Archives: Basics of China Business Law

China design PatentsWe have been writing a lot recently about design patents. In the old days, our China contract manufacturing clients normally did not use Chinese design patents. The reason is simple. Chinese design patent registration requires absolute novelty. If the design has been revealed in any way, registration is not permitted. Since our traditional contract manufacturing clients were normally working with a design that had already been marketed in America, Europe or Australia, registration of a Chinese design patent was not possible.*

However, with the rise of product co-development in China, the use of design patents has become essential. The co-development process assumes that the resulting product design will be entirely new. So long as secrecy is maintained during the design process, the design can then be registered for protection as a design patent in China. All foreign companies working on co-design in China should therefore be aggressively using the Chinese design patent system to protect their product designs.

The utility of a design patent applies in two quite different settings. In the first setting, the design patent is used as a defense against knock-off manufacturing by third parties. In the second setting, the design patent is used to make clear the rights of the foreign entity and the Chinese factory in the co-designed product.

In preventing third party factory knock offs, the most powerful tool is a Chinese invention patent. However, in most cases of co-development, invention patent protection is not an option due to technical or cost factors. Where there is no patent protection, other Chinese factories are free to manufacture knock-off copies of the product. If you have a good contract with your Chinese factory, this leads to the odd situation where your factory cannot independently manufacture the product, but every other factory in China is free to do so.

It is important to be clear about this situation. Where there is no Chinese patent protection, it is perfectly legal for an unrelated Chinese factory to knock-off the product. Only some form of patent can stop the knock-off. That is, absent patent protection, a knock-off does not constitute infringement. So where no invention patent applies, a design patent is a powerful tool. If the design is registered as a patent, the owner of the patent can prevent any other factory in China from making a product using that design. The patent owner can also register with customs, preventing the export of the knock-off product.

For this reason, in the co-development process, both the U.S. entity and the Chinese factory have a strong incentive to register a design patent so as to prevent knock offs from third party manufacturers. This then leads to the second issue: who will own the design patent? As I pointed out in China and The Internet of Things: Who Owns What? where the product is produced in a co-development process, the question of who owns the design is fundamentally unclear. Far too many foreign companies mistakenly believe that they own the design because they came up with the design or because they made some or all of the payments for the design.

This belief is entirely mistaken.

The default rule in the case of patents is that absent a formal agreement to the contrary, whoever did the work owns the patent. It is therefore essential for the Chinese factory and for the foreign entity to make a formal, written decision on who has the right to register the design patent. But this simple agreement is not enough. Once the foreign entity secures the right to register the design patent, it must be sure to register that design before the product is revealed to the world because any form of disclosure of the design will destroy the right to register. Sale is not required. A promotional photo published on the web or in a trade journal or trade show brochure is sufficient to constitute disclosure that defeats the right to register the design patent.

A design patent is particularly useful in the most difficult co-development setting where the foreign party design is being built on top of technology proprietary to the Chinese factory. In that setting, it is quite clear that the foreign party cannot assert ownership to the underlying technology of the co-developed design. However, the foreign party can and should assert ownership over the unique design of the co-developed product. Though a contract with the Chinese factory will establish who has the right to the unique design, the only way the foreign party can establish actual ownership of the design is by registering a design patent.

Finally, foreign parties should take note of one of the big dangers in doing product co-development in China. This is the same issue that arises continually in the China trademark area: if you do not do it, they will. That is, where there is a co-development project, if you do not register the design patent in your own name, it is likely that the Chinese factory (or its owner or someone connected with the company or the owner) will do the registration. You will not find out about it until either a) you see your own product being sold on Amazon or eBay or b) you try to move your production to a new factory and discover this is impossible.

The only way to avoid this kind of disaster is to take action on your own. Our China lawyers get at least a call a week from someone who has lost their IP to a Chinese company because they never registered it. If you do not take the responsibility of protecting your intellectual property in China, I can assure you that no one else will.

 

*Technically, because China design patents are not reviewed, it is very easy to register one, but if it isn’t novel, the registration will — if it is ever challenged — be deemed invalid.

 

China trademarks, patents and copyrights
China trademarks, patents and copyrights.    [BusinessSarah, http://bit.ly/2aewtwp]
EBN, an online publication geared to supply chain professionals, recently ran a piece called Why Apple’s Patent Fight With Baili Should Serve As A Wake-Up Call. Although the piece is well-meaning, and its generic thesis – that Western companies need to do more to protect their IP in China – is correct, many of the details are either misleading or flat out wrong.

I suppose the headline should have been a tipoff. Apple’s patent fight with Baili should only serve as a wake-up call for companies that have been asleep for the past decade. It is not news that Chinese registrants (I am chary of using the word “entrepreneurs” to describe trademark squatters) have gotten the better of Western companies for quite  some time.

The rest of the article unspools from an incorrect thesis: that trademarks, copyrights and patents are all registered solely on a first-to-file basis.

  1. Trademarks.

For trademarks, this thesis is largely correct. China is indeed a first-to-file country, and many Chinese companies have registered trademarks that “belong” to Western companies. We have written about this phenomenon (and how to combat it) about a thousand times. Okay, maybe not a thousand times. But enough that sometimes I feel like a Johnny One Note.

  1. Copyrights.

For copyrights, this statement is completely incorrect. China is NOT a first-to-file country. As a signatory to the Berne Convention, China recognizes copyrights from all 171 other Convention countries, which covers the vast majority of the world. China does not require formal registration (although it’s invariably a good idea to prove ownership). And it is simply not true that a random Chinese entrepreneur could register “your” copyright. The one caveat is that the Copyright Protection Center of China does not substantively review copyright applications at the time of registration, so anyone could register “your” copyright. A college student in Guilin could register a copyright for Ghostbusters tomorrow, but the actual owner of the copyright (presumably Columbia Pictures) could easily invalidate that registration by showing proof of ownership. I’m less sanguine about the outcome of a Huey Lewis – Ray Parker, Jr. battle over the theme song, but I’d love to see the Chinese courts take it on.

  1. Patents.

For patents, this statement is correct, but misleading. Even though China (like the US) is a first-to-file country, it is also a signatory to the Paris Convention and it has an absolute novelty requirement. If an invention has been marketed, sold, or otherwise made known to the public anywhere in the world, it can no longer be patented in China. So the idea that a Chinese company could take a bunch of existing American products and register valid patents for them in China is false.

But I must offer a few caveats to the above. First, design patents and utility model patents do not undergo substantive examination at the time of registration in China, so it is possible for almost anything to be registered. But in theory, a spurious patent will not survive an invalidity challenge. Second, it would not take much to alter an existing design so that it becomes sufficiently novel to survive an invalidity challenge. Third, just because a law is unambiguous doesn’t mean it will be applied correctly.

The main problem with the article’s discussion of patents, however, is that it ignores the common situation where a foreign company engages a Chinese factory to design a new product without benefit of a written agreement indicating who will own the related IP. Although the foreign company may reasonably think that it is the true owner of the patent for the new product, the factory may just as reasonably think that it is the true owner. Especially when the factory hasn’t been paid any extra money for product design.

The solution is not to complain that Chinese companies are taking unfair advantage of you; the solution is to act like a rational player and protect your IP. That means having proper agreements with your manufacturers and taking the initiative by filing patents of your own before having anything manufactured. My colleague Steve Dickinson covered the former issue in an excellent recent three-part series – see here, here, and here.

China lawyersOne of the most interesting things about representing foreign companies that do business in or with China is how Chinese companies all seem to operate from the same playbook. Our China lawyers can go years without a Chinese company doing XY and Z and then all of a sudden, we will have five deals in a row where the Chinese company does XY and Z. Right now we are seeing a slew of Chinese companies seeking to become distributers of American products via Joint Ventures. Though this post focuses on this one sort of transaction, it has lessons about China company negotiating tactics that have universal value.

We represent many foreign companies that have their product made in China under a contract manufacturing arrangement. At the start, the foreign company targets its product sales in the North American and European markets. But as China’s consumers grow wealthier and more sophisticated, it often happens that the foreign company is approached about selling its products  in China to Chinese customers.

When the foreign company investigates the situation, it turns out that such sales are more complex than they seem. Since the foreign company does not own the product until after the product is shipped outside China, sales within China involve a complex process of exporting out of China and then selling back into China. This results in the potential for VAT to be paid twice: once on the export and again on the import. As a result, the U.S. buyer of the contract manufactured product will often be approached by Chinese companies with elaborate schemes designed to avoid such taxation. Such schemes should virtually always be avoided.

Often the Chinese side will try to convince the foreign company to enter into a complex “partnership” or joint venture arrangement, so that the foreign entity participates in the conduct of the distribution business in China. Entering into such a partnership is almost always a mistake. Operating a distribution and sales business in China is complex and it rarely makes sense for a sensible Western company to get involved in this kind of business in China, particularly when tax avoidance and “incentives” for making sales is the major objective.

Instead the foreign product buyer should insist on operating via the standard distribution model used throughout the world. The foreign company should purchase its product from its Mainland China manufacturer, receive that product outside of China (in an export processing zone or when shipped) and then sell that product to a qualified PRC distributor. The distributor can be located in China, or in a PRC export processing zone or in Hong Kong. The foreign company buyer should earn its profit from that initial sale, freeing it from concerns with the financial side of the Chinese operation. On the other hand, the foreign company buyer should strictly monitor the operations of the Chinese distributor through a standard distribution agreement.

If the foreign company buyer wants to support its PRC distributor, it is free to offer incentives, such as the following:

  • Not charging the distributor for product that will be used as samples.
  • Reducing prices for a certain number of products
  • Providing cash incentives for advertising or seminars and/or to partially/completely cover the cost of registrations.

However, such incentives should be offered to a distributor that operates under a standard distribution agreement that allows the foreign company buyer to terminate the agreement if the distributor does not perform (which is common) and gives the foreign company buyer the absolute right to audit the performance of the distributor on an arms length basis and to terminate if the China distributor engages in irregular conduct such as bribery or kick backs (which are common). One major defect in any kind of partnership/joint venture approach is that it is difficult to hold the Chinese side to a tight performance standard when there is a business ownership relationship. It is like a marriage: easy to get into, but hard to get out of.

Due to the need export from China and then ship back into China, it often happens that the distributor will establish an entity in Hong Kong to handle the operations. If the foreign buyer wants to take an ownership interest in the Hong Kong distributor, it can do that, but the basic rules remain the same: The Hong Kong distributor should be treated as an arms length third party, operating under a standard distribution agreement with the foreign company buyer earning its profits from sales to the distributor (profits now), rather than from the very uncertain and tax disadvantaged distribution of profits from the distributor at some unknown inherently uncertain later date. The foreign company buyer should also understand that it is a myth that they will be able to exercise more control in a joint venture setting. The truth is exactly the opposite: joint ventures are nearly impossible to control by a foreign entity located thousands of miles away with no right to make a quick and decisive contract termination decision.

It is rare for Western companies to want to get involved in the business of distribution in a vast and complex market like the PRC. This is why so many major multi-nationals hire Chinese distributors to do the work. It is even rarer for Western SMEs that understand the issues to take on this difficult burden. However, it is inexperienced SMEs and start-up companies that get approached with these ill-conceived concepts, for obvious reasons. You should asses any such proposal by applying the three basic rules set forth below, which rules apply to just about any project concerning China:

  1. If the proposal is complex, don’t do it. You should be able to understand the proposal in a first reading.
  1. If the proposal involves an equity joint venture business, be very wary. Avoid China business relationships that you cannot terminate by a simple contract termination notice.
  1. If the proposal is not supported by a legitimate financial projections, don’t do it. A “business plan” full of fluff and fancy jargon that no one really understands does not count. What counts is a set of standard financial projections (hard numbers, not jargon) with each assumption clearly spelled out and supported with facts.

If you follow these rules you will save yourself time and money in doing business in China.

China trademarks and design patentsIn part 1 of this two-part series, I stressed the need for just about any company doing business in China or with China to register their brand name(s) and logo(s) as a trademark in China. We have considered registering your trademark in China as a no-brainer since we started this blog and the need to do that has only increased as trademark enforcement in China consistently strengthens. And, yes, this applies even if you are just outsourcing to China and exporting all that you are having made.

I ended part 1 by noting how about a year ago, our China lawyers became convinced that if you are outsourcing your product production to China or selling your product in China, in almost all instances you really do need to register a design patent on your product. Because if you don’t, someone else will and then you will find yourself either having to challenge that patent (which is relatively expensive and time-consuming) or just walk away from China.

A design patent in China is generally analogous to a design patent in the U.S. or a Community design in the EU and it covers novel product designs that (1) incorporate shapes, patterns, and/or colors, (2) are rich in aesthetic appeal, and (3) are fit for industrial application. China registers design patents without conducting a substantive examination of the design patent application and so it truly does not take much at all to secure one. Substantive examinations only occur if a third party challenges a patent’s validity after registration. A design patent applicant need only submit an application to SIPO that satisfies the procedural requirements, particularly with respect to proper formatting of documents and drawings.

Even though many of the design patents in China are nothing more than slight modifications of existing product designs they still can have substantial value because its owner can sue for design infringement and register the patent with Chinese Customs and have counterfeit or copycat products seized at the border. Even if you do not think your design is novel enough to be patented, there is a first mover advantage to your filing for the design patent simply because your design patent will be valid until successfully challenged by a third party. A Chinese design patent grants its holder exclusive use of the aesthetic features of a product, not its functioning portion. In other words, the patent is on how the product looks; its external appearance.

What thought does it really mean to have a China design patent? The typical design patent cases our China attorneys have recently handled are a good way to answer this question.

The case typically starts with a phone call from a Western company telling us that some company (usually a company it already knows and usually either its manufacturer or a competitor) just contacted the Western company (or the Chinese company that makes the Western company’s product) and said that the Western company’s product is violating the Chinese company’s China design patent. The Chinese company then threatens to sue the Western company for patent infringement damages and to block any of the Western company’s “infringing” product from leaving China. Needless to say, the companies that call us on these matters are more than a little bit concerned.

 

Nobody has yet actually had customs block their product from leaving China. The reason is because China customs generally requires a party seeking such a block to post a substantial bond. That substantial bond then becomes available to the party whose product has been blocked by customs. Again though, you want to avoid these cases if at all possible because even if you end up prevailing, you will need to incur considerable time, trouble and money to get there.

The Chinese companies threaten to get an order blocking our client from having its product made in China, but they never do. They never do because they know the cost of doing so is high and the likelihood of their getting such an order and having that order stick is low. I read somewhere once that something like 70 to 90 percent of all Chinese design patents get invalidated when challenged. These Chinese companies know that if we were to challenge their design patents we would prevail, so why spend big money only to lose in the end? The Chinese company’s power comes from the design patent threat, not from its reality.

 

What’s the best way to nip design patent hijacking? Register your design patent first, before anyone else can do so. And that is why we are adding design patents to our list of the one thing (well, maybe two) you must do if doing business in or with China if your business involves a physical product.

China trademarks and design patentsOkay, so that’s two, but you get the point.

Way back in 2011, I wrote a blog post entitled, China: Do Just One Thing. Trademarks. As you can guess from the title, the point of that post was to emphasize that no matter what else a foreign company does when doing business in or with China, it must, must, must file to secure China trademarks for its trade names and logos, because if it does not, someone else will and then the foreign company will not be able to use its trade names or logos in China, even if all it is doing is having its products made in China for export.

In talking with foreign companies looking to do business in or with China, I talk about how NNN Agreements can help prevent their China counter-party from competing with them, contacting their clients/customers, and duplicating their products. And if they are going to be manufacturing in China, I tell them about the importance of Product Development Agreements for protecting their intellectual property before their product is fully developed, and Manufacturing Agreements for protecting their intellectual property after their product is developed and for ensuring quality and timely deliveries.

These agreements are all very important and in some cases, not having one can be fatal to a company. But with the exception of an NNN Agreement, they are relatively expensive and in some cases — rightly or wrongly (almost always wrongly), we get foreign companies who believe that their Chinese counter-party can be fully trusted and such agreements are just not worth it to them. I have better things to do than to argue with such an analysis and so I don’t.

But when it comes to the need to have a trademark, I always fight back because I and the other China lawyers at my firm have seen far too many companies go under after having lost their trademark to China and having their goods seized at China customs for violating someone else’s trademark and then not being able to switch their manufacturing to some country other than China. When it comes to the need to secure the appropriate trademarks in China, I am blunt: anyone who doesn’t do it is making a big mistake:

I tell them how if they do nothing else, they should immediately register their trademarks in China. This one usually surprises them and they often think I have misunderstood what they are planning for China. They at first do not understand why I am emphasizing the need for their filing a trademark in China when they have no plans to sell their product in China. I then explain how China is a first to file country, which means that, with very few exceptions, whoever files for a particular trademark in a particular category gets it. So if the name of your company is XYZ and you make shoes and you have been manufacturing your shoes in China for the last three years and someone registers the “XYZ” trademark for shoes, that company gets the trademark. And then, armed with the XYZ  trademark, that company has every right to stop your XYZ shoes from leaving China because they violate that other company’s trademark.

And this happens constantly.

About a year ago, we started seeing the same thing with design patents and in tomorrow’s post I will explain how that works and what you need to do to prevent it.

 

Choosing your China company nameThough I generally recommend foreign companies filing for trademarks in China avoid the Madrid system and file a national application – that is, an application directly submitted to the Chinese Trademark Office (CTMO) – the Madrid system does provide one minor advantage. National applications must include the applicant’s Chinese name, whereas Madrid applications have no such requirement. Companies often spend considerable time and money in determining their Chinese branding strategy, and rightfully so. The annals of advertising are filled with tales of inopportune translations when companies go abroad. Indeed, we work with marketing companies whose sole raison d’être is to help foreign companies with branding in China.

That being said, it’s no big deal if you haven’t come up with a Chinese name for your company but still want to file a trademark application in China. First, it’s important to distinguish between the Chinese name for your company and the Chinese name for your product. For some companies, the company name is the brand; for other companies, the company name is of little import. Second, and most importantly, an applicant’s Chinese name on a trademark application is solely used for internal purposes at the CTMO. It has no meaning, relevance, or effect in the outside world.

If you have already determined the Chinese name for your company, then by all means use it in the trademark application. But if you don’t have a Chinese name and you don’t have the time, money, or interest to create one, it doesn’t matter what name you choose. You will want to continue using that name for any further trademark applications (to maintain internal consistency). But in all other respects, it will be as if your company does not have a Chinese name, so when it comes time to select a Chinese name for use in commerce, you won’t be limited by your choice on the CTMO application.

China NNN Agreement
         Was it a subcontractor?

One of the primary ways foreign companies lose their IP to China is via infringement by manufacturing or service subcontractors. Our China lawyers constantly see/hear of foreign companies that enter into “iron-clad” contracts with a primary Chinese company, only to lose their IP to a subcontractor for whose behavior the primary Chinese company has no responsibility. Often, the subcontractor is in some way related to the primary Chinese company and the infringement is intentional. In other cases, the subcontractor has no direct relationship with the primary Chinese company and is simply trying to create a new business for itself. Either way, subcontractors are a big threat to your intellectual property and they must be treated as such.

There are essentially the following three options for dealing with subcontractors in your China contract:

1. Prohibit subcontracting. This is our preferred option but it is often not practical. You should, however, always consider how it seldom it makes sense for your primary Chinese company to need to contact subcontractors at the NNN stage, rather than later at the product development or manufacturing stage. A China manufacturer (or service provider) that is claiming it must deal with its subcontractors at the NNN stage is oftentimes a Chinese manufacturer planning to steal your intellectual property. Some of the larger electronics and Internet of Things (IoT) hardware manufacturers are notorious for this.

2: Permit subcontractors, but make your primary Chinese contractor liable for the subcontractors’ conduct. This is the standard option to which most Chinese manufacturers and other Chinese companies will agree, simply because it is the easiest system to manage. In the last ten years, virtually no legitimate Chinese manufacturer or other Chinese company has objected to this option in the NNN stage for the reason discussed above: no subcontractors are usually involved at the NNN stage.

Option 3: Limit the use of subcontractors. We often draft contracts that limit the Chinese company to using subcontractors only when the following conditions are met: a) the primary Chinese company gives written notice of each subcontractor, b) our foreign client formally approves the subcontractor and c) the subcontractor enters into a separate NNN contract with our client. This is actually a very good system, since it gives you a direct contractual relationship with the subcontractors who have all signed binding contracts that explicitly protect your IP. Note though that this almost never comes up at the NNN stage, only after. This requires you draft and get signed formal agreements with each subcontractor and you may have to deal with your Chinese manufacturer (or lead service provider) that is worried about you cutting them out by going direct to their subcontractors.

Even though subcontracting should not be relevant at the NNN stage, we often put a subcontracting provision in our NNN Agreements because it can force the primary Chinese company to reveal that it is not really going to be doing the manufacturing or the work, but instead will be using a subcontractor to do everything.

China LawyersBack when I used to watch a lot of horror movies (a long long time ago), When a Stranger Calls was one of my favorites. Spoiler Alert: It was about a babysitter who was experiencing weird things and constantly getting calls from someone who kept asking “have you checked the children.” To make a long story short, the creep was in the house.

I mention that movie today because our China lawyers have been getting a spate of calls lately to assist from American and European companies who have just learned that the creep is in their house.

Let me explain by way of some examples:

1. U.S. company terminates its head of China operations and then a couple of its China employees reveal that the U.S. company’s leading supplier is owned by the former head of China operations who — almost needless to say — has been charging about 40% over market.

2. Spanish company terminates its head of China operations only to learn that it actually does not have any China operations. The WFOE this person claimed to have formed and which the home office for the last three years believed was there actually wasn’t. The head of China operations had pocketed all of the money for the WFOE and all of the money marked for China income taxes as well. Fortunately, it turned out it never made sense for this company to have a China WFOE in the first place and so it exited China and now contracts with a Chinese company to accomplish what its fake WFOE had previously done. I say fortunately because if it had to have remained in China, it would have been at risk for not having paid its China taxes. For more on this fake WFOE phenomenon check out So You Think You Have A China WFOE Or Joint Venture Or Trademark. What Makes You So Sure?

3. American company flies to China to meet with its nine employees, only to learn from one employee that it has only five employees and that the head of its China operations has been pocketing the extra funds that allegedly went to pay the salaries of the four phantom employees. For the past three years!

Why are we getting so many of these calls now? All of them can to at least some extent be traced to the downturn in China’s economy. Many foreign companies are checking on their Chinese operations more closely than previously simply because they are concerned because they are less profitable. To quote Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.”

Do you really know who’s in your house? Have you checked your children?

China employment contract

China permits only the following three categories of “dispatched” employees to be hired by a labor dispatch agency:

  1. Temporary employees with a term of no longer than 6 months.
  2. Auxiliary employees who provide supporting services that are not central to the employer’s core business.
  3. Substitute employees who perform tasks in replacement of permanent employees during a period when permanent employees are unable to work due to off-the-job training, vacation, maternity leave, etc.

Both the PRC Labor Contract Law and the PRC Interim Provisions on Labor Dispatch require that a dispatch agency and a dispatched employee enter into a labor contract for a fixed term of no shorter than two years. It should be noted that the labor dispatch agency is for legal purposes treated as the employer in this relationship.

As covered in some of my previous posts, China’s labor law mandates that an employee is entitled to an open-term contract after having executed two consecutive fixed-term labor contracts (unless grounds for termination exists). So a question arises: if a labor dispatch agency has consecutively executed two fixed-term labor contracts with an employee, will the employee be entitled to an open-term contract? In other words, will a dispatched employee be treated the same as a regular employee under this circumstance? Note that China’s labor law clearly states that at the time of renewal or execution of the labor contract, unless the employee requests a fixed-term labor contract, an open-term labor contract must be concluded.

Consider two recent cases in Beijing (I have simplified both a bit for purposes of this post). In the first case, after having executed two consecutive fixed-term contracts, the employee requested an open-term labor contract, however, the labor dispatch agency ultimately refused and served the employee with a termination notice. The labor dispatch agency argued that the law on open-term labor contracts does not equally apply to dispatched employees. The employee sued and the Second Intermediate People’s Court of Beijing ruled against the labor dispatch agency and instead held that China’s law regarding open-term labor contracts does apply to dispatched employees. And then, just as would have been the case had the employee worked for any other company in China, the Court required the dispatch agency pay the employee double the employee’s monthly wage and forced it to enter into an open-term contract with that employee and pay that employee damages for wrongful termination. And here’s the kicker: the company that retained the labor dispatch agency and used the employee was deemed jointly liable for both of those amounts (the wages and the damages), meaning it too was on the hook for payment.

In another case involving a dispatched employee, the Xicheng District People’s Court also concluded that China’s labor law applies with equal force to labor dispatch agencies. This court reasoned that even though the PRC Labor Contract Law states that a labor dispatch agency and a dispatched employee must enter into a labor contract for a fixed term of no less than two years, this provision does not preclude such a labor contract from being a regular labor contract. The court also discussed how since the law treats a labor dispatch agency as an employer for legal purposes, this means the labor dispatch agency is subject to the same responsibilities as an ordinary China employer, including the obligation to execute an open-term contract when conditions for being required to do so have been met. The Court went on to make clear that the general intent of China’s Labor Contract Law is to protect employees, and allowing a labor dispatch agency to be exempt from this requirement on open-term contracts would be contrary to that intent.

Though it is true that Beijing tends to be a pro-employee municipality and the above cases are not necessarily conclusive regarding how similar cases would turn out in other municipalities, this does reinforce the Chinese government’s generally negative view of labor dispatch situations. For how China’s on the ground labor law can vary from city to city, check out China Employment Law: Local and Not So Simple

The bottom line here is the same as the bottom line when doing just about anything regarding China employment law:

  1. Assume the Chinese courts will favor the employee.
  2. Figure out all of the laws and rules, and especially the local rules and cases, before proceeding.
  3. Know that China does not generally like the hiring of workers via third party hiring agencies. It never has and its distaste for such arrangements just keeps growing.
  4. You as the company that retains the third party hiring agency and uses the workers provided by the third party hiring agency can be held liable and hit with damages for the misfeasance of your third party hiring agency. I am tempted to repeat this (but I won’t) simply because there is a widespread belief that using a hiring agency eliminates any legal responsibility for the workers employed. This is just flat out wrong.
  5. If you are going to use workers from a third party hiring agency, you should make sure that you have a good contract with that third party hiring agency and that the third party hiring agency you use has a good contract with those who will be working for you.

 

 

China Manufacturing ContractsAs I mentioned in my first post of this series on China manufacturing contracts, Original Development Manufacturing (ODM) has become very common in China. Shenzhen in particular has become the “go to” location for start-up companies with an innovative product concept but no manufacturing facility. For low volume production of hardware and internet of things (IoT) products, China has become virtually the sole source for production.

The most common form of ODM for foreign start-ups in China is some form of co-development. This is a major change from the former standard practice in Asia. In the old days, U.S. entities went to Taiwan, Hong Kong, Japan or Korea for their development work. Under that model, the foreign entity paid for the development and the final product was delivered to the foreign entity as a deliverable with no strings attached. The ownership of IP was clear: the foreign entity paid the fee and the foreign entity had 100% ownership of the product.

With the co-development approach that is now almost universal in China, the approach is quite different.  There are two basic types of co-development in China. In the “new product” approach, a foreign entity approaches a Chinese factory with an idea for a new product. However, the foreign entity usually has just the bare outline for the new product: often no more than simple drawings and a specification sheet. The Chinese factory is then asked to develop that product with the often unstated assumption that the factory will manufacture the product when development is complete. In the “add-on approach”, the factory already has its own proprietary technology. The foreign entity then engages the Chinese factory to produce a new product based on the core technology owned by the factory.

The issue our China lawyers keep encountering is that the legal consciousness of all the parties to these transactions is stuck in the old model of straight development for a fee. But the issues that arise under the new, co-development model are quite different from the former “straight” development model. The purpose of this post is to set out in a preliminary way the basics on what a foreign entity must consider when engaging in co-development in China.

None of the issues are easy to resolve, and the alternatives are very complex. Because of the difficulty, many foreign entities seek to hide their head in the sand and just ignore the issues. This is a mistake. It makes no sense to go to all the trouble of developing your product if, in the end, someone else (the Chinese factory) either owns the rights to “your” product or monopolizes the right to manufacture it.

The basic issues to consider in a Chinese co-development project are as follows:

1. Will the Chinese side do the development work at its own expense or will you pay for the development work? This is the critical first decision. Note that if the Chinese side does it at its own expense, you have very little ability to control the development process. There are several ways Chinese companies deal with this issue.

  • Some Chinese companies will do the development work at their own cost on the assumption that you are required to use them for manufacturing.
  • Some Chinese companies will pay the development costs up front, but then charge them back to you by applying some sort of fee to your initial purchases. Again, this assumes you are required to use them for manufacturing.
  • Some Chinese companies will charge a fee for the development work. Often this is a partial fee, and the Chinese company will charge the remainder to you by applying some sort of fee to your purchases. For example, if the total development cost is around $150,000, the Chinese factory will charge you a $50,000 upfront fee and then amortize the remaining $100,000 over a two year period. If you do not repay the entire amount during this period, the Chinese factory will then expect you to pay the remainder in a lump sum at the end of the two year period.

Note that all of these alternatives assume the foreign buyer is required to use the Chinese factory to manufacture the product.

2. What is the time schedule for the product development work? What happens if, as is normal, the Chinese side fails to meet the time schedule? This issue should not be underestimated. In our experience, the Chinese factory almost never completes production within the required time period. It also is not uncommon for the Chinese factory to never succeed in developing an acceptable product.

3. What is the final price goal for the product? If the Chinese side succeeds in making a workable product, but the price is triple what you need to viably sell it, that does not constitute success. Sometimes the higher price is because the Chinese factory was unrealistic in its initial estimate or it accepted an unrealistic price from the foreign buyer just to keep the work away from a competitor. In other cases, the Chinese factory will intentionally set the price absurdly high simply to drive away the foreign buyer so it can make the product for itself.

4. What exactly are the “deliverables” and what is the process for determining whether the deliverables meet your goals? Often the “deliverable” is no more than a working prototype. However, a single prototype cannot be considered the property of the foreign buyer. So when a prototype is the sole deliverable, the foreign buyer has in fact acquired nothing of value other than perhaps a commitment by the Chinese factory to manufacture consistent with that prototype.

5. Molds and tooling are usually of critical importance in developing a new product. With respect to your molds, you need to consider the following: Who will arrange to design and manufacture the molds and tooling? Who will pay for the molds and tooling and on what schedule? Who owns the molds and tooling? If you want to move the molds and tooling (not the intellectual property for the product, just the molds and tooling) to a new factory, do you have the right to do that? Often Chinese factories will say: yes, you can move the molds and tooling, but you have to pay a fee. In other cases, the Chinese will claim to own certain molds and tooling that are directly connected to what they believe is their proprietary IP. Deciding what fits into what category can be very complex. For how to keep your molds, check out China Manufacturing: How To Hang On To YOUR Molds

Though these five issues are normally difficult to resolve, they actually are the easy part of the process. The more difficult issue is who owns what with respect to the intellectual property in the product. Determining that the factory owns 50% and you own 50% may be relevant for allocating income from commercialization of the IP, but it does not tell you anything useful on the practical level of manufacturing the product.

In tomorrow’s post, I will discuss the intellectual property issues related to determining who actually owns what in an ODM arrangement.