The Challenge of IP Protection in China

Outsourcing to China can entail taking steps to protect your business and assets, and provide for enforcement of Intellectual Property Rights (IPRs) by Kevin Colangelo, Associate, Kramer Levin Naftalis & Frankel LLP

THROUGHOUT 2005, A SEEMINGLY endless stream of articles, editorials and special reports touted China's new and growing role in the global economy. If the overload of commentary is to be believed, 2006 stands to be the first year in which mainstream corporate America seriously considers China-based technology service companies when discussing viable outsourcing destinations.

China's emergence as a true engine of global commerce has been happening slowly but deliberately over the last decade, with the most significant activity being the inclusion of China in the World Intellectual Property Organization in 2001. And, while the importance of this single event in promoting China as a safe and trusted business partner is undeniable, U.S. companies seeking to obtain technology-driven outsourcing services from Chinese companies still face numerous legal and practical challenges.

State of the Industry

China is in the midst of an extended period of tremendous growth, with its Gross Domestic Product (GDP) having quadrupled since 1978. In the manufacturing sector, annual exports to the U.S.A. alone rose from $66 billion to $163 billion in the period from 1997 through 2003. In addition, China is already the largest software-outsourcing base for Japan, which is understandable, given the proximity and relative cultural similarities between these two nations.

In contrast to the rapid pace of China's manufacturing gains and its stronghold on the Japanese outsourcing market, China has failed to attract significant attention from U.S. companies for technology-based outsourcing projects. This despite a Chinese workforce of approximately 500,000 professionals in the IT industry (with at least 80,000 expected to be added each year in the foreseeable future), and labor rates that are generally between 10%–15% below those found in India. But, even with outsourcing to India and other overseas destinations in full tilt in the U.S.A. for several years, the notion of outsourcing technology-related services and processes to China continues to be a tough pill to swallow for many U.S. companies, for a variety of obvious and not-so-obvious reasons.

Industry professionals and commentators cite a wide variety of factors for the slow acceptance of outsourcing to China (see below). But, perhaps the most well-publicized and, at least from the legal perspective, greatest risk factor in outsourcing to China continues to be inadequate and unpredictable protection and enforcement of Intellectual Property Rights (IPRs). The concerns on this issue are diverse, complex and unavoidable. At the core of the problem is a legal and judicial system that has historically had much difficulty enforcing western-style intellectual-property laws and regulations. The Chinese have traditionally viewed intellectual property as community property, and domestic competitors have frequently copied each other's products and ideas with impunity. In addition, as Chinese markets have opened up in the last three decades, many foreign companies have been expected to exchange their intellectual property and know-how for market access, something that U.S. companies that value their IPRs are simply unwilling to do.

As a further source of frustration, China's laws do very little to discourage trade-secret theft. And, from a patent perspective, China's adoption and implementation of the “first-to-file” rule (instead of “first-to-use” in the U.S.A.), enables unscrupulous companies to obtain Chinese patents on U.S.

companies' intellectual property by doing nothing more than copying these proprietary inventions and racing to the State Intellectual Property Office to file their claims.

Considering the above, it is clear that the reticent attitude of many U.S. companies toward outsourcing to China is not driven by a misperception that China continues to maintain substandard protection for IPRs. There are, however, discrete strategies that U.S. companies that decide to engage a Chinese company for an outsourcing project can and should adopt in order to minimize and manage the risks associated with such endeavors.

Establishing IPRs

When contracting for outsourcing work to be performed in China, it is critical for a U.S. company to use its pre-contract leverage and take all prophylactic measures to secure as much protection as possible for its intellectual property. Given the current state of the Chinese legal system, it is not advisable for a foreign company to depend on Chinese intellectual-property laws for such protection.

Prior to engaging a Chinese provider, a company must take the time to thoroughly evaluate the intellectual property it wishes to protect in a manner that goes beyond simply taking inventory of relevant technologies and processes. The company's internal due diligence should include an examination of all sources of competitive advantage in its product or service, and the unique features, processes, technologies (both proprietary and licensed from third parties) and relationships that define the company and/or its “brand.” This process should be approached from both a current and forward-looking perspective, as the company's ability to assist its Chinese service provider in influencing the development and enforcement of standards relevant to the company's products and services is often a critical aspect of establishing ongoing intellectual-property protection for such products and services in China.

A U.S. company must register its patents and trademarks with the appropriate Chinese agencies and authorities for those rights to be enforceable in China. Although not mandatory, registration of copyrights with China's National Copyright Administration is advisable, especially should an enforcement action become necessary. In addition, under Chinese copyright laws, copyrightable work performed by employees of a Chinese company that is not within the specific employment relationship may belong to the employee. Thus, the outsourcing contract should expressly designate all work performed by the Chinese provider and its employees (as well as any agents and subcontractors), including any derivative works based upon or improvements to the outsourcing customer's existing intellectual property, as “work made for hire.” It is also advisable to include a separate provision that clearly and irrevocably assigns to the company all associated copyrights and other IPRs in the work performed by the Chinese provider and its employees.

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