The first step in doing OEM manufacturing in China is finding a good factory to make your product. To protect your product at this early stage, you must require the Chinese party to execute an appropriate agreement before you reveal any information. This agreement must comply with three basic rules: First, do not use a U.S. style NDA (non-disclosure) agreement. Second, use an NNN (non-disclosure, non-use, non-circumvention) agreement written to deal with the specifics of OEM manufacturing in China. Third, draft the NNN agreement so it is enforceable in China.
I. Do Not Use a U.S. Style NDA
NDA agreements focus on protecting trade secrets. For a trade secret to be protectable property, the information must remain a secret. For this reason, NDA agreements are geared to preventing disclosure of a trade secret to the public. NDA agreements therefore focus narrowly on preventing secret information from being revealed to the public. Since U.S. companies generally focus on maintaining their domestic intellectual property portfolio, they have a natural tendency to believe they can rely on a single NDA agreement, written in English, subject to U.S. law, and exclusively enforceable in a U.S. city and state. But for the following two reasons, this kind of NDA is of no value in China.
First, the fundamental issue in China is not protection from disclosure to the general public. The Chinese company that steals your idea does not do so to reveal it to the general public. It steals your idea to use for its own benefit. This means that your contract with Chinese companies must make clear that whether the information you provide is a secret or not, the Chinese company agrees not to use the information in competition with you. Now that you know what is really required for China, you can see why US-style NDA agreements are far removed from what is needed to protect your IP from China.
The second fundamental problem with typical NDA agreements is that they are not enforceable in China. Chinese law allows for protecting trade secrets and for contracts that provide NNN protections. But if such a contract is going to be effective in China it usually should be written in Chinese, governed by Chinese law, and exclusively enforceable in a Chinese court. We discuss this issue in more detail in Section III below.
II. Use an NNN Agreement Written for China
You need a China-centric NNN agreement to protect your IP in China. The three “Ns” that make up a China NNN agreement are: non-use, non-disclosure, and non-circumvention. Consider each in turn.
Non-use means the Chinese factory agrees by written contract not to use your idea or concept or product in a way that competes with you, the disclosing party. The key here is that this obligation arises by Chinese contract, not from some abstract property rights arising under intellectual property law. A contractual provision prohibiting use will protect you not because your concept is classified as some form of intellectual property such as trademark, copyright, patent, or trade secret. Rather, it will protect you because the Chinese factory cannot use your work because if it does so it will be in breach of its contract with you. Getting a Chinese factory to sign a contract with a non-use provision means you will not need to look outside that contract for you or for China’s courts to be able to control the Chinese factory.
The next “N” in a China NNN agreement is non-disclosure. In most instances, you need not be terribly concerned with your Chinese counter-party making your secrets public. The Chinese factory usually has no interest in letting the general public in on its good thing as it typically wants to use your idea or concept for its own purposes. But as we mentioned above, this is usually all that a standard NDA can accomplish, and it cannot usually even accomplish that in a China context.
If you prohibit a Chinese factory from using your protected information, the clever Chinese entity will not directly breach the non-use prohibition; it will instead disclose the concept to someone in its “group” and then deny having breached the non-use prohibition because it did not directly use the protected information. For this reason, it is important to understand the type of group with which you are dealing and to make clear in writing that: 1) disclosure is specifically prohibited within the group and 2) if there is infringement by any member of the group, the factory that made the disclosure will be fully liable.
Usually some education on this issue is required because Chinese companies often do not view disclosure to a member of their group as violating a non-disclosure prohibition. The following are some of the most common situations we see when dealing with Chinese factories:
- It is common in China for an extended family to own a group of small- to medium-sized companies and for the family to consider all of these companies as the same entity for disclosure purposes.
- Chinese factories typically use a team of constantly changing subcontractors. Some of these subcontractors are part of the family group, some are related by co-ownership, some are viewed as related due only to their roles or even their physical proximity. Chinese factories often will assert that they must disclose to these subcontractors to provide costing for your product.
- Many Chinese factories are part of a large and extensive “group company” arrangement involving numerous subsidiaries owned by a single parent. Members of the group do not see other members as outsiders for disclosure purposes.
- Chinese state-owned enterprises often do not regard other SOEs as separate competitors. SOEs are all state-owned and so information held by one SOE should be freely shareable with another SOE. This is particularly true in sectors with a public service focus, such as healthcare and aeronautics. Since all SOEs in these sectors are pursuing the public good, there is no reason for them not to share your information with their brother SEOs.
Non-circumvention is the third and last “N” and its importance varies with the situation. Your Chinese factory knows you are purchasing product from it at the China price and then adding a big margin before you sell the product in a foreign market. How would you be impacted if your Chinese factory seeks to sell your product to your customers at 50% less than you charge? What if your Chinese factory were to start selling your product to the rest of the world? In industries where quality and service are critical, many of your customers would probably stay with you. But in other industries, this is less likely to be the case. The best way to prevent circumvention by your Chinese supplier is by having a China-appropriate non-circumvention provision in your China NNN Agreement.
III. Use an NNN Agreement a Chinese Court Will Enforce
Your NNN agreement should usually be written to be enforceable in a Chinese court with jurisdiction over the Chinese defendant. This means that Chinese law is the governing law, Chinese is the governing language, and exclusive jurisdiction is in a Chinese court with jurisdiction over the defendant. The fundamental reason for this China-focused approach is that in cases of infringement or circumvention, you must be able to move quickly against the Chinese defendant. Most of the time, any other approach will make the agreement unenforceable or delay enforcement for so long as to render the agreement useless.
Consider the following basic issues:
- U.S. judgments are not enforceable in China. So a provision that provides for U.S. jurisdiction renders the agreement unenforceable in China and therefore nearly always useless.
- U.S. arbitration awards are technically enforceable in China, but Chinese courts have a poor record of enforcing foreign arbitration awards. Chinese courts are generally of the view that disputes with Chinese companies should be resolved in China.
- Arbitration in China is subject to delay and uncertain enforcement. Arbitration panels also have no power to seize assets or take other action to force the infringer to cease its infringing conduct.
- Though Chinese law allows for a foreign law to govern a contract the Chinese courts will require the parties to prove every element of foreign law. Since interpretation of foreign law is virtually always subject to dispute, this leads to long delays.
- Though Chinese law technically allows for English as the governing language of a contract, most Chinese courts will not deal with foreign language documents and when they do, they will use a translation done by a court appointed translator Disputes over translation are common, again leading to long delays. This also means that you will essentially not know what your own contract says until you get the court translation of it.
- Chinese courts do not allow forum shopping. Litigation must occur in the court with jurisdiction over the defendant, usually the city where the defendant is registered or where it normally conducts business. Any provision that provides for jurisdiction in another court will be ignored.
Second, the NNN Agreement must be written so that the Chinese company genuinely fears that its breaching the agreement will have immediate and negative impact. The first step is to make the NNN agreement enforceable, as described above. The second step is to ensure that the NNN agreement provides for contract damages in a specific monetary amount for every act of breach.
A contract damages provision provides two benefits. First, it forces the Chinese party to realize that it will face real and quantifiable consequences if it breaches the NNN agreement. Second, a specific monetary amount provides for a specific minimum level of damages. This sum certain amount then provides a Chinese court with the basis for a pre-judgment seizure of assets. A credible threat of your seizing assets greatly increases the likelihood of the Chinese company abiding by your NNN agreement and of your being able to quickly bring the Chinese company to heel if it does not.
An NNN agreement must include a sum certain contract damage provision that a Chinese court can and will enforce by ordering seizure of the defendant’s assets. Care is required, however, because the Chinese legal system does not allow for punitive damages and it also does not allow for extensive consequential damages. It is therefore important to set the contract damages at an amount that reasonably substitutes for the damages that result from a breach of the agreement.
Because Chinese companies know that breaching a well drafted China-centered NNN Agreement, will likely lead a Chinese court to order a freeze on their assets, we encounter the following three responses from Chinese factories to our NNN agreements:
- Some Chinese companies refuse to sign. These are the companies that planned to steal the foreign technology from the very beginning. This sort of situation has in the last few years become incredibly rare.
- Some Chinese companies will enter into serious discussion about what they believe should be excluded from the NNN Agreement. This is usually a positive result because it often generates productive discussions regarding technical issues.
- Most Chinese companies execute the NNN agreement and then treat their NNN obligations seriously. This does not mean every Chinese company will abandon years of bad practice and begin behaving well. But it usually means that when a Chinese company violates the NNN agreement, litigation is not required. In most cases, a reference to the NNN agreement and the credible threat of litigation/asset seizure is enough to induce the Chinese company to step back into line.
The above illustrates the general approach our China lawyers take when drafting any agreement involving China. We do not want to see our clients have to litigate, but to be able to reduce the likelihood of having to go to court it is essential the Chinese side believe it would be relatively easy for you to sue and prevail. China appropriate NNN agreements do exactly that.