An effective Chinese manufacturing agreement must address various issues out of which the most vital part is the one constituting terms for purchase of the manufactured item. Three things are critical to a business establishment, quantity, price and date of delivery. Since these are the key factors, these must be addressed right at the beginning of preparing a contract. A Chinese lawyer is required to draft a contract by clearing explaining these terms right at the beginning.
Incorporating these fundamental terms right at the onset can be done in 2 ways. The ways are:
- The manufacturing contract drawn for purchase of goods is a binding one for a particular quantity of product to be delivered within a stipulated time frame and a fixed price. The outstation purchaser has an obligation to purchase while the manufacturer is compelled to sell. Failure in any of these will be considered as a breach of agreement. A letter of credit is often attached to this kind of agreement.
- A contract stating the purchase of goods is formed only after the foreign purchaser submits the purchase order which is also accepted by the Chinese manufacturer for which the terms and conditions are laid earlier. This contract is however not formed when the foreign buyer does not provide a purchase order and the Chinese manufacturer does not have anything to accept it. In case there is no submission of order or there is a rejection of order these are not considered as breach of contract. This type of agreement comes without a letter of credit.
The first option is opted by the multinationals ordering large quantities of products from Chinese firms. It comes with 2 advantages:
- The risk of price fluctuation is absent because it is locked for a particular period. However, in case of any cost changes, both the parties bear it equally.
- The delivery date for product is fixed and hence the buyer can plan for any kind of seasonal variation. The only risk involved in this is that the buyer might get stuck with a full inventory of products.
The second option is more viable for start-ups or for companies launching new items with an undetermined sales market. It allows the foreign buyers to test the waters before launching the new produce in the new market. Moreover, the buyers do not face any loss regarding failure of products and being stuck with unsold inventory.
The basic disadvantage integral to this arrangement is that the Chinese factory can deny any business terms anytime because there is no documentation of contracts. In fact, this is a tool used by Chinese manufacturers to raise price by rejecting the purchase order. They also reject if they are unable to provide required quantity and also unable to meet the delivery deadline. The toughest part is that the buyer really does not have much choice apart from accepting the rejection from the Chinese counterpart.
In a nutshell the situation is not in favour of the foreign buyer because the Chinese company can negotiate any price for producing the products. It is also not possible to force them to deliver products on time. Just imagine the kind of trouble a start-up will land into with a single new product. A start-up receives sustainable orders after lot of effort and it requires fulfilling the deadline in terms of time and delivery. The start-up is obligated to perform because the US and EU buyers stress on binding contract.
Now, the real trouble begins when the start-up submits their purchase order and the Chinese manufacturer rejects it asking for a price hike. The start-up can be subjected to a lawsuit in its home land due to failure of on time delivery of products and it is considered as a breach of contract. It suffers from bad reputation and also from financial loss and can only recover if it has financial backing; sad news is that, these companies generally do not recover from this blow. They realize late that they were working under the illusion of a binding contract with the Chinese manufacturer come product supplier.
China lawyers receive calls all the time from EU or USA retailers who get trapped into this “no business terms”. However, there is no solution expect from being careful the next time. The ‘business terms’ issue must be addressed properly for every manufacturing contract because it is confined to this only but spreads to other issues as well. For instance, the Chinese manufacturer you are working with is supposed to provide a certain type of packaging along with the product. However, it decides at the last moment not to do it but the price is included in it. Under the second option, the manufacturer will reject the purchase order expecting to negotiate which means that the original condition was illusory because the manufacturer has no obligation to perform.
It is only after the tide has passed that you discover who has been swimming naked. This adage is true for companies from EU and US working with Chinese manufacturers. It is often late when business owners realize that their Chinese manufacturers have left them with no clothes. The moment you decide to work with Chinese manufacturers, you also need to decide which option will be applicable to the contract that incorporates those terms that legalize your decision. Otherwise operating under an illusion will lead you towards unpleasant consequences.