Foreign Sourcing of Production -- Part 2

Issues for consideration before sourcing production abroad including contract enforcement and risk of loss.

As indicated in the first part of this two-part article, American manufacturers have increasingly looked abroad for the manufacturing of goods to be distributed in the U.S. or for parts to be used in goods to be assembled in the United States, and the recent turmoil in international currency and financial markets is not likely to change the trend. In this article about foreign product sourcing, the issues addressed include contract enforcement, use of letters of credit, risk of loss and other matters.

Personal Jurisdiction

Even with a solid warranty from the foreign manufacturer, the enforcement issues are problematic. Hopefully, the incentives to operate as a reasonable business person and live up to one's obligations will take care of most problems. If legal proceedings become necessary, however, the Hague Convention can be useful in terms of foreign service of process and taking evidence abroad. Unfortunately, not all countries including some key countries like India are parties to the Convention. It therefore may be necessary to litigate in a foreign jurisdiction in order to obtain personal jurisdiction over the foreign manufacturer. Travel expenses and bias in favor of the foreign manufacturer are among the problems with litigating abroad. If possible, the contract should provide for an agent located in the U.S. to be appointed for service of process on the foreign company to facilitate proceeding in the American courts if litigation is required.

Arbitration

We would generally advise our clients to choose arbitration instead of litigation. Many international arbitration forums are available and arbitration may therefore be a preferred method of resolving disputes. The Convention on the Recognition and Enforcement of Foreign Arbitral Awards (also known as the New York Convention) is used by many parties to settle their disputes. Many foreign companies are not comfortable litigating in China, for instance, because of the unsophisticated legal system and the local protectionism. In addition to personal jurisdiction issues, enforcement of a foreign court order in the supplier's home jurisdiction is often times impractically impossible.

Very few suppliers have enforceable assets abroad and usually a foreign court order is not recognizable in the supplier's home jurisdiction. Our experience also tells us that few foreign manufacturers agree to arbitration in a western jurisdiction. When a Chinese company is involved, international arbitration in places such as Hong Kong or Singapore is more acceptable. Another popular choice for arbitration in China is the China International Economic and Trade Arbitration Commission ("CIETAC"). CIETAC is a well-established international arbitration tribunal with three branches in China covering major economic centers. One of the advantages of choosing CIETAC is higher efficiency in terms of injunctive reliefs and attachment of assets against the supplier in China. At the time of contracting, it may be advisable to see if the country in question has a similar institution in place to provide arbitration services.

Venue and Forum Clauses

If the contract does not provide for binding arbitration, although it may not solve all of these problems relating to enforcing a judgment against a vendor with no assets in the U.S., the American company would be well advised to obtain the vendor's agreement that all actions will be filed and decided in a U.S. Court.

Judgments

Obtaining personal jurisdiction is only the first step in the process of a legal proceeding. The Hague Convention does not deal with judgments or provide a mechanism for enforcement. Enforcement of an American judgment abroad will depend upon the laws of the foreign country. Before entering into a transaction with a foreign entity, the American company should determine whether the foreign manufacturer has assets in the U.S. which could be attached. If the foreign company has no assets in the U.S. to attach, it will be necessary to enforce the judgment abroad.

Contacting local counsel in advance of the initiation of the proceedings in the foreign country is essential to determine what standards must be met to create an enforceable judgment which can then be transferred to the other nation. In some cases, the fact that the supplier does not have assets in the U.S. or that there is a difficulty in enforcing or obtaining judgments in the foreign country against its own residents may be reasons to reconsider outsourcing to the foreign country. In our experience, most American companies are willing to take this risk. Again, an agreement to arbitrate may ameliorate some of the risk.

Twist with Domestic Importers

The involvement of American importers acting on behalf of the foreign manufacturers raises special issues. The foreign manufacturer may have granted exclusive import rights to the importer in question. Questions arise as to how the funds will flow. In such cases, the supply contract may be between the American manufacturer/distributor and the domestic importer. As in foreign transactions, letters of credit are often a useful device. In particular, where there is an intervening American importer involved, a transferable letter of credit may be a good solution. With a transferable LC, the importer feels secure about getting paid but does not have to divulge to the American distributor the extent of its mark-up over the price charged by the foreign manufacturer. After collecting its mark-up, the importer can assign the letter of credit in part to the foreign manufacture to assure payment to the foreign firm. The following is a sample clause for use of a letter of credit to pay for goods shipped from abroad:

All payments owing to either party under this Agreement shall be made by check or federal funds wire transfer in United States Dollars. Prior to the beginning of each calendar quarter, Domestco will furnish Importco with an irrevocable, transferable documentary letter of credit from American Bank in the form attached hereto as Exhibit A ("Letter of Credit"), which may be amended from quarter to quarter in accordance with its terms, in favor of Importco in an amount equal to the Purchase Price of the estimated volume of Products to be purchased by Domestco for the ensuing quarter, the payment of drafts drawn under such Letter of Credit to be conditioned upon, among other things, the presentation of the following documents: (i) a full set of multimodal transport bills of lading consigned to the order of the shipper, endorsed in blank, marked freight prepaid and marked to require the notification of Importco and Domestco ("Bill of Lading") and (ii) a marine cargo insurance policy or certificate of insurance in negotiable form for at least 100% of the CIP commercial invoice value, endorsed in blank and covering the following risks: all risks from warehouse to warehouse (including riots and civil commotions), war risks and strikes. Importco and Domestco shall be listed as assureds therein. All payments made for Products hereunder shall consist of draws upon the Letter of Credit.

Foreign Tax Issues

The tax rules in the foreign jurisdiction may impact the price a foreign exporter is willing to accept for its product. The agreement usually provides that the parties will be responsible for their own taxes and fees payable under applicable laws and regulations.& However, in some cases, the change of tax law in a foreign jurisdiction may have an impact on the outsourcing contract between a foreign supplier and a U.S. company. For instance, exporters in China can obtain a tax rebate from the Chinese tax authority for their export products. In the last few years, the Chinese tax authority has greatly reduced the tax rebate rate for Chinese exporters, and for some industries, the tax rebate has been completely withdrawn. This in general will increase the cost of the Chinese exporters and many of them have requested a re-negotiation for the price of their products. To be in a better negotiating position, the U.S. manufacturers should assess the actual impact of the lower tax rebate rate on the actual cost of the Chinese manufacturers. Some exporters who request re-negotiation of price may not be qualified for a tax rebate at all as the Chinese export tax rebate system has many qualifications on the exporter.

Risks of Loss

It is important to make sure that risks of loss issues are adequately covered. The key here is to make sure the proper insurance is in place particularly if the goods are deemed delivered at the point of the foreign source, rather than at the American manufacturer's plant. This can be covered in the letter of credit provision discussed above.

Competition

The contract should also set forth any restrictions on the foreign manufacturer's ability to produce similar goods for others even if the design belongs to the American company. Depending on the American company's leverage, it may not be possible to prohibit the foreign manufacturer from making similar products altogether; however, the American manufacturer should at least obtain an agreement not to use the tooling developed for the American manufacturer's product. Provisions should be made for return of the tooling to the American manufacturer in any event at the termination of the Agreement if the tooling has been paid for.

Handling of Goods

Other issues which need to be addressed include who will arrange for shipping and procurement of insurance, and how the expenses of processing goods through customs will be allocated. If the goods will be stored in a location not owned by the American manufacturer, the American company should make sure that the warehouse is properly bonded.

Governing Law

If both countries are signatories to the Convention on the International Sale of Goods (CISG), the Convention will apply unless the parties expressly opt out. Whether or not to opt out requires careful consideration. If the parties decide to opt out of CISG, if possible, the contract should provide that the law of one of the 50 states will govern interpretation and enforcement of the contract. The governing law problem should be considered in conjunction with the dispute resolution mechanism as discussed above.

Conclusion

Although there are many other issues which may arise in connection with negotiating a contract with a foreign manufacturer for importing goods for distribution in the United States, the foregoing summary highlights some of the major business issues which need to be addressed and carefully considered before embarking on such a venture.

John Washburn is a partner with the Chicago law firm of Gould & Ratner LLP. www.gouldratner.com Steven Huang is a senior partner in Jade & Fountain's Shanghai office. http://www.jadefountain.com

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