At least once every 6 weeks, I get an email from the victim of a scam performed by a Chinese supplier. They ask me whether someone can help them recover the money.

Sometimes it is a scam (seller asks for a deposit before shipment, then ships nothing and stops responding to emails), and sometimes it is just a brutal retaliation (seller estimates he was poorly treated by the buyer on a previous order, and cancels a transaction after receiving some pre-payment).

Invariably, these people don’t have a contract with their supplier–not even one page in English. That tells you two things:

• These importers haven’t done their homework. Had they done some due diligence (is this supplier serious and earning money? do they have reference customers? do they already sell in my country?), they would not be in a difficult situation now.
• If you have a contract that was properly written by a lawyer familiar with the Chinese business environment, you are much less likely to get screwed by your supplier. I know, this is obvious, but some purchasers don’t give it any thought.

So, what can these importers do? Generally, not much.

The best strategy is often to contact a lawyer, who can send a demand letter and try to scare the supplier into paying. I don’t think the success rate is high, but it might work. Here are a few success factors:

• If you wired money directly on the company’s account (as opposed to a personal account, or another company’s account), it will help you.
• Same thing with the purchase order, if it was properly chopped by the supplier and returned to you.
• A clear email correspondence, where the supplier accepts the sale, is also a plus in your situation.
• A real company that owns assets (either a factory, or its own office space) is a good sign, too. They will probably not disappear overnight.

Unfortunately, the victims of scams are in the same situation as the purchasers who receive junk products after paying in full. Here is what I wrote six months ago:

From time to time, a reader who has received unacceptable products asks me how they can force a Chinese supplier to refund an order.

My response is usually “forget it, and do things right on your next order (make sure you read about best practices)”.

Now seems the good time to write about this topic, according a recent China Law Blog article:

December is fraud month because that seems to be when Chinese companies seem to decide whether they plan to continue operating as a viable business or not and oftentimes those who choose “not,” will decide at the same time to go out with all guns blazing.

A small proportion of suppliers are scammers in China. But they are out there, make no mistake about it.

Many importers end up feeling good about a particular individual, and hire him/her for a fixed salary. The objective is usually to communicate with suppliers, to follow new developments, to inspect product quality, and to source new products/suppliers.

Before you do that, you should be aware of the risks it represents for you.

When is it legal?

In theory, it is only legal in three cases:

• You have set up a company in mainland China (not in Hong Kong or Taiwan), and that company hires local workers.
• The person you want to hire sets up a company on her own, and you pay that company for consulting work.
• A company already established in mainland China hires that individual, dedicates her to your projects, and re-invoices you her full cost (plus a margin, one would guess). Actually this is not really legal either, except if that individual spends part of her time on projects for the company that hired her.

For more details on this topic, go and read Hiring A Chinese Employee Without A Chinese Entity. Good Luck With That on the China Law Blog.

If you go the illegal route…

If you are going to hire a Chinese citizen illegally, you should at least try to minimize your risks.

Do not transfer money to her private bank account, or you can be accused of not respecting the labor law, not paying social insurance, and evading taxes. It can catch you up anytime you visit China.

A less risky solution is to transfer the money to a third party that you have good reason to trust, and that third party wires it to that individual (with no way to link it back to you). This is a service you can pay for. You are still in the “dark grey”, but you probably run less risks.

Another tip is to sign no contract at all. Any signed contract will only be used against you, except if they are fully legal (no court of law will protect you on the basis of a contract that formalizes an illegal situation). Better be 100% illegal and “under the radar”.

Business risks are higher than legal risks!

That individual will know all about your supply chain: your suppliers, your prices, your products, your main customers. After talking to your suppliers, and doing a few internet searches, she will also know your main competitors.

Do you see how much can go wrong? Imagine she starts proposing your products to your competitors, and sets up a trading company (which might be owned by a relative of hers). Imagine if she contacts your customers directly with lower prices. This kind of things takes place every day in China.

If you hired that person illegally, you will not be able to sue her. Again, a Chinese court of law will not give any weight to your demands (even if you got a contract). You will have no way to pressure/punish that rogue employee.

Overall I feel importers should avoid this easy solution (see my previous post: Managing an employee based in China/HK).

Do you agree?

Many importers think of a new product and want to manufacture it in a Chinese factory, often without paying an engineer for DFM. Unfortunately, the manufacturer will seldom think of all the mistakes to avoid.

I found a good typology of injury sources (a concept at the heart of product liability) in New Products Management, a college textbook I used a few years back. It can serve as a good checklist for purchasers:

1. Inherent risks (example: dynamite might explode) cannot be avoided. There isn’t much an importer can do about it, except reduce the likelihood that bad things happen.

2. Design defects can cause the manufacture of an unsafe product in three different ways:

• The design may create a dangerous situation (example: a heavy piece of furniture that is not stable and can top over easily).
• A safety device might be missing (example: a hair dryer without an overheat switch).
• Design may call for inadequate materials (example: construction materials that may deterioriate quickly in performance).

3. Defects in manufacture are caused by inadequate or unstable processes. It results in defective units (example: poorly welded ladders).

4. Missing instructions for use or (more importantly) warning against particular uses are a big problem, even if the product itself is fine. Example: a barbecue that can’t be used indoor — there might be several warnings, but a court might conclude that they were not obvious enough.

5. Dangers can also appear after use (example: spray cans that explode when burned in fireplaces).

From time to time, an importer asks me about everything he can do to protect himself. Let’s say they just received a shipment of defective goods. Now they are willing to pay for extra protection.

They will want to know how to check the components, then how to check the beginning of production, then how to check again later in production, and how to check what is loaded in the container. Then I explain that it’s probably overkill, and that an inspection during production + a final inspection are probably enough in their case.

And it’s the same for supplier selection: a good discussion + a background check + a factory audit are usually enough.

I realized it’s the same when it comes to legal protection, when reading Getting Started On Manufacturing In China. The Legal Basics. on the China Law Blog.

A western buyer who needs to develop and manufacture a new product in China can do all of the following:

1. Before even showing any product information: “NNN” agreement (if the product to manufacture is truly unique and different from what the factory already manufactures).
2. Before the supplier starts developing prototypes: product development agreement (if it would take a long time to start development from scratch with another factory and/or if there are expenses for customized molds/tooling).
3. Before communicating any brand name: trademark registration (applicable to all importers who manufacture products under their own brand in China).
4. Before authorizing production/wiring a deposit: manufacturing agreement (always a good idea, especially if you don’t pay by letter of credit).

All four of these agreements are not always required, depending on the situation. They also cost money, so there is a business decision to make.

I guess it’s the same as quality control: it depends on your aversion for risk and on your past experiences…

There is a line that I heard several times, and that makes me cringe: “well, our product is difficult to manufacture, but the good side is that it will be hard to copy”.

I don’t give ANY value that that “good side”. If the product is successful and has some visibility, it better be REALLY hard to copy.

If all the China factories you contact tell you that your product is difficult to make, maybe you should re-engineer it. Or maybe you should make it in your home country, with a manufacturer that has the right equipment, the right flexibility, or the right know-how.

Here is what I just wrote on this subject to one of my clients:

Better have an easy product that you can switch from factory to factory, rather than a complex product that requires a mold and a lot of development work. It will give you more leverage over your suppliers, but it is not the only reason.

In most cases, copies will come from the very factory that manufactures for you. Samples and photos can find their way quickly around (in showrooms and online directories), especially as most [manufacturers of your product] are located in the same province.

That’s why you might want to keep working with the same factory, as long as their conditions and their quality are workable for you.

Of course, it doesn’t hurt to ask for prices around, and to have a backup ready. I stronly advise it.

For further reading on this subject: the China Law Blog just posted an article entitled What To Do About Chinese Companies Taking Your IP?. And the latest CSIC’s “Sourcer” contains a long article describing the headache of a buyer dealing with a factory that does not even respect exclusivity contracts.

Dan Harris, from the China Law Blog, just published the text of a speech he gave about outsourcing issues in emerging markets (including China, Vietnam, India…). It is FULL of insights for importers.

I think it makes for an excellent guide for ensuring successful production, so I am reproducing a few excerpts here:

About due diligence:

Don’t be afraid to push for the information you think will be helpful to you. American companies are oftentimes reluctant to be seen as pushing too hard for fear that doing so will indicate that they don’t trust their potential counterparty. In my experience, the legitimate foreign company actually welcomes the opportunity to prove it is bona fide and it will usually bend over backwards to get you the information you seek. On the other hand, the illegitimate foreign company will usually claim that what you are seeking is “never done” in their particular country.

This means that the way the foreign company reacts to your requests for information can be one of the best and cheapest indicators of the kind of company it really is.

About the need for detailed documents:

I am always stressing how international contracts almost always require much greater specificity than domestic contracts. Courts in emerging market countries tend to be good at enforcing simple, clear contracts where the standards for default are objective and where the penalty requires little analysis. They tend not to be good at making a contract for the parties, as is common in the U.S. legal system. In the United States, suing on an oral contract or a contract written on a napkin can work out just fine. Don’t think that will be the case in an emerging market country where your not having your contract sealed may preclude you from suing on it.

And here is a good example of this:

Not so long ago, an American company came to me after having received a large shipment of laptop bags that weren’t strong enough to hold a laptop. We called the Chinese company to ask about getting a refund and they told us that if our client had wanted a bag strong enough to hold a laptop, they should have paid 50 cents more per bag for one that could actually do that. This company should have specified in its contract that they wanted a bag that could hold x number of kilograms.

About intellectual property (including trade secrets, trademarks, industrial designs, patents, and copyrights):

If you are going to “loan” your IP to a foreign company you should make it clear in the contract what belongs to you. It is not going to work for you to claim a few years from now that “everyone knew it belonged to us.” You should also think about registering that IP in the country to which you are sending it. Registering it here in the United States is not registering it “there”, particularly when it comes to patents and trademarks.

I strongly advise you to go read it in full!

Intellectual property (IP) ownership is a frequent cause of dispute between importers and Chinese suppliers.

If you bring your own design or your own tooling, they might use it for other customers or share it with other factories. But you have probably already heard about this danger (if not, you can read IP protection in China).

I have something else in mind, something new importers rarely suspect: when a China factory invokes IP ownership and refuses to give certain data to the buyer.

Let’s say you operate a factory in your country. A customer needs you to design the packaging, based on the product they want you to manufacture. You promise them to do it, you get the order, and you put your graphic designer on the project.

Then you run into problems, and you lose the business to a more reliable producer. The customer asks for the original packaging design files, since they paid for it. It is natural to give it to them, right? Well, not everywhere, and certainly not in China.

Chinese suppliers can invoke IP regarding designs, molds, sources of components, nature or mix of components, processes, etc.

Why? Because it increases the cost of switching production to another supplier. Once you start giving orders to a factory, it will make sure you are stuck to them. Yes, you read it right… It is considered good business practice to twist your arm.

How to avoid such a situation? Do not try to reason them with logical arguments. It is usually useless. It comes down to being in a position of strength. If they feel like you have no good alternative, they will not make any favor.

Sometimes it really, really cannot be defended rationally. Such a situation iss described in Poorly Made In China. The factory had been told to copy some samples of shampoo bottles of a famous brand, and then refused to give the composition to the importer. They found out that several flavors smelled exactly the same, and they never knew if the shampoo was safe. The bottles were sold for years in major retail chains in the USA, and the importer was unable to switch production anywhere else…

What should the buyer have done, in this case? He should have worked with a laboratory to get the composition, then given this information to the factory, and finally checked if it was respected in production.

Most importers can easily find a quality control or an engineering firm to document a product’s IP, before (or at the same time) a factory works on development. In some complex cases it requires qualifying the sub-suppliers and preparing prototypes off site, but generally it is fairly easy to manage.

If you have solid product knowledge in your field, you can do it by yourself. The key is to keep a copy of all relevant information in-house, in a form that can easily be exploited by another factory.

I received several emails recently from readers asking how they can increase their control over a Chinese supplier.

They experience late shipments, unacceptable quality, and/or price increases mid-way through production. Sometimes they get no response to their emails. They have the feeling that the supplier does not care about them.

How can a supplier’s behavior be controlled more effectively?

Buyers should work on their suppliers incentives and follow production closely.

And how to do it? I have listed 4 solutions below (1 “carrot” and 3 “sticks”).

1. Be seen as a “good customer”

If you want to control your supplier’s behavior, do not be associated with small and unprofitable orders… Because they are seldom given attention and priority.

The objective is to ensure that your suppliers take care of your current production because they are happy about it and they hope to get future orders. There are two things you can do:

• Make your orders look more appealing: don’t drive their profit margin down to zero; be clear in your requirements and keep development work easy (for example by providing a sample to copy); avoid overly complex breakdown of colors or sizes; do not be unfriendly in their presence, etc.
• Find suppliers who will value your business: your orders might seem insignificant to a large factory, so try to find a smaller manufacturer. It is important that top management keeps an eye on your orders.

2. Know what is really going on

If you let your supplier ship the goods without somebody checking quality on your behalf, you are running huge risks.

When it comes to consumer goods for Western countries, it is safe to estimate that the average Chinese exporter ships products that are inadequate–for one reason or another–at least 20% of the time.

If you cannot control quality by yourself, get assistance from an inspection company. They propose tools for different situations. Here are two of them:

• You should try to detect quality problems before shipment, because a container cannot be returned to the factory. So most serious buyers conduct a final random inspection, to confirm that quality is acceptable.
• And if you suspect the supplier is not doing a good job, you should catch the issues early (and avoid poor re-work and late shipping) with an inspection during production.

If you don’t know where to start with QC inspections, you can read four simple steps for starting to do quality control.

3. Tie payments to results

As long as you owe money to a supplier, it is much easier to control his behavior (since he risks a cancelled order or a request for discount).

Then, how to ensure that (1) quality is satisfactory, and (2) timing is respected? The solution is to settle final payment only after an inspection is passed AND the goods are shipped out. This is totally standard, and you should not hesitate to require it.

Let’s take an example. You write “Penalties for late shipment: 5% per week after promised ETD” on your P/O, and you negotiate to wire 70% of payment after shipment. In this case, the supplier will think twice before delaying your order.

Unfortunately, there are cases where this will not help you control your supplier:

• You give orders in a continuous flow, and you depend on your supplier for a good part of your business. In this case, try to work with several suppliers to minimize risks.
• You purchase products with no customization, and the supplier can easily sell them to somebody else.

To know more about this topic, you should read Paying by bank wire (T/T) and Paying by letter of credit (L/C)

4. Sign a contract

If you cannot follow the above recommendations, you can try to do business on familiar grounds: with a legally-binding contract.
There are lots of misconceptions. No, a purchase order is not a contract. No, Chinese suppliers are not used to signing contracts, and sometimes they don’t even read them. But yes, a contract can be enforced (in China only, except if the supplier has assets in your country) if it is drafted by a lawyer specializing in Chinese law.

A contract can give you more control over a supplier’s behavior, in many ways. If you approve a factory, it can discourage sub-contracting. If you have valuable intellectual property, it can prevent copying (or re-use for other buyers). If you are not happy about your supplier’s behavior, a demand letter from your lawyer might frighten him into cooperating.

Contracts are mostly used for big orders, or for very sensitive projects. My clients (SMEs buying from China) do not use any contract. And, from what I observed, mega-retailers have contracts but seldom enforce them–they rely heavily on the hope for repeat orders, on quality inspections, and on the fear of penalties.

What not to do

Equally important is what I did not mention in the above list. Let’s take an example: developing a personal relationship with a factory boss. It might help. But importers often think that it is sufficient, and they are mistaken.
That’s why so many local trading companies cannot control the behavior of the manufacturers they work with–even when they pretend to own the factory. Sometimes they have all wrong:

• The factory sees them as a bad customer, since they have access to so many other local manufacturers and they push prices down.
• If they have a personal bond with the factory boss, they don’t dare to inspect quality (to avoid making him “lose face”), and they wouldn’t even think of a contract.
• Their payment depends on the importer’s payment, so this element of pressure is somewhat lost.

This is good news for savvy importers. If they use the right tools, they can be very effective without the need for any intermediary.

Related article: Managing Chinese suppliers: how to maintain your authority.

——————————————–

Photo credit Loren Javier