We represent a large number of foreign companies that do OEM manufacturing in China. In our discussions with these companies, one of the first issues we raise is how to protect the intellectual property of the foreign party. Foreign designers of products are quite properly concerned that by using a Chinese manufacturer, they are simply training a future competitor. They are concerned that the Chinese manufacturer will appropriate their designs and start selling the same product to their own customers or to the customers of the foreign party in the United States and in Europe.
As a result, we spend considerable time in training our clients in the basics of IP protection. We lead them through the basic elements involving execution of basic agreements and registration of the appropriate intellectual property instruments. When the product is an existing product of the foreign party, the response to our basic system has been remarkably good and we have had considerable success.
However, where the product is new and requires development work, we have had significant difficulty. In this area, it seems that our clients seem almost to intend to give their intellectual property to the Chinese manufacturer. Where product development is concerned, we tell our clients: you need three types of agreements: an NNN Agreement, a Product Development Agreement and an OEM Manufacturing Agreement. We have found remarkable resistance to the use of product development agreements. I personally find this difficult to understand, since it is product development that should be the area of greatest concern for intellectual property protection.
Since the foreign parties seem so interested in giving away their IP, the Chinese manufacturers have developed a very standardized system for accepting the gift. Here is how they typically do it:
The foreign party comes to the Chinese manufacturer with the basic idea for a new product. The foreign party has a basic design, but has done none of the engineering and related work required to take the design to the point where it can be manufactured in commercial quantities. In some cases, the design has not even been prototyped to determine the mechanical issues to confirm the practicality of the design.
The foreign party then requests that the Chinese side do all of the engineering and prototype work required to commercialize the product design. The Chinese manufacturer offers to do this work free of charge in exchange for a commitment from the foreign party to purchase the product from the Chinese manufacturer. The foreign side is excited. They are able to obtain high-level engineering and prototyping work at no charge. The Chinese side is happy because it has just captured a new client for a new product. The design work is not documented by a written agreement. The usual attitude is that if the product is developed in a way acceptable to the foreign party, then a formal OEM agreement will be drafted and executed. If there is no success, the foreign party will try elsewhere.
This casual approach is often a failure from a practical standpoint. The Chinese manufacturer is not being paid, so the design project is often placed on the “back burner” and the manufacturer gives its attention to it only when it has spare time. If the manufacturer is a successful company, this spare time may be hard to find. For this reason, extensive delay is common. Moreover, what exactly the manufacturer is intended to design at what standard is usually not specified. So even if the Chinese manufacturer finishes the project in a reasonable time, it is often not clear whether the final design meets the needs of the foreign party. For this reason, for any but the simplest of products, it is essential to enter into a design agreement that sets out a clear standard of performance together with specific milestones that ensure timely completion of the project.
Assume the manufacturer does manage to design and commercialize a final product. Now consider the fundamental issue: who owns the intellectual property in that product? Note that the manufacturer did all the work entirely at its own cost with no specific design agreement with the foreign party. Though an NNN agreement may be in place, the situation is at best ambiguous.
Now take this consideration to the next step. It is virtually certain that the Chinese manufacturer is a manufacturer of the same type of product that they either sell under their own name or that they sell to other foreign manufacturers. If they were not familiar with the product type, they would not have been selected for the development work. Now, the Chinese manufacturer looks at the product it designed and it decides that it would like to make this product for its own use. Why bother manufacturing for the foreign party when we can manufacture under our own name and make all the profit?
In this situation, what does the Chinese manufacturer do? As you will recall, there is no OEM or other purchase agreement in place. This then means that no final price for the product has been set. So the manufacturer simply quotes an outrageously high manufacturing price to the foreign company. In this situation, the Chinese manufacturer cannot lose. If the foreign party accepts the price, the manufacturer makes a windfall profit. If the foreign party rejects the price, the manufacturer has a new product for its own sales line.
After the foreign company rejects the price required to move forward with the Chinese manufacturer, some extremely careful Chinese manufacturers will take the additional steps required to secure the intellectual property in the product. They will register a trademark, register a copyright and register a design patent, all of which they will register with Chinese customs as well. In this way, they not have secured the product for themselves, they also have prevented the foreign party from moving to a different Chinese manufacturer to design and manufacture the product.
When the foreign party then threatens to sue, the Chinese manufacturer points out the obvious. The foreign party has no registered IP in the product. There was no written contract related to developing the product. The product was developed entirely at the cost of the Chinese manufacturer and the IP registrations were all done by the Chinese manufacturer in its name and at its own cost. The Chinese manufacturer then says “go ahead and sue us, in a Chinese court in our hometown.
Our China lawyers have seen countless foreign companies give away all rights to their designs in return for saving money on product development and avoiding having to pay their China counsel for an appropriate Product Development Agreement. What they actually have done is come to China to give away their intellectual property. Needless to say, the Chinese side is happy to accept the gift.