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Why Non Disclosures (NDAs) Alone Are Not Enough For China, Part II. At Least Make It Enforceable.

Posted in Basics of China Business Law, Legal News

This is part II of our series on what are commonly referred to as non disclosure agreements or NDAs. In Part I, “Why Non Disclosures (NDAs) Alone Are Not Enough For China,” we talked about how many companies are using inadequate, off the shelf American NDAs in China. Those agreements are inadequate for three primary reasons. First, they typically fail to cover internal disclosure within a network. Second, they oftentimes fail to prevent the Chinese signing party from manufacturing or using the product or information sought to be protected. To remedy this, non-use provisions are required. Third, they usually fail to prevent the Chinese signing party from circumventing the foreign company by going directly to the foreign party’s customers or clients. To remedy this, non-circumvention provisions are required.

But even if these NDA agreements were to account for the three issues discussed in Part I and more briefly above, most of the ones we see would still not be worth the paper on which they are printed because they are pretty much unenforceable in China. Let’s let co-blogger, Steve Dickinson, explain:

Most NDA agreements I see are just modifications of the standard NDA used in the U.S. The non-disclosure provisions do not deal with the special problems of related parties in China and the non-use/non-circumvention is treated inadequately or not at all. Only a carefully thought out NNN Agreement (non-disclosure, non-use, non-circumvention) that treats all the issues is of any real use in China.

Even the best agreement is of no use if it cannot be enforced. This is the other major defect of the typical NDA agreements I review: the agreement is usually not enforceable. It is absolutely required that an NNN Agreement be enforceable in China. And yet, most of the NDA agreements I read are governed by U.S. or English law with enforcement by litigation in the U.S. or England or by arbitration outside of China. This approach is almost always useless. U.S. courts almost never have jurisdiction over Chinese companies, so a judgment from a U.S. court is of no value. Arbitration outside of China is expensive and slow and proof is difficult or impossible and denies access to injunctive type remedies that would be available for arbitration in China.

To greatly increase your chances of having an NNN Agreement that will actually be enforced, the following nearly always makes sense:

  1.  The Agreement must include an accurate translation into the Chinese language.
  2. The agreement must provide for enforcement through litigation in a Chinese court or through CIETAC arbitration. To further ensure that the NNN Agreement will be enforced, the NNN Agreement should provide for specific monetary damages that will be awarded in the case of a breach. Though U.S. and other common law systems sometimes discourage using this sort of liquidated damage provision, the Chinese system is the opposite. Specific contract damage provisions are encouraged since they ease the court’s work.
  3. Most NDA type agreements rely almost exclusively on injunctive relief as the primary enforcement mechanism. This is a a major mistake in China. The preference for injunctive relief in common law systems (such as the United States or England) is because it is often difficult or impossible to prove the amount of economic damages that result from a breach. This is not really an issue under Chinese law, where parties to a contract are encouraged to set a fixed amount for damages that will result from a breach. If written correctly, the liquidated damage amount sets a floor on damages, but if actual damages exceed that amount, it is permissible to seek damages for the excess. In addition, money damages and injunctive relief are not exclusive. A court or arbitrator is free to order that damages be paid and that the infringing/breaching party terminate the infringing action.

NNN Agreements that set forth a specific damage amount that will result from a breach make the cost of a breach clear to the Chinese manufacturer and if set high enough, will go a long way towards discouraging a breach. Having a properly written liquidated damages provision in your NNN Agreement also makes for quick and effective litigation/arbitration, which is much to the advantage for the damaged party.

Many Chinese manufacturers quickly sign the traditional poorly drafted and unenforceable non disclosure agreement without even thinking about it. Why is that? Because they know that their signing it comes with little to no risk.

When a Chinese manufacturer sees a well drafted NNN Agreement, they will sometimes resist signing. For some manufacturers, the reason is simple. Their whole reason for doing your outsourcing work is to acquire your technology and designs for their own products. So long as your technology is not protected by patent or trade secrecy law, and you have failed to require the Chinese manufacturer sign a strong NNN Agreement, the Chinese manufacturer is free to use your technology for its own purposes. Absent an agreement that prevents them from doing otherwise, it is perfectly legal for a Chinese manufacturer to use your unprotected information for their own products manufactured under their own trademarks. However, if an NNN Agreement makes clear that the Chinese manufacturer cannot appropriate your technology and contacts, then the manufacturer that wanted your OEM manufacturing solely for these reasons is no longer motivated to enter into the arrangement with you.

Sometimes the manufacturer has more complex reasons for refusing to sign a well drafted and enforceable NNN Agreement. A well drafted and enforceable NNN agreement shows the Chinese manufacturer that the foreign party knows its way around China and that it plans to hold the Chinese manufacturer to the terms of their contractual commitments. For this reason, the Chinese manufacturer may reasonably decide it would be better off just manufacturing for those foreign companies that do not manifest an intent to hold the Chinese side to their commitments.

Therefore, using a well drafted and enforceable NNN Agreement does actually increase the risk that the Chinese side will refuse to sign. However, we see this as a good thing. If the Chinese side has a good reason for not signing, they will say so and the agreement can be modified to account for that. If the reason for the Chinese side refusing to sign is not a good one, the Chinese side will be forced to make this clear also. In either case, the foreign company benefits from finding out in advance what is really going on. This “advance notice” function is one of the main advantages of a good NNN Agreement; it forces both sides to face up to the real situation and to engage in a frank discussion of what is really required for a successful and long term relationship. This is a much better situation than ritually executing a meaningless agreement.

  • required reading

    This should be required reading for every person even thinking of doing business via China. Can it be made part of the Chinese visa application? Or maybe even every US state business license application? Great article.

  • http://www.pbl.com David Woronov

    For NDAs and the like, if doing business with a Chinese counterparty in Beijing or relatively nearby in Northern China, some colleagues are now recommending Beijing Arbitration Commission over CIETAC for purposes of jurisdiction and Venue for dispute/conflict resolution. Any thoughts?
    Thanks,
    David

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

    There is nothing specifically Chinese about most of these issues. They also are operative when working with domestic outsourcing.
    One thing to remember is that a badly drafted contract can be worse than no contract at all. If for example, you have both sides sign a contract in which it’s stated that all trademark disputes would be settled in California courts under California law, you are much, much worse off than if you had signed no contract at all. Without a contract, you can bring suit in a Chinese court and get an order stopping the bad behavior. If you sign this contract, you won’t be able to get a Chinese court to hear the case, and even if you can get a California court to do so, you’ll likely end up with a worthless judgment.

  • http://www.chinalawblog.com Dan

    required reading,
    Why thank you. Let’s make a law on that.
    Dan

  • http://www.chinalawblog.com Dan

    David Woronov,
    We had one arbitration before the BAC but it settled so quickly we never got a feel for it. I have heard that it is making real efforts to move things along faster than CEITAC and to be more accommodating to foreigners, but I don’t know if it is succeeding in that or not. I will post this question over at the China Law Blog Linkedin Group and see what sort of responses come back.

  • http://www.chinalawblog.com Dan

    Twofish,
    You are absolutely right about how no contract at all is usually better than a really bad one and you have highlighted my pet peeve of bad contract provisions: providing for exclusive jurisdiction in the hometown American court. I would guess that about 25% of all international contracts do this. I just got a call yesterday from an American lawyer acting as though I would be all existed to take on enforcing their “huge” judgment against a big Chinese company. I could hear the air escape from his lungs when I told him that we had no interest whatsoever in taking on the case, no matter what contingency fee percentage he would be offering.
    I always try to imagine the next phone call where the lawyer calls the client and says, “you know that US case I told you to bring after telling you to put Chicago as our exclusive jurisdiction, well it turns out that the $50,000 you spent to get the judgment in Chicago…..” I think I said this previously, but I used to feel bad for these people, but now that I am older and more cynical, I cannot help but see a bit of poetic justice in it.

  • http://www.chinalawblog.com Dan

    Here’s the link to the discussion I just started on comparing BAC with CIETAC: http://is.gd/9ai2t

  • Self Helper

    I only wish I had had one of these years ago.

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  • jugito

    I like this well written article.  I ask that the authors post some typical China manufacturer NNN agreements they consider practical.  Isn’t it time for some “out of the box” NNNs that actually work in China?

    Also, didn’t the authors forget something important:  NON-HIRE?  The Chinese slash-and-burn, thick-face-black-heart business mindset could lead them simply to hire key personnel from the foreign company, including the Chinese go-between.  That could destroy or set back the foreign company’s manufacturing operation and sabotage its business.

    I mean to say the agreement should become known as the NNNN agreement.

    It might seem onerous, but I consider it practical to require the manufacturer to purchase a surety bond to cover the liquidated damages, and to increase the bond as the relationship matures.  The potential damage increases as the manufacturer becomes more and more familiar with the foreign company’s business and the associated industry.  A serious risk exists that competitors will attempt to steal information from or suborn the manufacturer, including paying off the liquidated damages, if product economics justify it. 

    This remains true even for US companies contracting with US manufacturers, designers, programmers, engineers, chemists, and the like.  Stipulating liquidated damages not only relieves the judge of doing a lot of pesky math.  It also guarantees the originating party that the defendant will not engage in hanky panky with the judge to diminish the plaintiff’s award.

    Also, the agreement might require the manuracturer to name every employee or other party to whom the manufacturer divulges the name, nature, or details of the product or manufacturing process, and the nature of the information disclosed and reason for disclosing it (need to know), and to require them to sign the NNNN as well, making them personally liable for any unauthorized disclosure, circumvention, competition, use, or hiring.

    And to keep the manufacturer from getting out of hand, the foreign company should designate representative inspectors or private investigators of good character to check on the manufacturer periodically to sniff out violations of the NNNN.  

    Additionally, Far East manufacturers have often engaged in price fixing on many levels, such as the flat panels a few years ago that got several of them punished with millions of dollars in fines, and such as companies like ZOOM engage in right now with impunity.  Any manufacturers can do similar price fixing, and the contract should bar that by requiring the manufacture to divulge costs of parts, process, and overhead, as well as the identities of all subcontractors and subassembly manufacturers.

    We need only look at the fracas between Microsoft and Samsung to see the kind of damage that can occur from violations of the NNNN, and the cost of enforcing it.

  • Adarsh Runwal

    Great article!can you also give a link to a sample NNN agreement both in English and Chinese?i was in China last month and shall be going again for contract manufacturing of my products..thanks in advance