Overseas Manufacturing Due Diligence: A Guide for Avoiding Costly Mistakes

Home | China Law Blog | Overseas Manufacturing Due Diligence: A Guide for Avoiding Costly Mistakes Table of Contents Toggle Introduction A toy importer, thrilled about getting its toys from Vietnam at a great price paid $2 million upfront to a supposed "toy maker". The dream turned into a nightmare when they realized there was no such Vietnamese toy maker, and no toys would ever materialize. This importer isn't alone. Many foreign companies have faced similar pitfalls due to inadequate counterparty due diligence when contracting with an overseas manufacturer. This post delves into these pitfalls and provides clear recommendations on how to sidestep them. Know Your Counterparty: The Blueprint for Safe Overseas Contracting Entering into a contract with an overseas manufacturer requires you conduct meticulous due diligence on your putative business partner. This includes confirming that you are contracting directly with the manufacturing entity itself, rather than with an offshore parent company with no real assets. Vetting and fully understanding the company you are dealing with is one of the most important steps for avoiding pitfalls down the road. This may seem obvious but overlooking due diligence principles and/or contracting with the wrong company has sunk many foreign companies that have their products made overseas. Many companies erroneously trust third-party sourcing agencies, completely disconnected from the actual factory producing the goods. Should issues arise, such as product defects or missed deliveries, these companies find themselves cornered legally, able to challenge only the sourcing company they contracted with, not the core manufacturer. Similarly, some businesses contract with parent or holding companies based in locations like Hong Kong, Taiwan, or Singapore. These entities often possess minimal assets, adding layers of complications when seeking legal recourse. Before contracting with anyone, you should do your due diligence and make sure the party you are paying is not a shell entity or a sourcing company with little or no assets. As companies migrate out of China for manufacturing, my law firm's dispute resolution attorneys have seen a spike in such third-party complications with emerging manufacturers globally. This third-party problem is an issue around the world. Why Counterparty Due Diligence Matters Many foreign companies mistakenly believe that partnering with offshore holding companies provides added security. However, problems arise when these companies can only seek recourse against intermediaries, or when these offshore entities lack assets in the country in which the products are being made. Without in-depth research you risk being left with no legal recourse in cases of non-performance, quality issues, or even fraudulent activities. How to Find the Right Manufacturing Counterparty A direct partnership with the manufacturing entity is often the safest route. Offshore parent entities, generally devoid of significant assets, can leave you stranded without legal options. Understanding the genuine corporate structure is pivotal. Proper due diligence uncovers the true corporate structure. To solidify your overseas relationships, you should consider doing the following: 1. Legal Identity Verification Obtain the business name of the party you intend to contract with. In most of Asia, you should never rely solely on English names, which may differ from the company's actual legal name. 2. Due Diligence Procedures Conduct thorough due diligence on that exact entity, including: - Checking corporate registration documents to confirm legal ownership and structure - Reviewing financial statements to assess stability and resources - Verifying certifications like business licenses are up-to-date - Confirming the entity directly owns the relevant factory/assets - Searching for litigation history or disputes involving the company - Verifying the name characters and English name are consistent across all documents. - Review historical changes in ownership, management structure, or company name. Major shifts may indicate instability or risk. - For manufacturers, request copies of their factory certifications and audit reports to validate capabilities, but make sure you have an expert review these because these are often faked. - For big money deals, consider an on-the-ground audit of facilities and corporate documentation. 3. Working with Third-Party Agents If contracting with a third-party agent, validate it has a solid track record and real ties to the supplier. Require guarantees for performance. For more on sourcing agents, check out Sourcing Agents When Manufacturing Overseas: The Long Version. 4. Contract Negotiations Negotiate protective contract terms like security deposits, retention payments, and personal guarantees. The Costly Pitfalls of Counterparty Negligence Effective due diligence is paramount when navigating international business. Now let's look at real examples that illustrate the importance of counterparty due diligence. The following are just some of the real-world examples of companies that got in trouble by using third-party sourcing agents without contracts to protect them or by not conducting sufficient due diligence before moving forward. 1. The Bricks for Fish Delivery A company, lured by the competitive pricing of a Chinese company, eagerly purchased a significant quantity of fish for their business. As the shipment docked in Seattle and workers began offloading, anticipation quickly turned to horror. The initial layers of the container consisted of old, unusable fish, but as they dug deeper, a shocking discovery was made. The bulk of the container was filled with broken bricks, strategically placed to meet the weight specifications of the shipment. This deceptive tactic was a smokescreen. The delay in discovery, caused by the mixed shipment of bricks and fish, allowed the fraudulent Chinese company to dissolve its operations and vanish, but not before duping several other unsuspecting buyers. This unfortunate episode cost the client both in monetary terms and reputation damage. It was a classic bait-and-switch tactic with a costly aftermath. If the client had undertaken an initial, deeper due diligence on the vendor, this unfortunate event would have been averted. Moral: Never pay anyone overseas unless and until you know who they really are. 2. The No Fish At All Case A South Carolina company, looking to capitalize on the international demand for fish, made a significant order from what they believed was a reputable Qingdao company. The entire transaction was made more complex as they had already pre-sold this fish to a British company, making the timely arrival of the shipment crucial. However, as the delivery date neared, inconsistencies began to emerge. The Qingdao company that was expected to deliver the fish never existed in the first place; the entire deal was a facade. This duplicitous transaction had a domino effect. The British company, having not received their expected shipment, resorted to legal measures, and sued the South Carolina company. Upon reviewing the transaction documents, lawyers from my firm quickly identified multiple red flags that should have been cause for concern from the outset. This oversight not only resulted in significant financial loss for the South Carolina company but also entangled them in international litigation. Moral: Scrutiny of all details is a shield against fraud and cascading repercussions. 3. The Non-Existent Toy Company American company pays Vietnamese company a couple million dollars to make a toy for it. Vietnamese company never makes a single toy. American company hires my law firm to explore options for pursuing the Vietnamese toy manufacturer. Our international dispute resolution attorneys look at the manufacturing contract and notice that the signing party is a completely different entity than the Vietnamese toy manufacturer with which our client thought it had the contract. It turns out our client’s contract was with a “sourcing consultant” who operated out of a $600 a month single office in Hong Kong. Skeptical of ever being able to collect from this company, our client (wisely) chooses not to pursue litigation Moral: Always verify the authenticity and legal standing of your business partners before parting with any money. 4. The Delayed Christmas Lights Many years ago, an American company called us after just having learned that its two-million-dollar order of Christmas tree lights would not be delivered to the United States until December. We called the Chinese factory, and they told us they had no idea who our client even was. It turned out that our client had unknowingly been using a sourcing agent (we figured it out by looking at some Chinese language documents) and it had no contractual relationship with the actual factory. To make matters worse, the Chinese factory was intentionally not producing our client’s order because our client’s sourcing agent owed money to the Chinese factory. Our client ended up having to pay millions more to the Chinese factory to get it to deliver the lights on time. Moral: Direct contracts with manufacturers prevent middlemen issues and help ensure production priority. 5. The No Remedy Manufacturing Contract European company gets bad product from its Chinese shoe manufacturer and so refuses to pay the remaining $800,000 or so for the shipment. European company then gets sued in China and retains my law firm to assist. Turns out that the lawsuit in China has been brought by a Chinese sourcing agent whose contract with our client makes clear that it gets paid for brokering each transaction, whether the transaction goes well or not. In other words, there would have been a good chance this sourcing agent would have prevailed in its lawsuit against our client because it had fulfilled all requirements of its deal with our client, and the manufacturer providing bad product was irrelevant. These sorts of contracts are disturbingly common. Our client ended up settling. Moral: Contracts directly with manufacturers should be used to provide clear quality control requirements. 6. The Manufacturer without a Factory American company hires out the alleged best United States manufacturer for a particular type of sporting goods product. This U.S. manufacturer told American company that it would make the sporting goods product for the American company in China. American company agreed and within about a year it learned that the American company did not have any factories in China; it was outsourcing the manufacturing to an unrelated Chinese company. American company learned this after the Chinese manufacturer started selling the American company’s sporting goods product as its own. American company also learned that the Chinese manufacturer had secured a patent on the sporting good. This eventually led to incredibly expensive litigation involving six lawsuits, one in China, and four in three different states in the United States. Moral: Ensure clarity about your producers and always protect your intellectual property rights across borders. 7. The Falsified Certification A U.S. supplement company was lured by an Indian company claiming to have Good Manufacturing Practice (GMP) certification. Post-production, the importer found out the factory's GMP certificate was a fake, and the factory was ill-equipped for their manufacturing needs, causing them considerable financial losses. Moral: Double-check all certifications and avoid basing decisions based on the assumption that your manufacturer is acting in good faith. How to Safeguard Your Interests When Engaging in International Manufacturing 1. Conduct On-site Verification There's no substitute for first-hand observation. Visiting and inspecting a facility or office will give you an unfiltered view of a company's operations. Pictures can be misleading, and documents can be falsified. Standing on the manufacturing floor and meeting with on-site management gives insights that cannot be gained remotely. If you or a representative from your company cannot make the trip, consider hiring a trusted individual in the manufacturing country to assess the situation on your behalf. 2. Confirm the Exact Legal Identity This ensures you're partnering with a legitimate entity. Mistaking a company's identity can lead to contracting with fraudulent or unqualified partners. Ensuring you're dealing with the correct entity from the start can save countless headaches later. 3. Conduct Rigorous Background Checks By extensively vetting your prospective partner, you reduce the chances of partnering with entities that have a history of fraud or misconduct. It's better to discover potential red flags before entering into a binding agreement. 4. Verify Direct Connections to Manufacturing or Operational Assets This confirmation ensures that your partner has the necessary infrastructure to fulfill their contractual obligations. It prevents potential disruptions due to lack of resources on the partner's end. 5. Set Clear Contract Terms Clearly outlining expectations and remedies for non-compliance protects your interests. In case of disagreements or breaches, a well-drafted contract can provide legal clarity and protection. 6. Consider Third-party Verification If you cannot conduct on-site checks personally, it might be wise to engage a local expert or agency to do so on your behalf. Their local knowledge and unbiased perspective can unearth potential issues that might remain hidden to an outsider. By diligently following the above steps for every potential partner, you'll be ensuring that you're dealing with reputable, stable entities. The intricacies of international contracts might be intimidating, but the right level of due diligence drastically reduces risks. Conclusion The difference between a successful international venture and a costly misstep often lies in the level of due diligence conducted before pen meets paper. Investing time and resources in the appropriate level of due diligence will help safeguard your financial interests and protect your company's reputation from potential harm. Your upfront due diligence will save you heartache down the road. Check Out Our China Law Services Share Twitter Facebook LinkedIn E-mail Comment Dan Harris Dan Harris is a founding member of Harris Sliwoski, an international law firm where he mostly represents companies doing business in emerging market countries. Most of his time is spent helping American and European companies navigate foreign countries by working with the international lawyers at his firm in setting up companies overseas (WFOEs, Subsidiaries, Rep Offices and Joint Ventures), drafting international contracts, protecting IP, and overseeing M&A transactions. In addition, Dan writes and speaks extensively on international law, with a focus on protecting foreign businesses in their overseas operations. He is also a prolific and widely-followed blogger, writing as the co-author of the award-winning China Law Blog. 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