How to Avoid Inadvertently Gifting your IP to your Foreign Manufacturer

My law firm represents many foreign companies that do OEM manufacturing around the world — mostly China, but India, Mexico, Brazil, Vietnam, Thailand, Taiwan, Korea, Malaysia, Indonesia, Bangladesh, and Cambodia as well.  In our discussions with our clients that manufacturing in foreign countries, we nearly always discuss what they can and should be doing to protect their intellectual property in the country in which they will be having their products made and in the countries in which they sell their products. Many of our clients are rightly concerned using a foreign manufacturer to make their products is the equivalent of training that manufacturer to become a dangerous competitor. They are rightly concerned that their manufacturer will appropriate their designs and start selling the same product in the United States, Europe, Latin America, and elsewhere.

Not surprisingly, my law firm’s intellectual property lawyers spend considerable time training our clients in the basics of international IP protection. We lead them through the basic agreements and IP registrations that can protect their IP around the world. When the product is an existing product, the response from our clients to our basic system of IP protections has been remarkably good and we have had considerable success in protecting their IP.

However, when the product is new and requires development work, we have had greater difficulty. In this area, it seems our clients too often fail to understand how easy it can be to “gift” their intellectual property to the foreign manufacturer. Where product development is concerned, we tell our clients: you need three types of agreements: an NNN Agreement, a Product Development Agreement and a Manufacturing Agreement. We have found resistance to using product development agreements. I personally find this difficult to understand, since it is product development that should be the area of greatest concern for intellectual property protection.

Since the foreign parties seem so interested in giving away their IP, many foreign manufacturers have developed a standardized system for accepting the gift. Here is how they typically do it:

The US or EU (usually) company goes to the foreign manufacturer with the basic idea for a new product. The foreign party has a basic design, but has done none of the engineering and related work required to take the design to the point where it can be manufactured in commercial quantities. In some cases, the design has not even been prototyped to determine the mechanical issues to confirm the practicality of the design.

The foreign party then requests the foreign manufacturer do all the engineering and prototype work required to commercialize the product design. The foreign manufacturer offers to do this work free of charge in exchange for a commitment from the purchasing party to purchase the product from them. The purchasing party is excited about being obtaining high-level engineering and prototyping work at no charge. The foreign manufacturer is happy because it has just captured a new client for a new product. The design work is not documented by a written agreement. The usual attitude is that if the product is developed in a way acceptable to the foreign party, then a formal manufacturing agreement will be drafted and executed. If there is no success, the purchasing party will try elsewhere.

This casual approach is often a failure from a practical standpoint. The foreign manufacturer is not being paid, so the design project is often placed on the “back burner” and the manufacturer gives attention to it only when it has spare time. If the manufacturer is a successful company, this spare time may be hard to find. For this reason, extensive delay is common. Moreover, what exactly the foreign manufacturer is being tasked with designing at what standard is usually not specified. So even if the foreign manufacturer finishes the project in a reasonable time, it is often not clear whether the final design meets the needs of the purchasing party. For this reason, for any but the simplest of products, it is essential to enter into a design agreement that sets out a clear standard of performance together with specific milestones that ensure timely completion of the project.

Assume the foreign manufacturer does manage to design and commercialize a final product. Now consider the fundamental issue: who owns the intellectual property in that product? Note that the manufacturer did all the work entirely at its own cost with no specific design agreement with the foreign party. Though an NNN agreement may be in place, the situation is at best ambiguous in most countries.

Now take this consideration to the next step. It is virtually certain the foreign manufacturer you are using to design and then manufacture your widgets is a manufacturer of the same type of product they sell under their own name or to other purchasers. If they were not familiar with your product type, you likely would not have selected them for your development work. There often comes a time when the foreign manufacturer looks at the product it designed “for you” and decides it would rather just make this same product for its own use. Why should it bother manufacturing this product for you when it can manufacture it under its own name and make all the profit?

In this situation, what does the foreign manufacturer do? As you will recall, there is no manufacturing or purchase agreement in place. This means no final price for your product has been set in stone by contract. All the manufacturer need do is quote an outrageously high manufacturing price to the purchaser and if that price is accepted the foreign manufacturer makes a windfall profit by manufacturing the products for the putative purchasing party. If the purchasing party rejects the price, the foreign manufacturer has a new product for its own sales line. The foreign manufacturer cannot lose.

If the purchasing party rejects the price required to move forward with the foreign manufacturer, the more careful foreign manufacturers will take the additional steps required to secure the intellectual property in the product in the relevant countries. They will register a trademark, register a copyright, and register a design patent, all of which they will register with their country’s customs office as well. In this way, they have not only secured the product for themselves, they also have prevented the purchasing party from moving to a different manufacturer to design and manufacture the product.

When the purchasing party threatens to sue, the foreign manufacturer points out the obvious. The purchasing party has no registered IP in the product. There was no written contract related to developing the product. The product was developed entirely at the cost of the foreign manufacturer and the IP registrations were all done by the foreign manufacturer in its own name and at its own cost. The foreign manufacturer then says, “go ahead and sue us, in a court in our hometown.”

Our international manufacturing lawyers have seen countless companies give away all rights to their designs in return for saving money on product development and avoiding having to pay for an appropriate Product Development Agreement. What they have done is gifted away their intellectual property and the foreign manufacturer is happy to accept the gift.

This is particularly true for China. 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: take 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, many of which are set out above.