Our China lawyers have in the last six or so months been getting more than the usual number of manufacturing contracts that involve U.S. based sourcing companies, oftentimes one in a close (ownership connected?) relationship with the China factory(ies) at which the product or products are going to be made. Figuring out the appropriate party(ies) with whom to contract can be quite complicated in these situations, as can the drafting of the contract(s) as well.
The below is an amalgamation of some recent emails we have sent to clients that are working through an American sourcing company with close ties to the China factory. I am running this because it should prove helpful to other companies in similar situations.
Please advise on the below for your relationship with US Sourcing Company A. Keep in mind that US Sourcing Company A is a U.S. company that will be working with Chinese subcontractors. So you must permit a first layer of subcontracting to factories in China. We can call that first layer the Primary China Contractor.
You should require US Sourcing Company A to provide you with the following:
1. The identity of each Primary China Contractor.
2. You will have essentially the following two choices regarding the appointment of the Primary China Contractor:
a. You will have the right (but not the obligation) to inspect the factory of the Primary China Contractor factory and to approve the Primary China Contractor business and its factory chosen by US Sourcing Company A. US Sourcing Company A must also first provide you with notice of any change in Primary China Contractor and this same procedure will apply to that change as well.
b. No Primary China Contractor can be used until you first approve it in writing. If the Primary China Contractor will change its factory location(s), American Sourcing Company A must give you prior notice of this and you must approve this in writing as well.
3. You will have access to the factory(s) of the Primary China Contractor at all times.
4. US Sourcing Company A must provide the NNN Agreement we drafted for you and your company’s Code of Conduct to the Chinese Primary Contractor. No work will begin until after the Primary China Contractor has returned to you a) an executed version of the NNN and b) a written and signed acknowledgement it has received and will comply with your company’s Code of Conduct. We will revise your NNN to apply in this situation and we will also draft a short acknowledgement for the Code of Conduct.
After deciding on the basic policy towards the Primary China Contractor, we must together consider the issue of how to deal with subcontracting done by the Primary China Contractor.
It is common for the Primary China Contractor to further subcontract out part or even all of the manufacturing process. Will you allow such sub-contracting or not? This is a complex issue:
Though this kind of subcontracting is common (and especially so in your industry) this process greatly increases your intellectual property risks. If the subcontracting process gets too extreme, no one really knows who is doing what. I have worked in situations where there were five layers: U.S. sourcing company and Primary China Contractor with three layers of subcontractors under the Primary China Contractor. It was a mess when things went wrong with quality and with control of IP because everyone pointed to everyone else as the source of the problem. On the other hand, without the extensive subcontracting, no product at all would have been produced for this client.
In theory, we will want the subcontractors to abide by your NNN Agreement and your company’s Code of Conduct. You may inspect the Primary China Contractor factory and find all is in compliance. But, if you allow for subcontracting below the Primary China Contractor, the Primary China Contractor may then subcontract work to a different factory(s) that is not compliant in any way. But, if you require the NNN and Code of Conduct from EACH subcontractor below the China Primary Contractor, you could end up with 30 or more executed agreements and the costs to go with that.
You need to decide how to deal with the issue of subcontracting by the primary Chinese contractor. Your options are as follows:
1. The Primary China Contractor is not permitted to subcontract. At all.
2. The Primary China Contractor is permitted to subcontract. The subcontractors are not required to execute the NNN Agreement or your Code of Conduct. The Primary China Contractor and the US Sourcing Company A are liable for violations by the subcontractors.
3. The Primary China Contractor may subcontract, but only on the same terms under which US Sourcing Company A is permitted to subcontract.
In theory, Option 3 provides you with the most protection. However, as discussed above, the logistics of Option 3 can be very difficult. In addition, many Chinese subcontractors will refuse to execute an NNN Agreement (or any other agreement) with a U.S. company with which it has no direct purchase/sale relationship. For this reason, most U.S. companies (especially those without a massive amount of purchasing leverage) usually settle on either Option 1 or Option 2.
Please consider the above and provide me with your initial choices on how to proceed or let’s talk some more about your various choices. You may wish to discuss the above issues with US Sourcing Company A as well. If US Sourcing Company A will not allow its Primary China Contractor to subcontract, the China subcontracting issue disappears for this particular contract. However, this issue likely will come up in the future, so we should consider your basic company policy on the issue.This article was written by Dan Harris and published on China Law Blog. Original Post: http://www.chinalawblog.com/2017/10/china-manufacturing-and-subcontracting-its-complicated.html