Chinese civilization has a long history of innovation and creativity. However, due to a variety of historical reasons, China began developing and reforming its intellectual property (IP) rights protection system at a comparatively late date. Today, as manufacturing is becoming more concentrated in China, so too has IP rights infringement. According to the U.S. government, U.S. companies lose more than $1 billion each year to piracy alone. Other forms of IP infringement, such as the illegal inclusion of U.S. proprietary technology in Chinese goods, are equally, if not more, damaging. Therefore, IP protection is pivotal to successfully doing business in China.
In order to best protect the IP rights of a U.S. company seeking to produce goods through a Chinese manufacturer by providing a protected design, the U.S. company needs to take actions even before the contracting stages. The client should first identify the types of IP rights that may be involved in the project because, like the United States, China classifies IP rights according to the type of IP. For example, utility patents may protect a product’s structures, functions, and/or manufacturing process; design patents protect a product’s appearance; trade secrets protect technical know-how; and copyrights protect written materials.
Following identification of the different IP rights potentially at risk, the U.S. company should further ascertain whether appropriate registrations of certain IP rights have been sought in China and, if not, whether it shall pursue such registrations. Companies must register their patents and trademarks for those rights to be enforceable. However, copyright registration is optional, although it may buttress a U.S. company’s claim that it held title to the copyright in the event of a dispute.
Specifically, in the case of trademarks, it is advisable to seek trademark registrations in advance, as China employs a first-to-file system, under which it is likely that the first company to file the trademark application would be entitled to protection even though it may not be the first company to develop or use the registered trademark. As for product designs, it is also advisable to consider seeking utility patent and/or design patent registrations because, although it is possible to enforce trade secrets in China under Article 10 of the Anti-Unfair Competition Law, it could be difficult to do so in practice. The better alternative would be to seek protection under the Patent Law.
Such preparation work will better position the U.S. company in the negotiation with the Chinese manufacturers and may also prevent disputes from arising in the first place.
It is critical that before sharing any confidential information with its partner in China, the U.S. company should enter into a confidentiality agreement obligating the Chinese party to keep such information confidential and restricting the Chinese party’s usage of this information. The confidentiality agreement may need to be revisited and revised from time to time in accordance with the progress of the project. For example, in the initial discussion, the confidentiality agreement may only cover some general information disclosed to the Chinese party for evaluation purposes. When both parties enter into a formal business relationship, a separate confidentiality agreement may be required to cover the detailed technical know-how to be shared with the Chinese party for the purpose of manufacturing.
In manufacturing activities, the most important IP agreement is probably a licensing agreement that clearly defines ownership of the various IP rights, scope of the license, and royalty scheme, among other items. The ownership prong should encompass both existing and newly developed IP. The scope of the license also should encompass the term, territory, and exclusivity of the license. Finally, in the royalty scheme, the U.S. company should consider first the royalty rate and second whether a minimum royalty payment is required.
The U.S. company also should bear in mind that in certain circumstances, other alternatives to licensing may be beneficial. For example, when creating a joint venture (JV), which remains a fairly popular way to manufacture goods in China, the U.S. company may consider injecting its existing IP rights into the JV. Although this may dilute the U.S. company’s control over the IP rights, it will minimize the U.S. company’s capital investment, although valuation of such contributed IP rights is complex and lengthy, and ultimately most foreign JV partners end up structuring a license agreement from the affiliate owner of the IP rights to the Chinese JV. In any circumstance, the U.S. company should be aware that in a JV scheme, the newly developed IP by the JV will likely belong to the JV itself such that the U.S. company may be restricted from using the newly developed IP. This is in addition to the normal risks of unauthorized disclosure or use of IP rights to commercialize such rights outside of the confines of the JV itself and to the sole financial benefit of the Chinese JV partner or some other affiliated company.
Furthermore, the U.S. company should be aware that it will have diminished control over the existing IP that it has contributed or licensed to the JV. Thus, the risk of misappropriation of such IP becomes more significant. Actually, so long as the U.S. company has little control over the manufacturing process, such a risk also exists in most other possible schemes to manufacture in China, which are discussed below.
The second scheme involves a supplier relationship (e.g., a “factory-in-factory” arrangement) between the U.S. company and Chinese company. This arrangement may provide the U.S. company with tight control over its technologies if the U.S. company chooses to run operations on its own. However, the downside is that such an arrangement requires heavy investment on behalf of the U.S. company. The third scheme involves setting up a licensing and royalty arrangement. Doing so may give the U.S. company the option to work with other Chinese vendors if a non-exclusive license is entered. On the other hand, the U.S. company should closely audit the relevant sales and productions to ensure its royalties. Finally, a U.S. company has the option to engage in contract manufacturing. From the IP point of view, however, this scheme could be the most risky because little stands in the way of misappropriating IP, especially if proper patent registrations are not sought in China.
In recent years, China has enacted IP laws and has attempted to abide by international regulations. However, poor enforcement and cultural differences often frustrate the efforts of U.S. companies to enforce their IP rights in China. Thus, it is crucial for the U.S. company to make IP protection a core objective of the entire business endeavor. Specifically, the U.S. company needs to closely monitor the market to ascertain any possible infringement of its IP rights or violation of the manufacturing arrangement. Alternative forms of protection, such as technical controls, should also be explored. No one method of protection in China is perfect, but by using custom tailored strategies, it is possible to minimize the risk of IP loss.