China Manufacturing Contracts: China Product Defect Tensions are Rising

We often write about the increasing sophistication of China contract manufacturing. Fifteen years ago, the typical US-China manufacturing agreement involved the sale of socks or rubber duckies. Today, the typical contract involves a complicated electronics device involving hardware and software and all sorts of intellectual property and much greater risk of defect and injury than a pair of socks.

With the increasing sophistication of China manufacturing and China manufacturing contracts has (not surprisingly) come increasing business and legal sophistication by Chinese manufacturing companies. Two to three years ago the overwhelming majority of manufacturing contracts my firm’s China manufacturing lawyers wrote were accepted either unchanged or with only minor changes by the Chinese side. Today, Chinese manufacturing companies better understand the legal impact of the contracts they sign and they are becoming increasingly reluctant to sign contracts that pin major potential liabilities on them.

Today’s post is about liability issues for defects, which issue our China manufacturing lawyers are dealing pretty much every day and which issue is truly on the front lines in terms of the contract “war” that has broken out between China manufacturers and their foreign company buyers. The below is an amalgamation of three recent emails we sent to companies looking to our China lawyers to reduce their product defect risks when buying from China.

I understand your concerns. Defect rates from China are too high.

For China, the issues surrounding product defects are usually the following

1. You need a Chinese language, Chinese law agreement you can enforce in China.

2. Contracts typically used in the West are usually too vague and flexible for China. For China, you need to be blunt and clear. Defect beyond some rate means a monetary penalty of some amount. If your contract is not clear on what constitutes a defect and the price your manufacturer must pay for the defects, it is not appropriate for China. Do you want just a repair/replace warranty, or do you want damages also to include the costs of dealing with the issue or do you want it to include all the above, plus claims from customers and consumers. If ALL the damage is included, the number can be big and if the Chinese side understands this (and they probably will), there is a good chance they will not agree to it, unless you have sufficient economic leverage over them such that they feel they have no choice. Even if they do agree to it, you need to be concerned about whether they have the money or the insurance to pay on any major problems.

3. One of the biggest issues for China is how to enforce your defect contract provisions. We typically propose something like the following:

Step One: Determine a sum certain amount owed based on a mechanical formula. Calculation is entirely in our client’s control with no good faith participation by the Chinese side.

Step Two: Report the amount owing to the Chinese supplier through a formal invoice. Do this on a regular basis, say every quarter.

Step Three: Collect the amount owing. The most common way to do this is to apply the amount owing as a credit against the invoice for the defective product, against current invoice amounts, and against future invoices.

Step Four: If step three does not cover the amount, send an invoice for the remaining amount. If the invoice is not paid, file suit in China. If the lawsuit is based on a sum certain amount even the threat of the lawsuit can have some benefit.

You can see how the above can work well for what you are seeking to accomplish, but Chinese factories and Western buyers are in major battles now over defect issues. The Chinese manufacturers are concerned with agreeing to sell on a net 30 or net 60 or net 90 basis and then having the foreign side refuse to pay because of claimed defects. The Chinese is legitimately concerned with the foreign side using the defect issue to reduce payments actually owed. All of this is right now a hot topic within the Chinese export factory community so the odds are good that your China factories will be sensitive on these issues.

We should discuss the above and then formulate a strategy for dealing with your China manufacturers.

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.