One of the recurrent (sometimes underlying, sometimes explicit) themes of this blog is that if you combine best legal practices with best operational practices, you’ll do just fine in China.
For the second time in the last few months, this proposition has taken a major hit.
We are always preaching that if you 1) choose a good manufacturer, 2) use a China Manufacturing Agreement 3) engage in good quality control monitoring, and 4) register your trademark, the odds are overwhelming you will do just fine in outsourcing your product manufacturing to China.
In 2009 and 2010 and the first half of 2011, I my firm would receive maybe two emails a month from someone who had sent money to a Chinese manufacturer and received no product. And of those emails, nearly involved a relatively unsophisticated buyer who had done none of the four things listed out above.
In the last three months or so, we have received probably 4-5 emails from buyers who have been burned by Chinese manufacturers but have a very different story to tell. These buyers have been burned by Chinese manufacturers with whom they have been dealing successfully for many years.
Now today I learned about a foreign company that appears to have done everything right and yet still had its IP stolen in China. This all comes from a BusinessWeek article, China Corporate Espionage Boom Knocks Wind Out of U.S. Companies highlighting what happened to American company, AMSC.
Let me backtrack a bit first. Both here on this blog and in real life with our clients, we are always saying that companies must do two things to protect their intellectual property/trade secrets from Chinese (and other) companies: protect them legally and protect them operationally.
One without the other does not make much sense. For example, my law firm’s international IP lawyers can write the world’s best NNN Agreement, but every time you show your secret design or formula or whatever to a Chinese factory or company, the odds of your IP getting stolen increase. If you can get away with showing just a portion of your secret design or formula, the odds decrease.
To trust is nice, to control better. Know what is going on with your IP in China at all times and use “several anti-counterfeit technologies.” In other words, do not rely solely on the law to protect your IP in China.
Let’s face it, though a good contract and a good IP registration increase the ability to trust, neither of them equal total control.
That is why we suggest to our clients that whenever possible, they operate in such a way that even if some of their IP is stolen, all of it cannot be. By way of example, I often mention a client of ours who has a hardware/software product that cannot function optimally unless both are working together. This company keeps its software on a server at its home office in the United States so as to make it virtually impossible to copy. On top of that, even if it were copied, it would rapidly become out of date due to the lack of updating critical data. When I discuss this company, I often describe it as having found the “magic key” and I suggest to our clients that they too try to find their own “magic key.”
But based on what happened to AMSC, even magic keys are not so magic.
AMSC’s China business was not atypical:
AMSC began packaging the electronic components and selling them to China’s small but growing domestic manufacturers, which had plenty of capital and cheap labor to make the turbines’ steel skeletons but lacked the sophisticated gadgetry to run them. The arrangement was working the way it was supposed to: China would turn out the commodity hardware — the turbines — and a U.S. company would retain control of the high-margin intellectual capital-end of the business.
But the steps AMSC took to protect itself went beyond that of most companies: Secure Barriers
If McGahn [AMSC’s CEO] was going to bet AMSC’s future on partnerships with Chinese companies, he wanted secure barriers around its intellectual property. He designed AMSC’s China operations — in fact, reorganized much of the company — with that in mind. To hire AMSC’s first 30 employees in China, McGahn interviewed 400 people, handpicking the ones he thought he could trust. When AMSC opened a factory in China’s Jiangsu province to assemble power converters, McGahn made sure firmware and other technology-rich components were built in factories in the U.S. and then shipped to Asia.
Software was sequestered at the company’s research facility in Austria, which has a booming clean energy sector much like Germany’s. The source code to AMSC’s control system software sits on a secure server in Klagenfurt. To protect the code from hackers, the server isn’t accessible from the Internet.Strategy From Beginning “The idea of dividing up the intellectual property part of the content and not having them in China was part of the strategy from the beginning,” he said.
McGahn thought he’d planned for every contingency to keep AMSC safe. He also believed the company could find a way to have both partners benefit. He was wrong on both counts.
I have to admit, if a client had told me the above, I would have congratulated them for their good work, and just assumed they were fine. But in AMSC’s case, they weren’t: Han’s company, Sinovel, allegedly paid someone in AMSC’s Austrian office to provide the Chinese company with AMSC’s software code. Armed with this, Sinovel had all that it needed to compete with AMSC and it did. According to the BusinessWeek article, “what Sinovel realized was that it was cheaper, and easier, to convince a software developer to jump ship” than to create its own product.
Our law firm’s advice to companies focused on manufacturing for export has been that they should get their legal ducks in a row with patents and trademarks and copyrights (in China and elsewhere) and supplier agreements (with appropriate NNN provisions) and they should be fine.
That advice goes double now, particularly for firms who think China offers a market for their goods on ANY level going forward. But in my most cynical voice possible, I would add, “and good luck with that.”
What do you think?