Foreign Sourcing of Production

Feb. 5, 2009
Key issues for consideration before sourcing production abroad

Increasingly in recent years, American manufacturers have 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. There is nothing new about manufacturers outsourcing part or all of the manufacturing process, however, given the increasing tendency to outsource all or part of the manufacturing process, there are some twists and turns which American companies should be aware of when sourcing from foreign countries.

Although many of the points may be relevant even if the vendor or supplier is a domestic American company, for purposes of this article, it will be assumed that the ultimate seller is the American company and the vendor or supplier is a foreign company. To put things in perspective, we will point out how certain issues are often addressed in dealing with China.

Costs of Tooling, Duration of Agreement and Pricing There is usually a tension between the distributor and the vendor as to who bears the initial costs of product development. Product development requires collaboration on the design of the product and the cost of making dies and tools and other machinery to manufacture the part or product in question. The supplier does not wish to invest significant amounts in tooling without some guaranty of return on its investment. The supplier might think this would generally mean that a commitment of several years duration to purchase goods is essential if it is to bear the cost of tooling and otherwise gear up for production. The distributor however may not wish to tie itself to a particular manufacturer if for any reason the product does not sell well in its market. The parties will often agree upon some type of multi-year contract to guarantee that the endeavor is worthwhile for the foreign manufacturer, and agree to some kind of reimbursement of the tooling costs, often a sliding scale, if the agreement does not continue for a certain period of time. Alternatively, the distributor may simply advance all tooling costs at the beginning of the relationship.

If the parties agree to a multi-year contract pricing issues arise. Manufacturing costs are sensitive to material prices and labor rates. It is difficult to craft a formula which will govern the pricing changes from year to year. The parties are often left in the situation where the foreign manufacturer can propose a price change at the end of the year, but the American buyer can reject the price and terminate the contract, which in effect makes the agreement a short-term contract. Therefore, unless the distributor has advanced the tooling costs, some provision for reimbursement of the tooling costs may still be necessary. This issue can arise between domestic companies as well as with foreign manufacturers.

In any event, it is necessary to provide in the supply agreement that, if the American manufacturer pays for the tooling, the tools and fixtures are the property of the American manufacturer and the supplier has the obligation to return the tools and fixtures to the American manufacturer agreement upon termination.

Products Liability and Insurance The issue of products liability will be important, particularly in those instances where the foreign manufacturer will be producing the entire article to be distributed in the United States. The American distributor will want the risks of injuries to persons or property resulting from use of the product be borne by the foreign manufacturer (or its insurer). The American distributor will also want to be named as an additional insured on the manufacturer's policies. It will also request that the policy provide primary non-contributory coverage. Our experience has been that foreign carriers from jurisdictions where larger recoveries are a rarity may have broader exceptions to coverage than typical American policies.

Ideally, the foreign manufacturer will use an American insurance company for products liability. However, in some countries it may be difficult to shift the burden of obtaining such insurance to the foreign company. For example, in China it is rare for a manufacturer to purchase product liability insurance with foreign coverage and it is even more rare that such insurance is purchased from a foreign insurance company. Many small to medium sized Chinese manufacturers are very likely not to provide any product liability insurance. In such instances, the American company should take the insurance cost into consideration when negotiating price. Many Chinese manufacturers understand the product liability and its significance in countries like the U.S. However, they usually do not have the knowledge to choose and negotiate a proper and adequate insurance policy, in particular, if it is a foreign policy or with a foreign insurance company. They would rather have the foreign company purchase necessary insurance and lower the price accordingly if they believe the insurance cost is reasonable.

If the foreign company provides "claims made" coverage, it is important to require that the foreign manufacturer to maintain adequate "tail" coverage, which will continue coverage for a period of time after the termination of the relationship. Since claims could arise after termination of the relationship, the tail coverage can be critical, regardless of who buys the insurance.

If the foreign company obtains the insurance, there should be a provision for a certificate or evidence of insurance to be issued with a requirement of notice of any material change, cancellation of non-renewal to American company. The American company should have the policy reviewed by its own insurance broker.

Product Warranties While insurance can be used to insulate the American company from liability for personal injury, the warranty that will be delivered by the foreign manufacturer is the key element in terms of dealing with customer claims of defective product. Such claims are not covered by products liability insurance and the American company must look to the vendor's warranty for protection. Often times, the foreign manufacturer will be reluctant to give a warranty for problems resulting from a design defect because the design will have been developed by the American manufacturer either alone or in collaboration with the foreign manufacturer. This may be fair, but the foreign manufacturer should warrant workmanship and materials in any event. Of course, the longer the warranty the better, but at a minimum the warranty should last for a reasonable period of time after the product is sold at retail.

The American manufacturer may give its own warranty if the foreign goods are being incorporated into the final product. In that case, the American manufacturer may want to attempt to limit its liability by disclaiming any warranty as to parts manufactured by others.

Various warranty issues also need to be addressed. For example, who pays for shipping when products need to be returned to the American manufacturer or in some cases the foreign supplier for repair? We attempt to have the warranty cover the losses or potential losses of the buyer including extra cost of buying substitute products, repairing or replacement cost, return cost, cost for recall or disposal of the products, default liability to the customers of the buyer, anticipated loss of profits and expenses of pursuing the supplier. The supply agreement should also clarify that the vendor's liability for the warranty claims involving product delivered prior to the date of termination will not be affected by termination of the agreement.

The American manufacturer will want considerable discretion in dealing with its customers in resolving disputes. There is a tension here, however, and undoubtedly the parties will need to work together when problems arise. This underscores the need to perform thorough due diligence on the supplier to assure one is dealing with a company with a good track record and reputation in dealing with its customer's problems.

Currency Fluctuation Risk In order to avoid the risk of currency fluctuation, the American manufacturer will want payment to be made in U.S. dollars. This may or may not be agreeable to the foreign manufacturer, and if the transaction is large enough, hedging may be advisable if the purchase price is going to be denominated in a foreign currency.

Trade Names Often the agreement will provide that the foreign manufacturer will apply the name and logo of the American company to the product. The contract should specify that the rights of the foreign manufacturer to use the name and logo are strictly limited for that purpose and may not be used in production or sale of any other goods. It is also important to register the trademark in the home jurisdiction of the supplier.

Intellectual Property Issues; Indemnity and Exclusivity To the extent that the intellectual property is owned by the foreign manufacturer, a warranty or indemnification against third party claims should be obtained. It may also be important to provide that the design or technology will not be used in the manufacture of goods for other customers at least for a period of several years. If the design and/or technology is of high importance and patentable, the foreign company may also want to patent it in the supplier's home jurisdiction.

John Washburn is a partner with the Chicago law firm of Gould & Ratner LLP. Steven Huang is a senior partner in Jade & Fountain's Shanghai office.

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