Understanding the Necessity of a China NNN Agreement
Safeguarding your intellectual property (IP) against potential infringements in China is imperative, and a well-structured China NNN Agreement serves as a formidable shield in this regard. When executed with precision, these agreements can provide almost impeccable protection. However, a misconfigured one—which is quite common—could be even more detrimental than having no agreement at all. In this post, we’ll guide you through the fundamental steps to craft a China NNN Agreement that effectively serves its purpose.
Manufacturing in China usually starts with identifying a reliable factory to produce your product. Ensuring the protection of your product at this preliminary phase necessitates compelling your potential Chinese manufacturer to enter into a suitable agreement before you disclose any detailed information. This preliminary agreement should adhere to three cardinal rules: Firstly, avoid employing a Western style NDA (non-disclosure agreement). Secondly, opt for an NNN Agreement—encompassing non-disclosure, non-use, and non-circumvention—tailored to address the nuances of OEM manufacturing in China. Thirdly, ensure that your NNN Agreement is drafted to be enforceable in China.
Do Not Use a U.S. Style NDA
a. NDA Agreements are for Trade Secrets and That’s Not What You Need
NDA agreements focus on protecting trade secrets. For a trade secret to be protectable property, the information must remain a secret. NDA agreements therefore focus on preventing secret information from being revealed to the public. Since U.S. (and EU) companies generally focus on maintaining their domestic intellectual property portfolio, they tend to think they can rely on a single NDA agreement, written in English, subject to U.S. (or EU) law, and exclusively enforceable in a U.S. (or EU) city. 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 information does so to use it for its own benefit, not to reveal it to others. 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. Now that you know what is actually required for China, you can see why US-style NDA agreements are far removed from what is needed to protect your IP from China.
b. 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 usually must be written in Chinese, governed by Chinese law, and exclusively enforceable in a Chinese court. We discuss this in more detail in Section 3 below.
Use an NNN Agreement Written Specifically for China
The three “Ns” that make up a China NNN agreement are: non-use, non-disclosure, and non-circumvention. Consider each in turn.
Non-use means the Chinese factory agrees not to use your idea or concept or product to compete with you. The key is that this obligation arises by a Chinese contract, not from some abstract property rights 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 the Chinese factory cannot use your work because if it does so it will breach its contract with you. Getting a Chinese factory 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.
The next “N” in a China NNN agreement is non-disclosure. Chinese factories usually want your idea or concept for its own purposes, not to help the general public by revealing it to them. But as we mentioned above, this is usually all that a standard NDA can accomplish, and it cannot usually even accomplish that in a China context.
If you prohibit a Chinese factory from using your protected information, the clever Chinese entity will not directly breach the non-use prohibition; it will instead disclose the concept to someone in its “group” and then deny having breached the non-use prohibition because it did not directly use the protected information.
It is therefore 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 factory that made the disclosure will be liable.
Education on this issue is usually 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 most common situations we see when dealing with Chinese factories:
- 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 factories 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 factories often will assert that they must disclose to these subcontractors to provide costing for your product.
- Many Chinese factories 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 (SOEs) often do not regard other SOEs as separate competitors. Because SOEs are state-owned, the view is that 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.
Non-circumvention is the third and last “N” and its importance varies with the situation. Your Chinese factory knows you are purchasing product from it at the China price and then adding a big margin before you sell the product in a foreign market. How would you be impacted if your Chinese factory were to sell your product to your customers at 50% less than you charge? 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 to have a China-appropriate non-circumvention provision in your China NNN Agreement.
Use an NNN Agreement Chinese Courts Will Enforce
a. Draft your NNN for China
Your NNN agreement should usually be written to be enforceable in a Chinese court with jurisdiction over your Chinese counterparty. This means Chinese law should be the governing law, Chinese should be the governing language, and exclusive jurisdiction should be in a Chinese court with jurisdiction over the Chinese company. The fundamental reason for this China-focused approach is that in cases of infringement or circumvention, you must be able to move quickly against the Chinese defendant. Most of the time, any other approach will make the agreement unenforceable or delay enforcement for so long as to render the agreement useless.
Consider the following basic issues:
- Most foreign judgments are not enforceable in China. This means a provision that provides for local country jurisdiction will usually make the agreement unenforceable in China, and therefore relatively useless.
- Foreign arbitration awards 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.
- Arbitration in China is subject to delay and uncertain enforcement. Arbitration panels also usually lack authority to seize assets or take other action to force an infringer to cease its infringing conduct.
- Though Chinese law allows for a foreign law to govern a contract, Chinese courts will require the parties 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 not know exactly what your own contract says until you get the court 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. This is one of many reasons why template NNN Agreements almost never work for China.
For more on what it takes to draft a contract that works for China, check out Contracting in China: A Contract Worth the Paper it’s Written On.
b. Draft your China NNN Agreement to Convince your Chinese Counterparty not to Breach it.
Second, the NNN Agreement should be written so the Chinese company genuinely fears that if it breaches the agreement it will incur immediate and negative impact. The first step to cultivating this 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 China NNN Agreement with an Appropriate Damages Provision
A contract damages provision in your China NNN Agreement will provide you with two important benefits. First, it forces the Chinese party to realize that it will face real and quantifiable consequences if it breaches it. Second, a specific monetary amount provides for a specific minimum level of damages. This sum certain amount provides a Chinese court with the basis for a pre-judgment seizure of assets.
A credible threat of your seizing assets from your Chinese counterparty greatly increases the likelihood it will abide by your NNN Agreement and that you can quickly bring it to heel if it does not. Your China NNN Agreement should include a sum certain contract damage provision that a Chinese court can and will enforce by ordering the 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 that your China NNN Agreement set the contract damages at an amount that reasonably substitutes for the damages that result from a breach of the agreement.
Because Chinese companies know that breaching a well-drafted China-centered NNN Agreement likely will lead a Chinese court to freeze its assets, we encounter the following three responses from Chinese factories to our NNN agreements:
1. Some Chinese companies refuse to sign. These are the companies that planned to steal foreign technology from the very beginning. This sort of situation is incredibly rare.
2. Some Chinese companies will enter into serious discussions about what they believe should be excluded from the NNN Agreement. This is usually a positive result because it often generates productive discussions regarding technical issues. This is also a good indicator that the Chinese company takes the agreement seriously, and those companies tend to be less likely to breach.
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 China 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 our clients to have to litigate so we seek to reduce the likelihood of that by crafting NNN Agreements that convince the Chinese side it will be better off abiding by the contract than breaching it. Our China appropriate NNN agreements do exactly that.
Use the Right Lawyer for Your China NNN Agreement: There are Many Con Artists Out There
In China Contract Drafting Scams: From Bad to Much Worse, we wrote how our law firm’s China lawyers have since COVID seen a massive increase in people drafting NNN Agreements for foreign companies that facilitate Chinese companies stealing foreign company IP. That’s right, we have been seeing a ton of NNN Agreements that make it easier to steal IP, not harder.
I am going to borrow liberally from that post because we are seeing more such “IP theft” contracts than ever before and NNN Agreements are by far the most common place where we see them.
Since the onset of COVID, our China lawyers have seen a massive increase in websites and independent contractors on sites like fiverr purporting to provide the following China legal services at shockingly low prices:
- China Trademarks
- China Patents
- China Copyrights
- China NNN Agreements
- China Manufacturing Agreements
- China Distribution Agreements
- China Product Development Agreements
These “service providers” (note that I am not calling them lawyers, though many purport to be lawyers) will (for anywhere from $10 to $250) review or draft your contracts or provide you a template agreement for China. But many (most?) of them seem to have literally no ability to do these things and their results bear this out. Since the start of the pandemic, our China lawyers have had to tell a number of foreign companies that came to us after getting in deep trouble that their contracts were either completely useless or worse than having no contract at all. When we explain why their contracts are so harmful, their response is usually that they could not afford to use “a real law firm” and they “just figured these would be better than nothing at all.” The problem is that in most cases they are worse than nothing at all.
A few weeks ago, I got an email from someone who had contacted me many months ago regarding a potential litigation matter against a Chinese company. The case was not terribly complicated, and I recommended this person secure local Chinese counsel, particularly since this person spoke Mandarin. The new email was an update, and the news was not good.
Seems this person is convinced his local Chinese attorney passed on secrets to the Chinese company he intended to sue. I cannot say whether this is true or not, but I can tell you this is at least the third time in about a year I have become aware of something similar and I have never heard a story like this involving an American or British lawyer. Frankly, I have never heard a story like this involving a reputable Chinese law firm either. The other two instances involved American companies that had retained (two different) Chinese service providers for their trademark applications, only to have those law firms take forever to file for their trademarks and then report back that a Chinese competitor company had — in the meantime — beaten the American companies to the trademarks. Both companies were convinced (as was I) that their “lawyer” (who probably was not even a real lawyer) had given an advance tip-off to their Chinese competitors and, no doubt, been paid nicely for having done so.
To put it bluntly, Chinese lawyers are NOT required to maintain your confidence. We wrote about this in The Attorney-Client Privilege Really Matters When Doing Business Internationally, Especially in China, in a section entitled, “Be Wary of Hiring Chinese Lawyers and Even More Wary of Revealing Confidences to Them”:
Brad [Luo] concludes this post by saying “if I were a client, I’d hesitate to talk about certain things with my Chinese lawyer.” Brad is dead on with this advice and foreign companies using Chinese lawyers must be cognizant of this and this is something our China lawyers constantly have to explain to our somewhat disbelieving American clients.
. . . .
In China, for example, lawyers have a general duty of confidentiality (Art. 83, Law on Lawyers), but there is nothing to stop them from bearing witness against their clients in civil cases. And though Chinese criminal defense attorneys can choose to maintain confidentiality (Art. 46, Crim. P. Law) regarding their cases, the same discretion does not legally extend to other lawyers. Under this legal framework, an attorney defending someone accused of tax evasion could choose not to testify against their client, but the defendant’s tax attorneys would not be similarly protected.
In addition to these legal considerations, there are also practical ones. American lawyers are rightfully terrified of disciplinary action. Bar associations take complaints seriously and, for the majority of lawyers, disbarment would be a critical blow, both financially and reputationally. This is not to say that lawyers in China are not subject to disciplinary oversight from the government and bar authorities: they are. However, a study of disciplinary cases in Zhejiang found that only 11 out of 122 cases reviewed involved “some aspect of client protection”. Political concerns and the protection of law firms’ interests were usually the driving force.
It is hard to see how the average Chinese lawyer would be fearful of the consequences of revealing confidential information, especially if the affected client is a foreigner, even more so these days if it is an American company. This means you are in a vulnerable situation if your Chinese lawyer stands to benefit by revealing information you provide. Perhaps your Chinese lawyer has another client who would just love to take a look at that new patent application of yours. Perhaps your Chinese law firm stands to benefit by tipping off your competitor before it files your trademark application — we have many times heard of this happening. Or maybe it will be as simple as revealing that you told them that you would have paid $10 per widget, not just the $8 written in your contract. Worse yet, what if your Chinese lawyer is in hot water with Chinese governmental authorities and reporting the missteps of a foreign company will help them curry favor? All of these nightmare scenarios are real life possibilities.
Mindful of all this, savvy clients often take their China work to lawyers bound by the strict confidentiality rules of foreign countries. Of course, on occasion some information may need to be revealed to Chinese co-counsel, but it should always be done in a careful, measured, need-to-know basis.
Needless to say, you do not want to find out that your communication is not privileged after you have disclosed confidential information. The best course of action will usually be to talk to your international lawyers in the United States and design appropriate strategies before engaging with lawyers abroad. These lawyer trust issues have been out there for a long time, but with the increasing tensions between China and the United States, they are and will continue coming to the fore and this has spurred us to write about this again.
The risk of your Chinese lawyer using your information for its own profit has always been there, but it was rare for this risk to come to fruition until COVID. Now we are seeing this happen all the time and we think the bulk of this is coming from non-lawyers masquerading as lawyers and from online service providers selling templates.
That post provided the following statistics regarding these low-price contracts:
Roughly 40% of the China contracts we have seen done at shockingly low prices were so badly written as to be worse than no contract at all. Around 25% of these contracts appeared to involve a lawyer/fake lawyer who was paid by the Chinese side to “throw” the contract to the Chinese side. The remaining 25% of these contracts are roughly divided between those that are slightly better than nothing at all and those that are roughly the equivalent of nothing at all. In other words, paying a really low fee for a Chinese contract gives you about 10-15% chance of doing better than doing nothing at all and about a 75% chance of doing worse. How do you like those odds?
In addition to contracts written that simply do not work, we also often see issues with the type of contract chosen. We see someone who paid for a bad NNN agreement when they did not even need an NNN agreement at all — what they really needed was a Product Development Agreement. And we have seen the reverse of this. We have seen licensing agreements when a distribution agreement was what was actually needed and we have seen the reverse of this. We have seen distribution agreements when a manufacturing agreement was needed. In other words, people are not only paying for contracts so badly drafted as to be worse than no contract at all, but they often are also paying for the wrong contract for their specific situation! See China Contracts Templates for $99 Each.
I urge you to read the entire post because it is of particular relevance for China NNN Agreement because the statistics for NNN Agreements are far worse than those set forth above and the results of a bad NNN Agreement are often devastating. As one of our most experienced international manufacturing lawyers is always saying: More than anything else, it is stolen IP that destroys companies. How can you compete against a company that sells your product and for less than it costs you to make it?