I'm a buyer for a North American retailer and will be sourcing from China for several of our products. After some negative stories I've heard from peers in my industry, I feel I have to be very careful about finding the right supplier. How should I get started when looking to source and what should I be mindful of? Are there any special arrangements, strategies, or sourcing models I should consider? In general:

How do I initiate sourcing from China?

The international perspective

To start with sourcing from China, a proper local manufacturer is indispensable and it is advisable to conduct due diligence on the local manufacturer. The key areas of due diligence should include: 1) who is the owner of the local manufacturer; 2) whether the local manufacturer has the proper right to use the relevant land and factory building or buildings; 3) whether it owns the relevant manufacturing equipment and facilities; and 4) whether it holds a proper business licence or other required licences for manufacturing the relevant product (such as the manufacturing licence and hygiene licence required for manufacturing cosmetic products or food).

A foreign company should establish its strategy for protecting its intellectual property rights in China. First of all, it is advisable to register its trademarks in China, as in China only trademarks registered with the China Trademark Office are protected by Chinese law. Second, as patents registered with the China Patent Office are protected by Chinese law, in respect of the technology that the local manufacturer will need to manufacture the products, a company should consider whether to register it as a patent in China or protect it as a trade secret. There should be provisions to protect technological know-how and trade secrets in the contract with the local manufacturer.

A well-drafted contract is necessary. The foreign company should particularly consider provisions such as:

- governing law of the contract: it does not necessarily have to be Chinese law, but mandatory requirements of Chinese law (such as customs requirements, health and environmental requirements applicable on the manufacturing) cannot be evaded by choosing a foreign law as the governing law;

- dispute resolution mechanism: usually international institutional arbitration is preferred for the purpose of international enforcement;

- language: it is advisable to specify which language will prevail if the contract is signed in two or more languages;

- the right to audit the manufacturer, labour, and environment: this is advisable for the purpose of monitoring the local manufacturer's compliance with the foreign company's standards and requirements;

- the right to terminate the contract: in case of some material changes to the local manufacturer, such as change of the owner of the local manufacturer; and

- stipulations of the local manufacturer's responsibility in product liability disputes with customers.

Ning Lu
Counsel
Akin Gump Strauss Hauer & Feld

The domestic perspective

An outsourcing arrangement with the Chinese supplier may involve the exchange of intellectual property (IP). By entering into an outsourcing arrangement, a foreign company can lose direct control over its IP, which becomes available to the supplier, its employees, and even potentially competitors. The foreign company should take steps to achieve full protection of its intellectual property rights (IPR).

1. Perform diligence on a potential supplier. Before sharing critical IP with the supplier, the foreign company should make sure that it is dealing with a reputable and reliable party.

2. Register the intellectual property. China's IP registration regimes are generally consistent with international standards. Trademark registrations should be part of the China business strategy of any foreign company. Registration of copyright material may be helpful evidence of ownership rights in a copyrighted work.

3. Maintain workplace security. Many foreign companies choose not to register patents or software in China considering the risk of leakage is greater than the benefit of registration. If this is the case, measures should be taken to protect trade secrets (or know-how), including:

- Limiting the personnel that have access to the confidential information;

- Providing appropriate information storage facilities to prevent unauthorised data access;

- Password-protecting key information or storing it separately with added security;

- Regularly maintaining and updating information security systems; and

- Marking the confidential material with “Confidential Information” in Chinese to enhance its usefulness as evidence in people's courts.

4. Require the Chinese supplier to conclude proper contracts with its employees. Specifically, the Chinese supplier should be required to conclude confidentiality and non-compete agreements with its employees and other third parties who have access to the confidential information.

5. Stipulate clearly ownership of the IPR. Ownership of improvements and modifications to the IP should be properly addressed in the outsourcing contract. The foreign company should also enter into agreement with the Chinese supplier as to the ownership of any IPR associated with technology achievements arising from the outsourcing. Without such an agreement, the people's court may decide that improvement or modification belongs to the party who has accomplished the achievement.

Jie Chai
Partner
Tian Yuan Law Firm