"Everyone sources from China and therefore doing business is straight forward."
This is the expectation of many companies new to sourcing direct in China. But it's not true. The Chinese approach to contract and business culture is different to that in the UK/US. This is obvious, but it is surprising how many companies do not take basic steps to ensure their contract is appropriate, intellectual property is protected and that they know who they are doing business with.
Doing business with Chinese-based companies can be riskier then doing business in the UK/US – if only because it is different. Of course the risk may be a small price to pay for the benefit of the reduced costs, but applying caution is a sensible approach. We set out in this document sensible steps for anyone sourcing in China.
Due diligence is essential. All too often people do business with Chinese companies without understanding who they are doing business with. In an ideal world, we suggest the following basic steps:
- Identify the company's Chinese name (in Chinese script). Do not rely on the English or Pinyin name. The English or Pinyin name of a company is merely a trading name and has no legal status.
- Identify the company's legal representative, directors and shareholders. Are these the people with whom you are dealing? If not, who are these people? Ask to meet them.
- Identify the company's registered address. Is this the same as the company's place of business? If not, why not? Companies often register at false addresses to evade detection by the government authorities and enforcement of contractual obligations.
- Identify when the company was incorporated. If it is a relatively recent company, exercise caution.
- Identify whether the company has a business licence (all companies should be licensed) and, if so, check the scope of that licence. Does the licence cover the services you are seeking? Given the speed of growth it is not unusual for companies to be outside the scope of their licence. Even so, exercise caution as the conduct of the company outside the scope of its licence has not been approved by the Chinese government.
- Identify whether the company is licensed to export goods (all companies which export goods must be licensed).
- Consider engaging a third party to do an audit of the company.
- Identify the company's registered capital assets. Obtain a Capital Verification Report to check how much of a company's registered capital has actually been paid. In China registered capital is not automatically "paid up" just because a business licence has been issued. Exercise caution when dealing with companies which have limited capital assets or have not paid up all of their capital assets.
- Get a credit check done. The four big credit rating agencies (Standard & Poor's; Moody's; Dun & Bradstreet; and Fitch Ratings) are all present in China and/or Hong Kong.
- Consider engaging a private investigator to speak with the company's employees. This is often a quick and cost efficient way to ascertain whether the business is legitimate.
- Ask to see the company's accounts and a balance sheet. Have the accounts and balance sheet been audited? Do not trust financial data unless they have been audited by experienced professionals. It is very common in China for companies to carry multiple sets of accounts for tax or "management" purposes.
- Ask yourself whether the company has been open in providing information (for example, answering questions, providing accounts and other legal documents). If a company is nationally reputable or exports to large foreign clients, it will have provided this information before. If it has not been open, this is indicative that it may not be reputable.
- Ask the company to provide referees (preferably non-Chinese). Check these references.
- Inspect the premises. Ascertain whether, in practice, the business has the capacity and capability to meet that which you require.
Chinese businesses are used to doing business on an informal basis – short written agreements (if in writing at all!). They are also used to responding on an order-by-order basis. A company subject to Chinese law and the jurisdiction of the Chinese courts is therefore going to struggle with a typical UK/US contract which will be longer and more detailed then they are used to. It may be easier to establish an order-by-order relationship for straight forward products first and then develop a fuller relationship. However, ensure you enter into a written contract before engaging the manufacturer.
The written agreement should:
- Be short (the Chinese tend to refuse long detailed contracts out-right).
- Be bi-lingual (although English should be expressed as the prevailing language in the event of any inconsistencies).
- Be subject to Chinese law and the jurisdiction of the Chinese courts, or an arbitral body recognised by the Chinese courts. If you do not then you risk the contract being unenforceable in China. UK companies are likely to prefer the contract to be subject to the laws of Hong Kong as it is similar to English law and is also recognised by the Chinese courts. However, you should be aware that it is unusual for a Chinese company to sign a contract that is not subject to the laws of China.
- State clearly the type and quality of goods required.
- State clearly the responsibility for export and import.
- State clearly the responsibility for transport.
- State clearly the payment terms.
- State clearly what happens if a product is not of sufficient quality.
- State clearly what happens if there is a dispute between the parties.
- State clearly who owns the intellectual property.
If a Chinese business is unwilling to sign a formal written contract then the best alternative is to attach your standard terms and conditions of purchase/sale to the order/invoice. It is important that you adapt your UK standard condition of sale/purchase to ensure they are enforceable in the Chinese courts. For example, terms and conditions should be bi-lingual and subject to Chinese law.
Points to consider:
- China is no longer the "wild west" of the intellectual property (IP) world. There is growing respect in China and in its courts for IP and protecting it. Even so, as with any dealing in your IP, care should be taken!
- You should ensure that the product of which you are securing the manufacture does not infringe third party IP rights in China. For example, does a third party have a registered trade mark which is the same or similar to yours?
- Take steps to ensure you are able to monitor for "overruns" (i.e. surplus products made by your supplier to the original specification with or without your trade mark), "seconds" (i.e. surplus products made by your supplier which are substandard and with or without your trade mark) and "pirates" (i.e. copies made by someone other than your supplier).
- Consider registering trade marks in Chinese or Pinyin names – do not just rely on a trade mark registration for an English brand name.
- Bear in mind that if your supplier has expertise in making or sourcing products that meet your requirements they are probably working for your competitors too! Investigate and assess how comfortable you are with that.
- The best way to protect your IP in China is to register whatever rights you can and then enforce robustly when required.
- Seek advice on the reality of IP protection in China.
- If you require manufacturing that involves the use of important IP and the manufacturing can be separated into two or more parts, then have different (unconnected) manufacturers for each part and ensure that neither Chinese partner has access to all the IP, or knowledge of the existence, of the other.
Contract manufacturing is a popular option for western companies wanting to manufacture in China because it is flexible and relatively low cost. However, before taking this route, consider the alternatives which give you greater control: buying an existing manufacturing facility; setting-up a manufacturing facility; or entering into a joint venture.
If you are considering contract manufacturing, consider the following:
- If aspects of the manufacture are confidential or relate to IP rights, enter into a non-disclosure agreement prior to giving the manufacturer any information.
- Find a quality manufacturer using a China sourcing agent or a manufacturing directory. Visiting international trade fairs is also a good way to meet potential manufacturers face-to-face.
- Understand each manufacturer's payment terms – some manufacturers may ask for 100% upfront, while others will be prepared to get going for a 30% down payment. Likewise some may require a telegraphic transfer of funds (TT), while others will be prepared to accept a Letter of Credit (LC).
- Determine your import duties and responsibilities.
- Work out your landed costs with the help of a freight forwarder. Many manufacturers will only quote on an ex-works or FOB basis (i.e. the price from the manufacturer gates or at the port), meaning you will have to determine shipping costs, VAT and duty for delivery to your warehouse.
- Select your manufacturer based on service, pricing, lead times and terms and conditions.
- Make sure you are comfortable with the manufacturer's environmental and labour records.
- Check whether the delivery term is correct. It is common for FOB to be used, but this is often wrong; especially for container traffic (where the real point of delivery is likely to be before loading onto the ship).
- Set your quality standards before making any manufacturing commitments.
- Go and personally visit the manufacturer. Make sure you see the factory and not a sales office.
- Does the Chinese vendor run its own compliance checks on quality control and have sufficient oversight? Have you got confidence in their quality assurance process?
- Is the Chinese supplier likely to outsource the order? Second-degree outsourcing makes it more difficult to monitor the company's conduct. Do not rely just on the contract to control this.
- Ask the manufacturer to prepare pre-production samples of the product before an order is started.
- Factor Chinese holidays into your lead times – however, most manufacturers work over Christmas and the western New Year.
- Specify clearly how you want your goods to be packaged. Poor packaging can result in your products being damaged.
- Arrange for your order to be quality checked before it is sent.