China and The Internet of Things and How to Destroy Your Own Company

Many years ago, I spoke at a major technology event about how to protect your IP from China. I rarely use notes when I give a speech, which leads me to oftentimes riff on various things. At some point during that speech, I mentioned how technology companies were our dumbest clients when it comes to China and I went on to explain why. I talked of how the ethos of tech companies is to focus on building things (be it software or hardware or whatever) as quickly as possible, and not worry about much else. I talked of how tech companies (in an effort to save money) are reluctant to hire good management, choosing instead to put their money into the core of their business — their tech people.

I then talked about how I completely understood this, including how this modus operandi no doubt does make sense when operating purely domestically. But I then went on to explain why it is such a disaster for China, where it is usually impossible to “fill in” a legal foundation later. After my talk, the questions asked of me and the comments made to me made clear that though around a third of the audience wholeheartedly agreed with this assessment of mine, two thirds were moderately to very unhappy with them.

Well for what it is worth, I will no longer describe technology companies as our dumbest clients when it comes to China. No, that honor now clearly belongs to a subset of technology companies: Internet of Things companies. And mind you, we love, love, love Internet of Things companies. For proof of this, just go to our recent post, China and the Internet of Things: A Love Story. Internet of Things (a/k/a IoT) companies are sprouting all over the place and they are booming. Most importantly for us, they need a ton of legal work because just about all IoT products are being made in China, more particularly, in Shenzhen. And just about all IoT products need a ton of complicated IP assistance.

So then why am I saying they are so dumb about China? Because they are relinquishing their intellectual property to Chinese companies more often, more wantonly, and more destructively than companies in any other industry I (or any of my firm’s other Chinese lawyers) have ever seen. Ever. And by a stunningly wide margin.

In describing IoT companies and their problems to others, I use the following as my prime example, taken from at least a half dozen real life examples in just the last few months:

IoT Company: We just completed our Kickstarter campaign and we totally killed it and so now we are ready to get serious about protecting our IP in China.

One of our China Lawyers: Great. Where are you right now with China?

IoT Company: We have been working with a great company in Shenzhen. Together we are working on wrapping up the product and it should be ready in a few months.

China Lawyer: Okay. Do you have any sort of agreement with this Chinese company regarding your IP or production costs or anything else?

IoT Company: We have an MOU (Memorandum of Understanding) that talks about how we will cooperate. They’ve really been great. They have told us that they would enter into a contract with us whenever we are ready.

China Lawyer: Can you please send us the MOU? Have you talked about what that contract will say?

IoT Company: Sure, we can send the MOU. It’s one page. No, we haven’t really talked much beyond just what we need to do to get the product completed.

China Lawyer: Okay, we will look at your MOU and then get back to you with our thoughts.

Then, a day or two later we a conversation like the following ensues:

China Lawyer: We looked at your “MOU” and we have bad news for you. We think there is a very good chance a Chinese court would view that MOU as a contract. (For why we say this, check out China LOI and MOU: Don’t Let Them Happen to You) And the Chinese language portion of the MOU — which is all that a Chinese court will be considering — is very different from the English language portion. The Chinese language portion says that any IP the two of you develop (the IoT company and the Chinese manufacturer) belongs to the Chinese company. So what we see is that as things now stand, there is a very good chance the Chinese company owns your IP. This being the case, there is no point in our writing a Product Development Agreement because your Chinese manufacturer is not going to sign that.

IoT Company: (And I swear we get this sort of response at least 90 percent of the time) I’m not worried. I think you have it wrong. I’m sure that they will sign such an agreement because we orally agreed on this before we even started the project.

China Lawyer: That’s fine, but I still think it makes sense for you to at least make sure that the Chinese company will sign a new contract making clear that the IP associated with your product belongs to you, because if they won’t sign something that says that, there is no point in our drafting such a contract and, most importantly, there is no point in your paying us to do so.

So far, not a single such IoT company has been able to come back to us with an agreement from their Chinese manufacturer to sign.

We have lately been getting a slight variation on this theme, where the IoT company is farther along in its product development and is actually at the point of being ready to sell its product. This newer situation is exemplified by the email below, which is an amalgamation of various recently received emails:

I am hoping your firm can help us figure out the best course of action going forward. [A description of their company and their IoT product then follows, along with how they ended up going with a particular Chinese manufacturer and why they failed to seek out the advice of a China lawyer until now. This description too often involves their domestic attorney having said that he or she would turn them over to a “China specialist” as soon as that “becomes necessary.”]

We do not have any contracts in place with our current manufacturer. We started our relationship with our current manufacturer a year ago. He told us that POs are contracts in China and our lawyer here confirmed that. We sent him our design, paid for the molds, and he shipped us the products. We recently learned that he has been using our product pictures as marketing material on Alibaba and selling our products all over the world. I also just learned that he has filed for a design patent for our design in China.

We just started the working relationship with [online retailer]. Our manufacturer doesn’t know that. All I told him is that we are working with a big client and if he doesn’t sign any agreements with us at this point, we’re not going to place new orders. He then told me he’s willing to sign a non-disclosure agreement with us.

We’re filing design patents in the US. If we continue to work with him during this period, which agreement would help us get the best protection?

Since he already claimed our designs in China, will that prevent us from working with a new manufacturer? Do you advise we work with a new manufacturer at this point?

Our response has been something like the following:

A PO is not really a contract in China; it is the placing of an order. Unless your PO speaks to IP (which would be very unusual), it almost certainly will not help us here. On top of this, some Chinese courts do not see POs as a contract at all and some Chinese courts will not even look at a document not in Chinese. The ideal is a Chinese language contract sealed by the Chinese company.

Our biggest concern is that this manufacture has filed for a design patent for your product. This will no doubt pose problems for you and for any new Chinese manufacturer you might seek to use. Depending on how far along your present manufacturer is in the patent process, it may be able to sue you and your Chinese manufacturer for patent infringement damages and to force production of your product to cease. At minimum, your Chinese manufacturer will be able to cause you all sorts of problems unless you can stop or invalidate his design patent. There is a good chance this Chinese manufacturer literally owns your product in China and it can use that ownership to control what you do there.

If you seek to go to a new manufacturer you can be sure of two things: one, your old manufacturer will NOT give you the molds you think you bought from it and two, it will use its design patent to, at minimum, block your products from leaving China. It also very well may sue you for patent infringement in a Chinese court. In the meantime, making your product in China will be an extremely high risk proposition.

Based on the information you have provided, it appears you have four options, none of which are terribly good:

1. You leave China entirely and start manufacturing in some other country. Is this possible?

2. You seek to block or invalidate your existing manufacturer’s design patent. This will not be accomplished quickly or inexpensively.

3. You try to strike some sort of deal with your manufacturer whereby it assigns the patent to you and in return you agree to keep using your manufacturer to make your product for x number of years. It may agree to this if what you can pay it will exceed what it can make by selling your product on its own and if you commit to a certain number and/or a certain amount each year. The fact that your Chinese manufacturer has offered to sign a non disclosure agreement does not mean much at all, since such an agreement will not help you and your manufacturer almost certainly knows this. For why this is the case, check out Why Your NDA Does Not Work for China. You need it to sign a contract that actually makes clear what IP belongs to you and makes clear your manufacturer’s limitations in using your IP. At this point, it sounds like you need a China-centric Manufacturing Agreement, but I doubt your manufacturer will sign this.

4. You go to a new manufacturer in China. If you do this, you almost certainly will not have your molds and there is a good chance your existing manufacturer will cause you a lot of trouble by suing or threatening the new manufacturer, etc.

Don’t let the above happen to you. For more on how you can prevent this, read China NNN Agreements and China Product Development Agreements.