protect your ip in china

I was interviewed by a reporter yesterday who is doing a story on legal pitfalls for companies doing business in China.

I listed out some of the more common ones that American companies in China encounter, including the following:

At the conclusion of my litany, the reporter said something to the effect of “why does anyone do business in China at all?”  My response was because of the opportunities and then I told her of how I think that about 90 percent of my firm’s clients actually do quite well in China.  I then mentioned that I thought that virtually every AmCham survey reveals that American companies in China have higher profits there than in the United States.  I then talked about how everything is relative and that overall and as compared to most other emerging market countries, China is a relatively easy country in which to do business.
That was borne out for me today upon reading the World Economic Forum’s latest Global Competitiveness Index (2013-2014), which ranks China 29th out of 148, right behind Ireland and right ahead of Puerto Rico (since when did Puerto Rico become its own country?).  Not bad.
The report has this to say about China:
China leads the BRICS economies by a wide margin, well ahead of South Africa (53rd), Brazil (56th), India (60th), and Russia (64th).25 The Chinese institutional framework is improving slightly (47th), but weaknesses—including corruption (68th), security issues (75th), and low levels of accountability (82nd) and ethical standards (54th) among businesses—remain. In addition, problems endure in those areas that are becoming increasingly important for China as it becomes wealthier and can no longer rely on cheap labor: its financial market (54th) is undermined by the relative fragility of the banking sector; technological adoption by firms (86th) and by the population at large (79th) remains very low; and the efficiency of its goods market (61st) is seriously undermined by various barriers to entry and investment rules, which greatly limit competition.  On a more positive note, China’s macroeconomic situation remains favorable (10th). Inflation was back down to below 3 percent in 2012 (from 5.4 percent the previous year), the budget deficit is moderate, China’s public debt-to-GDP ratio at 22.9 percent is among the lowest in the world, and the gross savings rate represents a staggering 50 percent of GDP. However, this rate is probably too high in light of the need for China to rebalance its economy away from investment and toward more consumption. Although China receives good marks in health and basic education (40th), the assessment is more negative when it comes to higher education (70th) because of China’s low tertiary education enrollment, the average quality of teaching, and an apparent disconnect between educational content and business needs (54th). Finally, China’s innovation capacity has been improving recently, but much remains done for it to become an innovation powerhouse.
Seems about right to me.  What do you think?

We spoke with a software company the other day that has nearly fifteen “independent contractors” in China, who it views as “part of the corporate family.”  This company was contacting us to see about forming a WFOE in China.  They told me that they were not in any rush.

The first thing I did was to ask whether they knew that what they were doing in China is completely illegal. They did not.  I explained to them how there is almost no such thing in China as an independent contractor and that they essentially had nearly fifteen employees and because there was no company actually employing those fifteen people, what they are doing is illegal. I then told them of how China in the last year has stepped up even more its efforts to rid the country of foreigners there illegally and companies there illegally.  I also told them of how their existing structure puts all of their China assets at huge risk. Their China IP assets are at risk for the simple reason that they do not really own them.  A company operating illegally in China is just not positioned to be able to assert IP rights against anyone in China.  Their other China assets are at risk because the Chinese government will likely seize them if and when it cracks down on what they are doing.

They seemed very interested in going legal until I started laying out how doing so would greatly increase their China operating costs.  I told them how their forming a WFOE would necessitate their incurring the following additional costs/expenses:

  • WFOE formation fees and costs.  They expected this.
  • They would need to lease office space from an approved landlord.  This is a requirement for WFOE approval.  This would likely increase their office rent.
  • For every $1,000 in employee salaries, they would probably need to pay about $400 (40%) in employer taxes and benefits.  They were not expecting this at all.
  • In addition to the employer taxes, their employees will need to start paying income taxes. They seemed to think that their “independent contractors” are already paying all required taxes. I told them that I am virtually certain that they are not, and that their going legal will almost certainly lead to their “independent contractors” demanding higher salaries to make up for their take home pay being reduced by having to go onto the tax rolls.

I then talked of the advantages of having a WFOE, including the following:

  • You are operating legally.  Your risk of the government shutting you down tomorrow has essentially disappeared.
  • You are much better positioned to do real business in China, because you are legal.
  • You are much better positioned to protect your IP in China, because you are legal.
  • You are much better positioned to terminate employees because you do not need to keep them on forever for fear of their reporting you to the authorities.

After this phone call, I spoke with China-based co-blogger, Steve Dickinson, for the latest on how China’s government is treating foreign operations with multiple people working for them in China. Steve pointed out how the Chinese government is aggressively pursuing tax evasion claims against both the “independent contractors” and those connected to the illegal business. The government pursues the “independent contractors” for failing to pay their own taxes and it pursues the foreign business for Chinese income tax and related national and local business fees and taxes. Most importantly, the government also seeks to take action for back taxes against any representative (i.e., individuals) of the foreign company who happen to come to China. When the number of illegal employees is large, the claim for back taxes can be quite large. Often, the tax authorities time their raid on the illegal business to ensure that a representative of the foreign company is on site and, in many cities, they will not let the foreign representative leave China until after resolution/payment is achieved.

In other words, doing the “independent contractor thing” without having a registered business in China is asking for trouble.  Big trouble.

What are you seeing out there?

I am always getting emails from people seeking free advice on what jurisdiction/law they should put in their China contract.  My answer is always the same: I have no idea.  The reason I never have any idea of what to put in someone else’s contract is because the answer always varies based on multiple facts.

But one of the most important facts we look to when considering the dispute resolution jurisdiction for our contracts is that which would most harm our client. Let me explain. If a large company, let’s call it company ZZZZ is buying $100,000 worth of widgets each month from a Chinese manufacturer, ZZZZ is at risk for the following, among others:

  • Getting $100,000 of bad product
  • Not getting any product at all
  • Having the Chinese manufacturer try to steal ZZZZ’s customers
  • Having the Chinese manufacturer make ZZZZ widgets on the side and sell them all over the world
  • Having the Chinese manufacturer make ZZZZ widgets and sell them all over the world even after ZZZZ terminates the Chinese manufacturer

In many instances the last two examples, particularly the last one, are going to be a foreign company’s biggest risk.  Most companies can recover from one bad shipment. Having to fight off massive quantities of low priced product clones is usually more problematic.

So let’s say ZZZZ faces the last situation.  Its former manufacturer in China has all of ZZZZ’s molds and is refusing to return them. Instead, the Chinese manufacturer is using those molds to make ZZZZ widgets and then is selling those widgets around the world for half of what ZZZZ ordinarily sells them.  ZZZZ clearly has a massive problem on its hands.  What can it do?

Well if ZZZZ’s contract with the Chinese manufacturer called for litigation in the United States, ZZZZ could sue the Chinese manufacturer in the United States and presumably prevail. At that point, ZZZZ would have a United States judgment against the Chinese manufacturer but there would be little ZZZZ could do with that judgment.  ZZZZ could use that U.S. judgment to try to seize U.S. assets that belong to the Chinese manufacturer, but since most Chinese manufacturers have no U.S. assets, that is not likely to help much. And since Chinese courts do not enforce U.S. judgments, the U.S. judgment would be of pretty much zero value in trying to stop the Chinese manufacturer from continuing to produce ZZZZ’s widgets. For more suing Chinese companies in the United States, check out Suing Chinese Companies In US Courts. The Pros And The Cons.

If ZZZZ’s contract with the Chinese manufacturer called for arbitration in Hong Kong or Singapore, ZZZZ would be facing somewhat similar issues in that arbitral bodies in neither place have any authority to issue orders requiring a company in China to cease from manufacturing.

But if ZZZZ’s contract with its former Chinese manufacturer provided for litigation before a Chinese court, ZZZZ would have a decent chance of securing a court injunction against the Chinese manufacturer, stopping it from producing ZZZZ’s widgets.

In “Shanghai Courts Adopt New Methods to Compel Compliance of Preliminary Injunctions in Intellectual Property Infringement DisputesDenning Jin of China mega-firm King & Wood Mallesons, explains how this all works. Mr. Jin’s post is on how the Shanghai No. 1 People’s Intermediate Court recently took strong measures to ensure that its patent infringement injunction would be enforced.

After the injunction was issued, the judges in charge of executing the injunction went to the exhibition to serve the order on the Guangdong company. As part of execution of the preliminary injunction, the judges also ordered the company to remove displays of the allegedly infringing products. The judges gave the Guangdong Company 24 hours to comply with the orders. Several days later, the Court responsible for executing the order discovered that the Guangdong Company had not ceased the sale and display of the allegedly infringement products. The Court quickly assembled a group of more than ten judges and bailiffs to go to the Expo Center and enforce the order. At the Expo Center, enforcement was obstructed by employees of the Guangdong company. In response, the judges took the employees to court and punished the Guangdong company and certain individuals through fines and detention.

The post notes how in China preliminary injunctions are only available in intellectual property disputes. It then sets out the criteria for such injunctive relief, which criteria is very similar to that in the United States:

1.  The applicant must hold  stable and valid intellectual property right.  The party seeking the preliminary injunction must own the intellectual property at issue and it must be able to prove that its rights to the intellectual property are “legitimate, valid and stable.”

2. A preliminary review has determined that the respondent is infringing.  This requires that the respondent is the party infringing, that the respondent is highly likely to have been committing the alleged infringement, that the alleged infringement has been committed or is about to be committed, and that the alleged act is highly likely to be deemed an infringement after a full trial.

3. The applicant will be irreparably harmed if the infringement is not stopped.  Irreparable harm generally means that monetary damages will not be enough to make the applicant whole.  China’s courts may presume irreparable harm in the following circumstances:

  • The alleged infringement harms personality rights, such as copyright-related moral rights;
  • Occurrence or continuous occurrence of the alleged infringement will severely affect the applicant’s market share or other significant interests; or
  • The alleged infringement’s scope and harm, if not stopped, would severely expand. For example, in the case discussed above, the alleged infringing products were displayed at an international exhibition. If the alleged infringement was not stopped, the harm caused to the applicant would expand beyond the damages incurred from a simple, one time sale of the products at issue..

In addition, when evaluating “irreparable harm”, the court also considers the respondent’s creditworthiness and solvency. The worse a respondent’s creditworthiness, the more likely that a preliminary injunction will be issued against him.

In the United States, parties seldom fail to abide by a court ordered injunction and those that do generally face major consequences as that failure will usually be held to be a contempt of court.  See China Tooling/China Consulting — I Told You So. The problem with injunctions in China, however, has been its courts do not always have or employ the tools to make sure their injunctive orders are obeyed. This makes protecting your IP in China all that more difficult:

In China respondents may refuse to obey a preliminary injunction even after it has been served to them by a court. Such disobedience severely diminishes the value of the preliminary injunction system and may seriously injure the applicants’ interests. The issue of determining how to enforce a preliminary injunction has not yet been effectively resolved. A recent case involving the application of a preliminary injunction by an entertainment company against a singer and another entertainment company demonstrates the typical difficulties that arise when preliminary injunctions are issued. In that case, the first in which a preliminary injunction targeted which songs could be performed at a concert, the court demanded the singer not sing the allegedly infringing songs at a concert due to alleged copyright infringement. However, the signer ignored the injunction and sang the allegedly infringing songs. The court subsequently fined the infringing parties a total amount of RMB210,000, an amount considered grossly inadequate compared to the harm suffered by the applicant for the alleged infringement.

Mr. Jin sees this Shanghai court’s aggressive enforcement of its injunction as indicating an “increasing willingness” to enforce injunction and I agree. If you want to protect your IP in China and protect it fast, a preliminary injunction from a Chinese court will likely be your best bet. Think about that when you are trying to decide what to put in your contract’s jurisdictional clause.

What do you think?

 

 

 

 

 

Lawyers love checklist and China lawyers are, of course, no exception.

Me, I love clients, not only because they are the lifeblood of my law firm and thus my livelihood, but also because they so often are the ones who stimulate the ideas for this blog. I just spoke with a client who asked me to outline the legal issues he needs to consider as his company looks at doing business in China.

Amazingly enough, this is the first time I have been asked so explicitly for such a checklist.

This post “issue spots” the most common legal issues companies face when going to China. Though far from exhaustive (and not intended to be so), this list highlights the key legal issues foreign companies must consider when doing business in China.

  • Are You Legal? China has all sorts of requirements for doing business in China. If you are going to be doing business there anything more than occasionally, you probably will need to form a legal entity to do so. This entity can be a WFOE, a JV, or a Representative Office. Some businesses that are perfectly legal in the United States or in Europe are illegal in China.
  • Contract.  In almost every instance, it is wise to have a written contract and it is almost always best to have this contract be in Chinese. Chinese contract law is far less willing to imply things than western law.
  • Intellectual Property/Trade Secret Protection. Your intellectual property (IP) rights in your own country do not generally extend to China. To secure protection of your trademarks and patents (and to a lesser extent copyrights) in China you must register your rights there. Do it or do not complain when they are “stolen.” You should also be using your contracts (and not just your NDAs) to protect your IP in China.
  • U.S. Foreign Corrupt Practices Act. The United States vigorously enforces the FCPA, which penalizes improper payments to foreign officials by U.S. companies. In certain situations, U.S. companies can be liable under the FCPA for payments made by their Chinese partners. The most common situation is when the U.S. company uses the Chinese company as a distributor of the U.S. company’s products. Know these laws and know how to avoid running afoul of them. And make sure that your employees are trained in these laws. Canada and Europe have similar corrupt practices acts.
  • Compliance with Export Control Laws. Late last year a company asked one of our China attorneys to draft sales contracts for their technology product. Our first question to them was whether the U.S. would even allow them to export their product to China. This question had never even occurred to them, but it turned out that exporting their product to China would be illegal under U.S. law. Years ago, I was approached by a client ready to ship product to North Korea that would have violated U.S. prohibitions on doing business with that country. The client was simply unaware of the law. Some products (certain types of software are a good example of this) can be sent to China only with a validated license.
  • Product Liability Laws. Not sure this would have made it to this list a month ago, but in light of the recent issues surrounding toxic pet food, it deserves to now.
  • Antitrust/Labor/Tax/Termination Issues. If you are going to be doing business with China or, even more so, within China, these issues are often relevant, particularly since Chinese laws on these can be so different from those to which you are accustomed.

I think this covers the basics.

Long ago, The Wall Street Journal reviewed James McGregor’s book, One Billion Customers.  The review had a sidebar, entitled, “Crib Sheet,” listing various tips from the book, including the following:

  1. The Chinese will ask you for anything because you just may be stupid enough to agree to it.  Many are.
  2. Avoid joint ventures with government entities unless you have no choice. Then understand that the partnership is about the Chinese obtaining your technology, know-how and capital, while maintaining Chinese control.
  3. If you decide to sell your soul and succumb to Chinese corruption, get a good price and focus on charity work in your old age.
  4. Government officials can lie to you, but you must never lie to them. Exclude information, but never provide false information.
  5. Any tech company doing business in China should assume that its designs and products are being copied.  When forced to share your technology in China, isolate the pieces from each other so that your partner doesn’t have the whole picture.
  6. If your boss wants to come to China to do a quick deal, lose his or her passport.

Our china lawyers have seen deals proposed by Chinese companies where our American client is being asked to send a large sum of money to a Chinese company while receiving absolutely nothing in return. When we ask our clients why they are willing to enter into such an incredibly lopsided deal, they tell us either that they misunderstood it or they just “really want to start doing business in China” It should go without saying that such deals must be avoided.

We tend not to like joint ventures with anyone, not just state owned entities (SOEs). For more on this, check out our post, “China — Damn The Joint Venture.

Our advice regarding Chinese corruption is to not sell your soul at all, under any circumstances. If you think your deal is worth it, it is almost certainly because you are grossly overestimating the likelihood of the deal’s money making ability and/or grossly underestimating the likelihood of your getting caught. For more on the need to comply with both US anti-corruption laws (the FCPA) and China’s own anti-corruption laws, check out our post, “U.S. Company Bribery In China: Violate The Law, Go To Jail.

I completely agree about not lying to Chinese government officials. If you get caught in a little lie, you may well be done in China.

Whenever possible, it does make sense to make sure nobody in China is getting the full picture on your product as this can be one of the most effective ways to protect your IP in China. This is just one of many things one should do to prevent copying. For more on this, check out our post, “Protecting Your IP In China.

I love the passport advice. One of our China attorneys was handling the China legal work for a client whose CEO had never before done business with China, but thought it would be easy. His more sophisticated underling thought otherwise. I sent this list of tips to the underling to show to her boss. She told me the only way her boss would really learn about the difficulties of doing business in China would be by getting burned for not listening.   Therefore, instead of wanting her boss to lose his passport, she wanted him to go there as soon as possible.

These are all good tips.