OEM Manufacturing Agreements in China
Needless to say, China has become the world’s leading manufacturing base. However, with the recent product safety scares and the constant media attention, “Made in China” has become a high-profile issue for consumers and retailers. So how does a foreign company minimize the risks of tainted/substandard products manufactured in China? In this article, we discuss contract terms which foreign companies should consider when entering into OEM relationships with Chinese suppliers. (While we highlight some of what we feel are the main issues to be covered by the agreement, we recognize that each case is unique and there is no such thing as a ‘typical’ OEM arrangement.)
Standard Form Agreements
An OEM may have a standard form agreement which they will be more than willing to provide to foreign companies who wish to use their services. While this may lower costs at the outset and allow the foreign company to ‘build favor’ with their Chinese counterpart, using such an agreement is almost never advisable, and foreign companies would be wise to consult counsel, who will assist the foreign company to properly negotiate and prepare agreements.Note that we often advise that the written agreement is preceded by preparation and negotiation on the basis of a business term sheet, which will outline the major terms of cooperation. The agreed points in the term sheet then serve as the basis for the written agreement.
Major Terms of Agreement
Below, we highlight several major (though non-exhaustive) terms which should be included in an OEM Agreement:
1. Products and Specifications: The products to be manufactured should be well-defined in the agreement, along with product specifications which should be described in detail in relevant appendix(es).
2. Forecasts and Binding Purchase/Supply Commitments: As OEM Agreements often require that firm orders are placed through Purchase Orders, in order to ensure that there is a binding supply/purchase commitment in the agreement itself, the parties will often designate a certain minimum commitment on both sides, to produce and purchase a certain amount of product within a given time period. Aside from the minimum requirement, the buyer will often provide a non-binding forecast to supplier, such that supplier can plan and allocate adequate resources (often 6-, 12-, 18-, 24- month terms).
3. Price: For those products designated as described previously, the parties should determine firm prices, which will either be effective throughout the term of the agreement, or at least a portion thereof, subject to (we recommend) maximum periodic price increases. Further, it is beneficial to include for discounts upon meeting certain pre-determined purchase volumes.
4. Quality Control: Buyer and supplier will agree on certain terms afforded to buyer/required of seller for conducting product quality control. Typical terms include i) access (often on short or no notice) to production sites, and ii) random testing of each batch of products before dispatch to buyer. Further, the parties may, depending on the value of the contract, provide for a representative of the buyer to be on-site on a full-time/regular basis, for the purposes of assisting in quality control. (The buyer’s representative may also monitor supplier’s use of intellectual property and other improper dealings, though their effectiveness will invariably depend on his/her loyalty to the buyer.)
5. Term: The parties will determine an appropriate term for their contract, and may make the agreement renewable on request by buyer. This term should be sufficiently long so as to ensure that buyer’s initial investment can be adequately recovered.
6. Termination: Termination events, as in most agreements, will include those events which give rise to immediate termination rights (for example, unauthorized use of buyer’s intellectual property and violation of non-compete terms), and those which require a notice period and the breaching party’s right to remedy the breach (failure to supply products meeting specifications).
7. Consequences of Termination: In the event of termination, it is important for buyer specify those procedures necessary to protect its rights in the event of such occurrence. Often terms will include: sale of completed products to buyer, allowance for completion of partially completed products and sale to buyer, destruction or return of confidential information, and destruction or return of trademarks, logos, brochures, and other advertising materials.
8. Examination and Acceptance: Upon delivery of the products to buyer, it will be afforded a certain period to conduct inspection, subject to deemed acceptance in the event that a claim is not made within a certain period. Further, it is common for suppliers to require that upon buyer’s acceptance of the products, they will be absolved of all further liabilities. Note that we do not recommend that buyers wholly accept such terms (and provide a minimum carve-out and continued warranty), as buyer, after acceptance, will have little grounds for a claim (even for the use of sub-standard materials which are often difficult to visually detect).
9. Raw Materials/Components: As part of the quality control process, buyer should require that supplier provide a list of its suppliers along with purchase orders over a pre-set period to ensure that the agreed upon raw materials/components are being used.
10. Insurance: Due to the relatively unsophisticated nature of manufacturers/insurance industry in China, factories are often severely under-insured from risks. As a result, it is advisable for buyer to require that supplier obtain a minimum level of insurance.
11. Intellectual Property: All intellectual property used to manufacture the product, including trademarks, patents, copyrights, and other business secrets should be licensed to supplier, for the limited purposes of complying with its obligations under the agreement. Further, buyer should carefully draft related terms so as to restrict supplier from exercising any rights of ownership to the licensed IP.
12. Non-compete: As an OEM relationship necessarily involves substantial transfer of intellectual property and confidential information, buyer must not only be careful to ensure that additional products are not produced by the supplier, but also by its affiliated companies and directors and management. (Note that the implications of failing to adequately provide for such terms may result in not only the product being sold in China but more importantly in the same markets as buyer, and at significantly lower costs.)
13. Arbitration: As manufacturing tends to be concentrated in lesser-developed regions in China in addition to cost/time/reliability benefits often associated with arbitration, we advise clients to select arbitration for dispute resolution. Arbitration can be conducted in China or internationally (in any New York Convention signatory state), though domestic arbitration allows buyer access to Chinese courts for injunctive relief.
Arguably more or at least equally important as negotiating and concluding a strong contract, is buyers careful monitoring and enforcement of the agreed terms.
Finally, although long-term relations are often desirable and we encourage buyers to find and work with a reliable supplier, as a practical matter, it is imperative that buyers have one or more alternatives, in the event of required termination of the primary OEM supply arrangement.