By Steve Dickinson
Purchasing products manufactured in China has changed substantially over the past five years. in the old days, foreign buyers usually either purchased generic, off the shelf products or they hired Chinese factories to make products designed by the foreign buyer. The Chinese factories have gradually become more involved in the design process. Most recently, Chinese manufacturers have started to sell their own proprietary designs. This raises a number of contracting issues that are not fully understood by most foreign buyers.
In the early days, the situation was simple. The Chinese factory manufactured a basic consumer product for which no one in the world claimed any ownership of the underlying design. The product specifications were standardized. The task for the Chinese factory was to learn those standards and then manufacture a product that met the standards.
For example, for a simple white t-shirt there are a number of specifications that apply: sizes, fabric material, fabric color, thread count, neck size, ornament, label placement and label content. The foreign buyer provides the specifications and the Chinese factory is required to manufacture this standard item to meet all these specifications.
For this type of “fungible base product,” neither the factory nor the buyer make any claim to ownership of the underlying design of the product. The product is standard and the specifications are part of a product standard that applies to all manufacturers of the product anywhere in the world. If the Chinese factory cannot meet the specifications, the foreign buyer is free to manufacture for itself or purchase from any other factory in the world. On the other hand, the Chinese factory is free to sell these shirts to any buyer.
In today’s world, Chinese factories have become far more sophisticated. The extreme example of that sophistication is the situation where the product being sold is a sophisticated item designed entirely by the Chinese manufacturer. In this case, there is no open-source, standard set of specifications for the product. The manufacturer owns the design and the specifications are set by the manufacturer, not the buyer. The buyer often chooses from a menu of specifications.
The relation between the parties in this setting is quite different though most foreign buyers treat purchasing this type of “manufacturer proprietary product” the same as purchasing a fungible base product. In fact, the issues are quite different and a contract for purchasing this type of product requires a number of different provisions. For example:
a. How will the specifications be determined? What is the standard for failing to meet the specifications? For the manufacturer of a proprietary product, it is the manufacturer itself that sets the standards. So rather than providing that the Chinese factory must manufacture in accordance with industry standards or the specifications of the buyer, the contract must provide that the manufacturer warrants that it will manufacture in accordance with its own specifications. This then requires that those be stated clearly in a way that provides an objective reference point.
b. In many situations, the buyer will require the product meet safety and quality and other regulatory standards established by the law of the buyer’s country. For this situation, since the factory is entirely in control of the design, the factory must warrant that it is knowledgeable about all applicable standards and its product will meet those standards. The buyer cannot instruct the factory on the specifics of what to do. The buyer must rely on the factory to do it right. This then requires a warranty that the factory actually did what was required.
c. How does the foreign buyer know that the Chinese factory actually owns the design of the product? How does the foreign buyer know that the product does not violate the intellectual property rights of some other Chinese factory or some other entity located outside China? The risk that the Chinese factory design violates the rights of a third party is not low. The foreign buyer should understand this and do some basic due diligence to ascertain its risks of being sued for IP violations. As a contactual matter, the purchase contract should — at minimum — provide that the Chinese factory warrants that its product does not infringe on the intellectual property rights of any third party. The contract should further provide that the Chinese factory is required to indemnify the foreign buyer from liability from any infringement claims made by third parties.
d. Since the Chinese manufacturer owns the product design, the manufacturer has the right to sell the product to any buyer. This means that the manufacturer has the right to sell to other buyers who sell in the same market as the buyer. Most buyers of this type of expensive product will not want an identical product to be sold to its direct competitors in the market. For this reason, most foreign buyers will want some form of exclusivity that would not be possible in the case of fungible base product.
Chinese manufacturers will always agree that they will not sell their proprietary product under the trademark and logo of the foreign buyer. But absent a specific agreement, they can and they will sell the bare product to any buyer who shows up at their door. The Chinese manufacturer will only agree to provide exclusive rights to the foreign buyer in a case where the foreign buyer agrees to pay a price for that exclusivity. That price will generally be a hard agreement to purchase a certain number of units at a certain price for a certain time period. Chinese factories generally drive a hard bargain in this area and require a commitment that is often difficult for the foreign buyer to accept.
Many foreign buyers fail to clearly consider the type of product they are purchasing from China and so they end up treating the purchase of a Chinese manufacturer’s proprietary product as no different from the purchase of a fungible base product. This is a mistake. The terms for purchasing these two types of product should be very different and failing to understand the differences often results in the foreign buyer failing at its product purchase negotiations or ending up with a product purchase situation that does not make sense for it.
Having lived in China for years, and having mastered both its language and its legal system, Steve Dickinson’s unique expertise makes him an invaluable resource for clients of the Harris Bricken law firm. He co-authors the China Law Blog.