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Stop Your Proprietary Information from “Leaking” All Over China, Part 2
This is part two in a series of posts on why foreign companies doing business in China so often lose their proprietary information (intellectual property) to their competitors in China. The first post focused on how so many of these losses arise from what we call leakage — the situation where the foreign company has a contract preventing its Chinese counter-party (usually the manufacturer) from using the foreign company’s proprietary information, but fails to prevent that information from leaking to third parties that are not bound by such a contract.
This post focuses on the most common forms of leakage our China lawyers see from companies doing business in China, particularly those that enter into manufacturing contracts with Chinese companies. Part 3 will focus on how to prevent such leakage.
Related parties. When a China factory intentionally seeks to appropriate proprietary information from a foreign party, leaking that information to a related third party company is the most common technique it will employ to achieve that. There are three basic ways that this happens: First, a state owned enterprise will leak the information to other state owned enterprises in the same industry. For example, an SOE engaged in will obtain proprietary information from a foreign company and then — after mastering that technology — will share it with other SOEs. Since the owner of all of the companies is the same (the Chinese Government), the SOE often does not see anything wrong with sharing the information, particularly when the information is related to health care or environmental protection or some other industry that benefits the Chinese public.
Second, many Chinese companies are organized as part of a large group company. Many of these group companies consist of myriad separate companies ultimately owned by a single shareholder or shareholder group. In the classic scheme, the group company will form a special purpose entity that then enters into the contract manufacturing contract with the foreign company. This special purpose entity then leaks the proprietary information to a different company which, though a separate legal entity, is actually a member of the same group. The U.S entity has no contract with the entity that actually manufactures the infringing product. The factory that entered into the contract with the foreign company then asserts that it is free from liability because it is not the offending manufacturer.
Third, in a similar way, many private company contract manufacturers are part of a network of companies connected by family relationship, clan, village affiliation or other local guanxi networks. In fact, in south China (from Wenzhou south to Shenzhen) it is unlikely any contract manufacturer will not be embedded into this type of related party network. In this setting, a factory owner commonly will leak design information to one of the other member companies in the network on a product it finds valuable. The argument is the same: the factory will claim it did not commit the violation and should therefore not be on the hook. .
The list of other common ways leakage or proprietary information/intellectual property occurs is long, with the following the most common:
Employees. It does not take much investment to set up a factory operation in China, particularly in the south where many contract manufacturers are located. You should assume that many employees of your contract manufacturer are on the look out for a new idea (i.e., your idea) that will give them their start as factory owner rather than wage slave. Appropriating confidential information revealed by a foreign customer is a convenient way to get this kind of head start. Employees are quite enterprising: they will not only run off with your design, they will also run off with your customer list. In just a few months, they will be contacting your customers with offers to sell your product at 30% below your wholesale price.
Subcontractors. Our foreign company clients are nearly always surprised at the number of subcontractors involved in manufacturing their products in China and in some cases, their “factory” does not actually manufacture the product. All production is actually done in a different factory down the street. In other cases, when their factory has too much work, it subcontracts out its excess production. Complex products nearly always require subcontractors. Take Internet of Things products (IoT) as an example. Such products are usually a mix of a main product with numerous subassemblies and the contract manufacturer will often subcontract out production of subassemblies and related components, acting as little more than a assembler. These subassemblies and components often embody the truly innovative portion of the product. To get production done, the main factory is generally quite free in disseminating the foreign buyer’s confidential information through a large group of loosely related factories, none of which have any contractual obligation to protect the confidential information or refrain from using it to directly compete with both the foreign buyer and the Chinese contract manufacturer.
Molds and tooling. The key step in contract manufacturing is oftentimes the designing and production of the molds and tooling used in the manufacturing process. The molds are often the primary repository of the unique design of a product and the tooling often embodies years of manufacturing know-how on the part of the foreign party. Foreign buyers will often take great care in specifying the ownership of the molds and tooling. Few foreign buyers, however, understand that the molds and tooling are rarely made by their contract manufacturer. Instead, that factory hires third parties to do the mold design and tooling manufacture. As a part of this process, the factory discloses the foreign buyer’s confidential information related to those designs, who can (and often does) freely sell the design to a third party or use it for its own purposes. Consider the case of a foreign buyer who has not obtained a design patent on its basic product look and feel: its molds are likely the most important element of its product value. If the mold design leaks away the value of its product design can be destroyed.
Third party programmers and designers. Few small or start up companies have their own product designers, graphic artists or software programmers and so most contract out these tasks to third party shops. Foreign buyers frequently leave these tasks to their Chinese factory, which takes us back to the standard situation: to get the work done, the Chinese factory is required to disclose the foreign company’s proprietary information. Often, no one in the process pays much attention to who really has the rights to the work product of these third parties. Consider an example: say the GUI for the interface for your smartphone app that controls your IoT product becomes popular and is identified with your company and you want to use that GUI design as part of your branding. Do you own the copyright? Does your China factory own the copyright? Does the third party designer own the copyright? Does anyone know? Did anyone clarify this from the start? Do you know what Chinese or even United States or EU law says on this? This use of third party “shops” has become a significant source of leakage.
So how do we prevent leakage? Stay tuned for Part 3.
We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.
Source: http://www.chinalawblog.com/2016/08/stop-your-proprietary-information-from-leaking-all-over-china-part-2.html
