by Dan Harris
Renaud Anjoran over at the Quality Inspection Tips blog recently wrote on “How your Chinese suppliers might become your competitors.” Anjoran provides some excellent suggestions for preventing your China supplier from competing with you, based on his notes from a talk by Paul Melkebeke, Vice President Supply Asia for Samsonite.
Melkebeke talked of how building a brand and a distribution network is a long-term investment. No doubt about that.
He then noted how Samsonite protects its IP by all available means — patents, design registrations, copyrights, Non Disclosure Agreements (NDA), etc, but these things are “not enough.” I completely agree. Companies must do everything they can to protect their IP from China and from elsewhere and doing this requires more than just registrations and contracts, as we noted in our post, How To Protect Your IP From China. Part 2:
Though there are, of course, particular protections you can and should employ depending on what you are doing in China, it will almost always make sense for you do to do the following four things.
- Do business with the right people in China. Companies with nothing to lose are far more likely to take your IP than those with established businesses and reputations and incentives for not getting sued.
- Think about what you have that needs protecting. What do you have that others want? What do you have that your competitors would love to get their hands on? Is it your technology? Your customers? Your brand?
- Figure out how you (not your lawyer) can protect what needs protecting. Can you break into subparts whatever it is that you want to protect so that nobody in China gets access to the full thing? Can you get away with sending an older version to China? Can you lock it down in your building in China or on one computer such that your employees cannot leave with it? Can you keep the key portions on a server in the US? These sorts of protections are usually called structural protections and they can be absolutely critical.
Melkebeke noted how Samsonite helps its suppliers improve on efficiency and quality, knowing that the supplier’s other customers (Samsonite’s competitors) will also benefit from these efforts. This is a really important issue and one that is difficult to address. One way to handle this is to become the exclusive buyer from your supplier. But if you are not Wal-Mart, the odds of your being able to achieve that are incredibly slim. We have had clients that have purchased equipment for their Chinese suppliers with the proviso that equipment can be used only to make our client’s product. This too is pretty rare though.
Melkebeke noted how “many suppliers compare their FOB price to Samsonite’s retail price, and think it is all profit. Many of them start their own brand and push for distribution. But retail space is not cheap in China, and these companies are not expert at this game, so they end up losing money. So far, none has been successful.” This is something we often discuss with our manufacturing clients that outsource product to China, especially when they claim that “there is no chance our Chinese manufacturer will ever be able to compete with us.” I often give the following example:
We had an outdoor equipment manufacturer (“USA Company”) come to us after its Chinese manufacturer (“China Manufacturer”) had stopped making outdoor equipment for USA Company. China Manufacturer had not only stopped making outdoor equipment for USA Company, but it had also registered USA Company’s brand name as a China trademark in over a dozen different categories/classes (this was before China prohibited this sort of thing by agents). China Manufacturer’s plans were to sell the outdoor equipment to the two large hardware store chains to whom USA Company had been making the overwhelming bulk of its sales.
China Manufacturer completely struck out in its efforts to sell its own products to the two large hardware store chains. China Manufacturer went to those chains and offered to sell its product for about half the price of what USA Company had been selling them, but both hardware chains basically threw it out because China Manufacturer had no plans and no ability to maintain constant stocking of the products and no plans and no ability to repair the products and no plan and no ability to handle returns and other customer service needs. China Manufacturer’s plans to sell directly into the US market were essentially a joke.
Nonetheless, China Manufacturer had done huge harm to USA Company’s business. USA Company had to scramble to find a new supplier (it succeeded) and it also had to figure out how to get its products manufactured and shipped out of China without violating China Manufacturer’s trademarks (it did, by securing a trademark for small engines and then prominently plastering its name on the small engines of all of its outdoor products).
The moral of the above story is that you cannot count on your Chinese manufacturer not trying to compete with you even if doing so makes no sense at all.
Melkebeke went on to note how the internet has broken down selling barriers and OEM manufacturers can sell their products online, but only at “a very low price” and “this is not the way to build a brand.” China is Samsonite’s second largest market after the US. According to Melkebeke, Chinese consumers are willing to pay a premium price for Samsonite product and are “as picky as Japanese consumers.” Because of this, despite helping its manufacturers improve, Samsonite is not really hurt by suppliers that try to compete with Samsonite because Samsonite prevails because of its quality and brand recognition. But, Melkebeke rightly notes that companies with a weak brand, and in certain categories (e.g., electronics, where components and specifications are easily compared) are at much higher risk of losing business to a China supplier that seeks to compete with them. I completely agree.
Anjoran then wrote about how Melkebeke advocated for employing legal methods to keep suppliers in their place, “even if they are not 100% effective.”
The first comment to Anjoran’s post stated that “legal contracts are next to useless in most cases unless you are a Samsonite or an Apple. For SMEs, the only sustainable strategy is relentless innovation.” I completely disagree.
From the legal side, there is a lot that can be done to protect yourself from your China supplier, even though, like anything else, these things will not work 100% of the time. But really, legal protections are probably more important for small and mid-sized companies than for a massive company like Apple!
Let me explain.
First, I would urge everyone to read a post we did last week, entitled, The New Role Of Written Contracts For Product Purchases In China, in which we talked about how the importance of having real contracts with Chinese suppliers has increased and of how American companies are reacting to that:
This approach is changing and more and more foreign buyers are entering into long-term purchase contracts with their suppliers (typically called OEM Agreements, Manufacturing Agreements, Product Supply Agreements, or Product Sourcing Agreements). There are several reasons for this trend. Probably the most important reason is the drive for standardization on the part of buyers. Chinese product is just one part of a worldwide supply chain. Major retailers have diverse sources of product. All product has to meet a basic standard to fit smoothly into the chain. Product that is delivered late or that does not meet specifications fouls up the chain. Product that is subject to an intellectual property infringement challenge or that contains pirated, non-standard parts or that contains a non-standard component that raises safety issues disrupts the supply chain.
In the early days of buying product from China, the price was so cheap that these non-compliance issues and their resulting costs were simply absorbed by the foreign buyers at each stage of the purchase chain. However, in the current environment of tight supply chain management, the disruption is normally quite costly and cannot be tolerated by retailers already financially stressed by the current economic environment. As a result, retailers are imposing strict standards on their direct suppliers. The strictness of the controls and the magnitude of potential losses mean that foreign buyers can no longer simply absorb the costs of non-conformance by the Chinese manufacturers.
Foreign buyers now have no choice but to impose the same standards on their Chinese suppliers. Thus foreign buyers must enter into written contracts for product purchases from their Chinese suppliers that mirror their own obligations to their major retailer customers. These contracts must be supplemented with detailed supplier manuals and codes of conduct that seek to regulate the day-to-day business operations of the Chinese manufacturers.
None of this is unusual in North America and Europe, but the approach is very new to most Chinese export oriented manufacturers. The purpose of these agreements is quite simple. The purpose is not to make the situation better but rather to impose liability for non-performance directly on the Chinese manufacturer. That is, the foreign buyer is saying: “I no longer will simply absorb the costs caused by your lack of compliance with the conditions of sale. If you (Chinese manufacturer) do not perform, I will suffer a loss and I am going to pass that loss on to you.”
The first two things you will likely need are a Non Disclosure Agreement (NDA) and a registered trademark in China. We prefer to do what we call an NNN Agreement — non-disclosure, non-use and non-circumvention. This is an agreement that you use when you are trying to find manufacturers for a product. You have the manufacturer sign the agreement before you show them the product. It prevents manufacturers from stealing your design for themselves and from going around you to sell the product to your US customers.
Here is some more information on NDAs/NNNs:
- China Non Disclosure Agreements (NDA). A Really Good Thing
- Why Non Disclosures (NDAs) Alone Are Not Enough For China
- Why Non Disclosures (NDAs) Alone Are Not Enough For China, Part II. At Least Make It Enforceable
If you are not concerned about manufacturers in China copying your designs, you do not need an NDA/NNN Agreement.
The one thing you will almost certainly need to do (but maybe not right away) is to register your trademark in China. Before you use any of your trade names (think brands or product names) or trademarks in China (think logos), you absolutely must register them in China or someone else almost certainly will and then you will not be able to use your name in China, even if all you are doing is exporting your product from China. Here’s some info on that: China: Do Just One Thing. Trademarks.
Depending on your situation, you may also want/need a Product Development Agreement. If you are going to work extensively with a Chinese manufacturer to develop a new product, you need a specific product development agreement. These agreements cover the cost and procedure for development and ownership of the developed product. Many companies fail to enter into this kind of agreement and then discover the Chinese side owns “their” product and/or molds at the end of the process.
Once you have chosen the manufacturer for your widget, the next thing you will need is a Manufacturing Agreement (these are also called supplier agreements and OEM Agreements). Many US companies do all their manufacturing in China based on purchase orders. This is very bad for the US side. A good manufacturing agreement covers IP, quality control, NNN issues, warranty, ownership of molds, tooling, supplies, diversion, dispute resolution, and all the other various issues that arise in a manufacturing relationship.
Here is some more information on Manufacturing Agreements:
- China Manufacturing Agreements. Watching The Sausage Get Made
- China Manufacturing Agreements. Make Liquidated Damages Your Friend (please read the linked posts in this as well).
But what is a small company to do? The above. But what about the idea that contracts are “useless” for small companies? I am not sure why this commenter said this, but I do know that small companies often ask me whether it is worth having a contract if they cannot afford to sue to enforce it. I often respond by saying that if they cannot afford to sue on a breached contract, they also cannot afford bad product and that is all the more reason they need a contract. There are many reasons to have a good contract with your Chinese supplier and suing on a breach is but one of them.
As anyone who has been involved in litigation anywhere in the world will tell you, it is a horrible thing. It is expensive, time consuming, and imperfect. Litigation signifies the end of discussion between parties and, as such, it should only be undertaken after all other avenues have been exhausted. As I am constantly telling clients, “if you have to sue, you have already lost. You can win the litigation, but even so, you will have lost.”
Litigation virtually never brings anyone a complete remedy. If you are owed $250,000 and you sue and the court awards you $250,000 and the other side pays you in fairly prompt order, you still have not achieved a complete remedy. What about the time you spent trying to settle the case before suing? What about what you might have done with the $250,000 had you received it sooner? What about your attorneys’ fees in dealing with the problem? What about all the time you and your employees had to spend on the case? Litigation is not a complete remedy, which just underscores point number 1 on how it should always be a last resort.
There is huge value in having a contract with your Chinese counterpart that has little to nothing to do with winning a lawsuit. Even if you never intend to sue anyone in China, it makes sense to have a good contract, preferably in Chinese. There are three main reasons to have a good contract, and suing and winning on it is only one of them.
One of the main reasons for having a good contract with your Chinese product supplier is to make sure that the two of you are on the same page. We wrote about this reason in Chinese Manufacturing. Delivery Date? What Delivery Date?:
One of the most common problems we see between American companies and their Chinese manufacturers is “late” delivery. I put late in quotes because many times I think the problem is not so much that the Chinese manufacturer was late, but rather that the contract and the American buyer were unclear on the actual delivery date requirements.
Let me explain.
When we draft an OEM Agreement (a/k/a Manufacturing Agreement or Supplier Agreement), we are always very careful regarding delivery times. Most of the time, our clients come to us with a term sheet or an oral agreement with their Chinese manufacturer dictating something like 30 days for delivery. We like strictly tying the Chinese manufacturer to the “agreed-upon” delivery time and we usually do that with a liquidated damages provision tied to late delivery. Just by way of example, we might put into the OEM Agreement a provision saying something along the lines of delivery shall be within 30 days and for every day beyond thirty the Chinese manufacturer shall be required to pay US Company 1% of the purchase order price within ten days.
Perhaps more than any other contract provision, we tend to get blow-back on the delivery time provision from the Chinese manufacturer. Oftentimes when faced with the reality of having to pay a set amount for late delivery, the Chinese manufacturer gets really serious about delivery times and tells us that they simply cannot promise delivery within the previously “agreed” time frame. Our client usually realizes it is better to get real agreement (even if longer than originally anticipated) before ordering, rather than getting late delivery after ordering.
The other, somewhat related issue we face on delivery times is that when our client comes to us and says it has agreed with its Chinese manufacturer to a 30 day delivery schedule, we then have to figure out 30 days from what. We typically go with 30 days from the issuance of the purchase order, but oftentimes the Chinese company pushes for it to be 30 days from its receipt of payment or 30 days from its receiving proof of payment.
Bottom Line: Certainty is important with respect to delivery dates and, without a doubt, the best way to achieve that certainty is a written contract, in Chinese (so that there is no doubt the manufacturer understands what is on the paper) clearing setting forth the delivery date.
In my view though, the main reason to have a good contract is to prevent problems on which you might need to sue: We wrote about this way back in 2006, in China OEM the Smart Way:
The best solution for this is to prevent it from happening in the first place and the best way to do that is to choose the right supplier and use a good OEM contract. When we draft OEM contracts for our clients, we always put in a provision precluding the Chinese manufacturer from subcontracting out production. Without exception, the Chinese manufacturers have agreed to this provision and, again without exception (at least as far as we know), they have always abided by it. The reason for this is simple. The manufacturer may have twenty some companies for whom it produces goods, but probably less than half of them forbid subcontracting. When the Chinese manufacturer is so busy as to require subcontracting, it makes sense for it to first subcontract out work for those foreign companies for whom it is NOT prohibited by contract from doing so. I am always analogizing this to bike locks. Even the best bike lock cannot prevent all thefts, but its efficacy comes from the fact that bike thieves generally find it easier to steal a bike with a poor quality lock or none at all than one that is difficult to break.
Any contract that makes your Chinese counter-party think twice about messing with you has at least some value. My law firm has settled a number of matters with Chinese companies based on well-written contracts, but we decline to take on cases without contracts. Having a well written contract does not mean you will always win your lawsuit if you are forced to sue on it. But it does mean you will have some leverage if things go wrong and it does mean you will at least have a chance. Having no contract means no chance.
How do you stop your Chinese supplier from becoming your competitor?
It is that simple.
What do you think?