Authored by Dan Harris and Steve Dickinson of Harris Bricken China Law Blog discusses Chinese law & how it impacts business in China. Their aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.
The Western world — particularly the Anglo-Saxon/common law world — is used to ultra-long contracts for everything. A contract to buy $6,000 worth of rubber duckies will include all sorts of boilerplate provisions, making clear that by one party buying the rubber duckies from the other the two parties are not forming a partnership or a joint venture. The below is fairly typical for this sort of provision:
No Partnership. No Joint Venture. No Agency. Nothing contained in this contract nor anything involving the relationship between the two parties shall constitute a partnership between or joint venture by the parties or make any party the agent of the other. No party shall hold itself out contrary to the terms of this provision and no party shall become liable by any representation, act or omission of the other that is contrary to this provision. This Agreement is not for the benefit of any third party and shall not be deemed to give any right or remedy to any such party whether referred to in this contract or not.
The below are just some of the boilerplate provisions you typically will see in Western contracts, no matter how little may be at stake:
Representations and Warranties. Each of the Parties to this Agreement represents, warrants, and agrees as follows:
Each Party has been given the opportunity to seek legal advice from an attorney regarding the rights, obligations, and advisability of entering into this Agreement and regarding the rights, obligations, and advisability of executing the same. Each Party declares that it fully reviewed and understood this Agreement prior to signing it, knew and understood the contents of the same, and executed the same voluntarily.
Each Party to this Agreement has made such investigation of the facts pertaining to this Agreement and of all the matters pertaining thereto as it deems necessary.
Each Party acknowledges that no other person, and no attorney of any other person, has made any promise, representation or warranty whatsoever, expressed or implied, not contained herein, concerning the subject matter hereof, to induce the Parties to execute or authorize the execution of this Agreement, and acknowledges that it has not executed or authorized the execution of this Agreement in reliance upon any such promise, representation or warranty not contained herein. No Party relies on any statement of any other Party in executing this Agreement, except as expressly stated herein.
If either Party is a corporation, trust, partnership, or other entity, each individual executing this Agreement on behalf of such Party hereby represents and warrants that such Party has full right and authority to execute and deliver this Agreement and that each person signing on behalf of such Party is authorized to do so.
Then there is the provision to make sure the agreement applies to pretty much everyone possible:
This Agreement is binding on the Parties hereto and on their respective agents, attorneys, insurers, heirs, executors, administrators, affiliates, employees, members, shareholders, principals, officers, directors, predecessors, successors, and assigns.
And then there is the true boilerplate — that which goes into just about every contract:
Effective Date. This Agreement, once fully executed by all Parties, will be deemed effective as of the Effective Date, December 31, 2018.
Counterparts. This Agreement may be executed in counterparts. When each Party has signed and delivered at least one such counterpart, each counterpart shall be deemed an original, and when taken together with other signed counterparts, shall constitute one Agreement, which shall be binding upon and effective as to all Parties. Non-original signatures will have the same force and effect as an original.
Complete Agreement. This Agreement is the complete and entire agreement by and among the Parties with respect to the subject matter hereof and supersedes all prior and contemporaneous oral and written agreement(s), representation(s), negotiation(s), and/or discussion(s).
No Oral Modifications. This Agreement shall not be modified by any Party by any oral representation(s) made before or after the effective date of this Agreement. This Agreement may be amended or modified only by an agreement in writing signed by the affected Parties. Any amendment(s) or modification(s) must be in writing and signed by the Party or a duly authorized representative of the Party against whom such amendment(s) or modification(s) is/are sought to be enforced.
Good Faith Cooperation. The Parties agree, for their respective selves, agents, attorneys, members, shareholders, principals, officers, directors, insurers, heirs, relatives, representatives, affiliates, employees, attorneys, successors and assigns, that they will abide by the terms of this Agreement, which terms are meant to be contractual, and further agree that they will do such acts and prepare, execute, file, and/or deliver such documents as may be required to carry out the purposes and intent of this Agreement. Each Party hereto agrees to cooperate in good faith and to do all things necessary to effectuate this Agreement.
Headings and Titles. The headings or titles of the Sections contained herein are for guidance purposes only and have no force or effect, and they do not in any way alter the terms or meaning of this Agreement.
No Third Party Beneficiaries. This agreement does not create and shall not be construed as creating any rights enforceable by any person who is not a Party to this Agreement.
Severability. Should any provision in this Agreement be declared or determined to be illegal or invalid, the validity of the remaining parts, terms, or provisions shall not be affected thereby, and the illegal or invalid part, term, or provision shall be deemed not to be part of this Agreement, and all remaining provisions shall remain valid and enforceable.
Some or all of the above are not generally used outside common law countries like the United States (on a state level excluding Louisiana), Ireland, Northern Ireland, Australia, New Zealand, Bangladesh, India (excluding Goa), Pakistan, South Africa, Canada (excluding Quebec), and Hong Kong.
And yet, our international lawyers are often pushed by our clients from common law countries (even more often by their in-house lawyers) to include these provisions even in countries where they make no sense. These people/lawyers are simply uncomfortable with contracts that do not include such terms. When we tell them that such provisions are not needed, their response is often, “well, it can’t hurt.” But it can hurt.
Including terms in a contract that are strange and unfamiliar and unnecessary in a particular country can hurt in many ways. First off, it can increase the legal costs in drafting the contract. If we were to include all of the above terms in a contract we draft for, let’s say Vietnam, we would likely increase our billable hours on that contract by 1-10 hours. How?
Well, first off, we would need to figure out exactly what to say in each provision in English. Sure it is boilerplate but even boilerplate often needs to be adjusted for the particular situation. Also, some boilerplate makes sense in some contracts and not others. I pulled the above boilerplate from a U.S. settlement agreement my law firm drafted as between a Spanish company and an American company. That agreement contained boilerplate involving a foreign company and two ultra-long boilerplate provisions regarding the settlement of claims, neither of which would make sense in most contracts that did not involve a settlement and release.
Second, once we draft the boilerplate in English we would need to translate it into Vietnamese. That would add more time and fees for the client.
Third, and usually most importantly, if this contract gets sent to a Vietnamese company it may very well come back with all sorts of changes to the boilerplate provisions and all sorts of questions about it. Our lawyers would then need to draft responses to the Vietnamese company’s concerns, while at the same time, explaining to our client why the proposed changes from the other side do or do not make sense or should or should not be accepted.
Finally, once the new boilerplate terms have been agreed upon, we would need to re-draft them in both English and in Vietnamese, generating more time and more fees.
No suppose there is a contract dispute three years down the road and litigation ensues in Vietnam. The lawyers on that case will probably need to spend substantial time figuring out the meaning of the boilerplate provisions and then explaining them to the tribunal. I can remember well a case in Korea where I was called in to help Korean counsel understand a whole host of U.S. style contract provisions. I believe I billed about 20 hours on that alone.
But boilerplate provisions can hurt you — and deeply — in other ways too. Our international manufacturing lawyers are often given really long English language contracts by small companies that include a provision providing that the small company will conduct quarterly inspections of its overseas manufacturer and another provision calling for penalties to be paid for things like the overseas manufacturer failing to provide quarterly reports on x, y or z.
When our client then admits to never having once conducted a factory inspection or ever having received a quarterly report on x, y, or z and never once raising this failure as an issue with its foreign manufacturer, we recommend removing these provisions from their future contracts. Our client will often then say something to the effect of how these provisions come from the supply agreements used by the massive company at which they used to work and then they will mention their desire to keep these provisions in their contract because doing so “can’t hurt.” But it can.
If your contract requires your foreign counter-party to do six things and you completely let two of those things slide by without being done by your . foreign counter-party you are sending a message that you do not really care about what is in your contract. You are sending a message that you don’t really care about the other four things, even though you do. Or as one of our international lawyers often tells clients: “When an agreement contains this kind of provision that is not actually enforced, this weakens the entire agreement. The other side will believe that if you are not serious about this, you will not be serious about that either.” Not to mention all of the added legal fees and potential for confusion mentioned above.
We started this blog way back in 2006, and — needless to say — much has changed since then, including the attitudes our international lawyers have about China and things China. I have taken to quickly skimming old blog posts to see issues that have died, things that have changed, and issues we that need updating. I am starting with 2006 and it is in January, 2006, that I found what turned out to be a prescient post regarding incoming Chinese foreign direct investment (FDI). The post is entitled The Chinese are Coming — China FDI and it took the then almost revolutionary position that we should expect a massive increase in Chinese investment into the United States:
With the exception of the Wall Street Journal, the English language press is not giving enough coverage to China’s increasing liberalization of outbound foreign investment. Massive Chinese overseas investment is coming and those ready for it will profit.
For the last year or so, the Chinese government has been increasingly talking about ramping up outbound foreign investment. The government recognizes that few Chinese companies have the skills required to be true global players and that acquiring foreign assets and operating overseas will hasten the learning curve, just as it did for Japanese companies in the 80’s and Korean companies in the 90’s. It also makes for good world politics.
One of our Chinese clients heads the industry council of a mid-sized Chinese city. Around four months ago (just around the time the Chinese government increased the overseas investment limit) the government informed the council that its member companies should be investing overseas and that the government would match their investments. This past week, the Chinese government announced that sometime in 2006 it will end limits on foreign currency purchases by Chinese companies and do even more to encourage investment overseas. This will accelerate the buying binge among cash-rich Chinese companies looking to expand abroad. Many already are familiar with CNOOC’s failed bid earlier this year for Unocal and Lenovo’s purchase of IBM’s PC division, but there are smaller asset purchases and buy-out attempts going on all the time. Just this past week, Onyx Software Corporation, a publicly traded customer management software company in the Seattle suburb of Bellevue, Washington, turned down a buy-out offer from CDC, one of China’s leading enterprise software companies. The Yuan’s value will eventually increase, making foreign assets cheaper for Chinese companies and further accelerating their foreign investments.
Our sources in China tell us to be on the particular lookout for Chinese individuals looking for foreign real estate and Chinese companies looking to expand overseas in electronics, auto parts, software, and heating and air conditioning. Our law firm’s foreign investment lawyers are already seeing and getting some of this work.
In 2005, China foreign direct investment (this is Chinese companies investing outside China) totaled around $19 billion. In 2006, it more than doubled to nearly $42 billion. And in 2017, it was nearly $280 billion. But here is why this 2006 post/prediction seems so quaint now: Chinese foreign direct investment plunged to $180 billion in 2018 and it would not surprise me one bit if it falls below $100 billion in 2019.
I am also pretty certain that the numbers for North America and the EU are falling even faster and harder than for Africa and the Middle East and Latin America. All I know is what we see and what we are seeing in both the United States and in Spain (these are the countries outside China in which our law firm has offices) is that the number of potential incoming China deals is down and — perhaps most importantly — the number of deals that actually close are down even more. Far too often Chinese companies that want to do foreign deals are being blocked by the Chinese government from doing so. See China’s Economic Downturn AND the US-China Trade War AND their Impact on YOUR Company, where we talk about the increasing difficulty in getting money out of China.
Our China lawyers are constantly getting asked how China’s slowing economy and all that is going on between China and the United States will impact foreign business with China. We get asked this by clients, by reporters, and even by friends and those who ask us usually expect a simple answer, like “not well.” It is though more complicated than that. We have been seeing the following (some of which we predicted, some of which we did not):
The Chinese government — for the most part — seems to be bending over backwards to get foreign companies to set up WFOEs and Joint Ventures in China or to stay in China, at least for now. See The China-US Trade War. It’s All Good Inside China! China seems to recognize that its declining economy very much needs foreign capital.
The Chinese government has done nothing to stop foreign companies from registering their IP (trademarks, copyrights, patents, and licensing agreements) in China.
The Chinese government seems to be doing whatever it can to stop money from leaving China for investments in the United States, but this started even before the trade war. See Getting Money Out of China: NOT This Way.
Foreign companies that do any sort of deal with Chinese companies are facing more IP theft than ever. See below.
Foreign companies that are operating in China illegally are getting in trouble. Big trouble. See below.
Foreign companies that sell their products in China are getting worried, many of them just assuming they will face a steep downturn, but will they? See below.
Increased IP Theft. The big thing our China lawyers are seeing these days is an increase in Chinese companies sacrificing their relationships with foreign companies by stealing foreign company IP. We wrote about this previously in Your China Factory as your Toughest Competitor, but it is not just factories. Our China IP lawyers are seeing this in all industry sectors, especially technology. Why are China companies so willing to risk losing out on future business? When times are bad, greater risk becomes necessary to pay employee wages and to stay alive. We’ve become fond of pointing out that “since you will essentially be educating your Chinese counter-party in how to compete with you, you need contracts that will at least limit what they can do when they do so.”
Many China businesses have been hard hit by China’s slowing economy and by international businesses mover to lower wage and tariff-free countries in Southeast Asia. Many Chinese companies rightly believe they need to start competing with their foreign customers and partners just to survive.
Increased Legal Enforcement in China. In every China downturn for the last twenty years, the Chinese government has gone after foreign companies operating illegally there and this one has been no different. Why should the Chinese government allow illegal businesses to compete with their businesses without paying taxes, especially in a downturn? It shouldn’t and it doesn’t and going after illegally operating foreign businesses is a popular thing to do and it is exactly what the Chinese government has ultra-aggressively been doing for months now. In particular, China goes after foreign companies that are paying individuals in China without paying the required employer and employee taxes. This time around, however, this downturn’s round-up of illegally operating foreign businesses has stepped up a notch and the Chinese government has become quicker to arrest and imprison people on criminal charges. See Doing Business in China Without a WFOE: Will the Defendant Please Rise. If you have “independent contractors” in China, please, please, please do not go there until you change how you are doing business in China. See Doing Business in China with Deportation or Worse Hanging Over Your Head and Hiring A Chinese Employee Without A Chinese Entity. Good Luck With That.
What is always saddest about these crackdowns is that some businesses that thought they were operating legally are not, either because they misunderstood the laws or because someone lied to them about having done the required registrations and paid the required taxes. Now is the time for to make sure you are doing everything legally in China. Do you really have a WFOE or Joint Venture? See How’s Your China WFOE? Please Check. Does the scope of your China entity (your WFOE or Joint Venture) really include exactly what you are doing? See Forming a China WFOE: Scope is Key. Are you really paying all your taxes? China has gotten quite good at finding and punishing foreign companies that do not pay what they owe in taxes.
You would likely be shocked at how often foreign companies are deceived by their own people into believing that what they are doing in China is legal when it is not or that they have paid for something required when they have not. And then there are still those who operate illegally “because everyone does it.” See China Compliance: A Basic Checklist for the basics you should be checking in an effort to avoid China legal problems.
Selling Products to China. I have always found fascinating how macro economic issues (something like a country’s economic downturn) can have such widely varying micro economic impacts. By this I mean that when an economy starts tanking, the impact of this on individual businesses can be all over the map.
I first became starkly aware of this during the 1997 Asian Crisis, as I spent a large amount of time in Korea that year. A Korean newspaper did a story on the drop in imported goods coming into Korea. Now I do not remember the numbers very well, but I think imports had declined about 20%. But the really interesting part was how unevenly this fall in imports was among various products. The one that stands out for me is that some fruit (I am 99% sure it was either kumquats or quinces) had gone from $20 million in imports the year before to absolutely zero. Zero. The reason given for this was that it was a luxury item and luxuries were no longer in demand. Some staple food products (including some fruits) had seen virtually no decline.
I have a lawyer friend who represents a huge number of medical practices. He told me of a surgeon client of his whose practice had been decimated when insurance companies reduced their payments and stiffened their reviews. Again giving my best guess to the numbers, he said surgery rates had declined about 5% across the board in the country, but one surgeon client of his had seen his income go from something like $450,000 a year to around $50,000. There were various reasons this had happened, but obviously this particular surgeon contributed a lot more than most of the others to the overall 5% decline in surgeon payments.
I am also reminded of how pizza sales tend to increase or at least hold firm in recessions, while most restaurants see a decline in business.
I mention all this because I have seen very little written about how China’s decline has impacted businesses differently. Some of my firm’s clients are reporting either no downturn in their China sales or actual increases, while others have been hit hard. With the exception of companies that sell physical products, the hardest hit have been those that rely on Chinese companies sending large sums of money outside China. Go to Cramer: This earnings period revealed ‘brutal truths’ about US-China trade to see what investment guru Jim Cramer has to say about the varying impacts China’s downturn is having on publicly traded companies.
China’s new e-commerce law, which took effect January 1, 2019, threatens to upend the entire daigou business model. As we’ve written previously, daigou are individual shoppers who purchase goods overseas and then bring them back in their luggage for resale in China. Estimates of the value of goods brought into China this way each year ranges from about $6 billion to upwards of $100 billion.
The new e-commerce law requires anyone who sells products online to (1) register in China and in the country where they purchase goods and (2) pay all required taxes. If the law is strictly implemented and enforced, this would be the end of daigou, because the vast majority of daigou sales are online, and with few exceptions the daigou business model requires tax evasion.
Most of the articles about daigou refer to their wares as grey market goods. This is, at best, misleading. The term “grey market” suggests the existence of a legal loophole or ambiguity. But China’s rules on import tariffs, sales tax, and consumption taxes are quite clear: if you import goods into China, they are subject to tariffs. If you resell goods in China, they are subject to tax. If daigou paid the proper duties and taxes, they would have no business because they could not compete on price with legitimate importers. The major exception would be for goods that were difficult or impossible to buy directly in China.
China has attempted to crack down on illegal grey market importation through a number of means, including (1) higher taxes on goods brought in by travelers as part of their luggage, (2) lower taxes on goods imported through legitimate channels; and (3) increased penalties for those caught falsifying customs declarations.
Will this new attempt be more successful? Early indications are that it has teeth. Customs officials began cracking down on the import side last fall with enhanced inspections of luggage at airports. Rumors began flying on social media, and then, after LVMH informed investors of such inspections in a conference call last October, luxury goods companies’ stock prices slumped across the board, falling somewhere between 3 and 10 percent later that day.
How and when the e-commerce sites will implement the new law is yet to be seen. Many daigou are already migrating away from “classic” e-commerce and into social media or instant messaging, where they describe their products using code words. You would think this, plus the increased scrutiny at the border, would marginalize daigou as a viable sales option – if you make something difficult enough, only the true believers will remain. But I have learned not to be surprised by the ability of Chinese entrepreneurs (and consumers) to turn on a dime in response to changing market/regulatory conditions – to say nothing of their willingness to ignore tax laws.
It may be more difficult for luxury brands to adapt. I had previously posited that although manufacturers might not be concerned about relying on daigou sales, they should be.
It boggles the mind why any company – let alone a major luxury brand – would have a market entry plan dependent on third parties successfully committing tax evasion. See Grey Market Goods and China, Part Two. But that’s exactly what some brands did, and now they’re scrambling to put together a “real” China strategy. Just for the record, my firm’s China lawyers have always advised against relying on this strategy.
Meanwhile, the trade war lurks as subtext. Right now products brought in by daigou are unofficial in every sense. If they are reported and taxed, then China would reduce its trade imbalance by a significant amount AND increase tax revenues. Easier said than done, even in China. But the trend is clear.
With the Chinese economy slowing, concern has increased among Chinese policymakers about the outlook for employment, since ensuring a sufficient number of new jobs is seen as a necessary ingredient in maintaining social stability in the country. Employment was the top priority the Politburo set last July when it shifted its economic policy focus to stabilizing growth, leading the government to enact a series of policies to counter rising joblessness. This series will explore the employment challenges faced by different segments of the Chinese economy. The first installment examines the issues confronting small to medium-sized enterprises.
Chinese President Xi Jinping warned on January 21 that the Communist Party needed to pay particular attention to the risks to social stability from rising economic problems, as evidence increasingly suggests that the nation’s employment situation is deteriorating rapidly, particularly among small and medium-sized businesses.
The article goes on to talk about Chinese companies laying off workers but it does not talk about foreign companies doing the same, though of course they are as well, but perhaps more quietly. Our China lawyers are hearing from our clients with WFOEs in China that local government officials are stopping by essentially to make sure no layoffs are coming and if they are, that they are informed in advance.
Our China lawyers have been representing foreign companies in China for more than twenty years and that means we have gone through all sorts of economic and business cycles, including many downturns, though probably none as scary as this one. One of the things we have learned from past downturns is that China really really really does not want foreign companies to layoff or terminate employees during economic downturns and that alone should impact your layoff and termination decisions.
China is going through tough times right now and foreign companies that reduce employment will not be viewed kindly. Before you terminate any employee you should weigh the economic benefits of the termination against the possible detriment in your company’s local standing. If you must terminate any employee, by far the best (safest) way in these troubling times is via a mutual termination that includes a settlement. A private settlement is way less likely to be noticed by your local government and way less likely to cause major concern. For more on employee settlements, check out Terminating a China Employee: Why Mutual Termination is so Often the Key and China Employee Mutual Terminations: The Dos and the Don’ts.
Are you aware that nearly all of China’s major commercial centers allow you (or at least most of you) to visit visa-free for up to six days? Be honest, did you really know this? I ask because it seems like the China lawyers at my firm often have to explain this to our clients, including to those who go to China often and even to those with a China WFOE, Joint Venture, or Representative office. This 6-day visa free travel is relatively new (for most cities and provinces) and it has not gotten much publicity.
But since the start of this year you can enter into and stay in the following Chinese cities for 144 hours:
To do this you will need a valid passport from one of the following countries and transport tickets showing you will be leaving China (the PRC) within six days to a country (or is it just a city) different from the country from which you are entering China:
Because of this blog, our international lawyers get a fairly steady stream of legal questions from readers, mostly via emails but occasionally via blog comments or phone calls as well. If we were to conduct research on all the questions we get asked and then comprehensively answer them, we would become overwhelmed. So what we usually do is provide a quick general answer and, when it is easy to do so, a link or two to a blog post that provides some additional guidance. We figure we might as well post some of these on here as well. On Fridays, like today.
We are always preaching how if you are going to have your products manufactured overseas you should have the following:
But we are often asked by companies whether they need all of the above (or at least the first three) if they will only be buying X amount of product at a time or even over time. There are no hard and fast rules on this. We usually like a 10-15 minute phone calls to ask questions and then give answers. Will you be putting your brand name or your company name or your logo on your product? What about on its packaging? How much will you be paying for your initial order? Will you definitely be making future orders? For how much? What, if anything is unique about your product? In what countries will you be selling your product? Do you have any patents, trademarks or copyrights anywhere in the world? Where? What kind of patents? How terrible would it be for you if your product is sold by someone else before you can sell it? How terrible would it be if your product is sold by someone else but without your brand name or your logo? How easy would it be for someone who is not your manufacturer to duplicate your product? The answers to these questions allow us to give our advice.
Any general guidelines? Maybe the following:
If you are only going to be doing a one-time $10,000 or less purchase you probably do not need any of the four.
If you will be making a $10,000 purchase with plans to buy more if you do well selling your initial order, you can usually get away with just a trademark and maybe an NNN Agreement at the beginning, but maybe not.
We have seen too many start-up companies get shut down early for not protecting themselves early for us to tell anyone that not doing something will not put their future at risk.
This post outlines how creating a clear manufacturing agreement can alleviate the various legal issues inherent in manufacturing overseas. Before we discuss the key terms for your manufacturing contract, we will briefly address why it is so important to have such a contract at all, even in countries with weak legal systems. There are three reasons why it makes sense to have a contract with your manufacturer and only one of those reasons is enforceability in court:
Clarity. Having a well-written contract in the language of the manufacturing country will ensure that your manufacturer understands exactly what you want. For example, including a clause in your contract that fines the supplier for each day late will let your supplier know that you are serious about your manufacturing deadlines. At least half of the disputes we see between foreign manufacturers and their buyers from different countries stem more from cultural-linguistic misunderstandings as opposed to animus.
Prevention. A well-crafted manufacturing contract with well-crafted damages provisions will convince your manufacturer that it will be better off complying with your contract than violating it. If your contract has clear and strict written deadlines, your manufacturer will give your products priority over its buyers without clear and strict written deadlines when it is facing a production crunch.
Enforceability. Our law firm has written hundreds of manufacturing contracts and yet we have never been called to litigate any of them. This means that we cannot speak regarding enforcement of our own manufacturing contracts, but we can say that when our firm’s international litigators have sued or threatened to sue or arbitrated or threatened to arbitrate on well-written manufacturing contracts drafted by other law firms, we have seen the benefits of having a quality contract, even in countries notoriously bad at contract enforcement.
If your foreign manufacturer believes your manufacturing contract will be enforced it likely will act accordingly. Similarly, if your foreign manufacturer believes no court will enforce your manufacturing contract, it likely will act accordingly.
Most manufacturing contracts we draft involve one of three different types of manufacturing arrangements: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM), and Original Design Manufacturing (ODM). This post examines how these three different arrangements influence various legal issues inherent to overseas manufacturing.
Type 1: Original Equipment Manufacturing (OEM). In this arrangement, the foreign buyer purchases a product from a foreign country factory that is already being manufactured by that factory. The product buyer then “packages” this product with its own trademark and logo. The buyer and the factory may agree to certain cosmetic changes (color, shape, minor added features) that further customize the product for the buyer.
In this sort of OEM arrangement, intellectual property (IP) is usually clear: the buyer owns its branding (trademarks, logos and packaging) and the factory owns the product. Difficulty arises once the product is customized. Who owns the IP once the buyer has made changes to the product? An OEM agreement can provide clarity here. Usually, the buyer seeks to restrict the factory from using the customization in selling the base product to third parties.
Type 2: Contract Manufacturing (CM). In this arrangement, the foreign buyer has a fully developed product design. Traditionally, this design was of a product that had been manufactured by the buyer in its home country. More recently, the product is a new design being manufactured for the first time overseas. In a CM arrangement, ownership may seem simple: the foreign buyer owns all the IP, both in design and branding, and the factory owns nothing. In practice, however, the division is not always so clear. For example, your factory may change your product’s design and use those design changes to modify its own products it sells in direct competition with your products. Difficulties exist in every contract manufacturing project and they can be resolved with a clear, written agreement.
Type 3: Original Design Manufacturing (ODM). As outsourced factories are becoming more technically competent, foreign buyers have started entering into arrangements in which their overseas factory does some or all the design work for the product. There are many variations on this ODM approach. In its most fundamental form, the foreign buyer provides drawings and a specification sheet and the overseas factory does the rest of the work in consultation with the buyer.
Under this sort of arrangement, the obvious question is who owns the design of the product? Both the foreign buyer and its overseas factory will claim ownership of the design using conflicting arguments. The overseas factory will agree to make the product on an exclusive basis for the foreign buyer, but the foreign buyer does not have the right to have the product made by a third party factory. This position can come as a bad surprise to the foreign buyer, particularly when its overseas factory suddenly announces it will be doubling the price for manufacturing the product. These issues can get even more complex when the product incorporates or is based on technology clearly owned by the overseas factory. In this setting, the factory will often state that the buyer can go anywhere it wants to manufacture the buyer’s own portion of the product design, but no third party factory can make use of the factory’s proprietary technology in the manufacturing process. Consider this case for a foreign buyer who has spent considerable time and effort to develop a product design only to learn after a year that its overseas factory has decided to terminate the manufacturing agreement.
Once again, the only way to resolve these issues is to confront them in advance with a detailed written ODM agreement that sets out a resolution to these issues that is fair to both sides. There is no simple, legal default answer to any of these difficult issues. Or, rather, the legal default in most countries will favor the position of the overseas factory. Absent a clear agreement on how to proceed, the foreign buyer will lose pretty much every time.
Asia has become the main location for start-up companies with an innovative product concept but no manufacturing facility. The most common form of ODM for foreign start-ups in Asia is some form of co-development. Under the old model of co-development, IP ownership was clear: the foreign entity paid the fee and had 100% ownership of the product. The issue our manufacturing lawyers keep encountering is that the legal consciousness of the parties to these transactions is stuck in the old model of straight development for a fee. But the issues that arise under the new, co-development model are quite different from the former “straight” development model.
The basic issues to consider in an overseas co-development project are as follows:
Will your overseas factory do the development work at its own expense or will you pay for the development work?
What is the time schedule for the product development work?
What is the final price goal for the product?
What exactly are the “deliverables” and what is the process for determining whether the deliverables meet your goals?
Though these five issues are normally difficult to resolve, they are actually the easy part of the process. The more difficult issue is who owns what with respect to the intellectual property in the product. Determining that your overseas factory owns 50% and you own 50% may be relevant for allocating income from commercialization of the IP, but it does not tell you anything useful on the practical level of manufacturing the product.
A foreign buyer that wishes to move its production to a different factory can legally do so only if it owns 100% of the IP; if the overseas factory owns part of all of the IP, the foreign buyer cannot legally switch its production to a new factory without a license or permission from its overseas factory.
Overseas factories will usually take the following positions regarding IP:
The foreign buyer owns the exterior design (design patent) for the product. The customer owns its trademarks and logos.
The overseas factory owns the core intellectual property for the product.
The overseas factory agrees to manufacture the product for the foreign buyer on an exclusive basis. However, the overseas factory is free to continue using the core intellectual property in manufacturing for itself and in manufacturing products for other customers. This includes the overseas factory manufacturing products that will directly compete with the foreign buyer’s product. The only limitation on the overseas factory is that it cannot employ its IP to manufacture a product that uses the exterior design, trademark or logo of the foreign customer.
The foreign buyer cannot take have its product made by any other factory.
If your overseas factory takes the “you cannot go anywhere else” approach you will need to consider critical issues that arise at the production stage. Specifically, you will need to consider what will happen in the following common situations:
The overseas factory raises its price to an unacceptable level.
The overseas factory cannot meet your quantity or time of delivery requirements.
The quality of the product is not acceptable. There are consistently too many defects.
The overseas factory decides to stop manufacturing for you because it decides to manufacture a similar product for itself or for a larger company that generates larger or more consistent orders.
When these things happen, the remedy is to move to a different factory. Your ability to switch to a new overseas factory is what keeps your existing overseas factory “under control.” Now consider the situation where you cannot move your production to a different overseas factory. This puts you at the mercy of the factory and this is a situation you must avoid. For more on why it is so important to avoid this sort of situation, check out China and The Internet of Things and How to Destroy Your Own Company, where we talk about companies that have come to our law firm too late.
The international standard for dealing with the above intellectual property manufacturing issues is as follows:
The overseas factory must make your product for you for so long as you are interested in the product. If the factory chooses to stop making your product for you, it must provide you with a royalty free license to the technology necessary for you to be able to manufacture your product in a different factory. If the factory wants to avoid this result it must continue to manufacture your product for you.
The overseas factory is locked into a specific price for a specific period. Assuming a long term production arrangement there probably will be valid reasons for the factory raising or lowering the price. For example, exchange rate fluctuation can be a good reason to go in either direction on price. To provide for reasonable price changes, your contract should provide a mechanism for annual price adjustments. This mechanism can range from a simple index to a complex formula that accounts for multiple factors.
There are two primary mechanisms for dealing with the quantity/time issue. The first is to develop a production schedule that binds both parties. The second is to provide that if your factory is unable to meet your requirements it is contractually required to license production at an alternative location in the quantity necessary to meet the excess requirements.
Your manufacturing contract should provide for the situation where your overseas factory consistently violates your quality standards by giving you the right to terminate the manufacturing contract for breach. Your contract should state that if you terminate your manufacturing contract because of a breach by your overseas factory, your factory automatically licenses you to manufacture your product in a different factory. Some overseas factories will claim this rule allows you to claim breach simply to switch to a new factory. If this is a genuine concern, your agreement can provide for dispute resolution focused solely on this issue.
Though the above provisions are both fair and standard in international custom design and manufacturing, many overseas manufacturers refuse to discuss these matters or to accept a reasonable solution. The overseas factory knows its foreign buyer will be stuck and stuck is exactly where it wants its foreign buyer to be. Being stuck with a factory that behaves unreasonably is an unpleasant and usually very expensive experience. You should consider carefully whether you want to proceed in that kind of situation.
You need to get clear on these design and manufacturing and pricing and production and intellectual property issues from the start. This means you need an ODM agreement that sets forth how they will be resolved.
On February 4, 2019, The American Institute of Steel Construction, LLC (Petitioner) filed antidumping (AD) and countervailing duty (CVD) petitions against Fabricated Structural Steel (“FSS”) from Canada, China and Mexico. You can see that petition here.
Under U.S. trade laws, a domestic industry can petition the U.S. Department of Commerce (“DOC”) and U.S. International Trade Commission (“ITC”) to investigate whether the named subject imports are being sold to the United States at less than fair value (“dumping”) or benefit from unfair government subsidies. For AD/CVD duties to be imposed, the U.S. government must determine not only that dumping or subsidization is occurring, but also that the subject imports are causing “material injury” or “threat of material injury” to the domestic industry.
The proposed scope definition in the petition identifies the merchandise to be covered by this AD/CVD investigation as the following:
The merchandise covered by this investigation includes carbon and alloy (including stainless) steel products such as angles, columns, beams, girders, plates, flange shapes (including manufactured structural shapes utilizing welded plates as a substitute for rolled wide flange sections), channels, hollow structural section (HSS) shapes, base plates, plate-work components, and other steel products that have been fabricated for assembly or installation into a structure (fabricated structural steel). Fabrication includes, but is not limited to, cutting, drilling, welding, joining, bolting, bending, punching, pressure fitting, molding, adhesion, and other processes.
Fabricated structural steel products included in the scope of this investigation are products in which: (1) iron predominates, by weight, over each of the other contained elements; and (2) the carbon content is two percent or less by weight.
Fabricated structural steel is covered by the scope of the investigation regardless of whether it is painted, varnished, or coated with plastics or other metallic or non-metallic substances. Fabricated structural steel may be either assembled; disassembled, but containing characteristics or items, such as holes, fasteners, nuts, bolts, rivets, screws, tongue and grooves, hinges, or joints, so that the product(s) may be joined, attached, or assembled to one or more additional product(s); or partially assembled, such as into modules, modularized construction units, or sub-assemblies of fabricated structural steel.
Products under investigation include carbon and alloy steel products that have been fabricated for erection or assembly into structures, including but not limited to, buildings (commercial, office, institutional, and multi-family residential); industrial and utility projects; parking decks; arenas and convention centers; medical facilities; and ports, transportation and infrastructure facilities.
Subject merchandise includes fabricated structural steel that has been assembled or further processed in the subject country or a third country, including but not limited to painting, varnishing, trimming, cutting, drilling, welding, joining, bolting, punching, bending, beveling, riveting, galvanizing, coating, and/or slitting or any other processing that would not otherwise remove the merchandise from the scope of the investigation if performed in the country of manufacture of the fabricated structural steel.
Fabricated structural steel may be attached, joined, or assembled with non-steel components at the time of importation. The inclusion, attachment, joining, or assembly of non-steel components with fabricated structural steel does not remove the fabricated structural steel from the scope.
All products that meet the written physical description are within the scope of this investigation unless specifically excluded. Specifically excluded from the scope of this investigation is certain fabricated steel concrete reinforcing bar (“rebar”). Fabricated rebar is excluded from the scope only if (i) it is a unitary piece of fabricated rebar, not joined, welded, or otherwise connected with any other steel product or part; or (ii) it is joined, welded, or otherwise connected only to other rebar.
Also excluded from this scope is fabricated structural steel used for bridges and bridge sections. For the purpose of this scope, fabricated structural steel used for bridges and bridge sections is defined as fabricated structural steel that is used in bridges and bridge sections and that conforms to American Association of State and Highway and Transportation Officials (“AASHTO”) bridge construction requirements or any state or local derivatives of the AASHTO bridge construction requirements.
Also excluded from this scope are pre-engineered metal building systems. For the purposes of this scope, pre-engineered metal building systems are defined as complete metal buildings that integrate steel framing, roofing and walls to form one, pre-engineered building system and are designed and manufactured to Metal Building Manufacturers Association guide specifications. Pre-engineered metal building systems are typically limited in height to no more than 60 feet or two stories.
Also excluded from this scope are steel roof and floor decking systems designed and manufactured to Steel Deck Institute standards.
Also excluded from the scope are open web steel bar joists and joist girders that are designed and manufactured to Steel Joist Institute specifications.
The products subject to the investigation are currently classified in the Harmonized Tariff Schedule of the United States (HTSUS) under subheadings: 7308.90.9590, 7308.90.3000, and 7308.90.6000.
The products subject to the investigation may also enter under the following HTSUS subheadings: 7216.91.0010, 7216.91.0090, 7216.99.0010, 7216.99.0090, 7228.70.6000, 7301.10.0000, 7301.20.1000, 7301.20.5000, 7308.40.0000, 7308.90.9530, and 9406.90.0030.
The HTSUS subheadings above are provided for convenience and customs purposes only. The written description of the scope of the investigation is dispositive.
Alleged AD Margins
Petitioner estimated dumping margins of up to 31.46% for Canada, 218.85% for China, and 41.39% for Mexico.
Although Petitioner alleged numerous government subsidy programs that benefitted the Canadian, Chinese, and Mexican FSS industries, Petitioner did not allege specific subsidy rates.
It has been a tough year, what with the US-China trade war and all and with all that has been happening with China and Canada and China and the EU. Most of our law firm’s clients are looking at China in a new light and many have moved some or all of their business elsewhere. Relations between the people of China on the one hand and the people of the United States and Canada and the EU have to varying degrees become frayed.
But let us for at least just this week strive to move past all that and join in welcoming in the New Year. May this New Year bring all of you health and joy and success and peace. We wish all of you well.