On Trusting China Manufacturers

China manufacturing: Trust but verify. Better yet, just verify.

One of the things I love about my law firm’s China practice is its diversity. We represent all sizes of businesses, from start-ups that never really start, to Fortune 50 companies that have been in China for more than twenty years. This sort of diversity holds true on the manufacturing side of our legal work as well.

I mention this because with the massive changes we have been seeing lately in outsourced manufacturing, the operational differences between our biggest clients and our smallest clients have been coming to the fore. This is happening because having a product made in China is far more complicated today than it was five years ago, for the following reasons:

1. The U.S. tariffs. This is having a deep and a wide impact. Any company that has products shipped to the United States from China has already been directly impacted by this or likely will be within the next few months. Any company that has products made in China is — at least to a certain extent — already impacted by this.

2. Chinese manufacturing companies are concerned about the US tariffs and that has led to a massive increase in Chinese companies walking off (early) with the IP they are shown by their foreign buyers and potential buyers because they are convinced their buyers are looking outside China to avoid the tariffs. Chinese manufacturing companies are concerned about foreign companies leaving them and switching their manufacturing to Vietnam or to Thailand or to Cambodia or to Mexico or to the Philippines or to wherever and we see this switching happening with our own clients and our own clients are telling us their Chinese factories are saying this is happening. Our law firm drafted more contracts for Vietnam, Thailand, Mexico, India, Taiwan, and the Philippines in the last six months than probably the previous three years.

3. Chinese manufacturing companies are concerned about US tariffs and that has led to a massive increase in Chinese companies taking foreign company money and then disappearing. We also keep hearing rumors of Chinese factories that will not be re-opening after the Chinese New Year. If this rumor holds for a Chinese factory you are using, you should do whatever you can not to allow that factory to tie up your money in the meantime.

So what does this all mean for your China manufacturing and why did I start this post by talking about how the difference between big and small foreign companies is coming to the fore?

Let me start by describing how most big companies handle their outsourced China manufacturing. The typical large company will send 1-3 of its own people to China to research and investigate and examine and test potential Chinese factories. If they don’t send 1-3 of its own people, they will hire a highly regarded China sourcing company (expert in their particular products) to do this researching and investigating and examining and testing for them. Once the big company has found its potential Chinese factories, it might have them compete against each other to see who can make the best widget. Before doing anything with anyone in China, however, this big company usually secures its China trademarks for its company name, its brand name, and its logos — at least whatever names and logos it will be putting on the products and packaging that will be made in China. China Trademarks: Register Yours BEFORE You Do ANYTHING Else. This big company also likely required each of its potential Chinese suppliers sign a China NNN Agreement before it revealed any trade secrets.

Then once the big company determines the Chinese factory (or factories) it will use to make its products, it makes that factory sign a comprehensive manufacturing agreement. This contract usually is enforceable in China and contains well-thought out contract damages/liquidated damages provisions and IP protections. In other words, the typical big company analyzes its various China risks and it registers its IP in China and drafts its contracts for China so as to reduce those risks.

Unfortunately, small companies often do not act similarly even though their risks are now sky-high because so many Chinese companies are at great risk of going under and their fear of going under is causing them to do things they were less likely to do when times were good.

In China Trademark Theft. It’s Baaaaaack in a Big Way, we explained how we were seeing a massive increase in quick-fire trademark thefts:

For years my law firm has probably averaged a call a week from someone who had lost their trademark to someone in China who had filed for it before the non-Chinese company did so. Then, starting maybe 5 or 6 years ago, the number of these calls declined. I have ascribed this decline to two things. First, foreign companies started getting wiser about the need to get their brands, their logos and their company names registered as trademarks in China. Second, and of equal importance, China instituted rules to try to stop Chinese manufacturers and trading companies from registering as trademarks the brand names and logos and company names of the foreign companies for whom they were manufacturing or sourcing products. To simplify a bit, your China agent could not hang on to a China trademark that you were using before you brought them on for your manufacturing or product sourcing. We went from one China trademark “theft” call a week to maybe one a month.

But starting about a year or so ago, our China trademark lawyers started getting a ton of China trademark theft calls and the number of those calls has been accelerating ever since. Why has the tide on trademark “theft” come in again? Two reasons. One, there is hardly a sole in China who does not know how to get around the prohibition on an agent registering the trademark that rightfully should go to the foreign company for whom it is acting as an agent. If your manufacturer in Shenzhen wants to secure “your” trademark in China it will not register it under its own name as it knows that cannot work. So instead of registering the trademark under its own Shenzhen company name, it will ask a cousin or a nephew in Xi’an to register it under its company name, making it nearly impossible for you to invalidate the trademark. Two, many Chinese factories are hurting right now and they desperately want to improve their profit margins. What better way to do so than to sell a product under a prestigious or well-known American or European brand name — or even just any brand name? See Your China Factory as your Toughest Competitor.

Similarly, in just the last 4-5 months, we have also seen a rise in situations where a foreign company (usually American or European or Australian) has paid its Chinese factory for its products yet never received anything, or received product of such bad quality as to indicate the factory did not even try. We are also seeing an increase in small companies getting victimized by the China bank switch scam. See China Scam Week, Part 3: The Switched Bank Account Scam. But with this twist: half the time we believe the factory itself is somehow participating in this scam because it believes it will soon be out of business and so it’s grabbing money however it can.

Why do all of these terrible things happen to small businesses that want nothing more than to have good product made in China? To at least some extent it is because they have let their guard down at the absolute worst time. These small companies have seen how good it can be to have products made in China and they are ignoring how bad it can be.

What should these small companies be doing that they can actually afford to do? What is the baseline of what these SMEs should be doing to protect themselves from China? SMEs should, at minimum, be doing the following:

1. Go to China and check out potential China factories and, if possible, bring someone along who you trust who is fluent in Chinese.

2. Register your company name and your brand name as a China trademark before you reveal either to anyone in China.

3. Make your potential China factories sign a well-crafted China-centric NNN Agreement before you reveal ANY secret.

4. If it makes economic sense to do so, have a well-crafted China-centric agreement that protects your molds and tooling and that specifies exactly what it is your factory will be making and exactly when it must deliver that. See Getting Good Product From China; Specificity is THE Key To Your OEM Agreement.

5. Check in from time to time with your China factory, if only just by phone. Talk with the factory owner. Ask him or her “how things are going.” Oftentimes they reveal their fears.

6. Read China’s Economic Slowdown and YOUR Business: The Times they are a Changin’.

7.  Be careful out there. And towards that end, please note that the US State Department raised the risk level on going to China, with the following explanation:

Exercise increased caution in China due to arbitrary enforcement of local laws as well as special restrictions on dual U.S.-Chinese nationals.

Chinese authorities have asserted broad authority to prohibit U.S. citizens from leaving China by using ‘exit bans,’ sometimes keeping U.S. citizens in China for years. China uses exit bans coercively:

  • to compel U.S. citizens to participate in Chinese government investigations,
  • to lure individuals back to China from abroad, and
  • to aid Chinese authorities in resolving civil disputes in favor of Chinese parties.

In most cases, U.S. citizens only become aware of the exit ban when they attempt to depart China, and there is no method to find out how long the ban may continue. U.S. citizens under exit bans have been harassed and threatened.

U.S. citizens may be detained without access to U.S. consular services or information about their alleged crime. U.S. citizens may be subjected to prolonged interrogations and extended detention for reasons related to “state security.” Security personnel may detain and/or deport U.S. citizens for sending private electronic messages critical of the Chinese government.

What are you seeing out there? How do you protect your company and yourself from China?