When companies hire Chinese manufacturers, it is essential that they draw up contracts –known as OEM Manufacturing– that include certain provisions to safeguard their rights, especially those related to the quality of the products manufactured and the protection of intellectual property rights (trademarks, patents, designs).
Below we mention 10 provisions and explain how to draft them in a Manufacturing Contract for China:
OWNERSHIP OF PRODUCT DESIGN
Do you actually own the entire product design? It seems more likely that you own your logo, your trademark, your packaging, and the customization of your product. On the other hand, the factory likely owns the process/IP in the product. This is normal in the Contract Manufacturing. Since ownership of design and IP is critical for the products, this provision should be carefully drafted to reflect the situation on the ground. Please advise.
ACCEPTANCE OF PURCHASE ORDERS
Note that this provision usually does not require the Chinese factories to accept your Purchase Order (PO). This means they can “bail out” at any time by simply refusing to accept your PO. More specifically, it means the one-year price lock you requested is nearly meaningless because the factory can raise the price by refusing to accept your purchase order at the old price. This is all quite normal, but please ensure this “per Purchase Order” approach is what you want.
ONE-YEAR PRICE LOCK
As noted above, a one-year lock on price is not effective if the factory has the contractual right to refuse to accept your purchase orders during the price lock period. If you place all your orders in one-year lots, this will not be an issue.
INCOTERMS PREFERENCE
Pursuant to INCOTERMS, Free Carrier (FCA) is the preferred term to ensure that the foreign company picks up the goods on Chinese territory and manages all international logistics, so as to ensure that delivery times are met with their customers. This is critical for issues relating to the transfer of title and insurance.
Full information on the use of INCOTERMS can be found in the publication Practical Guide to Incoterms 2020. The 2020 version is the latest version published and is estimated to be in force until 2030.
PAYMENT TERMS
There is no explicit statement of payment terms, which means this will be dealt with in the Purchase Orders. This is normal, since you will likely vary payment terms from time to time and from factory to factory. Note that payment terms are critical. The timing of your payment vis-a-vis the inspection procedure is important. The general rule for China is that you should not pay the final amount for your products until after you have personally inspected them. Right now, you are providing for inspection upon receipt in the United States. This means if you have already made full payment before your inspection, you will have little to no bargaining power if you receive bad product. Your only relatively easy remedy will likely be a credit against future purchases, which will essentially trap you into making purchases from a factory you know makes defective products.
AQL INSPECTION/DEFECT SYSTEM
You are providing for a standard AQL inspection/defect system, which is the current best practice. However, you should specify the criteria for each level of defect and the remedy for each level. It is common in AQL systems for the remedy for each level of defect to be neglected, rendering the system without value. For your AQL system, you can either specify the entire system in the agreement or create a separate document that sets out the full system. The number of days you have for product inspection should be specified. This document can be attached as an exhibit or referenced as a separate document that you will provide to the factory.
LATE SHIPMENTS PENALTY
This section imposes a penalty of up to 30% of the invoice price for late shipments. This is normal. However, your Chinese factories usually complains about storage costs, so we need to be mindful of their response to storage costs plus a late delivery penalty. I suggest we see what they say.
GENERAL WARRANTY PROVISION
The general warranty provision must be coordinated with the AQL system. We need to resolve what constitutes a defect that triggers the warranty. Is the warranty applicable only to critical defects or to all defects in the AQL system? The easiest way is to limit the warranty to critical defects. This applies to both the general warranty and the epidemic failure sections.
WARRANTY PERIOD
The length of the warranty period needs to be confirmed. One year is normal for most of your products, but other warranty periods should probably be different, depending on the specific product.
BILINGUAL VERSION
In China, contracts are usually drawn up either in English or in a bilingual English-Chinese version. It is not common to sign contracts in other languages such as Spanish, French or German. For the version in Chinese, simplified Mandarin Chinese shall be used.
It is advisable to use the dual English-Chinese version as this will make it easier to negotiate the contract, and also help compliance with obligations and an amicable settlement in the event of conflict.
In conclusion, a well-drafted Manufacturing Contract is essential for foreign companies making the decision to manufacture in China. Chinese companies, like companies anywhere in the world, do not like to be sued. A good contract that incorporates quality requirements, protects intellectual property rights and sets out the responsibilities of the Chinese company in case of non-compliance is the best way to prevent problems.
To obtain different Model Contracts for China click here:
