My first post in this threeChina manufacturing lawyers part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law firm to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

My second post focused on the first four items on Renaud’s China product outsourcing list. In this, my last post in this three-part series on China manufacturing, I focus on the last three items from Renaud’s list.

Risk Five: Subcontracting. Subcontracting of production presents a number of risks often not clearly understood by foreign buyers. Renaud identifies the first and most common risk. The foreign buyer goes to substantial effort to verify that the Chinese factory it has chosen is capable of meeting its quality standards. If the factory then subcontracts the foreign buyer’s product manufacturing to another factory, all of the buyer’s verification work becomes meaningless. This then leads to other issues: How will inspections take place? How will quality control standards be enforced? How will worker safety or worker age rules be enforced? How will anti-bribery and related rules be enforced? Working to the next level, manufacturing by a third party where there is no contractual relationship means that confidential information agreements are automatically breached, and this is a primary way intellectual property gets lost in China. Finally, molds and tooling are often moved to the subcontractor, resulting in loss of control and the inability to retrieve these items when required.

There are three reasons Chinese factories typically subcontract. First, the “factory” is a front for a trading company that actually does no actual manufacturing on its own. This type of trading company will subcontract all of the manufacturing and will limit its involvement to supervising (usually very poorly) the manufacturing process. Second, the factory may be capable of doing the basic manufacturing process, but it requires subcontracting assistance on key elements of the production process. For example, it is normal for Chinese factories to subcontract mold making and electroplating of key components. Finally, the factory may decide that the foreign buyer’s purchases are too small to justify the effort of setting up production and it will subcontract to a factory with the time and the interest. Such a factory is almost guaranteed to be of lower quality, leading to the problems Renaud describes in his post.

Since subcontracting is always an issue when manufacturing in China, it is necessary to confront the issue directly in a formal agreement. The standard approach is to provide that subcontracting is prohibited without notice to and consent by the foreign buyer. The foreign buyer should condition its consent on inspecting the subcontractor and getting the subcontractor to execute a separate manufacturing contract with the same key terms as the foreign buyer has with its original manufacturer.

Though this approach is best, many Chinese factories insist on an absolute right to subcontract. In that situation, if the foreign buyer agrees, then the normal contract provision is to require (a) the Chinese factory at least identify its subcontractor(s) (b) the subcontractor grant the foreign buyer access to its premises for inspection and c) the Chinese factory agree to be directly liable for any violations committed by the subcontractor. Some Chinese factories will not agree to these conditions. When that happens, our China lawyers recommend the foreign buyer refuse to purchase its products from that factory.

Renaud identifies a more difficult problem: undisclosed subcontracting. This situation is unfortunately quite common. It arises most often during the busy season when a factory simply cannot keep up with the orders it has accepted. The best way to prevent this from taking place, the foreign buyer must regularly inspect the factory operations to ensure that the factory is really doing the work on the premises. Since the high season is the most likely time subcontracting will occur, this is the time when appropriate, unannounced inspections should occur. It is also crucial to enter into a formal agreement that prohibits undisclosed subcontracting as described above.

Way back in 2009, in The Six (Not Five) Keys To China Quality, we wrote about the tremendous value of putting a no-subcontracting provision in your China manufacturing agreements:

We typically put a provision in our OEM agreements (which we nearly always do in Chinese for better enforcement in China against the manufacturer) mandating that the Chinese manufacturer cannot subcontract out the manufacturing. We have been doing this for years and, as far as we know, no manufacturer has ever violated this provision. I know many of you are dubious of this record, but hear me out. Let’s say the Chinese manufacturer has 30 customers for whom it manufacturers product. Let’s say only four of those customers have a no subcontracting provision (my guess is this number is more like to be two, but for the sake of argument, let’s go with four here). The China OEM manufacturer gets really busy and has to subcontract out some of its manufacturing. It can subcontract out the product manufacturing of any of its 30 customers, so why wouldn’t it choose to subcontract out the product for the 26 customers who have no contract provision prohibiting subcontracting? I call this the bike lock theory of Chinese law because the no-subcontract provision operates like a good bike lock. The thief can still steal your bike, but why would he when there are so many easier targets out there?

In our experience, these no-subcontracting provisions work shockingly well.

Risk Six: Failure to Deal with Defective Product. The problem of defective products raises several issues. First, it is critical to identify a factory that will attain and maintain a reasonable defect rate. If the defect rate during production is over an “epidemic percentage” level, it is almost certain success will not be achieved. As Renaud illustrates in his post, the defects in Chinese factories are often at the cosmetic level. The base product is acceptable, but the finish is defective or scratched; fingerprints show up on glass in an enclosed case; greasy footprints are found on well sewn, elegant handbags.

There are two issues relating to dealing with such defects. The first is how to locate the defect. It is best to locate the defect during the production process. Second best is to locate the defect before shipping. Third best is to locate the defect after your receipt of the product. The worst case is to learn of the defect after delivery to the down stream customer.

As Renaud notes, once defects are found, the parties must have in place a formal plan that clearly deals with what will be done with the defective product. It is critical not to allow the defective product to enter into the retail market. Many Chinese factories will sell defective product “out the back door.” When this product gets into the market, the damage to your reputation can be substantial.

But what should be done with defective product? We usually provide that the defective product must be destroyed. However, this is not always the best alternative. In some cases, the defective product can be repaired or otherwise reworked. This is a common approach for complex and expensive cast metal parts for large equipment. In other cases, the defective product can be disassembled so that valuable components, such as precious metals, can be recovered.

Once you resolve how to handle defective products you receive from your China factory, your next issue is how to get reimbursed for the defects. The Chinese side will usually propose that the value of the defective product be applied as a credit against your future purchases. This is a bad system because the foreign buyer can only obtain credit if it makes another purchase. This forces the buyer into a relationship with a factory that makes defective product. Even worse, the amount paid to the factory is going down for each new purchase, which means the factory has even less incentive to do a good job.

The practical solution is for you to inspect your product before making any payments for its manufacture and reducing the invoice price to account for any short delivery resulting from removal of defective product from any given shipment. If the defect level reaches an epidemic failure rate (this rate must be determined on a product by product basis), your manufacturing contract should provide for you to be able to impose additional penalties. Foreign buyers that delay dealing with quality issues until after they have made full payment for their product are virtually never able to successfully resolve their China product defect issues.

The above discussion shows that a detailed, formal system for dealing with quality control and handling of defects is required and the only way to do this is with a formal, written manufacturing agreement. The common one line statement that the Chinese factory will warrant the quality of its products will never work. Manufacturing in China will ALWAYS result in defects. A workable plan for dealing with those defects is therefore not optional. It is required.

Renaud’s post raises an even more important issue. In some cases, the defect level from the factory will be high and will remain high. In that situation, where a defect rate is over 20%, it is normally impossible to develop a workable solution with the factory. The solution here is to monitor the process from the very beginning. In China, factories do not do better work over time. Their performance almost always only gets worse over time. As soon as an excessive defect rate is identified, you should take immediate action. Usually that immediate action means cutting your losses and moving to a new factory. A good manufacturing agreement will make this transition as easy as possible.

Risk 7. Logistics Cost Increases Due to Factory Error. As Renaud notes, you need to beware of increased shipping costs due to your factory making an error in the size of container required to ship your product. This issue arises from a common mistake make by foreign buyers. Inexperienced foreign buyers often do not understand that in international transactions, “logistics” is an integral factor for success. Shipping costs, shipping timing, method of shipment (air/ground/ocean), port of delivery and a host of other factors can have substantially impact the marketability/pricing of your product.

This then leads to the standard mistake. The foreign buyer looks for the lowest China Price. So the China manufacturer provides a product price that does not include the shipping cost: free carrier or the (erroneous) FOB price. Under these terms, it is the foreign buyer’s responsibility to make arrangements for shipping. The illusory concept is that the foreign buyer will then negotiate the lowest shipping rate, making for an even higher profit.

In fact, however, foreign buyers are normally unable to effectively manage shipping in China. So even though they specify free carrier terms, they in fact end up needing to rely on their Chinese factory to make all the arrangements for shipping. But under this scenario, the foreign buyer has taken on all liability for mistakes and yet it has no effective control to prevent those mistakes. This then is a perfect setting for the kind of disaster that Renaud describes.

From a legal perspective, resolution of this problem is simple. The foreign buyer’s contract with its China factory should reverse impose all of the responsibility and liability for shipping on the China factory. This is done with a manufacturing contract that provides for the product price to include shipping fees. The standard CIF (cost insurance freight) shipping term will achieve this goal. Use of CIF terms does not mean that your China factory will not make mistakes, but it does mean that your factory (not you) will be liable for those mistakes. Your China manufacturing agreement should also include a provision that requires your factory ship by air freight if delivery of your product will be delayed beyond a certain number of days. The only way to ensure that your China factory treats your key business issues as important is for your manufacturing agreement to impose an immediate penalty on your factory that does not require a cross border lawsuit to enforce.

 

China manufacturing contractMy first post in this three part series focused on a post entitled The 7 Major Risks You Run With Your China Manufacturers, by China manufacturing expert Renaud Anjouran. In that post, Renaud outlined the business risks foreign companies face when having Chinese factories manufacture their products. I noted how Renaud’s list nicely accords with what our China lawyers tell our clients who retain my law frim to draft their Chinese manufacturing contracts. See China Manufacturing Agreements: Binding Contract or Contract Terms. I noted how our manufacturing clients usually want to focus on a) intellectual property protection/prevention of counterfeiting, ownership of molds and tooling and after sales warranty service. In other words, the sorts of things legal agreements are really good at resolving. But oftentimes, core business issues like price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping are of at least equal importance.

The source of the problems for Western companies that manufacture in China is the pervasive use of the purchase order approach to purchasing contract manufactured product from China. In China Manufacturing Agreements: Binding Contract or Contract Terms, I wrote how there are two basic ways to structure a China contract manufacturing agreement.

Option One is to enter into a legally binding contract (in Chinese!) that addresses all of the basic manufacturing issues. The agreement on price binds both the Chinese factory and the foreign buyer, and even if costs change, the parties remain obligated to pay and sell the product at the agreed-upon price, no matter which party benefits or loses from the changes. This sort of contract is common in much of the world, but less so in China. China, however, the entire risk tends to be loaded on one side or the other. The same applies to the other key business terms in China manufacturing agreements, such as the terms for payment, quantity, delivery date and quality. Foreign buyers who do not want to be bound or who cannot be bound due to lack of resources will follow Option Two. Under Option Two, the contract terms and conditions are binding on the parties only after a purchase order is presented by the foreign party and then accepted by the Chinese party. It is this lack of a binding agreement that is the primary cause of the seven manufacturing risks Renaud discusses in his post.

The obvious path to contract certainty  is to enter into an Option 1 manufacturing contract that formally commits both parties to the basic business terms for a specific period of time. However, the lure of China for many foreign buyers is that Chinese factories are willing to do small runs on a purchase order basis. The purchase order system is oftentimes THE reason why the foreign company is having its product developed and made in China. For this reason, our primary task as lawyers is to develop contract manufacturing agreements that deal up front with the risks that come from using the purchase order approach. Our job as China attorneys then is to make sure that our foreign buyer clients understand the risks and then to work on mitigating those risks in a practical way.

I explain below and in Part 3 of this series how our China manufacturing lawyers do that with each of the seven risks Renaud identified.

Risk 1: Lack of “Motivation.” The major risk we see stems from the foreign buyer loading the development costs onto the Chinese side with no incentive for the Chinese side to follow through on development. Renaud calls this risk “loss of motivation” and we see this all the time. The foreign side relies on the Chinese factory to do the product development, normally loading the cost on the Chinese factory. After two years, the development is not completed and the market has moved on, leaving the foreign side high and dry with no marketable product. The Chinese side assures the foreign buyer that they are “working on it,” but in fact the product development project is a low priority as compared to their ongoing manufacturing that pays their bills and so they are “working on it” only when times are slack. It is also common for Chinese factories to agree to take on a development project when they do not actually have the capability to do the work. In this situation, the delay results from the Chinese side being pushed up against the limits of what it can actually do.

The best way to address this lack of motivation risk basic method is to enter into a legally binding product development agreement with the Chinese factory that includes the following:

  • Milestones: hard dates for development of prototypes or samples.
  • Allocation of costs. If all costs are loaded on the Chinese side, the chance of success is dramatically reduced.
  • A real incentive for the Chinese side to succeed. This incentive can be payments for the Chinese factory hitting its milestones or it can be a commitment to purchase reasonable (but predetermined) quantities of the developed product at a fair price.

Few foreign buyers follow this approach, with the predictable results described by Renaud.

Risk Two: Quality Failure at the Production Stage. The Chinese side agrees to manufacture the product at the “China Price.” Initial samples are acceptable in terms of quality, but once production starts, the quality is consistently bad. When pressed, the Chinese side says: “We gave you the China Price and you knew that at that price we would never be able to produce a quality product. It is your fault: you have to choose. If you want the China Price, you don’t get assurance of quality, quantity or delivery date. If you want all those items to be acceptable to you, we need a binding contract that covers all four issues in a manner that works for us too. But if you insist on the China Price and you do not provide us with a binding commitment for orders, you will have to accept what we provide.”

Price is not the only issue; there are four key factors involved in having your products made in China: price, quantity, delivery date and quality and if you fail to hold your Chinese factory legally accountable for all four of these things, you are likely to have problems. If your Chinese supplier takes all four factors seriously, its pricing must increase. Foreign buyers who are not willing to accept such an increase will continually face the Chinese factory failing to comply with the other factors. Quality will suffer, delivery will be short or late, or the factory will suddenly quit accepting orders right at the height of the delivery season.

Risk Three: Low Priority in Production Schedule. The Chinese side accepts your purchase order for a small run of product at a low “China” price. Then another buyer shows up and offers a slightly higher price for a larger quantity of product. The Chinese side then pushes your order down the line for priority and your delivery is delayed. In some cases, the delay extends to the point where delivery never takes place. The Chinese side is not concerned about failing to deliver on the purchase order, since the litigation risks are extremely low because you do not have a Chinese language contract that works. See China Contracts: Make Them Enforceable Or Don’t Bother.

This situation regularly occurs when the relationship is based on “one off” purchase orders. See How To Get Bad Product From China With No Legal Recourse. The way to deal with this issue is to have a contract manufacturing agreement that clearly incorporates your purchase orders into the legally binding contract and that provides specific monetary penalties if your factory accepts a purchase order and then either delays or fails to deliver. When pressed to enter into this sort of agreement, Chinese factories will treat accepted purchase orders seriously and their delay/default rate goes way down. In our experience, factories that intend to take a relaxed view towards their legal obligations under an accepted purchase order will simply refuse to execute a formal contract manufacturing agreement, which is exactly what you want. See How To Write A China Contract. Liquidated Damages.

Risk Four: Sudden and Unpredictable Price Increases. Under the standard scenario, the Chinese side agrees to manufacture your product at a goal price, without ever having undertaken any serious examination of what it will actually take to manufacturer your product. The Chinese side then does the product development and the production implementation. The samples are acceptable and it is time to begin production. The foreign buyer then submits the first purchase order at the goal price. The Chinese side refuses to accept the PO and announces a substantial price increase. If the price increase is not accepted, the factory states that it will not accept any future purchase order.

There are two reasons China factories do this. The first and most common is that the factory never understood the price issue and never planned to meet the proposed price. The factory merely accepted the goal price to prevent you from going to another factory. The Chinese factory assumes you will be compelled to accept a purchase at the “real” price (whatever that price is) because you will be unwilling or unable to spend another 6-12 months (or whatever it will take) to start over with another factory.

The second common reason Chinese factories will take on a product development project with no intention of giving you the product you want at a price and delivery schedule that can make sense is that the factory is treating you as its outsourced R&D center. The idea comes from the foreign side, the implementation comes from the Chinese side. But the ultimate goal is for the Chinese side to make and sell the product on its own. The Chinese factory never planned to make the product for the foreigner. So they offer a very high price. If the foreigner accepts, they make the product for the foreigner at a price higher than they ever imagined. If the foreigner refuses the price, they move on to make and sell the product on their own. This sort of thing is incredibly common and hardly a week goes by without someone calling one of our China lawyers for our help to “require the Chinese factory to get its price in line with the market.” But unless you have a written contract that works for China and made pricing clear, there is nothing we can do to help at that point.

If the foreign buyer is purchasing an off the shelf product that is part of the Chinese factory’s standard inventory, the risk of any price issue is low. If you are engaging the Chinese factory to make minor customization of its standard product (maybe just adding your logo or changing the color), the risk is also low. But if the Chinese factory will be modifying/customizing its existing product, you should have a legally binding contract that the Chinese factory feels compelled to honor. The way to deal with this is under a product development agreement that includes the following three key components:

  • A strict timeline for developing the working prototype.
  • A provision that makes clear you own the prototype and all data, drawings and tooling required to manufacture based on the prototype.
  • A provision that states that if the factory meets the target price, you will purchase exclusively from the factory, but if the factory cannot meet the target price, you are free to take the prototype and have it manufactured at any other factory.

Without an agreement like this, you should expect a price increase as an almost a certain result of the product development process.

In part 3 of this series (coming later this week), I will examine how best to deal with the last three business risks inherent in having your product made in China, including one of my favorites, subcontracting.

 

China manufacturing lawyersIn a post entitled The 7 Major Risks You Run With Your China Manufacturers, China manufacturing expert Renaud Anjouran outlines the business risks foreign companies face when outsourcing their product manufacturing to Chinese factories. Renaud’s list nicely accords with what our China lawyers tell our clients for whom we draft Chinese contract manufacturing agreements. See China Manufacturing Agreements: Binding Contract or Contract Terms. When we first talk, our manufacturing clients usually want to focus on the following: a) ownership of intellectual property, b) prevention of counterfeiting, c) ownership of molds and tooling and d) after sales warranty service. This is the kind of thing legal agreements are really good at resolving and it is easy to allow the discussion to center on these issues.

But in my 25+ years of working in China, it is rarely these issues that result in bankruptcy of the foreign purchaser. The matters that result in bankruptcy are usually on the list provided by Renaud. That is, the most serious issues are the core business issues tied to outsourced manufacturing: price, quantity, delivery date, quality and resolution of quality issues, subcontracting and shipping.

Renaud describes the basic issues, but, we should ask at the outset: what is the source of these issues and what can be done to address them. The source of the problems is the pervasive use of the purchase order approach to purchasing contract manufactured product from China. In China Manufacturing Agreements: Binding Contract or Contract Terms, I wrote how there are two basic ways to structure a China contract manufacturing agreement.

Option One is to enter into a binding contract with the China factory that directly confronts all of the basic manufacturing issues in a manner that is legally binding on both the parties. Under this option, the agreement on price binds both the Chinese factory and the foreign buyer. If material costs change, if labor costs change, if production costs change, the parties remain obligated to pay and sell the product at the agreed-upon price, no matter which party benefits or loses from the changes. Both parties are taking the price risk. If the agreement is long term and if the various input costs are likely to change over time, then the parties either take the risk or develop a detailed system for adjusting in response to the change. In most of the world, this is what is done. In China, however, the entire risk tends to be loaded on one side or the other. The same applies to the other key business terms in China manufacturing agreements, such as the terms for payment, quantity, delivery date and quality.

The issue for many foreign buyers is that under Option One, both parties are bound. Foreign buyers who do not want to be bound or who cannot be bound due to lack of resources will follow Option Two. Under Option Two, any form of contract manufacturing agreement is little more than terms and conditions. Such terms and conditions are binding on the parties only after a purchase order is presented by the foreign party and then accepted by the Chinese party. If the Chinese manufacturer does not accept your purchase order, there is no binding agreement you and your Chinese manufacturer. It is this lack of a binding agreement that is the primary cause of the seven manufacturing risks Renaud discusses in his post.

Consider for a second why that is the case from the perspective of the Chinese factory. Under the purchase order approach, the factory has no assurance that its foreign buyer will place even a single order. During a fiscal year, the Chinese factory has no assurance on price, quantity or delivery date. The Chinese factory is expected to develop the product, taking on the risk and expense of commercialization. The Chinese factory is then expected to turn over to its foreign buyer the plans, molds and tooling so the foreign buyer can move production to a lower cost factory down the road. In this type of situation, the factory really has nothing solid in the relationship with the foreign buyer. So the factory acts in the manner described by Renaud. This is perfectly natural and it is to be expected. That is, any foreign buyer that expects a Chinese factory to act differently under the purchase order approach option is living in a dream world.

So what is the solution? The obvious solution is to follow Option 1 by entering into a binding agreement with the Chinese factory that formally commits both parties to the basic business terms for a specific period of time. However, the lure of China for many foreign buyers is that Chinese factories are willing to do small runs on a purchase order basis. The purchase order system is oftentimes the reason why the foreign company is having its product developed and manufactured in China. To tell these buyers to follow Option 1 is unrealistic.

For this reason, our primary task as lawyers is to develop contract manufacturing agreements that recognize that the purchase order approach will be used and deal up front with the risks that come from that. The key here is that the foreign buyer understand the risks and work actively with the Chinese factory to deal with mitigating those risks in a way that is practical and fair.

We can now consider the situation in China in relation to the risks Renaud identifies. In my follow-up post (on Sunday) I will discuss the first four of these risks and how best to mitigate against them. In part 3 of this series, I will conclude by examining how to deal with the last three of these risks.

China lawyers
Do not fall for manufacturing contract illusions

A good China manufacturing agreement must address many issues, including, most importantly, the basic business terms for purchase of the manufactured product. The key business terms are price, quantity and date of delivery. When our China lawyers draft a manufacturing agreement for a China factory, we have to determine at the outset how to address these essential terms in the agreement.

There are two options.

Option One. With respect to the purchase of goods, we make the manufacturing agreement a binding agreement for a specific quantity of product to be delivered within a specific timeframe at a specific price. The foreign buyer is obligated to purchase and the manufacturer is obligated to sell and failure to perform is a breach of contract. This type of agreement is often supported by a letter of credit.

Option Two. The agreement provides the terms and conditions for a purchase of goods contract formed only after a purchase order is submitted by the foreign buyer and only after that purchase order is accepted by the Chinese manufacturer. If the foreign buyer never submits a purchase order to its Chinese manufacturer or if the Chinese manufacturer rejects the purchase order submitted by the foreign buyer, no purchase of goods contract is ever formed. The failure to submit a purchase order is not a breach. In the same way, the rejection of a purchase order is a also not a breach. Since there is no binding contract, this type of agreement is not supported by a letter of credit.

Multinationals that purchase large quantities of product from Chinese manufacturers generally follow Option One. This provides two major benefits. First, the product price is locked for a specific period. The risk of cost changes for materials or exchange rate or anything else is borne by the two parties equally. Second, the delivery date for the product is mostly fixed, allowing the buyer to plan for seasonal variations in demand. The major risk the buyer takes is that its product will not sell and then the buyer will be “stuck” with a substantial quantity of unsold product.

Buyers not willing to take this risk follow Option Two. Option Two is typical for startups and for entities introducing a new product with an uncertain sales market. This arrangement provides the foreign buyer with substantial flexibility. It allows the foreign buyer to test the market for its product and if its product fails, the buyer is not locked into purchase obligations and being stuck with unsold product.

But this flexibility comes at a cost. Many foreign buyers will do not realize that with this sort of agreement, there really is not agreement on business terms. If the Chinese factory decides it does not want to accept the foreign buyers’ terms it can and will simply reject the foreign buyer’s purchase order. If the Chinese factory wants to raise its price, it rejects. If the Chinese factory is unable to meet the required quantity, it rejects. If the Chinese factory is unable to meet the required delivery date, it rejects. Such a rejection is not a contract breach and the buyer has really no choice other than to accept the rejection.

At its simplest level, this situation means it is impossible for the foreign buyer to negotiate best terms with the Chinese factory. Since the foreign buyer has no real leverage, it cannot negotiate effectively on price. The foreign buyer may think it forced its Chinese counterpart to agree to a rock bottom “China price,” but the China manufacturer can easily turn the table by waiting until the foreign buyer has fully committed to the factory and is hard against a time deadline. The Chinese manufacturer then rejects an important purchase order and negotiates a price increase.

Consider what this means for a startup company with a single new product. The company has worked hard on marketing its product for the holiday sales season. After substantial effort, the startup receives enough orders. Those orders require delivery of the new product on a specific date, in specific amounts and at a specific price. The U.S. or EU buyers insist on a binding contract. The startup is obligated to perform.

Only after receipt of these orders does the startup then submit a purchase order to the Chinese manufacturer and then the Chinese manufacturer rejects the purchase order. The Chinese manufacturer may demand a higher price or it may say: “Sorry folks but you waited too long to place your order. We are all booked up and we don’t have the manufacturing capacity to handle your order.”

Consider what this means for the startup. It has fully binding sales obligations to its U.S. or EU retail customers and its failure to deliver on those obligations is a breach of contract that will subject it to a lawsuit in its home country. Its inability to fulfill its contracted for orders is both a financial liability and it also destroys the credibility of the startup as a real player in the retail field. If the startup does not have deep financial backing, it is usually impossible for it to recover from this blow. Usually, this all comes as a complete surprise to the startup, since it was operating under the illusion that it had a binding contract with its Chinese product supplier on all relevant business terms.

Our China attorneys get desperate calls and emails from U.S. and EU retailers who have unknowingly put themselves in this “no business terms” trap, but our phones ring off the hook with these from October to December. And usually all we can tell them is to do it right the next time (all while wondering if they will have a next time).

This business terms issue must be resolved for every manufacturing contract. It extends to other issues too. For example, say your contract provides for your Chinese manufacturer to provide a certain type of packaging which is included in the price of the product. The manufacturer decides to make a change. Under Option Two, the Chinese manufacturer simply rejects the purchase order and negotiates for a change. The original provision was an illusion since the manufacturer was not obligated to perform.

Warren Buffet once sad that “only when the tide goes out do you discover who has been swimming naked. The holiday season is when so many U.S. and EU companies learn that their failure to have a good manufacutring contract with their Chinese manufacturers has left them with no clothes. If you are looking to have your products made in China, the first thing you must decide is which option will apply to your purchases and you then need a contract that reflects and legalizes your decision. An illusion about your real situation with your Chinese manufacturer can and usually will lead to unpleasant consequences.

For more on what you should do to protect yourself when manufacturing in China, check out Having Your Product Made In China: The Basics on Protecting It and You.

China cybersecurity lawsThe PRC government promulgated its Cybersecurity Law on November 7, 2016, with an effective date of June 1, 2017. To say that foreign tech firms are concerned about the impact of this new law on their business in China would be an understatement. In addition to tech firms, our China lawyers have received a steady stream of questions from clients with China WFOEs who are concerned about an entirely different set of issues. Article 35 of the law states that “personal information and other important data gathered or produced by critical information infrastructure network operators during operations within the mainland territory of the People’s Republic of China, shall store it within mainland China.” Our clients keep asking what this will mean for them.

The surprising answer is not much.

Any company that operates a WFOE in China collects personal information about its employees. China’s new cybersecurity law defines personal information as “all kinds of information, recorded electronically or through other means, that taken alone or together with other information, is sufficient to identify a natural person’s identity, including, but not limited to, natural persons’ full names, birth dates, identification numbers, personal biometric information, addresses, telephone numbers, and so forth.” Certainly, the standard information any company maintains on its employees will qualify as personal information under China’s new cybersecurity law.

In the EU and various other jurisdictions, such personal information must be maintained within the jurisdiction and there should be no transfer of such information across borders. This causes many problems for companies that seek to manage an international workforce through a central location.

So what clients keep asking our China attorneys is whether China’s new cybersecurity laws will establish the same sort of protective system within China? The simple answer is that it will not. China does not have a comprehensive law or regulations relating to the collection, processing or transfer of employee data gathered by a WFOE or other business entity in the normal course of its China business operations and China’s new cybersecurity law does not change that situation.

The cybersecurity law specifically provides that its personal data maintenance and collection rules apply only to critical infrastructure network operators. Network operator is defined as “network owners, managers and network service providers.” In more general terms, this means telecom operators and Internet ISPs. The requirements do not apply to the China business operations of normal private businesses with respect to their normal record keeping requirements for their employees.

Even though nothing has legally changed in China, it is still best practice for foreign companies employers in China to follow the basic rules the PRC government imposes more generally in the consumer context on the collection and maintenance of personal information, including the following:

1. Be sure the disclosing party (your employee) is aware that the company maintains personal information. The company should have a written policy (in Chinese and in English) on how long that information is maintained and that policy should be revealed to the employee.

2. You should not collect more personal information than necessary.

3. You should maintain the confidentiality of the personal information you collect and maintain. That means you should limit internal access to that information and you should take proper security measures to prevent a data breach of the company’s online systems.

4. You should not sell or otherwise transfer the personal information to any third party. Stated more bluntly, do not sell employee personal information to marketers or spammers.

China manufacturing lawyersIn Part 1 of this series, I discussed how the increasing complexity of products made in China has led to a corresponding increase in the complexity of the molds for those products, and of how that means our China attorneys increasingly must draft contracts to protect our client’s IP within those molds. I concluded the first part of this series by noting how most mold IP issues arise in two settings: dealing with third party mold fabrication shops in China and dealing with the Chinese outsource factories themselves. In Part 2 of this series, I addressed mold IP issues when dealing with third party mold fabricators, sometimes called mold fabrication shops. In this, Part 3, I will discuss the sorts of issues our China lawyers have been seeing lately with Chinese manufacturers on mold issues.

The Chinese manufacturer has produced a series of molds for a product for its foreign buyer. Now that the product has become commercially successful, we often see the following three basic problems arise:

  • The Chinese manufacturer announces a substantial increase in the price of the product. This is often a surprise to the foreign buyer, who had expected the per unit price of the product to go down as production increased.
  • The Chinese manufacturer is not able to keep up with increased production requirements. This is often a surprise to the foreign buyer, who had been assured by the manufacturer that it has ample capacity for any scale of orders.
  • The stress of increased production demand causes the quality level from the Chinese manufacturer to progressively decline, reaching unacceptable levels. This is often a surprise to the foreign buyer, who had expected quality to improve over time.

In response to these issues, the foreign buyer gives notice to its Chinese manufacturer that it intends to move production to a different manufacturer, often a direct competitor of the current manufacturer. In the past, the issues that arose at this stage mostly focused on ownership of the physical molds. This issue can be resolved by a relatively simple mold ownership agreement. To the extent that a mold ownership agreement resolves the issues, this is old news. See Product Molds And Tooling In China: Three Things You Must Do to Hang on to Yours.

However, in the past year we have seen Chinese factories make arguments (like those below) that render the situation far more complex:

  • The Chinese factory says: “It is true you paid the fabrication fee for the molds. But that fee only covered the material costs and the time involved. However, in addition to that, we at the factory spent a lot of time and money doing the CAD drawings and related specifications required to fabricate the molds and we also spent additional engineering time in integrating the molds into our production process. Before you can take the molds, you have to compensate us for those costs. We won’t even charge you a markup. Just pay us for our out of pocket costs.” Then the factory provides an unreasonably high invoice for those costs and if you do not pay the invoice, the factory will continue to hold your molds hostage. This has become almost standard practice in outsource manufacturing, particularly in southern China. It is therefore essential for foreign designers to make clear in a written contract that all amounts paid for molds include both design and fabrication costs and that no additional payments will be required when the foreign buyer seeks to take possession of the molds.
  • The Chinese factory says: “It is true that you own the molds and you can take them whenever you want. However, we did all the design work on those molds so we own the design embodied by the molds. We will give you a license to use the molds in production in another factory. However, that license is limited. You have no right to copy the molds. We, on the other hand, have the right to copy the molds and we have the right to use the mold design for our own production or to provide copies of the molds to third party factories for their own production. The only thing you own is the physical object. You do not own anything else.”
  • In the more extreme case, the Chinese factory says: “We did all the design work for the molds so we own that design and we already registered a design patent in the molds. Since we did all the work, we are the inventor for patent purposes. It does not matter that you paid us for the molds. We still remain the inventor and our design patent protects us. You can have the physical molds, but if you want to use those molds for production at a different factory, you must pay us a royalty fee.” This royalty is then quoted at a price so hight that you cannot economically have your product produced at a third party facility.\
  • Lately, the more honest Chinese factories make the situation clear. The foreign buyer pays for fabricating the mold, but that payment does not convey any ownership interest in the molds to the foreign buyer. The Chinese factory does the design work and the Chinese factory owns the molds. The Chinese factory will agree to use the molds only for the purpose of producing the product for the foreign buyer, however, the foreign buyer has no right to move the molds to any other factory. In this setting, some Chinese factories will say that you are free to make new molds at your new factory, but some will assert ownership to the mold design and not allow you to have copies made at the new factory. Often Chinese factories will make this contention even when they do not have a registered design patent. To them the situation is obvious. They both designed the mold and arranged for its fabrication and so they own all rights in the mold without any need to register a design patent. Whether this position would be supported by a court is unclear. But since it is unclear, most Chinese factories will refuse to work with the new factory. What is so interesting about this approach is that the Chinese factory is clear about its intent from the beginning. The Chinese factory intends to hold the foreign buyer hostage by guaranteeing that the foreign buyer cannot go to any other factory in China as an alternative manufacturer of the product. By holding the foreign buyer hostage, when the Chinese factory raises its price or delivers the products late or produces defective products, the foreign party is pretty much trapped. It has no place else to go and no real leverage for dealing with the issues. We are getting a call a week from foreign companies in these situations, with little that can be done beyond essentially starting over.

This is where outsource manufacturing is going in China. Foreign product designers need to deal with it. At a first level, the foreign designer can enter into written contracts that provide protection. However, at a second level, if the Chinese factory intends the “hostage” result, it will reject signing a contract that will prevent that. When that happens the foreign designer is forced to face reality and decide whether manufacturing its new and innovative product in a setting where it is hostage to a Chinese factory makes economic sense or not. Or whether it can or should try to find another manufacturer. Our clients often argue that it does make sense. We are not so sure.

China Mold ownership
Control Room

In part 1 of this series, I talked about how the increasing complexity of products being made in China has led to a corresponding increase in the complexity of the molds for those products, and of how that means our China attorneys are increasingly needing to draft contracts to protect our client’s IP within those molds.

I concluded the first part of this series by noting how most mold IP issues arise in two settings: dealing with third party mold fabrication shops in China and dealing with the Chinese outsource factories themselves. In this part 2 of my series, I address mold IP issues when dealing with third party mold fabricators, sometimes called mold fabrication shops. .

The issues that typically arise with mold fabrication shops arise because of a change in procedure that no one has really noticed. It is standard procedure to provide that the Chinese factory that is making your product is responsible for fabricating the molds for the product. In the old days, the same factory almost always made the molds and the product. However, it has now become more common for the factory to outsource mold fabrication to a third party. In many cases, even the design of the molds is outsourced to that third party.

What this means is that a mold agreement with your factory that has been drafted to control the ownership of the molds and to control the IP in the product is compromised or eliminated when all of the specifications and the responsibility for fabrication gets sent off to a third party mold manufacturer. Given the economics of mold fabrication in China, it is not likely that the mold fabricator will use the mold design for its own purposes. Rather, the fundamental risk here is that the mold manufacturer will sell copies of the molds to other Chinese factories who have an interest in cloning your product.

This type of cloning is of course a thriving business in China. Foreign designers often wonder how a terrific copy of their product got to market before they have even gone into full scale production. Well this is how it happens: the mold manufacturers conduct a thriving trade in selling the “latest” molds. Though it is common to blame the factories for this leakage, this blame is often misplaced. Your China factory has an incentive to keep the mold for its own use since once the mold gets out into the world, the molds are then used by your factory’s competitors. When this happens, the Chinese factory is damaged in much the same way as the foreign designer.

Though losing one’s molds via a third party mold fabrication shop is an enormous risk, few foreign designers and virtually no Chinese factories make much to control the mold fabricator. In other words, clearly drafted written contracts dealing with this issue are rarely entered into between the Chinese factory and the mold fabricator. The foreign designer not only hardly ever enters into any sort of contract with the mold fabricator, the foreign designer normally does not even know the identity of the fabricator. This leaves a gigantic hole in IP protection. This hole can and should be closed through a simple set of contracts.

Consider also what this uncontrolled release of the design of the product means in terms of intellectual property in the product. Many products designs are protected primarily as trade secrets. When the design is released to a third party fabrication shop with no written agreement, the secrecy in that product is broken, and this eliminates any trade secrecy protection.

Consider also the issue of patent protection. In acquiring a patent anywhere in the world, one of the first questions that has to be answered is who invented the item. In a case where the design of the mold has been outsourced to a third party fab shop, the question of who is actually the inventor is now unclear. Is it the foreign designer who developed the basic idea? Is it the Chinese factory that did some preliminary drawings? Or is it the mold fabricator that did the detailed drawings and produced the final working model? Or is it all three, each entitled to an uncertain percentage of the patent?

With this sort of tripartite structure, the usual answer is that no one owns any IP in the molds: no patents, no trade secrets. Often that then means that no one owns any IP in the product itself. This obviously then leads to disaster in the commercialization phase for the product.

In part 3 of this series, I will consider how to approach these issues when dealing with the Chinese factory to which you are outsourcing your manufacturing. Note that though the parties differ from the situation I discuss above, the fundamental issue remains the same: when a third party does the design and fabrication work on behalf of a foreign designer, who owns the IP in the resulting design will be at issue. For the product, the question is who owns the design for the product. For the molds, the question is who owns the design in the molds. Where the molds ARE the product, this becomes a core issue that cannot be ignored.

 

China manufacturing lawyers
China molds. Keep them to yourself.

In working with outsource manufacturing in China, one of our primary goals is to control the molds used in the manufacturing process it is critical to make clear that the foreign buyer owns the physical molds. To accomplish this, our China manufacturing lawyers concentrate on two issues when drafting mold provisions that are part of a larger contract (such as a manufacturing agreement or a product development agreement) or that essentially stand alone as part of a mold ownership contract.

First, we want to make clear that the Chinese factory can use the molds only for producing our client’s product and not for producing for any other party. Second, we want it clear that when our client chooses to move its production to a different factory, it will have the right to take possession of the molds and transport them to the new manufacturing location. Negotiation of these terms is usually quite difficult, since the Chinese manufacturer has a strong incentive to hold molds “hostage” so as to prevent the foreign buyer from moving its manufacturing to a new factory. The only way to succeed is with a stand alone mold ownership agreement or well-crafted mold ownership provisions inserted into a written manufacturing agreement. For why it can be so important to be clear regarding mold ownership in China and some of the specifics on what you should be doing to prevent your Chinese factory from walking away with your molds, check out Product Molds And Tooling In China: Three Things You Must Do to Hang on to Yours and Want Your China-Based Molds? You’re Probably Too Late For That.

As manufacturing in China has become more complex, molds for products have become correspondingly more complex as well. In many cases, the mold embodies most or all of the intellectual property in the product. I can give two examples. First, in some products, the interior mechanism is based entirely on open source hardware. The external enclosure surrounding the mechanism is therefore the primary protectable IP for the product. The IP resides entirely in the molds used to manufacture the product case. The”look and feel” of the enclosure then becomes the identity of the product, and If that “look and feel” is not protected, the foreign designer owns nothing at all in the IP of the product. Without the IP in the molds protected, Chinese factories can freely copy the product.

Second, in some products, the form embodied in the mold is in fact the entire value of the product. Take for example a complex part used in the manufacture of a turbine or jet engine. After all the engineering and testing is complete, what remains? What remains is a single part produced by casting into one or more molds. In this situation, the molds embody the entire intellectual property in that part. and thus the party that owns or controls the intellectual property in the molds is essentially in complete control of the product. More importantly, if no party owns any IP in the molds, the molds are effectively open source, and no one owns any IP in the molds or the product.

Chinese factories have figured this out, making protection of molds much more difficult. In figuring out what to put into our clients’ contractual mold provisions, our China manufacturing attorneys can no longer focus solely on the issue of ownership; we now also must focus on ownership of the intellectual property in the molds as well.

The new mold IP issues frequently arise in two settings. First, in dealing with third party mold fabrication shops in China. Second, in dealing with the Chinese outsource factories themselves. In part 2 of this series, I will address mold IP issues when dealing with third party mold fabricators and in part 3 I will discuss how to approach these issues when dealing with the Chinese factory to which you are outsourcing your manufacturing.

 

Cover_design,_A_Book_of_MythsIn my previous post Three Myths of China Technology Transfers, I focused on the misconceptions Western companies so often have regarding China technology transfer deals. In this post, I focus on two commonly held misconceptions foreign technology owners have regarding “partnering” with Chinese companies.

Due to a partnership relationship, the foreign side often wrongly believes it is somehow better protected against IP theft. The foreign side then lets down its guard, only to learn that its China partner has appropriated its core technology. This sense of partnership is most common with SMEs and technology startups, especially those companies whose owner is directly involved in the relationship with the Chinese entity.

The two primary “we are partners” myths our China lawyers see are the following:

Myth One: Our personal connection will protect us. The Chinese company will not appropriate our technology because I (the owner of the U.S. company) have a close personal relationship with Mr. Zhang (the owner of the Chinese company). Usually this statement is followed with some bit of personal data, such as: “He came to my daughter’s wedding” or “I sponsored his son’s admission to college” or “I helped bring his family to the United States” or “He is my son’s godfather.” Trust me when I say our China attorneys heard them all. This idea that a close personal relationship will somehow insulate your company from China IP theft is probably results in more technology transfer disasters than any other myth about China. It is a myth for two quite different reasons:

On the most basic level, personal relations are not a barrier to committing acts of appropriation or other breaches of trust or contract. For most Chinese business people, personal relations, such as attendance at weddings and other shows of friendship are strategic matters, done to achieve some form of business benefit. When that benefit involves breaching a contract and appropriating technology, the Chinese side will often do it. Of course, this is not always true, but it is certainly true often enough that this possibility cannot and should not be ignored.

When the foreign party points out that this is a breach of trust, the Chinese side will often reply with something like the following: “In China, business is like warfare and contract like a treaty between nations. We will honor the treaty when it benefits us, and we will breach when it benefits us. Personal matters are not relevant. As soon as we see a benefit, we will take it. The situation is really all your fault. You should not have presented me with a situation where I had the opportunity to betray you. By leaving me an opening, you forced my hand, because the rule in China is that when an opportunity presents itself the prudent businessperson must take advantage of it opportunity.”

I have many times heard a Chinese company owner state this sort of argument with a certain amount of bitterness. They actually say: “It’s your fault. You made me do it.” They resent you for having forced them to the friendship in a way that was painful to them. But again, the common Chinese view is that when a foreign company provides an opportunity to seize a benefit, the Chinese company is obligated to seize. Personal feelings do not count; action is required.

In many cases, however, the Chinese company owner has no reason to appropriate your technology, so it is safe not because of an emotional commitment but because there is no benefit from the theft. But, the technology is still stolen. This is because the technology is stolen by an employee of the Chinese entity.

In fact, for technology that requires a small investment to commercialize, theft by a Chinese company employee is probably the most common way foreign technology gets appropriated. This is particularly true of software products, where no large capital investment is required. In these low barrier to entry businesses in China, senior technical employees are constantly on the look out for an opportunity to steal technology and leave their employer to start out on their own.

This is part of the aggressively entrepreneurial mindset of Chinese technical personnel. Appropriating a nice piece of foreign software is often seen as the perfect way to get a head start on forming a new company. In the same way, if an employee can make off with a full set of production molds, he or she can start up a small factory at a very low cost in China. So the opportunities abound and the foreign technology disappears, leaving both the Chinese owner and the foreign entity frustrated as their mutually advantageous business relationship is destroyed by a low cost Chinese competitor.

Myth Two: Our partnership is secure because of investment by the Chinese side. We hear this argument a lot and it is essentially that it is not necessary to formally protect the technology because the Chinese company plans to invest significantly in the foreign company.

This argument has two variants, both of which are false:

Variant Number 1: The Chinese side plans to purchase a majority ownership interest in our company. In effect the Chinese side will own the technology in the end. Since the Chinese side will eventually own it, there is little reason to try to protect it from appropriation by its future owner. In this way, the Chinese side convinces the foreign entity to transfer the important technology to the Chinese entity prior to the date with the investment occurs.

But, then, there are always delays in closing that investment transaction and in many (most?) cases the full (sometimes any) investment never occurs. The Chinese side assures the foreign entity that the investment funds are on the way; the delay is only temporary. In the meantime, the Chinese entity obtains all of the relevant technology. Finally, the Chinese side announces that it sincerely regrets the transaction cannot be concluded. There is always some good reason. Either the bank that was going to finance the investment deal got cold feet or the Chinese government withdrew its approval of the transaction at the last minute. Either way, the deal is off with no liability on the part of the Chinese side. But the Chinese side got what it wanted. It obtained the key intellectual property without having to pay anything approaching market price for it.

Now that Chinese companies are perceived as wealthy, this investment promise has become a standard technique Chinese companies use to convince foreign companies to drop their guard. The way to prevent the unfortunate result is simple. Up until the day the purchase transaction closes and the funds are clearly in your bank account, treat the Chinese entity as a neutral third party. Protect your intellectual property in exactly the same way you should (or at least would) if you were dealing with an unrelated third party. The Chinese side will complain about the expense and inconvenience, and your reply should be: if you do not like it, pay the money now.

Variant Number 2: The Chinese side will purchase a minority interest in your company, just to provide support for developing the technology. In this variant, Western companies believe protection of their intellectual property is not required because: “Why would the Chinese company want to harm the interests of a company in which it is a part owner?”

This argument assumes that the Chinese company sees greater future benefit in the earnings it will get from its minority share of the U.S. entity as compared to walking away with the American company’s technology.  The U.S. side often tells us that “when we go public, the Chinese side’s share will give them a huge profit. Why would they screw things up now and prevent that public offering from ever happening?”

The Chinese side rarely sees it this way. First of all, few Chinese companies focus on the long term. So for many, the promise of a future IPO or other monetary benefit from their minority investment means little or nothing to them. Second, when the Chinese side makes a minority investment, they do not see it as a investment in stock. They are making the payment to hire the foreign entity to do research and development work on their behalf and usually what they pay for such work (via the minority investment) is far less than they would pay for an arm’s length R&D program.

The investment in this R&D work is valuable to the Chinese company, but only to the extent it can take control of the technology. So the Chinese company will invest in the foreign development efforts for only so long as it receives direct benefits in the form of transfer of technology. The Chinese side has no intention of allowing the underfunded foreign start up to commercialize that valuable technology. Instead, the Chinese entity will transfer the technology to one of its many well funded subsidiaries for entry into the market. Normally, the Chinese entity expects the foreign start up to then simply die. They do not see this as a loss of their investment. Instead, they figure they see themselves (usually rightly) as having received an excellent return on their payments. It paid the money and the foreigners did the development work which it (the Chinese company) now owns. That is the end of the analysis.

The solution here is the same as the solution for Variation 1. Treat the Chinese entity like you would any third party entity. Disclose as little as possible to the Chinese entity and thoroughly protect what you disclose. If the Chinese side continues to seek access to your technology, consider carefully why it is  making such requests. A normal investor does not need such information. If the Chinese side is asking you for more than a normal investor would ask, you have to ask why. The answer will almost certainly be that the Chinese company wants access to the intellectual property underlying your technology and it wants  that for its own use.

In this situation, if the Chinese side complains or says something like “Don’t you trust us? We’re your partner.” This is sure sign of trouble. If the Chinese side requests access to your proprietary technical information, you have to ask: why are they making such a request? The real reason is seldom what you will want to hear.

Bottom Line:  Do not be lured into believing that the nature of your relationship with your Chinese counter-party or the structure of your deal will be enough to protect your intellectual property from being appropriated. Or as my co-blogger, Dan Harris, always likes to say: Be careful out there.

China lawyers
Three myths of China technology transfers

Many technology transfer licenses in China fail. Though it may be true that not all Chinese companies plan from the very start to violate the terms of their licensing agreements, you must not ignore that many do. A fascinating thing though is that when Chinese companies plan to breach their licensing agreement with a foreign party, they almost always cannot help but reveal this from the outset.

A Chinese company that intends to violate a licensing agreement and run off with the foreign company’s IP will usually have a very clear plan. What the China lawyers in my office call the Standard Plan works as follows. First, the Chinese company will negotiate in a way that guarantees a weak license that cannot be enforced against them by the foreign party. The tricks used to do this are quite standardized. Second, the Chinese company will ensure that it does not make any (or else it makes very few) payments until after it has already received the technology. If the Chinese company makes any payment at all, it will make a minimal number of payments, usually late and in violation of the agreement and then once it has received enough of the technology it seeks, it will cease making any payments entirely.

When our China attorneys encounter a Chinese company clearly working on the Standard Plan, we warn our clients. However, it is also typical for our clients to nonetheless want to forge on ahead. The client will usually explain how their situation is unique and that means the Chinese could not possibly be planning to breach.

These explanations are often based on common misunderstandings about how China works, or on what so many call China Myths. Here are three of the many such myths I have heard from clients in just the past six months:

1. Myth One: The Chinese company will not breach our technology licensing agreement because it needs us. The usual argument is that the technology is complex and the application know-how is critical and the important/critical information will not be disclosed until the Chinese company has made its last payment. The problem with this argument is that even though it may be factually true that the Chinese company cannot successfully implement the technology without the final data and continuing support from the foreign licensor, what really matters is that the Chinese company believes otherwise.

Far too often the Chinese company is convinced that once it gets some relatively small percentage of the technology from the foreign licensor, it no longer needs the foreign licensor. First, Chinese companies commonly believe with respect to the technology itself that the whole package is not important; the only thing truly important is the magic formula. Based on this the Chinese company will seek to extract the magic formula as soon as possible in the transfer process and with as few payments as possible, and once it has done that, they see no reason to continue the relationship with their foreign licensor. The Chinese company believes (often with good reason) that once it knows some key portion of the technology it can just hire key engineers to assist them in the implementation phase for considerably less than it would cost them to continue making their licensing payments. And get this: many times the Chinese company will bring in your former employees and consultants and former employees and consultants from your competitors to do this work.

2. Myth Two: The Chinese company is acting this way because it is inexperienced or incompetent, not because it plans to breach. This myth is based on Western arrogance and it is the rare Chinese company that does not know how to exploit it. Our China legal team sees this myth in a number of settings, including the following:

  • The Chinese company submits its response to a carefully crafted technology licensing agreement 2-3 days before the deadline for executing it. The document comes back from the Chinese company with substantial revisions to the agreement terms, but with no redlining and no explanation.
  • Immediately after executing the technology transfer or the technology agreement, the Chinese side insists on assigning the agreement to a newly formed subsidiary that has no assets.
  • When the Chinese company’s payment is due, it reports that the bank has imposed restrictions that either make its payment impossible or that require substantially revising the agreement. And no surprise, the revisions the Chinese company contends must be done to free up payment are the exact revisions it sought but was denied during the technology license negotiations. The Chinese company will then press for the foreign company to continue transferring technical information while this payment issue gets resolved.

When we describe the above tactics as standard tools of the Standard Plan, used almost by rote by Chinese companies planning to breach their license agreement our clients will sometimes counter by arguing that these are not indicators of an intent to breach, but rather just mistakes that reveal the Chinese company’s lack of international experience and general incompetence.

This argument is based on a myth and it is seldom correct. First, Chinese companies are not incompetent. They know what they are doing just as much as Western companies and on international technology licensing agreements, probably better. If you can read Chinese, you can go to any bookstore in just about any Chinese airport and find books (yes plural) that explain exactly how to take advantage of Western companies on technology licensing deals. Second, Chinese companies are not inexperienced in the procedures that apply in international technology transfer agreements. Tech transfer has been a core of Chinese business since 1981. Chinese companies, together with their lawyers, bankers and government/private consultants know exactly how the system works. What is true is that Chinese companies know exactly what to do to get Western companies to let down their guard and give them what they want. In this way, Chinese companies that intend to breach are masters at fooling foreigners into thinking (wrongly) that they are inexperienced and incompetent. Our Chinese lawyer friends readily (and laughingly) admit all of this to us.

3. Myth Three: The Chinese company will not breach this technology transfer agreement because it takes a long view of business and it will not want to sour relations for the future. This myth is based on a general view that due to their long history, the Chinese take a long term view toward business relations. This is often explained by some vague reference to a Confucian ethic that still underlies Chinese culture, even in the PRC, a communist country.

This is just a cultural stereotype not based on recent Chinese history. I am not going to discuss Chinese culture or Chinese history in this post, but I am going to tell you what I have seen over the decades in which I have been providing legal representation on Chinese transactions (coupled with what the other China lawyers have seen in their practices as well) and that is that Chinese companies — if anything — tend to take the long view far less often than the Western companies (mostly North American, Latin American, European, and Australian)  I represent. In fact, many of the Chinese business people I know and with whom I speak (in Chinese) are very skeptical about the future and tend to evince a “get it while I can” attitude about business, particularly when dealing with foreign companies, who tend to come and go and have little power or even relevance. Benefit now is real, calculation for the future is for suckers. See Is There A Chinese Mindset, And So What If There Is?

These are three commonly held myths by foreign companies that do technology transfer deals with Chinese companies. They are not true; they do not reflect reality. If you are negotiating with a Chinese company based on any of these myths, you will likely fail. Don’t do it.