Penalty Clauses: Do they work when sourcing from China?
In today’s blog:
- we’ll answer the 3 most common questions surrounding penalty clauses,
- offer a case study on penalties
- explain one big mistake you certainly want to avoid when dealing with Chinese suppliers.
Will Chinese suppliers be offended if I put a penalty clause in my contract to protect me against quality problems, late shipments, IP infringement and other contract violations?
Professional suppliers that are confident in their ability to produce a given product at the agreed quality, price and lead-time will have no problem with having a reasonable penalty clause in the purchase contract. If suppliers aren’t willing to consider a penalty clause, you should consider finding a new supplier!
But you may need to be flexible about the terms of the penalty clause if it’s the first order with a new supplier for a new product. If the supplier is dealing in new materials, new designs and new production methods, they may not have a firm grasp on lead times and defect rates. You very much still need to have standards in place for quality and expected lead times, but you may want to build in some padding in case the supplier doesn’t get it right on the first time as is often the case in China.
How to decide the size of the penalty amount to put in the contract?
The usual process is to wait for the lawyer to review the particulars of the case and make a recommendation. But here are some guidelines:
- Selection of the penalty amount is part of the negotiation process between buyer and seller, just like price or payment terms. So there isn't a fixed rule. For example, some suppliers are willing to sign a high penalty clause if the price is high, but won't sign if the margin is too low.
- Keep in mind that it's a very positive signal if the seller accepts a penalty clause, as it shows they are confident in their ability to meet the terms of the contract.
- In accordance with Chinese Contract Law, the guideline is that the penalty should not exceed 30% of the contracted obligation. If we set up a high penalty in the contract and things end up in court, the court may cut the rate to 30% if they see fit. But there may be cases where the supplier breaks the contract in extreme, and a penalty larger than 30% may be awarded if a larger amount was agreed in the contract. As long as the other party is willing to accept it, there is no harm to agree on a high penalty, unless the penalty amount is directly linked to an important aspect of the transaction such a price, lead time, quality and such.
What should I do if I discover defects or missed lead-times and wish to enforce the penalty clause?
Assuming you have the penalty clauses mutually agreed in the contract, as soon as there appears to be contract violation, the first step is to define the damage (both direct and indirect damage) and put a value on the costs to repair or replace. For example, do you have a few units with issues or are you looking at total recall?
Second step is to present your detailed report on the problem. It’s not always easy, but try to avoid getting emotional and stick to the facts. The initial emphasis should be on fixing the problem (keeping your customers happy), then comes finding the root cause and taking corrective action so it doesn’t happen again (assuming you wish to continue to do business with this supplier) and finally assign blame and sort out compensation. Don’t “point fingers” until the discovery session is done. Stay professional. It’s a lot easier to talk penalties and compensation once both sides have agreed on the damage.
If the supplier fails to honor their contractual obligations, contact a Chinese lawyer that specializes in dispute resolution.
Case Study: What really happens when penalty clauses are inserted into the contracts?
I ran a sourcing agency for almost 20 years, at some point in your career you will receive non-conforming goods, despite the best efforts to prevent it.
In those 20 years of working with suppliers in Asia, I've had lots of missed lead times because of quality problems. But in all those years, not once have I had a supplier say to me “Mike, we missed the lead time by about a week, let us pick up the FedEx charges to send the replacements to you in the USA.” Not once. Until I started putting in my contract, if the lead time is missed by X days I get X discount.
Sometimes the suppliers forget about those agreed terms and I get a call at the eleventh hour saying “Mike, you know we’re friends and I hope you understand but we just got this big order from Disney, is it OK if we ship your items a week late? Can you do me a favor on this one?”
And my answer is always pretty much the same. “Mr. Wang, sorry to hear about that and luckily I knew that this might happen because it’s close to Chinese new-year so I built in a two week window or padding with my customers but more importantly I’m so glad that we have this contract in place because we could really use that five percent discount, so you take your time I'll give you up to 14 days to ship out.” What happens next you asks…it magically ships out the next day to avoid the discount that is applied for each day late! Because the penalties were pre-agreed, Mr. Wang can’t renegotiate at the 11th hour.”
Big Mistake: Don’t ask for favors, respect the contract or it will come back to haunt you.
Let’s say… that as the years goes by, you and your supplier become more and more comfortable as friends and business partners.
Let’s say… you wish to have your order delivered early. Your contract has an agreed delivery date, but you’d like it expedited.
Let’s say…you say to your supplier “Mr. Wang, my customer would love it a week early, can you ship ahead of time?”
Realize you’re asking them a favor. Don’t think that the supplier is not keeping score. (Double negative used for emphasis as this situation is doubly negative!)
Later, when they have a problem meeting the ship date or getting the quality right or respecting your IP, they’re going to call in that favor! Don’t break the terms of your own contract because that leaves the supplier an open door to break the contract as well.
1. In an earlier blog posts we covered the topic of how to manage quality when sourcing from China in order to help ensure that defects don’t make it into your supply chain. It’s worth reading now if you missed it when it was originally published.
2. If you want to see how a professional contract manufacturer lays out the internal inspection standards for inspectors and workers on the production line, visit PassageMaker’s Product Quality Manual or watch this video on QC and Contract
About the Author: Michael J. Bellamy
Originally from Upstate New York, Mike moved to Asia in 1993 and is a China business advisor to both Fortune 500 companies and small businesses. Recognized as an expert on doing business in China, he has been interviewed by WSJ, CNBC, FT & Bloomberg.
A featured presenter on China issues at seminars, trade shows and corporate events across the globe.
Learn more about Mike and AsiaBridge Law at