I will be chairing a panel on litigating and licensing patents in China on Tuesday, October 24 at LES 2017. Please come by, email me at firstname.lastname@example.org or text me at 713-498-6047 if you would like to meet!
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 brief memorandum addresses TIER and some ways to possibly deal with it, best practices for forming joint ventures 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, China’s Technology Import Export Regulation 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.
B. 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.
C. 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.
D. 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.
E. 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.
F. 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.
G. 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. 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 joint venture. Since most foreign investors wish to maintain control over their Chinese joint venture entity, this issue is usually paramount. Often foreigner make the mistake of assuming that Chinese joint ventures are managed according to a Western model, under which the board of directors has controlling power over the company. Most foreign investors strive to obtain a 51% ownership interest in the equity joint venture, assuming this gives them the right to elect the entire board and thereby control the company. After winning the struggle for percentage ownership of the joint venture, foreign investors will frequently allow the Chinese side to appoint the equity joint venture’s two key management positions, the Legal Representative and the General Manager. But these “concessions” are all part of the Chinese side’s plan, and effectively render board control meaningless.
Control over a Chinese joint venture actually comes from the following:
The Chinese side to a joint venture will typically refuse to give the foreign party the above three measures of control. It will argue that it should control the joint venture for reasons of both efficiency and expertise. In many cases, it also will claim that it cannot bring its political connections, or guan xi, into play unless its own people fill the Legal Representative and General Manager slots. This argument is usually just a smoke screen for the Chinese side trying to secure the true levers of joint venture control.
If you want control over your China joint venture, you should follow the rules set forth above. Otherwise you might find yourself in a venture with no legal right to guide it.
B. Safeguard intellectual property the traditional way
Multinational companies still struggle to protect their intellectual property in China, and joint ventures are particularly vulnerable. Companies have traditionally had some success with more pragmatic, operational efforts, including the following:
C. Manage talent
Most leading multinationals learned from the first round of joint ventures in China that getting the right managers in place was critical. Many of these companies had simply dispatched available executives—often not top performers but rather average executives searching for new challenges. Most of these executives therefore had limited credibility with the corporate parent and were ill-prepared to manage demanding joint-venture partners. Today, experienced multinationals recognize that a successful joint venture requires credible, high-performing executives supported by strong local teams.
Yet with so many companies competing for the best local candidates, those men and women can afford to be choosy, and they understandably prefer leading companies that have a strong image and offer good prospects for career progression. So today, joint ventures must not only invest in their corporate brands but also partner with top universities to sponsor undergraduate and graduate students and to establish a training platform for current employees. CEIBS, a leading business school in China (and itself a joint venture), has more than 80 corporate sponsors, which provide funding and in return can recruit on campus and send their executives on advanced training courses.
Finally, companies must continue their commitment even after candidates are hired. In our observation, this means sending some of a multinational’s best people to the joint venture to create a strong team, compensating employees at or above relevant market rates, and fast-tracking the advancement of high performers—even breaking away from more tenure-based advancement systems.
D. 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 Joint Venture. 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 joint venture agreement before they become problems. *Note the prior discussion of TIER in this regard.
E. Investment Capital Contribution
The transfer of technology or IP of a foreign investor into a joint venture can serve as a contribution of capital. Depending on the investment sector of the JV, the transfer can make up a certain percentage of the JV. Although there are some exceptions, the maximum limit is usually 20%.
F. License/Royalty Fees
Licensing or royalty fees from the transfer of IP in a joint venture 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 the 0.3% royalty rate ceiling of sales revenue in the retail sector for the use of a trademark.
G. 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.
Welcome to the China Patent Blog by Erick Robinson. Erick Robinson's China Patent Blog discusses China's patent system and China's surprisingly effective procedures for enforcing patents. China is leading the world in growth in many areas. Patents are among them. So come along with Erick Robinson while he provides a map to the complicated and mysterious world of patents and patent litigation in China.
Erick Robinson is an experienced American trial lawyer and U.S. patent attorney based in Beijing. He is a Partner at Porter Hedges LLP, where he manages patent litigation, licensing, and prosecution in China and the US.
The ideas and opinions at ChinaPatentBlog.com are my own as of the time of posting, have not been vetted with my firm or its clients, and do not necessarily represent the positions of the firm, its lawyers, or any of its clients. None of these posts is intended as legal advice and if you need a lawyer, you should hire one. Nothing in this blog creates an attorney-client relationship. If you make a comment on the post, the comment will become public and beyond your control to change or remove it.