Navigating OEM-related IP challenges

1 minute read

Original equipment manufacturing in China is increasingly popular but rights holders must be aware of the threats to their intellectual property. Because the manufacturing partner has easy access to a lot of your intellectual property, finding a partner you can trust is key. Rights holders need to conduct thorough background checks on their would-be partners and build in safeguards for worst-case scenarios. Some of these safeguards include liquidated damages, granular and specific dispute resolution provisions and very detailed written record keeping, in case a dispute has to go to court.

China's rise in the last two decades to become one of the world's pre-eminent low-cost manufacturing powerhouse is well documented and provides an overarching narrative to outsourced manufacturing investment in the Asia Pacific region. The breathless sprint to achieve manufacturing growth has come with its share of horror stories for foreign IP owners, and now with lower-cost neighbours in the region competing for the same investment, it is worthwhile to take stock of some of the lessons learnt the hard way. China's manufacturing might, and what some say is most attributable for China's poor reputation in IP protection, is its original equipment manufacturing (OEM) sector. A common misunderstanding is that OEMs are "original" in the sense that they are responsible for everything from manufacturing to branding of a product, as opposed to third party manufacturers of aftermarket products and customisations. In reality, OEM production refers to an arrangement between an entrusting party and an OEM, whereby the OEM is merely responsible for manufacturing products pursuant to specifications of the entrusting party's purchase order. In many cases, the entrusting party will then apply its own branding, sell the product using its name, provide product support and licensing and other services.

To properly understand the IP pitfalls with OEM products one must first consider some basic truths. There are numerous advantages for a company to entrust a Chinese OEM with production, such as:

• Massively lowered production costs (up to 80% in some cases);

• Higher product volumes;

• Increased production efficiency leading to time savings;

• The flexibility to rapidly expand product lines;

• Access to the OEM's personnel and production processes; and

• Access to the Chinese domestic market.

"In many cases the only difference between counterfeit and genuine goods is the time of day they were produced within the same factory"

However, every class of IP asset, be it copyright, trade secrets, trade marks, patents, designs or utility models, may be shared in the course of outsourcing relationships and are vulnerable.

The high-tech export leader in the region is Japan. Japanese companies have taken advantage of some spectacular OEM opportunities in China but also suffered at the hands of some high profile cases of IP and identity theft. Perhaps the most egregious case involved NEC, which several years ago discovered entire unauthorised product lines being manufactured and sold under the NEC brand from fake NEC factories. Despite these issues and rising labour costs in China in recent years, Japanese high-end manufacturers continue to make plans to increase production in China, contributing to the annual growth rate of 30 percent annually for the Chinese OEM sector.

A general definition of counterfeit goods is any goods which infringe upon the IP rights of another. A more subtle definition is one that has been adopted by the JPO, which refers to "free-riding" goods that are produced with no investment and are infringing on another party's IP rights, including trade mark rights, design rights, patent rights and copyrights.

OEMs are in a unique position to produce counterfeit goods because:

• It may be necessary for an entrusting party to share proprietary IP such as know-how, trade secrets, designs, trade marks and patents with the OEM, giving the OEM a head start in assimilating the technology.

• Equipped with the entrusting party's IP, the OEM can manufacture unauthorised batches of counterfeit goods. In many cases the only difference between counterfeit and genuine goods is the time of day they were produced within the same factory.

• The enticing financial incentive for OEMs to produce and sell unauthorised batches of goods goes in hand with the sentiment that OEMs do not feel they owe any loyalty to entrusting parties, whom are often foreign companies.

• OEMs may use their entrusting parties' designs, know-how and technology as a base to develop more sophisticated counterfeit products of their own.

• OEMs may share their entrusting parties' IP with other customers or potential customers to retain or earn their business, giving these third parties an unfair advantage or even an invitation to produce further counterfeit goods.

• Chinese OEMs have shown that they are often undeterred by the consequences. This is particularly so in smaller and more isolated locales where local protectionism may be a relevant factor. In some cases these OEMs are the largest employer around and local officials may be under great pressure to protect local economic interests.

• Lastly, in some cases OEMs may simply lack an understanding of the importance of IP rights, or the parties' position in respect of IP rights were not clearly set out at the onset of the relationship.

Counterfeiting is a major problem in China. In 2012, the International Chamber of Commerce estimated that the global value of counterfeit goods amounted to $1.7 trillion and China alone accounted for 70% of the seized counterfeits globally.

These goods also often make it back to their home country. In a study conducted in 2014, the Japanese Ministry of Finance found that 96.5% of counterfeit goods found in Japan were imported from China. While it is true that a portion of these counterfeits are attributed to third party counterfeiters and not OEMs, it is probably a reasonable assumption that a good portion of counterfeit goods, particularly of the more sophisticated or even identical counterfeits, are produced by OEMs or based upon proprietary information provided by them.

It is worth stressing that there are really only two key strategies to dealing with OEMs, whether Chinese or not:

• Know your counterparty and build a relationship; and

• Assume at the outset that things will go wrong at some point, and plan accordingly.

Below are some recommended best practices before engaging with a Chinese OEM, and what to do when an entrusting party finds that its IP has been infringed.

The OEM checklist

These are some of the key issues to keep in mind when engaging an OEM in China: 1) Know your OEM counterparty: to be forewarned is to be forearmed. Consider conducting litigation searching to see if the OEM or any of the senior management have been involved in IP infringement cases previously. 2) Know your own IP: ask yourself what IP can you live with being leaked, and what IP you cannot. Consider on-shoring production of key critical components and processes. 3) Structure your agreements and contracts to a granularity that acknowledges different forms of IP-related disputes: consider arbitration clauses where appropriate, and litigation carve-outs for other red-line situations. Consider what language to draft the agreements in and what governing law. 4) State specific amounts of compensation for certain eventualities. Even if it is only a ballpark figure, that might be just enough of a warning to dissuade counterfeiting. 5) File your IP in China and file often. Enforcement of unregistered rights is extremely difficult by and large. Take advantage of different forms of IP protection available in China, such as utility models which might be a more efficient and effective form of enforceable right depending on circumstances. 6) Litigation may sometimes be your best – and only – recourse. Prepare accordingly by quickly securing evidence of infringement when becoming aware of counterfeit behaviour. Know also that worthwhile damages are available in China: in a recent patent infringement case over RMB 150 million ($23.55 million) was awarded to the patentee. 7) But also be aware of quirks in Chinese IP law protection – in a Supreme People's Court (SPC) decision in 2012, Ryohin Keikaku, the holding company of the well-known Muji stores, opposed a registration for the Chinese version of "Muji". Ryohin Keikaku based its opposition on its use of the mark on OEM goods that were manufactured in China but exported elsewhere and not sold in China, which it argued constituted "prior use". The SPC rejected Ryohin Keikaku's argument and held that this alone was not sufficient to prove use of the mark.

• IP due diligence – before engaging any OEM an entrusting party should first conduct an IP due diligence exercise. This will include: (i) identifying what IP assets there are, their registration or application statuses in China and whether there are any IP contracts or licenses attached to them; (ii) assigning classes for each asset based on their value and importance; (iii) determining which classes of IP can and cannot be shared; (iv) assessing the level of risk and ease by which each IP asset may be copied if shared; and (v) in consideration of the above, conducting a risk analysis to determine whether the benefits of OEM production outweigh the potential risks of infringement.

• Register your IP! This cannot be stressed highly enough. Trade marks, patents, designs, utility models and copyrights are all registrable in China. An entrusting party should register at least its identified key IP before engaging an OEM. In many cases it is significantly more difficult to defend IP on the basis of unregistered rights should infringement occur. Tactical use of utility models should be considered where perhaps invention patent protection is either not available or unsuitable due to time and cost issues.

• Keep all records of trade marks use – courts in China place great emphasis on documentary proof. Retention of all documents pertaining to use of a trade mark from the earliest date will pay dividends in the event that prior use of a mark has to be proved in court.

• OEM due diligence – conduct due diligence to investigate the OEM's legitimacy, track record, reputation for respecting IP, ownership structure, who their business partners are and how it has dealt with the IP of its business partners in the past.

• Contracts and agreements – entrusting parties should include well-drafted IP protection clauses in OEM and IP contracts that adequately protect the IP to be shared. Consideration should be given at the outset for "what if?" scenarios. For example, disputes over quality and materials may be something that an entrusting party would want to work with the OEM to resolve, in which case having an arbitration clause as a fall-back position in the contract might be suitable. However, if unauthorised production runs are discovered by the entrusting party then arbitration – with a potentially lengthy process and enforcement issues – would not be suitable and a carve out to preserve the entrusting party's right to litigation should be included. Similarly, providing in any agreement a liquidated damages amount – even if just a rough amount – for certain situations, for example the non-return of proprietary moulds or tooling, might be enough to make a wayward OEM think twice.

• When sharing prototypes, know-how or trade secrets that may not be covered by prior contracts, entrusting parties should always enter into non-disclosure agreements prior to disclosure.

• Communicate with the OEM – even if IP protection have been set out in a contract, it is important for the entrusting party to clearly communicate to the OEM what each party's rights and obligations are in respect of IP and that the entrusting party takes its IP rights seriously.

• Investigations – an entrusting party should consider engaging a private investigator to collect as much evidence of infringement as possible, as soon as possible. There is no evidence discovery litigation in China so oftentimes evidence of infringement can only be obtained through investigators. Evidence preservation options are available through the court, but their effectiveness is questionable in practice so acquiring evidence of infringement before the OEM party has had a chance to render the evidence out of reach is important.

• Warning or cease and desist letters are not a pre-requisite for commencing legal proceedings in China. Nonetheless, they are recommended in most cases not only because they are potentially a cost-effective method to stop infringement, but because they also place infringers on notice such that they cannot raise an innocence defence in court.

• Administrative raid actions are a cost-effective enforcement method and the response time from administrative authorities to seize goods is also relatively quick. Any evidence that is collected by the administrative authorities may also be admissible in court proceedings. As mentioned, this is especially useful in China where it may be difficult to collect evidence due to the lack of an evidence discovery step in the litigation process.

• Criminal enforcement – the entrusting party may make a direct complaint of infringement to the Public Security Bureau. This is a cost-effective method of enforcement that may result in fines and a jail sentence for the infringer. This is a strong deterring factor to prevent repeated infringements. However, there are no damage awards available for losses to the entrusting party.

• Civil litigation – an aggrieved entrusting party may consider initiating civil proceedings against an infringing OEM. While this is often the most expensive and time consuming option, unlike in administrative raid actions the Chinese courts can award damages to the IP owner, including the infringer's profits. However, local protectionism and consistency of the quality of the courts remains a problem in some areas in China.

Outsourcing production to OEMs in China can be highly lucrative. However, counterfeiting remains a widespread problem in China. An entrusting party should not be fixated on the benefits of OEM production and overlook the potentially significant IP risks. Enforcing IP may be a costly and time-consuming affair and some forms of IP, such as trade secrets, may be permanently lost once disclosed. Entrusting parties must therefore ensure that they have as many factors in their favour before they commit their key IP to the OEM.

Gordon Lee

Ted Chwu

© 2015 Ted Chwu and Gordon Lee. Chwu is a partner at Bird & Bird in Hong Kong, while Lee is a legal assistant, also in Hong Kong