a patent on the sporting good. This eventually led to incredibly expensive litigation involving six lawsuits, one in China, and four in three different states in the United States.

We could go on and on with the sourcing agent horror stories but I trust the above should be enough to make you feel uncomfortable with believing that using a “local” sourcing agent will reduce your overseas manufacturing risks.

The views, opinions and images in this article are purely the author’s own. Global Sources does not own responsibility for what is presented in the article.

Dan Harris is founder of the Harris Bricken 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 ChinaLawBlog.com as a source of China legal and business information.