China NNN Agreements: Don’t Do That

Don't feed the bears and don't feed a China factory your IP without an NNN.

You are in China, looking for a factory to produce your innovative product. How do you prevent the Chinese factories from appropriating you brilliant new idea. As I discussed in my post yesterday, a US-style NDA will be worthless; what you need is a China NNN agreement.

The three Ns stand for non-use, non-disclosure and non-circumvention. Let’s look at each in turn. By non-use we will require the factory contractually agree not to make use of your idea/concept/product in a manner competitive with you, the disclosing party. The critical point is that this obligation arises by contract. This protection is not based on abstract property rights arising under intellectual property law. The prohibition protects you not because your concept is classified as some form of intellectual property such as a trademark, copyright, patent, mask work or even a trade secret. The factory is prohibited from using your work because it executed a contract that prohibits it from using your work. Getting a factory to sign a contract with a non-use provision means there is no need to look outside that contract to other areas of law for you (and China’s courts) to be able to control the behavior of the Chinese factory.

The next element is non-disclosure. As noted in my earlier post, most companies should not be terribly concerned with disclosure to the public. This is because Chinese factories usually have no interest in letting the general public in on their good thing. If they want to use your concept, they want to use it for their own purposes, not to publicly disclose it.

But if you prohibited the Chinese factory from making direct use of your concept, the Chinese factory now has a problem. The clever Chinese entity will not directly breach the non-use prohibition. It will simply disclose the concept to someone in their company group and then accurately claim it has not breached the non-use prohibition because it is not itself making use of your protected information.

For this reason, it is important you understand the type of group with which you are dealing and you must make clear in your NNN Agreement that disclosure is specifically prohibited within the group and if there is any infringement by any member of the group, the factory that made the disclosure is fully liable.

Often, some education on this issue is required because many Chinese companies do not see disclosure to a member of their group as violating the non-disclosure prohibition. The situations you will normally confront are as follows:

  • In many regions of China, family members own a large group of small to medium sized companies. The family sees all these companies as the same entity for disclosure purposes.
  • Many Chinese factories use a team of constantly changing subcontractors. Some of these subcontractors are part of the family group, some are related by co-ownership, some are related only by physical proximity. The factory will often claim they must disclose to their subcontractors to be able to properly evaluate or cost your product.
  • Many Chinese factories are part of large and extensive “group company” 集团公司 arrangement where numerous subsidiaries are owned by a single parent. Members of the group do not see other members as outsiders for purposes of prohibition of disclosure.
  • Many state owned enterprises do not see other SOEs or even the Chinese government itself as separate competitors. In their view, they are all owned by the state and the information held by one company should be freely shared with other SOEs in the same business. This is particularly true in sectors with a public service background such as medicine, healthcare and aeronautics. Since all the companies are pursuing the public good, they see no reason not to share the wonderful information you provide to them.

Finally you need to deal with non-circumvention. The Chinese factory knows you are purchasing the product at the China price and you are then adding a margin and selling at a profit in the foreign market. In this situation, it is only natural for the Chinese factory to work to obtain a list of your customers they can contact to sell the product absent your trademark at the original China price. After going through your customer list, they start marketing “your” product to the rest of the world. Trust me when I tell you that at least a half dozen times a year the international dispute resolution attorneys at my law firm get contacted by a company on the verge of going under or has already shut down after having been taken out by a Chinese factory using this tactic. What would your customers do if offered your product for 50% less? In many industries (especially those where quality and servicing is critical), most customers would say no. But in many other industries — including consumer products — they quickly and almost uniformly say yes.

This is circumvention, and you must prohibit circumvention by contract. There is no other way to do it. A good NNN agreement is your only protection.

These are the three elements of China NNN agreements (and also for most NNN Agreements around the world). As you can see, the situation is complex and the contract must be carefully drafted to deal with your specific situation. Now that you have torn up your worthless NDA and you have mastered the three Ns, one more step remains. You must ensure your NNN agreement contract has some teeth that provides you with the tools required to keep the Chinese factory under control. I will discuss how to accomplish that in my next post.

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