Emerging Contractual Issues With Modern Chinese Manufacturing

As the Chinese manufacturing industry becomes more sophisticated, its customers must reassess contracting practices to mitigate their risks.

Mnet 156390 Ap China Trade 0
Tod A. NorthmanTod A. Northman Michael T. AdelsheimMichael T. Adelsheim

Changes in the Chinese manufacturing industry have created numerous potential legal problems for the industry’s customers. As those customers have grown to rely on greater expertise from the Chinese manufacturers and sought ever-more complex products, the stakes of Chinese procurement have skyrocketed, as illustrated by a preliminary injunction entered by the Fuzhou Intermediate People’s Court in favor of Taiwan’s UMC against subsidiaries of chip maker Micron in a patent case, shutting down production and sales. Parties contracting for products made in China that are more complex than a simple widget should consider:

  • Intellectual Property and Manufacturing Rights – Intellectual property provisions that are standard in a Western-style contract are too broad to be enforceable by Chinese courts. Customers can achieve more practical protection from Chinese courts by clearly addressing manufacturing rights — such as ownership of development products (e.g., prototypes and molds), and location of manufacture — instead of relying on IP protections such as ownership of the design or utility. Wresting away manufacturing rights was UMC’s approach against Micron. Without such provisions, a customer may not have rights to tangible or intangible materials developed in the course of the relationship and would need the Chinese manufacturer’s permission to use the development products. Designating the location of manufacture will also protect against the use of subcontractors without customer’s permission.
  • Product Specifications – Failing to properly define a term in the contract or relying on now-absent industry standards for proprietary designs and methods opens the door for misunderstandings and disagreements. Chinese courts interpret contracts literally – a “chair” is any “chair” without reference to the context in which the parties negotiated. Similarly, if the parties rely on a general specification, such as one dealing with raw materials, customers should include a bill of materials that details specific components to be used in manufacturing to prevent the substitution of substandard materials. Additionally, the contract should incorporate clear, objective specifications and define the standards that will be applied to evaluate compliance. The manufacturer should warrant that the products will be manufactured in accordance with the contracted specifications.
  • Safety and Quality – The contract should require the manufacturer to warrant that the purchased product meets or exceeds specific safety, quality, and other regulatory standards established by the law of the countries where the good or assembly will be sold or used, and that the product is produced in humane work conditions. The contract should also provide for factory inspections to verify the desired manufacturing standards and catch problems at the onset before delivery of the goods. Ideally, this clause should also permit inspection of goods during production, before shipment, and upon arrival.
  • Contracting With the Right Party – Customers sometimes unwittingly contract with third-party sourcing companies that are not affiliated with the actual manufacturer. These third-party companies are often shell entities with few assets. Even if the contract is well drafted, a customer can be disappointed if a product defect arises, but the contracting party ends up being a shell company that doesn’t have sufficient financial resources to cover any identified liabilities.
  • Timeliness of Performance – The contract should address the means of shipment, risk of loss, and responsibility for compliance with import and export obligations. Liability and mode of transportation is often addressed through the incorporation of Incoterms. Customers should evaluate appropriate means to resolve disputes such as liquidated damages (which are favored in Chinese courts), termination rights, and payments for partial performance.
  • Competition and Exclusivity – If the manufacturer owns the design and/or manufacturing process, the manufacturer will have the right to sell the product to any buyer, including competitors. To address this risk, customers should negotiate an exclusive right of purchase. In exchange for exclusivity, Chinese manufacturers may insist on a minimum purchase requirement.
  • Dispute Resolution – Customers should evaluate strategically choice of law and jurisdiction to determine where the most damage could occur from the manufacturer’s breach. If the biggest risk relates to misappropriation of customer’s IP, where an injunction against a third party is most valuable, the best option may be to designate a U.S. court as the jurisdiction. If knock-off products are a threat, then Chinese law and jurisdiction may be the best choice. If the customer envisions the need to seek full performance or a remedy beyond monetary damages, such remedies should be through litigation in Chinese courts. UMC effectively used the Chinese court system against Micron.

Since designating a jurisdiction other than China may leave the contract unenforceable in China, a typical middle ground is to provide for arbitration outside of China. Even if the designated jurisdiction is a signatory to the New York Convention on the Enforcement of Arbitral Awards (such as the U.S.), China does not consistently enforce arbitration awards. Chinese courts are reticent to enforce an award if the Chinese party has not participated in the arbitration (e.g., in the case of a default judgment) or if the award is considered an affront to Chinese sovereignty. Specific performance sought through arbitration outside of China may also be challenged successfully, whereas Chinese judicial procedures allow for preliminary seizure of assets, liquidation damages, and attorney fees in some cases. As a result, frequently the best option for obtaining an enforceable judgment in China is to designate a Chinese court as the jurisdiction.

Likewise, designating the customer’s home country’s law as controlling of the agreement may not be enforced by Chinese courts and, even if the designation is enforced, Chinese courts frequently comingle Chinese legal principles with the designated law. (If enforcement is anticipated in a Chinese court, the original contract should be executed both in a language of the customer’s choosing, as well as in Chinese. Chinese courts will need a translator for any other language, which increases possibilities for misinterpretation.)

As the Chinese manufacturing industry becomes more sophisticated, its customers must reassess contracting practices to mitigate their risks. Without thoroughly evaluating and regularly assessing new existing provisions, customers may experience disappointment and have unexpected legal exposure.

Tod A. Northman is a Partner in the corporate group at Tucker Ellis LLP; Michael T. Adelsheim is Counsel in the IP Department at Tucker Ellis LLP; Kelsey Ewing is a Summer Associate, Intellectual Property at Tucker Ellis LLP.

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