NDAs Do NOT Work for China but NNN Agreements Do

As we have been writing of late, IP theft is on the rise in China. In Tariffs Against China Increase China IP Problems, we explained why this is the case:

I first wrote about the increase in China IP risks back in August, 2018, in China Trademark Theft. It’s Baaaaaack in a Big Way. Back then I attributed it mostly to China factories “hurting”:

Many (most) Chinese factories are hurting and they desperately want to improve their profit margins. What better way to do so than to sell a product under a prestigious or well-known American brand name — or even just any American brand name? See Your China Factory as Your Toughest Competitor.

I now attribute the increase in China IP thefts/problems to the trade war. Many Chinese companies are hurting and that explains the increase in IP theft, but of course many are hurting because of the trade war. But even beyond that, Chinese companies view foreign companies — especially US and Canadian companies — as looking to leave China, and that is because so many US and Canadian (and many European companies too) are indeed looking to leave China, or at least reduce their footprint there.

In response to so many foreign companies having one foot out the China door, many Chinese companies no longer consider their relationships with foreign companies as long-term. When a Chinese company does not believe its relationship with its foreign company counterpart will be a long term one, its incentives for stealing the foreign company’s IP greatly increases. It does not make economic sense to steal IP worth a million dollars from a company from which you can make $500,000 in yearly profits over the next ten years, but it does make economic sense to steal IP worth a million dollars from a company you believe will be jettisoning you within the next year.

We concluded that post by promising in “subsequent posts . . . [to] lay out what exactly foreign companies should do to protect their IP. Consider this part one of our posts setting out exactly what foreign companies should do (and not do) to protect their IP in China.

I lead this post off with the following amalgamation of a bunch of emails our China IP lawyers received in just the past week.

My name is __________ and I am reaching out to you because I was told you might be able to assist with a situation that just happened to me.  Any advice and recommendation regarding this matter will be much appreciated.

In April I chose a product I wanted to have made in China to sell on Amazon. I reached out to a Chinese manufacturer and I got a sample back. I did not like the product as it was so I developed a few changes that could be done to it to make it better. I realized that at least one of my ideas/changes could be patented so I reached out to a patent lawyer in the United States and I now have a patent pending.

After I filed for my patent I reached back out to the same manufacturer in China and got them to sign the attached NDA. I then gave them my product information and the design for the mold. They told me the mold would be ready in early August but ever since then they just kept telling me that they needed more time. Yesterday, however, they told me that they need a little more time to complete my mold, but in the meantime they wanted to show me their new product. To my surprise the picture of “their” prototype product they sent me has the exact same new features and functions I requested for my mold and my product.

They are now claiming that they started developing the same product with the same features that I requested back in April and that some of their clients placed orders for their product last month with deliveries starting this upcoming week. The only difference between my product and “their” product is the color.

How can they do this after signing the NDA and when I have the patent? Can you help me and what will you charge?

The below is the amalgamated responses from our China intellectual property lawyers:

Thanks for writing. There is not much you/we can do here because the NDA you had this Chinese manufacturer signed is worthless in China. See this: China NNN ≠ Foreign NDA. You might have a trade secrets case in against the manufacturer in a Chinese court but those are usually very difficult cases to prove and win on and that means pursuing such an action will almost certainly be difficult and expensive. We rarely recommend pursuing such cases, but we would be happy to analyze your case to determine whether it might make sense for you to move forward with such a claim. That would involve our gathering up a lot more facts and then working with you in weighing the costs versus the benefits of moving forward with such a claim. Trade secrets cases are virtually always very fact intensive and that is one of the reasons why they are so expensive.

 U.S. patents will protect your product in the United States, but even with a patent the odds are not good that U.S. customs will discover and seize the infringing products and getting products taken off online marketplaces for alleged patent infringement is also not very likely. I urge you to read China and Worldwide: Trademarks Good, Patents Bad where we discuss why patents for companies like yours are not as valuable as so many believe. Also, your U.S. patent is not going to help you in most other countries in which your product will be sold.

If I were you I would consider moving forward with getting your product made elsewhere as quickly as I could and we can help you with that too and making sure that you avoid a repeat of this IP theft in the next country you go to for manufacturing your product. Moving Your Manufacturing Out of China: The Initial Decisions. If you will be looking to move your manufacturing elsewhere, the first thing we will need to look at is whether you can claim ownership in the mold that they claim to have been working on making for you and whether it will even make economic sense to do so. Do you have any agreement with them regarding the mold? Maybe something like what we describe here

Please let me know how you wish to proceed.

Your takeaways from the above should be as follows:

  1. Do not rely on a Western contract to protect your IP from a Chinese company.
  2. NDAs do not work for China. You need a China-Specific NNN Agreement. See China-Specific NNN Agreements Versus a Template Non Disclosure Agreement (NDA).
  3. Patents are sometimes great, but oftentimes they cost way more than other, better, ways to protect your IP from China.
  4. You need to protect your molds by contract as well. See How to Protect Your Molds and Tooling When Manufacturing Overseas, Part 1, Part 2, and Part 3.

Non Disclosure Agreements in China.

It is understandable why so many Western entrepreneurs believe an NDA Agreement will protect them in China; they are simply used to pulling one out for signing just about everywhere in Western world. What you must realize though is that the Chinese legal system is very different from those in the United States, the EU, Australia, Canada and Latin America (and many other places as well) and you just cannot assume that the procedures/standards/analysis/laws that apply in the West will apply equally in China, especially because they rarely do and they certainly do not when it comes to non-disclosure agreements. It is nearly pointless to use a Western-style NDA with Chinese companies and oftentimes using such an NDA is worse than having no contract at all. See Why Your NDA is WORSE Than Nothing for China.

But why?

For oh so many reasons, but most critically for the following two:
1. NDAs normally require the party receiving the confidential information maintain the confidentiality of the trade secrets it receives. This is NOT What You Need for China.
NDA agreements focus on protecting trade secrets. For a trade secret to be protectable property, the information must remain a secret. For this reason, NDA agreements are geared to preventing disclosure of a trade secret to the public. NDAs focus on preventing secret information from being revealed to the public. Since Western companies generally focus on maintaining their domestic intellectual property portfolio, they have a natural tendency to believe they can rely on a single NDA agreement, written in English, subject to the laws of their home country and exclusively enforceable there. But for the following two reasons, this kind of NDA is of no value in China.
First, the fundamental issue in China is not protection from disclosure to the general public. The Chinese company that steals your idea does not do so to reveal it to the general public. It steals your idea to use for its own benefit. This means that your contract with Chinese companies must make clear that whether the information you provide is a secret or not, the Chinese company agrees not to use the information in competition with you. Your primary risk is NOT your Chinese counterparty revealing your confidential information to the public and thereby violating its non-disclosure risks. Your primary risk is your Chinese counterparty using the information you give it to create a similar product or service and then using that similar product or service to COMPETE against you.

The protection you need therefore is not merely protection of confidential information but also, prevention of usage of your confidential information by the Chinese manufacturer to build their own version of your product for sale or to allow an unauthorized third party to do it. Now that you know what is really required for China, you can see why Western-style NDA agreements are far removed from what is needed to protect your IP from China.

2. NDA Agreements are Not Enforceable in China.

The second fundamental problem with typical NDA agreements is that they are not enforceable in China. Chinese law allows for protecting trade secrets and for contracts that provide NNN protections. But if such a contract is going to be effective in China it should be written in Chinese, governed by Chinese law, and exclusively enforceable in a Chinese court. See China NNN Agreements: Do Them Correctly or Walk Away. What you need is something that clearly prevents your Chinese counterparty from using any information you give it (whether it be a trade secret or not), to compete against you. And that something must also be crafted in such a way as to dovetail both with the reality on the ground in China and the reality of China’s courts. What you really need instead of an NDA is an NNN Agreement that works for China and that typically requires — among other things — the following:

  1. Include all necessary parties
  2. Make Chinese law the governing law.
  3. Make Chinese the official language.
  4. Do not choose two official languages. See Dual Language China Contracts: Don’t Get Fooled!
  5. Choose China courts as your jurisdiction (usually).
  6. Do not choose arbitration (usually).
  7. Choose the right Chinese court as your venue.
  8. Protect against subcontractors and related parties.
  9. Include a contract damages provision.
  10. Make sure your contract damages amounts are in line with what Chinese courts will accept.

More specifically, it should provide for all of the below.

NNN Agreements for China

You need a China-centric NNN agreement to protect your IP in China. The three “Ns” that make up a China NNN agreement are: non-use, non-disclosure, and non-circumvention. Consider each in turn.

a. Non-Use

Non-use means your China counterparty agrees not to use your idea or concept or product in a way that competes with you. The key here is that this obligation arises by Chinese contract, not from some abstract property right arising under intellectual property law. A contractual provision prohibiting use will protect you not because your concept is classified as some form of intellectual property such as trademark, copyright, patent, or trade secret. Rather, it will protect you because your Chinese counterparty cannot use your work because if it does so it will be in breach of its contract with you. Getting a Chinese company to sign a contract with a non-use provision means you will not need to look outside that contract for you or for China’s courts to be able to control the Chinese factory.

b. Non-Disclosure
The next “N” in a China NNN agreement is non-disclosure. In most instances, you need not be terribly concerned with your Chinese counterparty making your secrets public because it usually has no interest in letting the general public in on its good thing as it typically wants to use your idea or concept for its own purposes. But as we mentioned above, this is usually all that an NDA can accomplish and it cannot usually even accomplish that in a China context.

If you prohibit a Chinese company from using your protected information, the clever Chinese company will not directly breach the non-use prohibition. It will instead disclose the protected information to someone in its “group” and then deny having breached the non-use prohibition because it did not directly use the protected information. For this reason, it is important to understand the type of group with which you are dealing and to make clear in writing that: 1) disclosure is specifically prohibited within the group and 2) if there is infringement by any member of the group, the company that signed the agreement and made the disclosure will be fully liable, no matter what.

Usually some education on this issue is required because Chinese companies often do not view disclosure to a member of their group as violating a non-disclosure prohibition. The following are some of the common situations our China lawyers see when dealing with Chinese companies:

  • It is common in China for an extended family to own a group of small- to medium-sized companies and for the family to consider all these companies as the same entity for disclosure purposes.
  • Chinese companies typically 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 viewed as related due only to their roles or even their physical proximity. Chinese companies often will assert that they must disclose your information to these subcontractors to provide a costing for your product or project.
  • Many Chinese companies are part of a large and extensive “group company” arrangement involving numerous subsidiaries owned by a single parent. Members of the group do not see other members as outsiders for disclosure purposes.
  • Chinese state-owned enterprises often do not regard other SOEs as separate competitors. SOEs are all state-owned and so information held by one SOE should be freely shareable with another SOE. This is particularly true in sectors with a public service focus, such as healthcare and aeronautics. Since all SOEs in these sectors are pursuing the public good, there is no reason for them not to share your information with their brother SEOs.

c. Non-Circumvention
Non-circumvention is the third and last “N” and its importance varies with the situation. By way of one common example: Your Chinese factory knows you are purchasing product from it at the China price and then adding a big margin before you sell it in a foreign market. How would you be impacted if your Chinese factory seeks to sell your product to your customers at 50% less than you charge? What if your Chinese factory were to start selling your product to the rest of the world? In industries where quality and service are critical, many of your customers would probably stay with you. But in other industries, this is less likely to be the case. The best way to prevent circumvention by your Chinese supplier is by having a China-appropriate non-circumvention provision in your China NNN Agreement.

Use an NNN Agreement a Chinese Court Will Enforce

a. Draft your NNN for China 

Your NNN agreement usually must be written to be enforceable in a Chinese court with jurisdiction over the Chinese defendant. This means Chinese law should be the governing law, the Chinese language should be the governing language, and exclusive jurisdiction should be in a Chinese court with jurisdiction over your Chinese counterparty. The fundamental reason for this China-focused approach is that you must be able to move quickly against your Chinese counterparty if it breaches its NNN Agreement with you. For the following reasons, any other approach will make the agreement unenforceable or delay enforcement for so long as to render the agreement useless

  • Foreign judgments are generally not enforceable in China. So a provision that provides for jurisdiction in your home country will likely render your NNN agreement unenforceable in China and therefore nearly always useless.
  • Foreign arbitration awards from most countries are technically enforceable in China, but Chinese courts have a poor record of enforcing foreign arbitration awards. Chinese courts are generally of the view that disputes with Chinese companies should be resolved in China. Even if your foreign arbitration award ends up getting enforced in China, the time and the cost of getting to that point will likely be too much.
  • Arbitration in China is subject to delay and uncertain enforcement. Arbitration panels also have no power to seize assets or take other action to force the infringer to cease its infringing conduct.
  • Though Chinese law allows for a foreign law to govern a contract, the Chinese courts will require the parties to prove every element of foreign law. Since interpretation of foreign law is virtually always subject to dispute, this leads to long delays.
  • Though Chinese law technically allows for English as the governing language of a contract, most Chinese courts will not deal with foreign language documents and when they do they will use a translation done by a court appointed translator. Disputes over translation are common, again leading to long delays. This also means you will essentially not know what your own contract says until you see the court’s translation of it.
  • Chinese courts do not allow forum shopping. Litigation must occur in the court with jurisdiction over the defendant, usually the city where the defendant is registered or where it normally conducts business. Any provision that provides for jurisdiction in another court will be ignored and might even void your contract.

b. Draft your NNN Agreement to Convince your Chinese Counter-party not to Breach it.

Your China NNN Agreement must be written so your Chinese counterparty truly fears breaching it. This requires your NNN agreement will have an immediate and negative impact on your Chinese counterparty if it breaches it. The first step to generating this necessary fear is to make your NNN agreement enforceable, as described above. The second step is to ensure that your NNN agreement provides for contract damages in a specific monetary amount for every act of breach.

c. Draft your NNN Agreement with an Appropriate Damages Provision

Contract damages provisions in a China NNN contract provide two main benefits. First, they force the Chinese party to realize it will face real and quantifiable consequences if it breaches the NNN agreement. Second, a specific monetary amount provides for a specific minimum level of damages. This sum certain amount then provides a Chinese court with the basis for a pre-judgment seizure of assets. A credible threat of your seizing your Chinese counterparty’s assets greatly increases the likelihood of that Chinese company abiding by your NNN agreement and of your being able to quickly bring the Chinese company to heel if it does not.

An NNN agreement must include a sum certain contract damage provision that a Chinese court can and will enforce by ordering seizure of the defendant’s assets. Care is required, however, because the Chinese legal system does not allow for punitive damages and it also does not allow for extensive consequential damages. It is therefore important to set the contract damages at an amount that reasonably substitutes for the damages that result from a breach of the agreement. See China Contract Damages Done Right.

Because Chinese companies know that breaching a well drafted China-centered NNN Agreement, will likely lead a Chinese court to order a freeze on their assets, we typically encounter the following three responses from Chinese companies to our NNN agreements:

  1. Some Chinese companies refuse to sign. These are the companies that planned to steal the foreign technology from the very beginning. This sort of situation has in the last few years become incredibly rare.
  2. Some Chinese companies will enter into serious discussion about what they believe should be excluded from the NNN Agreement. Our China lawyers usually view this as a positive because it indicates the Chinese company is taking the NNN Agreement seriously and it often generates productive discussions regarding technical issues.
  3. Most Chinese companies execute the NNN agreement and then treat their NNN obligations seriously. This does not mean every Chinese company will abandon years of bad practice and begin behaving well. But it usually means that when a Chinese company violates the NNN agreement, litigation is not required. In most cases, a reference to the NNN agreement and the credible threat of litigation/asset seizure is enough to induce the Chinese company to step back into line.

d. Draft Your NNN Agreement to Avoid Litigation

The above illustrates the general approach our China lawyers take when drafting any agreement involving China. We do not want to see our clients have to litigate. To reduce the likelihood of you having to go to court it is essential the Chinese side believe it would be relatively easy for you to sue and prevail. China appropriate NNN agreements do exactly that.