China Manufacturing Agreements: Closing the Barn Doors before the Horses Escape

The value of a China OEM agreement lies largely in its ability to avoid conflicts between the purchaser and the manufacturer

by Jeffrey C.P. Wang and Trevor K. Roberts

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* This article first appeared in Inside Counsel Magazine on November 12, 2014: http://bit.ly/1ELMN16

When it comes to working with an original equipment manufacturer (OEM) in a country as distant as China, avoiding a lawsuit is almost always better than winning a lawsuit. By following the steps below, parties will be better able to craft a manufacturing agreement that not only helps them reach their business goals, but that also discourages breach. Simply put, an effective manufacturing agreement has teeth, and it makes it very clear that if anyone cheats, they will get sued - and they will lose!

Preliminary steps to take

Trademark!

Long before the parties begin hashing out the fine details of the manufacturing agreement, the U.S. purchaser should first register its mark in the U.S. and in China. The failure to take out a trademark as early as possible in China (in both English and Chinese) can leave a company vulnerable to a "trademark squatter." A trademark squatter is an entity that preemptively obtains the rights to a foreign mark and then demands a large "settlement" in exchange for returning the brand to its rightful owner. Apple, Pfizer and Tesla have all had to spend a great deal of time and money battling such entities.

Key issues to consider

It is equally important to have a signed non-disclosure agreement (NDA) in place prior to commencing negotiations. An NDA is intended to prevent confidential material, knowledge or information from becoming public knowledge. Getting an NDA signed after discussions have commenced may be like closing the barn doors after the horses have already gotten out. It is important to note that, to be binding in China, the NDA must be sealed with that entity's "chop." A chop is the official name stamp of individuals and companies, and it is used to endorse virtually all legal documents in China.

Include "non-use" and "non-circumvention" provisions within the NDA

When it comes to working with Chinese manufacturers, the concern is not merely that the information will be disclosed to others, but that manufacturers will use the information themselves! Therefore, "non-use" provisions should be included within the NDA to forbid the manufacturer and its affiliates from appropriating confidential information to make the same or similar product. Similarly, a "non-circumvention" clause should be included to prohibit the OEM from appropriating contact information and directly selling the product to the U.S. purchaser's customers.

Make it expensive to breach

Provisions for liquidated damages should be included in both the NDA and the OEM agreements. Liquidated damages serve to put a price tag on breach by requiring the payment of a specific amount of

money in the event of a violation. Penalties of this sort are generally favored by China's courts and by the China International Economic and Trade Arbitration Commission (CIETAC). Terms can also be included that provide for injunctive relief and the payment of attorney's fees.

Key issues to consider

Startup costs

While the initial concern of the U.S. purchaser will likely be preventing the piracy of its intellectual property, the Chinese OEM will mainly want to avoid getting stuck with thousands of dollars' worth of unpaid-for tools, molds, prototypes and custom-made products. Thus, the parties must set forth who will pay these costs and what will happen to such items once the contract is completed.

Price

The purchaser must decide if, in order to obtain a lower price, it is willing to obligate itself to making a minimum purchase. At the same time, the manufacturer must decide if it is willing and able to fulfill all purchase orders at the agreed upon price. This is the kind of agreement that big retailers use with their suppliers. However, such a binding contract may be risky for smaller firms. If the manufacturer does agree to such an arrangement, it will likely want to include provisions that will allow it to raise prices if events beyond its control drastically impact exchange rates or the costs for raw materials.

Guarding against risk

The Chinese manufacturer will likely seek to be absolved of all further liabilities once the product has been inspected and accepted, but the U.S. purchaser may desire a warranty against defects that are not detectable through reasonable inspection. The purchaser may also require that, during the production process, one of its representatives be allowed on site without notice - or even on a full-time basis - for quality control purposes. A provision requiring that the OEM maintain a minimum level of insurance may also be needed, as Chinese companies tend to be severely underinsured.

Choice of forum

Choosing the right forum for settling disputes is a decision that must be made on a contract-by-contract basis. For example, arbitration may be the most effective way to settle disputes with manufacturers that are located in in China's more remote or lesser-developed regions. Arbitration can either be conducted in China or any of the 140 countries that have signed the New York Convention on Recognition and Enforcement of International Arbitration Awards. However, it will likely be necessary to provide for litigation in China's courts if one hopes to obtain injunctive relief.

It is vital that U.S. purchasers understand that, while China has ratified the New York Convention pertaining to arbitration awards, there is no such international convention for the enforcement of judgments handed down in U.S. or other foreign courts. U.S. firms should therefore seek counsel from a law firm that has boots on the ground in China when crafting a China OEM agreement.

The language of the agreement: English, Chinese or both?

U.S. purchasers will naturally prefer that the controlling agreement be written in English, but this may not be the best idea. If disputes are to be resolved in China, it may be best for the controlling agreement to be in Chinese. The U.S. firm should consider hiring its own Mandarin-speaking attorneys to draft the Chinese version in order to make sure no ambiguous terms are used. In so doing, no wiggle room will be left for the manufacturer to take advantage of "vagueness" between translations.

However, it is important to note that Chinese standard contracts are very different from American standard contracts. A manufacturing agreement that is drafted in Chinese should be tailored to meet the expectations of a Chinese judge. This means that the contract should not be a direct translation from the English, and it should not include boilerplate provisions.

Conclusion

The value of a China OEM agreement lies largely in its ability to avoid conflicts between the purchaser and the manufacturer, thereby making it unlikely that litigation will ever be necessary. To be effective in this regard, the agreement should not be vague or ambiguous. Rather, the agreement should be thorough and precise, and, ideally, it should be enforceable in a court in China. It is therefore important to work with attorneys that understand both U.S. and international law, as well as the idiosyncrasies of Chinese contract law, when crafting a China manufacturing agreement.

About the Authors

Jeffrey Wang

Jeffrey Wang

Jeffrey C.P. Wang is the managing partner and founder of WHGC, P.L.C.in 1994. Mr. Wang's practice focuses on handling the legal concerns of international and domestic corporations. In addition to his J.D., Mr. Wang has two advanced Mastersof LawDegrees fromthe University of Washington and the Southern Methodist University School of Law. JeffreyWang@WHGCLaw.com

Trevor K. Roberts

Trevor K. Roberts

Trevor K. Roberts is Of Counsel at WHGC, P.L.C. Mr. Roberts studied Mandarin at Taiwan Normal University and worked in Taiwan for almost ten years as a magazine editor and television host. In addition to his work for WHGC, Mr. Roberts is an adjunct professor at Trinity Law School and California Baptist University.