An Overview on Contract Best Practice for Australian customers sourcing products or inputs from China.

Despite the recent Covid 19 interruptions to international trade and the supply chain routes which serve Australian customers and their Chinese suppliers, China still remains the world’s factory.

However, with international travel curtailed, a lack of direct flights and the difficulty in obtaining China business visas plus quarantine delays, the ability to vet potential suppliers in person is now limited and proper due diligence and proper contract formation are increasing imperatives when dealing with overseas manufacturers.

While this paper deals specifically with China based suppliers, the tips outlined below are generally applicable to all offshore suppliers you deal with, although specific local legal advice for each jurisdiction is always advised.

Thanks to globalization and outsourcing, a lot of manufacturers in China today are large and sophisticated, but many of them still like to use supplier agreements that equate to no more than a purchase order.  Best practice dictates that you ensure your agreements contain sufficient detail and protections to cover critical issues.

1. Are you contracting with the correct party?

Always ensure you have correctly identified the party with whom you are contracting and always request a copy of their Business License ( 营业执照) chopped with their company seal to check their correct name is set out in the contract. It is not uncommon for Chinese manufacturers to suggest that the contract be signed with their Hong Kong subsidiary or related entity however these may be entities with little or no assets and the preferred approach is to ensure that both entities ( the manufacturer and Hong Kong entity) are parties to  the agreement and are jointly and severally liable for performance. Sometimes the Chinese supplier will offer a company guarantee where the Hong Kong entity is the contracting party but this is best avoided. Guarantees to foreign parties are subject to registration with the State Administration of Foreign Exchange and if registration has not been obtained, may be unenforceable.

Once you have a copy of the Business License, at a minimum you should conduct an online search with the State Administration of Market Regulation (SAMR) to check who controls or owns the company, its assets, paid up capital and its business scope. In respect of business scope it is important to check that its business scope is consistent with its proposed offering under the contract. There have been many instances of customers entering into a supply agreement with a Chinese party only to find out later that the Chinese side did not have a manufacturing business scope or required import / export licenses.

If the arrangement with the Chinese supplier is intended to be long term, we recommend obtaining a detailed credit report from local providers which will run to about $2000. This is not a large expense, where the goods value under the supply agreement may be in the $100,000s or higher.

2. Consider a NNN Agreement while in negotiations

NNN stands for Non-Disclosure, Non-Circumvention and Non-Use. It is often required where the Australian customer, during negotiations is supplying samples of its production molds, technology or trade secrets such as production processes. Not surprisingly, as a major manufacturing economy, the Chinese courts are quick to recognise and enforce intellectual property or trade secret rights provided a comprehensive NNN agreement is in place. As well as non-disclosure of intellectual property or trade secrets a well drafted agreement will ensure that if negotiations break down, the Chinese supplier cannot use the information received, when price quoting for manufacture, or approach other customers or make the product utilising your intellectual property or production molds etc (non-circumvent and non-use).

China has Anti Unfair Competition laws and regulations which can be relied on provided you have a detailed NNN agreement in place. Should you later proceed to a binding OEM or supply agreement these NNN obligations can be repeated in the supply agreement.

As it is important to obtain court injunctive relief it is recommended the NNN agreement contain a Chinese court jurisdiction clause so this relief can be applied for. A liquidated damages clause is also useful so that damages can be easily quantified for the court.

3. Protection of Intellectual Property

One assumes that you have registered your patents, trademarks or copyrights in your major markets and in China. Such registrations can prevent the export of counterfeit goods from China, and also prevent a competitor or trademark squatter from registering the same intellectual property rights in China. Where your core IP is know-how and trade secrets, which cannot be protected by formal registration, it is important when providing these trade secret to the Chinese party, to identify or properly label what is a trade secret or is  confidential property, on the materials or documents supplied to the Chinese manufacturer. The Chinese courts have confirmed in previous decisions that they are willing to protect trade secrets, provided that the disclosing party (the Australian customer) has properly identified to the recipient, which materials or information constitute trade secrets.

The supply agreement needs to state that know-how and trade secrets and any new intellectual property rights, including any new know-how and trade secrets, that are created during the manufacture of your products vest in you as the customer under the supply agreement.

Non-compete covenants and non-circumvention obligations will need to be properly drafted as well as the obligations on the manufacturer to retain products and molds for delivery up and disposal by a customer when the contract arrangements come to an end. The right of the customer to arrange third party inspection to ensure Quality Control needs to be included and also how defective product is to be disposed of or destroyed. Liquidated damages clauses are also a useful in the agreement, so that if intellectual property breaches occur, compensation can be quickly obtained.

4. Dispute Resolution 

Historically China has been a country which favours negotiation or mediation over court based dispute resolution processes. The reasons are because “face” plays a large part in the conduct of China business and privacy is valued on the Chinese side, when seeking to resolve a dispute. A well drafted dispute resolution clause will usually include an obligation on the parties to engage in friendly negotiations at a senior management level for a fixed period and before a party can exercise a right to proceed to either (a) the courts or (b) to arbitration.

On balance, arbitration in a jurisdiction outside of China and governed by local law might be preferred.  Historically, arbitral tribunals are prepared to order damages which accurately reflect a party’s loss whereas Chinese courts have often been criticised for awards of damages far below actual loss. China is a signatory to the New York Convention on Foreign Arbitral Awards, and foreign arbitral awards in over 150 countries are readily recognized and enforced in China through their courts.  In contrast, no reciprocal enforcement of judgment treaty exists as between Australia and China.

In some circumstances, where the Chinese party objects to arbitration in Australia, a compromise can be reached on Hong Kong as an impartial arbitration jurisdiction for resolution of disputes because Hong Kong and China, have a reciprocal agreement for mutual recognition and enforcement of their respective arbitration awards.

Alternatively, and if injunctive relief is required, the preference may be to resolve the dispute by litigation in Chinese courts.  This may be required if the aim is to prevent the Chinese side from disclosing trade secrets, or from selling product to your competitors or fails to deliver up products or molds. Under those circumstances, having an international arbitration clause might be ineffective.  On balance, a dispute resolution clause which provides for arbitration, but retains a contractual right of a party to pursue injunctive relief through the courts in urgent circumstances, may be the best compromise although the risk can exist that if the arbitration clause is not precisely drafted, it may be construed by a court or tribunal as unenforceable.

5. Australian Government Procurement Issues

For those Australian customers who are sourcing products or construction materials in respect of Government infrastructure tenders and contracts, it is also incumbent on the Australian party to ensure that a Chinese supplier has signed specific contractual undertakings which will cover the issues of (i) anti-bribery, (ii) anti money laundering or terrorism financing  prohibitions (iii) modern slavery prohibitions and (iv) undertakings that the Chinese supplier is not a politically exposed or connected entity or does not have connections with politically interested parties. It is likely that there will be additional warranties required that cyber security risk measures are in place and undertakings to engage in “sustainable” procurement practices, where possible.

It is often a requirement of Government tender documentation that these undertakings be given in a particular format or for copies of the underlying supply agreements provided to the Government bodies for review.

The writer has assisted a number of clients to fulfil these compliance and contract drafting obligations.