When our law firm started drafting manufacturing agreements on behalf of Western companies having their products made by Chinese manufacturers, we mostly dealt with simple items like socks, shoes, rubber duckies, etc. Those contracts were relatively fast and cheap and easy. The core of the contract was essentially something like this: “Your Chinese company will make rubber duckies out of these specific materials and with these additional specifications and you will deliver them to our facility in the United States or in Spain or in Australia within 45 days after we issue our purchase order.” Becuase these contracts were so routine and so simple, we virtually always always charged a flat fee for them.
Those days are mostly over for China, though these sorts of agreements are still relatively common for Vietnam, Cambodia, Thailand and Sri Lanka. These days the typical manufacturing agreement on which our China lawyers work is far more complicated because the products made in China are far more complicated. And with complicated products comes complicated intellectual property issues involving trade secrets, trademarks, copyrights and patents.
I called up an email this morning to review a China intellectual property issue on an existing matter. That first email led me to a couple more emails and today’s idea for a blog post. The below is a merger of three emails (further modified to remove any identifiers), which should be helpful to anyone looking to manufacture IP sensitive products in China, especially those that include software.
Oh, and for further incentive to get you to parse through the below email, go read China and The Internet of Things and How to Destroy Your Own Company to see what can happen if you fail to realize how critical intellectual property protections have become when having your products made in China.
We still need more clarification regarding the issue of ownership of the various technologies that will be going into your product.
Based on my review, there are four separate forms of technology embodied in this single product:
- The case or external shell.
- The internal mechanism: electrical/mechanical.
- The internal mechanism: firmware.
- The smartphone/computer application software.
Based on this, my questions are as follows:
1. For the external shell (Item 1):
a. Who will do the design? Who will prepare the actual CAD drawings for the mold? Who will fabricate the physical molds?
b. How and when will you pay for the molds to be made? Will you do this as part of a separate contract or will you fold this process into the manufacturing agreement?
c. Note that you will need to be clear that you own the shell design. If it will be done before/outside the manufacturing agreement, we will a clear document that provides for ownership and control. Note that if a third party does the mold (which is likely), there is a risk of the third party appropriating the design and selling it to someone else. However, for this specialized product, the risk is low.
2. For the application software (Item 4):
a. Who will create the application software? If it will be outsourced, you need to know. If it will be done in-house, will it be done by _________? You need to know.
b. Has a fee and timeline been determined for the software application? If so, what is it? If not, when will this be done?
c. What if the application software does not work? What if the application software does not have the “look and feel” you want? How will you work with the programmers to ensure all this is done how you want?
d. The fee, once determined, will be amortized against the purchase of the first 200 units. Does this mean the price of each of the first 200 units will be increased by 1/200 of the application software fee? What happens if you never buy more than 200 units? What happens if you end up buying only 100 units? You need to determine the fee to be sure this makes economic sense for you.
e. Will you own the application software copyright for the entire world? If so, we will need to specifically provide that the application software will be done as a “work for hire” and that your company will own the copyright on it. If you own the copyright, the Chinese side cannot sell the software to anyone else or use it for their own purposes. Will they agree to this? If the Chinese side is sophisticated, they will NOT provide you with the software copyright because they plan to reuse the core software for other projects. In fact, they may not even own the copyright to the core software. They may instead agree only to provide you with the rights to the “look and feel.” Many U.S. buyers ignore these software issues, leading to many problems down the road. You may recall that the multi-billion dollar legal battle between Apple and Samsung is centered on these difficult “look and feel” issues.
3. For the electro-mechanical/firmware (Items 2 and 3).
It is not clear who will own and control this item because there is an internal contradiction in the description. On the one hand, the Chinese side says it will provide you with all data necessary for your company to patent and copyright items 2 and 3 in the U.S. (Note that firmware is protected by copyright, as are mask works and related). This means you would then own 100% of the rights to items 2 and 3 for the United States: permanently and forever, to the exclusion of everyone, including _________. This means you would not even be required to purchase the product from ________ because you could have it manufactured by anyone in any location where a conflicting patent and copyright has not been registered. It also means even if you do not secure a patent or copyright on this, you still have an exclusive and perpetual license to the technology for the U.S. This perpetual license would have essentially the same effect as a patent or copyright registration with respect to your relation to __________ and its attempts to license to any third parties in the future. The point here is that a patent is not revokable; once you have it, it is yours for the term. On the other hand, the Chinese side wants to have the right to allow other U.S. entities to make use of the technology to sell competing products in the United States if your company does not meet certain sales quotas. Under this approach, the Chinese side is providing you with essentially a limited license with these terms: a) the product must be purchased from _________ and no one else, b) your sales territory is limited to the United Sates, and c) your license terminates if you fail to meet the sales quota. This has in fact become the normal approach for sophisticated Chinese companies making products like yours.
The issue though is that these two approaches are contradictory. Only one can stand. So which one is it? As I have noted, the second option (limited license) is most common. However, that means your company’s product development would be placed on a very weak footing because your entire product line could be terminated if you fail to meet the sales quotas. This termination could come either from the license becoming non-exclusive, (allowing the Chinese side to license to and manufacture for other U.S. companies) or from the Chinese side terminating the agreement.
This issue goes to the core of your agreement and so it is crucial that we get clear on on this for the agreement. As noted, most Chinese manufacturers/designers will take the limited license approach instead of terminating the agreement. If this is their approach here, their offer to provide you information for a patent application is not consistent because a limited license and absolute ownership rights are contradictory.
4. There is an additional issue related to the rights of non-U.S. entities to sell into the U.S. market. This can only be resolved after we get answers to the questions above.
5. There is an additional issue concerning what to do if _________ is unable or unwilling to manufacture your product at an acceptable price, at acceptable quantities, with acceptable delivery dates and at an acceptable level of quality. If ________ owns the core technology and is merely providing you with a limited license you could find yourself “stuck” with bad pricing, bad quantities, bad delivery times and/or bad quality products. The normal remedy would be for us to state that if any of the above problems occur, you have the right to have your product made by some other manufacturer and that ________ will provide you with a license to the technology that will allow this. Though this is the normal remedy, many Chinese manufacturers strongly resist this, putting you in a difficult position. You have indicated that ____________ will be required to accept purchase orders that meet the price agreement. You have also provided for penalties for late delivery and for defect issues. Though this is not ideal, it may be the best you can do in your current bargaining position. So the key issue is whether you are required to purchase from __________ or not. If you are required to purchase exclusively from ___________, you will need to face the fact that you are in a very weak bargaining position on many critical business issues and ____________ can fairly easily make life difficult for you by forcing you to fail to meet the sales quotas that will then enable it to start working with U.S. company that competes with you.
Please advise on the above. After we get clear on these various issues, I can begin drafting the agreement. I realize these issues are difficult, but it it is best to take a clear position from the start. Please let me know if you have any questions or if you need any additional explanations.