China is awash in money these days and plenty of Chinese companies have plenty of it. What Chinese companies really need is good technology. However, they do not want to pay for that technology. Their goal is to “assimilate” foreign technology with minimal expense. One of the techniques they use to accomplish this is the fake investment scheme.
Here’s how it often works. A foreign (usually a U.S., Canadian, European or Australian) company develops an innovative technology. To implement the technology, the foreign company contacts a Chinese manufacturer. with the goal of entering into a product development relationship. The Chinese manufacturer will take the basic technical idea and ultimately produce a prototype for commercial manufacture.
There is a catch. The Chinese company is interested in the project not so much because it wants to become a low margin manufacturer of a product for the benefit of a foreign company, but because it wants to use the technology to develop and manufacture its own line of products. See Your China Factory as your Toughest Competitor.
This can be true of a Chinese manufacturer that already makes directly competing products. It can also be true of a Chinese manufacturer looking to enter into a new line of business that uses new, cutting-edge technology not currently available in China. This second type of manufacturer is the most dangerous since their direct interest in assimilating the foreign technology is not obvious.
To assimilate the technology, the Chinese manufacturer must convince the foreign company to hand over its technology with no limitations. But how can the Chinese company convince the foreign company that no protection of its technology is required? The Chinese manufacturer makes the following investment pitch:
We really like your new concept. In fact, we like it so much we want to invest in your company. We are not interested in short term profits. What interests us are the profits at the end from an IPO. To accomplish this, we will make an initial series of investments in your company and then we will take the lead in managing your IPO to take place after your company starts marketing the product(s) we will develop together.
The next and critical step then follows. The Chinese company then says something like the following:
Our company will become one of the owners of your U.S. entity. And since we will be co-owners of the technology underlying your product, there is no reason for you to protect the technology from us. There is no reason to enter into an NNN agreement or a Product Development Agreement. We will handle product development together. In fact, our Chinese entity will not even require payment from you. We will do the product development without charge to ensure the product is brought to market as quickly as possible. We do not want legal or financial hurdles to get in the way of the IPO that will make us all wealthy.
So the foreign company provides its technical information to the Chinese manufacturer it now sees as its partner and benefactor and, as promised, the Chinese manufacturer develops a successful prototype. But then the Chinese company lowers the boom. It is now time to enter into a formal manufacturing agreement for the product, but In reviewing the manufacturing agreement, the foreign company is shocked to see that it states that the Chinese manufacturer owns the rights to the intellectual property in the product. The Chinese company agrees to make the product exclusively for the foreign company, but under highly restrictive conditions. For more on how this “shift” in IP ownership can happen, check out China and The Internet of Things and How to Destroy Your Own Company.
When questioned on this IP legerdemain, the Chinese company will announce something like the following:
1. The Chinese company did all the work developing the product and it also incurred all of the expense. Absent a written agreement to the contrary, the Chinese company owns the IP in the product. Since there is no such agreement, the matter is settled.
2. Oh, and by the way, sorry guys but we won’t be able to make that investment in your U.S. entity. We really wanted to make the investment, but the Chinese government must approve all foreign investments from China and it will not approve this one. We were not able to obtain approval and you, of course, would not want us to make an illegal investment. [#sorrynotsorry]
By using this “fake investment” technique, the Chinese manufacturer has legally acquired the technology while paying little or nothing for it and there is nothing the foreign company can do. The Chinese company did both conduct and fund the development so under Chinese law it does indeed own the technology. And it is true that foreign investment from Chinese companies must be approved by the Chinese government. So what is there to say?
Our China lawyers have also often seen the fake investment proposal used in other technology transfer settings not involving manufacturing. One way this is done is that a Chinese entity will want to acquire technology in the software sector normally protected by copyright and a license. The technique is similar. The Chinese company wants the underlying technology but does not want to be restricted by a license or a copyright. So the Chinese company offers to invest a large sum in the foreign company and as part of its grand plan, it will propose to set up a company in China that will eventually be owned by the foreign company. It will then arrange for the software technology to be released to the Chinese entity without restriction: Why should the foreign company spend time and money licensing its software to this Chinese company that it will eventually own a part of in any event. Oh, and this Chinese company will surely be doing an IPO very soon anyway.
In this scheme, there are various delays in getting approval for both the investment in the foreign company and in providing for foreign ownership in the Chinese entity. After two or three years of delay, and after the Chinese company has extracted all of the technology/information it requires, it apologizes for being unable to secure Chinese government approval to invest in the foreign entity and for not being able to give the foreign company any ownership in the Chinese entity because foreign investment in Chinese domestic companies is prohibited. See The China Stock Option Scam.
The end result is that the Chinese company has acquired the foreign technology virtually free of cost and there is usually nothing the foreign company can do about that.