International Manufacturing Contracts: Why Templates are a No-Go

Last week a relatively large company emailed me to ask what our law firm charges for “template Thailand and Vietnam Manufacturing Agreements.” A few hours later, I got the same request from a different company for Mexico. In response to these emails, I explained to both companies why we never do “template” manufacturing agreements anywhere in the world and why they should not want such an agreement. See China Contract Templates for $99 Each.

Then over the weekend, in cleaning up my emails, I came across one on which I had been cc’ed. This email was from one of our international manufacturing lawyers to a client. This lawyer was in the midst of working with a small company with a great product that is working quickly to get its product made in Thailand in time for the upcoming holiday season (a/k/a Christmas/Hanukah/Kwanza). This company — like so many — is running a bit late because it switched its manufacturing from China to avoid the tariffs. See Moving Your Manufacturing Out of China: The Initial Decisions and US-China Tariff Updates: What You Can (and Should NOT) do NOW.

I post the email below (stripped of any identifiers) because it so starkly illustrates why an off the shelf manufacturing cannot work and makes no sense, even in a rush situation.

If you will not have finalized your product specifications until after we can get your manufacturing contract executed, we can provide in the contract that those specifications will be “as later provided by Buyer.” You will need then to clearly identify your final specs that control the manufacturing process and the criteria for defects. The same holds true for the final production prototype. If that is not going to be complete until after your manufacturing agreement will  executed, we will need to write in that will be “as approved by Buyer prior to start of production.” Again, you will then need to be clear with your factory regarding what constitutes the final, approved production prototype.

It is not unusual for these matters to not be complete until the last minute. In fact, it is not unusual for these to change after production begins. The challenge for you is to keep track of what has been approved and what applies to the final product that will be manufactured. We will also need to keep clear with the factory that even though it will be participating in some or all of this process, your company owns everything and the factory will have no IP rights to anything.

For me, now that it is clear you will not be finished with these materials, I can begin drafting your Contract Manufacturing Agreement accordingly and we will do our best to complete our drafting and translation as soon as possible. In the interim, I suggest you work with the factory in Thailand to clarify your plan and to get confirmation that it has sufficient capacity to complete your order in your required timeframe.

Before we can begin drafting, we need to clarify/confirm terms. Please advise on the following. After you have answered all these questions, I will begin drafting the agreement. Once all the below items are clear, I can usually complete a draft in two to three days, so getting this stage done as soon as possible is key for completing the draft on an expedited basis.

1. Please provide a clear and complete description of the product you will purchase. You can do this with a simple one sentence description supported with an exhibit.

2. What agreement have you reached on price? Do you have a price quote we  include in the manufacturing agreement? If not, we can reference a separate price quote. What is the basis for the price? Note that FOB is meaningless for international shipments by sea. Free Carrier (FCA) is the proper term. It appears you will be shipping intermodal. Most intermodal carriers suggest FCA as the correct term, but this does not answer the question of where the factory will be making delivery to the carrier. Will this be at the factory or the port? As we discussed, you should get clear on the procedure and the correct shipping term and provide me with the information

3. You indicated you have already paid for your “tooling.” Please describe and provide a copy of the PO or other documentation showing this. We provide for a detailed tooling and ownership procedure in our standard contract. If you want to make this shorter and less threatening, we can simplify the tooling provisions. This would make sense if the value of the tooling is low and easily replaceable.

4. Do you have a written QC program/procedure? If yes, please provide. If no, we will draft a general description.

5. How will you pay for packaging? Will this be included in the cost of the goods or will it be charged separately? Have you agreed on a packaging program with the factory? If yes, please describe who pays for what, who will deal with the printer, who designs what, who obtains what materials, and please lists out any timeframes. Have you paid any deposit or other security or will you pay either of those? I assume you will own the copyright to the design of the packaging. Are there other concerns you have?

6. Your product is a custom product. You own the entire IP and the factory is prohibited from manufacturing for itself or for any other customer. Correct? For confidential information, we will provide that your existing NNN agreement controls. Confidential information will be limited to what is required in additional to the NNN if anything. I would urge you to read this article on NNN Agreements as it will give you a better idea on what and how they protect your IP. This article is on China NNN Agreements, but virtually everything is the same for Thailand.

7. What will be the term of your Contract Manufacturing Agreement? Since you are not required to submit an order, I recommend a three year term with automatic renewal thereafter for one year renewal terms unless either party gives advance notice in writing of its intent to terminate the contract. This does not put any obligation on you but it requires the factory to cooperate with you for three years.

8. Your pricing will be locked for one year. After one year, prices may be raised or lowered on an annual basis based solely on a) changes in costs, up or down and/or b) changes in the exchange rate. The adjusted price will then be applicable for another year. At the end of the three year initial term, if the parties cannot agree on price, the agreement will terminate.

9. To lock in the factory so it musts accept your reasonable purchase orders, you will provide a 12 month rolling estimate of purchases and you will update that on a quarterly basis. The factory will five days to reject this in writing and if it does not do so it will be deemed to have accepted. The factory then must accept any PO you submit within the projection in terms of quantity and delivery date so long as it is in accordance with the agreed price. You should complete a first estimate we can attach as an exhibit.

10. Your POs should provide an “anticipated” delivery date. If delivery is made more than two weeks after the anticipated delivery date, a 1% per day charge will be applied for up to 30 days. This amount will be treated as a credit and the purchase price payable from your initial payment on your next order will be reduced by the amount of the credit. After 30 days (now six weeks from anticipated delivery date), the factory will be deemed to have breached the contract and you will have the right to terminate. If you do not terminate, the 1% per day penalty will continue to apply.

11. For QC: you will do QC. Defective product will not be shipped; defective product will be destroyed. The preferred option is to require the factory replace all defective so as to avoid a short order. If this is not possible AND the defect rate is below 3%, then a short order is permitted but the amount payable is reduced. If the defect rate is above 3%, the factory is liable for all direct losses of buyer and the buyer has the right to terminate the order or the agreement. Note that we base this defect rate on what we have seen agreed to around the world with products similar to yours.

12. You are paying on 35/65 terms. When exactly is each payment due? 35% five days from acceptance of PO? Note if the manufacturing on your product does not begin until the factory has received your initial 35% payment this further delays work on your product. It is therefore important we get clear on this. When is the 65% payment due? “On completion” of your product? “On delivery” of the product to you or “on delivery” to the carrier.  “Shipment” is common and means nothing and leads to all sorts of problems. What documents will be provided to you in relation to that second payment? This can be quite complicated and we need to get this clear with the factory. If it is unclear, I will provide you with a general provision that you can clarify in your accepted PO.

13. After you receive your products in the United States you will have the right to inspect. For defects discovered on that inspection, the factory will be obligated to repair or replace or credit against your next order, at your discretion. The 3% “epidemic failure” rule still applies. Will the factory also be providing you with a product warranty? If yes, will that be for one year or two years or for some other period of time? What is the factory’s if there is a product recall due to its negligence. Full costs? Do full costs include consumer lawsuits and government mandated penalties. Due to the nature of your product, these are obviously important issues we need to discuss.

14. How will compliance with U.S. product safety laws be handled? Will you assume the factory knows all the rules? Will you be responsible for communicating the rules to the factory? What is the penalty if the factory fails to follow these rules? Direct costs or all costs, including consumer litigation and government penalty? Is there any product/safety certification that must be obtained for your product before it is allowed into the United States? Same questions for the EU. If yes, who is responsible?  We have done a lot of work with products very similar to yours and so if you need any help in figuring out any of these things, just let me know.

I look forward to hearing from you soon on the above.

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.