On the importance of aligning your overseas manufacturing contracts with your product sales contracts

I recently came across an email from a few of our international manufacturing lawyers to a new client who had asked us to review their “China contracts”.

This article emphasizes the need to ensure that your contracts with your foreign product manufacturers match your contracts with your product buyers. Below is an email (almost verbatim, but with the company names changed) in which we noted the great risks our client would face if he did not secure a new manufacturing contract with his Chinese manufacturer:

Your request was to have us review your manufacturing agreement for intellectual property issues. We provided you with our comments on these matters in the memorandum we sent to you yesterday. This email is to inform you of our concerns regarding basic business issues.

Your contracts put you in a very difficult position. You have contracted with (American Business Company) ABC to distribute your products worldwide, but you do not control the manufacture of your Product. Instead, you have your products manufactured by China Manufacturing Company (CMC) and CMC itself depends on layers of subcontractors and suppliers located in China.

Your great business risk arises from the inability to meet your obligation to ABC due to your relationship with CMC and its various relationships with its subcontractors and suppliers. It is therefore essential that you do something to ensure that your agreements with ABC and with CMC do not directly conflict and are as harmonious as possible. Absolute agreement is not normally possible, but there should be no big holes. An example of a big hole is where you are obligated to fill an order from ABC at a specific price, but CMC has the right to reject the corresponding purchase order from you.

Here are some examples of the problems that can arise if you do not respect both of your contracts:

a. ABC places an order with you which you must fulfill and you then submit the corresponding purchase order to CMC for the products to be supplied to ABC. CMC simply rejects the PO because it doesn’t have to fulfill it.

b. As above, but CMC rejects in violation of your contract manufacturing agreement with CMC.

vs. As above, but CMC does not deliver or delivers late due to failure of its Chinese subcontractors.

D. Your contract with ABC requires you to accept a fixed price for two years, but your contract with CMC is silent on prices. This means that CMC may within two years increase its prices to such an extent that you are literally losing money on every sale to ABC.

e. CMC consistently delivers late, short, or defective products.

The overarching issue here is that you need a contract manufacturing agreement with CMC that seeks to the extent possible to reduce or limit your risk/liability to AMC for any of the above.

In general, the terms of your contract manufacturing agreement with CMC should parallel the terms of your product sales/distribution agreement with ABC. At a minimum, this means that we should strive to accomplish the following with CMC:

a. CMC is obligatory to accept your purchase orders that are in your forecast.

b. CMC is required to lock in its prices for at least two years. There are other options here.

vs. CMC shall be subject to the same consequential damages for all breaches of its contract manufacturing agreement with you. This means product liability violation, defective product violation, late/short delivery, and refusal to accept a valid purchase order.

D. CMC should not be allowed to use a force majeure defense relating to anything happening in China regarding the operations of its Chinese contractors. CMC should be required to assume the full risk of what is happening in China.

None of the above is currently covered in your existing agreement with CMC and for the most part the ABC agreement and the CMC agreement are out of sync. Here are some examples of ABC contract issues that do not comply with the CMC Agreement:

a. Section 3.3 and Section 9.2 on liability for late delivery.

b. Section 9. Price is EXW, CA, but CMC price is FOB, China.

vs. Article 15: Your CMC contract prohibits subcontracting, but we know that there are at least two levels of subcontracting and probably more.

That said, the CMC agreement was intentionally designed by CMC to be inaccurate and to eliminate CMC’s liability as much as possible. Major revisions to this agreement could therefore be difficult. At a minimum, however, the following should be clarified:

a. What is CMC’s obligation to accept purchase orders? Usually, we expect the manufacturer to be obligated to accept the purchase order if it falls within a rolling average annual projection. What is often not covered is what happens if the buyer does not purchase or suspends purchases during the term.

b. What is your agreement with CMC on the price?

vs. What is CMC’s responsibility in case of late delivery of your products or short delivery?

D. What is CMC’s responsibility for defects? CMC wants to limit its liability to the issuance of a credit. This is bad for two reasons: first, it means you can only get the credit back if you make another purchase. Second, your credit is limited to the price of the defective merchandise and does not cover other losses. Other losses can be considerable in the event of defaults. If a recall is ordered, the dollars lost can be enormous.

All of the above must be stated in simple and direct language. The vague language of your existing contract manufacturing agreement with CMC is the opposite. Sounds okay, but if you really analyze it, most of them say nothing or are designed to troubleshoot CMC for just about anything. Frankly, this is typical of what we see when our customers accept the manufacturing agreement provided to them by their suppliers.

We will await your instructions on the next step(s) you would like us to take. Do not hesitate to call us to discuss.

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