Why NDAs Do Not Work for China

The other day, I did a post, China NNN and NDA Agreements, on why China NNN Agreements are so important for those doing business with China. Within a few hours of that post, my co-blogger, Steve Dickinson, pointed out that if we are going to encourage China NNN Agreements over non disclosure agreements (commonly referred to as an NDA), and the below is that post.

Most lawyers tell their clients who are doing outsourcing work in China that they need an NDA. Many businesses see the typical NDA as an unnecessary and unenforceable “piece of paper” they use only if their legal department forces them to do so. The normal questions I get about NDAs are the following:

  1. How can I prove the information mentioned in my NDA was revealed?
  2. How can I prove what was revealed was actually confidential per my NDA?
  3. How can I enforce the NDA agreement even if I could prove the facts?”

Their concerns are well founded, particularly when dealing with China. In fact, most of the NDAs our China lawyers are completely useless because for China because they are directed at the wrong issues and they are unenforceable. Pulling your English language NDA and having it translated into Chinese is a complete waste of time as your resulting document will be either worthless or worse than having nothing at all.

I feel compelled to repeat this. A Western-style NDA is worthless or worse for China. For China, you need a China NNN Agreement.

When my law firm’s international manufacturing lawyers  work on international manufacturing arrangements, we never just draft a “straight NDA.” Instead, we draft a “non-disclosure/non-use/non-circumvention agreement” that we refer to as an NNN Agreement.

When a foreign company client contracts with a foreign/Chinese company to manufacture a product, the NNN focuses on the three primary “bad acts” the foreign company client needs to prevent:

1. The foreign company does not want its design revealed to a third party. To prevent this, a non-disclosure agreement is required. Though this is an important issue, disclosure to an entirely unrelated third party is actually fairly uncommon with China manufacturers. The bigger risk is disclosure to a related party. Many Chinese businesses have multiple subsidiaries and manufacturing is often done through a large network of subcontractors. Chinese companies are quite relaxed about passing around information within this network. A good non-disclosure agreement must focus on controlling information within a network that the Chinese manufacturer itself does not consider as falling within the scope of a non-disclosure requirement.

2. The biggest concern of the foreign company is usually not disclosure to a third party. They are usually are most concerned about preventing their Chinese manufacturer from making use of the foreign company’s own product design to compete with the foreign company. For this purpose a non-use agreement is required. A good non-use agreement focuses on two issues. First, the agreement identifies the applicable intellectual property or confidential information of the foreign company and then authorizes the Chinese manufacturer to use that intellectual property or confidential information solely to manufacture product for the foreign company. Second, the agreement requires the Chinese manufacturer agree not to manufacture the product or any similar product other than for the foreign company. This second provision prevents the Chinese manufacturer from manufacturing a similar product under its own trademark. Since many products are not covered by patent or trademark or other IP protections, the only way to prevent such “copy-cat” manufacturing (for which China is deservedly famous) is with such a non-use provision. Normal IP protections will not work, so a contractual agreement is essential. NDAs utterly fail to account for this.

3. The foreign company also does not want its Chinese manufacturer to go around (circumvent) them by selling their product directly to the foreign company’s existing or future customers. After the Chinese manufacturer has manufactured the product for some time, it will likely have learned about the market and the customers for the product and you do not want that manufacturer to then go to your customer and say: “Look, we are the company actually making this product and since this product has no patent or other IP protection, why don’t you just buy the product directly from us, for a lot less?” This is called circumvention and it is extremely common in China. If you want to avoid getting “cut out” in this way, a non-circumvention agreement is required. Again, NDAs just ignore this.

Most non disclosure agreements our lawyers see are just modifications of the standard NDA used in the United States or in Europe and those agreements simply do not address the special problems of related parties in China or the need to protect against circumvention either inadequately or not at all. Only a carefully thought out NNN Agreement that thoroughly resolves all these issues is of value for China.

But even if these NDA agreements were to account for all three of these issues literally none of the NDAs our China lawyers have been provided by foreign companies were worth the paper on which they were printed because they were all unenforceable in China.

The NDA agreements we see for China are just modifications/Chinese language translations of standard NDAs used in the U.S.  and in Europe. The non-disclosure provisions do not deal with the special problems of related parties in China and the non-use/non-circumvention is ignored. Only a carefully thought out China-specific NNN Agreement (non-disclosure, non-use, non-circumvention) that treats all the issues is of any real use in China.

But even the best agreements are of no use if they cannot be enforced. This is the other major defect of the NDA agreements we have reviewed: they are simply not enforceable.

For an NNN Agreement to be enforceable, it must be enforceable in China. And yet, the ones we see are governed U.S. or English or Spanish or French. or German or whatever law, with enforcement by litigation in the U.S. or England or Spain or France or Germany or by arbitration outside of China. This approach is almost always useless because the foreign court may not have jurisdiction over the Chinese company and because Chinese courts almost never enforce foreign judgments. This means you can get the foreign judgment, but you cannot get paid on it. Arbitration outside China is expensive and slow and proof is difficult or impossible to provide and it means no access to injunctive type remedies that would be available for arbitration in China. And though China is supposed to enforce foreign arbitration awards, its record of doing so is abysmal.

To greatly increase your chances of having an NNN Agreement that will be enforced, the following nearly always makes sense:

1. The agreement must provide for enforcement through litigation in a Chinese court or through CIETAC arbitration. To further ensure that the NNN Agreement will be enforced, the NNN Agreement should provide for specific monetary damages that will be awarded in the case of a breach. Though U.S. and other common law systems sometimes discourage using this sort of liquidated damage provision, the Chinese system is the opposite. Specific contract damage provisions are encouraged since they ease the court’s work.

2. If you are going to be litigating your NNN Agreement in a Chinese court, the official language of that agreement should be Chinese. Otherwise, there is a good chance the Chinese court will never hear your case, and even if it does, it will use its own translator to translate your agreement into Chinese and those translations are rarely good for the foreign company.

3. Most NDA agreements rely almost exclusively on injunctive relief as their primary enforcement mechanism. This is a a major mistake in China. The preference for injunctive relief in common law systems (such as the United States or England) is because it is often difficult or impossible to prove the amount of economic damages that result from a breach of the contract. This is not really an issue under Chinese law, where parties to contracts are encouraged to set a fixed amount for damages that will result from a breach. If written correctly, the liquidated damage amount sets a floor on damages, but if actual damages exceed that amount, it is permissible to seek damages for the excess. In addition, money damages and injunctive relief are not exclusive. A court or arbitrator is free to order that damages be paid and that the infringing/breaching party terminate the infringing action. Lastly, China’s court procedures make seizing bank accounts relatively fast and easy up to the amount of the liquidated damages set forth in the contract.

NNN Agreements with a liquidated damages provision that complies with Chinese law make clear to your Chinese counter-party that they will be putting their company at major risk if they breach your contract and, by doing so they go a long way towards discouraging a breach. Having a properly written liquidated damages provision in your NNN Agreement also makes for quick and effective litigation/arbitration.

Most Chinese companies will eagerly sign NDA agreements  because they know that signing those comes with almost no risk.

When Chinese companies see a China NNN Agreements, they sometimes resist signing. For some Chinese companies, their reason for this resistance is simple: they wanted to work with the foreign company to acquire the foreign company’s technology and designs and contacts for itself. So long as your technology is not protected by Chinese patent or trade secrecy law, and you have not required your Chinese counter-party sign a strong NNN Agreement, your Chinese counter-party is free to use your technology and designs and contacts for its own purposes. Absent an agreement that prevents them from doing otherwise, it is perfectly legal for a Chinese company to use your unprotected information for its own products manufactured under its own trademarks. However, if your China NNN Agreement makes clear that the Chinese company cannot appropriate your technology or designs or contacts, then the Chinese company that wanted to work with you solely for these reasons is no longer motivated to do business with you.

Sometimes the Chinese company has more complex reasons for refusing to sign a well drafted and enforceable China NNN Agreement. A well drafted and enforceable NNN agreement shows the Chinese company that the foreign party knows its way around China and that it plans to hold the Chinese company to the terms of their contractual commitments. For this reason, the Chinese company may decide it would be better off just working with those foreign companies that do not manifest an intent to hold them to their commitments.

We see driving away these sorts of Chinese companies as a good thing. If the Chinese side has a good reason for not signing, they will say so and the agreement can be modified to account for that. If the Chinese side refuses to sign for bad reasons, it will be forced to make this clear also. In either case, the foreign company benefits from finding out in advance what is really going on. This “advance notice” function is one of the main advantages of a good NNN Agreement; it forces both sides to face up to the real situation and to engage in a frank discussion of what is really required for a successful and long term relationship. This is a much better situation than ritually executing a meaningless agreement.

What are you seeing out there with your NDA and NNN Agreements?