China Memorandum of UnderstandingThis is part 2 in what will be series of posts detailing the current methods Chinese companies use to get a “free look” at the intellectual property and trade secrets of foreign companies. In part 1 of this series, we looked at how Chinese companies use their purported interest in investing into a foreign company to convince the foreign company to give the Chinese company access to the foreign company’s IP.

This first post generated a number of posts by various people on Linkedin along with a slew of comments, including complaints. The complaints about our post fell into two categories: those who said foreign companies do the same thing and those who said we would not be complaining about these tactics were they not being done by Chinese companies. Our response to these two complaints is that they are both true and irrelevant. This is a blog about China, so what did you expect?

Today’s post describes how Chinese companies use Memorandums of Understanding (MOUs) as a trap for gaining access to foreign company IP.

I will though first start with the standard problems our China attorneys see with MOUs, which include the following:

1. The foreign company negotiates and signs the MOU before they speak to an attorney who knows and understands China. In most cases the foreign company does not speak with an attorney at all before signing an MOU. In some cases though, they speak only with their in-country (not China) investment counsel. These attorneys focus on the domestic (not China related) investment issues and they usually do an excellent job. However, they know little to nothing about China, so the China side of the MOU is not properly reviewed before it is signed.

2. The Chinese side will nearly always draft the MOU. This virtually always means the Chinese side is using an attorney who knows and understands Chinese laws relating to MOUs. Where the MOU is drafted by the Chinese side, it normally is drafted as a formal, binding agreement with dispute resolution and penalties for default included. This is of course exactly the opposite of what is required for an MOU. The MOU must be written as a non-binding document, with no dispute resolution and no penalties. See In China, Treat A Memorandum Of Understanding Like A Binding Contract.

3. The MOU usually provides for two sets of terms to ensure the success of the free look scheme. First, it will propose a large investment, but with non-standard investment terms that require the foreign side to reveal technical information not normally in an investment project. Second, it will suggest forms of cooperation that are illegal under Chinese law.

The U.S. side assumes the Chinese side simply does not understand how investment works in the U.S. but does understand Chinese law and therefore would not be proposing a China business structure that is either illegal or impractical. Both assumptions are incorrect and what the Chinese side does here is done intentionally as part of its free look scheme.

4. The MOU will normally be open ended and vague in terms of the time for completing the various steps required to complete the project. This is a major mistake. In any project working with a Chinese company, it is essential to set clear and strict deadlines and to be willing. Most MOU documents contemplate eventually drafting a definitive agreement. The date for drafting and execution should be set for 30 days, 60 at the very most. The reason for setting a tight deadline is because the foreign party must be prepared to deal with the standard Chinese approach to drafting the definitive agreement, which goes like this:

a. The Chinese will offer no input. If the foreign side provides an outline or a term sheet, the Chinese side will simply state that it looks “OK,” with no further response and thus force the foreign company to do all the drafting of the definitive agreement. This document is then submitted to the Chinese side early, giving the Chinese side ample time to respond. But, the foreign side hears nothing.

b. As the deadline for completing the definitive agreement approaches, the foreign side begins to get concerned about the deal collapsing due to a failure to agree on a final definitive agreement. The Chinese side then responds, usually 4-7 days before the deadline. Note that it does not matter whether the deadline is 30, 60 or 90 days; the Chinese side will respond hard against the deadline, with the hope that the pressure of the deadline will soften the resolve of the foreign company in holding to its terms.

The Chinese side’s right up against the deadline response will usually provide for changes in the definitive agreement that completely reverse the terms of the MOU and any subsequent term sheet. No explanation is ever given for these massive changes. The foreign side often will simply capitulate and the Chinese side prevails. In other cases, the foreign side will respond and there is a tense period of last minute and significant revisions to the definitive agreement. Again, the Chinese side’s strategy is that the last minute negotiations will force the foreign side to make drafting mistakes that will prove beneficial to the Chinese side.

4. The result is either that a) the parties ultimately draft a definitive agreement so flawed that it is never implemented or b) after months of unproductive negotiation, the parties walk away. But during this period, the Chinese side will have been working to gain access to technology of the foreign party. Walking away is exactly what the Chinese side planned from the start and impossible terms guarantees this in the end. The Chinese party succeeds in obtaining the free look, with no risk that it will be burdened with making a substantial investment or working with the foreign party at any time in the future.

You can prevent this by doing the following:

1. Do not enter into a binding MOU. A simple term sheet is best. Even using the MOU term exposes the foreign entity to risk in China.

2. Separate the investment from any cooperation project. Do the investment on a very short time frame pursuant to a standard Western-style investment agreement. Do not tie the investment to future cooperation in China. Do not do the investment in installments. Require the Chinese side invest the entire amount in a very short time frame. Limit due diligence to the financial condition of your company. Do not allow any due diligence on your technology or your trade secrets or your business plans.

3. If there will be future cooperation, require all discussions on future cooperation occur only after the full amount of the investment has been received.

Of course, a Chinese company planning to employ an MOU free look scheme will not agree to these terms above. But, that tells you what you need to know and if the Chinese side will not agree, you should probably send them on their way.