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China Product Development: Focus on Manufacturing Rights

Wednesday, November 16, 2016 5:24
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China lawyers
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I recently wrote a series of posts on product development in China, entitled, Hardware Co-Development in China: Do it Right. (Go here for Part 1, here for Part 2, here for part 3, and here for Part 4 of that series). That series resulted from my recent trip to the Hardware Valley in Shenzhen, during which time I was able to discuss our legal approach with foreign hardware developers on the ground in China and the various manufacturing consultants and mentors that help them.

If you read my four part series on developing hardware products in China, you can see that the product development situation is complex, particularly as it relates to who ends up with the related intellectual property as between the foreign developer and the Chinese manufacturer. A number of clients, readers and fellow lawyers have asked me to summarize our current understanding of to practically structure these product development relationships so the foreign company, not the Chinese manufacturer, ends up with the right to the developed product.

We have found that the key in the process is to focus on manufacturing rights, rather than on intellectual property rights, especially when the PRC or Taiwan factory presents the foreign product developer with an already prepared manufacturing agreement. Lawyers all over the world have become masters at writing complex and sophisticated intellectual property provisions for insertion in development and manufacturing agreements. Because these IP provisions are written to cover every possible situation, they tend to be written at such a high level of abstraction that they often have no real meaning on the ground in Asia. When a client asks me to review such a provision provided by a PRC or Taiwan factory or designer, my response is usually that the PRC/Taiwan party chose vague language intentionally so as avoid letting our client know that it plans to usurp our client’s IP or that the language clearly does not to benefit our client.

Our solution at this point is not to further refine already highly refined IP language. Instead, we advocate temporarily forgetting about IP rights altogether and focusing instead on the practical issue of manufacturing rights. At the end of the development process the Chinese factory and its foreign customer (our client) will be looking at a set of prototypes and the sole issue for the foreign party at that point is usually what can I do with those prototypes? If the answer to this question is not clearly resolved at the start of the development process, the answer will usually be that the foreign party can do nothing more with the prototype than what the Chinese factory will allow.

To avoid this result the foreign party should at the inception of the development process secure an agreement that includes the following:

  1. A clear statement of what will be done, who will do it, and when it will be done. This includes a clear description of the product to be designed and a clear statement of the work to be performed. Many product design projects in China fail at this stage. No one knows what is going on, and after a year or two of development, no progress is made on the prototype.
  2. A clear statement of the costs, allocation of costs and payment dates for the costs. Most important is a clear understanding of what will be provided by the Chinese manufacturer in return for your payments. This provision typically should address molds, tooling, software, design, working model.
  3. A provision making clear that if the design project fails, all of the tangible and intangible materials developed during the project should be transferred to the foreign customer. Nothing should be retained by the Chinese factory or designer.
  4. A provision stating that if the design project succeeds and prototypes are developed, you, the foreign customer, shall have the right to manufacture the product in any factory anywhere in the world. This is the key issue. The foreign party should at any time be able to determine what factory will manufacture the prototyped product. Normally, this will mean manufacturing it in the factory of the co-developer. But what if that factory cannot give you a satisfactory price, quantity, delivery date or quality? What if the Chinese factory seeks to raise prices on you six months later? For you to be able to maintain control over your product, you must have the right to move part or all of the manufacturing of your product to the facility of your choice, for any reason at all.

This issue of right to manufacture should be clearly understood by both sides before the parties start discussing the more abstract issues of intellectual property rights. The reason I say this is because every factory owner and every foreign party clearly understands the issue of manufacturing rights and if you negotiate for this at this basic and practical level, the real situation will be revealed in a way both parties can clearly understand. We have found that once the parties reach a clear agreement on manufacturing rights, the technical intellectual property provisions become relatively easy for our China lawyers to draft.

You must though seek to reach agreement with your China factory on manufacturing rights before product development even begins because if you wait until the product development process is complete, you will have relinquished all of your leverage. If you wait until the prototype is completed, the Chinese factory can say no to you having any manufacturing rights and then it can raise its manufacturing prices with near impunity.

This means you must complete your negotiations on the product manufacturing rights before the Chinese side has acquired all the power through its control of the final prototype. This means you must have a China appropriate contract making clear that you (not them) own the manufacturing rights. Without this document, there is a good chance the Chinese manufacturer will be able to stop your product from being made by any other factories in China or from leaving China if it is.

Bottom Line: When beginning the product development process in China it will often make sense for you to skip abstract discussions of intellectual property rights and just focus on the key practical issue both parties can understand: when the prototypes are finished, what can you do with those prototypes? Discuss this issue early on with your Chinese manufacturer.

In my next post, I will discuss what to do when your China manufacturer tells you that you cannot use any other company to manufacture “your” product.

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.

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