With the continued push for reform in China and greater emphasis on protection of intellectual property, Chinese technologies and brands are growing in scale and recognition globally. As a result, foreign enterprises are starting to look at acquiring Chinese businesses to further establish its foundations or discover new ways to work together that fit their needs. Given the strong local element in intellectual property, its key differences from tangible property and the uncertainties in appraising its value, this chapter will provide a short overview of important intellectual property issues in China that foreign enterprises should be aware of and plan for in a merger with a Chinese company.
Intellectual property law and regulations and the competent regulatory authorities in China
Structure of intellectual property law
Intellectual property law in China is comprised of the basic laws, laws that specifically govern a type of intellectual property, and other laws.
The intellectual property provisions in basic law
Of the basic laws drafted by the National People’s Congress, the following contain provisions dealing with intellectual property:
- the General Provisions of the Civil Law of the People’s Republic of China (the Civil Law General Provisions);
- the Contract Law of the People’s Republic of China (the Contract Law); and
- the Criminal Law of the People’s Republic of China (the Criminal Law).
According to the Civil Law General Provisions, a civil subject is entitled to intellectual property rights, defined as rights over works, inventions, utility models, designs, trademarks, geographic marks, trade secrets, integrated circuit-layout design, new plant species and other objects designated by laws.2
The Contract Law has provisions stipulating the rights and obligations of the parties in technology ‘transfer, development, consultation or services’ agreements.3
The Criminal Law imposes criminal liability for serious intellectual property rights infringement. This primarily covers counterfeiting registered trademarks; selling merchandise bearing counterfeit registered trademarks; unlawful production and sales of others’ registered trademarks or identifications; counterfeiting patents; copyright infringement; sales of infringing copies of goods; and infringement of trade secrets. The penalties range from fines up to a seven-year prison sentence.4
Specific intellectual property laws
The current specific laws are the Patent Law of the People’s Republic of China (the Patent Law), the Copyright Law of the People’s Republic of China (the Copyright Law) and the Trademark Law of the People’s Republic of China (the Trademark Law)
The Patent Law
This is a specific law designed to protect inventions. The three types of inventions protected are inventions, utility models and designs. Invention patents have a term of 20 years, while utility model and design patents have a term of 10 years, all starting from the date of application.5
Inventions that are novel, inventive and useful may apply for an invention patent or a utility model patent, but invention patents have a higher inventive threshold compared to utility model patents, with a requirement of being ‘outstanding substantive special features as well as demonstrating a clear improvement’, while utility model patents only require ‘substantive special features and improvement’. Design patents are primarily provided for designs that are clearly distinguishable from current designs.6
In addition to the Patent Law, the State Council of the People’s Republic of China has also promulgated the Patent Law Enforcement Rules.
The Copyright Law
Works authored by a Chinese citizen, legal person or other organisation are protected by copyright under the Copyright Law regardless of whether such works are published. Works by foreign entities may be protected by copyright pursuant to the international treaties that the foreign country and China have entered into, such as the Berne Convention. The Copyright Law protects written works, oral works, music, drama, buildings, photography, etc; the right to publish, the right of authorship and the right to revise such works; as well as the right of integrity, right to reproduce, right to distribute, right to rent, right to exhibit and the right to disseminate such works via information network.7
For the duration of copyright, the right of authorship, the right to revise the works and the right of integrity of the work is permanent. For all other rights, if the author is an individual, the term is the life of the author plus 50 years after his or her death. If the author is a legal person or other organisation, the term shall be 50 years after the first publication of such works.8
In addition to the Copyright Law, the State Council has also promulgated other laws and regulations such as the Copyright Law Enforcement Rules, the Provisions on the Protection of Computer Software and the Provisions on the Protection of the Right of Transmission over Information Networks so as to provide more detailed rules on copyright.
The Trademark Law
Under the Trademark Law, natural persons, legal persons and other entities may apply to the Trademark Office of the National Intellectual Property Administration (the Trademark Office) for registration of a trademark if they need to obtain the exclusive right to use the mark on their products or services. The types of trademarks that may be registered include product trademarks, service marks, collective marks and certification marks. Any label that can distinguish the applicant’s products from the products of others, including wording, images, letters, numbers, 3D logos, colour combinations and sounds, may be applied for registration as a trademark. A registered trademark is valid for 10 years starting from the date the registration is approved. It may be renewed for another 10 years if the applicant completes the renewal procedure within 12 months of the expiry of the term.9 Other related trademark law includes the State Council’s Trademark Law Implementation Rules.
In addition to the aforementioned three laws for patents, copyrights and trademarks, there are also other laws for specific intellectual property-related fields such as the Anti-Unfair Competition Law of the People’s Republic of China (the Anti-Unfair Competition Law), the Provisions on Prohibiting the Infringement of Trade Secrets, the Provisions on the Protection of New Plant Species, the Provisions on the Management of Special Marks, the Provisions on the Protection of Integrated Circuit-Layout Design, and the Provisions on the Protection of Geographic Indication Products.
Other intellectual property related rules
In China’s legal system, the Supreme People’s Court may also issue supplemental interpretations regarding the aforementioned laws. For example, with respect to the Patent Law, the Supreme People’s Court has issued Several Provisions of the Supreme People’s Court on Issues Concerning Application of Law in Trying Cases Involving Patent Disputes and Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of Law in the Trial of Patent Infringement Dispute Cases, among others. For the Trademark Law, there is Interpretation of the Supreme People’s Court on Issues concerning the Jurisdiction over Trademark Cases and Application of Law after the Implementation of the Decision on Amending the Trademark Law.
Rules regarding the security review for intellectual property transfers in the acquisition of a Chinese company by a foreign enterprise
According to the Notice on the Establishment of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, if foreign investors are looking to get involved in a military industry, national defence, key agricultural product, key energy source, key infrastructure, key facilities and other important domestic entities that would cause the foreign investor to gain substantive control of the domestic entities, the Ministry of Commerce and the National Development and Reform Commission as well as other relevant authorities shall conduct a merger security review.10 In 2018, the State Council also promulgated the Working Measures for Outbound Transfer of Intellectual Property Rights (for Trial Implementation), which require the authorities who are conducting the security review for a foreign investor’s purchase of a domestic company to ask the relevant competent authority (depending on the type of intellectual property involved) for opinions for all intellectual property that will be transferred overseas with the proposed transaction.11 As such, a foreign investor’s purchase of a Chinese company involving the aforesaid business activities may be required to undergo a security review assessment conducted by the Ministry of Commerce, the National Development and Reform Commission and other intellectual property-related competent authorities, the scope of which will include but is not limited to the intellectual property to be transferred outside of China.
Even if no safety review is involved, if technology or know-how is to be transferred inbound or outbound via commerce, investment or economic cooperation (including a patent right transfer, a transfer of patent application rights, licence for practising a patent, transfer of technological secrets, technology service or other form of technology transfer), the Regulations of the People’s Republic of China on the Administration of Import and Export of Technologies (the Technology Import and Export Regulations) stipulate different control mechanisms depending on whether the technology involved may be freely imported or exported abroad or is restricted from doing so. For example, the transfer of technology that may be freely exported and imported will only require a recordation after the fact.12
Supervisory authorities for intellectual property rights
If it is necessary to check on the validity of a piece of intellectual property in the course of a merger, or proceed with the transfer of an intellectual property right, the appropriate intellectual property rights supervisory authority shall be consulted depending on the type of intellectual property involved.
The National Intellectual Property Administration and the regional intellectual property offices13 are primarily responsible for the acceptance, examination, application and protection of trademarks, patents, geographic labelling of place-of-origin and integrated circuit-layout design. The registration of trademarks shall be made directly to the Trademark Office, while patent applications are made to the Patent Office of the National Intellectual Property Administration (the Patent Office). Applications for integrated circuit-layout design and place-of-origin geographic labels are made directly to the National Intellectual Property Administration. The National Copyright Administration14 and the regional copyright offices are responsible for the registration and protection of copyright. Authors who wish to offset the risk of infringement may register his or her works with the National Copyright Administration or the local offices. The State Administration for Market Regulation15 and the local market supervisory offices are responsible for administration of unfair competition, infringement of intellectual property such as patents and trademarks, as well as the manufacturing and sales of counterfeit goods.
Intellectual property issues in the course of a merger
Issues to be aware of for patents involved in a merger
Validity of the patents
It is important to confirm the validity of the patents. For invention patents, an investor needs to determine whether the inventions have been granted patents. For utility model patents and design patents, the investor needs to determine whether they have passed preliminary examination or whether they have completed the substantive examination. Further, the investor needs to take the effort to remain fully apprised of whether any patents have been declared as invalid.
The validity of the patents of the target company should be confirmed before the consummation of the transaction.
In China, the grant of an invention patent requires a substantive examination by the Patent Office, which greatly increases its validity, but utility model patents and design patents only undergo preliminary examination. Nevertheless, the applicant may request the Patent Office to conduct a more in-depth examination for those patents and issue a patent assessment report. This patent assessment report will be needed in practice later on in the routine protection and maintenance of intellectual property rights, or in defending against an invalidity claim from another party. As such, if it is discovered at the commencement of the merger process that the target company has utility model patents or design patents that have passed preliminary examination but not substantive examination, further analysis may be required to determine whether those patents are valid, given the impact such determination may have on the valuation of the target company or even the conditions precedent of the transaction.
It is also necessary to continue to monitor for patent invalidation petitions to the patent re-examination committee, so as to keep abreast of new developments and to assess the stability of the patent portfolio.
Confirm the actual patentees of the target company’s patents. This means determining whether the underlying inventions were developed as part of employment, in cooperation with another, or entrusted by another.
For inventions that were developed as part of employment, it is recognised that the invention was created by a natural person, and the natural person’s employer business unit is considered as a patentee only because of a legal construct. Hence, inventions developed out of employment are defined in the Patent Law as inventions that were created: (i) while performing the business unit’s instructions; or (ii) primarily through the use of the unit’s resources.16 The right to submit a patent application for the invention belongs to the business unit, and the business unit becomes the patentee's upon approval of the application. However, for patents under (ii) where the inventor or designer has an agreement with the business unit regarding patent application and patentees rights, the agreement prevails. As such, it is important that not only should information regarding the patentees be examined during the due diligence process, but whether the target company had agreements regarding inventions with its employees must also be determined. Sufficient evidence showing that the target company employee’s invention is considered an invention developed out of employment would help to prevent potential disputes from the departing employee in the future regarding the ownership of the patents in question.
For inventions developed in cooperation, according to the Contract Law and the Patent Law,17 co-owners of a patent for an invention developed in cooperation may practise the patent royalty-free, so it is necessary to verify during due diligence which of the target company’s patents are co-owned. Any agreements regarding the practice and transfer of the patent between the co-owners will directly affect the post-merger entity’s strength of intellectual property ownership and related business strategies.
For entrusted inventions, many businesses receive supporting funds from multiple sources in the course of the patent R&D,18 and those contributors may be considered as entrusted entities under the Contract Law, which means they may practise the patent royalty-free and have right of first refusal in patent transfers under equal terms. As a result, a search into the target company’s funding sources shall be conducted and agency/entrust agreements shall be carefully reviewed during the due diligence process to prevent defects in the acquired patents from causing legal issues later on.
Confirm whether the transaction would trigger any prohibitory clauses in the licensing agreements for patents that the target company was granted a licence to use
In practice, the target company may have entered into patent licensing agreements that prohibit the disclosure of the technology underlying the licensed patents to a third party. There may even be a clause in the agreement that would immediately terminate the patent licence if the target company (as the licensee) has been acquired by another entity, which could potentially render the entire transaction meaningless. It is thus important for the foreign investor to have investigated this issue early on in the transaction process and review the relevant licence agreements to prevent having to spend extra time and resources later on.
Expected valuation of patents
It is important to investigate whether the underlying technologies are needed by the investor, and to determine whether the scope of the patent could effectively prevent use of such technology by competitors.
The valuation of patents is often one of the most important parts of an acquisition. Whether the underlying technologies of the intended target company are needed by the potential investor, which patents have better market prospects or can more effectively prevent use by competitors will be different for each case. Therefore, a patent valuation expert is often retained to provide such analysis.
As mentioned above, because utility model patents and design patents may only have passed preliminary examination without undergoing substantive examination,19 this means the investor will need to assess the validity and the valuation impact of those patents. The aforementioned patent assessment report is not defined as an administrative ruling, so the party receiving the report cannot request an administrative re-examination or initiate administrative litigation on the basis of the report alone. The investor is therefore advised to make a decision on whether to apply for a substantive examination and a patent assessment report of the utility model/design patents of the target company from the Patent Office, as well as the timing for such applications, after having comprehensively considered a number of factors, such as the importance of those patents to the transaction, the effect of the relevant intellectual property strategies employed by the target company so far, patent planning, the requirements for patents protection, the time needed for the applications and the costs involved.
From another perspective, if a target company’s patent is a key part of its competitive strength, then it is usually possible to find external documents or reports on that patent. Similarly, if a target company’s patent has considerable market influence, there is a greater likelihood that provisions about its use or non-disclosure may be found in the target company’s upstream and downstream agreements. All such information may be useful in determining the market valuation of those patents.
Issues to be aware of for trademarks involved in a merger
Verify the validity of the trademarks and monitor their status
Given that trademarks may be objected to, revoked, invalidated and require to be renewed, it is important to monitor the current status of the trademarks and confirm whether the target company’s trademarks are facing any objections or revocation actions, as well as conduct an analysis on the possibility of the relevant trademarks being objected, revoked or invalidated.
Investigate and ask the target company whether competitors have registered similar trademarks and have started using them
In China judicial practice, an applicant often believes it can rest on its laurels after it has completed the registration of a trademark for goods or services, while remaining oblivious to competitors registering and using very similar marks for products or services in identical or similar trademark classes. It is thus important to timely raise an objection with the Trademark Office or request the trademark re-examination committee to invalidate those marks to prevent competitors from free-riding on the target company’s trademarks.
Determine whether the marks may be considered well-known in China, which may entitle such marks to cross-class protection later on
According to the Trademark Law, a registered well-known mark may have its coverage scope expanded to different or dissimilar products, while a well-known mark that is not registered only covers identical or similar products.20 A mark is recognised as well-known on a case-by-case basis by the competent administrative authority for trademarks, the market supervisory authority or the people’s court.21 Although a business operator in China is no longer allowed to affix wording such as ‘well-known mark’ or use such status for advertisement, exhibition or other commercial activities, past judicial cases have shown a tendency for marks that have been recognised as well-known to receive more support from the legal authorities in the rights protection process, compared to other ordinary registered marks.
Determine whether the target company has appropriately used its trademarks and took measures to avoid such marks from becoming generic
The Trademark Law stipulates that if the entity that registered the trademark has improperly used the mark, such as unilaterally revising the mark, the name of the registrant and other registered matters, the market supervisory authority may order rectification of such inconsistencies within a certain period of time, and a failure to do so may result in the revocation of the mark by the Trademark Office. Other inappropriate use of the mark may also cause the mark to lose its distinctiveness. As a result, the more well-known marks of a target company should be reviewed for how they are used, and rules should be prescribed regarding their usage. For example, promotional materials should note that the mark is not the name of the product but is its trademark so as to prevent suppliers of the same type of products or consumers at large to commonly refer to similar products by the mark, which would ultimately cause the Trademark Office to deem such mark as having become generic.22
Issues to be aware of for copyrights involved in a merger
Investigate the right holders of the target company’s copyrights, determine whether the necessary copyright registration was timely completed, and review whether the works are considered the target company’s work-for-hire
Unlike the patents and trademarks above, under the Copyright Law,23 a work is copyrighted as soon as it is complete regardless of whether it is published or registered. Registration is not required for the author to obtain copyright over the work. However, if the work will be widely licensed for use, then a timely completion of the registration procedure would be beneficial for the subsequent licensing and copyright protection. As such, an investor should consider finding out during due diligence whether the target company has applied for registration of its works with the state or regional copyright office.
Copyright is also similar to patent in that a distinction is made between works-for-hire and works or inventions made outside the course of employment. The difference between copyright and patent is that if the employee performs his or her duties for the company, but did not use the company’s materials and know-how, the copyright of the work belongs to the author exclusively, while the company has a priority right of use within the scope of business, a two-year right to allow the author to license a third party to use the work, as well as pro rata royalties for licensing the third party’s use.24 There have been a large number of disputes in practice over the authorship of works, so it is very important to audit and determine the target company’s key works-for-hire and agreements relating to such works-for-hire so as to assess the likelihood of authorship disputes over such works in the future.
Investigate how the works are being licensed and confirm the legality and completeness of such licensing
Under certain circumstances, copyright provides certain particular rights to neighbouring right holders as well. This is seen in the Copyright Law’s provisions on special rights for performers with respect to a performance, producer with respect to their created audiovisual works, broadcast entities with respect to their broadcasted signals and publishers with respect to their layout design.25 As such, for right holders of works in different fields, the way such rights are exercised and the relevant neighbouring right holder issues have generally already become settled in complete and fixed business models. It is therefore important to investigate such business models, and if a defect or risk of breach is discovered during due diligence, it should be pointed out early on during the transaction so that it may be rectified and a mature, complete industrial operation model is established.
For a transaction of copyright in software, the purchase agreement needs to stipulate terms regarding the handover of the source code
Copyright in software has become a key asset for certain companies in recent years, but unlike conventional copyrighted works, the transfer of ownership for such works is done through a handover of the source code; receiving only the software itself merely constitutes being granted a licence to use instead of a transfer of ownership. As a result, in drafting the purchase agreement, there must be stipulations regarding the handover of the source code so that the right holder may use the source code as a foundation for further commercial use.
Issues to be aware of for trade secrets involved in a merger
Determine the coverage scope of the target company’s trade secrets and verify that they do indeed cover commercial information that is not known by the public and possesses commercial value
According to the Anti-Unfair Competition Law, trade secrets are defined as commercial information, such as know-how and business operations information, that is not known by the public, possesses economic value and is protected by secrecy measures implemented by the right holder.26 During due diligence, it is important to evaluate the actual scope of confidentiality of the target company so that during the rights maintenance procedures in the future, it is possible to assert with a strong basis that certain information is a trade secret and provides such information with the protection afforded to trade secrets.
Audit whether the target company has taken reasonable, substantive and effective confidentiality measures for its trade secrets
In examining the confidentiality measures taken by a business for its trade secrets, the courts in China will look at how the information is carried and stored, the right holder’s intent in keeping such information secret, the degree that the confidentiality measures taken can be recognised, the difficulty outsiders face in obtaining such information legally, among other factors. In conducting due diligence, the following may be audited:
- Did the target company take measures to limit knowledge of the confidential information, and are only need-to-know personnel informed of the contents?
- Did the target company take security measures to protect such information, such as keeping it locked away, or using passwords or other codes?
- Did the target company mark the form of media that the information appears in to denote it as ‘confidential’?
- Did the target company enter into confidentiality agreements?
- Did the target company require confidentiality measures to limit visitor access to the machines, server room, workspace, etc, or request non-disclosure?
- What other reasonable measures did the target company take in protecting the secrecy of the information?27
Review the target company’s confidentiality and non-competition agreements
Since most unauthorised leaks of trade secrets occur as a result of departing employees failing to strictly abide by their confidentiality obligations, a key measure to protect confidentiality is to enter into non-disclosure and non-compete agreements for the effective protection of the target company’s trade secrets. It is strongly recommended to put a higher priority on this issue during due diligence in order to determine whether the target company’s trade secrets are being properly protected so as to bring the expected benefits of such information to the business.
To summarise the above, if, during the process of acquiring a Chinese company, the foreign enterprise buyer becomes aware that the target company has or is using intellectual property licensed by others, to ensure that the target company (if no intellectual property is transferred) or the company receiving the intellectual property can continue to enjoy complete usage rights to such intellectual property after the transaction, an effort must be made to understand the relevant laws and how they are practised so that appropriate language may be proposed when drafting and negotiating the purchase agreement.
For the due diligence process, an investor must first confirm the validity and completeness of each piece of intellectual property, their actual right holders, how they are used, whether there are any restrictions put upon transfers, whether the original licence agreement will be impacted by the merger, and whether the target company has taken a certain level of confidentiality measures for its trade secrets as the law requires, among others. In addition to making the relevant inquiries with the intellectual property supervisory authorities, the above may be done in practice through reviewing the agreements related to those intellectual properties. Because intellectual property, especially patents, tends to involve specialised knowledge, to better understand the contents of the rights involved and the usage restrictions, a need may arise during due diligence to retain experts in the field to conduct non-legal due diligence on those intellectual properties for making analyses and decisions regarding the validity and competitiveness of the associated intellectual property rights.
Next, the parties shall begin negotiating and drafting the purchase agreement based on the results of the due diligence. This includes but is not limited to a joint venture or partnership agreement, a capital injection agreement, an intellectual property licence or transfer agreement and others. While each case is different, as a buyer and an investor receiving intellectual property, the following items should be provided for in the purchase agreement so as to protect one’s own rights:
- The target company is to represent and warrant the validity, completeness and non-infringement of the intellectual property that it owns or uses, and a breach of such representation and warranty terms shall result in compensation for damages.
- If permits are required in advance, or for cases where the recordation of a know-how export or import agreement is to be performed, those matters shall be clearly stipulated as a condition precedent or a condition subsequent in the agreement.
- The responsibilities of the parties in maintaining the intellectual property rights shall be clearly stipulated, and the relevant documents for such procedures shall be timely provided by the responsible party.
In modern transactions, the importance and value of intellectual property and other intangible assets have continued to rise, and sometimes they are the key piece as to whether a transaction may be smoothly consummated. As such, in actual practice, it is imperative to pay attention to the nature of the intellectual property rights involved and the relevant laws and contractual arrangements in order to obtain valid, complete and competitive intellectual property rights after the transaction and achieve the original purpose of engaging in the transaction.