China Manufacturing Agreements: Make Liquidated Damages Your Friend

One of the hallmarks of a good China OEM Contract is that it provides for very specific penalties if the Chinese manufacturer fails to abide by its crucial terms. These penalties will typically be in the form of a liquidated damages provision, which Wikipedia defines as follows:

Liquidated damages (also referred to as liquidated and ascertained damages) are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach (e.g., late performance).

Chinese courts tend to view contractual liquidated damages provisions favorably and so long as they are not unreasonable, they will usually be enforced. Most importantly, Chinese courts will freeze Chinese company assets based on a liquidated damages provision and they will freeze these assets before trial. Chinese companies know and fear this.

Liquidated damages provisions make sense in many different types of contracts with Chinese companies and they make particular sense in the context of a product supplier relationship.

We most often put in liquidated damages provisions to “encourage” the Chinese supplier to comply with the following:

1.  Shipping Dates.
 If the product our client is having made in China is at all time sensitive, it is the practice of our China manufacturing lawyers to specify the delivery date and the penalty to the Chinese manufacturer for not meeting that date. We sometimes set the penalty at a flat dollar amount and at other times, we make it a percentage of the value of the order. We sometimes set out just one penalty and at other times, we have the penalty escalate as the lateness increases. The key is to make sure the provision is clear on the date (or dates) that trigger the penalty.

2. Quality Specifications.
We also often put in a liquidated damages provision for product that falls short on what was promised by the contract. These provisions make sense if what you receive can still be sold, but for less money. For example, if you are buying a food product that is industry-rated from A to D and you pay for an A product and you get a B product, you will be better off with a contract that states you get $1 for each level below A the product falls than having to prove your damages by showing how you could have made X dollars more with the A product than with the B you were provided.

We generally strive to make the penalties reasonable both because the Chinese courts are more likely to enforce such penalties and because the Chinese manufacturer is more likely to take them seriously as well. The thing to remember about contractual penalties is that the best ones need never be enforced because they were so effective in convincing the manufacturer to comply.