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.

China manufacturing contractsIn China Product Development: Focus on Manufacturing Rights, I set out the ideal resolution of product manufacturing rights issues that arise in co-development projects in China. As I noted in that post, in our experience it is often difficult to convince the Chinese side to agree to that ideal option. So what do you do when the Chinese side refuses to agree? You have a number of options, including the following:

Option 1: License the underlying technology from the Chinese side. When the Chinese side takes the position that it will retain the rights to the underlying technology in your product, your next step is to try to negotiate a license to that technology. This kind of license is common around the world, and it can take many forms, including the following:

a. Negotiate a standard license for the underlying technology for which you will pay a license fee. You can pay this fee as a lump sum or as a per unit royalty for each item manufactured in a separate facility. In some settings the license payment is based on purchasing a certain number of units at a premium price. After that amount has been paid, the foreign party then has a license to manufacture elsewhere. This standard license approach is a very common procedure around the world, but it is seldom used in China. As Chinese manufacturers become more sophisticated about monetizing their technology, this type of agreement will become more common, and our China lawyers are already starting to see that happen.

b. Negotiate an agreement with your Chinese manufacturer side that allows you the freedom to manufacture the product in a different facility, but only if your Chinese manufacturer is unable to meet predetermined quantity, delivery date or price terms. Often this license will allow manufacturing in a different facility only for amounts in excess of a predetermined minimum. For example, the Chinese factory may produce 100,000 units per year at a set price and the foreign party is permitted to use a different facility only to manufacture anything in excess of 100,000. The flaw in this approach is that it assumes the Chinese side will be capable of manufacturing the first 100,000 units, both in terms of quantity and quality. Where this is not true, this leaves you as the foreign product developer hostage to the Chinese factory, which can be financially devastating.

Option 2: Walk away. It is surprising to me how many times foreign hardware entrepreneurs fail even to  consider the basic option of refusing to work with a Chinese company that will not cooperate on key manufacturing rights issues.

It is critical to understand what the Chinese side means when it states it will under no circumstances release the manufacturing/IP rights in a co-developed product. What the Chinese side means is: We own the product. We will manufacture the product and we will allow you to sell the product on our behalf in a foreign market. If you succeed, great. If you do not succeed, we will simply refuse to accept your future purchase orders. We will then either market the product ourselves or we will engage some other company to market the product. That “other company” will normally be an established player in the market, and not a mere start-up like you. In other words, you will be reduced to becoming essentially the Chinese company’s sales agent and you will be subject to being terminated even for that at any time. 

Most start ups are looking for new money. Consider how hard it is to raise new money when you are in the situation where you have no control over “your” product. Since the result will be an economic disaster, it is often best to simply walk away when it is clear that the Chinese side is trying to put you in an untenable situation.

Option 3: Turn the tables. Some foreign developers do not walk away because they feel they have no other option; they think they are forced to work with the Chinese manufacturer. Though this situation is dangerous, it can work so long as the foreign entrepreneur is willing to turn the tables and operate how a Chinese company would operate in the same situation.

In the turn the tables approach, the foreign developer basically “writes off” the co-developed product. The product is not treated as the foundation for the start up company. Instead, the co-developed product is treated as a research project that will provide the foundation for an entirely new product. For this new product, the foreign product developer will work to achieve control over the technology and the manufacturing rights. It may take several rounds of development, but the goal of the foreign developer is always to achieve complete product control, using the Chinese manufacturer as a test bed for developing a new technology.

Many foreign product developers are confident that they can pull off this reversal of roles. They tell me that they will not walk away because they have this plan. In my experience, it is quite difficult to turn the tables on Chinese manufacturers. Chinese manufacturers have been using this strategy themselves for many years and they usually can see what is happening in time to take early action to protect themselves. However, if well planned, this strategy can be successful. The key is in the planning. If the plan is not laid out clearly from the very start, there is very little chance of success.

China lawyers
Document who owns what

I recently wrote a series of posts on product development in China, entitled, Hardware Co-Development in China: Do it Right. (Go here for Part 1, here for Part 2, here for part 3, and here for Part 4 of that series). That series resulted from my recent trip to the Hardware Valley in Shenzhen, during which time I was able to discuss our legal approach with foreign hardware developers on the ground in China and the various manufacturing consultants and mentors that help them.

If you read my four part series on developing hardware products in China, you can see that the product development situation is complex, particularly as it relates to who ends up with the related intellectual property as between the foreign developer and the Chinese manufacturer. A number of clients, readers and fellow lawyers have asked me to summarize our current understanding of to practically structure these product development relationships so the foreign company, not the Chinese manufacturer, ends up with the right to the developed product.

We have found that the key in the process is to focus on manufacturing rights, rather than on intellectual property rights, especially when the PRC or Taiwan factory presents the foreign product developer with an already prepared manufacturing agreement. Lawyers all over the world have become masters at writing complex and sophisticated intellectual property provisions for insertion in development and manufacturing agreements. Because these IP provisions are written to cover every possible situation, they tend to be written at such a high level of abstraction that they often have no real meaning on the ground in Asia. When a client asks me to review such a provision provided by a PRC or Taiwan factory or designer, my response is usually that the PRC/Taiwan party chose vague language intentionally so as avoid letting our client know that it plans to usurp our client’s IP or that the language clearly does not to benefit our client.

Our solution at this point is not to further refine already highly refined IP language. Instead, we advocate temporarily forgetting about IP rights altogether and focusing instead on the practical issue of manufacturing rights. At the end of the development process the Chinese factory and its foreign customer (our client) will be looking at a set of prototypes and the sole issue for the foreign party at that point is usually what can I do with those prototypes? If the answer to this question is not clearly resolved at the start of the development process, the answer will usually be that the foreign party can do nothing more with the prototype than what the Chinese factory will allow.

To avoid this result the foreign party should at the inception of the development process secure an agreement that includes the following:

  1. A clear statement of what will be done, who will do it, and when it will be done. This includes a clear description of the product to be designed and a clear statement of the work to be performed. Many product design projects in China fail at this stage. No one knows what is going on, and after a year or two of development, no progress is made on the prototype.
  2. A clear statement of the costs, allocation of costs and payment dates for the costs. Most important is a clear understanding of what will be provided by the Chinese manufacturer in return for your payments. This provision typically should address molds, tooling, software, design, working model.
  3. A provision making clear that if the design project fails, all of the tangible and intangible materials developed during the project should be transferred to the foreign customer. Nothing should be retained by the Chinese factory or designer.
  4. A provision stating that if the design project succeeds and prototypes are developed, you, the foreign customer, shall have the right to manufacture the product in any factory anywhere in the world. This is the key issue. The foreign party should at any time be able to determine what factory will manufacture the prototyped product. Normally, this will mean manufacturing it in the factory of the co-developer. But what if that factory cannot give you a satisfactory price, quantity, delivery date or quality? What if the Chinese factory seeks to raise prices on you six months later? For you to be able to maintain control over your product, you must have the right to move part or all of the manufacturing of your product to the facility of your choice, for any reason at all.

This issue of right to manufacture should be clearly understood by both sides before the parties start discussing the more abstract issues of intellectual property rights. The reason I say this is because every factory owner and every foreign party clearly understands the issue of manufacturing rights and if you negotiate for this at this basic and practical level, the real situation will be revealed in a way both parties can clearly understand. We have found that once the parties reach a clear agreement on manufacturing rights, the technical intellectual property provisions become relatively easy for our China lawyers to draft.

You must though seek to reach agreement with your China factory on manufacturing rights before product development even begins because if you wait until the product development process is complete, you will have relinquished all of your leverage. If you wait until the prototype is completed, the Chinese factory can say no to you having any manufacturing rights and then it can raise its manufacturing prices with near impunity.

This means you must complete your negotiations on the product manufacturing rights before the Chinese side has acquired all the power through its control of the final prototype. This means you must have a China appropriate contract making clear that you (not them) own the manufacturing rights. Without this document, there is a good chance the Chinese manufacturer will be able to stop your product from being made by any other factories in China or from leaving China if it is.

Bottom Line: When beginning the product development process in China it will often make sense for you to skip abstract discussions of intellectual property rights and just focus on the key practical issue both parties can understand: when the prototypes are finished, what can you do with those prototypes? Discuss this issue early on with your Chinese manufacturer.

In my next post, I will discuss what to do when your China manufacturer tells you that you cannot use any other company to manufacture “your” product.

China lawyers for the internet of thingsI am coming off two straight days of speeches before and meetings with start-up hardware technology companies here in Shenzhen. Early last week, in Hardware Co-Development in China I wrote about how our China lawyers often see situations where a foreign developer of a hardware or an Internet of things product loses that product to its Chinese manufacturer after having spent years in co-developing that product with the Chinese manufacturer. The foreign designer and the Chinese factory will work together for months or years to develop a commercially viable product and then when the prototype is finally finished, the question then becomes whether the foreign developer that came up with the idea owns the product or the China factory that helped take it from concept to esign. In a cooperative co-development setting, the foreign party and the Chinese factory work together to create the prototype of the commercial version of the new product. All the work is done on a purchase order basis, with no written contract or other documentation.

When the Chinese factory completes the prototypes it will almost always retain them (rather than just hand them over to the foreign developer) in anticipation of moving to the manufacturing phase. However when the parties move to the manufacturing phase, it is normal for something to go wrong. This usually happens in two ways. The Chinese factory substantially increases the unit price to manufacture the product or it announces that it cannot meet the product’s quantity or delivery date requirements. Alternatively, the Chinese factory consistently manufactures defective products.

Facing these problems, the foreign party will tell its Chinese manufacturer that it will be taking the prototypes to have its product manufactured elsewhere. The Chinese manufacturer then announces that it owns all of the IP in the product (and oftentimes it will have registered some of this IP completely unbeknownst to the foreign developer) and only it has the right to manufacture that product.

In Hardware Co-Development in China: Do it Right, Part 2, I explained how Chinese factories far too often end up owning the hardware product prototype and its accompanying IP, much to the surprise and disappointment of the foreign developer. In Hardware Co-Development in China: Do it Right, Part 3, I explain how it is that the Chinese factory can end up owning the hardware product prototype and its accompanying intellectual property, and the basics of what you need to do to prevent that in a simple co-development situation. In this, the final part of this series, I explain how to protect your product and its IP in a situation involving blended technology.

The method for contracting to resolve the ownership issues of your product and its intellectual property depends on whether the technology is a wholly owned or blended technology. Many foreign parties at the outset will just assume they are working with wholly owned technology and that they are the owners. It is essential right from the start to confirm whether your Chinese factory agrees with this assessment. In the written contract that governs ownership of technology in the prototypes, do not fall into the trap of working with formalistic legal definitions of who owns what IP in the product prototype.

Instead, use the following as your functional rules:

  • The Chinese factory will deliver production ready prototypes to the foreign party.
  • The foreign party has the right to do the following with the prototypes:
    1. Register applicable IP anywhere in the world.
    2. Manufacture the product in its own facility or contract to have the product manufactured in any factory anywhere in the world
    3. Make use of the design (reverse engineer, clone, etc.) as the basis for the product and manufacture derivative products without restriction.

If the Chinese factory contractually agrees to the above, the IP in the new product will be wholly owned by the foreign party.

In most instances, the foreign companies that retain our China manufacturing attorneys believe from the outset (pretty much without question) that they wholly own the IP in the product prototype. They just assume this is the case and so it does not even occur to them to contractually document this before the inception of the development process. These foreign companies are then surprised when their Chinese factory refuses to agree to these conditions. But waiting until the process is complete means that it is too late to resolve the issue.

Often the Chinese factory will take a compromise position and will agree that the IP in the prototype is an example of blended technology. As with wholly owned technology, dealing with blended ownership should be resolved in a written contract at the outset of the development process. As with wholly owned technology, the goal is to avoid vague legal descriptions and to instead use a functional description of how the prototype will be used in practice.

Blended ownership is not co-ownership. By blended ownership we mean that the final prototype incorporates IP owned by different parties. The foreign designer owns some of the IP and the Chinese factory owns some of the IP. As a result, the production prototype is a blend of IP from different sources.

The functional definition starts with the delivery of production ready prototypes to the foreign designer. The issue that needs to be resolved is what can the foreign designer do with these prototypes. There are three basic options for resolving this issue:

Option One. The foreign designer owns all of the IP produced as a result of the co-development process and can register and make use of that IP without restrictions. To the extent the prototype includes underlying technology of the Chinese factory or of a third party, the foreign designer will be granted a perpetual, royalty free license to make use of that technology solely for the purpose of manufacturing the prototype and any products derived from that prototype. Note that this license if far more restrictive than the situation that prevails in the case of wholly owned technology.

If the foreign party waits until after the development process is complete to raise the issue of securing a technology license from its Chinese factory, the Chinese factory will almost always refuse to grant such a license. Since all the power rests with the Chinese factory by this point, its position is perfectly natural. Nonetheless, foreign product designers are usually surprised when they find out that they are permanently stuck with the developing factory and cannot use any other manufacturer to make what they thought to be their own product.

Option Two: The Chinese manufacturer agrees to manufacture the prototype exclusively for the foreign designer. The parties agree in advance on price, quantity, time of delivery and quality terms for the product. So long as the Chinese factory can meet these conditions, the exclusive manufacturing agreement remains in effect. However, if the Chinese factory fails to meet any of these terms, the foreign designer has the right to have someone else manufacture the prototype under the license terms stated in Option One.

Option Three: Some Chinese factories will agree to “release” the prototype under the terms of Option One, but only after payment of a substantial fee to the factory. Oftentimes the Chinese factory will set this fee so high that this option is not practical.

Note that these three options assume the Chinese factory is willing to resolve the technology ownership issue in a way that will allow the foreign party to move production to a different factory. In our experience, if the matter is discussed after development is completed, it is the rare Chinese factory that will agree to any of these options. Even if technology ownership is discussed in advance, the negotiation of acceptable terms can be very difficult. However, it is critical that this difficult discussion take place before production starts. It is critical that the foreign party must understand its exact situation on technology and prototype ownership before it wastes months or even years and incurs and spends substantial sums of money developing a product it will neither own nor control.

Consider the situation when your start-up approaches an experienced angel investor for series A financing. One of the first things any experienced investor will review is the ownership status of your core technology. Imagine what will happen when the investor realizes you do not own your core technology because your Chinese factory either owns or controls it. That is almost always the end of that discussion and it is often the end of the start-up as well.

To avoid “gifting” their technology to their Chinese factory, start-ups must treat proper legal documentation as an essential and this means they must set aside the funding necessary for doing the proper legal work from the start. Proper documentation is not a luxury to be used only by major corporations. In fact, proper documentation is even more important for hardware developers at the start-up stage, since a loss of ownership at the start dooms the company down the road. A major multi-national has many products. If it loses one, it does not kill the company. But for a start-up, the loss of its key technology usually means death.

Bottom Line: Do your hardware co-development right at the start and give yourself a chance for success.