© Sheppard Mullin Richter Hampton LLP 2006

Outsourcing: U.S. operational and logistical issues when

outsourcing to China and MexicoACC Presentation – September 21, 2005

Moderator: Andy Quinn – Sony Electronics, Inc.

Panelists:Richard Freeman, Partner, Sheppard Mullin Richter & Hampton LLPJerry Gumpel, Partner, Sheppard Mullin Richter & Hampton LLPAmar Thakur, Partner, Sheppard Mullin Richter & Hampton LLPRobert Gerber, Partner, Sheppard Mullin Richter & Hampton LLP

The Scenario The Sheppard Co. designs, manufactures and sells

high technology "gizmos" in a San Diego facility.

Certain design features of the gizmos are protected

by trade secrets.  Additionally, the manufacturing

process involves protected technology.  The gizmos

competitive advantage is based substantially on

these trade secrets and protected technology. 

The Scenario The company has approximately 1000 employees in

the San Diego facility, 250 are involved in

manufacturing gizmos.  Most of those employees’

duties involve relatively low skill duties, but about 2%

of the manufacturing workforce are highly skilled, and

have specialized training necessary for ensuring the

gizmos are properly manufactured.

The Scenario The company CEO and CFO, have decided the

company could save millions of dollars by

manufacturing gizmos in Mexico or China.

Additionally, there are significant Balance sheet

advantages to moving the manufacturing assets off

the balance sheet.               

The Scenario I am Sheppard Co.'s general counsel.  The day isslow, and I was thinking about sneaking out to playa little golf.  Suddenly, the two burst into your officeand say, "We want to outsource to China orMexico.  What do we need to do? What should webe concerned about?  We need to do this rightaway!"

What type of business issues will I need to address?

Intellectual Property – How do you handle intellectual property ownership / control, security, technology transfer, location for design and development, product differentiation vs. commoditization.

Structure/Entity - What is the best choice of entity for your foreign operation, including regulatory approvals and tax implications.

What type of business issues will I need to address? Operations - What are the operational and logistical issues

associated with outsourcing operationally cost of transportation, lead times/transit times, supply chain costs, just in time inventory issues, duties, taxes and licenses fees, cost of management and quality control, balance sheet items (equipment), warranty, service, and support issues.

Labor – What are the U.S. labor issues involved in outsourcing to a foreign country including issues that arise with foreign facilities and immigration/visa issues.

What type of business issues will I need to address? Risk / Liability – What are the hidden costs of outsourcing

environmental, government, privacy, insurance risk/management, product liability, recalls, intellectual enforcement, piracy, and erosion.

Cultural – What are the corporate cultural and international cultural challenges associated with outsourcing such as corporate culture, language barriers, and normal business practices.

Panelists:

Dick FreemanPartner

Labor & Employment

Bob GerberPartner

Litigation & Intellectual Property

Jerry GumpelPartner

Corporate

Amar ThakurPartner

Intellectual Property-

Licensing & Litigation

Andy Quinn

Director, Law Department, Sony Electronics, Inc.

Moderator:

© Sheppard Mullin Richter Hampton LLP 2006

Questions?

Intellectual Property Intellectual property ownership/control

– Technology transfer/export controls– Location for design and development– Piracy, erosion– Confidentiality and trade secrets– Works-made-for-hire and employee invention assignment– Subcontracting and assignment– Non-circumvention, non-solicitation, non-competes– Development vs. licensing

Product differentiation v. commoditization

Structure China – Choice of Entity

Wholly foreign owned enterprise (WFOE) Joint Ventures

– If a Chinese partner is required/desired a joint venture takes longer to establish

– Equity Joint Venture (EJV)– Cooperative Joint Venture (CJV)

Projects– Encouraged projects– Permitted– Restricted (requires Chinese partners)– Prohibited

Holding Companies Foreign Investment Companies limited by shares Partnerships

Operational China – Choice of Entity

Tax Issues– Corporate tax is same for WFOE, EJV’s and CJV’s– Uniform tax rate 33% (30% central tax, 3% local)– Can have tax holiday– Interest and royalties can be subject to a 10% withholding tax– Dividends from taxed profit can flow tax free

Tax Holidays/Incentives– By location (SEZ’s) (ETDZ’s)– By induty (export oriented)– Refund of taxes previously paid upon reinvestment

Structure Mexico – Choice of Entity

Representative office – mere promotion of goods or services

Branch offices – requires registration with Mexican Public Registry of Commerce and authorization of the Minister of the Economy

Investment Associations – a contractual joint venture Company investment vehicles

– Sociedad Anónima – "SA" – Sociedad de Responsabilidad Limitada – ("S. de R..L.")

Structure Mexico – Choice of Entity

Foreign Investment Regulations– Activities restricted for the Mexican state– Activities restricted to Mexican individuals and entities (without

foreign participation)– Activities that allow limited foreign investment participation– To participate in a percentage higher of 49%, prior approval of the

Ministry of Economy

Tax Issues– Wide network of tax treaties– Transfer pricing is a sensitive issue– Tax relief through the maquiladora program.

Operations - Product Cost of transport (freight forwarders)/lead time/transit time Product labeling/specifications and documentation Packaging and insurance Supply chain costs / just in time inventory issues Duties, taxes and licenses fees

– Income characterization; U.S. v. Local taxation– Transfer pricing on inter-company sales– Tariffs, NAFTA– Export/import licenses, customs brokers

Cost of management and quality control– IT systems integration and management– Performance metrics/milestones and reporting

Balance sheet items (equipment) Warranty, service, support issues

Labor and Employment

Does the State and Federal WARN Act apply? Is there a U.S. union in place? If so, “effects bargaining” will

be required. Also, will the layoff stimulate a union organizing drive by the employees who are going to lose their jobs or those who remain?

Mass layoff issues will require an analysis of age, ethnicity impacts and a review of the legality of the layoff criteria. Are we laying off employees who we have been accommodating under the ADA?

Severance pay liabilities under employee handbooks or otherwise? Vacation accrual liabilities etc.

Evaluate accelerated pension vesting issues

Labor and Employment Impact on employment contracts that have performance

based bonus plans and agreements Evaluate stock option vesting issues COBRA notices must be implemented Evaluate impact on health insurance rates Golden handcuff agreements must be created There will be VISA issues for foreign employees and VISA

issues for U.W. employees working in foreign countries. Employment compensation for travel issues Analysis of employment agreements for managers in the

foreign country Analysis of impact on workers’ compensation rates

Risk / Liability –Trade/Commercialization Local Law Compliance

– Antitrust– Permits, regulatory licenses– Environmental– Privacy– Ownership restrictions (joint venture required)– Bankruptcy/insolvency in host country

Trade Barriers– Import/export restrictions– Bribery/corruption (FCPA)– Tariffs/duties

Insurance risk/management, product liability, recall– General liability/key man policies– Disaster recovery

Risk / Liability – Litigation Security Enforcement/arbitration

– Enforcement of judgment– Prosecution for IP infringement– Audit and inspection rights– Governing law and forum selection– Arbitration specifics – International arbitration

Contractual rights– Power to terminate without cause– Indemnity, limitations on liability– Survival of obligation on termination (confidentiality, non competes,

indemnity)

Cultural Corporate culture of “not invented here” or “made in the

USA” could adversely impact overall company operations Language barriers that may impede operations International issues that may impact results

– Openness to confrontation/dispute– Regard/disregard for contract provisions– Culture of bargaining– Time zones/national and religious holidays– Incentives/values