Fortune Magazine just ran a fascinating article on the trials and tribulations endured by the New Balance shoe company in trying to stop its former Chinese Original Equipment Manufacturer (OEM) company from manufacturing and distributing counterfeit New Balance athletic shoes.  The article is entitled, “Not Exactly Counterfeit.”  Anyone who does OEM in China should read it.

The gist of the story is that New Balance’s Chinese OEM company continued to manufacture “New Balance” shoes after New Balance terminated their contract.  The OEM company sold these shoes in what appears to be a clear violation of New Balance’s trademark.  Eventually, the OEM company stopped selling the shoes as New Balance shoes and started selling them under the name “Henkee,” using an “H” logo that looks suspiciously like New Balance’s “N” logo, as can be seen by comparing the shoes here and here.  The Counterfeit Chic Blog has its own photo comparing the two shoes side by side, here (h/t to IP Dragon for this one.)  Though there is now some indication the Chinese courts will finally do something against the OEM manufacturer, for years they consistently ruled against New Balance without any apparent legal basis.

This unauthorized manufacturing of product to the trademark holders’ exact specifications can take on many forms and goes by many names:

The simplest and most dramatic form of the problem is something that Asia-based investigators jocularly refer to as the “third shift,” the “midnight shift,” or the “ghost shift.” Say a U.S. company orders 20,000 dresses from an overseas factory. The contractor fills the order during its two day shifts but then runs off 10,000 extra at night, possibly using inferior materials. Those he sells out the back door, so to speak, trademark and all.

When I was dealing with issues like these in South Korea, we usually just called it “selling out the side door.”   The profits for the “third shift” seller can be huge because they can sell the name brand goods as the real thing.

When I read articles like this one, I am always looking for what the foreign company did wrong in China so I can prevent something similar from happening to my clients.  The problem here is that it appears New Balance did everything right.  They had a written contract with their Chinese manufacturer making clear that upon termination of their relationship, the Chinese OEM company would cease producing New Balance shoes and return all New Balance “confidential technical, production, sales, and marketing information, including molds, specifications, signs, labels, packages, wrappers, and ads.” This is exactly the kind of provision New Balance should have had, but the Chinese OEM company and the Chinese courts ignored it.

New Balance’s contract with the manufacturer called for arbitration, which is something we are always preaching.  Indeed, New Balance was able to get the Chinese manufacturer to agree to arbitrate in New Balance’s Boston hometown, applying Massachusetts law.

The contract between New Balance and its Chinese manufacturer appears not to have explicitly given the arbitrator authority to issue injunctive relief, so she was unable to enjoin the Chinese manufacturer from continuing to sell and distribute the unauthorized New Balance shoes.  However, it is still very controversial as to whether arbitrators can be given authority to issue injunctions and there are a number of country’s courts that would not enforce an arbitrator’s injunction under any circumstances.  Based on how the Chinese courts treated New Balance throughout this case, it is a virtual certainty the Chinese courts would have completely ignored any such Boston issued injunction in any event.  Ideally, in addition to the arbitration provision, the contract would have allowed for New Balance to go directly to court for injunctive relief to stop any trademark infringement, but this is probably nit-picking on my part.

I often talk about the fairness of Chinese courts, most recently in a post I did only two days ago, entitled, “China’s Courts are Fair.”  The Chinese courts do not appear to have been fair to New Balance.  The Fortune Magazine article rightly notes that the laws in China are not usually the problem in China’s handling of intellectual property (IP) rights, enforcement is.  The article also correctly notes that many Chinese judges were not trained as lawyers, which gives them an oftentimes inadequate understanding of the law.  I have also found that the typical Chinese judge also lacks any real understanding of business either, much less international business.  Adding to all of this, it appears that a key judge in New Balance’s legal journey was corrupt.

Most would read this article to say the judge more than “appears” to have been corrupt: he was corrupt.  My own experiences in dealing with judicial corruption, however, lead me to be cautious here.  I have experienced what is sometimes referred to as “false corruption,” where someone claims to be seeking money on behalf of a judge when, in reality, the person purporting to be acting for the judge is really just acting on his or her own behalf.  For “false corruption” to be effective, however, there has to be at least enough real corruption in a country’s court system for the false corrupters to believe they can succeed in taking other’s money.

Despite the Dickensian (for Charles Dickens, not for China Law Blog’s own Steve Dickinson) legal ordeal to which New Balance was subjected, both their glass, and mine, remain half full.  New Balance rightly notes that had not done OEM in China it probably would still have had its products copied there and, bottom line, it still makes economic sense for New Balance to continue outsourcing to China:

Despite all the challenges, New Balance has never considered withdrawing its factories from China. The economic allure is too compelling, and as Haddad [New Balance’s vice president for intellectual property] points out, its products would have been counterfeited in China to some degree no matter where the company made them.

New Balance continues taking necessary steps, including good contracting, to minimize its future problems in China:

Like others with experience in Asia, New Balance monitors its supply chain to the extent it can, checks out contractors in advance, writes tough audit clauses into contracts, and enforces them. It now embeds encrypted information in security tags and monitors the number of tags it issues to combat third shifts. Other companies use invisible inks and dyes both to authenticate their products and to trace diversions from authorized distribution channels.

Nobody ever said it would be easy.

Now I know there will be those who will use what happened to New Balance to justify their own failures to do things by the legal book in China, but they would be wrong to do so. Just as not smoking helps prevent lung cancer but cannot guarantee against its onset, good contracts help prevent the sorts of problems that befell New Balance, but cannot guarantee they will never occur.  New Balance is smart enough to realize this, despite its own concrete evidence to the contrary.

Clients have asked me if a particular contract provision I am recommending will prevent them from being sued.  I always respond by saying virtually nothing can stop someone from suing them, but a good contract provision can greatly decrease the likelihood of being sued and greatly increase the likelihood of their prevailing quickly in any such lawsuit.  The same holds true in China.

Just less often.