Unprotected Tooling: High Risk Practices in Chinese Manufacturing Part 2 | Article

Auto mechanic taking working toolsIn part 2 of this series, we’ll discuss common problems in tooling as well as tooling in the real world and the importance of comprehensive, enforceable tooling arrangements.

 

Part 1 defines tooling as part of the integrated outsourcing process as well as tooling financing and ownership.

As a result of globalization and the ability of consumers to purchase products at the lowest cost, manufacturers in China have become an integral part of the supply chains of many consumer product companies. With the high level of integration of consumer product companies and their overseas manufacturers in China, there is an increasing reliance on manufacturers to finance, fabricate and manage customer tooling for plastic injection, metal stamping or die casting — the core equipment components in the manufacturing process.

Common Problems in Tooling

A common problem with manufacturer-financed toolings is that it is often difficult for the parties to track the number of “useable” shots from the tooling that have been charged back to the customer through the amortization process. Unless the customer remains vigilant, it is likely that the manufacturer will continue to charge for tooling amortization well after actual amortization complete.

Another common problem is the use of the tooling for “second shift” production: production of product for the local market, or for a customer in another market, beyond the first customer’s knowledge. Tooling agreements need to specifically allow for conditioned use of the tooling as well as licensed use of any customer intellectual property in the tooling. Further, the provisions that outline those restrictions need to survive the agreement. Revocation of the license to use the intellectual property in the tooling is a means of restricting the supplier from legally using the tooling or creating another set of tooling with the intellectual property.

Tooling agreements should also contain a manufacturer guarantee that requires the manufacturer, as the fabricator or commissioner of the tooling, to replace a broken or defective tooling during the useful life of the tooling equipment. To avoid difficulties, it is often advisable to require the manufacturer to take out insurance to cover the cost of replacing the tooling.  Additionally, as the tooling is in the supplier’s use, control or possession during its useful life, the supplier should be required to clean, repair and maintain the tooling according to industry norms. Manufacturer should further be required to engrave (not tag) the customer’s asset number into the tooling with a statement to the effect that the tooling belongs to the customer.  This should help to give notice to a potential buyer that title in the tooling is vested in the customer and not the manufacturer.

Customers should have the right to dictate the fate of the tooling used in their products at the end of product life cycle and importantly, must maintain the discipline to take action at that moment—for a variety of reasons. The first reason is offensive—maximizing useful life value of the equipment.  As mentioned above, many toolings are amortized over their expected “commercial” life rather than their physical life—meaning that a hardened steel tooling equipment may be fully amortized over 200,000 pieces yet have an actual useful life of more than 1 million pieces. Thus while the product cycle for one market may be completed, there actually may be much more life in the tooling (value), and it is possible for the tooling to have a highly productive “second life” for years after its “completed” initial use. This situation is compounded when there are multiple cavities and sets of the same tooling created to meet initial market requirements.

The second reason the customer should hold the right to dictate the fate of the tooling is defensive. If the fate of tooling equipment is not entirely in the hands of the customer, the manufacturer may be motivated to do make independent use if the toolings, whether to recover any remaining payments or merely seek to optimize the manufacturer’s return.  Ideally, a customer should be able to dictate what happens to all tooling for the customer’s products throughout the equipment life.  A good customer tooling management agreement includes clear end-of-life provisions, including collection to a central customer-controlled repository or certified destruction on site.

Tooling in the Real World

In order to analyze the risk associated with manufacturer-owned and managed tooling, it is useful to consider two different real-world scenarios: (i) where the customer needs to move production to another manufacturer and (ii) where the product life-cycle ends before the end of the amortization period.

In the first scenario, although the customer has effectively paid for a portion of the tooling value through production payments, such amortization does give rise to any clear customer title or rights to the toolings. With title remaining vested in the manufacturer, the manufacturer has a number of options (provided the tooling does not contain any of the customer’s intellectual property); it can use the tooling for its own purposes (production and sales), sell it to a third party or destroy it.

If the tooling does contain the customer’s intellectual property, then the manufacturer can legally hold or destroy the tooling but cannot use it for its own purposes or sell it.  However, it is not uncommon in a situation where relations have broken down between the parties that a manufacturer would use or sell a tooling that contains customer intellectual property to recover remaining value of the tooling.

To avoid this problem, the customer should insist that title to the tooling vests in the customer at first production and that the tooling is then subject to a bailment arrangement.  In essence, such an arrangement has the customer lending the tooling to the manufacturer for the customer’s use.  This bailment arrangement is coupled with a financing agreement—essentially a mortgage agreement with the tooling as mortgaged collateral but with the important distinction of the customer having legal title to the tooling and an equitable right to redeem the mortgage and reclaim possession.

Repayment of the tooling value is still done on a piece-count basis. Under such an arrangement, the parties are more likely to record the actual number of products made.  This offers a twofold benefit to the customer.  First, the customer is more likely to get a lower “close–to-market” tooling quotation, because the manufacturer is not required to hedge its risks by building in a contingency factor. Secondly, the direct costing impact makes the customer more likely to be vigilant in counting the number of products shipped in order to ensure discharge the mortgage and avoid being overcharged by the manufacturer.

In the second scenario, product manufacture has stopped before the amortization piece-count was achieved and the manufacturer has title to the tooling equipment that has not been fully paid for.  Despite not having met the full amortization piece count quantity, the customer will likely have some interest in preventing the manufacturer from using the tooling for the manufacturer own sales and keeping the tooling from falling into the hands of a third party, especially a party that may feed a market competitor.

It is important that the customer be able to exercise its rights to collect or immobilize the tooling for safe keeping or to have the tooling destroyed by the manufacturer. A bailment and mortgage arrangement as outlined above is well suited to provide the customer with this power.  Depending on the circumstances, the customer may want to license, sell or grant to the manufacturer the right to the use the toolings and some or all of the intellectual property or simply pay off the outstanding amount to discharge the mortgage.  Under such an arrangement, the customer will have tools that should enable it to control how the tooling is managed for the remainder of the tooling life cycle.

Importance of Comprehensive, Enforceable Tooling Arrangements

For the reasons highlighted above, tooling agreements should include comprehensive provisions that take into account the full range of possible issues and that hold the realistic prospect of enforceability.  For this, with Chinese manufacturers, contracts governed by Hong Kong can be effective. Hong Kong judgments as well as Hong Kong arbitration awards orders can be enforced in Mainland China.  Court awards from the United States and many other jurisdictions are not afforded such enforcement.

It is inevitable that in any given customer-manufacturer relationship, different factors govern different pieces of tooling in use at any given time.  Tooling agreements need to incorporate specific terms for all relevant tooling based on their circumstances.

Customers that source products through Chinese manufacturers using their own capital for manufacturer fabricated and managed tooling face much the same range of problems as those who use manufacturer capital.  It is good practice to create and diligently work through an issues checklist that takes into account each of the problems highlighted above in each customer-manufacturer relationship and insure that tooling agreements include provisions to address them.

Conclusion

Tooling constitutes one of the most basic components of manufacture, and consequently is a critical issue to get right in any arrangement for manufacture in China.  Careful consideration and treatment of the tooling issues in any customer-manufacturer arrangement can avoid problems and set the stage for predictable manufacture and protection of customer assets and business opportunities both during the product life cycle and afterwards.


Geof Master is a partner in Mayer Brown JSM’s Business & Technology Sourcing practice. He can be reached at [email protected]

Tom Keenan is a Registered Foreign Lawyer (Victoria, Australia) in Mayer Brown JSM’s Business & Technology Sourcing practice. He can be reached at [email protected]

 


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