How to Protect Your Company Against China Supply Chain Risks

“After more than two years of battling to get sufficient goods into the country, many U.S. companies suddenly have too much of some items and not enough of others. The disconnect between overflowing warehouses and changing consumer tastes reflects the challenge confronting many businesses, as the economy twists in unpredictable ways.” That was The Washington Post last week on inventory management and the ongoing disruption to supply chains that has resulted from COVID-19, the so-called “Trump tariffs”, and the international shipping snafus that have resulted.

The article – which I recommend reading – clearly explains how many (most?) manufacturers are in the middle of a perfect storm of challenges that make it very difficult for them to calculate how much to manufacture (or order), how long it may take for goods to arrive, and how much consumers are likely to buy.

Complicating things is the Chinese domestic retail market; if Chinese consumers continue reducing their spending through the end of the year, Chinese manufacturers will try to ship their surplus products to export markets, and their first port of call will be U.S. retailers.

And Chinese consumers have been spending conservatively this year, in large part because tens of millions of them have been locked down as part of Xi Jinping’s “zero-COVID” public health strategy. Chinese factory inventories have climbed to a 12-year high, and trans-Pacific shipping remains thoroughly snarled (and extremely expensive).

With factory, shipper and consumer behavior all difficult to predict, big U.S. retailers are trying to ensure that they have enough goods to meet demand through the end of the year, and especially for the Christmas season.

The Post reported that at Lands’ End, Q1 inventory rose by $52 million, while at Kirkland’s, which sells home décor products, Q1 inventory was up more than 71 percent from 2021, to almost $131 million. “This inventory situation caught a lot of us off guard. I think everyone is a little bit bloated on inventory and they don’t want to be,” Kirkland’s CEO Steve Woodward told investors last month. To mitigate its exposure, Kirkland’s is discounting products that are in stock, and canceling or delaying $50 million in orders for products it forecasts will not sell quickly. Big box retail giants Target and Walmart are also discounting heavily across their entire product ranges.

Industrial equipment manufacturers have also seen their inventories increase – by nearly 11 percent over the past year – in part because of upstream supply chain issues. Agricultural equipment manufacturer John Deere has seen “work in process” inventory increase to $1.6 billion from $967 million one year ago, largely because they cannot obtain critical components. Last week we wrote about auto maker Tesla’s efforts to pull some of its supply chain back under the company’s control. Over the past 18 months, many auto manufacturers have had to slow down or suspend production due to semiconductor shortages.

On the flip side, pretty much every week we hear from companies that are not getting any of the product they ordered from China or way less than they ordered. For every factory in China with a sudden surplus of product, there seems to be another factory that has a shortfall, oftentimes due to a reduction in workers unable to make it to work due to China’s zero-COVID policy.

Obviously, some manufacturers (and retailers) are more affected than others by supply chain uncertainty. If you manufacture dominoes, that’s a pretty timeless product that can be stored indefinitely, and at some point, hopefully, you’ll be able to sell your inventory. But if you’re a retailer specializing in teenage girls’ fashion, and your autumn 2022 collection doesn’t arrive until winter, you’re in deep trouble.

If you’re a big box retailer with $100 million committed to Christmas decoration manufacturing in China, and your factory is running behind, or worse, you suspect it may be going out of business (and in China, there really is almost no “too big to fail”), you’re probably not sleeping that well at night.

As attorneys and advisors to many, many companies that have manufactured and are manufacturing in China, we are frequent and loud advocates of well-written contracts that provide as much protection as possible. As we have written often, these contracts should be written in Chinese, and should cover the entire production process from concept to conveyance.

Just yesterday, in the longest blog post we’ve ever written, we outlined the basics of international manufacturing contracts, but in brief, your contracts need to cover 1) manufacturing exclusivity and IP protections, 2) your factory’s obligation to fulfill your order, 3) ports and terms of delivery, 4) payment terms, 5) warranty terms, and 6) penalties for breaches of the contracts.

Breaches of your contracts are likely to fall into several categories: A) quality control issues, B) intellectual property theft issues, and C) delivery issues.

If your factory does breach your contract – and in the context of this post we’re focused mostly on delivery timing – your best remedy is contract damages (similar to liquidated damages under common law).

In standard commercial contracts, our China lawyers usually include a specific damage amount for certain (but not all) violations of the contract terms. We always say that coming up with the right amount and the right combination of contract damages is an almost magical combination of experience and art, not a science.

We vary the amount of contract damages based on a combination of: 1) the amount at stake in the contract, 2) the likely amount of damages if there is a breach, 3) the location of the court in which disputes will be resolved, 4) the moral culpability of the breach, 5) the industry, 6) the financial wherewithal of the Chinese party, 7) the power/prestige of the Chinese company, and sometimes 8) even the country in which our client is based.

The only constant is that we try to make the amount as high as we can, while at the same time erring on the side of keeping it low enough so that a Chinese court will enforce it and so the Chinese company will be fearful of breaching the contract. Your contract with your Chinese manufacturer is your best chance to persuade your Chinese product supplier that prioritizing its relationship (and fulfilling its contracts) with you is in its best interests.

Chinese contract law clearly provides for contract damages and Chinese judges tend to like them. Though contract damages are both permitted and encouraged, they cannot be used as a penalty and Chinese courts therefore usually will allow a defendant to argue that the contract damages are too high, and that the court should therefore ignore them and award a lower amount. The court is then free to accept this argument and award the lower amount. Far too often, foreign companies and their lawyers will write such a high amount into their contract damages provision that the Chinese company will happily sign the contract, knowing it will never be enforced.

Done right, contract damages can be a near-miraculous thing and our China attorneys love them for the simple reason that they work. Putting the right contract damages provision in your China contract does the following important things:

  • Increases the likelihood your Chinese counter-party will not breach your contract.
  • Increases the likelihood you will be able to avoid litigation if your Chinese counter-party breaches your contract.
  • Increases the likelihood you will prevail quickly in litigation if you do end up needing to sue your Chinese counter-party.

Importantly, your manufacturing contracts should provide cover for you if your factory does not deliver on time. Typically, manufacturing contracts require that buyers pay 50-70 percent upfront. If delivery is delayed and the buyer doesn’t make the second payment, the factory is likely to complain to China’s Export and Credit Insurance Corporation (Sinosure), which is likely to sue you in your own country for non-payment of a debt. However, if your contract makes clear that late delivery means the seller must pay X percent of the order for every day the shipment is late, you will have a great argument for not making the second payment. Having a contract that will stop Sinosure from trying to destroy your company — which is essentially what it does — is one of the best things you can ever do.

Though our firm has written close to a thousand manufacturing agreements with Chinese factories, not a single one of the companies for which we wrote such an agreement have ever been pursued by Sinosure, at least as far as we know. The reason for this is simple: contracts help prevent China factory problems and Sinosure’s involvement virtually always stems from a China factory problem.

The Washington Post noted, “Selling off these mountains of goods will shape growth rates in the world’s two largest economies,” and yes, from a macroeconomic perspective that’s true. But as a business manager, your first concern is your own business’s survival. Bulletproof contracts that include contract damages are a vital part of the manufacturing process.