China Manufacturing Contracts: Not So Simple

Last month I wrote about the three basic types of manufacturing agreements commonly used by foreign companies that get their manufacturing from China: Original Equipment Manufacturing (OEM), Contract Manufacturing (CM), and Original Development Manufacturing (ODM). But this apparent simplicity is deceiving because there are three ways this division breaks down in the real world of manufacturing. Our task in China is in dealing with this breakdown of the simple set of distinctions.

Let’s start with a quick review of the three main types of China manufacturing agreements:

• OEM (original equipment manufacturing): In an OEM arrangement, the factory owns the design.

• CM (contract manufacturing): In a CM arrangement, the foreign buyer owns the design.

• ODM (original development manufacturing): In an ODM arrangement, the party that does the development work owns the design. This is usually the Chinese factory.

In the practical world of outsourced manufacturing, these neat distinctions often get blurred. There are three essential ways this happens.

First, when starting out with a manufacturing agreement, our China lawyers always ask our clients which of the three types of manufacturing arrangements (listed above) will apply to their China manufacturing. Often, their answer is “all three.” That is, the client wants a single agreement covering all three types of manufacturing arrangements. Though it is possible to draft a contract that covers all three of these manufacturing relationships, the result is complex.

The problem with this type of complex manufacturing agreement is that it requires the client make a decision with every factory and with every product. The client must specify in each case which of the three categories apply. In working with a single factory, all three of the categories may apply to individual items purchased from that factory. In this kind of complex situation, the tendency is for both sides is to default to a single result. More often than not, that default choice is not appropriate. When the choice is not appropriate, the contract then fails to provide the foreign buyer with adequate protection.

Second, the three categories of manufacturing agreements themselves do not crisply mirror a more complex reality. In an OEM arrangement, the foreign buyer often requires changes to the Chinese factory’s standard product. Who then owns those changes? In a CM arrangement, the foreign buyer often requires the Chinese factory modify the design to make for more efficient production. Who owns the modified product? In ODM, the foreign buyer and the Chinese factory normally work closely together in developing the new design. When two design teams work together, who owns the resulting product?

The third and most interesting situation is when neither side of the transaction actually “owns” anything related to the product’s design. What many on both sides of these manufacturing projects often do not understand is that the ownership implies there is a formal property right. In the world of manufacturing, intellectual property is the applicable concept of property.

There are four basic forms of intellectual property: patent, trademark, copyright and trade secrecy and though there are differences in detail, both China and the United States follow this basic division. Though the parties throw around the term “intellectual property” in discussing the product being manufactured, it is often the case that no form of intellectual property covers the product being manufactured. There may be no patent rights because nobody ever applied for a patent or because applicable patents have expired. Though a trademark may exist, a product design can be copied with the trademark not used on the copied version. Copyright does not cover functional items. Trade secrets either never existed or have been abandoned through disclosure.

This means that the China attorneys at my firm often face a situation where both sides to the manufacturing transaction claim they “own” a design of a product or a manufacturing method when neither side actually does. When we do a careful investigation, we learn neither side owns any formal intellectual property rights in the product design, whether in the base design or in the design innovation. Both the Chinese factory and the foreign buyer are often surprised by this result. In terms of formal intellectual property protection, anyone is free to copy the product design. The factory is free to manufacture the design for others and the foreign buyer is free to have the design made by another factory.

So even though we start with a clear set of concepts, in the real world of China manufacturing, we usually find ourselves in what can be a confusing mess. How do we get out of this mess? With a contract or a series of contracts that set out clear solutions accepted by both sides of the transaction.

That is, both the foreign buyer and the Chinese factory must understand that there is NO default answer to any of the key issues concerning the right to manufacture. This is yet another reason why a simple purchase order approach virtually always fails when having products made in China. Purchase orders assume an underlying set of clear rules when there are in fact no clear rules. The parties have to make their own rules by using clear contracts that force them to face the issues and make and document their decisions on those issues.

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.