Grey Market Goods and ChinaIn this projected 4-part series we’ll take a closer look at grey market goods and China. In part 1, we discussed what grey market goods are and why manufacturers get so worked up about them. Today, in part 2, we’ll look at how grey market goods are regulated in China. In part 3, we’ll look at how grey market goods are regulated in the United States. And in part 4, we’ll look at grey market goods and Chinese factories, and what foreign companies can do to protect themselves.

Part 2: How Are Grey Market Goods Regulated in China?

One of the minor mysteries of modern China is how every mall has so many luxury-brand stores that seem never to have anyone shopping inside. I’ve read numerous explanations for this disparity, none of them entirely satisfactory: the shops are loss leaders in an effort to build brand loyalty in China; the shops are highly subsidized by mall owners to bring in other tenants and/or to give them face; all of the sales are made after hours to Party officials’ relatives and mistresses; people just aren’t paying attention at the right time.

But one answer for the empty stores, surely, is the enormous size of China’s grey market for luxury goods. In 2015, Chinese citizens spent $22.5 billion on luxury goods purchased in China – and more than twice that amount abroad.

As noted in part 1, grey market goods exist because there’s a market for them, and that market exists because grey market goods are either cheaper or have better availability. But in China there’s a third driver of the grey market: quality. It’s ironic because in the US, grey market goods have a strong whiff of caveat emptor; if you buy a product outside the normal channels you accept the risk that it might be lower quality. But in China, the calculus is flipped: because counterfeiting is so rampant, the chance of buying a fake is considered to be much lower if the goods come from overseas.

Historically, a significant proportion of grey market luxury goods in China have come via daigou, personal shoppers (usually young Chinese women) who live or travel overseas and purchase luxury goods for well-heeled clients in China. I’ve seen this in action: at Seattle Premium Outlets’ Burberry Store, you sometimes have to wait in line just to get in the store, only to be ignored when it becomes clear you’re not there to drop twenty thousand bucks.

Other grey market goods in China are purchased directly by consumers, either while traveling overseas, or from foreign reseller sites like eBay. Grey market goods can also be found on Chinese e-commerce sites like Taobao and 1688.com; these goods are usually purchased “on spec” overseas and then resold in China. (The daigou as impersonal shopper.) Baby formula and iPhones have, at various times, been extremely popular grey market goods in China.

Grey market goods are legal in China, or at least not an infringement of the brand owner’s IP rights. Indeed, Shanghai’s Free Trade Zone has a car dealership that specializes in grey market automobiles.

But many grey market goods in China run afoul of the law in another way: customs fraud. When the goods are brought into China, they are not declared at all or are declared at lower values. Defrauding Chinese customs is an essential part of many a daigou’s profit margin, because China has historically imposed significant duties on a range of luxury imports.

China has attempted to crack down on illegal grey market importation through a number of means, including (1) higher taxes on goods brought in by travelers as part of their luggage, (2) lower taxes on goods imported through legitimate channels; and (3) increased penalties for those caught falsifying customs declarations.

The effectiveness of these measures is a bit hard to gauge: some reports say the measures are eliminating large-scale daigous; others suggest that the enforcement is both haphazard and overbroad, and that when Chinese people attempt to order directly from overseas retailers, the packages are frequently rejected at the border, with the result being that people are even more reliant on daigous to get the products they want.

On a certain level, foreign brand owners might not be that concerned about grey market imports in China – Christian Louboutin gets paid whether a pair of pumps is bought in Shanghai or in Houston and then taken to Shanghai and resold. But they should be concerned, for several reasons. First, they want to be seen as cooperating with the Chinese government on tax and customs issues. Second, having to deal with so many purchases by Chinese travelers overseas is a drain on resources (staffing, marketing, logistics) and distorts the worldwide revenue stream. Third, sometimes the prices in China, even accounting for taxes and tariffs, are higher than they are abroad — although a number of brands have normalized prices in China in an attempt to dissuade gray market sales. Fourth, the daigou phenomenon increases the amount of intermediation between brands and their consumers, which is exactly the opposite of what companies want. How can you market to customers when you don’t know who they are? And how can you control your brand identity when you are not the seller?

In part 3 of this series, we’ll look at how the United States regulates grey market goods.

Grey Market GoodsIn this projected 4-part series we’ll take a closer look at grey market goods and China. In part 1, we’ll consider what grey market goods are and why manufacturers get so worked up about them. In part 2, we’ll look at how grey market goods are regulated in China. In part 3 we’ll look at how grey market goods are regulated in the United States. And in part 4, we’ll look at grey market goods and Chinese factories, and what foreign companies can do to protect themselves.

Part 1: What are grey market goods, and why do they matter?

Grey market goods are authentic goods sold by unauthorized means. Unauthorized does not necessarily mean illegal; it simply means the goods are coming from someone other than (1) the original manufacturer or (2) a third party to whom the manufacturer has granted permission to resell the goods.

E-commerce has made all manner of grey market goods readily available. When I purchase Gillette razor blades on Amazon for delivery in the United States, the cheapest sellers are all offering grey market blades packaged for sale overseas (typically, Asia, Eastern Europe or South America). Although it’s unclear if these blades are exactly the same as what I would buy at a drugstore in the U.S., the price difference is significant enough that I’m willing to take the chance. And that’s just one example. Any product that has a significant difference in price or availability across different countries is likely to be sold on the grey market. And the flow of goods could go in any direction; it just depends on price and the demand. As China’s consumer class has grown in strength, so has the market for grey market goods. Products as disparate as Apple’s iPhone and Pfizer’s Viagra did significant business in China as grey market goods before they were officially available there.

Grey market goods are hardly a creation of the Internet, though.

A Vancouver, BC man named Michael Hallatt grew tired of waiting for Trader Joe’s to come to Canada, and since 2012 he has operated a store in Vancouver called Pirate Joe’s that stocks nothing but goods bought at Trader Joe’s stores in Washington State. All of the goods are purchased at retail prices in Washington and then marked up for sale in Canada. Trader Joe’s has been trying to shut Hallatt down for years, and has sued him for trademark infringement, unfair competition, false designation of origin, and false advertising.

Two weeks ago Pirate Joe’s announced it was closing its doors, which would have made the lawsuit moot, but at the end of last week Hallatt reversed course and announced on the PJ’s website that he was back in business. What makes Pirate Joe’s story interesting for IP attorneys is how it calls into question the limits of grey market sales. Hallatt certainly seems to enjoy tweaking Trader Joe’s and skirting the edge of the doctrine, but as the Freakonomics blog pointed out in 2013, reselling Trader Joe’s goods is no different than reselling goods on eBay or at a yard sale. The case is still pending.

In another well-known story, Costco purchased large quantities of Omega Seamaster watches from an authorized reseller in Europe, then resold them in the U.S. as grey market goods. Because the prices in Europe were so much cheaper than the retail prices in the U.S., Costco was able to add its usual markup and still price the watches at a substantial discount. Omega sued, but after a protracted battle, Costco prevailed in 2015.

It may be self-evident that the reason grey market goods exist is because there’s a market for them: grey market goods are either cheaper than the goods available through standard channels (e.g., the Omega watches at Costco and the Gillette razor blades on Amazon) or they are simply unavailable through standard channels (e.g., the goods at Pirate Joe’s). A reasonable argument can be made that grey market goods are in fact good for many manufacturers, because they increase brand recognition and product loyalty. And profits! All of these products have been sold by the manufacturer at a price (if not a use) they deemed acceptable.

Nonetheless, grey market goods are often decried by original manufacturers for reasons including the following:

  1. Grey market goods are often difficult to distinguish from counterfeit goods, which harms the reputation of the brand and the manufacturer.
  2. Grey market goods are often customized for the particular market for which they are made, and are unsuitable for use in other markets. This too harms the reputation of the brand and the manufacturer.
  3. Grey market goods often have different warranty protection — or none at all — when sold or used outside the market for which they were made. This causes customer frustration and dissatisfaction.
  4. Grey market goods sometimes are of lower quality (hence the lower price), which harms the reputation of the brand and the manufacturer.
  5. Grey market goods often interfere with the business expectations of the original manufacturer and its licensees.

In Part 2 of this series, we’ll examine how China regulates grey market goods.

China IP lawyerClients often ask us which of their entities should own their IP (patents, trademarks and copyrights) in China. The basic answer is usually simple: whichever entity will be using the IP in China.

There are some perfectly legitimate reasons for wanting to separate the ownership and exploitation of IP rights – reasons related to tax, liability, or corporate structure. But in the vast majority of situations, the only time IP ownership matters in China is when you are trying to enforce your IP rights. Chinese lawyers are expert at creating delay, and they know exactly how to exploit evidentiary gaps. And if you are attempting to bring an enforcement action in China but the plaintiff is not the registered owner of the IP, expect your dispute to take much longer than usual.

The Chinese lawyer on the other side will likely argue that someone who is not the registered owner of the IP cannot bring an action to enforce the IP rights and the mere fact the companies are under common control won’t be sufficient. A properly drafted license agreement might be sufficient – so long as the agreement is written in Chinese, registered with the appropriate authorities in China, enforceable under Chinese law, notarized, and authenticated by the Chinese Embassy, and so long as you do not run into any use issues. See China Trademarks: When (and How) to Prove Use of a Mark in Commerce. You can probably guess how often all of these things are done and done right by American and European companies. Most of the IP license agreements we are asked to review – no matter whether the company that comes to us is a two-person startup or a Fortune 100 company – are in English and governed by the laws of whatever country the plaintiff is in.

You better believe the Chinese lawyer for the Chinese company you sue in China for infringing on your China IP will be questioning each link in the evidentiary chain of your IP and pointing out each potential problem. If you’re lucky, you’ll have the chance to fix each of these problems in time before you sue, but doing so could add weeks or months or years to the process. And meanwhile, the infringing party will be going about their business using “your” IP. It’s death by a thousand (paper) cuts, and it’s a losing game.

Unless you have a really good reason to split ownership and use of your China IP into different entities, just keep it simple and use one company.

China contract lawyers
Too many China contracts deserve this appellation

Pretty much every week, at least one of our China lawyers will — after a five minute review — have to tell a potential client their contract is worthless. We see all kinds of worthless contracts. NDA and NNN Agreements, Manufacturing Agreements, Licensing Agreements, Distribution Agreements, Product Development Agreements, Employment Agreements. It goes on and on. And as tempted as I am to ask why they would think a US law contract that calls for disputes to be resolved in Boston or Des Moines would make sense in China, I always refrain from doing so, and I have seen some doozies, including the following:

  • A Seattle company that was being sued by about a dozen of its China employees and its employment contracts were drafted in English under Washington State Law. Their Seattle lawyer had told them that he had drafted their employment contracts this way because China “has no real law.” I explained their problem by pointing out how my law firm cannot hire Chinese people in Seattle and use Chinese law to pay them a dollar an hour because that is the minimum wage over there. They got and we ended up settling as quickly as we could with all of their China employees.
  • Countless companies that have used US or European style NDA agreements and have had their IP or trade secrets stolen by the Chinese company that signed that NDA. They want to know their chances of prevailing in a lawsuit against the Chinese IP thief and I have to tell them that unless the Chinese company has assets in the United States (and incredibly few do), it would probably not be worth it to them for our China lawyers even to look at their agreement. I then explain how China does not enforce United States court judgments and if they are going to continue doing business in China or with China they can do better the next time with a China NNN Agreement.
  • An American company that was using a Chinese company to market and sell the American company’s product in China came to us after the Chinese company had started selling its own products under the American company’s name and was refusing to cease doing so, even though the distribution agreement between them prohibited exactly that. The American company wanted to retain our China legal team to make this stop, but we had to tell them that we probably would not be able to succeed at that because their distribution agreement provides for US law and US court jurisdiction and because the Chinese company had registered the American company’s brand name as its own Chinese trademark. See How To Protect Your Trademark In China; How To Stop Your Distributor From “Stealing” Your Trademark.

Oh and one more thing. Far too many times when we tell someone how their contract precludes us from being able to help them, they tell us something like “we knew it would not work but we knew we needed something.” Wrong. Many times no contract at all is better than a bad contract. 

China has its own laws and its own official languages and its own court system and its own way of doing things, just like every other country in the world. So if you are going to do business in China or with a Chinese company, you almost certainly will need a contract that satisfies China’s legal requirements. There is nothing our China attorneys hate more than having to tell potential clients there is nothing we can do, but we have to do this all the time when given contracts that were not written with China in mind.

Please don’t let a worthless contract happen to you.

China manufacturing contractA houghtful and helpful blog post over at the Dragon Innovation Blog, entitled, Recalls, Returns and Failures: Let History Be Your Guide. This post is geared to companies that have their hardware made in China, but its words of wisdom apply to the manufacturing of pretty much any product in China.

The post starts out by emphasizing the need to focus on how your product may not work as promised and how product defects can harm your company, perhaps even bankrupt it:

When it comes to quality planning, hardware startups tend to spend most of their time working on ensuring that a product will work as promised however many teams do not spend significant time addressing the subject of how the product will not work as promised. Returns, return logistics, and possible recalls can be financially devastating especially in the early life of a product. What may appear as a small change in warranty rates can have significant impact on a company’s bottomline and financial viability.  For example, if a company assumes a $250.00 total cost, $50.00 margin and sales of 100,000 units per year, a change from a 5% to a 7.5% warranty rate can decrease profits by 17% and increase working capital by $50,000. A recall or major quality failure can easily bankrupt a company.

It goes on to advise that you figure out the what if scenarios for your product and then include those factors in your design process as early as possible. It then lists out various tools and techniques you can employ to tease out potential product problems. It even lists out the “major root causes” of recalls, including the following:

  • Loosening of joints/connection
  • Small parts or magnets swallowed by children
  • Not following or adhering to federal safety standards.
  • Pinch, cut or severing risks for fingers
  • Breaking/cracking or other failure
  • Overheating
  • Battery failures
  • Excess material or insufficient material
  • Small pieces or magnets falling off
  • Poisoning

If you are looking to have your product(s) made in China, I urge you to read this post. And to further protect against product defects — especially those that are the fault of your Chinese manufacturer — I urge you read the below posts on China manufacturing contracts as well:

 

 

US-China trade warTo say that my law firm’s international trade law team has been busy lately would be like saying the Great Wall of China is long. They have been crazy busy because the United States has gone wild with trade case against Chinese companies and their U.S. importers — and against other countries and their importers as well.

If you import products from China, listen up.

US Importers of Record are liable for antidumping and countervailing duties tied to the product they import. The Importer of Record is the company listed in Block 26 of the U.S. Customs 7501 form.

Under US Antidumping, Countervailing Duty and Customs laws, the Importer of Record must exercise reasonable care in importing products and in filling out Customs forms. The Importer of Record must correctly state a product’s country of origin and also whether Antidumping and Countervailing duties apply to the imported product. A knowingly false statement on a Customs form constitutes criminal fraud.

If AD or CVD rates go up in a subsequent review investigation, the Importer of Record is retroactively liable for the difference, plus interest. Retroactive liability for AD and CVD cases is a particular problem involving goods imported from China because the United States treats China as a non-market economy country. Since China is a non-market economy country, the U.S. Commerce Department refuses to use actual China prices and costs to determine whether a Chinese company is dumping. All this makes it nearly impossible for U.S. importers to know whether it is bringing in dumped goods. See Don’t Get Crushed When You Import.

In the last week or so, the Trump trade war has escalated big time with new U.S. antidumping and countervailing duty cases being filed against Mechanical Tubing, Tool Chests and a new Section 232 National Security case against all Steel imports. These trade cases move and at warp speed and that means that if your company shows up as the producer or the importer on any of these cases, you have no time to waste. A brief summary of each of these three cases follows.

 1. Cold-drawn mechanical tubing from China, Germany, India, Italy, Korea and Switzerland. On April 19, 2017, ArcelorMittal Tubular Products, Michigan Seamless Tube, LLC, PTC Alliance Corp., Webco Industries, Inc., and Zekelman Industries, Inc. filed Antidumping and Countervailing Duty cases against hundreds of millions of dollars of cold-drawn mechanical tubing from the six countries in 2016.  The petition alleges antidumping duties ranging as follows:

  1. China: 88.2% – 188.88%
  2. India: 25.48%
  3. Italy: 37.23% – 69.13%
  4. Germany: 70.53% – 148.32%
  5. Republic of Korea: 12.14% – 48.61%
  6. Switzerland: 40.53% – 115.21%

The cold-drawn mechanical tubing covered by the complaint is used to produce numerous different products in the United States, including auto parts and machinery.

The United States International Trade Commission (ITC) will conduct its preliminary injury hearing on May 10, 2017 and US importers’ liability for countervailing duties on imports from China and India will start on September 16, 2017, and Antidumping Duties will start on November 15, 2017. Antidumping and countervailing duty orders can last for 5 to 30 years. These sorts of duty orders can and often do mean the end of U.S. imports and sales for many of the named companies, especially those that do not fight the cases against them from the very beginning.

2. Tool chests from China and Vietnam. On April 11, 2017, Waterloo Industries Inc. filed Antidumping and Countervailing Duty cases against hundreds of millions of dollars of imports of certain tool chests and cabinets from China and Vietnam. The ITC will conduct its preliminary injury hearing on May 2, 2017 and US importers’ liability for countervailing duties on imports from China and Vietnam will start on September 8, 2017 and for Antidumping Duties on November 7, 2017.  

3. National Security Section 232 case against steel imports from many countries, including China. On April 20, 2017, President Trump announced a new trade investigation of steel imports under section 232 to determine if tariffs should be imposed because increased steel imports pose a threat to national security. If the United States Department of Commerce determines that steel imports are a threat to national security, President Trump will be empowered to levy high tariffs and quotas on imports of steel products from various countries. Under Section 232, the Commerce Department will investigate the potential national security threat posed foreign steel entering the U.S. market and then issue its findings and recommendations  to the White House. Once Commerce completes its review President Trump will have 90 days to decide whether to accept or reject its recommendations and to impose trade restraints, including tariffs or quotas on steel imports.

If your company has been named in any of these three cases and you want to avoid having to pay massive duties and/or just walk away from the U.S. market for five to thirty years, you need to start organizing your defense NOW.

international Trade lawyersEmboldened by President Trump’s promise of tougher enforcement of U.S. trade laws, a fresh wave of new antidumping and countervailing duty (AD/CVD) petitions were filed in March by domestic U.S. industries seeking relief from imports. The petitions cover five products (silicon metal,  aluminum foil, biodiesel fuel, wire rod, and carton closing staples) from all over the world from Argentina and Australia, to the UAE and UK. And of course, China. These petitions will trigger 25 separate AD/CVD investigations at the Department of Commerce.

However, one of President Trump’s first executive orders was to freeze hiring of any new or replacement federal government employees.  If this hiring freeze continues, the Department of Commerce (DOC) may not have enough manpower to administer all these new AD/CVD cases. The DOC already has about the same number of on-going investigations that must be completed, along with an even bigger number of administrative reviews of all the existing AD/CVD orders that are still in effect. For each case, a DOC case analyst and attorney must draft and issue multiple rounds of questionnaires, review the responses and comments submitted, analyze all the issues raised, calculate AD/CVD margins, and draft decision memoranda.  All these necessary tasks require a certain minimum amount of time to be completed. Without reinforcements, the expanding new case load threatens to stretch the DOC trade remedy team well past a reasonable or manageable work load.

Nine U.S. Senators have already asked President Trump to lift the hiring freeze for trade enforcement personnel at a variety of agencies such as DOC, Customs and Border Protection, USTR, and Department of Justice. They specifically noted that these agencies have been tasked with more extensive trade enforcement responsibilities, but the hiring freeze would have the effect of reducing the resources available for such enforcement.

Since the hiring freeze does not apply to military personnel or those deemed essential to security, maybe President Trump will find trade enforcement is essential to national security or carve out some other exception to allow new hires for the DOC and other trade related agencies.  But if the DOC cannot hire enough personnel to administer cases properly, then perhaps it will develop leaner and meaner ways to handle these new AD/CVD cases. That is the fear of the international trade lawyers at my law firm and elsewhere, and it should be the fear of any company, Chinese or otherwise, that finds itself caught in the crosshairs of an AD/CVD petition.

For example, DOC may now try to decide more cases based on applying total adverse facts available (AFA), after finding the respondent exporter or producer to be non-cooperative because their questionnaire responses are deemed untimely or inadequate. Making this sort of finding will allow the DOC to avoid crunching all the submitted sales and cost data to get AD/CVD margins that often are not that high (particularly for non-Chinese market economy cases). This will give the DOC the highest AD/CVD margins possible with the least amount of work if the exporter/ producer gives up or is given a death blow.

Even if a respondent survives the questionnaire process and avoids a total AFA determination, the DOC now can generate higher AD/CVD margins by applying a new trade law provision which allows it to find a “particular market situation” justifying an upward margin calculation adjustment. This is what Peter Navarro, head of the newly formed National Trade Counsel, recently urged Secretary of Commerce Wilbur Ross to do in an on-going administrative review of Korean OCTG oil drilling pipe. In that case, Navarro and the domestic pipe producers wanted the DOC to make a “particular market situation” finding the Korean pipe producers benefited from subsidies embedded in their purchases of Chinese steel. Navarro relied on a “logical” presumption that the Chinese steel subsidies of 60% found in a prior unrelated case would be passed through to benefit the Korean pipe producers to generate a margin of at least 36%. Navarro’s back of the napkin calculation lacked even a napkin to support the calculation. Respondents in that case complained that Navarro’s email was an unprecedented intervention and an overt suggestion that DOC calculate a politically acceptable but factually unsupportable AD/CVD margin.

U.S. AD/CVD cases have long had a reputation for being more objective and fact/data intensive than those conducted by most other countries. But if political pressure and personnel limitations push DOC to make more arbitrary AFA determinations or politically motivated findings of a “particular market situation” U.S. trade remedy cases will soon lose any advantage of perceived objectivity or credibility. The Department of Commerce already has significant discretion to weigh the record evidence and make judgment calls favoring the domestic industry. But at least those judgment calls have been based on an analysis of specific record evidence. The new “particular market situation” provision appears to give DOC even more discretion to make adjustments based only the thinnest of factual basis. This shift towards a more politically-driven AD/CVD process may result in the Department of Commerce issuing higher margins in the short term, but over the long term, the AD/CVD process risks losing significant credibility. Trade remedy cases, by definition, are intended to be remedial, not punitive. DOC’s AD/CVD process is supposed to determine the “fair” normal value for subject imports. If DOC’s definition of a “fair” export price is not factually or legally based, but is instead arbitrarily determined by politically influenced adjustments, an exporter or US importer has no way to determine whether or how their pricing should be adjusted in order to be deemed “fair” by DOC.

What this means in real life for Chinese companies sending products to the United States, and to those who import products made in China, is that they need to be even more careful not to run afoul of U.S. AD/CVD laws and pricing. And when tagged for any AD/CVD violation, it is more critical than ever that they respond quickly and with as many facts as they can muster, thus making it harder for the DOC to make quick and random and financially deadly decisions.

China lawyersNo idea why but we have lately been seeing an increase in clients interested in getting their products from China anonymously. These companies want to have their products made in China without anybody knowing who in China is making them, and sometimes that that they are being made in China at all. There are many reasons why companies seek an ultra-low profile when having their products made in China, including the following:

1. They do not want their buyers to know that the products they are buying are made in China. But what about place of origin requirements? What about them? If you are selling an item that says “hand burnished in the United States” most of your buyers will believe your product is made in the United States even if all you do to hand burnish them is to have some $8.90 an hour employee (perhaps even from China) spend five seconds running a clothe over your product before it goes on retailer shelfs. There are plenty of items that people buy all the time without realizing they come from another country. For example, about 90 percent of seafood sold in the United States is imported, yet in my experience pretty much nobody realizes it is even more than half. Whenever someone tells me that they refuse to eat anything made in China I tell them that if they eat garlic or anything with garlic, they do eat something from China. About 80 percent of garlic in the US comes from China and that number is almost certainly considerably higher when it comes to processed and frozen foods. The point is that many (most?) companies that are completely truthful about where their product would prefer their buyers not know their products come from China.

2. They do not want their competitors to know that their products are made in China and they especially do not want their competitors to know exactly where in China their products are made. This is incredibly common. If you are making better widgets than any of your competitors and selling them at a better price, you can bet your competitors want to know how you are pulling this off. And if you are accomplishing this by using a super high quality super efficient Chinese manufacturer, you can also be that your competitor(s) would seriously consider using your same Chinese manufacturer if they could find out who it actually is. I cannot tell you how many times one of our China lawyers has asked a client how it chose XYZ Chinese manufacturer and gotten the following sort of response: “Well, company X is the leader in our industry and so I tracked down who company X uses in China to make their widgets and I went to them to have them make our widgets too.”

3. They do not want their Chinese manufacturers to know where their products are made in China. I’m being somewhat facetious here, but not really. In fact, it is this reason that has been driving the increase in clients seeking China manufacturing anonymity. They want to have portions of their product(s) made by three to six different Chinese manufacturers, without any of the manufacturers knowing about the others and without any of the manufacturers knowing to what use its portion will be put.

But all of the above is easier said then done, and I would estimate that most SMEs do not achieve the secrecy they seek, either because they mess up somewhere along the way or because doing so is simply too expensive.

The below are the pressure points where we see companies frequently fall off the secrecy track:

  1. The initial email to a potential Chinese manufacturer. Yes, the initial email. If your name is Luis Twederluski (I made that name up so please don’t even bother to look it up) and you send out emails to ten companies in China from your LuisTwederluski333@gmail.com account, you have probably already revealed more than you wanted. From just your email address, there is a good chance someone can figure out your full name (this is oftentimes possible even if your email address is goshijustreallyloveparis@gmail.com). And then from your full name there is a good chance they can figure out your company name and from that what you are intending to have made in China.
  2. The parts in your product. Take the company that does not want anyone (especially its China constituent part suppliers) to know what it is making. This company has company A in Suzhou make part 1, Company B in Xi’an make part 2, Company C in Dongguan make part 3, and company D in Shenzhen make part 4, and then it calls it a day. Wrong. What if one of these companies somewhere stamp their name on the parts that are going into the product? What if even without any stamping of names their parts are identifiable by those in the industry? The more typical problem with having 3-6 companies operating completely independently of each other is cost. If you are a large company with personnel who can coordinate logistics, timing and interoperability of parts between your various suppliers, then you should be covered. But if you are a small company and you think you can coordinate all of this things will sitting home in Pittsburgh, well that just isn’t terribly likely. Most importantly, where are you going to put the 3-6 parts together into your product and then have it packaged? If you were thinking of doing these things in the United States for anything near to as low a price as you would pay in China, well that is not likely going to happen.
  3. Importing the product into the United States. It never ceases to amaze me how few people realize how easy it is to review import records on the web. Just by way of an example, Google search “Lululemon (which is NOT a client of our firm) import records” and the first item will take you to www.importgenius.com which for free shows you a “sample shipment record” showing Lululemon imported “hustle pants” from Mactan Apparel out of Taiwan, but the pants actually came from Cebu, Philippines. If I actually cared from where Lululemon gets its products, my next step would be to sign up and pay for Import Genius (there are other search services as well) and then start going through all of Lululemon’s import records. Your competitors might be doing that with your import records even as I write this. We have had client companies tell us of the amazing lengths they have gone through to keep their name off U.S. import records. A few years ago it was the rage to form a company in Hong Kong and have that HK company buy your products from the PRC manufacturer and then have the PRC manufacturer actually ship your products to your Hong Kong entity and then that way the US import records would not reveal the name of the PRC manufacturer because your own HK company would be the exporter. There was (and still is) usually a far easier way, especially if you are in a large industry. Let’s say your company is called World’s Best and Finest Toys and you sell toy dolls that you have made in China and you do not want your competitors (or anyone else for that matter) to know from which toy factories you are getting your dolls. You can set up an import management company and call it World’s Most Mediocre Hamburgers and Kielbasa’s and use that company to import your dolls. This is a cheap way to make it far harder (perhaps impossible) for anyone to know what you import.

A word of warning is definitely in order though: some of these methods may not work or may even be legal for your particular industry or your particular country or may increase your taxes or just otherwise make your life miserable. In other words, don’t anyone write me an email months from now saying (and I do get these) I did what you told me to do in this [link] blog post and now I am wondering if….” The above are examples; I am not telling you to do anything at all. In fact, I am telling you that you will be making a huge mistake to do any of these things without first consulting with an international trade law attorney and with your tax professional.

The goal of this post is not to solve your product secrecy problems but rather just to get you thinking about the issues and not to blow your cover with your first email.

What do you do to maintain your product secrecy?

China manufacturing lawyers
China product manufacturing: the tensions are rising

We often write about the increasing sophistication of China contract manufacturing. Fifteen years ago, the typical US-China manufacturing agreement involved the sale of socks or rubber duckies. Today, the typical contract involves a complicated electronics device involving hardware and software and all sorts of intellectual property and much greater risk of defect and injury than a pair of socks.

With the increasing sophistication of China manufacturing and China manufacturing contracts has (not surprisingly) come increasing business and legal sophistication by Chinese manufacturing companies. Two to three years ago the overwhelming majority of manufacturing contracts my firm’s China manufacturing lawyers wrote were accepted either unchanged or with only minor changes by the Chinese side. Today, Chinese manufacturing companies better understand the legal impact of the contracts they sign and they are becoming increasingly reluctant to sign contracts that pin major potential liabilities on them.

Today’s post is about liability issues for defects, which issue our China manufacturing lawyers are dealing pretty much every day and which issue is truly on the front lines in terms of the contract “war” that has broken out between China manufacturers and their foreign company buyers. The below is an amalgamation of three recent emails we sent to companies looking to our China lawyers to reduce their product defect risks when buying from China.

 

I understand your concerns. Defect rates from China are too high.

For China, the issues surrounding product defects are usually the following

1. You need a Chinese language, Chinese law agreement you can enforce in China.

2. Contracts typically used in the West are usually too vague and flexible for China. For China, you need to be blunt and clear. Defect beyond some rate means a monetary penalty of some amount. If your contract is not clear on what constitutes a defect and the price your manufacturer must pay for the defects, it is not appropriate for China. Do you want just a repair/replace warranty, or do you want damages also to include the costs of dealing with the issue or do you want it to include all the above, plus claims from customers and consumers. If ALL the damage is included, the number can be big and if the Chinese side understands this (and they probably will), there is a good chance they will not agree to it, unless you have sufficient economic leverage over them such that they feel they have no choice. Even if they do agree to it, you need to be concerned about whether they have the money or the insurance to pay on any major problems.

3. One of the biggest issues for China is how to enforce your defect contract provisions. We typically propose something like the following:

Step One: Determine a sum certain amount owed based on a mechanical formula. Calculation is entirely in our client’s control with no good faith participation by the Chinese side.

Step Two: Report the amount owing to the Chinese supplier through a formal invoice. Do this on a regular basis, say every quarter.

Step Three: Collect the amount owing. The most common way to do this is to apply the amount owing as a credit against the invoice for the defective product, against current invoice amounts, and against future invoices.

Step Four: If step three does not cover the amount, send an invoice for the remaining amount. If the invoice is not paid, file suit in China. If the lawsuit is based on a sum certain amount even the threat of the lawsuit can have some benefit.

You can see how the above can work well for what you are seeking to accomplish, but Chinese factories and Western buyers are in major battles now over defect issues. The Chinese manufacturers are concerned with agreeing to sell on a net 30 or net 60 or net 90 basis and then having the foreign side refuse to pay because of claimed defects. The Chinese is legitimately concerned with the foreign side using the defect issue to reduce payments actually owed. All of this is right now a hot topic within the Chinese export factory community so the odds are good that your China factories will be sensitive on these issues.

We should discuss the above and then formulate a strategy for dealing with your China manufacturers.

 

China intellectual property lawyersWhen our law firm started drafting manufacturing agreements on behalf of Western companies having their products made by Chinese manufacturers, we mostly dealt with simple items like socks, shoes, rubber duckies, etc. Those contracts were relatively fast and cheap and easy. The core of the contract was essentially something like this: “Your Chinese company will make rubber duckies out of these specific materials and with these additional specifications and you will deliver them to our facility in the United States or in Spain or in Australia within 45 days after we issue our purchase order.” Becuase these contracts were so routine and so simple, we virtually always always charged a flat fee for them.

Those days are mostly over for China, though these sorts of agreements are still relatively common for Vietnam, Cambodia, Thailand and Sri Lanka. These days the typical manufacturing agreement on which our China lawyers work is far more complicated because the products made in China are far more complicated. And with complicated products comes complicated intellectual property issues involving trade secrets, trademarks, copyrights and patents.

I called up an email this morning to review a China intellectual property issue on an existing matter. That first email led me to a couple more emails and today’s idea for a blog post. The below is a merger of three emails (further modified to remove any identifiers), which should be helpful to anyone looking to manufacture IP sensitive products in China, especially those that include software.

Oh, and for further incentive to get you to parse through the below email, go read China and The Internet of Things and How to Destroy Your Own Company to see what can happen if you fail to realize how critical intellectual property protections have become when having your products made in China.

 

We still need more clarification regarding the issue of ownership of the various technologies that will be going into your product.

Based on my review, there are four separate forms of technology embodied in this single product:

  1. The case or external shell.
  2. The internal mechanism: electrical/mechanical.
  3. The internal mechanism: firmware.
  4. The smartphone/computer application software.

Based on this, my questions are as follows:

1. For the external shell (Item 1):

a. Who will do the design? Who will prepare the actual CAD drawings for the mold? Who will fabricate the physical molds?

b. How and when will you pay for the molds to be made? Will you do this as part of a separate contract or will you fold this process into the manufacturing agreement?

c. Note that you will need to be clear that you own the shell design. If it will be done before/outside the manufacturing agreement, we will a clear document that provides for ownership and control. Note that if a third party does the mold (which is likely), there is a risk of the third party appropriating the design and selling it to someone else. However, for this specialized product, the risk is low.

2. For the application software (Item 4):

a. Who will create the application software? If it will be outsourced, you need to know. If it will be done in-house, will it be done by _________? You need to know.

b. Has a fee and timeline been determined for the software application? If so, what is it? If not, when will this be done?

c. What if the application software does not work? What if the application software does not have the “look and feel” you want? How will you work with the programmers to ensure all this is done how you want?

d. The fee, once determined, will be amortized against the purchase of the first 200 units. Does this mean the price of each of the first 200 units will be increased by 1/200 of the application software fee? What happens if you never buy more than 200 units? What happens if you end up buying only 100 units? You need to determine the fee to be sure this makes economic sense for you.

e. Will you own the application software copyright for the entire world? If so, we will need to specifically provide that the application software will be done as a “work for hire” and that your company will own the copyright on it. If you own the copyright, the Chinese side cannot sell the software to anyone else or use it for their own purposes. Will they agree to this? If the Chinese side is sophisticated, they will NOT provide you with the software copyright because they plan to reuse the core software for other projects. In fact, they may not even own the copyright to the core software. They may instead agree only to provide you with the rights to the “look and feel.”  Many U.S. buyers ignore these software issues, leading to many problems down the road. You may recall that the multi-billion dollar legal battle between Apple and Samsung is centered on these difficult “look and feel” issues.

3. For the electro-mechanical/firmware (Items 2 and 3).

It is not clear who will own and control this item because there is an internal contradiction in the description. On the one hand, the Chinese side says it will provide you with all data necessary for your company to patent and copyright items 2 and 3 in the U.S. (Note that firmware is protected by copyright, as are mask works and related). This means you would then own 100% of the rights to items 2 and 3 for the United States: permanently and forever, to the exclusion of everyone, including _________. This means you would not even be required to purchase the product from ________ because you could have it manufactured by anyone in any location where a conflicting patent and copyright has not been registered. It also means even if you do not secure a patent or copyright on this, you still have an exclusive and perpetual license to the technology for the U.S. This perpetual license would have essentially the same effect as a patent or copyright registration with respect to your relation to __________ and its attempts to license to any third parties in the future. The point here is that a patent is not revokable; once you have it, it is yours for the term. On the other hand, the Chinese side wants to have the right to allow other U.S. entities to make use of the technology to sell competing products in the United States if your company does not meet certain sales quotas. Under this approach, the Chinese side is providing you with essentially a limited license with these terms: a) the product must be purchased from _________ and no one else, b) your sales territory is limited to the United Sates, and c) your license terminates if you fail to meet the sales quota. This has in fact become the normal approach for sophisticated Chinese companies making products like yours.

The issue though is that these two approaches are contradictory. Only one can stand. So which one is it? As I have noted, the second option (limited license) is most common. However, that means your company’s product development would be placed on a very weak footing because your entire product line could be terminated if you fail to meet the sales quotas. This termination could come either from the license becoming non-exclusive, (allowing the Chinese side to license to and manufacture for other U.S. companies) or from the Chinese side terminating the agreement.

This issue goes to the core of your agreement and so it is crucial that we get clear on on this for the agreement. As noted, most Chinese manufacturers/designers will take the limited license approach instead of terminating the agreement. If this is their approach here, their offer to provide you information for a patent application is not consistent because a limited license and absolute ownership rights are contradictory.

4. There is an additional issue related to the rights of non-U.S. entities to sell into the U.S. market. This can only be resolved after we get answers to the questions above.

5. There is an additional issue concerning what to do if _________ is unable or unwilling to manufacture your product at an acceptable price, at acceptable quantities, with acceptable delivery dates and at an acceptable level of quality. If ________ owns the core technology and is merely providing you with a limited license you could find yourself “stuck” with bad pricing, bad quantities, bad delivery times and/or bad quality products. The normal remedy would be for us to state that if any of the above problems occur, you have the right to have your product made by some other manufacturer and that ________ will provide you with a license to the technology that will allow this. Though this is the normal remedy, many Chinese manufacturers strongly resist this, putting you in a difficult position. You have indicated that ____________ will be required to accept purchase orders that meet the price agreement. You have also provided for penalties for late delivery and for defect issues. Though this is not ideal, it may be the best you can do in your current bargaining position. So the key issue is whether you are required to purchase from __________ or not. If you are required to purchase exclusively from ___________, you will need to face the fact that you are in a very weak bargaining position on many critical business issues and ____________ can fairly easily make life difficult for you by forcing you to fail to meet the sales quotas that will then enable it to start working with U.S. company that competes with you.

Please advise on the above. After we get clear on these various issues, I can begin drafting the agreement. I realize these issues are difficult, but it it is best to take a clear position from the start. Please let me know if you have any questions or if you need any additional explanations.