If ten (or more) years ago most of foreign companies ‘products manufactured in China had no added value or technology involved, the now booming technology (and internet of things) companies are coming to China to manufacture products that involve a fair degree of technology and intellectual property (IP).
Although the type of products changed, foreign companies manufacturing their products in China keep making the same following mistakes:
(i) considering that a simple Purchase Order may be regarded as a contract;
(ii) having their “domestic attorneys” to advise on how to do business in China;
(iii) believing that with a standard Non Disclosure Agreement they would protect the IP disclosed to the Chinese manufacturer;
(iv) start producing (after disclosing their IP) in China based solely on oral agreement;
(v) when and if decided they need a contract, using a standard contract made for their home country or have their “domestic attorney” to draft one for China.
We have seen those mistakes happening countless times and it is surprising how some companies can be fairly careful and anticipate issues when doing business on their home country, but go on doing business on other countries almost totally unprotected and unaware of the risks they are taking.
Problems related those mistakes normally range from quality, inspection, warranty, delivery and delays, payment, obligation on producing, to trade secrets and IP protection issues. Without a proper protection, if any issue arises, the foreign company will face a conflict with their Chinese manufacturer and most likely will need to bear some losses.
In addition to that, when it comes to new technology products (such as sophisticated hardware, internet related devices, industrial equipment, etc), the list of issues and losses that can arise from engaging a factory to manufacture in China without protecting your IP and other interests beforehand are way more extensive (and expensive too).
Here is a list of some examples of practical issues that should be addressed from the start and why standard contracts used in the west most of time will not cover it:
- Ownership of IP: To whom will belong the new work, process or product developed as part of the product design process? Most of standard contracts (NDA or others) provide that trademarks, logos, patents and other trade secrets disclosed by the contractor (in this case the foreign company) shall remain their property, along with the product developed under the manufacturing agreement. However, often it does not set forth to whom will belong any changes, new parts, new process and new products developed as a result of the production process.
- Production by other factories: The issue of ownership is key here, because if your IP is not fully protected (or is not clear that new designs or process created during the manufacturing process will belong to you) and you decide to engage a different factory to manufacture your products, you may find out you cannot do it without the authorization of the Chinese factory which first produced (or registered) it.
- License from the manufacturer: Even if you took several protective measures regarding IP ownership, it may be that the factory that you hired ended up using one or more components (or processes) which are patented by them and that were used to manufacture your products without additional royalties’ payment. You may want to include in your contract that if it is terminated because of a breach by the factory, the factory automatically licenses you to manufacture your product in a different factory. I have never seen a standard contract with such type of provision.
- Obligation to produce: Manufacturing a new technology product normally takes time, investment, molds, tooling and other expenses by the foreign company. In this sense, making sure, before you start, that you have agreed on a clear schedule for how long and which quantity your Chinese manufacturer shall produce of that new technology product may protect you from making that investment all over again.
- Exclusivity: It is better to determine from the very beginning whether the agreement with your manufacturer will be exclusive or nonexclusive. In the future, that may also define whether or not you are allowed to engage a different factory to manufacture the same product.
- Quality, inspection, rejection of defective products and payment terms: Besides describing in detail the quality standards (including raw material and components standards), make sure you include on your contract how inspections would be done throughout production, quality test certified by an specific entity, rejection and replacement of defective products and ideally final payment after inspection/acceptance. Most of standard contracts have general comments on quality standards and do not provide details on how dispute on quality standards would be solved. If both parties agree, from the start, that in case of quality problems, samples of the product shall be sent to a well known quality test lab (specified) for testing and that the result shall be binding, then disputes on quality issued can be more easily addressed and solved.
- Non competition and non circumvention (in addition to non disclosure): These provisions should be really tailor made to meet Chinese reality and it should be as broad as possible, because you want to avoid as much as possible that factory next door will starting producing a very similar product to yours. Western standard contracts almost never cover it.
- Prohibited parties to contract: Again, because you do not want your manufacturer to find out who your costumers are, then circumvent and compete with you by stealing your clients and selling your products directly to them, you may want to include a list of contacts of costumer that your manufacturer is not allowed to do business with.
Obviously, depending on your product, investment and other specificities, you may want to add many other provisions on your contract. We just highlighted here the common issues that are normally not specifically addressed on standard or NDA contracts used by foreign companies in China.
Note that all the above comments regarding IP presume that the foreign company did take the most basic protection measure regarding their own IP: registered their IP (trademark, patent and so) in China before exposing it in China or to any manufacturer.
We suggest that you bear in mind the importance of some issues in China (and for that only professionals that really worked with China would likely know or foresee it), how important it is to have certain protections very clear from the very beginning (and before you start any cooperation) and that you need an agreement that provides for how the main issues which may arise would be resolved.