Proprietary Product Purchases

Purchasing proprietary products raises contracting issues not fully understood by many foreign buyers.

In the old days, the typical overseas product purchase was for something like a simple white t-shirt. This t-shirt would have a number of specifications: sizes, fabric material, fabric color, thread count, neck size, ornament, label placement and label content. For this sort of purchase, the foreign buyer typically provides the specifications and the overseas factory is required to manufacture this standard item to meet specifications. For this type of “fungible base product,” neither the factory nor the buyer have any ownership in the underlying product design. The product is standard and its specifications apply to all manufacturers of the product anywhere in the world. If the factory cannot meet the specifications, the foreign buyer is free to manufacture for itself or purchase from any other factory. Likewise, the factory is free to sell these t-shirts to any other buyer.

Many overseas factories have become more sophisticated. The extreme example of that sophistication is the situation where the product is a sophisticated item designed entirely by the manufacturer. In this case, there is no open-source, standard set of specifications for the product. The manufacturer owns the design and the specifications are set by the manufacturer, not the buyer. The buyer often chooses from a menu of specifications.

Though most foreign buyers treat purchasing this type of “manufacturer proprietary product” the same as purchasing a fungible base product, the contract issues are quite different For example:

1. How will specifications be determined? What constitutes failing to meet specifications? For the manufacturer of a proprietary product, it is the manufacturer itself that sets the standards. So rather than providing that the manufacturer must make the product in accordance with industry standards or the specifications of the buyer, the contract must provide that the manufacturer warrants it will manufacture in accordance with its own specifications. This then requires the specifications be stated clearly in a way that provides an objective reference point.

2. The buyer often will require the product meet safety and quality and other regulatory standards established by the laws of countries in which the product will be sold. Since the factory controls the design, it must warrant that it is knowledgeable about applicable standards and its product will meet those standards.

3. How does the buyer know its factory actually owns the product design? How does the foreign buyer know the product does not violate the intellectual property rights of some other factory? Because the risk that the factory design violates the rights of a third party is not low, the buyer should do some basic due diligence to ascertain its risks of being sued for IP violations. As a contractual matter, the purchase contract should — at minimum — provide that the factory warrants its product does not infringe on the intellectual property rights of any third party. The contract should further provide that the factory is required to indemnify the foreign buyer from liability from any infringement claims made by third parties.

4. Since the Chinese manufacturer owns the product design, it has the right to sell the product to any buyer. If you as the buyer do not want an identical product to be sold to your direct competitors you will need some form of exclusivity. Your manufacturer will virtually always agree not to sell their proprietary product with your trademark and logo, but absent a specific agreement to the contrary, they can and will sell the product to any buyer who shows up at their door. The manufacturer typically will only agree to provide exclusive rights to a foreign buyer that agrees to pay a price for that exclusivity. That price will usually be written agreement by the buyer to purchase a certain minimum number of units at a certain price.

Bottom Line: The type of product you purchase determines the type of contract you should use.

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.