Sourcing Your Products From China, Your Intellectual Property - Part 1


By Merritt R. Blakeslee

Sourcing Your Products From China…

…Without Losing Your Shirt, Your Intellectual Property or Your Customers—Part I

A useful way to approach this issue is to categorize the risks
of sourcing from China that differ from the risks of doing business
with a U.S. supplier. 


There is a saying about sourcing from China: Anything is possible,
but everything is difficult. This article, the first in a two-part
series, discusses some of the difficulties of sourcing from China and
offers a set of strategies for dealing with them.

This series will consider problems confronted by a U.S.-based
company supplying the automotive aftermarket in the United States that
wishes to source products from China on an ongoing basis, including how
to find a suitable Chinese supplier; how to build a productive and
durable relationship; how to prevent problems in your relationship with
your supplier; and how to protect your intellectual property rights and
your customers. (As you will see, the issues raised are applicable to
many other countries beyond China.)

What Can Go Wrong: Nightmare Scenarios

Before talking about how to get it right, let’s first discuss what
can go wrong. Here are three nightmare scenarios that you should keep
in mind if you intend to begin sourcing your products from China.

Nightmare 1: Company A carefully selects a Chinese manufacturer to produce its
which contains proprietary software or other proprietary technology.
Without Company A’s authorization, the Chinese manufacturer copies the
technology and uses it to manufacture products that compete with those
of Company A. As a result, Company A loses its competitive edge and
substantial market share to low-priced counterfeits produced using the
misappropriated technology.

Nightmare 2: Company B sells high-performance
aftermarket wheels, which it sources from a supplier in China. As with
most products sold in our industry, these wheels are safety critical. A
wheel bearing Company B’s name breaks, causing a fatal accident in the
United States, and B is sued for product liability. Company B inspects
the defective wheel and suspects that it was not an authorized product
but cannot be sure since it does not mark its products in a way that
would permit it to identify counterfeits. Ultimately, Company B must
defend a product liability suit and do an expensive product recall. It
believes, but can never prove, that its supplier was doing “midnight
runs”—making unauthorized production runs of its product with relaxed
quality controls—and selling the unauthorized products into the United
States market. The fatal accident, the lawsuit and the product recall
were the result.

Nightmare 3: Company C sources fully finished and
packaged products from China. It has its supplier drop-ship these
products directly to C’s customers in the United States. After a few
months, C finds its orders declining. Upon investigation, it discovers
that one of its largest customers is buying directly from the Chinese
supplier, which is supplying Company C’s products under a different
brand name.

What Are the Risks of Sourcing Your Products From China?

A useful way to approach this issue is to categorize the risks of
sourcing from China that differ from the risks of doing business with a
U.S. supplier. Let’s divide these into background and specific risk

Background risk factors include:

  • Information deficit
  • Language
  • Distance and logistical risks associated with transnational transactions
  • Time and calendar differences
  • An absence of U.S. and U.S.-type legal remedies
  • Currency exchange risks
  • Geopolitical risk

The four specific types of risks that come with sourcing from abroad are:

  • Risks associated with your relationship with your Chinese supplier (quality, delivery, payment, etc.)
  • The risk that the integrity of the supply chain for your products will be compromised
  • The risk that your company’s intellectual property will be misappropriated
  • The risk that your customers will be stolen

Managing Risks in the Relationship With Your Chinese Supplier

You already have a relationship with a supplier or suppliers in the
United States, whether you manufacture in-house or purchase your
products fully or partly finished. In large measure, the
issues—quality, delivery and payment—you will face with a Chinese
supplier are the same as with a U.S. supplier and the solutions are the
same. This article discusses techniques for minimizing and managing the
risks specific to doing business with a Chinese supplier.

In large measure, the issues—quality, delivery and payment—you
will face with a Chinese supplier are the same as with a U.S. supplier
and the solutions are the same.


Finding a Reliable Supplier

The first and most fundamental risk of sourcing from China flows
from your lack of information about the Chinese industry where you wish
to place your manufacturing. While you should be able to identify
reliable suppliers of quality products in the United States, it is
unlikely that you will have the same level of expertise concerning your
Chinese suppliers. Thus, the first challenge is to find a reliable

It is recommended that you get professional help with your search to
overcome the information deficit. There are many search services—called
match-making agencies—that work in China to assist foreign purchasers
in locating a suitable manufacturer. However, many of these agencies
work for the suppliers, much in the same way that a real estate agent
in the United States works for the home seller, not for the buyer.

The challenge is to find an agency that is rigorously independent.
Organizations, such as the U.S.-China Business Council, the American
Chambers of Commerce in China and the Department of Commerce’s Foreign
Commercial Service, assist U.S. companies doing business in China, and
they are a good starting point for locating a reliable search agency.
Once you have selected a prospective supplier or suppliers, you should
go through the normal qualification process that you would use with a
U.S. supplier.

In addition to the considerations that would govern the selection of
a supplier in the United States—capacity, capability, core competence,
size, design capability (do they have the ability to adapt your designs
to their manufacturing processes) and quality certifications—here are
two more considerations that should factor into your selection of a
Chinese supplier.

Look for a supplier that has prior experience with
exporting—particularly experience with exporting to the West. By
selecting such a supplier, you have some assurance that the company
understands the supply-chain and logistics issues associated with
supplying a foreign purchaser and, more important, that it has some
experience in meeting the demands of a Western customer.

Language is also a background risk factor. It is not true in China,
as it is in some other parts of the world, that “there is nothing to
worry about because everybody speaks English.” Some Chinese
manufacturers hire young English-speakers fresh out of university to
interact with their U.S. customers. These young people effectively
become the project managers in charge of your relationship with the
supplier. Frequently, however, they lack technical knowledge and
experience; their sole expertise lies in speaking English.

This is a recipe for trouble. You should consider carefully whether
you want to begin a relationship with a company where you cannot
communicate directly in English (a) with the managers, with whom you
will have to work to solve delivery and relationship problems, and (b)
with the engineering department, with whom you will have to work to
solve technical and quality-related issues. Most people will tell you
that it is impractical to try to work through an interpreter. Thus, you
may want to make English-language competence on the part of key
personnel a requirement in selecting a supplier.

General Techniques for Managing Risk

Most risks in your relationship with your supplier can be minimized by reliance on a combination of the following:

  • A well-drawn contract
  • Ongoing onsite inspections
  • Payment terms that shift the risk of non-performance to the supplier
  • Use of multiple suppliers

A significant background risk factor of sourcing from China is the
absence of reliable legal remedies if things go badly. If your supplier
lets you down in the United States, your ultimate remedy is the U.S.
court system. But with a Chinese supplier, several things are
different. Unless the Chinese supplier has a presence in the United
States, even if you sue and win in a U.S. court of law, it is probable
that you will be unable to collect a judgment—either in the United
States, where the defendant has no assets, or in China, where the
courts and the authorities will not assist you in enforcing a monetary
judgment obtained in the United States.

It is, of course, possible to sue in a Chinese court, but this
carries with it a different set of difficulties. You will need reliable
Chinese counsel, and the uncertainty as to the outcome that is always a
fact in U.S. litigation is even greater in China where the legal system
is still developing. Moreover, even if you win, the enforcement
mechanisms in China are weak. In short, obtaining a satisfactory
litigated solution to problems with your supplier is even more
uncertain in China than in the United States, and an important goal of
the four techniques mentioned above is avoiding the need to resort to
litigation against your supplier.

A Well-Drawn Contract

A carefully thought-out and drafted contract can provide the basis
for a long, productive relationship with your supplier. Think through
the problems that could arise—including those discussed in this
article—and provide solutions to those potential problems in the
contract. Think of the contract first and foremost as a blueprint for a
harmonious relationship with your supplier. In addition, however, your
contract should be an air-tight legal document that can be enforced in
a Chinese (or U.S.) court if you have no other alternative but to sue
your supplier.

Inspection Service

There are many independent, reliable companies in China that will
inspect the goods you are purchasing during the manufacturing process
and/or prior to shipment, and it is recommended that you use one.
Ideally, the inspection should be done in the factory, and your
contract should give your inspector unfettered, around-the-clock access
to your supplier’s facility. Not only will a competent inspection
service identify quality problems before the goods are shipped, but it
can also alert you to upcoming delivery problems and possibly detect
diversion of your product or misappropriation of your intellectual

Payment Mechanisms

Chinese companies often do business on the basis of letters of
credit. However, where you pay for your merchandise with a letter of
credit at the time you take delivery in China is where you bear the
risk of receiving non-compliant goods unless the letter of credit
contains an inspection provision. Moreover, letters of credit are
expensive. Trouble with quality and other problems that can arise in
the relationship with your supplier are managed more effectively if you
negotiate payment terms that protect you against quality and delivery
problems. Such payment terms can include: (a) a delayed payment term,
where you are not required to make payment until 30 or 60 days after
delivery, allowing you time to identify quality problems; (b) a
non-payment term, in the event of severe problems with the merchandise;
and (c) a reserve in the initial payment specifically to cover
potential warranty problems that do not appear within the payment
period. Moreover, your supplier has an incentive to agree to such terms
in order to build a durable, productive relationship with you.

Use of Multiple Suppliers

Using more than one supplier carries obvious problems: Do you have
enough demand? Are you sacrificing buying power by splitting your
order? Are you unnecessarily complicating your operations?

On the other hand, supplier redundancy can confer important
benefits: It can protect you against quality, delivery and capacity
problems. It ensures that you are not hostage to a single supplier. It
may actually help you in negotiating price.

Managing the Risk of Receiving Non-Conforming Goods

Quality is the single most important issue in the supplier
relationship. We have already discussed using a match-making service to
locate a reliable supplier, using an inspection service to catch
quality problems at the production stage and using payment terms that
give you the recourse of withholding payment where quality problems
arise. Another vital element in ensuring quality is the use of
production-process documentation that spells out for you and your
supplier, at the beginning of the relationship, all the steps that he
or she will follow in manufacturing your products. This may be the
single most important technique for creating successful production

Finally, your contract should spell out warranty terms and provide a
detailed understanding of how quality defects will be handled by your

Managing the Risk of Delivery and Customs Problems

Delivery problems can be divided into two types: those that are the fault of the supplier and those that are not.

Contract provisions specifying a penalty for late delivery and
requiring rush delivery by air at the supplier’s expense when the goods
would otherwise be late if delivered by ocean freight, place the risk
of late delivery on the supplier; it is wise to include such provisions
in your contract with your supplier.

But what about those background risk factors that are outside the
control of the supplier? Most goods from China are shipped to the
United States by ocean freight. Transportation by ship from China to
the United States adds about five weeks on top of the normal
manufacturing lead time.

In addition to sheer distance, there are the twin risks of
weather-related delays and of bottlenecks at the ports of lading and

To guard against these hazards, you should consider maintaining
safety inventories in the United States, with the additional cost that
it entails. You should also be prepared to make emergency shipments by
air at your own expense when your goods are delayed in transit for
reasons that are not the fault of your supplier.

A related but different risk of delay arises from the fact that your
Chinese-origin goods are subject to the U.S. Customs laws when they
enter the United States. You should hire a competent Customs broker
and, when necessary, a good Customs attorney to ensure that your
products are not delayed in Customs and to take quick, competent action
if they are.

Avoid the temptation to use a Chinese freight forwarder as your U.S.
Customs broker, even though that may be less expensive in the short
term. This is an invitation to problems with Customs. If possible, use
one—and only one—U.S.-based Customs broker and work closely with him or
her to ensure that your goods are correctly classified and documented
to avoid Customs problems. This will help you to avoid overpaying
Customs duties and thereby losing money or underpaying Customs duties,
thereby placing yourself at risk that you will be on the receiving end
of a Customs enforcement action.

Managing the Problems Associated With Time and Calendar Differences

One very practical problem that you must solve is coordinating a
work schedule with your supplier in the face of time differences and
very different national holidays. Unlike many western factories, where
the holiday schedules are staggered to maintain operations, factories
in China often close completely during holidays to allow workers to be
at home with their families. Moreover, most American holidays do not
overlap with Chinese holidays.

Time differences add to the difficulty of communicating and
coordinating with your supplier. Where there is a 12-hour time
difference between you and your supplier (the difference, for example,
between Detroit and Shanghai), there is never a time when the business
hours of your company and your supplier’s overlap. Moreover, leaving
aside the time difference, there is only a three-day overlap in the
five-day business week. When it is 7:00 a.m. on Friday morning in the
United States, it is 7:00 p.m. in Shanghai and the business week (if it
ends on Friday) is already over. By the time the U.S. company opens for
business on Monday morning, it is already Monday evening in Shanghai.
Thus, you will have to find practical means of maintaining good
communications with your supplier and of ensuring that your delivery
schedule is not disrupted by Chinese holidays. Your contract with your
supplier should lay out how these problems will be addressed.

Managing the Risk of Currency Fluctuation

Whenever a U.S. company purchases abroad, currency risk is an issue.
In the short term, the risk of currency fluctuation can be shifted to
your supplier by doing business in dollars. This means that it is your
supplier that will have to absorb these fluctuations if the exchange
rate between the dollar and the yuan fluctuates. But this arrangement
protects you only as long as the effect of the fluctuations does not
become intolerable for your supplier. If it does, your supplier will
insist on renegotiating prices.

A contract provision could provide that the price will not change if
the input cost rises or falls by a certain percentage. If the cost goes
outside the agreed-upon band, then the price will be raised or lowered
by an agreed-up percentage. (You can use the same technique to provide
for spikes in the cost of inputs not related to currency
fluctuation—for example, changes in the price of copper or steel.)

The currency risk in China is magnified by geopolitical risk. As you
know, China is under intense pressure from the international community
to revalue its currency upward. From your point of view, this means
that there is a risk that the yuan will be revalued upward at some time
in the future and the products that you have been purchasing at an
attractive price will suddenly cost more in dollars, even though the
price in yuan remains unchanged. By using more than one supplier, and
by ensuring that at least one of your suppliers is not located in
China, you minimize the geopolitical risks specific to sourcing from

Use of a Non-Compete Provision

Finally, you may also want to obtain assurances that your supplier
is not selling to your competitors and to include a provision in your
contract that it will not do so in the future.

Part II of this article will appear in a future issue of SEMA News.


Merritt R. Blakeslee, a partner in the Washington, D.C., office of deKieffer & Horgan (,
has practiced in the field of international law and trade law
regulation since 1991. He advises clients on compliance with U.S. and
international trade regulations and represents clients before federal
agencies and U.S. courts on a wide variety of issues, including the
enforcement of U.S. intellectual property rights against imported
merchandise, antidumping and countervailing duty proceedings, Customs
issues (including proper classification and valuation of imported
merchandise) and general commercial transactions. He may be reached at

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