Legal Risk Points to Note for Raw Material Procurement by Chinese Overseas Factories/Subsidiaries

Raw material procurement in overseas scenarios typically includes two models: (1) Overseas factories sourcing raw materials from China or other overseas regions; (2) Chinese domestic factories sourcing raw materials from overseas. This article focuses on the perspective of procurement by Chinese companies’ overseas factories/subsidiaries, analyzing the key legal risks that overseas factories need to pay attention to when purchasing raw materials from China or other overseas regions.

1. Verification of Suppliers’ Qualifications

(1) Check Suppliers’ Import and Export Qualifications

Before initiating cooperation, confirm whether the supplier holds valid qualifications for importing and exporting the target raw materials (e.g., import-export licenses, customs registration certificates, and industry-specific permits). Lack of such qualifications may lead to customs clearance delays, seizure of goods, or even legal penalties for both parties.

(2) Joint Liability for Agent-Based Sales

If the supplier sells raw materials through a third-party agent, clearly stipulate in the procurement contract that both the agent and the supplier shall bear joint and several liability for any breaches (e.g., substandard goods, delayed delivery). This avoids situations where the agent and supplier shirk responsibility to each other when disputes arise.

2. Risks Related to Raw Material Recycling and Transportation Qualifications

(1) Compliance with Environmental Regulations and Transportation 资质

• First, confirm whether the raw materials involved (e.g., chemicals, hazardous substances) have a history of causing the supplier to be penalized by environmental authorities. Request the supplier to provide certificates proving its qualification for recycling waste materials (if applicable).
• For the transportation of dangerous chemicals or hazardous waste, verify that the carrier holds valid transportation permits (e.g., international dangerous goods transport certificates) and meets local environmental protection standards. Properly dispose of waste materials generated during procurement to avoid fines or business suspension orders from local environmental agencies.

(2) Include Environmental Compliance Clauses in Contracts

Explicitly set out environmental compliance requirements in the contract (e.g., the supplier must ensure that raw material production, packaging, and transportation do not pollute the environment around your factory). Non-compliance may trigger negative public opinion, damage your company’s reputation, or even lead to overseas import-export restrictions.

3. Prevent Supplier Non-Performance During Tendering/Bidding

After winning the bid, suppliers may refuse to sign the formal contract or propose new conditions that are unacceptable to the buyer (e.g., increasing prices, reducing quality standards). To mitigate this risk:

• Require suppliers to pay a bid bond during the tendering stage. Clearly state in the tender documents that if a winning supplier refuses to sign the contract without just cause, the bid bond will not be refunded.
• Specify the consequences of non-performance (e.g., compensation for losses caused by delayed procurement) in the tender terms to deter suppliers from breaching agreements.

4. Assessment of Suppliers’ Performance Capability

(1) Conduct Due Diligence on Suppliers

Before signing the contract, conduct in-depth background checks on the supplier’s performance capability, including:

• Company size (e.g., production capacity, number of employees);
• Financial status (e.g., solvency, profit margins, credit ratings);
• Equity structure (e.g., whether there are major shareholders with potential risks);
• Ongoing or historical legal disputes (e.g., breach of contract lawsuits, intellectual property disputes).

Prioritize suppliers with strong comprehensive strength to reduce the risk of non-performance.

(2) Establish an Internal Credit Evaluation System

Build a credit database for cooperative suppliers, sorting and rating their historical performance (e.g., on-time delivery rate, quality compliance rate, after-sales service quality). Give priority to suppliers with high credit scores for subsequent procurement.

(3) Monitor Long-Term Contract Suppliers’ Operations

For long-term procurement contracts:

• Track the supplier’s operational status in real time through public news reports, credit inquiries from China Export & Credit Insurance Corporation (Sinosure), or industry databases;
• Arrange for business personnel to conduct regular on-site visits to inspect production lines, inventory levels, and financial health;
• Include a right of uneasy defense clause in the contract: if the supplier faces material adverse changes (e.g., bankruptcy, major production accidents), your company has the right to suspend or terminate the contract to avoid further losses.

(4) Require Performance Bonds or Guarantees

Request the supplier to provide a performance bond or obtain a performance guarantee from a third-party financial institution (e.g., a bank). If the supplier delays delivery or fails to meet quality standards, your company can claim compensation through the bond or guarantee, and pursue its liability for breach of contract.

5. Payment Terms

(1) Avoid Large Advance Payments

Minimize or avoid paying large advance payments. If advance payment is unavoidable:

• Stipulate the shortest possible period for offsetting the advance payment (e.g., offsetting it against the payment for the first batch of goods);
• Clearly state that the supplier must refund the advance payment in full if it breaches the contract (e.g., fails to deliver goods).

(2) Clarify Inclusions in Contract Price

Define the contract price as all-inclusive (i.e., covering taxes, transportation fees, insurance, loading/unloading costs, installation and commissioning fees, quality assurance fees, and intellectual property (IP) royalties). Specify the applicable Incoterms® 2020 (e.g., FOB, CIF) to avoid disputes over cost allocation.

(3) Price Locking for Long-Term Contracts

For long-term contracts, include favorable price adjustment clauses for the buyer:

• Stipulate that the price remains unchanged if market prices rise during the delivery period, but decreases if market prices fall;
• Define the price as the lowest market price under the same conditions, and set a “price reduction trigger mechanism” (e.g., if the market price drops by more than 5%, the contract price shall be adjusted accordingly);
• Add a penalty clause for failure to reduce prices: if the supplier refuses to adjust the price as agreed, your company has the right to terminate the contract and claim liquidated damages.

(4) Installment Payments and Performance Guarantees

Adopt an installment payment model, and link payment to key milestones (e.g., 30% payment after contract signing, 50% after goods acceptance, 20% after the quality guarantee period expires). Require the supplier to provide a performance bond before the first payment to ensure that it fulfills its obligations. Do not pay the majority of the payment until the goods are received and inspected.

(5) Avoid Fixing Quantity and Price in Long-Term Contracts

For long-term contracts, do not lock the total procurement quantity and price in the framework contract. Instead, specify that the specific quantity and price for each batch shall be determined in separate Purchase Orders (POs) issued under the framework contract. This allows flexibility to adjust procurement plans based on market changes and production needs.

For additional details on payment terms, refer to the previous article: “English Contract Review: Payment Terms in International Sales Contracts” (from the buyer’s perspective).

6. Procurement Volume and Production Capacity

(1) Avoid Committing to Minimum Procurement Volumes

Do not promise a “minimum procurement volume” to the supplier. Instead, include a clause allowing your company to adjust the procurement volume:

• If there are changes in technology (e.g., replacement of raw materials due to technological upgrades) or industry policies (e.g., new environmental regulations), your company has the right to reduce or adjust the minimum procurement volume.

(2) Secure Supplier’s Production Capacity Commitment

Require the supplier to confirm in writing that its production capacity can meet your company’s procurement needs. Add a “capacity guarantee clause”:

• If the supplier cannot meet the delivery requirements due to insufficient production capacity, it must notify your company in advance (e.g., 30 days) and provide alternative suppliers recommended by it;
• Your company has the right to switch to other suppliers without bearing liability for breach of contract, and the original supplier shall compensate for any losses caused by the capacity shortage.

7. Goods Inspection and Acceptance

(1) Clear Assessment Standards for Service-Related Items

If the procurement involves services (e.g., raw material testing, technical support), define specific assessment criteria in the contract (e.g., testing pass rate, response time for technical support). If the goods or services do not meet the quality requirements, the supplier must promptly arrange for replacement or refund, and bear all liabilities for quality defects.

(2) Designate a Neutral Third-Party Inspection Agency

Raw material quality standards are often provided by the supplier as standard terms. If new quality standards are required, notify your company’s technical department to revise them in a timely manner. To ensure impartiality:

• Stipulate in the contract that disputes over quality shall be inspected by a third-party testing agency designated by both parties or by your company (not the supplier’s exclusive designated agency). The inspection report shall be the basis for resolving quality disputes.

(3) Set a Reasonable Acceptance Period

Specify a clear acceptance period (e.g., 7 working days after receiving the goods) in the contract. Do not accept clauses such as “failure to raise objections within the acceptance period shall be deemed automatic acceptance of the goods.” If acceptance is delayed due to force majeure or other legitimate reasons (e.g., delayed arrival of testing equipment), it shall not be deemed as automatic acceptance.

(4) Address Latent Defects

Include a clause on latent defects: if hidden quality issues (e.g., internal corrosion of metal materials) are discovered within a certain period after acceptance (e.g., 3 months), your company still has the right to request replacement, refund, or compensation. The supplier shall bear all losses caused by latent defects.

8. Liability for Breach of Contract

(1) Cap on Liability for Breach

Some dominant suppliers may propose a “cap on liability for breach” (e.g., limiting compensation to 10% of the contract value), which may be insufficient to cover your actual losses. When evaluating such clauses:

• Consider your company’s market position and the supplier’s monopoly power (e.g., if the supplier holds exclusive patents for the raw material, you may need to accept a reasonable cap);
• Estimate potential losses from the supplier’s breach (e.g., production shutdown losses, alternative procurement costs), and negotiate to increase the liability cap (e.g., to 30% of the contract value);
• Add exceptions to the liability cap: the cap does not apply to losses caused by the supplier’s intentional misconduct or gross negligence (e.g., intentional delivery of substandard goods).

(2) Indirect Losses

Generally, do not accept clauses where the supplier excludes liability for indirect losses (e.g., loss of profits, damage to business reputation, loss of business opportunities). If negotiations reach a deadlock, propose a compromise:

• The supplier shall bear liability for indirect losses caused by personal injury or death resulting from its breach (e.g., accidents caused by defective hazardous materials).

(3) Avoid Your Company’s Breach Due to Logistics Issues

Plan logistics arrangements in advance (e.g., booking shipping space, confirming customs clearance procedures) to avoid delays in receiving goods due to empty logistics vehicles or cargo detention. Such delays may lead to your company’s breach of downstream sales contracts.

(4) “Back-to-Back” Clauses for Upstream Supplier Risks

If your company’s delivery obligations to downstream customers depend on the supplier’s performance, include a “back-to-back clause” in the procurement contract:

• If the supplier’s delay causes your company to breach its contract with downstream customers, the supplier shall compensate for the losses your company incurs from the downstream breach. This is a common risk transfer method used by buyers.

9. Termination Clauses

For detailed information on contract termination, refer to the previous article: “English Contract Review: Term and Termination Clauses in Contracts.” In general:

• If the supplier intends to terminate the contract, it must provide advance written notice (e.g., 60 days in advance). The notice period must be sufficient to allow your company to find alternative suppliers and avoid disrupting production.
• Specify the circumstances under which your company has the right to terminate the contract unilaterally (e.g., the supplier’s material breach, insolvency, or revocation of business licenses).

10. Defects in Ownership

The supplier must warrant that the raw materials have no ownership encumbrances or defects (e.g., mortgages, co-ownership disputes, judicial seizures). The contract shall stipulate:

• If ownership disputes arise (e.g., the goods are claimed by a third party), the supplier shall resolve the dispute at its own expense;
• The supplier shall compensate your company for all losses caused by such disputes (including production shutdown losses, price differences from purchasing alternative goods, and legal fees).

11. Supplier’s Compliance Guarantee

Include compliance clauses in the contract:

• Require the supplier to sign a Supplier Code of Conduct (covering anti-corruption, labor protection, environmental protection, and anti-money laundering requirements);
• The supplier must establish a raw material traceability system and retain complete evidence chains (e.g., production records, inspection reports) to prove the legality of the raw materials;
• If government authorities (e.g., customs, tax agencies) detain the goods for investigation, the supplier shall provide necessary supporting documents (e.g., origin certificates, tax payment proofs) to assist in resolving the issue.

12. Force Majeure

Be cautious of clauses that classify market price fluctuations or labor strikes as force majeure—this is extremely unfavorable to the buyer, as it allows the supplier to avoid liability for non-performance due to these common market risks. To prevent disputes:

• Explicitly exclude these situations from the definition of force majeure in the contract;
• Clearly list the events that constitute force majeure (e.g., natural disasters, wars, government mandatory orders) to avoid ambiguous interpretations.