Do NOT Use Template Manufacturing Contracts for China
Our law firm has always avoided using template manufacturing contracts for China—or anywhere else. We have many reasons for this stance, but the primary one is simple: we’ve never seen a template that works for China manufacturing, nor do we believe it’s possible to create one that does.
Custom Contracts are Required
This came to mind today after I reviewed an email from one of our international manufacturing lawyers to a client. Despite several exchanges, our lawyer was still seeking more information and clarity from our client before starting the initial draft of the Contract Manufacturing Agreement the client needed.
I repeat: this was just for the initial draft. Once our lawyer gets the needed answers, the next step is to generate an initial draft for the client’s review, followed by revisions to produce the final version. Then, one of our lawyers who is completely fluent in Chinese will rewrite the English version into Chinese. See Our China Manufacturing Agreements: In Chinese and for a Flat Fee.
I defy anyone to read the above and the below and then contend that an off-the-shelf, one-size-fits-all Contract Manufacturing Agreement has any value at all.
A China Manufacturing Contract Example
Here’s the email, modified to hide any client identifiers:
Here are the remaining open items for the draft Contract Manufacturing (CM) Agreement:
Section 1.3: 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 CM world. Since ownership of design and IP is critical for this product, this section should be carefully drafted to reflect the situation on the ground. Please advise.
Section 1.5: Acceptance of Purchase Orders — Note that this provision does not require the Chinese factories to accept your Purchase Order. 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.
Article 2: 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.
Section 3.2: INCOTERMS Preference — Pursuant to INCOTERMS, Free Carrier is the preferred term. This is critical for issues relating to the transfer of title and insurance.
Section 3.3: 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.
Section 3.4(c): Approval Required — The 7-day period marked in yellow requires your approval.
Section 3.5: 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 are already complaining 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.
Article 5: 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. This document can be attached as an exhibit or referenced as a separate document that you will provide to the factory.
Section 6.1: Inspection Period — The number of days you have for product inspection should be specified.
Section 6.2: Full AQL Process The full AQL process must be stated. As the draft notes, the draft language is a placeholder for your consideration and is not complete. The standard trigger points for acceptance of defect levels are as follows: Critical defects, 0%; Major defects, 2.5%; Minor defects, 4%. These percentages are not fixed and may be adjusted based on the product. The real issue is what will be done when you find defects beyond the acceptable level. This can be complex. For example, what do you do if the ENTIRE shipment shows minor defects, which is relatively common?
Section 6.3(c): Placeholder Language — This placeholder language requires your review and confirmation.
Article 7: Ownership of Tooling — This means the factory owns the tooling and can use it for any purpose without any obligation to provide it to you after termination of the agreement. Please confirm this is your intent. This is important because this provision conflicts with Section 1.2 if the tooling is customized to manufacture your proprietary product for which you own all IP. Normally, tooling is part of that IP. If this is not an issue, the current language is acceptable.
Article 8: 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.
Section 8.1: 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.
Section 8.2: Epidemic Failure — What constitutes “epidemic failure” needs to be defined, and we should discuss this.
Section 9.1: Initial Term — The Initial term must be specified.
Please provide your input on the above points so we can finalize the draft. Once finalized, our team will draft the official version of this contract into Chinese.
The Importance of Tailored Contracts
This detailed breakdown shows why a one-size-fits-all template simply doesn’t work. Every manufacturing agreement needs to be tailored to the specifics of the product, the manufacturing process, and the relationship between the parties involved. This is the only way to ensure that all potential issues are adequately addressed and that both parties are protected.
For more on why China contract templates don’t work for China Manufacturing Contracts, check out China Contract Templates and Getting your China Counterparty Right.
