When working on complex contract manufacturing agreements, most of our clients tell us their main goal is to protect their intellectual property. This is particularly true for designers of start-up products where much of of their IP consists of trade secrets and know-how that require a formal agreement with the manufacturer. However, as we work with the client, we frequently learn that the client has already gifted their IP to the Chinese manufacturer. Making a gift to your family or to a friend is a nice gesture. But no foreign designer of a product intends to make a gift to a Chinese factory owner. The gift is unintended, and the consequences are virtually never good.
Here is what usually happens. We begin drafting the contract manufacturing agreement. In our standard set of questions, we ask about the status of molds. The client then reports something like the following: “We have already provided the designs for our molds to our Chinese manufacturer and the manufacturer has already fabricated the molds. The current issue is focused on payment for the molds.”
We then ask our client about its plans for commercializing their product idea and fabricating production prototypes. The client then reports: “We have been working with the manufacturer for months to fabricate a production prototype. The manufacturer agreed to engage its own engineers and designers for this process. We now have two prototypes and we are ready to begin production. The only issue now is how to pay for the work on the prototypes.”
In both cases, we ask the following sorts of questions:
- What form of documentation did you use in connection with providing your confidential design information to the manufacturer?
- What did you do to formally protect your IP?
- What did you do to make clear you own the entire design in the molds?
- What did you do to make sure you own all of the design work that went into the design and manufacture of the prototype?
Far too often, our client answers with something like this: “The only documentation we have in place is a simple purchase order for the molds. There is no documentation at all relating to the prototype. We were told that using purchase orders at this stage is standard so we did not think about it.”
The above scenario with slight variations is almost standard for start-up companies making their first foray into China’s manufacturing market. We then have to tell our client something like the following: “You indicated your primary goal is to protect your intellectual property. But, by providing your design data to your Chinese manufacturer with no documentation and by allowing the Chinese side to design and fabricate molds and prototypes, you have effectively given your IP to the Chinese manufacturer. The issue for us now is to determine whether or not the manufacturer will agree to return this gift. Sometimes they will, usually they will not.
In this setting, it is possible for the Chinese manufacturer to appropriate the product and to begin producing the product in its own name. When the foreign designer protests, the Chinese manufacturer points out that it did the actual design and fabrication work for the molds and it also did all the design and fabrication work for the product prototype. And since it did all of this work, it owns the design. And here’s the thing: legally, so long as the Chinese manufacturer does not infringe on the registered trademark of the foreign party, it is generally free to manufacture the product and sell it wherever it wants.
Absent formal written agreements, litigation in most countries to determine who owns what in terms of the product is fact intensive with the eventual outcome usually unclear. The lack of clarity simple kills off the chances for most start ups to market its product effectively. So when this situation happens to a foreign start-up, it can mean commercial death. The Chinese side is counting on this. A dead company cannot support litigation required to resolve the issue. Even for well established companies, this situation can cause substantial economic damage, since the effective marketing of a new product is made so difficult.
In most cases, however, the Chinese manufacturer is not interested in selling the product under its own name; what it usually wants is to create a situation where the foreign buyer does not have the option to have its product manufactured by any other manufacturer. The Chinese manufacturer wants to ensure that will be the sole entity with the right to manufacture the product. By getting this it essentially has the pricing power of a monopoly on manufacturing the product.
Here is how it works out on the ground. At some point, the foreign buyer decides it wants to change to another manufacturer because a) the manufacturer substantially raises its price, b) the product is consistently defective, or c) the manufacturer cannot keep up with the required production volume. The foreign company wanting to go to a new manufacturer requests its existing manufacturer transfer its molds and the product prototype to the new factory.
The manufacturer refuses to comply with this request. The manufacturer says: “we own the design of the molds and we own the design of the product prototype. We will agree not to manufacture the product for ourselves or for any third party. On the other hand, you are not free to take the molds and prototypes to any other factory. You can only manufacture the product if you use our manufacturing services to do so. In legal terms, the Chinese manufacturer is saying it will provide an exclusive license to the foreign company to manufacture a product for which the design is owned by the Chinese side.
If the foreign buyer insists that it wants to move its manufacturing elsewhere, some Chinese manufacturers will say that the foreign buyer is free to start from scratch with a new factory. Other Chinese manufacturers will take a harder line and state that manufacturing the product in any other facility is an infringement on its IP and it will take action to prevent that infringement. In the last couple of years, more and more Chinese manufacturers are doing whatever they can (usually via cease and desist letters and litigation) to make manufacturing by others impossible. Either way, if the product is complex in any way, the foreign buyer is in a situation where it is required to work with the original Chinese manufacturer. This then means the foreign buyer can take no practical action to deal with the various issues that caused them to want to move to a new manufacturer. In particular, the foreign buyer is helpless in dealing with a price increase.
Many clients are skeptical when we explain this situation to them. They simply cannot believe they gifted their most valuable asset to another company. Some tell us that their Chinese manufacturer is an honest and upright company that would never act in the ways set out above. Others say that since they paid for the work, it must be the case that the Chinese factory will recognize that the foreign side owns the design and is free to take the molds and prototypes to any other factory for manufacturing.
In our experience, the situation is quite different. In the past decade, in every case on which any of our China lawyers have worked, the Chinese factory took one of the positions outlined above and refused to back down. In other words, once you have gifted your IP, you should not expect the Chinese side will graciously return the gift. Once the gift has been made, the Chinese side will keep the gift and make use of the gift to its advantage.
What does the manager of the start-up tell its investors after having given away the IP at the core of its product and its business? Our China attorneys have had to help with these sort of conversations and we probably hate these conversations almost as much as the managers themselves.
So in an effort to make life easier for product manufacturing start-ups we fervently propose you EARLY ON make use of the following agreements when working with Chinese manufacturers:
- An NNN Agreement
- A Product Development Agreement (a/k/a A Product Design Agreement)
- A Contract Manufacturing Agreement
These agreements should be executed in advance of any transfer of design information to the Chinese manufacturer. Purchase orders come at the end of the process, not at the beginning. Unless you want to gift your IP to your Chinese manufacturer without realizing it. Oh, and while you are at it, you should seek to register your trademarks in China and look into registering your design patents (and maybe other patents) in China as well.