China NNN Agreements — No, Don’t Do That

So you are in China, looking for a factory to produce your innovative product. The factory is looking for the same thing. So how do you prevent the factory from appropriating you brilliant new idea. As I discussed in my post yesterday, a US-style NDA will be worthless; at this early stage what you need is an NNN agreement.

What are the three N’s? They are non-use, non-disclosure and non-circumvention. Let’s look at each in turn.

By non-use we will require the factory to agree by contract not to make any use of your idea/concept/product in a manner competitive with you, the disclosing party. The critical point is that this obligation arises by contract. The protection is not based on abstract property rights arising under intellectual property law. The prohibition protects you not because your concept is classified as some form of intellectual property such as trademark, copyright, patent, mask work or trade secret. The factory is prohibited from using your work because it executed a contract prohibiting it from using your work. Getting a factory to sign a contract with a non-use provision means there is no need to look outside that contract to other areas of law for you (and China’s courts) to control the Chinese factory.

The next element is non-disclosure. As noted in my earlier post, most companies should not be terribly concerned with disclosure to the public. This is because the Chinese factory usually has no interest in letting the general public in on their good thing. If they want to use the concept, they want to use it for their own purposes. They rarely have any interest in disclosing to the public.

But if you prohibited the Chinese factory from making direct use of your concept, the Chinese factory now has a problem. The clever Chinese entity will not directly breach the non-use prohibition. It will simply disclose the concept to someone in their group and then accurately claim that it has not breached the non-use prohibition because it is not directly making use of the protected information.

For this reason, it is important that you understand the type of group with which you are dealing and you must make clear: 1) disclosure is specifically prohibited within the group and 2) if there is any infringement by any member of the group, the factory that made the disclosure is fully liable.

Often, some education on this issue is required because many Chinese companies do not see disclosure to a member of their group as violating the non-disclosure prohibition. This confusion arises in many settings were the factory owner by custom will not see that sort of disclosure as being prohibited. The situations you will normally confront are as follows:

• In many regions of China, family members own a large group of small to medium sized companies. The family sees all of these companies as the same entity for disclosure purposes.

• Many Chinese factories use a whole team of constantly changing subcontractors. Some of these subcontractors are part of the family group, some are related by co-ownership, some are related only by physical proximity. The factory will often argue that they must disclose to their subcontractors to be able to properly evaluate or cost your product.

• Many Chinese factories are part of large and extensive “group company” 集团公司 arrangement where numerous subsidiaries are owned by a single parent. Members of the group do not see other members as outsiders for purposes of prohibition of disclosure.

• Many state owned enterprises do not see other SOEs as separate competitors. In their view, they are all owned by the state and the information held by one company should be freely shared with other SOEs in the same business. This is particularly true in sectors with a public service background such as medicine, healthcare and aeronautics. Since all the companies are pursuing the public good, they see no reason not to share the wonderful information provided to them by foreign companies.

Finally you need to deal with non-circumvention. The Chinese factory knows that you are purchasing the product at the China price and that you are then adding a margin and selling at a profit in the foreign market. In this situation, it is only natural for the Chinese factory to work to obtain a list of your customers. They then contact your customers and offer to sell the product absent your trademark at the original China price. After going through your customer list, they then start marketing “your” product to the rest of the world. Trust me when we tell you that at least a half dozen times a year the China lawyers at my firm get contacted by a company that is on the verge of going under or has already had to shut down after having been taken out by a Chinese factory using this tactic. What would your customers do if offered your product for 50% less? We realize that in many industries (especially those where quality and servicing is critical) most customers would say no. But in many others, they quickly and almost uniformly say yes.

This is circumvention, and you absolutely must prohibit circumvention by contract. There is no other way to do it. A good NNN agreement is your only protection.

These are the three elements of China NNN agreements. As you can see, the situation is complex and the contract must be carefully drafted to deal with your specific situation. Now that you have torn up your worthless NDA and you have mastered the three Ns, one more step remains. You must ensure that your NNN agreement contract has some teeth that provides you with the tools required to keep the Chinese factory under control. I will discuss how to accomplish that in my next post.

The post China NNN Agreements — No, Don’t Do That appeared first on China Law Blog.

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.