China joint venture schemesThis is part 3 in our 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. In part 2, we explained how Chinese companies use Memoranda of Understanding (MOUs) to get free looks at foreign technology. And in this part 3, we explain how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it.

Chinese companies dangle the formation of a joint venture as a means to view (and then use) foreign company intellectual property. Just to be clear, I am not saying all China joint venture proposals are made solely to get a free look at foreign technology. As dubious as our China lawyers are about most (but not all) China joint ventures, plenty of them are legitimately proposed and formed. Here I am not so much talking about real joint ventures as I am about proposing a joint venture with no real intent to form one and doing that to get at your IP.

The Chinese side wanting a free look at your IP will normally propose forming a joint venture in China for developing and marketing a product. In these cases, however, even if a well formed Chinese joint venture would be commercially reasonable, this is not the case when a free look joint venture scheme is being employed. Normally, the type of joint venture proposed by the Chinese side is not permissible or practical under Chinese law and business conditions. In these situations, it is normally best to accomplish the commercial objectives of the U.S. side through a well drafted license agreement rather than by creating a JV company.

As a quick aside, if you want to learn more about China joint ventures, I suggest you read China Joint Ventures: The 101 and China Joint Ventures: Testing the Dream.

The basic issues related to Chinese companies using a Chinese joint venture to garner a free look at your IP are as follows:

1. Forming a JV means forming a separate legal entity pursuant to the PRC Sino-Foreign Joint Venture law. This means establishing a separate company with a separate address, separate facilities and separate officers, directors and employees. It is rare that the Chinese side really intends to do this.

2. When the entity is formed, the stock must be issued to both investors. All of the stock must be issued to the foreign side on the date the JV entity is formed; here can be no waiting for issuance of the stock. Issuance of the stock cannot be triggered by some event such as authentication of the technology or government approvals.

3. The Chinese side normally will offer the foreign company share ownership in the Joint Venture in exchange for the foreign company licensing the foreign technology to the joint venture and for general cooperation in the future. The Chinese side does not require the foreign side to contribute cash or to contribute the technology to the JV company. The proposal is that the U.S. side will get “something for nothing.” It will get ownership in the China Joint Venture without having to pay anything for it, beyond licensing its technology to the Joint Venture and getting licensing fees for that. Of course, no successful business gives something for nothing. In China, however, this would also not be legally permissible.

China does not allow “sweat equity” or equity issued based on some separate benefit conferred on the Chinese entity (say, preferred investment in a foreign company). Stock must be issued for cash or for a hard asset like equipment. A license to technology does not qualify as equity in a China joint venture. For technology, the investment only counts if the technology is formally contributed to the JV entity as an asset. Since a license is revokable, a license is not treated as an asset under China Joint Venture law. Even where technology is contributed as an asset, the value of the technology must be independently appraised and normally the contribution of IP by the U.S. side is limited to a maximum of 15% of the foreign company’s total investment in the Joint Venture.

This means the Chinese company that is offering the above “something for nothing” terms is doing so as a ploy to convince the foreign side to drop its guard and reveal confidential technical and business information. The argument by the Chinese side to facilitate this intellectual property look-see is: “We will be partners soon, so why hide anything from us.” But since the terms of the JV are not legally permissible you really won’t be partners soon and the result of this ruse is either that the JV never forms and the Chinese side blames this on the government (always beware of force majeure clauses in Chinese contracts) or the JV is legally formed but never actually does any business.

4. It takes at least three months to form a JV company and it often takes six months or more. Forming a Joint Venture in China is expensive and time consuming and this timing and expense should be taken into account in the business plan. And as noted above, it is entirely possible the Chinese government will not approve the formation of your JV company, especially if — as described above — the equity structure is not allowed. Often, however, the Chinese side will draw the joint venture formation process out for a year or more. During this entire period, the Chinese side is working to extract confidential information from the foreign side. One standard trick at this stage is for the Chinese side to say that it is bringing other “big player” investors into the JV company and these new investors are skeptical and need to see proof of the technology before they will invest. Of course, these big players will assist in taking the JV public in China, resulting in a major returns for the foreign side. So in a case where the foreign side is not required even to pay for its shares in the JV, this becomes “something for nothing” squared. Like all good con games, this one too plays on greed.

5. If the Chinese side scheme involves actually forming a Joint Venture, rest assured that you will own less than 51% of it. And with your less than 51% JV ownership, you will have no control over the JV and no meaningful rights of any kind. Many (most?) foreign investors believe that their ownership in a Chinese JV entity will allow them to exercise at least some control over the operations of the entity, but exactly the opposite is true. China has no effective minority shareholder protections. The management of the JV will simply ignore the “rights” of any minority investor, including the “rights” of the foreign investor. So, in the end, the foreign investor in a Chinese JV has less power and control than a foreign party that simply licenses its technology to the Chinese side.

6. Nearly all commercial reasons for doing a JV in a technology development and sale project can be duplicated with more certainty via licensing. For example, a license can be drafted where the JV entity pays a royalty that provides exactly the same economic benefit as a percentage ownership in the JV entity. If the foreign side truly believes in the prospect of a PRC IPO (even though these are incredibly rare), the license agreement can be drafted to provide for the Chinese company licensee to pay a royalty in the event of a sale of the Chinese entity that will provide the exact same financial return to the foreign licensor that it would have gotten had it had an equity interest in the Chinese entity. For more on China technology licensing agreements, check out China Technology and Trademark Licensing Agreements: The Extreme BasicsChina Technology Licensing Agreements: The Questions We Ask, and China Licensing Agreements – Look Before You Leap,

7. The control benefits of a license can be considerable. As noted above, if the foreign entity is a less than 51% owner in a JV company, the foreign entity basically has no remedy at all if the Chinese side does not perform. There may be remedies on paper, but Chinese company law is defective in this area and minority shareholders pretty much have no effective rights. On the other hand, a well-drafted license gives the licensor very powerful rights. If the Chinese side does not perform, the licensor can both terminate the license and sue the Chinese side for damages. This is exactly why Chinese entities prefer the JV approach and why they avoid licenses.

Bottom Line: In considering cooperation with a Chinese company, a standard technology transfer agreement/license is nearly always better than forming a PRC joint venture entity.

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.

China U.S. investment lawyersThe era of large scale “take over” type Chinese investment in U.S. companies appears to be over. However, our China lawyers still seeing a lot of interest in smaller investments from China in U.S. companies involved in emerging technologies. Though it is possible this investment interest from the Chinese side is completely legitimate, just over half the time, that is not what we are seeing. What we usually see is what our China attorneys have taken to calling the “free look investment scheme.” This is the first in what will be a series of posts on Chinese company free look schemes.

The free look investment scheme usually applies to when the Chinese company or individual that purports to want to invest in a U.S. company but actually has no interest in a long term investment. Instead, what the Chinese side is seeking is a “free look” The goal of the Chinese side is to investigate the American company’s innovative technology and then appropriate that technology for its own use. The Chinese side uses the promise of investment and financing to convince the U.S. side to drop its guard. The Chinese side then takes what it wants and disappears when it is time to make the full investment.

Our firm is seeing these free look investment schemes virtually every week and we are seeing these schemes become more refined. The result is always the same: no investment from the Chinese side and lost time, money and confidential information from the U.S. side. Though losing confidential information is always a disaster, the lost time and money is oftentimes even more damaging for smaller U.S. target companies, particularly for start-ups that cannot afford to wait around for magic.

The free look investment scheme is usually organized in one of the following three ways:

Free Look Investment Scheme Number One: This scheme is normally limited to smaller but established U.S. companies. The Chinese side proposes to make a substantial investment in the U.S. target company. The amount to be purchased is either a controlling interest in the stock of the target company or substantially all of the stock in the target.

The Chinese side enters into a stock subscription agreement to purchase the stock, but insists on performing extensive due diligence before making the purchase. During the due diligence period, the Chinese investor works to obtain as much confidential information about the operations of the U.S. target company as possible. Often, the proposed closing date is extended several times as the Chinese side seeks more and more sensitive information. The U.S. side provides the information, believing that since the Chinese side will eventually own the company, it cannot hurt to provide them with what would otherwise be considered information that should not be disclosed. But in the end, when the closing date arrives, the Chinese side announces the deal cannot close because the Chinese government will not allow for payment to be made from China. The Chinese side then argues that it cannot be held liable for breaching the subscription agreement because the actions of the Chinese government constitute force majeure and therefore frees them from having to close on the deal. In some cases, the Chinese side will have paid a modest initial deposit or down payment. In those situations, the Chinese side will then argue that the American company must refund its deposit due to its force majeure defense. If the deposit is not refunded, many Chinese investors will file suit demanding the refund. Litigation is always expensive, and that is even more true of this sort of complicated cross-border type of litigation.

Free Look Investment Scheme Number Two: The Chinese side proposes to invest in a U.S. company. The focus of the investment is not the U.S. company itself, but rather the technology either currently owned by the U.S. target company or (more often) the technology the U.S. target company is developing. The Chinese side offers to make a substantial investment in the U.S. company, but conditions its investment in one of two ways: First, the U.S. target must prove to the the Chinese side that its technology is commercially viable. Second, the U.S. target company must enter into a China Joint Venture with the Chinese investor to develop and market the technology in China.

Normally this scheme is structured as follows:

a. Minimal initial investment amount.

b. Payment of the remaining investment amount will be in a series of small installments, often five or more.

c. The China Joint Venture business structure is presented in a way that appears very attractive to the U.S. target company, but this attractive structure is not permitted under Chinese law. The usual “bait” is either i) no financial investment from the U.S. side in exchange for the U.S. company getting a large percentage ownership interest in the China Joint Venture and b) the false promise of an early IPO on one of China’s public markets.

What then actually happens is the following:

a. The Chinese side delays making the initial payment and then delays making each installment. The Chinese side then presses for more and more confidential information, even though it has not made the required payments.

b. At some point in the process, the Chinese side decides it has obtained enough information and it then defaults on its remaining payments. In the old days, that would be the end of it. More recently, the Chinese side has become bolder and will file a lawsuit seeking a refund of its initial (and any subsequent) payments, usually by alleging some breach by the American side.

c. The China Joint Venture never comes into existence because i) the Chinese side never planned to do it and b) the business/ownership/control terms do not comply with Chinese law in any event. But during the bogus formation process, the Chinese side will use the prospect of future cooperation in the China joint venture to extract more information from the U.S. target. The American side thinks it is working with the Chinese side on the joint venture when in reality they are working at cross-purposes.

Free Look Investment Scheme Number 3: The Chinese side offers to “invest” in the U.S. entity by providing working capital and by helping create a market for the product in China by acting as the PRC distributor. The Chinese side offers to provide a working capital line of credit and to enter into a PRC distribution agreement. Both are offered on extremely attractive terms, which is the bait for entering into the relationship.

As with the previous two free look investment schemes, the Chinese side conditions its “investment” on completing its due diligence concerning the product or technology owned by the U.S. target. And just as is true with the first two schemes, what the Chinese side really wants is access to confidential information it can then use for its own purposes. Once that purpose is achieved, the Chinese side bails.

This free look investment scheme usually works as follows:

a. The Chinese side will work hard to obtain the desired confidential information before providing any financing or entering into any form of distribution agreement.

b. If the Chinese side is forced to provide financing, it will structure it in such a to allow it to walk away from the financing at will. The Chinese will normally structure the financing as a monthly line of credit payments based on an informal agreement. A formal financing document is not used. Virtually no Chinese company or individual has U.S. dollars in the U.S. available for providing a monthly financing payment. The cash must be sent from China and this payment must be converted from RMB to dollars. The conversion is subject to approval by the Chinese government and the local foreign exchange bank. When the Chinese side decides it is time to default on its financing obligation it simply states that payment from China is no longer approved. They then use this denial/alleged denial by the Chinese government to claim they are no longer obligated to pay, using the familiar force majeure argument discussed above.

c. The standard procedure for the distribution agreement is as follows:

i. Endless delay in drafting even a first draft of the agreement.

ii. The attractive terms disappear, to be replaced by commercially unreasonable terms. Typical of this is that all profits on sales are earned in China, while the U.S. entity sells at cost to China and earns nothing.

iii. In the end, the Chinese side never orders any products.

As you would expect, all three of these free look investment schemes can be very damaging to U.S. companies. If you are confronted with one of these schemes, you have two ways to proceed. One, just walk away. Two, if you decide to move forward draft the terms of your deal in a way that is both commercially reasonable and that protects your company from the damage that results from the free look.

In my next posts in this series, I will discuss other free look methods used by Chinese companies, along with  some of the ways our China lawyers work to render these free look schemes harmless. Note, however, that Chinese companies construct these free look schemes intentionally. They are not done by accident or because the Chinese side is inexperienced with the U.S. investment market.

UPDATE: This post generated a number of posts by various people on Linkedin, along with a slew of comments, including complaints. The complaints fell under two categories: those who said that American companies do the same thing and those who said that we wouldn’t be complaining about these tactics were they not being done by Chinese companies. We have the same two responses to both of these complaints. One, they are true. Two, so what? We write here for foreign companies doing business in China and with China. That’s it.

China Manufacturing Lawyers. China IP Lawyers

I wrote a four-part series on product development in China, entitled, Hardware Co-Development in China: Do it Right — Part 1 is here, Part 2 here, Part 3 here and Part 4 here. This series helped explain why developing products in China can be so complex and why it is so important to protect your intellectual property during the product development process. In response to those posts a number of people have asked our China lawyers how to structure product development relationships with Chinese companies so the foreign company actually ends up with the rights to the product that gets developed. This post addresses that issue.

The key is to focus on manufacturing rights, rather than on intellectual property rights, especially when the PRC or Taiwan factory presents the foreign product developer with an already prepared manufacturing agreement. Lawyers all over the world have become masters at writing complex and sophisticated intellectual property provisions for product development and manufacturing agreements. Because these IP provisions are written to cover every possible situation, they are usually written at such a high level of abstraction they often have little to no real meaning on the ground in Asia.

Our solution at this point is not to further refine or revise the already highly refined IP language. Instead, we recommend focusing instead on the practical issue of manufacturing rights. At the end of the development process the Chinese factory and its foreign customer (our client) will be looking at a set of prototypes and the sole issue for the foreign party at that point is usually what can I do with those prototypes? If this question is not clearly resolved in an enforceable contract at the start of the development process, the answer will usually be that the foreign party cannot do anything with the prototypes beyond what the Chinese factory allows it to do. For what is required for a contract to be enforceable, check out China Contracts that Work.

To avoid this result, at the inception of the development process the foreign party should secure a written and enforceable contract that includes the following:

  • A clear statement of what will be done, when and by whom. This should include a clear description of the product to be designed and the work to be performed.
  • A clear statement of the costs, the allocation of costs, and the payment dates for the costs. It is important that your contract be written to provide a clear understanding of what will be provided by the Chinese manufacturer in return for the payments. This provision should address molds, tooling, software, design, and a working model.
  • A clear statement that if the design project fails, all the tangible and intangible materials developed during the project will be transferred to the foreign customer with nothing retained by the Chinese factory or designer.
  • A provision stating that if the design project succeeds and prototypes are developed the foreign customer shall have the right to manufacture the product in any factory anywhere in the world. The foreign party should be free to determine what factory will manufacture the prototyped product. Normally, this will mean manufacturing it in the factory of the co-developer, but what if that factory cannot make the product for a satisfactory price, or in satisfactory quantities, or with satisfactory delivery dates or quality? What if the Chinese factory insists on raising its prices six months later? For you to be able to maintain control over your product, you must have the right to move some or all of the manufacturing of your product to the facility of your choice, for any reason at all.

This issue of the right to manufacture should be clearly understood by both sides before the parties start discussing the more abstract issues of intellectual property rights. Every factory owner and every foreign party understands the issue of manufacturing rights and if you negotiate this early on, the real situation will be revealed in a way both parties understand. When the parties reach clear agreement on manufacturing rights, the intellectual property provisions become relatively easy for our China IP lawyers to draft.

If you wait to seek agreement on manufacturing rights with your China factory until product development has concluded you will have relinquished your leverage. If you wait until your Chinese factory completes the prototype, it can deny that you have any manufacturing rights and it can raise its manufacturing prices with near impunity. You need a China appropriate contract making clear you (not your Chinese factory) own the manufacturing rights because without this your Chinese manufacturer will probably be able to stop your product from being made by any other factories in China or from leaving China if it is.

When beginning the product development process in China it will often make sense for you to skip abstract discussions of intellectual property rights and just focus on the key practical issue both parties can understand: when the prototypes are finished, what can you do with those prototypes? It pays to discuss and resolve this issue early on with your Chinese manufacturer. For what should go into a China product development contract, check out China Product Development Agreements.

China IP lawyersChina (Shenzhen mostly) is the primary destination for manufacturing of small electronic consumer products. And since Internet of Things (IoT) products are red hot, this means our China lawyers get a steady stream of China IoT legal matters.

The big issue we most often see is this: the IoT product has now reached the mass production stage and is being produced in large quantities. Now that it has a commercial product, the U.S. or European (usually) buyer now seeks financing for its start-up company. The financier (be it angel, VC, private equity, or even someone’s father-in-law) then asks who owns the intellectual property in the product? With the rise of the Internet of Things (IoT), this question is often difficult to answer definitively.

How did we get to this point where the IP rights of a product are so often vague? The process has worked its way through three general stages:

Stage One. In the good old days (roughly 1981 to 1995), the situation was simple. There were two possibilities. In the first, the Chinese manufacturer made a standard consumer product. The foreign buyer purchased that existing product and perhaps required the Chinese manufacturer take the extra step of placing the buyer’s own trademark/logo on the product. In that setting, ownership of the intellectual property was clear: the Chinese manufacturer owned the product design and the foreign buyer owned its trademark/logo. In the second, the product was a long standing, well developed product of the foreign buyer. The foreign buyer brought the completed product to the Chinese manufacturer and contracted with the Chinese manufacturer to make a copy. In that setting, ownership of the intellectual property was clear: the foreign buyer owned all the intellectual property and the Chinese manufacturer owned nothing.

The simplicity of this sort of relationship encouraged the somewhat lazy practice of documenting the entire manufacturing relationship with purchase orders. NNN agreements, product development agreements and OEM agreements were seldom used, since IP ownership was clear and the price and delivery terms were resolved via the purchase orders. This approach would often lead to product defects, but that is for another post.

Stage Two. In stage two (roughly 1995 to 2015), a new form of manufacturer-buyer relationship developed. Foreign buyers began coming to China with no completed project in mind; they instead would come with a product idea or proposal. The foreign buyer would then work with the manufacturer to co-develop a product. In some cases the Chinese manufacturer would simply take a completed prototype and commercialize that prototype for mass production. In these cases, the foreign buyer arrived with little more than a basic idea and the two sides worked to co-develop the product. See China Product Development Agreements, for pretty much everything you need to know about China product development agreements.

The Chinese manufacturer usually would perform the product development work at its own expense, with the implied agreement being that it would be the exclusive manufacturer of the product. This co-development process typically used the same lazy “purchase order only” approach from stage one. This approach then led to the many issues we see today that make answering the “who owns what IP” question so difficult. To do the co-development process properly, the parties must define their relationship with three agreements: 1) an NNN Agreement, 2) a Product Development Agreement and 3) an OEM Agreement.

When these agreements do not exist, a standard set of issues arises: Who owns the product design? Who owns the molds and other tooling? Who owns the manufacturing know-how and similar trade secrets? If the buyer decides has the product made by a different Chinese factory, what compensation is owed to the Chinese manufacturer that co-developed the product? What are the  Chinese manufacturer’s obligations to comply with the foreign buyer’s price and quantity requirements? If the Chinese manufacturer terminates its relationship with the foreign buyer and manufacturers the product under its own trademark/logo, is this a violation of any agreement between the parties? Absent clear written agreements, none of these questions have clear answers. In these unclear situations, the Chinese factory will nearly always be in a much stronger position than the foreign buyer and the Chinese factory will typically prevail in any IP dispute.

Stage Three. In stage three (2015 to today), we arrive at the IoT era. In designing, developing and manufacturing consumer products for the IoT market, the already unclear and problem-filled relationships of the stage two era are now magnified. In the IoT era a whole new set of issues has arisen. In the stage two era, there was at least the simplicity of two entities designing and/or manufacturing a single product. In the IoT era, the situation is considerably more complex. In most of the IoT projects we have done, the development process has expanded to include the following:

1. Product “concept” from the foreign (usually United States or European) buyer.

2. Product external design, from an international design firm.

3. Internal design and function, owned by:

a. The foreign buyer;

b. The Chinese manufacturer;

c. The provider of sensors and other components required to connect the IoT product to an outside network.

4. Design of the IoT product “app” (usually for smart phones). This involves two completely separate sets of software: the communication sending software residing on the IoT product and the communication receiving software residing in the application. In the same manner as the internal design, these software components may be written/designed by multiple parties: the foreign buyer, the Chinese manufacturer and (quite often) third party software design firms.

What happens then when the product is complete, and manufacturing is ready to start and the foreign buyer starts to seek funding: The funding source almost invariably will ask who owns the IoT product? Who owns its underlying IP? What our China lawyers have far too often found when we ask the foreign buyers these questions is that they usually don’t really know.

This “we don’t know” response does not sit well with potential sources of serious financing. Even worse, when the foreign buyer is pushed to answer the question, it becomes clear that it is not clear who owns the new product. Far too often the only ownership issue that is clear is that the one entity that the foreign buyer is the one entity that does NOT own the rights to the product. Even worse, it is usually not possible to fix the situation by this point.

Bottom Line: As manufacturing in China and the IP issues attendant with that become more complex, it becomes even more important that you have clear written agreements that answer the obvious IP questions in advance. It does not make sense for you to devote your time and your energy and your money developing an IoT product for someone else to own.

For more on the issues involving China and the Internet of Things, check out the following:

China IP lawyers and artificial intelligenceI have received a number of emails in response to my recent post on China’s artificial intelligence plan. Many who wrote me seek to reduce China’s plan to the following simple, three step process:

  • Catch up in AI by 2020.
  • Learn to make some basic products by 2025.
  • Lead the world by 2030.

This does not accurately summarize the plan, though it is how much of the English language media describe it. The full PRC AI plan is set out in 35 pages of dense, jargon heavy, Chinese bureaucratic prose. I will be doing a series of blog posts seeking to explain the full plan. My first post, China’s Artificial Intelligence Plan — Stage 1, dealt only with stage one, and as you can see from that post, stage one is not written as “catch up.” Stage one is a full-on plan to continue developing technologies with which Chinese companies are already working. I note also that manufacturing automation robotics is not featured. On the robotics side, the emphasis is on service robots.

Note also that the Chinese companies are already way ahead of this plan. They are not waiting around for guidance from the government on their AI projects; they are moving ahead full speed. In general, Chinese companies are succeeding most with the software/network based applications of AI. This is the focus of the Baidu research center in Silicon Valley. They are not doing as well with mechanical devices such as robotics and smart vehicles and sensor based IoT devices. However, they know that and they are making strong efforts to advances in these areas. We touch on this a bit in China IP Challenges for Automotive Suppliers. One of the areas on which many Chinese companies are focusing is on human/AI interaction and they are having good success with that in the field of medical imaging and diagnosis.

There is little doubt that part of China’s AI strategy involves acquiring technology and then selling in back into the developed market from which it came. This has been and still is the strategy of businesses in pretty much every developing country. The U.S. followed this approach during the entire 19th and early 20th centuries. Japan and Korea and Taiwan did it with great success in the post WWII era. China and India are now moving into that phase. That is how technical progress is made and we write about to guard against this sort of IP appropriation nearly every week. See How To Give Away Your IP In China, How to Give Away Your IP in China Without Realizing It and China and the Internet of Things and How to Destroy Your Own Company.

The real question is whether this strategy will work in the AI era  In general, Chinese companies are not good at working on their own to appropriate foreign technology. They prefer to enter into a manufacturing or joint venture arrangement where they convince the foreign entity to teach them how to use the technology. See China Joint Ventures: Keeping Your Friends Close and Your IP Closer. Then, later, they appropriate the technology and sell the cheaper product back into the same market. This is what Chinese companies did with high speed rail and with the Russian designed fighter jet and this is what they are trying to do it now with commercial aircraft. They will undoubtedly seek to do the same thing with AI and robotics. See China-US Trade Wars and the IP Elephant in the Room.

Will China succeed it purloining AI IP? It depends on a couple of factors. First, if the technology is protected by patent and copyright and trade secrecy, then they cannot sell into the markets where those IP protections exist. This would mean that North America and the EU would be closed to them, at least during the period where the IP protections are in place. Second, can Chinese companies master the technology to point where they can really compete? Normally, the Chinese companies simply clone the product and then seek to compete solely on the basis of price. For some products, this works. For more sophisticated IoT, AI, “smart” products, the success rate of the Chinese companies has been low. How many U.S. consumers get excited about the purchase of a Lenovo computer or a Xiaomi cell phone? How many U.S. customers are interested in buying PRC knock offs of virtual reality headsets? Not many. Price is not the significant issue for these more technically sophisticated products. When Chinese companies cannot compete on price, they traditionally don’t know what to do. There are many programs in place in China focused on changing this “price is the only issue” mindset. So far, progress has been sporadic at best.

However, without regard to whether China can succeed with its AI program, it is clear that appropriating foreign AI technology is the goal of most Chinese companies operating in this sector. For that reason, foreign entities that work with Chinese companies need to be aware of the significant risk and take the necessary steps to protect themselves. There are many ways to do this, using a mix of IP registrations and carefully drafted agreements. See China Contracts: Make Them Enforceable or Don’t Bother. This is what the China lawyers at my firm focus on and this is the issue we discuss most often on this blog. Stay tuned.

China IP attorneysIn the old days, purchasing products from China was relatively simple. The product was a basic “off the shelf’ product. The product was a fungible, internationally traded products, such as white t-shirts, underwear, medical gauze, rubber gloves, tableware and similar. For that reason, specifications were set based on an internationally accepted standard. Neither party set the standards; the standards were set by the market. For these types of products, purchases based on standard international purchase orders was the norm. Though the purchase order approach never worked well, at least for outlining the basic quality standards and business terms, purchase orders were adequate.

The first stage in complicating the system was when foreign buyers began requiring their Chinese factories to do some simple customization of the factory’s off the shelf product. This usually involved little more than putting the buyer’s brand name on the item and its packaging. The next stage of complication came when foreign buyers came to China with a completed product and requested their factory copy it. Since there was a physical item as a basis, there was a clear standard for determining specifications and quality. The copy was either good or bad and it was relatively easy to decide. So even in this era, a simple purchase order usually was sufficient to set out the basic terms of the agreement between the parties.

In the current world of contract manufacturing in China, the situation has become far more complex. It is no longer sufficient to simply set out the terms of the agreement in a simple purchase order or a purchase memorandum. One reason for this complexity is that there is no longer a single type of product being purchased. Dealing with the proliferation in product types has made drafting contract manufacturing agreements progressively more challenging.

For example, even in a very basic contract manufacturing relationship, the foreign buyer is typically dealing with four completely different types of product. The China lawyers at my firm call that the “standard mix.” For this set of products, we typically use the following terms:

1. Manufacturer Standard Product (“Standard Product”).

2. Customized Standard Product (“Custom Product”).

3. Buyer Designed Product.

4. Co-Designed Product, where Buyer claims to own the design IP.

We often call call both 3 and 4 “Buyer Designed Product,” since the buyer claims to own the intellectual property in each case, so there is no real need for two different terms. However, one of the first issues we often confront is that in the case of 4, Co-Designed Product, the Chinese factory usually does not agree that the buyer owns all the intellectual property. For this reason, in defining the term, we make clear the entire ownership rests with the buyer, without regard to the participation of the factory in the design process. This forces the factory to make clear at the start whether will it assert that its own the IP.

Working with these four categories of product in a single contract manufacturing agreement is difficult, but there are other types of products where IP ownership is even more difficult to nail down, making drafting (and doing business) even more difficult. Consider the following:

1). Buyer standard product, base product, or “off the shelf” product is often what we can more technically call an “open source” product where specifications are an industry standard. That is, no one owns the design of a white t-shirt or a pair of flip flops or surgical gauze. These products are standard and made all over the world and they are international set specifications. For these products, the specifications are taken from the international industry standard and the factory is held to that standard. An example is thread count for the fabric used to make t-shirts or underwear.

2. There is, however, another type of “off the shelf” product: this is product for which the factory claims that it owns the design of that product. In some cases, the manufacturer did the design and really does own the design. In other cases, the factory “borrowed” or “appropriated” the design from someone else. Often, these are more complex devices like equipment, machines and electronic devices for which the patent has expired and anyone is free to make a copy. However, in other cases, the factory did in fact steal the design from some other entity that claims design ownership.

In the past, we tended to call both 1. and 2. above “manufacturer base product” or “standard product” or “off the shelf product”. But it is important to note that these two types of product are really quite different. For example, for 2, the specifications come from the factory (not industry standard), the warranty is that the factory will meet its own specifications and there should be an additional warranty from the factory that the manufacturer really does own the IP rights in the product.

Since the issue is usually ignored, there has been no good term for identifying product type number 2. That is, buyers tend to treat product type number 2 as if it were the same as number 1, which is a mistake. For clarity, 1 should be called “off-the-shelf” product or “standard product” or “base product” while 2 should be called “manufacturer proprietary product” or something like that. On the ground, these two types of products are often not clearly identified by the factory, making it even more difficult to determine what is going on.

But the fact is the legal situation for these two types of product is entirely different. In some cases, truly fungible product of type number 1 can be purchased using a purchase order or a standard form agreement. This is not true for the type 2 product where a  completely different legal approach is required. But it is not possible to know what to do until the type of product has been properly identified.

3. There then is a third type of product where the factory owns the core technology but the foreign buyer owns the external “shell.” We see this a lot with medical and electronic devices. The factory owns the technical internals and the foreign buyer owns the design in the case and other housing for the technical internals. The normal position of the IP ownership taken by the factory is that the buyer is free to take the shell to another factory, is not free to take the technical internals to any other factory.

Many buyers do not understand this. They come to the factory with the opposite interpretation. The foreign buyer believes they should be free to take the entire unit to another factory for manufacturing. This mistake in interpretation has become quite common in the past three years and it has caused many disputes and eventual failures in production. In every instance seen by the China attorneys at my firm, the foreign buyer wanted to take the entire product to a different factory and just assumed it could do so and actually built its business model on that assumption. In each case, the Chinese factory refused late in the process and basically halted the product commercialization process. No venture capital fund would provide funds for a product where a single Chinese factory controls production.

4. Finally, there is a the truly co-designed product. In this case, both the buyer and the factory developed the product working together. This is the type of product for which a Product Ownership or Co-Development agreement is required. See Hardware Co-Development in China: Do it Right, Part 4 (and the previous three posts in this series). Without such an agreement, the buyer often believes it owns the design, but in fact either a) both parties have equal ownership in the design or even worse b) the Chinese factory owns the entire design because it did the hard creative work. The foreign buyers are usually unaware of the basic legal rules in this area and during the co-design process they lose ownership and control over their key product IP. Usually this happens before the buyer contacts a lawyer with China manufacturing experience. For examples of how companies lose their IP, check out China and The Internet of Things and How to Destroy Your Own Company.

As you can see, the issue of just what type of product is being purchased from a Chinese factory has become complex. The situation will become even more complex as more IoT and related smart products are produced that combine design, hardware and software with inputs from heterogenous sources, many of which are not in the control of either the buyer or the manufacturer. So the days of a bare purchase order are long over. Moreover, the days of a simple, one size fits all purchase agreement are also over. But many buyers still think of the process as being the same as in the old days of purchasing fungible off the shelf products.

Sell to ChinaChinese companies tend to operate from the same playbook, oftentimes pushed down to them by the government or their trade or industry association. Chinese companies can go years without doing XYZ and then all of a sudden, the China lawyers at my firm will see five deals in a row where the Chinese company does XYZ. We have lately been seeing a slew of Chinese companies seeking to become distributors of foreign products via joint ventures, a structure that rarely makes sense for the foreign company. See China Joint Ventures: The Tide is Out.

Our foreign company clients that have their products made in China usually start by selling their products in North America, Europe, and/or Australia. But as China’s consumers continue growing wealthier and more sophisticated, Chinese companies are increasingly approaching foreign companies that have their products made in China with proposals to sell the foreign company’s products within China.

When the foreign company investigates the situation, it turns out that such sales are legally far more complex than they initially imagined. To legally sell their products within China, these foreign companies usually must first export their products out of China and then sell them back into China. This typically means having to pay VAT twice — on the export and again on the import. Chinese companies will often try to entice the foreign company with elaborate schemes that purportedly avoid such double taxation. Such schemes are usually either illegal or dangerous for the foreign party and they should virtually always be avoided.

The new thing in the China-side playbook is for the Chinese side to try to convince the foreign company to enter into a complex joint venture arrangement. The Chinese side pitches these arrangements by claiming it will allow the foreign company to participate in the product distribution business in China. Almost always, the foreign company would be better served by operating via the standard distribution model used throughout the world. The foreign company should purchase its product from its China manufacturer, receive that product outside China (in an export processing zone or when shipped) and then sell that product to a qualified China distributor. The foreign company should earn its profit from that initial sale, freeing it from concerns with the financial side of the Chinese operations. The foreign company buyer can and should strictly monitor the operations of its Chinese distributor through a standard distribution agreement. See China Distribution Agreements In Real Life.

If the foreign company buyer wants to support its China distributor, it is free to offer incentives, such as the following:

  • Not charging the distributor for sample product
  • Reducing prices for a certain number of products
  • Providing cash incentives for advertising
  • Funding the cost of certifications and registrations

The foreign company should insist on a standard distribution agreement that allows the foreign company to terminate if its China distributor does not perform. This distribution agreement should also give the foreign company buyer the right to terminate the China distributor for conduct that might put the foreign company or its reputation at risk. One major defect in any kind of partnership/joint venture approach is that it is difficult to hold the Chinese side to a tight performance standard when there is a business ownership relationship. It is like a marriage: easy to get into, but hard to get out of.

Due to the need to export the product from China and then ship it back into China, the China distributor often will establish an entity in Hong Kong to handle the operations. If the foreign buyer wants to take an ownership interest in the Hong Kong distributor, it can do that, but the basic rules should remain the same: The Hong Kong distributor should be treated as an arm’s length third party, operating under a standard distribution agreement with the foreign company earning its profits from sales to the distributor (profits now), not from a share of the distributor’s future profits at some inherently uncertain later date.

A foreign company will be able to exercise more control over its “Chinese partner” by entering into a distribution agreement than by entering into a joint venture relationship. Joint ventures are nearly impossible to control by a foreign company located thousands of miles away with no right to make a quick and decisive contract termination decision.

Western companies that understand China rarely want to get involved in product distribution in such a vast and complex market like China. However, companies inexperienced with China too often fall prey to the ill-conceived concepts — like joint ventures — their Chinese counterparts pitch to them for getting their products to China’s consumers.

In assessing a business proposal from China, you should abide by the following three rules:

  • You should be able to understand the proposal in a first reading.
  • You should avoid a business relationship you cannot end by a simple contract termination notice, and be wary of any proposal described as a joint venture
  • You should reject any proposal not supported by legitimate financial projections. A “business plan” consisting of fluff and fancy jargon that you don’t really understand does not count. If your Chinese counterpart cannot provide you with standard financial projections (hard numbers, not jargon), with each assumption clearly spelled out and supported with facts, walk away.

China contract lawyersPurchasing products manufactured in China has changed substantially over the past five years. in the old days, foreign buyers usually either purchased generic, off the shelf products or they hired Chinese factories to make products designed by the foreign buyer. The Chinese factories have gradually become more involved in the design process. Most recently, Chinese manufacturers have started to sell their own proprietary designs. This raises a number of contracting issues that are not fully understood by most foreign buyers.

In the early days, the situation was simple. The Chinese factory manufactured a basic consumer product for which no one in the world claimed any ownership of the underlying design. The product specifications were standardized. The task for the Chinese factory was to learn those standards and then manufacture a product that met the standards.

For example, for a simple white t-shirt there are a number of specifications that apply: sizes, fabric material, fabric color, thread count, neck size, ornament, label placement and label content. The foreign buyer provides the specifications and the Chinese factory is required to manufacture this standard item to meet all these specifications.

For this type of “fungible base product,” neither the factory nor the buyer make any claim to ownership of the underlying design of the product. The product is standard and the specifications are part of a product standard that applies to all manufacturers of the product anywhere in the world. If the Chinese factory cannot meet the specifications, the foreign buyer is free to manufacture for itself or purchase from any other factory in the world. On the other hand, the Chinese factory is free to sell these shirts to any buyer.

In today’s world, Chinese factories have become far more sophisticated. The extreme example of that sophistication is the situation where the product being sold is a sophisticated item designed entirely by the Chinese manufacturer. In this case, there is no open-source, standard set of specifications for the product. The manufacturer owns the design and the specifications are set by the manufacturer, not the buyer. The buyer often chooses from a menu of specifications.

The relation between the parties in this setting is quite different though most foreign buyers treat purchasing this type of “manufacturer proprietary product” the same as purchasing a fungible base product. In fact, the issues are quite different and a contract for purchasing this type of product requires a number of different provisions. For example:

a. How will the specifications be determined? What is the standard for failing to meet the specifications? For the manufacturer of a proprietary product, it is the manufacturer itself that sets the standards. So rather than providing that the Chinese factory must manufacture in accordance with industry standards or the specifications of the buyer, the contract must provide that the manufacturer warrants that it will manufacture in accordance with its own specifications. This then requires that those be stated clearly in a way that provides an objective reference point.

b. In many situations, the buyer will require the product meet safety and quality and other regulatory standards established by the law of the buyer’s country. For this situation, since the factory is entirely in control of the design, the factory must warrant that it is knowledgeable about all applicable standards and its product will meet those standards. The buyer cannot instruct the factory on the specifics of what to do. The buyer must rely on the factory to do it right. This then requires a warranty that the factory actually did what was required.

c. How does the foreign buyer know that the Chinese factory actually owns the design of the product? How does the foreign buyer know that the product does not violate the intellectual property rights of some other Chinese factory or some other entity located outside China? The risk that the Chinese factory design violates the rights of a third party is not low. The foreign buyer should understand this and do some basic due diligence to ascertain its risks of being sued for IP violations. As a contactual matter, the purchase contract should — at minimum — provide that the Chinese factory warrants that its product does not infringe on the intellectual property rights of any third party. The contract should further provide that the Chinese factory is required to indemnify the foreign buyer from liability from any infringement claims made by third parties.

d. Since the Chinese manufacturer owns the product design, the manufacturer has the right to sell the product to any buyer. This means that the manufacturer has the right to sell to other buyers who sell in the same market as the buyer. Most buyers of this type of expensive product will not want an identical product to be sold to its direct competitors in the market. For this reason, most foreign buyers will want some form of exclusivity that would not be possible in the case of fungible base product.

Chinese manufacturers will always agree that they will not sell their proprietary product under the trademark and logo of the foreign buyer. But absent a specific agreement, they can and they will sell the bare product to any buyer who shows up at their door. The Chinese manufacturer will only agree to provide exclusive rights to the foreign buyer in a case where the foreign buyer agrees to pay a price for that exclusivity. That price will generally be a hard agreement to purchase a certain number of units at a certain price for a certain time period. Chinese factories generally drive a hard bargain in this area and require a commitment that is often difficult for the foreign buyer to accept.

Many foreign buyers fail to clearly consider the type of product they are purchasing from China and so they end up treating the purchase of a Chinese manufacturer’s proprietary product as no different from the purchase of a fungible base product. This is a mistake. The terms for purchasing these two types of product should be very different and failing to understand the differences often results in the foreign buyer failing at its product purchase negotiations or ending up with a product purchase situation that does not make sense for it.

China lawyers for manufacturing

Having just returned to Qingdao after a fairly long absence, I met over the weekend with a group of expats engaged in various forms of manufacturing in China to get their  take on current conditions and their feelings about the future. The participants in the discussion were from many regions: United States, Canada, England, Germany, Norway, Finland, India, Pakistan, Spain and Italy.

The discussion was interesting because the opinions expressed were very consistent. Every person said that they were having problems with their manufacturing in China and that they were interested in diversifying into other countries. They identified the following issues as causing them problems in China:

a. Rising wages. When productivity is factored into the analysis, China can no longer be considered a low wage country. Many participants stated that on a purely wage basis, Chinese manufacturing is not significantly cheaper than parts of the United States.

b. Rising costs. The main complaints were directed at soaring rental rates and rising utilities costs. Many of these costs were formerly subsidized. These subsidies are being removed and the cost is being reflected in the price of manufactured products.

c. Declining manufacturing quality. All of the participants in the discussion agreed that instead of improving, the rate of manufacturing defects has risen over the past five years. This rise in defects has been coupled with a general decline in service from Chinese manufacturers.

d. Increase in scams. In recent posts (see part 6 here and follow the links to the previous five posts in this “Scam Week” series) we have discussed the rising number of scams our China lawyers are seeing involving both foreign manufacturers and investors. The participants in this discussion have also seen a rise in irregular practices in the manufacturing sector. Swapping out product components for lower quality items was a major complaint and these swaps are happening more now than five years ago.

Given the above complaints, I asked the participants “To what country would you choose to move your manufacturing operations?” Their responses to this question was surprisingly consistent: they all agreed they would move to Malaysia or Indonesia.

Given the above, I assumed that a move for all the participants was imminent. So I asked the natural question: have any of you actually moved your operations out of China to the countries you have identified or to any other countries in the world? The response was surprising to me. In spite of the consistency of their complaints, NONE of the participants had moved their manufacturing operations out of China. Most had tried some other country, with Viet Nam, The Philippines, Malaysia, India and Bangladesh being the most common countries explored. But every person in the group had abandoned these plans and had either kept their operations in China or moved their operations back to China.

The reasons given for the returning to China or just staying here were as follows:

a. Inadequate supply chain. For larger, established companies the primary reason was the lack of a good supply chain. They found it impossible to obtain all of the components required to manufacture on a consistent and price competitive basis.

b. Low productivity. Though wages in the other countries were lower than China, the skill in manufacturing and the quality of factories is low. When calculated by productivity, none of the alternative countries showed any benefit when compared to Chinese manufacturers who have been in the business for 20 or more years.

c. Lack of engineering and design support. Foreign buyers of product from Chinese factories routinely make use of the staff of the Chinese factory to deal with final design and commercialization of product. Molds and tooling are routinely designed and fabricated in China. Production prototypes are designed by the factory engineering staff. When factories in the other countries are approached about these services, the factory staff is eager to learn, but the expertise is simply not there.

d. Small scale production is not available. Many foreign buyers come to China to manufacture small runs of product. One participant said he had just worked with a local Qingdao manufacturer on a limited run of 100 items for a new product produced to test the market. When I asked him if he could have a short run like that done in any country other than China, his immediate answer was: “Of course not. I can get these items made in Viet Nam, but I have to order at least 10,000 items. I also have to provide my own engineers and design staff and it just does not pencil.”

Every participant in our meeting was extremely critical of current manufacturing conditions in Chine. Every participant expressed an almost ardent desire to move out of China. Every participant stated they had made at least one effort to move production to some other country in Asia. But in the end every participant also stated they are currently not able to leave China because no other country offers the conditions required for small and medium sized companies to produce their product.

The general conclusion from the discussion was that it may be possible for large multinationals to move their manufacturing operations out of China to other countries in Asia. But for the “near future,” for start ups and for small and medium businesses, China remains the only practical place to do outsource manufacturing. What does “the near future” mean? The general impression was that this current situation will last for at least five years. Of course, “five years” really means “we just don’t know.” Or to sort of quote Winston Churchill, China is the worst place to manufacture your product except for all the others.