International Manufacturing: Sourcing Agent or Not?

Many companies engaged in international manufacturing outsource their products from overseas by using a sourcing agent. Tomes have been written about the pros and cons of using a sourcing agent versus dealing directly with the foreign manufacturer and I have no intention of rehashing all that here. My relatively succinct and simple and mostly unhelpful view on the issue of sourcing agents is as follows:

About 45 percent of all sourcing agents are corrupt. About 45 percent of all sourcing agents are incompetent/worthless. About 10 percent of all sourcing agents are invaluable.

I cannot tell you how many times a client has retained one of our international manufacturing lawyers to assist in making the switch from using a sourcing agent to going direct with a brand new and far cheaper factory only to have the old factory tell our client it can now reduce its prices by 30-40 percent because it will no longer need to kickback 30 to 40 percent to the sourcing agent. When we tell the client this, it usually responds by saying that the sourcing agent was supposed to be getting 5 percent.

I also cannot tell you how many times a client or a potential client has given us some completely invalid reason as to why their sourcing agent is “different from the rest.” We commonly hear that such and such sourcing agent must be good and honest because it is being used by some competitor or because it has an office in the United States or in their home country. If only it were that clear-cut. As near as I can tell, there is little to no correlation between a sourcing agent having an office outside China and its quality. I will, though, say that I know of many good sourcing agents with no U.S. office and that if the U.S. office really has people in it, the odds of it being a scam are less.

One of the legal issues we often must resolve is whether our client who is using a sourcing agent would be better off contracting with that sourcing agent for the manufacturing of its product, or contracting directly with the factory, while still paying the sourcing agent for its services. One of our manufacturing lawyers recently explained to a client some of the things the client should consider in determining whether to contract with its sourcing agent or to contract directly with its overseas manufacturer, as per the below, with any identifiers stripped off:

You raise the usual and standard issues related to this kind of contract. To start, it makes no sense to have essentially the same contract with two parties. You must choose with whom you are going to contract. Will it be your sourcing agent or will it be the factory? You should contract with the entity that will issue the invoice for the product and in this case (unless we change things) that is your sourcing agent. But if you contract with your sourcing agent, you can and you should also have a contract with the factory that deals with issues like ownership of intellectual property, ownership and control of the materials, non-circumvention and non-compete and similar. However, many factories are not willing to enter into that kind of contract if they are not the direct seller of the product.

The old way was to enter a contract with the sourcing agent, loading all liability on them. Since Sourcing Company X is a U.S. company, operating in this way is pretty much like making a purchase from any U.S. company that outsources its manufacturing around the world. The question is: can Sourcing Company X perform? Does it have the resources to do the work and the asset base to deal with any problems?

As you have figured out, there can be many problems with the “old way.” If you are purchasing from a huge company like Apple, you don’t really care about who their ultimate suppliers are because you know Apple will do the work and you know Apple will stand behind the products and you know it has the resources to handle pretty much anything that can go wrong. For a small company like Sourcing Company X, the analysis is more difficult.

If there is a defect, can you rely on Sourcing Company X to fix things? If there is a late delivery or a short delivery, can you rely on Sourcing Company X to address this in a way that does not require your staff go to your overseas factory? Can Sourcing Company X ensure the materials are properly processed and securely stored and maintained in a situation where you have no direct contract with the overseas factory? What if the factory goes bankrupt: what happens to the materials then? Will Sourcing Company X remain liable in that situation?  Can Sourcing Company X ensure all payments will be made to the factory and to the suppliers of the factory? Can Sourcing Company X ensure the factory and its suppliers and the suppliers to its suppliers will not steal your IP or circumvent you by going directly to your customers? If circumvention happens, will Sourcing Company X aggressively take care of the issue and does it have the financial resources to cover for liability?

If the answer is yes in each case, then you should contract with Sourcing Company X. The more difficult situation is if you conclude Sourcing Company X may not be fully able to deal with these issues. In that situation, we have to consider whether you are better off with a contract with the factory overseas or better off with a contract with Sourcing Company X here in the U.S. and insured here as well.

We have to assess two issues: a) can Sourcing Company X really perform and b) if you contract with a single overseas factory, does that put you into a better position if something goes wrong. You will need to make this decision based on your own business judgment, since you are the one with direct contact with the players. We can help you with this by conducting due diligence checks on the two companies.

What do you do? Later this week we will talk about how using a sourcing agent can expose you to greater IP risk and what you can do to reduce those risks.