Overseas Product Manufacturing and the Importance of Knowing That Your Manufacturer is Actually Your Manufacturer

Our international manufacturing lawyers draft 5-15 NNN Agreements every month. It is usually the initial agreement we draft for our clients that are looking to do pretty much any  deal overseas. NNN Agreements are the lowest fee agreements we do and yet for every one we include a company search that does little more than prove out that the foreign company on the other side of the deal is actually a registered company and licensed to do what our client believes it can do. In other words, if our client is looking to reveal secrets to a company in the hope of having that company eventually build airplane parts for it and our quick research reveals that company is not licensed to make anything but socks, we immediately know there is a problem.  Ten years ago, these quick searches revealed problems slightly more than ten percent of the time. These days, that number is probably hovering at around five percent, but I am getting the sense that with all the turmoil in global trade, that number is on the rise. Five percent is not a lot, unless it is your multi-million dollar deal at stake.

I recently was cc’ed on an email from one of our China manufacturing lawyers that explained a problem we had discovered when tasked with drafting . a Manufacturing Contract with our client’s China “manufacturer.” The so-called China manufacturer was not a manufacturer at all, but rather a Hong Kong sourcing company.

The below email briefly explains the issue and the problems.

This is why we wanted to see the business license. This business license shows ___________ is an HK company not a PRC company. HK is a separate jurisdiction from the PRC. Contracting with an HK entity to make product in China is just like contracting with a U.S. company to make product in China and for all sorts of reasons it does not usually work well. The factory and all of the company’s assets and the production will all be in the PRC. A contract with the HK entity does not give you direct control over the factory and you do not really know what factory will be used. The contract can state that the HK entity is responsible for product safety and delivery dates and maintaining your trade secrets, but if the HK entity is just an office with a phone, no assets and a bank account that they sweep every day, then your real protection is very low. And this description of HK entities tied to China factories is usually the case.

We can draft a contract with this HK entity if you are willing to take these risks. This contract will be more like a typical sourcing agreement with a United States product sourcing company that ultimately manufactures product in the PRC than a China manufacturing agreement. But the risks with an HK company are going to be considerably higher than for a US company. The U.S. company says it makes parts all over the world and we will take responsibility and assume liability for whatever happens. In that setting, you have no direct contact with the actual factory that is making the parts; your only contact is with the U.S. seller. When the seller is a big U.S. company located down the road from you, you know you can sue that company in your local court so it is less of an issue than when it is a small assetless company in Hong Kong.

It will probably make sense for you to go back to ______ to see if they have a Chinese entity with which you can contract directly. If they do not, you should ask how they get their manufacturing work done in China. Often, this kind of company will refuse to answer questions about the PRC and they will refuse to allow you to have contact with the actual factory in China because they fear you will cut them out and go direct to the real factory. You should find out the situation before we start drafting something they will simply reject. For example, we do not want to draft a long inspection provision if you are not permitted access to the factory. Note that if you never have any plan to interact directly with the factory in China, all of this is acceptable, provided that you are comfortable taking the risk that all liability will be assumed by an HK entity that likely has only minimal assets.

I assume they will want you to pay to a Hong Kong account as this is normal for an HK company, but you should get this clear. Payment to a Hong . Kong account is further confirmation that you will have no protection at all in the PRC.

For more on the issue of using a middleperson for your overseas manufacturing, check out China Manufacturing: To Broker or not to Broker, That is the Question. 

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.