Manufacturing in China: Do Not Be Assimilated

My message to foreign tech companies (particularly those involved with Internet of Things devices) who do manufacturing in China is:

Protect yourself. It can be done.

Despite the horror stories you read about Chinese technology theft and counterfeiting, you can prevail against Chinese manufacturers provided you understand what is going on and provided you make use of key weapons available to you.

In previous posts on China NNN Agreements and China Product Development Agreements, we described how foreign companies need to protect their technology prior to full, production-ready commercialization. In too many transactions my law firm’s international manufacturing lawyers have seen over the past year, foreign tech companies gave away their valuable technology during the product development phase. By the time the product is ready for commercial production, the IP in technology is already lost.

One reason for this is that the Chinese government has concluded that Chinese companies will never develop the R&D expertise required to develop their own technical base, so the only alternative is for Chinese companies to “assimilate” foreign technology.

The term “assimilate” is just a nice way to say: appropriate the foreign technology without paying for it. The basic situation in China is laid out clearly in a CASS (China Academy of Social Sciences) report issued around ten years ago, stating as follows:

  • Japan and Korea developed their industrial base by licensing or purchasing foreign technology as their first step.
  • After Japan and Korea legally acquired the technology, their companies and technicians devoted considerable effort to mastering the technologies so they could commercialize them. Japan’s work with the transistor is one example.
  • CASS research shows Japan spent about $2.50 in R&D and commercialization for every $1.00 in technology it purchased. Korea went beyond Japan and spent $5.00 for every dollar.
  • The companies of Japan and Korea did not steal the foreign technology; they paid real money for it. Moreover, private companies made these technology purchases, not the government. These fund outlays put tremendous pressure on these companies to turn their expenses into marketable products as quickly as possible.

CASS reported that the situation in China is quite different. There are two fundamental differences:

  • Chinese companies have been reluctant to pay the fees required to legitimately acquire foreign technology. Chinese companies have preferred infringement over legitimate purchase.
  • Without regard to the method by which Chinese companies have acquired foreign technology, they have invested very little in the R&D required to master the acquired technology. As many Chinese commentators have stated, it is not possible to do any creative commercialization work until after the technology has been mastered. As an illustration of the fundamental issue, CASS reported Chinese companies spend about 78 cents on R&D for every $1.00 in technology they acquire. This work is also not really R&D. Instead, most of this effort by Chinese companies is spent on dumbing down the advanced technology to make it suitable for more primitive Chinese devices and manufacturing techniques.

CASS then concluded there is no way in the near term to convince Chinese companies to change their approach to technology R&D and technology transfer. Therefore Chinese companies will never be able to develop the technology required for advanced products on their own.

You might then conclude that CASS would recommend Chinese companies increase their budget for legitimate purchases and licensing of foreign technology. You would be wrong.

This is NOT what CASS recommended. Instead, CASS recommended Chinese companies abandon their independent R&D efforts and instead devote their efforts towards “assimilation” of foreign technology. By assimilation they mean: appropriate the foreign technology in violation of IP protection terms and without paying for it.

The CASS report then gives two examples of how to do this:

  • The theft by Chinese manufacturers of Russian jet fighter technology that resulted in the production of the current J20 fighter jet line.
  • The theft by Chinese manufacturers of high speed rail engine technology from five different foreign manufacturers.

CASS uses these two projects as examples for how Chinese companies should proceed in the future. Both projects used the same technique. The first step is to enter into a technology licensing agreement. The second step is to provide for a long term pay out, where the technology is transferred early and payments are made very late in the process. The third step is to convince the foreign parties to teach the Chinese side how to use the technology in a commercial setting. The fourth and final step is triggered on the day the Chinese have decided they have learned enough to go forward on their own. When this day occurs, the Chinese company will breach the technology transfer agreement by refusing to make any more payments and by producing the product in direct violation of the technology transfer agreements. With so many of the payments pushed so far into the future, the Chinese company acquired the technology and received the training at a substantial discount.

Our China IP lawyers see this approach all the time by Chinese companies. This approach to assimilating foreign technology is standard procedure in China and every foreign company looking to transfer technology to China must take measures to prevent assimilation from taking place. It can be done, but it requires an aggressive strategy that combines proper documentation with other, practical techniques. In my next post, I will discuss how to fight back against assimilation.