On the Importance of Having Your Overseas Manufacturing Contracts “Line Up” with Your Product Sales Agreements

I recently came across an email from a couple of our international manufacturing lawyers to a new client who had asked us to review its “China contracts.”

This post focuses on the need to make sure your contracts with your overseas product manufacturers line up with your contracts with your product buyers. The below is an email (nearly word for word, but with the company names changed) in which we noted the great risks our client would be facing if it did not secure a new manufacturing contract with its Chinese manufacturer:

Your request was to have us review your Manufacturing Agreement for IP issues. We provided you with our comments on those issues in the memo we sent you yesterday. This email is to let you know our concerns regarding basic business issues.

Your contracts put you in a very difficult position. You contracted with (American Business Company) ABC to distribute your products around the world, but you do not control the manufacturing of your Product. Instead, you are having China Manufacturing Company (CMC) manufacture your products and CMC is itself dependent on layers of subcontractors and suppliers located in China.

Your big business risk stems from not being  able to meet your obligation to ABC due to your relationship with CMC and to its various relationships with its subcontractors and suppliers. It is therefore critical that you do something to ensure that your  agreements with ABC and with CMC do not directly conflict and are in harmony as closely as possible. Absolute agreement is not normally possible, but there should not be any big holes. An example of a big hole is one in which you are obligated to fill an order from ABC at a specific price, but CMC has the right to reject the corresponding PO from you.

The below are some examples of the issues that can arise by not truing up your two contracts:

a. ABC places an order with you that you must fill and you then submit the corresponding PO to CMC to get the products to provide to ABC. CMC simply rejects the PO because it is not obligated to perform.

b. Same as above, but CMC rejects in violation of your Contract Manufacturing Agreement with CMC.

c. Same as above, but CMC does not deliver or delivers late due to a default on the part of its Chinese subcontractors.

d. Your contract with ABC has you agreeing to a fixed price for two years, but your contract with CMC is silent on pricing. This means CMC can between now and two years from now raise its prices to a point at which you literally lose money on every sale to ABC.

e. CMC consistently delivers product late, or short or with defects.

The overriding issue here is that you need a Contract Manufacturing Agreement with CMC that seeks to the greatest extent possible to reduce or limit your risk/liability to AMC for any of the above.

In general, the terms of your Contract Manufacturing Agreement with CMC should be parallel to the terms of your product selling/distribution agreement with ABC. At a minimum, this means we should strive to accomplish the following with CMC:

a. CMC is required to accept your POs that are within your forecast.

b. CMC is required to lock its prices for at least two years. There are other options here.

c. CMC must be made subject to the same consequential liability damages for all breaches of its Contract Manufacturing Agreement with you. This means product liability breach, defective product breach, late/short delivery and failure to accept a valid PO.

d. CMC should not be permitted to use a force majeure defense relating to anything that happens in China regarding the operations of its Chinese subcontractors. CMC should be required to take on the full risk of what happens in China.

None of the above is currently covered in your existing agreement with CMC and, for the most part, the ABC agreement and the CMC agreement are not in sync. Some examples of ABC contract matters that are not consistent with the CMC agreement are as follows:

a. Section 3.3 and Section 9.2 on liability for late delivery.

b. Section 9. Price is EXW, California, but CMC price is FOB, China.

c. Section 15: Your CMC contract prohibits subcontracting, but we know that there are at least two layers of subcontracting and probably more.

Having said the above, the CMC agreement was intentionally crafted by CMC to be unclear and to eliminate as much liability as possible for CMC. Major revisions to this agreement may therefore be difficult. At a minimum, however, the following should be made clear:

a. What is the obligation for CMC to accept Purchase Orders? Usually we provide that the manufacturer is required to accept the PO if it falls within an annual rolling average projection. What is often not covered is what happens if the buyer does not purchase, or suspends purchases during the term.

b. What is your agreement with CMC on price?

c. What is CMC’s liability for late delivery of your products or for short delivery?

d. What is CMC’s liability for defects? CMC wants to limit its liability to the issuance of a credit. This is bad for two reasons: One, this means you can only collect on the credit if you make another purchase. Two, your credit is limited to the price of the defective goods and does not cover other losses. The other losses can be considerable in the case of defects. If a recall is ordered, the dollars lost can be huge.

All of the above should be stated in simple, blunt language. The vague language of your existing Contract Manufacturing Agreement with CMC is the opposite. It sounds okay, but if you truly analyze it, most of it either says nothing or it is designed to get CMC off the hook for just about everything. Frankly, this is typical of what we see when our clients go with the manufacturing agreement provided to them from their suppliers.

We will wait for your instructions on the next step(s) you want us to take. Feel free to call to call us to discuss.