Steve focuses on assisting foreign companies in doing business in and with China. He prides himself on working in the “real” China: the world of factories, fish plants, and farms that lie outside of Beijing and Shanghai. Having mastered the Chinese language and legal system, Steve’s unique expertise makes him an invaluable resource to our clients.

China Transactional LawyersOur China transactional lawyers often work on deals involving the foreign subsidiary of a Chinese parent company. When we raise the issue of getting paid on these deals, our clients sometimes insist these deals are secure for two reasons. First, the contract is enforceable in the United States so there is no need to deal with the Chinese legal system. Second, the Chinese parent is sitting on a pile of cash and if the subsidiary cannot pay its debts, the U.S. based contract will force the Chinese parent company to bail out the subsidiary. This premise is just wrong.

Consider this very real scenario. A (formerly) cash rich Chinese company forms a Virgin Islands subsidiary. That subsidiary then sells bonds on the international market. To repay the bonds, the subsidiary must pay in dollars or whatever foreign currency the bonds are denominated.

The foreign subsidiary does not do any real business. The basis of the bond valuation is that the parent Chinese entity is sitting on a pile of RMB in China. When the bonds are due, if the foreign subsidiary is unable to roll over the bonds or to find alternative financing, it is assumed the Chinese parent company will convert its RMB to dollars and then remit those dollars to the foreign subsidiary. Because of this “the parent will cover it” assumption, the bonds are priced at investment grade. (For purposes of this analysis we will assume the pile of cash held by the Chinese parent company is real, though often it is not. But that is another story).

The fundamental issue is that the Chinese parent does not have the power to freely carry out the conversion from RMB to dollars. The Chinese government has the right to not allow the RMB/dollar conversion for payment on these bonds because it wants the RMB to stay in China. See Getting Money Out of China: It’s Complicated, Part 6, along with the previous five parts of this series.  The Chinese government might deny this RMB conversion because it was a speculative venture and it will not allow PRC foreign exchange reserves to be depleted to cover that speculation. “Invest your RMB at home or at least repay your creditors at home,” it might tell the Chinese parent company.

As a result of the Chinese government prohibiting the conversion and off shore remittance the subsidiary will have no ability to pay on the bonds and it will default if no alternative funding source is found. We are assuming that the parent has plenty of cash in the form of RMB, so it is not a matter of the parent company not having the resources to pay its debt to its foreign bondholders. The issue is that the Chinese government will not ALLOW the group company to pay its debts.

Something along the lines described above actually happened in the case of one of China’s largest and best known companies — Wanda. There was a credible threat the PRC government would not allow offshore remittances to cover payment on Wanda foreign bonds. For this reason, the Wanda foreign denominated bonds have been reduced to junk status by all the rating companies (BB or lower). Junk status means the chance of a rollover or other funding alternative is relatively low. This is a problem for Wanda, but it is even worse for the original owners of the bonds.

Our China lawyers are often called on to review deals with VIE entities formed in the Cayman or the Virgin Islands. The Chinese side of the VIE asserts that it is sitting on a mountain of cash. This assertion pumps up the value of the foreign issued stock. But when the shareholders insist that the cash be remitted offshore for distribution to shareholders, the Chinese side nearly always states: we would really like to do that, but the Chinese government will not allow us. Sorry.

Your takeaway from all this should be that if you are doing a financing or other project with a subsidiary of a Chinese company, you cannot rely on payment support from the Chinese parent company. If the Chinese parent company’s money is not already in a bank account outside China, even if the mountain of cash exists, there is no certainty that  money will be permitted to leave China. In fact, the most likely scenario is that the cash will not be permitted to leave China. Why should debts to foreigners be paid when there is plenty of need for the funds in China?

This then relates to the question of the reliability of investment from Chinese companies in general. Big Chinese companies are fond of making announcements regarding their huge investment plans. People (especially Western businesspeople) rely on these announcements, but in the end nothing happens. The Chinese investment community has a term for this: “We heard the thunder and we saw the lightening, but we never felt the rain.” That is, until the money is in the bank, never believe a thing. The Chinese don’t. Why should you?

China self driving cars As I outlined in my previous post, Self Driving Cars in China: The Roadmap and the Risks, the Chinese government is pushing hard for development of a Chinese based self driving car. In reviewing China’s proposed legislative framework and recent books from China, we can see how Chinese’s system offers unique advantages for developing fully autonomous vehicles.

China does not seem to have the atavistic fear of robots and AI common in the Western world. Recent surveys show that over 75% of Chinese car buyers have a favorable opinion of self driving vehicles, as opposed to only 50% in the U.S. More significant is that 60% of Chinese auto buyers believe developing self driving cars is a significant issue, as opposed to less than 20% in the U.S. and in Germany.

Fear of autonomous driving is not a factor in China. The issues in China are more direct. Is a self driving car available? Will it be available in a reasonable time frame? Will a self driving car work well? How much will it cost? Will the vehicle be owned by an individual or by a ride sharing entity or (in China) by some service owned or managed by the government? These are rational economic considerations, not gut level fear of robots and artificial intelligence.

A Chinese consumer may decide self driving cars are not an important issue because they rationally believe they will never happen. But they do not oppose self driving cars due to a fear of robot control. The Chinese are generally not in love with driving. Driving in China basically sucks, and if they can leave the driving to someone else, the Chinese are generally happy to do that. And if the someone else is a robot, they don’t care. The issue to the Chinese consumer is: how much will that robot cost? [Editor’s Note: Peter Hessler’s book, Country Driving: A Chinese Road Trip, makes for a great read on driving in China.]

The Chinese also do not generally make unreasonable requirements on the safety of a self driving car. In the U.S. and in Europe there is an unstated but very real demand that self driving cars must be perfect. Every accident involving a self driving car is head line news and endlessly reported online. At the same time the 40,000 U.S. deaths and the ~25,000 EU deaths per year from human controlled driving are taken as business as usual.

The Chinese regulators and public make no such unreasonable demands. One goal of the Chinese government is for self driving cars to reduce the current very high Chinese passenger vehicle accident rate (~260,000 people die on China’s roads a year). However, the goal is to reduce the accident rate by a reasonable percentage. No one in China demands self driving cars be accident free. It is assumed they will NOT be accident free. The issue in China is whether the rate of accidents will be at an acceptable level or not. In China, it is assumed that the accident rate will decrease due to autonomous vehicles, but no one expects that rate to be dramatically lower than the current rate. For that reason (and probably some others), accidents involving self driving cars simply are not news in China.

Finally, the Chinese are free of the Western (especially U.S.) need to assign blame for accidents involving self driving cars. U.S. legislation and discussion of self driving cars almost obsessively focuses on this issue. Who will pay if there is an accident? Will it be the software developer? The auto manufacturer? The vehicle owner? What if the accident is determined to have been caused by a flaw in the software? Or a flaw in the installation? Or a flaw in the smart transportation network? Or the result of hacking by a third party? Or by operator error? Or by circumstances beyond the control of any party? Or even something as relatively routine as failed brakes?

If you examine U.S. based discussions of self driving vehicles, you will see these issues are primary and this is certainly even more true among the lawyers. Self driving projects then focus on issues like the ethics of driving decisions, insurance coverage, liability and damage allocation. Though these are primary issues in the U.S., they hardly exist in China. I have 200 pages of Chinese government proposed rules and regulations for autonomous vehicles on my desk. I have five full length Chinese language textbooks on self-driving cars, all published in the last two years. The issue of liability and insurance is simply not discussed at all in these thousands of pages. It is a complete blank.

There are two reasons for this. First, the Chinese are generally far less concerned with assigning guilt than Westerners. In Chinese traditional morality, guilt is not the main focus of an enquiry of what to do when a person is harmed or injured. In China, the focus is on how the social equilibrium can be restored as quickly as possible. The damage is repaired and the parties move on. Guilt and the associated liability for guilt is usually not a fundamental issue. Second, the Chinese insurance system is a no fault system so there is no reason to assign guilt. Auto accidents do not give rise tot moral issues. The issues arising from auto accidents in China are usually clear: what was the damage and what sort of payment is required to restore the parties to their original situation. Lawyers are virtually never involved, the award is limited to economic compensation and there is no high value award for non-economic matters like pain and suffering.

From the U.S./Western side, the fear of robots, along with unreasonable safety demands and allocation of liability in a guilt based system create substantial barriers to developing self driving cars. In the U.S., these barriers are at least as significant as the considerable technical barriers. In China, these non-technical barriers do not exist. It’s not that they are reduced; they don’t exist at all.

China can therefore focus on the technical issues. It is the technical issues that will drive the development of the vehicle of the future. So thought Chinese companies are currently behind the West on the technical side, they can move forward free from so many of the non-technical barriers that will both slow down and increase the costs of autonomous vehicle development in the West. This means China will reign as the primary testing ground for new technical solutions in the self driving car field. So even if China is not the place where the technology is developed, China will be the place where the technology is applied in real world applications. This is already happening in the electric vehicle market and this same trend will continue in the self driving car market.

Autonomous VehiclesDevelopment of the self driving car is the centerpiece of the Chinese government’s plan to redesign its manufacturing and technology sector. The Chinese have coined the term Intelligent and Connected Vehicles (ICV) (智能网联汽车)as their own technical term for describing the China version of what is an international race towards a difficult technical goal. The ICV is an ideal goal for China because it combines elements of all three of its current key technology programs: Made in China 2025, Internet+ and the Artificial Intelligence Strategic Plan.

As is typical of the Chinese system, the central government seeks to place itself on the top of the system, providing guidance and control from the top down. In furtherance of this goal, the PRC Ministry of Industry and Information Technology together with a number of related PRC agencies just issued a comprehensive set of national guidelines (建设指南) to provide the framework for development of ICVs in China.

The full set of guidelines is as follows:

(i) the National Guidelines for Developing the Standards System of the Telematics Industry (Overall Requirements) (国家车联网产业标准体系建设指南 (总体要求)). (June 2018)

(ii) National Guidelines for Developing the Standards System of the Telematics Industry (Intelligent and Connected Vehicles) (国家车联网产业标准体系建设指南 (智能网联汽车) (December 27, 2017)

(iii) the National Guidelines for Developing the Standards System of the Telematics Industry (Information Communication) (国家车联网产业标准体系建设指南 (信息通信) (June 2018).

(iv) the National Guidelines for Developing the Standards System of the Telematics Industry (Electronic Products and Services) (国家车联网产业标准体 系建设指南 (电子产品和服务) (June 2018).

Though the Guidelines are detailed and complete, these are only guidelines. That is, this is a standard to be followed for the drafting of binding regulations and statutes. The Guidelines merely set out the path to be followed. The real work remains to be done.

To date, the most important regulation with substantive impact is the Intelligent and Connected Vehicle Test Management Practices (智能网联汽车测试管理规范) issued on April 12, 2018. Under this regulation, individual Chinese cities are permitted to develop standards that allow for on the road testing of autonomous driving vehicles on public roads. In response to this new regulation, Chinese cities that seek to host the development of ICVs are working with the players to host testing in their own city. The typical regional divisions that characterize Chinese technology development are already taking form:

a. Beijing has set up a licensing program for Baidu.

b. Shanghai has set a licensing program for Ali Baba.

c. Shenzhen has set up a licensing program for Tencent.

Each city is seeking to establish its own regional champion in this new area. To avoid being left behind, other Chinese cities are joining in to create their own ICV on road testing programs. For example, the city of Tianjin recently announced its own ICV testing program in collaboration with the Tianjin Intelligent Connected Vehicle Industry Research Institute. It is expected that other Chinese cities will follow suit, with all of them seeking to create a regional (not national) ICV champion.

This movement towards regional rather than national ICV champions is of course contrary to the MIIT goal. But the overall development of the Chinese vehicle market shows that regional rather than national development is the dominant trend. There is little prospect that the Beijing authorities will be able to do anything to stand in the way of these regional developments. Note that this move to city/regional based ICV fiefdoms is dramatically different from the experience in the United States. California recently opened its roads to self-driving car testing. In response, over 50 different manufacturers have chosen to conduct tests on California roads. Consistent with general U.S. policy, California makes no attempt to favor one company over the other. The market will choose the winner. The Chinese system is developing in exactly the opposite direction, where regional governments are picking their winner in advance. Developments over the next decade will show which system works best.

This then leads to my central theme in considering this issue. In the development of the ICV, technology is everything. The Chinese central and regional governments have plenty of money for developing this program. But that money will be used in classic Chinese fashion. It will be used to purchase land and to build factories. That is, the money will be used for hard infrastructure.

But the question for China is what will those factories actually do? Without the most advanced technology, the factories will do nothing more than build the sort of low standard electric vehicles that already clutter the roads of China’s second tier cities. For the second tier cities like Tianjin, the technology issue is even more acute because the players in Beijing/Shanghai/Shenzhen are not planning to share their technology. In this project, it is every region for itself. So each regional player is faced with a existential issue: after the factories are built, from where will the ICV technology come?

The search for technology will be intense. A huge company like AliBaba can perhaps develop the technology on its own. But that only works for the Shanghai fiefdom. What about everyone else? In response, Chinese regional governments, research centers and production companies will be scouring the world for the latest in ICV technology. Since China currently appears to be the major market for electric and ICV vehicles, foreign companies will need to decide whether or not they want to work in China. For those companies that decide to work in China, the real issue will come down to the issue we continuously raise on this blog. Will you retain control over the technology or will you give it away? Will you get paid for what you give away, or will you wrap it up as a gift?

This growing market for ICV technology is an opportunity for foreign companies. The demand will increase over time, making the market for the transfer of ICV technology to China a long term trend. The question for foreign companies is whether China is a market where a profit can be made or is it just a trap leading to bankruptcy?

Though U.S. companies continue to complain about IP theft and forced transfer of technology to Chinese companies, there are ways to avoid presenting your technology to the Chinese side as a gift. But avoiding this result requires two things. First, you have to accept that if you refuse to make the gift, the Chinese side may walk away and you will then be excluded from that market. Second, you have to do the work required to provide yourself with protection. That means entering into tough, enforceable contracts and making the required patentcopyright and trademark registrations in China. If greed blinds your eyes to the risk, then you will not do either and the result will be predictable.

China attorneysThis is part 5 in our series on what we have dubbed “China free look schemes.” Essentially, China free look schemes are methods employed by Chinese companies 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 in 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. In part 3, we explained how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it. In part 4, we noted how there are plenty of legitimate Chinese companies seeking legitimate deals with foreign companies and then explained how to determine whether the Chinese company with which you are dealing is serious about doing a real deal or is just trying to get a free look at your IP.

In this, part 5, we address how best to deal with the risk of a China company free look scheme.

The Chinese money looks good, but you don’t want to give away the technology base of your company and then never see the cash. So how do you spot the schemer? The first step is to get clear about the motive of the potential investor from China. Is the Chinese investor focused on financial return or on the technology?

It is possible the investor from China is what we can call standard financial investors. These are venture capital or private equity funds focused on financial return. It is relatively easy to identify a financial investor. Their interests are not focused on the content of technology; they are interested in making money. Negotiations with a financial investor will focus on business terms: price, payment schedules, control, board representation, exit strategy and related. Negotiations on these critical issues with Chinese investors is usually quite difficult. In particular, Chinese investors like to make a last minute bid for a reduced price.

But their motivation remains clearly financial. Such an investor will not seek to investigate the technology. Such an investor will not propose joint ventures and tie ups in China. Discussion will be limited to hard nosed business terms. U.S. companies and their advisors are used to this type of investor. The approach is the same all over the world. So the standard deal techniques and documentation generally will apply.

Note, however, that just because the Chinese investor bills itself as a private equity or VC fund does not mean it is not focused on technology. In fact, in today’s China, the opposite is most likely to the be the case. Beneath its indigenous innovation rhetoric, the Chinese government understands that Chinese companies and academic institutions do not have the capability to develop modern technology quickly enough for Chinese government plans. For example, the deadline for a program like Made in China 2025 is already drawing quite near and to jump start development the Chinese government has made acquiring foreign technology a primary goal.

To implement this acquisition program, the Chinese government has taken two approaches. First, it has pressed Chinese companies to make acquisitions in their areas of business that are not focused on financial benefit but rather are focused on acquisition of technology. Second, the Chinese government has instructed private investment funds and banks to quit investing in non-essential sectors such as foreign real estate and media and instead to concentrate on the acquisition of technology. Existing Chinese funds have changed their focus. New funds are being created that are focused solely on acquiring foreign technologies in government mandated key sectors.

In the old days, the way you spotted a technology focused investor was to simply ask whether the Chinese company directly competes with your company? Now though far more research is required. If the investment comes from a Chinese based fund, you have to ask whether the goal of this fund is limited to financial return or is its goal to acquire advanced technology for the benefit of China as a whole, rather than for the financial gain of the holders of the fund.

Once you determine the potential investor is focused primarily on technology you then have another set of decisions to make.

Our China attorneys typically see three types of investor that should be rejected because they are only planning on a free look:

1. The investor has no intention of investing. They only want a free look. This type of investor should be rejected as soon as possible.

2. A more clever Chinese investor strategy is to seek to access to the technology of the target company in exchange for a modest investment. It is common for Chinese investors to take this position. Their position will go even beyond the standard free look. They will say: “We are now part owners of the company so the company should provide us with free access to all the technology information owned by the company and it should follow our direction in doing business in China. Joint ventures, distributors and business partners should be selected by us.” This is a violation of basic company law. A minority investor usually does not have a right to access confidential information or to direct the operations of the company. This is particularly true when that minority investor directly competes with the company. When Chinese investors make this kind of demand, this usually shows they are just planning on following the free look strategy. When they reveal their real intention, they should be shown the door.

3. The more difficult type of investor is the investor who at least claims it intends to purchase a majority interest in the company. As is generally known, acquisitions by Chinese investors face a number of obstacles: a) agreement on the business terms, b) approval by the Chinese government, and c) approval by the U.S. government. So even when the Chinese investor is sincere in its intent, an acquisition from China can take a lot of time and may never happen at all. The risk here is that the investment from the Chinese side will turn into a free look scheme. This is a very common result and must be resisted.

The conversion into free look centers on the due diligence period and the content of due diligence demanded by the Chinese side. The sequence generally works like this:

The Chinese side starts the negotiation agreeing to a very high price. Then, just before the initial closing date, the Chinese side pushes for a substantially lower price and give one of three reasons: a) It no longer has faith in the technology, b) The Chinese government will not allow the investment, or c) The ultimate backers of the Chinese side (banks and funds) will not agree. In each case, the solution proposed by the Chinese side is that the investment target provide inside data about the technology or it enter into a cooperative project in China to demonstrate and prove the technology.

The process continues, as the Chinese side pushes for more and more technical information. In the end, if the U.S. side finally agrees to substantially reduced prices, the Chinese side will close on the deal since it has acquired the technology at a bargain price. Sometimes the deal simply fails, with this failure never attributed to the decision of the Chinese investor. Instead, the Chinese company usually blames the failure of the deal on a decision of the Chinese government or the unknown Chinese “backers” of the deal.

In the end, the Chinese investor either acquires the technology at a bargain price or converts the deal into a free look scheme. So what looks like a legitimate investment proposal turns into a free look scheme or an absurdly cheap one. This common situation, where a failed Chinese acquisition turns into technology theft, is often reported in the financial press. See, for example this weeks New York Times story, Inside a Heist of American Chip Designs, as China Bids for Tech Power. 

But you are a start-up and you need the cash. So what do you do to weed out the genuine Chinese investors from the free look schemers. We will set out the basic plan in our next and last post in this free look scheme series.

This is part 4 in our series on what we have dubbed “China free look schemes.” Essentially, China free look schemes are methods employed by Chinese companies 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 in 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. In part 3, we explained how Chinese companies use Joint Ventures (real, fake and non-existent) to get at foreign technology without paying for it.

In this, part 4, we note how there are plenty of legitimate Chinese companies seeking legitimate deals with foreign companies and explain how to determine whether the Chinese company with which you are dealing is serious about doing a real deal with you or just trying to get a free look at your IP. There is no doubt that there are a large number of Chinese companies, fund managers and investors who see the potential in bringing Western technology and know-how to China and are willing to pay Western companies for that and/or share the profits from that with Western companies.

The core of the free look scheme is the proposal of a Chinese company to make an investment in a foreign technology focused entity. To prevent the Chinese side from playing out a free look scheme, it is essential to work out a “clean” investment agreement. The basic features of a clean agreement are as follows:

1. U.S. and European style investment agreements are normally too vague to be effective in working with Chinese investors. For Chinese investors the investment agreement should include at least the following:

a. An exact date when funds must be paid.

b. Funds must be paid free and clear, in cash, to the company bank account on the closing date. Any claim that funds have been or will be wired from China or Hong Kong or wherever should be ignored. Only cash actually in your bank account, free and clear, counts as an investment.

c. Require the Chinese side to agree that no approval from the Chinese government or any other foreign government is required to make the investment and that no decision of a foreign government or foreign bank will excuse the Chinese side’s obligation to make the payment by the closing date.

d. To give teeth to these provisions, you should require your Chinese counter-party to make a substantial good faith escrow deposit on the date the investment agreement is executed. Provide that the escrow deposit will be forfeited if the investor does not make payment on the closing date. Absent this hard deadline with a substantial penalty, the Chinese investor is almost always late in paying, even when payment is made from a Hong Kong or a U.S. or a Canadian account.

Using the above approach will usually prevent the Chinese side from making use of the free look approach and tell you whether they are free real or not. This is because no Chinese company planning to use the free look approach will agree to the above terms. In refusing to agree, the free look schemer will argue that you need have to prove the viability of your technology before it (or its so-called outside investors) can make any payment or investment. At this point, the best thing to do is usually to walk away.

But most U.S. and European companies choose to continue working with the Chinese side, attracted by the potential of  substantial investment and developing the massive PRC/Asia market for their product. The U.S. or European side will at this point agree to a due diligence period before the final investment is made. This due diligence period is where the free look scheme is executed. The U.S. or European side should enter into an agreement with its Chinese counter-party that is specifically designed to prevent the free look scheme from succeeding.

Some of the following issues arise from this:

1. Who will be the actual investor in your company or your technology? Many Chinese companies find it difficult to transmit funds from China for making an investment. Even for good faith investors, it is often impossible to to make the investment directly from the PRC. To get around this problem, Chinese investors often provide that “their” funds will be paid by some other entity located outside China. This raises a number of issues. First, under U.S. and European know your investor and anti-money laundering rules, it is critical you know from exactly where this funding is coming. Second, payment from a different party is a common source of delay and delay must be avoided in this kind of transaction.

2. Most investment agreements prohibit ownership of stock by nominees. This follows on the know your investor and anti-money laundering rules discussed above. But when the actual PRC investor proposes to use funds provided from another entity, they often then request that this other funding entity own the stock in your company on behalf of the PRC entity as some sort of nominee. This kind of nominee ownership is common in the PRC, but the practice should generally be avoided in the West.

3. If the Western company is working with other potential investors, it is usually important it make sure any special terms provided to the Chinese side do not conflict with agreements with other investors. For example, it is often provided that for a single round of investment, the round will not close until after all investments have been made. If the Chinese side is given a substantial due diligence period prior to being required to invest, this may conflict with the basic requirement imposed on other investors.

5. In this setting, the standard Western style investment agreement is not adequate. You need a separate and specialized escrow/due diligence agreement with the proposed PRC investor.

The following are some of the key points for these due diligence agreements:

a. Who will be the final owner of your company’s stock? Will it be the PRC entity with which you are negotiating or will it be some Hong Kong or Canadian or Cayman Island or Isle of Man or Luxembourg company you have never heard of nor ever dealt with? Even if your due diligence agreement is with a PRC entity, it is not unusual for that PRC entity to demand provisions giving rights to some third party you do not know. Are you willing to issue stock in your company to an entity of which you know nothing?

b. Even riskier is the situation where the PRC entity requires the investment/due diligence agreement be done directly with their non-PRC nominee. Since these nominees are usually mere shells with no assets it is judgment proof. This renders meaningless the entire due diligence agreement.

c. The U.S. side must describe with reasonable clarity what access and information will be provided to the putative investor during the due diligence period. First, the information disclosed should be strictly limited. The Chinese side will nearly always demand more and it is important you set and maintain your disclosure limits. Second, the participants in the due diligence process must be carefully controlled. The Chinese side usually works with a group of related companies. A standard technique is for the Chinese side to negotiate a provision that allows them to disclose your information to one of its related companies. When an infringement of your IP later occurs, it is done by that related but independent company with which you have no contractual relationship. This means you have no contractual basis for making a claim against the actual infringer and your Chinese counter-party thus can walk away with a free look.

d. If you are going to require other investment conditions you must list those with hard deadlines. For example, if PRC government approval of the deal is going to be required, you should put in your contract that such approval must be received by the end of the due diligence period. If a license is required, drafting must be complete at least one month before the end of the due diligence period. If a JV company will be formed, the Joint Venture’s registration must be complete by the end of the due diligence period, with only capitalization remaining — this means the JV registration process must start immediately after execution of the due diligence agreement.

e. At the end of the due diligence period, the Chinese side must be required to “go hard,” meaning all of the conditions to closing the investment must be met or waived by the end of the due diligence period. That is, the Chinese company either walks away or enters into a formal investment agreement that provides for either payment in full in five days or payment of a non-refundable escrow deposit with closing to occur within thirty days. Chinese companies that are working the free look scheme will usually not agree to this quick close. They will instead seek a process where negotiating and drafting the investment agreement and other collateral agreements begins only after due diligence is completed. To avoid the free look scheme, you should insist the investment be made immediately after completion of due diligence. It is not uncommon for Chinese companies to stretch the approvals/documentation period out for several years with no investment in the end.

f. As noted above, the investment and due diligence agreements should provide that no action of the Chinese government or of any Chinese bank or any other Chinese agency will be a defense to the requirement that the Chinese investor perform and if the investor does not perform, its escrow deposit or advance payment will be forfeited. Chinese companies often will insist on including a long force majeure provision in an otherwise simple investment agreement. If you allow for this sort of provision, you are all but guaranteeing there will never be any Chinese government approval. It is actually a good idea to include the exact opposite provision whereby the Chinese side warrants that its investment has already been or will be approved by the Chinese government and that no action of the Chinese government can used by them as a defense.

There are a number of ways to neutralize the free look scheme, even in cases where you agree to prove your technology to the Chinese side. Legitimate Chinese companies will work with you to resolve the issues, but Chinese companies that are in it for the free look will not. It is important you determine where they stand as soon as possible. You do that by providing clear and reasonable terms to the Chinese side along the lines discussed above.

If the Chinese side has problems with the straightforward terms outlined above, you should ask them to outline their specific concerns in writing. If their concerns are legitimate, you probably can deal with them. If the Chinese side does not respond or if its concerns are not legitimate you know where you stand. Chinese companies can run you around for a very long time — years in some cases. You cannot afford that. You need to quickly get to a reasonable arrangement with the Chinese side or move on.

China technology IPThe standard story is that the Chinese government has decided to “corner” the world market for electric vehicles. The most expensive and important component for an electric vehicle (“EV”) is the battery pack. So the the logic goes that the first step in this plan is for Chinese companies to dominate production of EV batteries.

The recent Shenzhen stock exchange IPO of Ningde, Fujian based Contemporary Amperex Technology Ltd (CATL) has been seen as a key phase of this process. According to the press reports, CATL raised USD $830 million in its IPO completed on June 10. Though far less than the $2.0 billion CATL had originally planned to raise, this is nonetheless a substantial sum.

CATL plans to use the proceeds from its IPO to buildd new production capacity for 24Gwh of batteries focused on the EV market. CATL plans for its Ningde facility to become the largest EV battery maker in the world, with a final projected capacity of 50 Gwh scheduled to come on line by 2020. This can be compared with the Tesla Nevada Gigafactory 1 which is projected for 34Gwh capacity.

Though this is a considerable achievement for a company located in the isolated country town of Ningde, its significance is not as reported. The real issue here is not the Chinese government’s decision to promote high volume manufacturing of a basic industrial product. The issue is rather with the technology behind the product and the control of that technology. Production within China may become controlled by Chinese owned companies, just the way so many other basic industrial commodities are under such control today. But it is unlikely China will develop new EV technology through indigenous innovation. That is where the real challenge rests.

Consider the basic issues:

  1. CATL’s advantage rests almost entirely on China’s preferential policies. First, the Chinese government is providing substantial subsidies to EVs for domestic transport. Second, the Chinese government has set the rules so that only EVs using product from Chinese battery makers (CATL and BYD) qualify for these subsidies. This is not a market phenomenon, it is simply an artifact of Chinese government subsidies. This means CATL is entirely dependent on the subsidy program. If the subsidies end, the CATL market advantage disappears
  2. Production of EV batteries in China is largely irrelevant to U.S. EV manufacturers. Batteries are heavy and dangerous and so battery manufacturers seek to locate as close to vehicle manufacturers as possible because long distance shipping is not practical. China is currently the largest market in the world for EVs so the big battery manufacturers are moving as much production capacity to China as possible. Panasonic, LG Chem and Samsung are major players that have invested heavily in China production. Even Tesla has announced plans for a battery gigafactory in China. But the key is that the production for those factories is limited to China EVs. Regardless of the capacity built in China, it will have little impact on the market for EV batteries in the United States or in Europe.
  3. What CATL is doing is just old fashioned Chinese industrial policy. It is manufacturing a product that has mostly become a commodity. Its strategy is to make an “adequate” product in high volume, competing almost solely on price. In 2017, CATL reduced its product price by 30%. As it expands production, further price reductions are expected. Usually this policy leads to overproduction and value/market destruction and this could happen in China as CATL and BYD and others engage in a race to the bottom. However, unlike what Chinese industry has done in steel and electronics, this race to the bottom will not have a major impact on world markets because the product cannot be readily exported. The situation is more like that of cement in China: the destructive industrial policy has no impact on the rest of the world because the product cannot be exported.

The real issue here is that CATL is investing huge sums in manufacturing a product with a less than rosy future. CATL makes old generation versions of lithium cobalt oxide batteries. Though lithium is readily available, cobalt is rare and expensive. More importantly, it is well known in the EV world that lithium cobalt batteries do not have the energy density to compete with petroleum based engine systems and other battery types are already being developed to replace lithium cobalt. Though lithium remains a constant, other metals such as manganese, nickel and even iron are being developed as alternatives to cobalt.

Though CATL appears to have a large R&D department, it does not seem to engage in its own cutting edge research related to developing the new generation of EV batteries. R&D for CATL is confined to two areas: a) additional cost cutting and b) assimilating existing battery technology developed outside China. As CATL continues cutting its prices, its ability to do cutting edge research and development will likely be further constrained.

So what’s the real take away here? CATL and other Chinese EV battery makers do not need help on the investment and production side. They have that covered. But they need access to evolving battery technologies to achieve increased energy density, reduced material costs, reduced weight and increased safety. In other words, we should expect them to fall back on another standard Chinese industrial policy strategy: assimilation of foreign developed technology.

What I expect to see in the next decade of electric vehicles in China is an avid interest in foreign technology in all related fields, centering on power supply (batteries/rechargers) and on vehicle technology. Chinese companies will use all the standard techniques that we have discussed on this blog to try to acquire foreign technologies that are already rampant in the auto tech and other high tech industries: The question is not so much what the Chinese companies will attempt to achieve; the question is whether foreign developers of these critical technologies will give them away or demand adequate compensation.

For more on the “giving away” intellectual property to China versus getting adequately compensated for it, check out the following:

And for more on China IP issues directly related to the automative industry, check out China IP Challenges for Automotive Suppliers.

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.