IP issues in outsourcing in China

According to Han Yu, a famous littérateur from the Tang dynasty, different people specialise in different things or fields. He predicted the present-day form of outsourcing and the increase in outsourcing, particularly in the era of globalisation.

The most significant advantages of outsourcing are time and cost savings; however, any negligence or lack of preparation in respect of intellectual property in outsourcing may backfire and result in losses in the marketplace in addition to time and money.

Outsourcing involves patent, trademark, copy­right, trade secrets and other relevant IP issues, which IP owners should scrutinise in advance to prevent later troubles and challenges from arising. This chapter will focus on the required preparations to shed some light to overseas companies, in particular those that engage or tend to engage in outsourcing in China.

Being well prepared for outsourcing in China entails various steps: the company must review its existing IP strategy, research the IP protection environment in China and identify what to protect and how to protect it.

Among other things, a non-disclosure agreement (NDA) is undoubtedly necessary to properly secure anything disclosed in relation to intellectual property from the start of the process to prevent misappropriation while discussions about outsourcing are ongoing; however, it is even more important to seek appropriate protection for intellectual property in China before contact and discussion with any potential suppliers or manufacturers for outsourcing purposes.

Further due diligence of potential suppliers or manufacturers is also absolutely necessary.

Formulate an IP strategy for outsourcing

The first step is to identify what kinds of intellectual property the company owns and how it is protected.

After studying the IP environment in China, it is important to evaluate the company’s current IP strategy and, with the help of local professionals, work out an adequate IP strategy, particularly for the Chinese market based on the laws and practices in China.

IP protection and enforcement is territorial; the IP legislation and protection environment differs in different countries. China is a first-to-file country for patents and trademarks, and it has been atop the global list in recent years for the number of patent and trademark applications filed within a year. Further, updates have continued to be implemented to China’s IP system with increasing frequency in recent years.

The first-to-file system means registered IP rights are, in most cases, enforceable in China, but it is difficult or conditional for unregistered IP rights to be enforced, particularly in respect of trademarks and patents.

As the world becomes more like a single city owing to globalisation and telecommunications, as soon as a company’s intellectual property becomes publicly accessible in its hometown, it also become publicly assessable in China as a whole. This provides patent and trademark thieves and other people of a similar mindset with the opportunity to try to get ahead and register the IP right first.

Owing to various laws, regulations and administrative policies that target such opportunists by, among other things, rejecting their applications, imposing administrative penalties, enjoining them from enforcing their IP right and adjudicating to order punitive damages in civil disputes if bad faith is found, the number of bad faith filings and IP opportunists is dramatically decreasing.

In general, trademarks and patents are enforceable when they are registered in China while artwork is protected worldwide as soon as it is created. Some technology is know-how protectable as a trade secret but not patentable, and in some cases, an IP owner will choose to protect its technical know-how as a trade secret rather than a patent.

By considering the IP protection environment, the legislation in China and the types of intellectual property in the outsourcing product, an appropriate IP strategy can be created, particularly for the specific product to be outsourced in China.

Choose the outsourcing model

From the point of view of IP protection, a supplier model should be chosen based on the protection that is required for the intellectual property in outsourcing.

There are, in essence, two supplier models: the single supplier model and the multi-supplier model.

The single supplier model can be further classified into the sole supplier model and the major supplier model. In the sole supplier model, only one supplier is used, while in the major supplier model, one major supplier is responsible for the whole supply process and subcontracts the work to other minor suppliers that the company does not need to know.

In the multi-supplier model, several suppliers are involved, and each is responsible for a component or process of the product. All the suppliers are under the management of the company, and they do not need to know of the existence of the others.

The single supplier model is easier to manage, but the confidentiality of the technology in the product may be a challenge to uphold. The multi-­supplier model can reduce the risk of leakage of confidential information but is more expensive to manage.

With the tailor-made IP protection strategy and the IP protection environment in China in mind, it is possible to calculate the benefits and risks of each model and make the best choice for the outsourcing product.

If the product is a common one without much know-how or privileged technology, and the main IP right in the product is trademark or copyright, a single supplier model is sufficient. In this case, at least one backup supplier is always recommended in case any issues arise with the primary supplier. A regular small supply from a backup supplier can also help pressure the primary supplier to provide a competitive and better-quality service.

If the product or its components are technology­intensive or mainly involve high-end technology, trade secrets or patents, the multi-supplier model is undoubtedly more appropriate from the point view of IP protection, despite being much more expensive and complex to manage and monitor.

By dividing the production process or products into small parts and allocating those to different suppliers, it becomes more challenging for imitators to copy the whole production process or product. It is also possible to assemble all the components outside the outsourcing state if the assembly process is crucial and confidential for the product.

Act early to register IP rights

By the time the company is in the planning phase – or even at an earlier stage – of the outsourcing process in China, the requisite trademarks or patents should have already been registered in the relevant registers in China. The IP owner can obtain legal protection to use and enforce its registered IP right sagainst unauthorised use by third parties.

Outsourcing without any sales in China is also regarded as using the intellectual property in China. If the IP right is not registered and protected, other IP holders may accuse the outsourcing product of infringing IP rights and aim to stop the process.

The official cost to register a trademark or patent and its maintenance in China is far from expensive. Registering the IP right in China is cost-effective owing to the potentially lucrative outsourcing business given China’s status as a growing market with billions of customers; there is no reason to overlook the market, even if the company has no definite plan to outsource in China in the near future.

Investigate candidates

There is a Chinese saying that goes “if you know the enemy and know yourself, you can fight a hundred battles with no danger of defeat.” In accordance with this saying, a company should both know itself and the people or the company with which it cooperates to ensure the success of the deal or cooperation.

Conducting an internet search is a first and easy step to learn about potential candidates. Visiting their websites and e-stores on e-commerce platforms that target overseas purchasers is the quickest way to obtain a first impression of a candidate: the company can learn about the candidate’s history, capacity, size, location, products, business partners and site photos.

It is well known that the information that an individual discloses on its own website is not completely reliable; however, purchasers’ comments on the products at the candidate’s e-store on a well-known e-commerce platform and the sales records are more trustworthy. The store’s rating on an e-commerce platform and the commercial register of the store owner are also often accessible.

The company can also request an interested candidate to provide information for evaluation; however, it must search the internet and other professional and government databases to verify the information provided. The information may include the capacity of the candidate, including its registered capital, its paid capital, its employees, its business scope, its business partners, the lawsuits in which it is involved, the IP infringement lawsuits in which it is or has been involved and the administrative penalties, and the trademarks and patents in the name of the candidate.

In any event, it is not too cautious to have more information than needed about a suitable candidate. Conducting a teleconference, a virtual meeting and even a site visit to meet and talk with the candidate personally will also help the company obtain a complete picture of the candidate. If a site visit is not practical, a reference letter or an email from a business partner of the candidate that is known to the company will be highly preferred.

Conducting due diligence of candidates reuduces IP risks and ensures the successful performance of the outsourcing agreement. Even after the completion of the investigation, a company should not rest on its laurels: it should fully prepare itself to negotiate an outsourcing agreement.

Sign an NDA

To protect its business information, technology, know-how, trademark secrets and other types of intellectual property (confidential information), it is essential for a company to have an NDA in place before discussion about the contact and negotiations are started.

Even if the NDA is in place and negotiations are ongoing, confidential information is recommended to be provided on a need-to-know basis. The company must always bear in mind what to disclose and the extent of disclosure to avoid unnecessary leakage of confidential information.

Conclude a good outsourcing agreement

A well-worded and detailed outsourcing agreement with sections on intellectual property or a separate IP agreement is essential for a company to define ownership of its existing IP rights and the obligations of the parties arising from IP issues.

The ownership of other IP assets arising from the product development or improvements in the performance of the outsourcing agreement should also be stated in an unambiguous manner. A non-compete clause and a clause regulating surplus products or products that are returned owing to inadequate quality should also be considered in IP protection.

The governing law and jurisdiction are also crucial issues should any dispute or breach of contract arise. It is also necessary to put in conditions for earlier termination of the agreement that will release the non-defaulting party.

As the agreement will be carried out in China, it is recommended to have any disputes settled in a Chinese court or arbitration centre to ensure the verdict or ruling is enforceable in China, at least without the extra step of getting a foreign ruling recognised by a Chinese court.

Comment

It is of great importance to establish in writing and properly monitor during the whole outsourcing process anything in connection with patents, trademarks, trade secrets or copyright matters to prevent losses and minimise the chances of entering disputes regarding ownership, infringement, unfair competition or even monopoly.

Although IP issues are expressly stated in the outsourcing agreement, uncontrollable or unpredictable issues may arise while outsourcing. In addition to regular quality checks of products or production processes, it is also necessary to inspect and exchange information regarding any new intellectual property in the name of the suppliers in the database of the China National Intellectual Property Administration and to monitor the performance of IP clauses. This can be conducted by hiring local professionals, who can help prevent or rectify in a timely manner any breaches or potential breaches.

Hard work pays off. The company’s IP strategy and the corresponding measures for the Chinese market should be constantly evaluated and modified to keep up with the changes in the local law and practice. If the outsourcing agreement is terminated early owing to breach by one of the parties or the expiration of the agreement, the company must conduct the requisite preparations again.

Finally, for any conflict that cannot be amicably settled through negotiation, working closely with local attorneys with good experience and other professionals, including private investigators, is necessary and recommended to obtain a better chance of prevailing in an action in front of either an IP court or government agency.