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Why Non Disclosures (NDAs) Alone Are Not Enough For China.

Posted in Basics of China Business Law

The other day, I did a post on why Non-Disclosure Agreements are so often critical for those doing business with China. Within a few hours of that post, entitled, “China Non Disclosure Agreements (NDA). A Really Good Thing,” my co-blogger, Steve Dickinson, was pointing out how if we were going to talk about non disclosure agreements (commonly referred to as an NDA), we should also discuss how and why we nearly always recommend such agreements contain non-use and non-circumvention provisions as well. I agreed with Steve, suggested he write such a post, and, voilà, here it is:

Most lawyers tell their clients who are doing outsourcing work in China that they need an NDA. Many businesses I work with see this as an example of an attorney demand with little practical application. They see the typical NDA as an unnecessary and unenforceable “piece of paper” that they only use if their legal department forces them to do so. The normal comment I receive is “1) how can I prove the information was revealed, 2) how can I prove what was revealed was actually confidential and 3) how can I enforce the agreement even if I could prove the facts?” I am usually dealing with experienced business people and, frankly, their concerns are well founded. In fact, most of the NDAs I see in China are useless because they are both directed at the wrong issues and are unenforceable. Pulling your English language NDA and having it translated into Chinese is pretty much a complete waste of time.

When we work with sourcing companies and related OEM manufacturing arrangements, we almost never just draft a “straight NDA.” Instead, we draft a “non-disclosure/non-use/non-circumvention agreement” that we refer to as an NNN Agreement. When a foreign company contracts with a Chinese company to manufacture a product, the NNN focuses on the three primary “bad acts” that the foreign company needs to prevent:

  1. The foreign company does not want its design revealed to a third party. To prevent this, a non-disclosure agreement is required. Though this is an important issue in China, disclosure to an entirely unrelated third party is actually fairly uncommon. The bigger risk is disclosure to a related party. Many Chinese businesses have multiple subsidiaries and manufacturing is often done through a large network of subcontractors. Chinese companies are quite relaxed about passing around information within this network. A good non-disclosure agreement must focus on control of information within a network that the Chinese manufacturer itself may not consider as falling within the scope of a non-disclosure requirement.
  2. The biggest concern of the foreign company is usually not disclosure to a third party. The real concern is that the foreign company does not want the Chinese manufacturer to make use of the product design to compete with the foreign company. For this purpose a non-use agreement is required. A good non-use agreement focuses on two issues. First, the agreement identifies the applicable intellectual property or confidential information of the foreign company and then authorizes the Chinese manufacturer to use that property/information solely to manufacture the product for the foreign company. Second, the agreement requires the manufacturer agree not to manufacture the product or any similar product under any circumstances, other than for the foreign company. This second provision is the most important as it prevents the Chinese manufacturer from manufacturing a similar product under its own trademark. Since many products are not covered by patent or other IP protections, the only way to prevent such “copy-cat” manufacturing is with such a non-use provision. Normal IP protections will not work, so a contractual agreement is essential. Virtually all “off the shelf” NDAs fail to account for this.
  3. The foreign company also does not want the Chinese manufacturer to go around the foreign company by selling the product directly to the foreign company’s existing or future customers. After the Chinese manufacturer has manufactured the product for some time, it will likely have learned about the market and the customers for the product. It is only natural for the Chinese manufacturer at some point to go to the ultimate customer and say: “Look, WE are the company ACTUALLY making this product and since there is no patent or other IP protection applicable to the product, why don’t you just buy the product from us, for less?” This is called circumvention and it is extremely common in China. If you want to avoid getting “cut out” in this way, a non-circumvention agreement is required. Again, an “off the shelf” NDA is not going to cover this.

Most non disclosure agreements I see are just modifications of the standard NDA used in the United States or in England and those agreements simply do not deal with the special problems of related parties in China and they treat non-use/non-circumvention either inadequately or not at all. Only a carefully thought out NNN Agreement that thoroughly resolves treats all of these issues is of any real value in China.

Stay tuned, as the day after tomorrow we will talk about the other typical fatal flaw of “off the shelf” NDAs and why those NDAs are usually not enforceable in China.

  • http://twofish.wordpress.com/ Twofish

    However you may get push back over some of these provisions. If you are using the Chinese company to manufacture a commodity product (say plastic bowls), the company you work for may simply refuse to manufacture the product for you under these sorts of conditions, since this limits their ability to manufacture the same type of product for your competitor. A lot of Chinese manufacturing involves products for which there are very few IP rights (plastic bowls for example).
    There are also situations where for strategic reasons, a foreign company will partner with a Chinese company with the full intention of turning the Chinese company into a future competitor. An example of where this could happen is if a company’s expansion is limited by anti-trust or regulatory reasons to X% of the market, and creating a Chinese competitor makes the pie bigger, which allows the first company to expand. This happens in banking.

  • Roxanne

    This is so dead on I can’t even tell you. When my company first started doing business with China, we went to our local lawyer who gave us an English language NDA and we thought we were set. It wasn’t until the Chinese factory started selling directly to our customers until we realized how inadequate it had been. I just hope your excellent advice here helps someone from avoiding our fate.

  • chinateaching

    Nice writing! I hope to be teaching in Shanghai and am trying to read everything about China I can find.

  • Zhang Ke

    As in the case with negotiating a JV with a CN company , I have experienced the value in going through the process (negotiating, dining, drinking, girls, KTV, whatever) of getting to agreement (NNN or others). It is an important part of your due diligence process for your potential partners. As another commenter has suggested, this not a just a party and you need to be looking for any indications of problems with their side. My advise: build relationships quickly in these situations, try to split the herd, and look to gather intelligence about their management, processes, strengths, weaknesses, how they treat other customers, etc. Having a good and trusted interpreter by your side that has been coached in this process is also valuable. Many times, despite them working for you, they can be viewed as being “inside the fence” with the Chinese group in the room.
    However, my question to you is; what is the reality of enforcement of this NNN agreement should the company act against it? How much time and money will it take? What is the CN court system’s history of deciding in the foreign company’s favor? And if you happen to be successful with a judgement, what about enforcement? How does the foreign company compel action by the CN company whether it be a cease and desist or some sort of financial compensation?
    Thanks.

  • Andrew

    This is a very interesting article, would it possible for you to supply some kind of NNN agreement template?
    many thanks

  • http://www.asiafactorydirect.com Robert Richard

    I am in full agreement with Zhang Ke. Agreements in China are worth about the value of the paper they are printed on. Enforcement? Unless you have unlimited time and funds, enforcement in the courts is mostly a joke. You will spend years in litigation, spend your life getting every page authenticated by the Chinese Embassy in the USA (paying authentication fees per PAGE, before they will authenticate you will need authentication by your State’s division of corporations… then you will have to repeat the process several times because the Chinese courts didn’t like the size of the paper, the color, or the lunar year in which it was done.
    My comment about China business is to carefully partner with a long term vendor. China is not about agreements, not about legality, it is all about relationships. If you have a key product with intellectual property value, consider a country with a more practical legal environment, practically speaking there is no legal protection in China. The cost savings by Chinese manufacturing may be quickly offset by having your idea stolen. On the other hand China has many, many advantages in certain applications. Know when to do business in China, when not to!
    Conclusion: hospitals and courts are the places where you don’t want to be in China… or divorce court in the USA!

    • http://www.facebook.com/profile.php?id=100004247142792 Frank Magnifico

      So do I marry the manufactures daughter?

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