Unprotected Tooling: High Risk Practices in Chinese Manufacturing – Part 1

By Thomas Keenan and Geofrey L. Master, Mayer Brown JSM

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Unprotected Tooling: High Risk Practices in Chinese Manufacturing – Part 1

As a result of globalization and the ability of consumers to purchase products at the lowest cost, Chinese manufacturing has become an integral part of the supply chains of many consumer product companies.

With the high level of integration of consumer product companies and Chinese manufacturing, 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.

During the last 15 years, many product companies viewed the use of manufacturer capital for tooling as “free money” and subsequently lowered their own financial thresholds for moving forward with a project—and in doing so did not fully appreciate the issues that emerge when the proper safeguards are not in place.

The value of the tooling involved is not small, and it is not uncommon for a manufacturer to hold and manage millions of dollars of customer tooling at any one time.

Managing the issues relating to tooling assets remains one of the more difficult elements of Chinese manufacturing arrangements. Unclear apportionment of rights and responsibilities, including use of underlying intellectual property, repair, misuse and “end of life” issues can give rise to a number of concerns.

This article will look at the most common issues relating to Original Design Manufacturer (ODM) and Original Engineering Manufacturer (OEM) supplier-managed tooling, and discuss some solutions that should be incorporated in any manufacturing agreement that contemplates a manufacturer’s use and management of customer tooling.

Tooling—An Integral Part of the Outsourcing Process

Manufacturing agreements often include provisions for the handling of customer-supplied equipment (including machinery, jigs and fixtures) but do not adequately cover the manufacturer’s responsibilities across the full tooling life cycle from fabrication, use, maintenance and end-of-life.

Due to the potentially severable nature of a piece or set of tooling from the overall manufacturing processes, it is best practice to incorporate all terms relating to tooling in a separate tooling agreement so that the unique issues that arise with respect tooling are less likely to impact the other manufacturing activities.

Manufacturer-customer relationships differ significantly according to the nature of the manufacturer, the provenance and ownership of the product design, the incorporated intellectual property and the ownership of and rights in the tooling in question.

A common mistake many customers make is to incorporate blanket terms in their purchase agreements stating that they own the exclusive rights to all tooling used in the manufacture of their products, regardless of ownership of the toolings.

Purchase agreements where the customer will not own the tooling (for ODM products) should also contain basic warranty clauses that provide that the manufacturer owns and has an unencumbered use of the toolings to manufacture the products.

These agreements should also include manufacturer indemnity clauses that protect the customer against future infringement actions taken by others claiming that the products infringe their intellectual property rights. Absent outright ownership of the tooling, customers cannot move their manufacturer’s tooling in the event the customer wants or needs to change their source of supply.

In the case of the ODM manufacturer, the customer typically purchases a product “off-the-shelf,” and the tooling will have already been designed, financed and fabricated by the manufacturer. The customer’s rights to the underlying toolings will be accordingly limited.

Tooling Financing and Ownership

Tooling financing and ownership are the most difficult tooling issues because of the intersection of title, use and equity liens on tooling in the possession and use of Chinese manufacturing.

If a customer has agreed that the manufacturer will fabricate tooling (tool-up) a product or purchase from a third-party tooling house, then issues of funding must be settled.

Under ordinary agreements, if a manufacturer is to finance the tool, it is common practice for the manufacturer to quote for tooling at up to several multiples of the actual fabrication cost/sub-contractor quotation to account for interest on the capital employed and to hedge against possible non-recovery of some portion the amortized value of the tool.

Most manufacturer employ a simple tooling amortization mechanism based on a proportion of the expected commercial life requirements, not physical life-cycle capabilities, in production shots of the tooling.

In a traditional tooling arrangement, the customer has provisions that allow for the manufacturer to finance the purchase or fabricate the tooling and charge-back the customer on a per piece (amortized) basis as the finished products or components ship.

However, unless title is specifically vested in the customer at the outset (first production), title will remain in the manufacturer until the end of the amortization period despite any payments that the customer already made. This is important because, unless properly structured, tooling agreements can leave the customer hamstrung and married to a supplier that jeopardizes their supply chain if the relationship turns sour.

This leaves the customer to consider financing a second tooling with a second manufacturer and running the risk of leaving partially paid-for tooling with the first manufacturer.

Look for our part 2 discussion in two weeks where we cover common problems and tooling in the real world.

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]

About the Author: Ben Trowbridge is an accomplished Outsourcing Consultant with extensive experience in outsourcing and managed services. As a former EY Partner and CEO of Alsbridge, he built successful practices in Transformational Outsourcing, BPO, IT Outsourcing, and Cybersecurity Managed Services. Throughout his career, Ben has advised a broad range of clients on outsourcing and global business services strategy and transactions. As the current CEO of the Outsourcing Center, he provides valuable insights and guidance to buyers and managed services executives. Contact him at [email protected].

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