By Steve Dickinson
The US-China trade war has led many US and European companies to diversify their supply chains. Companies whose products have been made in China for many years under a single contract system are now having to deal with factories located all over the world. Where they once managed a production system in a single country, they now face managing production in many countries.
One common situation is where a single parent company owns factories throughout S.E. Asia. For example, a Taiwan or Hong Kong company may own factories in the PRC, Vietnam, Thailand and Bangladesh. How should a U.S. or European company set up their manufacturing contracts in this very common situation? Our international manufacturing lawyers are now having to help our clients decide whether there should be a single contract with the parent company or separate contracts with each of the independent factories? And if there are independent contracts, what should be the method of their enforcement, particularly in countries with weak legal systems like Bangladesh or Myanmar?
There are typically three main options for dealing with a parent company in one country with subsidiary manufacturing companies in multiple countries. No option is perfect, but a choice must be made and I discuss below how to make that choice.
— Option One: A single contract with the parent company.
Say the parent company is located in Hong Kong and the U.S. or European company enters into a contract with just the Hong Kong parent. The contract would be subject to Hong Kong law and would be enforced by litigation or arbitration in Hong Kong. Payments would be made to the Hong Kong company. There would be no direct contract with any of the factories in other countries. Hong Kong still has an excellent legal system that is relatively easy for foreign companies — especially for U.S., Canadian, British and Australian companies because it is based on the British common law system. Disputes will be resolved in a modern legal system and enforcement of the contract will be nearly certain.
From the standpoint of enforcement, the concept behind this option is that the Hong Kong parent will be responsible for any contract violations committed by its factories. This leads to efficiency: a single contract enforced in a single jurisdiction.
This option is often used when there are multiple factories all over the world that are owned, controlled and managed by a single parent entity. However, taking Hong Kong as the example, this approach should be followed only if the parent company is a “real” company with substantial fixed and monetary assets located in Hong Kong. If the Hong Kong parent is a mere “shell”, with little more than an office with a bank account that gets swept to zero every day, contracting with just the Hong Kong parent company will probably not be a good option because the Hong Kong shell company will not have assets available to pay a judgment. In fact many shell parent companies are created to prevent legal action against the subsidiary factories that have real fixed and monetary assets that could be used to satisfy a court judgement or arbitration award. If the Hong Kong parent company is this type of shell entity, contracting with that parent is not a good option because the prospect of effective enforcement will be an illusion.
Even when the Hong Kong parent is a real company, Option One may not be your best option because it does not give you any direct contractual relationship with the individual factories. This lack of direct relationship can make it difficult for you to manage the factories or to resolve issues that arise on a factory level. Under Option One, it is also not possible to make payments directly to the factory. For that reason, Option One is normally used when the buyer assumes the Hong Kong parent actively manages the work of its factory subsidiaries. If this is not true and the factory subsidiaries are highly independent, Option One is not ideal from a practical management standpoint.
When Option One is not a good choice, Options Two and Three must be considered.
— Option Two: Separate contracts with each entity that will manufacture the product.
Under option two, our international manufacturing attorneys usually write the contracts with each of the factory companies using the same approach we use for our China manufacturing contracts. Governing law is the law of the factory location. Enforcement is litigation or arbitration (if available) in a court or arbitration panel within the country where the factory has its hard assets. Governing language is hard to decide. The best is dual language with the local language controlling, but this can sometimes be awkward and hard to manage. English is an acceptable alternative in many S.E. Asian countries. Litigation in English is generally not available. In some countries arbitration in English is possible, but rare. Taken together, these factors show that enforcement in these jurisdictions is likely to be uncertain. But there usually is no practical alternative to having your contract written for the country in which the factory is located since effective enforcement requires action be taken in that very country. If enforcement will be difficult, the U.S. or European entity must face the risks and design its overseas manufacturing business in such a way so as to reduce the risks. For example, it can set up inspection and payment so that quality control problems will be identified before payment is made. It is better to face the risk and work to mitigate it than to pretend that there is an alternative. Because each company and each country are different, there is no cookie-cutter answer on how to draft these country-specific manufacturing contracts.
The problem with Option Two is that many companies find it difficult to manage separate contracts for each jurisdiction in which they operate. For the purpose of efficiency as opposed to enforcement, a single master contract is preferred. This leads to Option Three.
— Option Three: A Single master contract for all factories.
Under this option, the U.S. or European buyer develops a single master contract all factories are required to execute. The contract is with each individual factory and payment is made to each factory. Management of the relationship is directly with the factory, with no Hong Kong or other intermediary.
For S.E. Asia, we usually draft these master contracts with enforcement by arbitration in Singapore, with the arbitration in English and the governing law being the law of the U.S. state or the European country where the product buyer is formed and registered, with English as the governing language of the contract. This then provides for a uniform set of rules applied in all jurisdictions against all factories. If the primary goal is uniformity and ease of management, this is the preferred option.
However, from an enforcement standpoint, Option Three is in many ways “the worst of all worlds.” First off, S.E. Asian countries are not so good at enforcing Singapore arbitration awards and this is especially true when the defendant factory does not bother to appear in the arbitration (leading to a default award) or when the defendant factory claims there was some form of irregularity at the arbitration level, such as a lack of notice. On the other hand, the U.S. and every country in Europe typically enforce Singapore arbitration awards. So purely from the standpoint of enforcement of the award, Option Three puts U.S. and European buyers into the worst possible situation: the Singapore arbitration award is unenforceable against the foreign factory but enforceable against the U.S. and European buyers. But the business practice need for ease of management and consistency of application may make the enforcement issue a subordinate matter. So long as the U.S. or European entity understands the issues, Option Three can make business sense.
Our international manufacturing lawyers usually conduct the following analysis when working with our clients in choosing how to contract for multiple factories owned by a single parent:
Consider Option One first. There are two issues. First, is the parent a shell company or a real company? Second, even if the parent is a real company, as a practical matter does the parent company manage the factories in a way such that it controls the manufacturing operations? If the answer is yes in both cases, then stop. If not, then move to Option Two or Option Three.
From a practical standpoint, the advantages of Option Two are many. One, the relationship with the factory is direct. Two, over time it is possible to modify the terms of agreement to fit the specific situation in the factory. Three, the purpose of a Contract Manufacturing Agreement is not so much to provide for later litigation, but to set out the specific “rules of engagement” with the factory. Four, if enforcement in court will be difficult or practically impossible, this option forces the U.S. or European entity to change the “rules of engagement” to deal directly with the risks by, for example, contracting for no payment before inspection and a monetary penalty that can be taken from current or future payments, etc. Five, even if litigation in the local court will be difficult, providing for that litigation in the home town of the factory shows a serious attitude and is actually seen as a real threat to the foreign factory, whereas arbitration in Singapore is seen as not much of a threat due to the lack of enforcement power.
However, even with its inherent weakness in enforcement, Option Three (a single master contract with all factories) is often preferred. Many product buyers simply do not want the flexibility of Option 2. Companies that deal in many jurisdictions often prefer Option 3 because it allows them to set out a single, consistent set of terms for all factories. These buyers want a single, unchanging set of rules and they want those rules to be interpreted in a single place using a single governing law with a single result that applies to a single set of contract terms no matter where the factories are located. The fact that Singapore arbitration is not enforceable is not their primary concern. They want a single set of rules consistently enforced by an adjudicator with a reputation for expertise and fairness. In their practical operations, enforcement of an award is a secondary issue. They deal with the enforcement issue by understanding the risk and taking action to cover the risk in advance.
Large buyer companies often choose option three and they tell us they like it best even though they realize their factory can easily not pay the award the large company receives at Singapore arbitration, it likely will pay anyway because it will either realize that it was in fact in the wrong and/or (and most importantly) that if it does not pay, the large buyer company will cease doing business with it. There is a lot of truth to this analysis for big product buyer companies, but not so for smaller companies.
Option Three can be the best choice, provided the buyer understands the enforcement issue. However, I find that most U.S. and European companies do not understand how Option Three results in long, complex contracts that are not in fact directly enforceable against the individual factories. It is this lack of understanding that concerns me when US or European entities choose Option Three.
Bottom Line: You generally have three options for contracting when dealing with a parent company in one country with subsidiary factory companies in multiple other countries. No option is perfect but you as the product buyer still must choose. Our goal as lawyers is to give you the information and advice you need so that your choice is made with a full understanding of the consequences and trade offs, as opposed to being based on an illusion of safety and enforceability.
The views, opinions and images in this article are purely the author’s own. Global Sources does not own responsibility for what is presented in the article.
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.