The Limited Value of Chinese Factory Indemnification
Navigating the differences between Western and Chinese legal systems is seldom an easy endeavor, but this is especially true for indemnification clauses. Though these clauses are robust and effective tools in Western countries with mature legal frameworks, their efficacy in China-based manufacturing agreements is considerably murkier. This post explains the issues with using indemnification clauses in Chinese manufacturing contracts, highlighting their limitations and suggesting alternative strategies for product buyer protection.
Western Lawyers Like Factory Indemnification Clauses
Indemnification clauses are contractual provisions where one party agrees to compensate the other for specific potential future losses or damages they might incur due to certain events or actions. They are quite common in manufacturing contracts, and usually require the manufacturer to indemnify the product buyer for damages the buyer might incur due to bad product or even for the late delivery of product.
American and European lawyers love indemnification provisions in product manufacturing agreements. They love them so much they often use them in China manufacturing contracts (OEM Agreements) even though they rarely work well there.
American and European lawyers will put in a provision stating that if a product defect leads to a recall or injures anyone, the Chinese manufacturing company must indemnify the American/European company for any fees/costs/damages incurred by the American/European company caused by the defective product/recall.
Why Indemnification Clauses Seldom Work for China
These sorts of provisions sound really good, but they usually aren’t.
If a Chinese manufacturing company breaches a contract in a way that damages the American/European buyer, the Chinese side is legally liable for the damages that flow directly from such a breach, including the damages set out in a typical manufacturer’s indemnity provision. It is therefore usually unnecessary to include indemnity provisions in contracts that will be enforced in China under Chinese law. For why it usually makes sense to have your manufacturing contract be enforced in China, check out China OEM Agreements: In Chinese and for a Flat Fee.
American/European companies are right to be concerned that if their Chinese manufacturer provides them with defective products they (the American/European companies) could incur damages in amounts much greater than the purchase price of their product. In that situation, a claim against the Chinese manufacturer for a refund of the product price, or repair or replacement of the products is not going to come close to covering the American/European company for the damages it incurs. This is very real risk in purchasing products from China.
The Problem with Chinese Court Enforcement
The problem though is that you cannot expect to get a Chinese court to find a Chinese company liable for such damages — certainly not to their full extent. Foreign judges generally — and Chinese judges in particular — think American courts are out of control with the damages they impose in product liability cases. So even when a Chinese manufacturer has clearly breached its contract (lead paint in children’s toys for example), Chinese courts and Chinese arbitrators typically will limit the damage award to nothing more than the direct costs: a refund, a repair or a replacement, plus maybe reimbursement of penalties imposed against the American/European company for something like a late delivery. Chinese courts and Chinese arbitrators almost never enter judgments or awards that will fully cover the losses an American/European company might suffer from product liability claims, whether made by consumers or by a government. This is true both with and without a contract with an indemnification provision.
Now before anyone thinks that the solution to this problem is to contractually require your Chinese manufacturer agree to resolving disputes in an American or European court, I have to mention that Chinese courts rarely enforce foreign court judgments — especially U.S. court judgments and judgments from European countries with which they do not have a judgment enforcement treaty.
Getting Your Own Insurance is Usually Your Best Protection
Usually, the best way to protect your company from product liability and product recall damages is by securing the right insurance, with the premium costs of this insurance viewed as part of the cost of you doing business with China. You can try to get your Chinese manufacturer to pay your insurance premiums, but in our experience few Chinese manufacturers will agree to this and those that do will either raise their product pricing or — even worse — lower their product quality to cover it. See China Manufacturing and Product Insurance.
The same holds true for mandating that your Chinese manufacturer secure its own product liability insurance, only worse. In this sort of situation, you will need to retain a lawyer to review the Chinese insurance policy that purports to provide your Chinese manufacturer with liability protection, and you will also need to make sure that it lists your company as a beneficiary to the policy. Then, if you do ever have a claim on the policy, you will need to work with or sue the Chinese insurance company to get it to pay for the damages your company incurred.
When looking at product coverage, you should, at minimum, do the following:
Coverage: Ensure your policy covers the specific risks associated with your product, be it potential consumer injury, property damage, or recall expenses.
Geographic Scope: Ensure the insurance is valid internationally and, in particular, in both China and your home country.
Claim Process: Familiarize yourself with the claim process. Some policies might have faster claim processes for international incidents or may have dedicated personnel to handle international cases.
Other Methods for Reducing Your China Product Risks
1. Performance Bonds/Escrow Services
These are a form of security provided by the Chinese manufacturer that can be claimed by the foreign company if certain contract conditions aren’t met, like quality standards or timely delivery. It’s easier to claim a bond for a clear contractual breach than it is to claim damages in Chinese courts. You might also consider using an escrow service where funds are held by a third party and are only released to the Chinese manufacturer once certain conditions, like product quality or delivery timelines, are met.
Unfortunately, it is the rare Chinese manufacturer that agrees to either of these.
2. Alternative Dispute Resolution (ADR)
Given the challenges with Chinese court enforcement of foreign judgments, it sometimes makes sense for your manufacturing agreement to provide for arbitration in a neutral jurisdiction as the primary means of resolving disputes. The problem with this is that there are usually more important reasons than indemnification for having your contract provide for disputes to be resolved in a China court — in particular, IP protection.
3. Choosing a Good Chinese Manufacturer
Choosing a good Chinese manufacturer and then building a strong relationship with that manufacturer is often the best way to prevent product quality and late delivery problems. See Overseas Manufacturing Due Diligence: A Guide for Avoiding Costly Mistakes for how to choose a good manufacturer.
Conclusion
In summary, indemnification clauses in Chinese manufacturing contracts provide only limited protection and foreign companies should not rely on these clauses as their sole remedy. Robust quality control protocols, insurance coverage, and working with reliable partners offer more tangible risk mitigation. Though including indemnities in contracts often makes sense, businesses must enter these agreements with realistic expectations. With sufficient planning, manufacturing in China can still achieve good protection against bad product and late deliveries.
