I. OVERVIEW

The good news is that China’s entire civil litigation system has significantly improved, not just its patent enforcement system. Contracts are fairly and effectively enforced between foreign and Chinese parties. This means that if the contract is breached, a foreign company can get monetary damages and/or injunctive relief from a Chinese court so long as a foreign company: (1) executes a valid contract with a Chinese company, (2) that contract is sufficiently straightforward that a Chinese court can make a ruling of fact without significant investigation, and (3) the contract is not subject to China’s Technology Import Export Regulation (“TIER”), or the foreign company builds in a business advantage to incentivize the Chinese company not to escape the contract via TIER.

This post addresses TIER and some ways to possibly deal with it, best practices for forming JVs with Chinese companies, and how to protect core and non-core IP in China.

II. CHINA’S TECHNOLOGY IMPORT EXPORT REGULATION (TIER)

A. TIER Restrictions

Licensing is the primary means by which technology flows into markets and it may also set the stage for joint additional advances. The challenge to parties negotiating a licensing agreement is to find terms that are mutually beneficial, so that agreement is in the interest of both sides. Especially in the context of high technology, and associated intellectual property, it is critical that the parties have great flexibility in arriving at mutually beneficial terms as the market and circumstances demand.

Unfortunately, TIER imposes rigidities as they relate to certain key terms, making it more difficult for the parties to reach agreement. The Chinese government, via the Ministry of Commerce (Mofcom) has mandated certain conditions be a part of any license of technology into China, regardless of whether those terms are in the parties’ contract, or even if these terms are specifically contradicted by contract. TIER mandates that foreign licensors fully indemnify Chinese licensees, surrender ownership to any improvements, and not prohibit marketing rights of Chinese licensees.

The first potential problem with TIER pertains to indemnity terms, which govern which party should bear the burden if the licensee’s right to the licensed technology is challenged by a third party. Given the wide variety of circumstances, there is no single best approach to indemnity terms, which should be left to the parties to address in a mutually beneficial manner. TIER, however, inflexibly imposes all indemnity risks on the foreign licensor.

Interestingly, many open source licenses are incompatible with TIER because they mandate that no indemnity is provided. For example, most open source licenses do not provide any warranties of non-infringement or any provisions for indemnification and some licenses specifically disclaim any warranty or indemnification. This obviously contradicts TIER and requires a violation of either the open source license or TIER. As use of open source-licensed code grows in China, this will be an important issue. Although TIER does not have a strong record of enforcement, open source licenses do. Indeed, the penalties for violation of such license terms can be draconian, including enjoining distribution and use of the software, as well as damages and attorneys’ fees.

The second potential problem with TIER pertains to rights in technology improvements developed by the licensee. A licensor will often desire to have shared rights in improvements, in exchange for giving the licensee more favorable terms, such as by lowering any royalty payment. A licensor unable to share in improvements developed by the licensee risks being locked out by the new development, and so it may conclude that it cannot reach a deal with a Chinese partner due to the great uncertainty created by TIER. Absent the flexibility to negotiate shared access to improvements, a technology licensor may choose to avoid China completely, or to deal with an affiliated company that it can trust. Again, many open source licenses require any derivative works, including improvements, to be freely available to the public, so that the parties must violate either the open source license or TIER.

The third concern pertains to licensing parties’ allocation of marketing rights. The business-driven bargaining in a licensing transaction often involves allocating market rights between a licensor and a licensee. For example, a given technology transaction may give a Chinese company the exclusive marketing rights in China and a U.S. company the exclusive marketing rights in North America. However, TIER prohibits licensing agreements that “unreasonably restrict[s] the export channels” of the licensee. Under this TIER provision the licensing parties cannot freely negotiate allocation of market rights according to their business needs and proposed level of license fees. Absent the flexibility to allocate marketing rights, a foreign licensor and a Chinese licensee may have to forgo their licensing partnership despite interest by both.

B. Ways of Managing TIER Restrictions

There are very few cases in China in which TIER has been asserted by China or Chinese companies to void specific provisions of a contract. Although this is good news, it is still not all that comforting to foreign businesses forced to accept uncertainty in licensing technology into China. There are a few ways of managing the potential dangers of TIER.

First, it is clear that if a Chinese company voids important contract provisions using TIER, then that company will have significant problems ever working with a foreign company again. Foreign licensors, and foreign partners in general, will no longer trust such a Chinese entity to abide by its word. Such a consequence would be, therefore, bad for the Chinese entity as well as the foreign entity. Presumably, a Chinese company would only void the contract provisions via TIER in an instance where the value of doing so is very high – higher than the loss of future ability to work with foreign companies. Therefore, it may be possible to avoid such a case by providing business incentives (such as additional revenue, equity, or geographic share) to the Chinese partner in the event that the deal leads to great commercial success.

A foreign company may also be able to protect itself by simply writing the TIER restrictions into the contract and valuing them properly. Alternatively, the licensor could simply accept the risk of TIER and go along with the contract as if TIER were not a factor. There are also other means of possible protection (in addition to the general “best practices” mentioned in the next section. For example, instead of licensing to a company in China, it may be possible to license to a Chinese company outside the PRC. The foreign entity could provide a written contract provision prohibiting import of the technology into China, but with the unwritten understanding that the licensor will not object to such import so long as the licensee does not attempt to exploit TIER to change the contract. While this is not exactly fair for the Chinese company, neither is TIER, and it shifts the uncertainty from the licensee to the licensor. While not a perfect solution, it does reallocate the trust issue to the Chinese side.  

Another option (at least for technology involving open source licensed technology) would be to contract to terms violating TIER, and then if anything goes wrong, seek to have the Free Software Foundation sue the Chinese company for violation of the open source license. This would be risky, and would require a very close relationship with the FSF and open source community. There are other possible creative solutions involving the foreign licensor using its own Chinese-owned subsidiary as the contracting party, or insisting that the licensee be a non-Chinese entity. The problem with all of these is that they have not been tested, because TIER itself has not been effectively tested. As with most business deals, it depends on the amount of risk that is tolerable to both sides.

III. BEST PRACTICES ON JOINT VENTURES/TECHNOLOGY LICENSING WITH CHINESE COMPANIES

While there is no guarantee that any contract will not be violated, there are many things that a foreign licensor can do to maximize its chances of making itself whole in the event that the contract is breached. Courts, judges, and arbitrators in China are getting more sophisticated each day. Also, such forums are generally quite fair and effective in enforcing foreign parties’ rights in China. However, the more complex the issue, the less clear the outcome and the slower the process. Therefore, several best practices should be followed in addition to general best practices regarding technology licensing outside of China.

A. Make the contract simple: define breach and liquidated damages

Although courts in China are more sophisticated than ever, they are burdened with a huge number of cases. They also are more reticent to give injunctive relief of large damages if they are not sure they are correct in their judgment. Therefore, make it easy for them: make the contract simple. Define specifically what constitutes a breach and what the penalty should be. Liquidated damages are a must. Make it so that all the aggrieved party has to show is: (1) there is a contract, (2) the contract was breached, and (3) the parties agreed at the outset what the penalty for such a breach would be. This should lead to a very fast and effective judgment.

B. Define “Confidential Information” (“CI”) clearly and put the onus on the licensee to show that information is not Confidential Information

Courts in the US get bogged down in determining what is CI under contracts. Chinese courts have the same problem. A solution to keeping up with what falls under CI is to make every bit of information provided to the Chinese partner fall under the definition. The contract should provide that all information is assumed to be CI, unless the Chinese party objects in writing within a specific period, say two weeks from receipt. There should be a provision for determining disputes quickly, including destruction of any material or information provided to the licensor that cannot be agreed as to confidential nature. Then, the licensor should provide a regular report to the licensee listing the information that it has sent the licensor and that it has received from the licensee as not constituting CI. Such a process would allow a judge of any dispute to quickly determine what was CI and provide quick redress.

C. Choices of venue and law and right to enforce judgment in China

Although the courts and arbitrators in China can now generally be trusted, if the licensee is particularly well connected, it may make sense to dictate that the choices of law and venue be in the licensor’s jurisdiction with the right to enforce any resulting judgment or adjudication in China.

D. Get a full list of officers, executives, and principals

The licensor should obtain a notarized list of officers, executives, and principals, with photos. The guards against the possibility that licensor’s CI and IP could end up in another company headed or run by the principals of the licensee. Depending on the size of the licensee and its reputation, it is very possible for the licensee to close down, move, and start up again under a new company name. Proving that this has happened will be much easier if the licensor has a list of those holding power at the original licensee. It is probably also worthwhile to get a list of lead engineers on the project.

E. Have in-document translations of each section

The contract may be in either English or Chinese, whichever the parties prefer. It is important to have in-document translations of each section. This allows for easier negotiation and for easier adjudication. One language should be controlling (likely the language corresponding to choice of venue). It may be helpful to get a notarized official translation of each section. This is not required, but for large deals is likely worth it.

F. Lay a trap

Foreign licensors of software may want to lay a trap by including in comments to the code or elsewhere specific information linking the code to the licensor. For example, add the abbreviation for the company as a note hidden multiple times throughout the code. This way, in case the licensee ever tries to argue that the code is theirs, they will have a hard time explaining why links to the licensor are there.

IV. TOP IP ISSUES WHEN FORMING A JOINT VENTURE IN CHINA

A. Keep control

One key to protecting IP in any deal with a Chinese partner is to make sure that the foreign entity will control the JV. Since most foreign investors wish to maintain control over their Chinese JV entity, this issue is usually paramount. Most foreign investors strive to obtain at least 51% ownership interest in the equity JV, assuming this gives them the right to control the company. However, control over a Chinese JV actually comes from the following:

  • The power to appoint and remove the JV’s Legal Representative.
  • The power to appoint and remove the General Manager of the JV company. The JV agreement must make clear that the General Manager is an employee of the JV company employed at the full discretion of the Legal Representative. Note that this agreement will be enforced under Chinese law and its controlling version should therefore be in Chinese.
  • Control over the company seal, or “chop.” The JV partner that controls the JV’s registered company seal has the power to make binding contracts on behalf of the JV company and to deal with the JV company’s banks and other key service providers.

B. Safeguard intellectual property the traditional way

Multinational companies still struggle to protect their intellectual property in China, and JVs are particularly vulnerable. Companies have traditionally had some success with more pragmatic, operational efforts, including the following:

  • Bringing only older technology. This approach works for products that may have been available in developed markets for some time but are still competitive in China’s market. It also works in industries where innovation cycles are short.
  • Leaving the specs at home. Multinationals can protect their IP by delivering equipment or technology ready to be installed, without detailed design specifications.
  • Avoid parts of the business having important IP in creating the JV. It may be possible to limit the JV to parts of the value chain that involve limited intellectual property, like mechanical parts of the process.
  • Assume the IP will be stolen, so make the Chinese company pay for the IP up-front. A company may just want to sell their intellectual property to the JV, either through up-front cash payments or licensing fees..

C. Improved and New Intellectual Property

In the growth and development of a JV, new IP will come about, and these will be regarded as belonging to the JV. Therefore, it is also up to the JV to assign it or to apply for protection. If the foreign investor only holds a minority stake in the JV, then s/he may find themselves in a weak position regarding control over new IPRs. It is recommended to deal with these matters in the JV agreement before they become problems. *Note the prior discussion of TIER in this regard.

D.  License/Royalty Fees

Licensing or royalty fees from the transfer of IP in a JV deserves close attention. In China, royalties are subject to income withholding tax and business tax. Also, in some sectors, the royalty rate may have a ceiling, such as a 0.3% royalty rate ceiling of sales revenue in the retail sector for the use of a trademark.

E. Getting the money out of China and paying taxes

Transferring money out of China has always been a challenge and is only getting harder. See, e.g., https://www.nytimes.com/2016/11/29/business/economy/china-tightens-controls-on-overseas-use-of-its-currency.html. Make sure to have a plan to transfer any revenue out of China, or keep it there, and know what taxes will be applied.