China manufacturing IP
Do not gift your IP to your Chinese factory

For all the talk of moving manufacturing out of China, most hardware companies that develop cutting edge hardware are pretty much stuck there, at least for a few more years. They have to go to China to have their product manufactured. There simply are not factories elsewhere willing and able to do small-scale manufacturing of these products. Not only that, but Chinese factories are pretty much the only manufacturers that will work with foreign start-up hardware developers to commercialize products that are often mere “concepts” when they arrive in China.

The problems arise when foreign hardware developers work with Chinese factories on projects that are more involved than the simple manufacture of a fully developed product design. In many situations, the foreign designer and the Chinese factory will work together over months and even years in order to develop a commercially viable product. When the prototype is finally complete, the question then becomes which entity actually owns the prototype: the foreign developer that came up with the idea or the China factory. The foreign developer says it owns it. The Chinese factory says it owns it. The sad result is that way more often than not, the Chinese factory is correct. It owns the prototype and it will “allow” the foreign developer to market its product for them. If the foreign developer succeeds, that’s great. But if the foreign developer fails, the Chinese factory will have the product marketed by someone else, leaving the foreign developer who came up with the idea high and dry.

We have seen instances where the foreign designer and the Chinese factory worked together for years to develop a commercially viable product and then when the prototype is finally finished, the question then becomes who actually owns the prototype: the foreign developer that came up with the idea or the China factory. The foreign developer says it owns the product while the Chinese factory says it owns it. Who does legally own it? Way more often than not, the Chinese factory does.

The standard scenario goes something like this. A foreign product designer works with a Chinese factory to commercialize an innovative hardware or IoT product design. In a cooperative co-development setting, the foreign party and the Chinese factory work together to create the prototype of the commercial version of the new product. All the work is done on a purchase order basis, with no written contract or other documentation.

At the end of the development cycle, the Chinese factory announces to the foreign developer that the prototypes are completed. The factory retains the prototypes in anticipation of moving to the manufacturing phase. However when the parties move to the manufacturing phase, it is normal for something to go wrong. This usually happens in two ways. First, the Chinese factory surprises the foreign designer by substantially increasing the projected unit price for the product or it announces that it cannot meet the quantity or delivery date requirements for the product. Second, the factory consistently manufactures product with substantial product defect/quality control issues.

Facing these problems, the foreign party confronts the Chinese factory and announces it will take the prototypes and have them manufactured by another factory. The Chinese manufacturer replies: “You cannot do that. We own all the IP contained in the product. We agree to manufacture the product for you exclusively for as long as you are willing to order on our terms. But you cannot take that prototype anywhere else. Only we have the right to manufacture that product. And, if you are not successful in making substantial sales, we will cut you off and market the product ourselves.”

The real problem with this scenario is that in most cases the factory is absolutely correct about the legal situation concerning the intellectual property in the new product because without a written contract to the contrary, the Chinese factory almost certainly does own the intellectual property in the product.

This situation where the foreign company loses all that it has been focused on for the last many months or years is due to the failure of the foreign designer to properly document the co-development process. If properly documented, this unfortunate result can be avoided.

How to Keep Your Product IP

The first step in dealing with China hardware co-development is to understand how the basic law of inventions works. Simply stated, a foreign developer that does not enter into a written agreement is relying on the default provisions of intellectual property law, particularly the law of patents. This reliance on the default provisions is a mistake because the default provisions greatly favor the Chinese factory.

It is a basic provision of the law of inventions in China that the party who came up with the “idea” does not own the invention; the party that takes the idea through to practical implementation does. This is generally true even when the party that achieves practical implementation has been paid to do so. What this means in real life is that even if you pay your Chinese factory for some or all of the costs of the development work done by the factory, if the factory in fact did the work, the Chinese factory owns the invention unless you have a valid contract to the contrary.

Since the default provisions of law do not protect the foreign designer, a contract that sets out the ownership rules is required. Though the factory may own the IP as a matter of law, the Chinese factory is also free to assign all or even a part of its ownership in the IP to the foreign designer via a written contract. However, this assignment is only effective if done with a clear written contract (in Chinese) subject to Chinese law and enforceable in China. This contract must state exactly what will be developed and which party will own the IP in the resulting product. Properly drafted, the foreign designer will own everything, as the foreign product designer intends. But, without such a contract — as in the case where there is nothing more than a purchase order — the result is the reverse. The entire result turns on the content of the contract.

 

How not to get Blindsided by Blended IP

In the above analysis, we assume a single product is developed and all IP in the product prototype was created during the development process. We refer to that setting as wholly owned IP. But increasingly, our China attorneys are seeing product prototypes that involve “blended IP.” For blended IP, the situation is more complex. In many projects, the co-developed product will make use of underlying IP independently developed and owned by the Chinese factory. In this setting, the new product prototype is like a surface shell layered over existing technology owned by the Chinese factory. The product prototype is a “blend” of entirely new technology and existing technology owned by the Chinese factory. The danger here is that many foreign parties think they are dealing with wholly owned technology when in fact they are dealing with blended technology.

Consider what will happen if the foreign party thinks its prototype is wholly owned technology when in fact the technology is blended. The standard problems arise and the foreign party threatens to take the prototype to a different factory. In this situation, the current Chinese manufacturer will often say something like the following: “We agree you [foreign developer] own the newly developed IP and you can do what you want with that IP. However, this is blended technology and we own the underlying technology in the prototype. For that reason, you cannot have your prototype made by another factory, so you are stuck with us. This result can be a disaster when the business and quality issues discussed above arise and cannot be resolved.

The Appropriate China-Specific Contract Can Save Your IP

The method for contracting to resolve the ownership issues of your product and its intellectual property depends on whether the technology is a wholly owned or blended technology. Many foreign parties at the outset will just assume they are working with wholly owned technology and they themselves own. It is essential right from the start to confirm whether your Chinese factory agrees with this assessment. In the written contract that governs ownership of technology in the prototypes, do not fall into the trap of working with formalistic legal definitions of who owns what IP in the product prototype.

Instead, use the following as your functional rules:

1. The Chinese factory will deliver production ready prototypes to the foreign party.

2. The foreign party has the right to do the following with the prototypes:

  • Register applicable IP anywhere in the world.
  • Manufacture the product in its own facility or contract to have the product manufactured in any factory anywhere in the world.
  • Make use of the design (reverse engineer, clone, etc.) as the basis for the product and manufacture derivative products without restriction.

If the Chinese factory contractually agrees to the above, the IP in the new product will be wholly owned by the foreign party.

In most instances, the foreign companies that retain our China manufacturing attorneys believe from the outset (pretty much without question) that they wholly own the IP in the product prototype. They just assume this is the case and so it does not even occur to them to contractually document this before the development process begins. These foreign companies are then surprised when their Chinese factory refuses to agree to these conditions. But waiting until the process is complete means it is too late to resolve the issue.

Often the Chinese factory will take a compromise position and agree that the IP in the prototype is an example of blended technology. As with wholly owned technology, dealing with blended ownership should be resolved in a written contract at the outset of the development process. As with wholly owned technology, the goal is to avoid vague legal descriptions and to instead use a functional description of how the prototype will be used in practice.

Blended ownership is not co-ownership. By blended ownership, we mean the final prototype incorporates IP owned by different parties. The foreign designer owns some of the IP and the Chinese factory owns some of the IP. As a result, the production prototype is a blend of IP from different sources.

The functional definition starts with the delivery of production ready prototypes to the foreign designer. The issue that needs to be resolved is what can the foreign designer do with these prototypes. There are three basic options for resolving this issue:

Option One. The foreign designer owns all IP produced from the co-development process and can register and make use of that IP without restrictions. To the extent the prototype includes underlying technology of the Chinese factory or a third party, the foreign designer will be granted a perpetual, royalty free license to use that technology solely to manufacture the prototype and any products derived from that prototype. This license if far more restrictive than the situation that prevails in the case of wholly owned technology.

If the foreign party waits until after the development process is complete to raise the issue of securing a technology license from its Chinese factory, the Chinese factory will almost always refuse to grant such a license. Since all the power rests with the Chinese factory by this point, its position is perfectly natural. Nonetheless, foreign product designers are usually surprised to learn they are permanently stuck with the developing factory and cannot use any other manufacturer to make what they thought to be their own product.

Option Two: The Chinese manufacturer agrees to manufacture the prototype exclusively for the foreign designer. The parties agree in advance on price, quantity, time of delivery and quality terms for the product. So long as the Chinese factory can meet these conditions, the exclusive manufacturing agreement remains in effect. However, if the Chinese factory fails to meet any of these terms, the foreign designer has the right to have someone else manufacture the prototype under the license terms stated in Option One.

Option Three: Some Chinese factories will agree to “release” the prototype under the terms of Option One, but only after payment of a substantial fee to the factory. Oftentimes the Chinese factory will set this fee so high that this option is not practical.

These three options assume the Chinese factory is willing to resolve the technology ownership issue in a way that will allow the foreign party to move production to a different factory. In our experience, if the matter is discussed after development is completed, it is the rare Chinese factory that will agree to any of these options. Even if technology ownership is discussed in advance, the negotiation of acceptable terms can be difficult. However, it is critical that this difficult discussion take place before production starts. It is critical that the foreign party understand its exact situation on technology and prototype ownership before it wastes months or even years and incurs and spends substantial sums of money developing a product it will neither own nor control.

Consider the situation when your start-up approaches an experienced angel investor for series A financing. One of the first things any experienced investor will review is the ownership status of your core technology. Imagine what will happen when the investor realizes you do not own your core technology because your Chinese factory either owns or controls it. That is almost always the end of that discussion and it is often the end of the start-up as well.

To avoid “gifting” your technology to your Chinese factory, you must treat proper legal documentation as an essential and not a luxury reserved only to large companies. Proper documentation is even more important for hardware developers at the start-up stage because a loss of ownership at the start dooms the company down the road. A major multi-national has many products. If it loses one, it does not kill the company. But for a start-up, the loss of its key technology usually means death.

Innovation race

 

— By Scott Holbrook and Adam-Paul Smolak

This is Part 2 in what will be a long-running series by Scott Holbrook and Adam-Paul Smolak on how the United States and the rest of the world can take back much of the manufacturing they sent to China and thereby bring high-level manufacturing jobs to the United States and to allied countries.

 

THE US-CHINA COLD WAR NOW, THE EU-CHINA COLD WAR LATER

China and America are in a Cold War and innovation is the new Arms Race.

This can be seen by the nearly unlimited government resources China has put into areas where the United States (and to a somewhat lesser extent, the EU and Japan and a few others) have traditionally been the world leaders: Electronic Communications and Software, Space Exploration, Military Weapons, Energy and Biometrics. China’s actions to dominate the world in these areas include the following:

  • Decades of technological espionage
  • Installing global 5G networks by, among other things, using government subsidies to undercut pricing
  • Creating Beidou, the Chinese competitor to GPS
  • Launching a Mars rover mission
  • Developing electric vehicles (EVs) and Green Energy, with the benefit of government subsidies and few safety regulations
  • Developing A2/AD missile capabilities
  • Developing genetics and DNA identification techniques, with the benefit of government subsidies and minimal ethical or safety restrictions
  • Developing a COVID-19 vaccination, with the benefit of government subsidies and minimal ethical or safety restrictions
  • Using its Belt and Road initiative to expand its geopolitical footprint, entrench itself in the domestic affairs of member countries, and expand development and usage of its technology and military capabilities

In China Doubles Down on Industry Subsidies: No Exit, this blog described how China government subsidies are at the core of its efforts and at the center of its “Made in China 2025” Initiative:

After the trade talks with China broke down, the PRC government immediately announced measures designed to support the development of Chinese semiconductor manufacturing. On May 8, 2019, the [China] State Council under the guidance of Li Keqiang announced it would extend a long-standing series of Chinese government policies supporting development of the domestic PRC chipmaking capabilities. This group of policies is just the type of Made in China 2025 subsidy measures that have been at the core of the U.S. dispute with China. In fact, it has been reported that failure to resolve the subsidy issue is the primary reason the trade agreement collapsed. See Trade talks face moment of truth as US pushes China on subsidies: Beijing’s state support for core industries remain as sticking point in negotiations. So in other words, in response to U.S. complaints, China decided immediately to report that it would go full speed ahead on a collision course with the U.S.

To clarify, chip promotion policies are typical of the Made in China 2025 program. There are three core elements, all of which critics of China deem unacceptable:

1. Chinese chipmakers receive a tax benefit. The basic plan for general chipmakers is no taxes for 2 years and a 50% reduction for 3 years. For chipmakers that can break the 9 nanometer barrier, there will be no taxes for 5 years and a 50% reduction for 5 more years. This plan was initiated in 2011 in the (国务院关于印发进一步鼓励软件产业和集成电路产业发展若干政策的通知) here. The State Council apparently plans to extend the benefits of this old plan.

2. Creation of the government controlled and funded China National Integrated Circuit Industry Investment Fund (国家集成电路产业投资基金) under the lead of CBD Capital, a wholly owned subsidiary of China Development Bank. The plan of the fund is to invest billions in chip manufacturing R&D and manufacturing capacity. This fund was created in 2014 and it did a second round of fundraising in 2018. See China invites overseas investors to propel local chip ambitions.

3. Overal planning and control exercised by the central government. This plan is outlined in the State Council Guideline for the Promotion of the Development of the National Integrated Circuit Industry which was issued in 2014.

As you can see, The PRC semiconductor program is a textbook case of all the U.S. finds objectionable with China’ high tech industrial policy: central government direction and control, subsidies in the form of tax breaks and funding from central government sources (funding with “strings attached”).

What this means is that in the face of the failure of the trade negotiations and the subsequent Huawei Entity List sales ban, the PRC has “doubled down” on its Made in China 2025 subsidy program. Not only will the PRC not back down on the subsidy program, the notice from the State Council makes clear China will in fact redouble its efforts to ensure that the program meets its intended goal. This basic policy position was made clear in a recent announcement from Wang Zhijun of the Ministry of Industry and Information Technology (MIIT). Wang announced that the Chinese government will continue its support of its domestic chip industry and will expand that support to software and the high tech sectors. Mr. Wang announced that China welcomes the Huawei ban as a push from the U.S. on reviving the chip design and production program: “To offset the possible implications of the ban, the ministry said it would this year introduce a two-year waiver on corporate tax payments for software developers and integrated circuit manufacturers, and reduce the rate on subsequent payments to 12.5 per cent over the next three years.”

As the South China Morning Post concluded after reporting the comments of Mr. Wang, “Beijing’s role within Chinese industry, in particular its financial support for the state sector, has been a major sticking point in the trade negotiations between the world’s two largest economies. Washington complains it puts US companies at a disadvantage, but Beijing says the matter is one of principle and it has no plans to change.”

China’s heavily subsidized approach to dominating various critical global industries is a symptom of the world’s “fundamentally failed approach to China.”

The failed approach is the idea that after its accession to the WTO, the PRC would gradually transform into an open, market oriented system along the lines of the U.S., Europe and Japan. The policy is what the Germans (and much of the EU as well) call “change through trade.” See EU’s China policy is no longer just carrots. That policy failed. That failure is permanent. Ten years ago, many believed China would change. Few believe that now and that is why so many who have dealt with China for 10+ years are so frustrated. Fool me once….

The proper way to look at China is the approach taken by German industry in its recent report on China issued in January, 2019.  In the Report, China is identified as “systemic competitor” to the open market economies. As the Report states:

For a long time it looked as if China would gradually move towards the liberal, open market economies of the West by integrating into the world economy and reshaping its economic system. This theory of convergence is no longer tenable. China is no longer developing structurally in the direction of a market economy and liberalism but is in the process of consolidating its own political, economic and social model. At the same time, China as an emerging economic power is shaping other markets and the international economic order. The Chinese model of an economy marked by substantial state control thus enters into systemic competition with liberal market economies.

The Report concludes that China has developed an integrated set of policies in direct opposition to and competition with the liberal open market system. Countries with open market systems must deal with China’s policies as they are and without any hope those policies will change. This characterization of China a systemic threat is a remarkable change for German industry which had until 2019 been reluctant to speak out against the Chinese system. See Germany Industry Comes Clean on China  

Though China has mostly failed to develop at anything beyond a fairly low level most of the industries it has been heavily subsidizing and for which it has been stealing IP, it has no intention of of ending either of these programs that so offends a large part of the world:

Stated bluntly, China is reviving a set of policies that completely failed. As James Lewis bluntly stated in a recent report, “despite 40 years of effort, investment, and espionage, China is unable to make advanced semiconductors.”(See China’s Pursuit of Semiconductor Independence. The tax breaks were a scam, as they always are in China. The chip fund investments, if they were made, were a waste of money. The brutal fact faced by the State Council and the MIIT is that China has made no meaningful progress on chip manufacturing over the past two decades. China makes cheap memory chips, but sophisticated chips still come from Taiwan. China has made little to no progress on chip design. Without design technology from ARM and testing technology from various U.S. companies, no Chinese entity (Huawei included) has any real hope of building a new advanced chip. China is stuck with bulk memory chips or copies of foreign designs. .

The whole policy has been a colossal failure and the Chinese authorities know this. The reports of revived and redoubled efforts are typical of the Chinese bureaucracy: don’t worry, we will do it right THIS TIME. But they won’t. So we should view the PRC for how Germany describes it and how pretty much everyone in the semiconductor industry sees it: a systemic competitor that cannot compete in the world of high technology. Low end, low margin, high volume manufacturing is the world from which China seeks to escape. Nothing from its recent announcements (or the realities on the ground) suggests this escape will ever occur. This means that as the U.S. accelerates cutting Chinese companies off from U.S. technology, the impacts will be far more severe than is generally understood. The Chinese authorities know this. But they are in a box from which there is No Exit.

Like it or not the Cold War between the United States and China (and soon Europe and China as well) is here and if you are not already looking to have your products made somewhere other than China — might we suggest Thailand or Vietnam or Taiwan or Mexico or the Philippines or Indonesia or wherever — you should start. See The US-China Cold War Starts Now: What You Must do to Prepare.

Though China is dead set on winning the innovation race, few Americans yet know we are in a new Cold War with China that will likely soon include the EU against China as well. However, Americans are beginning to awaken to the crisis, due largely to recent event involving China, such as all that happened in just this past week:

 

NECESSITY IS THE MOTHER OF INVENTION/INNOVATION 

First, “Innovation” is more than a buzzword to Americans. It’s deeply tied to the self-reliance internalized by early settlers. Self-reliance and innovation were necessary for survival. It is a way of life ingrained into America’s DNA before there even was a United States. Innovate or die.

This same sense of self-reliance inspired Thoreau to live at Walden Pond for two years and write his magnum opus, Walden. This mixture of self-reliance and innovation was responsible for Thoreau experimenting with different ways to measure the depth and shape of the bottom of the supposedly “bottomless pond.” It was this self-reliance that led the Wright Brothers, whose lack of a university education “and little money never stopped them in their mission to take to the air. Nothing did, not even the self-evident reality that every time they took off, they risked being killed.” We could go on and on describing similar such American inventors, but suffice it to say that this streak of innovation still runs strong today. That is why the quintessential American “homestead” includes a workshop/shed/garage or some place where tools are stored and artifacts are built. Everyday, Americans put their self-reliance and innovation to work in these home-based workshops where they “tinker” and build solutions to problems they face in the course of their everyday lives.

DIVERSITY IS KEY  

Second, a key component of innovation is having access to the problems you are innovating to solve. This means users and manufacturers need to be able to work together to innovate new products or processes. This feedback loop is critical.

Diversity is one of America’s core strengths. Ethnic diversity, racial diversity, religious diversity, diversity of activities, diversity of cultures and views. China is far more homogeneous, especially in its most developed regions. The United States (despite Trump’s anti-immigration push) pulls in the best and the brightest from all over the world. “More than half of the top American tech companies were founded by immigrants or the children of immigrants.” Apple, Amazon, Google, and Facebook were all founded by first or second generation immigrants. Add in that Microsoft CEO Satya Nadella comes from India and one can quickly see that America’s largest and most influential tech companies (with a combined market capitalization of nearly $7 trillion) all are where they are due in large part to immigrants. How many non-Hans can you name in any true leadership role in China?

What this means on a practical level is there is more opportunity for innovation in America than China. Every ethnicity, activity, culture, view, etc. represents an opportunity to innovate China lacks. All of these American tech companies have employees from at least 150 different countries. If any need help figuring out how to localize a product for Ethiopia, Egypt or the Ukraine, they can tap in-house employees for assistance. If any need help figuring out what Jordan, Ghana or Portugal need, they can tap in-house assistance. If any need help in buying a business in Ireland, or Kenya or Mexico that is developing cutting edge products, they can tap in-house assistance. The closest China comes to doing the same is sending its best and brightest to be educated overseas and even that is being restricted.

 

THE NEED FOR SPEED

Third, accelerated innovation requires accelerated design processes and product cycles — from ideation to prototyping to the final commercial product.

Chinese factories take months to develop new products. Jigs must be designed, tools must be built and machinery must be calibrated. The prototype then must be taken to the field for use — which is usually not in China. Then feedback must be relayed between three or more parties. And any changes usually require new jigs, new tools and new calibrations. The whole process is time-consuming and expensive because it’s not what Chinese manufacturing was set up to do.

Manufacturing in China has been optimized to take advantage of certain elements present in China that America lacks. Massive amounts of cheap labor, a lack of rigorous safety and pollution laws, homogeneity throughout the society and an aversion to creativity. Perfectly suited to mass producing widgets based on designs provided by others. Innovating under such conditions is mostly detrimental to the process.

 

AMERICA’S HEAD START 

Fourth,  America already has the “bones” required for immediate feedback loops, drastically shortened design processes and simplified supply chains.

Companies like Stratasys have been working with American manufacturers for years to help them implement advanced manufacturing tools and techniques in their operations. Using tools like 3D printers, companies such as GM, Ford, Lockheed Martin and others have been able to reduce production costs in half, while simultaneously reducing the time required for prototyping from months to days, sometimes hours. Imagine being able to create and test three prototypes/week. This is not happening in China.

In addition to rapid prototyping, American companies are almost invariably better at controlling inventory than Chinese companies.  For example, if an American company finds a defect in a product it manufacturers, it is far less likely to be stuck with tens of thousands of products of dead inventory. This ability to produce products and components according to need (rather than per a Chinese MOQ), allows companies to save money, thereby increasing the resources available for innovation projects.

 

AN UPHILL BATTLE — INNOVATION AND COMMERCIALIZATION 

China did not want an innovation war with the United States this soon; it would have preferred to wait another five to ten years, but that war started early. Nonetheless if the United States does not move quickly and with alacrity and with cooperation from allies to utilize the advantages it possesses, it will not necessarily win this war.

Even if China cannot win the innovation battle it can do enough to win the commercialization battle and here is how, in three steps, China could make that work.

Step One: Convince the West to keep transferring its technology to China and allow what is not transferred voluntarily to be stolen.

Step Two: Allow China to continue using its standard technique of commercializing technology within its closed market, free of foreign competition.

Step Three: After perfecting commercial applications in China, sell the commercialized product back to the West at a subsidized price. If the West won’t buy from China (unlikely absent legislation or tariffs/duties), sell to the captive countries in the Shanghai Cooperation Organization and to Belt and Road countries.

In other words, China will win the commercialization battle if the West continues to support China’s system with tech transfers and funding. This is an international issue: action by the U.S. is not enough. More deeply, it is fairly certain China can win the innovation battle with Step Three alone. In very basic terms, even if China’s product is one generation behind, if it is “good enough” and subsidized enough to be 30% to 50% cheaper, then for most of the world, China will prevail.

Rational Western government policy needs three parts: One, support for Western innovation. Two, Positive action to neutralize China’ commercialization advantage. And three, international support to shut down China’s commercialization advantage.

China will not change so Western measures must assume no change and involve direct action. No tech transfers to China. No transfers of capital to China. No China contract manufacturing. No purchasing of any Chinese made product that incorporates critical technologies. This only works if done on an international basis. Ramping up U.S. competitiveness within the U.S. is essential for beating China head to head, but it will be difficult to prevail under this strategy if we continue to transfer tech and capital to China and to the other members of the SCO and the Belt and Road.

In our next post we will take a deeper look at what advanced manufacturing is, why it is perfectly suited to the American way of life and business, and the resources already available to companies that wish to reduce their dependance on a China so filled with risk. See Has Sourcing Product From China Become TOO Risky? and The Top 14 China Wild Cards/Future Risks.

 

Scott Holbrook and Adam-Paul Smolak together operate a number of product and manufacturing companies and they both have a long history assisting educational institutions in developing and enhancing manufacturing and logistics programs and events.

China problem solving

Our China lawyers are often called in to fix things that have gone wrong between a Chinese business and a foreign company. The style for dealing with problems in China is much different than in the West and it behooves foreigners to learn the Chinese style of dealing with problems.

If you are trying to get something important done in China, you often must rely on the Chinese side to accomplish this. The Chinese party may be a Chinese company your company has hired, a joint venture partner or an employee. But when a major problem arises, the tendency will be for all these folks to tell you: “There is a problem. We cannot do what you need us to do. It is not my/our fault. It is the fault of someone else.” This statement is usually not accompanied with any plan to take care of the issue.

How do you motivate the Chinese side to take control, do their job, and resolve the problem to get things done? The basic rules in China are as follows:

  • Never show anger. If you show anger, it will not motivate the other side to act. It will instead likely cause the other side to freeze up and refuse to act for fear things will get worse.
  • Go ahead and assign blame. The Chinese side will be very sensitive not to admit any fault for the problem. However, if the Chinese side is at fault, it is important you state this clearly. You should point out the duties assigned to the Chinese side in your contract so the Chinese side has a clear understanding of why they are at fault. With Western companies, I usually wait to assign fault until after the problem has been solved. In China, it is the opposite. It is better to assign fault at the outset.  This motivates the Chinese side to resolve the problem.
  • Rely as much as possible on human feeling and the personal connections between the parties as the motivator for resolving the issues. Make it clear some identified individual the Chinese side has come to know will suffer if the problem is not resolved. This is far more effective than an abstract discussion of what is provided in the written contract. The Chinese side is much more likely to act under the motivation of human feeling than under the abstract notion that the contract requires them to act.

These basic rules were illustrated for me in a real estate transaction on which I worked many years ago. I represented a U.S. client purchasing a substantial piece of Shanghai real estate. We were represented in this deal by a sincere but not terribly experienced Shanghai real estate agent. It was important to the U.S. client to complete the transaction before a specific date.  My client and the seller had completed all the necessary contracts and it was now the job of the Chinese real estate agent to work with the bank and the local government to close the deal.

We were contacted by the agent three days before the closing. The agent announced that all our careful plans to complete the closing would not work because the bank could not perform certain procedures over the weekend. In a manner typical of this type of situation, the agent announced: “The deal will be delayed by two weeks. It is not my fault. There is nothing we can do.” The agent offered us no contingency plan of any kind. Since we were relying entirely on the agent to perform the closing procedure, this placed us in a very difficult situation. Though both my client and I were upset, I carefully controlled my anger, though I refused to let the agent off the hook on the blame issue. I pointed out that we were all relying on the agent for the bank side of the transaction and that it was the agent’s fault for not checking with the bank in advance on the procedures to be followed. I then pointed out the tremendous disappointment and loss that would be suffered by my client (who the real estate agent had come to know) if the deal did not go through as scheduled. Then I simply stopped.

The transformation in the agent was remarkable. The agent converted from the passive giver of bad news to a dynamic problem solver. Ultimately, three of her staff were on the phones and various creative solutions were devised. As a result, on Monday evening we were drinking champagne in my client’s office instead of sending reports to his bosses at home explaining why the deal would not go through on time. This all came about because we did not show anger, and we assigned blame and we relied on human feeling as the final motivator.

How do you solve your doing business in China problems?

China Music royaltiesChina is digital. Its music market is almost entirely digital. Physical sales here comprise only about 20% of the total market.  China has more than twice as many internet users as the US has people. There are about 900 million mobile internet users here, 70% of whom consume music online. That means there are around 630 million mobile digital music consumers. With mobile payment penetration at about 85%, there are around 540 million consumers in China who can easily buy music on their phones. They may only be spending ¥10 ($1.45) a month for a premium service, or to download an album, but Chinese audiences are being conditioned to pay for their digital music and that is a big development that has taken a long time.

Despite the actual and potential growth, China’s music industry is beset by systemic royalty accounting problems. The temptation is to blame China for this. But when you take a closer look at the royalty ecosystem, the blame doesn’t lie squarely at China’s feet. Entrenched global practices in the music industry seem to have a lot to do with it.

As I said during a recent webinar, there are three main factors contributing to China’s royalty accounting problems.

 

Inadequate Metadata.

To account properly to foreign labels, Chinese DSPs (digital service providers) need adequate data, but according to Chinese DSPs, the majority of publishers do not generally provide the complete song lists or other data sets required. In many cases, there are technological reasons for this — many foreign publishers use systems not commonly used by the Chinese DSPs, such as the common works registration or CWR system. But the MCSC (Music Copyright Society of China) is also sometimes criticized for not providing full song lists and other data to the DSPs. The result is that proper accounting is impossible or impracticable. There are insufficient data for matching. As one DSP executive puts it, it’s a case of “garbage in, garbage out”.

 

Exclusive Deals, Big Advances.

China’s market for foreign music has been dominated by exclusive deals granted to Chinese DSPs in return for big advances for the major labels. Under these exclusive deals, minimum guarantees have been paid instead of royalty income based on actual transactions. Payments structured in this way tend to overvalue music catalogues and are effectively buy-outs in which transactional accounting is impossible or discouraged. The major labels have left themselves open to the criticism, often made in China, that big advances with no prospect of reporting are the desired outcome as they result in non-allocable surpluses or “breakage” that may be retained.  Exclusive deals also support webs of sub-licensing and copyright transfer agreements which contribute to the inadequacy of metadata, attract multiple payments for the same properties, and give rise to accusations of anti-competitive conduct. About the only good thing people have to say about exclusive deals is that they have driven a rapid reduction in piracy because exclusive licensees have had the incentive to eradicate infringers.

 

Messy Copyright Collections.

I mentioned in a recent post on audiovisual copyright  that one of the ongoing difficulties with Chinese copyright law is that, although it enumerates the rights comprising copyright, it does not clearly state which of these rights apply to which copyright works or other subject matter. An indeterminate class of rights — such as the rights of “consent” or “remuneration” — is often the only link. In the Chinese music business, distinctions between mechanicals, public performance and streaming are therefore unclear. Other markets have developed customs and practices to handle these kinds of distinctions. In the UK, for instance, 75% of a download is regarded as mechanical and 25% as public performance, while streaming is divided between those rights 50/50. In China these kinds of customs and practices do not yet exist. To make matters worse, the “streaming” right — the right of network communication or online dissemination — is poorly understood and rarely, if ever, anticipated in a grant of rights under a music publishing agreement between foreign parties. The rights acquired under such agreements aren’t assimilated easily into the Chinese system.

The legal issues are compounded by unclear or overlapping local industry practices. For instance, though foreign publishers deal directly with the Chinese DSPs, the main Chinese collection society, the MCSC, also deals with the DSPs for the same music. Publishers and the MCSC then make competing claims to the DSPs. The very existence of these competing claims means the distinction between the writer’s share and the publisher’s share is unclear or in practice non-existent. The writer’s share is, as Outdustry’s Ed Peto recently put it, “a cultural import largely met with shrugs”.

 

Despite these royalty accounting problems, there have been some encouraging developments in copyright law, and China’s digital environment is clearly driving substantial investment activity in the music business. A recent $3.4 billion deal in which a Tencent-led consortium bought 10% of Universal Music Group certainly evidences this. The Chinese music business may now even have eclipsed the film business in the international investment arena. Still, investment has it limits. Foreign investment in production of audio-visual products and network publications in China remains prohibited.

Listen above or stream on SpotifyApple PodcastsGoogle Play or Stitcher!

The large-scale shift to telework brought on by the COVID-19 pandemic is prompting businesses around the world to explore new avenues to engage with clients and friends. Harris Bricken is no exception, and we are proud to announce our new podcast series: Global Law and Business, hosted by international attorneys Fred Rocafort and Jonathan Bench.

In Episode #15, we discuss international schools with Arlo Kipfer.  We cover:

  • An overview of the global international school market.
  • The Chinese legal and regulatory environment for its international schools.
  • Important issues for foreign schools to consider when establishing their school brand in China.
  • How Covid-19 is impacting K-12 international schools.
  • Advice for people who want to teach in international schools around the world.
  • Reading, listening, and watching recommendations from:

If you have comments on this episode or if you’d like to suggest topics for future episodes, please email globallawbiz@harrisbricken.com.

And please follow Fred and Jonathan on social media to stay informed on upcoming guests and topics:

We’ll see you next week for another discussion on the global business environment with guest Mariana Gallegos García Conde as we discuss the legal and business dimensions in Mexico.

The U.S. has ordered China to close its consulate in Houston. Having received word of their impending closure, staff at the consulate began to burn documents in a courtyard. According to the State Department, the move was taken “to protect American intellectual property and Americans’ private information.” Senator Marco Rubio’s description of the Houston consulate as a “spy shop” and the “central node of the Communist Party’s vast network of spies & influence operations in the United States” provided additional clues as to what lay behind Washington’s decision. A U.S. official described the mission as an “epicenter” of economic espionage. Reports the Chinese consulate in San Francisco was sheltering a Chinese researcher whom the FBI alleges “lied about her connection to the Chinese military in order to receive a U.S. visa” further added to the mix on a heady day.

Immediately, speculation on both sides of the Pacific began, not on whether China would retaliate, but how. It is expected China’s response will include the closure of at least one American consulate. According to Reuters, “China was considering closing the U.S. consulate in Wuhan, where the State Department withdrew staff and their families early this year due to the coronavirus outbreak that first emerged in the city.” However, closing Wuhan would be a meek response. The diplomatic post there is relatively unimportant: It was only established in 2008 and does not yet issue visas or provide services to American citizens.

Closing down the consulate in Hong Kong would be much more impactful. In addition to the symbolic value, it would impose hardships on the large American community living there, as well as on Hongkongers who are looking for a U.S. escape plan. Shuttering the consulate would send a clear message not just about Houston, but also about U.S. policies toward Hong Kong. At the same time, it would draw even more attention to China’s own actions in Hong Kong, as controversy over the recent National Security Law (NSL) endures (for our own take on the NSL, see Requiem for Hong Kong). It would become very hard for Beijing to pay even minimal lip service to the idea of Hong Kong autonomy and “one country, two systems” if it kicks out the Americans. Maybe they don’t mind, maybe they do.

Though it probably wouldn’t garner as much attention as a move in Hong Kong, the practical impact of shutting down the U.S. consulate in Guangzhou could be greater. Guangzhou handles all immigrant visa (IV) applications in Mainland China. Close down the consulate, and American citizens won’t be able to reunite with their Chinese spouses, elderly parents, and adult children.  IV operations also include visas for adopted children. According to the State Department, more than one-third of all international adoptions in the U.S. are from China.

In due time, IV operations could be transferred to a different China post, such as the embassy in Beijing. However, even if the Chinese don’t actively hinder the process (and why wouldn’t they?), it could take months before a transfer is complete. Dozens of American and local staff would ultimately need to be repurposed, and workspace restrictions at other posts could mean that nonimmigrant (NIV) visa applications (including those for student and work visas) are deprioritized. And let’s not forget all of this will be happening as the State Department comes to grips with the backlog that continues to build as visa operations are suspended on account of COVID-19 .

Messing with immigrant visas would surely engender ill will toward China, and this is presumably entering into Beijing’s calculations. If they want to avoid the bad PR that comes from keeping adopted babies separated from their parents (which would bring up problematic comparisons to things that happen both in the U.S. and China), then Shanghai might be the ticket. The large American business community would be negatively impacted, with expats having to trek out to Beijing for passport renewals and other services, and local staff having to do the same for visas.

As to the remaining consulates in Chengdu and Shenyang, the inconvenience factor would be greater than in Wuhan’s case, as they both offer visa and American citizen services. But in the grander scheme of things, their choice would have to be seen as a measured response by China.

It’s hard to imagine a response that doesn’t include a consular shutdown, but this is not the only thing that China can do or is likely to do. Beijing may also wish to respond to Senator Rubio’s concerns about Chinese spying out of their mission in Houston. To be sure, what would be surprising is if they did not have spies working out of Houston, or any of their other U.S. consulates. But China isn’t the only country that uses its diplomatic posts as spy bases. A measured Chinese response could include the expulsion of one or more suspected U.S. intelligence operatives. A Wolf Warrior response would have all suspected spooks expelled (maybe with some regular diplomats thrown in as well), while at the same time revealing the identities of American operatives elsewhere in the world.

Of course, not all spies work out of diplomatic missions. This would be a perfect time for China to snatch up an alleged U.S. spy or two who do not get to invoke diplomatic immunity. Whether those persons are in fact spies is beside the point, as Canada’s Two Michaels can attest.

We are on the edge of the precipice. Anything other than a muted Chinese response could lead to further U.S. ripostes. At a minimum, the lives of everyday people in both countries will be impacted. Americans with family or business in China will face further hardships getting visas and authenticating documents, and vice versa. And if cooler heads don’t prevail, we could be entering a dangerous spiral of escalation that could move beyond diplomatic games. The Wolf Warriors may be about to be released.

It isn’t just classified documents in Houston that are burning. The entire U.S.-China relationship is going up in flames. Not that we didn’t predict this way back in May 2019, in The US-China Cold War Starts Now: What You Must do to Prepare. Now for our next prediction: the EU will soon more markedly join with the United States in opposing China.

international lawyer path

After my last post on this topic, I fielded several inquiries via phone, email, and LinkedIn from people who took me up on my offer to try to help them think through their path in the international legal world. My offer – to be a sounding board for anyone contemplating this path – still stands. You know how to reach me. In this part two, I address some additional concerns I shared 10 years ago as a law student full of promise and insecurity as I tried to divine my future.

Law school is hard. Being a lawyer is much better. It’s no secret that I hated law school. I absolutely hated it. I won’t go into the gory details here, but there were some good parts, few and far between. This was not really anyone’s fault but my own. My over-healthy ego meant that I expected to excel in law school from the gate, but it took me about a year to figure out what was going on. It took me a long while to get comfortable with the pressure, the competition, the workload, and the recalibration of my brain (all with the backdrop of the 2008 financial crisis weighing on my future).

I felt like I had gone from a reasonably smart undergraduate to the dumbest person in every one of my law school classes. My classmates knew more about history, politics, government, finance, and every other subject (except China and Chinese) than I did. But I was tenacious. I was not going to quit or let it beat me, even though I wanted to quit.

But guess what – being a lawyer is significantly better than being a law student. Why? For starters, you get paid to do what you were previously paying to do. You get to learn every day of your life. You get to solve puzzles. You get to be an oracle to help your clients see into the future. It is fun. It is rewarding. No matter the area of law you get into, you get to help your clients. And if you’re an international lawyer, you get to meet and work with people from all over the world and learn about their cultures, their legal systems, and their individual and national quirks. If you love learning – even if you hate law school – you’re going to love being an international lawyer.

Make yourself uniquely valuable. In law school and at my first law firm, I studied everyone else. What were their top skills? What did they do extremely well? What did I do well? And most importantly, what skills and experiences do I need to learn to myself uniquely valuable? This takes some introspection, and you may not be able to figure all of this out on your own. That’s fine. But pay attention and keep in mind that you need to make yourself irreplaceable. For me, that meant adding an MBA degree to my law degree so that I could think and speak like the businesspeople I would be advising. (And candidly, my MBA was also my parachute in case I wasn’t going to enjoy being a lawyer.)

In retrospect, it is clear to me that no one can replicate “you,” but you still want to make sure that your skills and experiences make you stand out in some way. Recognize and build on your strengths. Do you like foreign languages? Then learn one that is difficult and is or will be important to international business in the future. Do you like people? (Not everyone does.) Build your domestic and international network incessantly so that you can draw on those people when you need them (and encourage them to lean on you when they need to). Do you like writing? Then read works from good writers constantly and hone your writing craft until you can create beautiful sentences on the first (or fifth) try.

Be willing to adapt. Maybe you thought you were going to be a law clerk or litigator, but you end up hating the pressure and deadlines and confrontation of litigation. Maybe you wanted to be a business lawyer but ended up liking your clerkship better because you prefer to sit alone in your office rather than deal with people. Maybe you thought you wanted to work with clients but end up liking law firm marketing or management better. Maybe you decide that law firm life isn’t for you and that you would rather work as in-house counsel because you enjoy building a brand and being on a board of directors and developing international strategy for your company. Maybe you decide that you’d rather stay in your home country than travel around the world because you realize international travel is only glamorous for those who love the excitement and anxiety of feeling lost and culture-shocked. If you become an international lawyer, you’ll start to pine for some semblance of normalcy in your life, even if you love all things international. And you’ll need to be flexible even if you don’t become an international lawyer.

Lawyers (and others) at the top of their game are often willing to mentor talented, ambitious people. I have benefited in so many ways from more mentors than I can count. Professors, students, family, friends, colleagues, and many others have answered my naïve, simplistic, selfish, and (sometimes) informed questions. The more people I meet who are at the top or on a trajectory to the top, the more I understand that those ranks are filled with good, normal people. They are smart, ambitious, resourceful, and dedicated people, but don’t believe for a minute that they are any smarter or more ambitious, resourceful, or dedicated than you are.

When you “arrive” at the top of your career, I encourage you to be one of those who remembers what it was like to have fallen on your face and lost all confidence in yourself. Keep your eyes open for those who are struggling and be the mentor they need. You will not regret the time you spend helping someone else.

In The Chinese Government is Accessing YOUR Network Through the Backdoor and There Still is NO Place to Hide, I explained how Chinese banks are requiring their account holders — including all foreign companies in China — to install malware which allows the Chinese government to see all account holder data. In China Malware: Sorry, Techno Geeks, There Still is no Place to Hide, I explained how, “in China, the government itself is the hacker and it will not allow any foreign or domestic technician to provide services that will defeat the hacker’s ultimate goals.”

In yesterday’s first part of this series, I explained the Chinese government’s hacking goals, how it does its hacking, and why it is virtually impossible for foreign companies to avoid being hacked by the Chinese government or to fight back against it. In this post, I will explain how China, acting as a nation-state hacker, accomplishes its goals in the network sector by setting out the four basic ways the PRC government gains access to foreign company networks and company data.

 

1. Forced use of government software that contains malware. The Golden Spy/Golden Helper malware included in the tax payment software required by the PRC government is an example of this method. Subsequent to its initial report on this issue, Trustwave has issued a series of reports on this malware and on Aisino’s response in dealing with the public revelations regarding this software. See GoldenSpy: Chapter Two – The Uninstaller, GoldenSpy Chapter 3: New and Improved Uninstaller, and GoldenSpy Chapter 4: GoldenHelper Malware Embedded in Official Golden Tax Software. These Trustwave reports should be required reading for any foreign company that plans to operate a business in China.

Trustwave’s follow up reports reveal the following three key things;

First, Aisino used the auto-update system in the Golden Spy software to propagate an uninstaller that removed the malware and any files or other traces of its existence. Their software uses a standard update procedure that can then be used to download malware or other unauthorized software at any time. A clean system today can be infected tomorrow. This means this software is a constant source of risk.

Second, Trustwave discovered a related but separate malware program concealed in the Golden Tax software. This malware, dubbed Golden helper, was active in 2018 and 2019. From this, Trustwave reasonably concludes that the tax software malware program is not a recent event, but has been going on for several years at least.

Third, Trustwave confirmed my earlier description of the technique used by the Chinese banks for delivering the Golden Tax software and its malware payload:

During our investigation, we have been informed that the Golden Tax software may be deployed in your environment as a stand-alone system provided by the bank. Several individuals report receiving an actual Windows 7 computer (Home edition) with this Golden Tax software (and GoldenHelper) preinstalled and ready to use. This deployment mechanism is an interesting physical manifestation of a trojan horse.

See GoldenSpy Chapter 4: GoldenHelper Malware Embedded in Official Golden Tax Software.

The description from Trustwave is basically the same as what I previously wrote here, even down to the use of the Windows 7 operating system. See The Chinese Government is Accessing YOUR Network Through the Backdoor and There Still is NO Place to Hide and China Malware: Sorry, Techno Geeks, There Still is no Place to Hide,

When I previously wrote of this prevalent and unstoppable CCP hacking, we received comments that none of this could be correct because it would mean the proliferation of compromised computer systems. It seems odd to people who don’t work in the PRC that the PRC government would require companies use an insecure computer system. But this is not odd when you consider the government’s goals. A compromised system is easy to hack. The government is the hacker, so they make it easy on themselves. The banks may be unaware of the details of the malware and the compromised system; the bank staff is just following orders.

 

2. Use of network hardware with backdoors installed. It has long been assumed that PRC manufactured network hardware is filled with backdoors that allow unauthorized intrusion by the Chinese government and a recent report confirms this assumption. As reported by ZDNet, a research group has found seven separate instances of malware/backdoors in critical network fiberoptic cable connection devises. See Backdoor accounts discovered in 29 FTTH devices from Chinese vendor C-Data.

ZDNet describes this these intentional backdoors as follows:

Two security researchers said this week that they found severe vulnerabilities and what appears to be intentional backdoors in the firmware of 29 FTTH OLT devices from popular vendor C-Data. FTTH stands for Fiber-To-The-Home, while OLT stands for Optical Line Termination.The term FTTH OLT refers to networking equipment that allows internet service providers to bring fiber optics cables as close to the end-users as possible.

As their name hints, these devices are the termination on a fiber optics network, converting data from an optical line into a classic Ethernet cable connection that’s then plugged in a consumer’s home, data centers, or business centers. These devices are located all over an ISP’s network, and due to their crucial role, they are also one of today’s most widespread types of networking devices, as they need to sit in millions of network termination endpoints all over the globe.

The simple evaluation of this malware is that it is as bad as it gets.

C-Data, the vendor identified here, is a major source for this type of hardware within the PRC. The takeaway here has to be that if this company feels free to include this backdoor system in products it sells outside the PRC, it undoubtedly is unconstrained in doing the same thing within China. This then means any foreign company operating in China should assume that its Internet connection is completely compromised by this type of malware/backdoor in its entire network system. If it is not included in its office system, it is almost certainly included at the ISP or cloud provider level.

This system is installed by telecom providers owned or controlled by the PRC government. Once again, it is the hacker — the Chinese government — setting up the system and it is the hacker that enters company network systems through these back doors.

 

3. Use of PRC mandated antivirus software. One of the core directives under the new PRC Cybersecurity Law regime is the requirement that networked users use antivirus software provided by the PRC government. Think about this for a minute: the Chinese government requires companies use only the “antivirus” software it provides. This antivirus software both provides a convenient platform for Chinese government hackers to enter the user’s computer network but it also no doubt is programmed to not reveal Chinese government malware.

The risks in hacked antivirus software are well known in cybersecurity circles. In Former U.S. spies say antivirus software makes for a perfect espionage platform, Cyberscoop discusses how antivirus software is great for espionage:

Because most antivirus vendors have designed their products to autonomously search for computer viruses on users’ systems by directly scanning files and then sending that data back to a server for analysis, the software is highly intrusive by nature.

Aside from the remote risks, antivirus can extend the attack surface of a host,” said Blake Darche, a former computer network exploitation analyst with the NSA. “If an attacker can gain access to the central antivirus server within an organizations network, that central server can be used for malware distribution.”

Software updates, which can help patch bugs or other issues in a product, adds another attack vector because it provides a trusted avenue for the remote introduction of code into computers around the world.

Chinese hackers are well acquainted with using antivirus software for this purpose. See: Research claims CCLeaner attack carried out by Chinese-linked group.

Within the PRC, use of mandated PRC antivirus software takes Chinese government hacking risks to an even higher level. Within the PRC, there is no need for a remote hack. The hacker itself (the Chinese government) provides companies with what is essentially a pre-hacked system.

This pre-hacked system has two major effects. First, the system will not screen against malware created by the PRC government. Second, the system will serve as the vector for inserting a continuous stream of malware provided by the PRC government and its partners.

Consider the parallel situation in the U.S. Imagine a scenario where the NSA and the FBI are the only vendors of antivirus software. This software might be effective at screening malware from criminals and foreign actors. But nobody would expect that software would protect users from NSA or FBI intrusion. That would be silly. It is sillier still to believe this about the PRC and its government mandated antivirus software.

4. Shift from email to WeChat. After the Chinese government banned Gmail in China, Chinese government agencies began pushing foreign companies to communicate using PRC approved email services. These services do not work well and are widely known to be insecure. Most foreign companies therefore continued to use alternative U.S. and European based email providers. These services are relatively secure from message interception by the Chinese. Proton mail and other systems with end to end encryption are quite secure in China.

The Chinese government could have taken a next step by blocking access to all foreign based email providers. But the Chinese agencies have taken a more creative approach. Now that the Chinese government has assumed essentially complete control over WeChat, Chinese agencies force all communications onto the WeChat application. If you send an email to your bank, your bank will not respond. If you send an email to your local tax office, it will not respond. If you send an email to the local police department concerning your visa status, it will not respond. The same holds true for Chinese courts, which typically respond to us simply by requesting we communicate with them using WeChat. This is even true when documents are submitted. Chinese government agencies almost invariably require submissions as a WeChat attachment rather than as an email attachment.

This then means a shift from adequate security to no security at all. This can be seen by the recent Amnesty International rating of instant messaging applications. Amnesty International rated the 11 top messaging applications on their use of encryption and protection of user privacy on a scale of 0 to 100. Facebook received the highest rating of 73. WeChat received a zero rating. In other words, Amnesty International concluded that WeChat provides literally no protection at all from hacking. None. Nada. Zero. Zilch. 没有. See FOR YOUR EYES ONLY? Ranking 11 technology companies on encryption and human rights.

This forced move to a completely insecure communication platform was done in a typical CCP way. There is no law or regulation that says foreign based email is prohibited. There is no law or regulation that says using a completely insecure WeChat is required. The “rule” is imposed in practice. If you send an email, it will not be returned. If you call or visit a government agency to complain, the response is: “Use WeChat. Everyone else does. You should too.” And so the rule is imposed, with no obligation on the part of the Chinese authorities to formalize or publish the rule.

 

Conclusion

My goal with these posts on cybersecurity in China is to describe the on the ground cybersecurity realities for foreign companies operating in China. As you have seen, the Chinese government is the hacker so it can have full access to all information about the foreign entities that operate in its midst — from critical information concerning protected technologies down to the most mundane facts about the daily activities of the foreign company and its employees. In our digitized world, that information is available on computer systems and networked communications of the foreign owned entity.

The Chinese government obtains the information it wants by using the techniques I have described. In fact, I have outlined only a subset of the various techniques it uses to gain access to information.

Of course, the Chinese government encourages foreign owned entities to protect themselves from from criminal hackers and from intrusions conducted by their non-state owned business competitors. Under the new cyber regulations, this form of self-protection is legally required for enterprises operating in critical sectors.

But the flip side to this requirement is that the Chinese government allows for no protection against its own acquisition of that same information. Attempts to block access by the Chinese government are futile. One attack vector may be blocked in one case of infection. But as a practical matter, it is not possible to defend against attacks by a PRC government that uses a full set of penetration techniques. The only question is whether the Chinese government is interested or not. If they are interested, they will succeed. There is no place to hide.

 

UPDATE: A federal grand jury in Spokane, Washington, returned an indictment charging two hackers, “both nationals and residents of the People’s Republic of China (China), with hacking into the computer systems of hundreds of victim companies, governments, non-governmental organizations, and individual dissidents, clergy, and democratic and human rights activists in the United States. . . . The hackers stole terabytes of data which comprised a sophisticated and prolific threat to U.S. networks.

This hacking program was conducted over a 10 year period and they were just recently caught. This shows how difficult it is to protect against Chinese government hacking even outside the PRC where there is actually access to the best cybersecurity tools available.

China Government hacking

In The Chinese Government is Accessing YOUR Network Through the Backdoor and There Still is NO Place to Hide, I explained how Chinese banks are requiring their account holders — including all foreign companies in China — to install malware which allows the Chinese government to see all account holder data. In China Malware: Sorry, Techno Geeks, There Still is no Place to Hide, I explained how, “in China, the government itself is the hacker and it will not allow any foreign or domestic technician to provide services that will defeat the hacker’s ultimate goals.”

In this post, the first of a two part series (part 2 will come out tomorrow), I explain the Chinese government’s hacking goals, how it does its hacking, and why it is virtually impossible for foreign companies to avoid being hacked by the Chinese government or to fight back against it.

 

A. The Chinese Government is the Hacker.

The basic goal of the PRC Comprehensive National Security (总体国家安全)concept in the network realm is for all network communication and information to be open and available to the Chinese government while blocked from access to parties outside the state. In keeping with this concept, the government seeks to ensure all network activity conducted within China is transparent to the state. This program is applied to all persons (individuals or entities) that operate within the borders of the PRC (and now Hong Kong and Macao). If you operate in China, you must assume all of your networked data and communications are subject to capture by the Chinese government. There is no longer any privileged status given to foreign invested companies or to foreign nationals; Once within the borders of the PRC, their treatment is the same as for domestic companies and Chinese nationals. Just as is true for any PRC citizen, there is no place to hide.

So how does the PRC government implement this program? The key point is that the Chinese government is the hacker. When the hacker is directly involved in creating and policing the Internet and the key agent for implementing cybersecurity, it is axiomatic there will be no protection from the network intrusion/data collection activities of that hacker. The hacker dictates how the system will work and it of course provides no protection against its own activities.

B. Aisino Corporation

This basic fact is illustrated by the Golden Spy/Golden Helper malware program discussed below. Trustwave reports that the Golden Spy software was written by Aisino Corporation: (Aerospace Information Joint Stock LLC. – 航天信息股份有限公司) Listed IT company specializing in information security. Their website states they are owned by the state company CASIC (China Aerospace Science & Industry Corporation Limited – 中国航天科工集团公司). See GoldenSpy Chapter 4: GoldenHelper Malware Embedded in Official Golden Tax Software.

CASIC is the PRC’s leading manufacturer of missiles and related aerospace devices. It sells missile systems to North Korea and it works closely with the Russian military. As a weapons provider, it is an SOE directly under the control of the PRC government and the CCP. That is, it is the government. Recently, as part of the PRC plan to promote indigenous development of network operations and cloud computing, CASIC entered into the commercial network business via Aisino, its subsidiary that had been active in payment processing and other accounting systems. Aisino’s drafting of the Golden Shield tax software and implementation of the related system is part of that process.

 

C. The Golden Spy/Golden Helper Malware

Aisino’s drafting the Golden Spy malware means the PRC government drafted this malware. Simply stated, the PRC government is the hacker and this hacker is shielded from any liability arising from its hacking activity. This is why Aisino employed a crude and easy to identify trojan horse system for this malware. It is at no risk of getting caught or getting punished or getting taken down.

Some have commented to us and to security professionals that such an obvious intrusion somehow shows the PRC government cannot be behind the malware program. ArsTechnica responded to this type of comment in clear terms:

Comment from reader: “Use of a trojan downloader is not subtle.”

Response from ArsTechnica: As for it being less subtle… malware like this isn’t subtle period by the standards you’re applying here, so that’s a bizarre argument. It’s also a bit odd that you think the Chinese government cares about subtlety when we’re talking about software that’s distributed by government mandate within their country. Like… what, are the Chinese authorities going to crack down on them?

So this is the situation in the PRC. As Arstechnica makes clear, when the malware or illicit gathering of data is done by the government itself, there is no remedy and no escape. The Chinese government and its related group of hackers do not need to be subtle or hide their tracks when they are operating within the borders of the PRC.

 

D. Part 2, Tomorrow

Tomorrow, in Part 2, I will explain how the Chinese nation-state hacker accomplishes its goals in the network sector by setting out the four basic ways the PRC government gains access to foreign company networks and company data.

 

 

China employee lawsuit

With the economic downturn and so many companies looking to reduce HR costs, our China employment lawyers have been seeing a fairly large increase in China employment litigation matters. Most of these cases involve foreign companies doing business in China and most arise from one (or more of the following):

  • Terminating an employee for a reason not explicitly mentioned in the employee’s employment contract or the employer’s Rules and Regulations or otherwise permitted under Chinese law.
  • Implementing a demotion or pay cut against an employee without complying with all applicable law.
  • Not paying overtime.
  • Terminating an employee who did not have a written contract.
  • Discontinuing a relationship with someone whom the employer never considered to be an employee.
  • Terminating an employee for whom the employer did not make required social insurance payments.

As bad as all this sounds, our law firm’s experience with threatened and real employee lawsuits has, almost without exception, revealed the following:

  • Oftentimes, those foreign companies being sued or threatened with legal action did actually fail to comply with the national or local employment laws. This is a good thing in that it implicitly means companies that fully comply with China’s employment laws are far less likely to get sued.
  • With the above said, we have seen many instances where China employees will bring a labor arbitration claim no matter how weak their claims because they view arbitration as a bargaining tactic, as they know the arbitrator will likely ask the parties to settle before formal arbitration begins. Normally if the foreign employer has done nothing wrong, it should not give in to the employee’s demands or even settle with the employee just because it got sued. In our experience, the employer that is not at fault and has good evidence (such as having a well-written, signed contract that supports the company’s position) usually can prevail even if the employee does follow through with legal action.
  • Nonetheless, if the foreign company was in the wrong, it makes sense to try to settle these lawsuits fast. The last thing you want to do is to drag the employee through the courts in a case where the company was clearly at fault, leaving a bunch of public records showing all sorts of wrongdoing on the company’s part. It will hurt the company’s reputation and result in low workplace morale, in addition to the time and money cost by the lawsuits and an eventual bad verdict.

The takeaways from all this are that even in these hard economic times it still pays to comply with all applicable employment laws and, if you are sued, it pays to act quickly to settle. Settling quickly usually not only makes economic sense for the lawsuit before you, but it usually also makes sense to help keep your company in good graces with the Chinese government. See China’s New Company Tracking System: Comply, Comply, Comply.

We predict that employment cases in China will continue to rise as foreign companies that are hurting due to the pandemic continue to adopt HR measures that could be considered to be adverse to their employees. Your best “defense” is to take China’s national and local employment laws very seriously.