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Hardware Co-Development in China: Do it Right, Part 3

Sunday, November 6, 2016 6:46
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China product development contractI am coming off two straight days of speeches before and meetings with start-up hardware technology companies here in Shenzhen. Early last week, in Hardware Co-Development in China I wrote about how our China lawyers often see situations where a foreign developer of a hardware or an Internet of things product loses that product to its Chinese manufacturer after having spent years in co-developing that product with the Chinese manufacturer. The foreign designer and the Chinese factory will work together for months or years to develop a commercially viable product and then when the prototype is finally finished, the question then becomes whether the foreign developer that came up with the idea owns the product or the China factory that helped take it from concept to esign. In a cooperative co-development setting, the foreign party and the Chinese factory work together to create the prototype of the commercial version of the new product. All the work is done on a purchase order basis, with no written contract or other documentation.

When the Chinese factory completes the prototypes it will almost always retain them (rather than just hand them over to the foreign developer) in anticipation of moving to the manufacturing phase. However when the parties move to the manufacturing phase, it is normal for something to go wrong. This usually happens in two ways. The Chinese factory substantially increases the unit price to manufacture the product or it announces that it cannot meet the product’s quantity or delivery date requirements. Alternatively, the Chinese factory consistently manufactures defective products.

Facing these problems, the foreign party will tell its Chinese manufacturer that it will be taking the prototypes to have its product manufactured elsewhere. The Chinese manufacturer then announces that it owns all of the IP in the product (and oftentimes it will have registered some of this IP completely unbeknownst to the foreign developer) and only it has the right to manufacture that product.

How can you as hardware developer stop the above sort of situation from happening to you?

The first step in dealing with China hardware co-development is to understand how the basic law of inventions works. Simply stated, a foreign developer who does not enter into a written agreement is relying on the default provisions of intellectual property law, particularly the law of patents. This reliance on the default provisions is a mistake, because the default provisions favor the Chinese factory.

It is a basic provision of the law of inventions in China and the U.S. that the party who came up with the “idea” does not own the invention; the party who takes the idea through to practical implementation does. This is generally true even when the party who achieves practical implementation has been paid to do so. What this means in real life is that even if you pay your Chinese factory for some or all of the costs of the development work done by the factory, if the factory in fact did the work, the Chinese factory owns the invention unless you have a valid contract to the contrary. 

Since the default provisions of law do not protect the foreign designer, a contract that sets out the ownership rules is required. Though the factory may own the IP as matter of law, the Chinese factory can also assign part of all of its ownership to the foreign designer via a written contract. However, this assignment is only effective if done with a clear written contract (in Chinese) subject to Chinese law and enforceable in China. This contract must state exactly what will be developed and which party will own the IP in the resulting product. Properly drafted, the foreign designer will own everything, as the foreign party intends. But, without such a contract, as in the case where there is nothing more than a bare purchase order, the result is the reverse. The entire result turns on the content of the contract.

In the above analysis, we assume that a single product is developed and that all the IP in the product prototype was created during the development process. We refer to that setting as wholly owned IP. But increasingly, our China attorneys are seeing product prototypes that involve “blended IP.” For blended IP, the situation is more complex. In many projects, the co-developed product will make use of underlying IP independently developed and owned by the Chinese factory. In this setting, the new product prototype is like a surface shell layered over existing technology owned by the Chinese factory. The product prototype is a “blend” of entirely new technology and existing technology owned by the Chinese factory. The danger here is that many foreign parties think they are dealing with wholly owned technology when in fact they are dealing with blended technology.

Consider what will happen if the foreign party thinks its prototype is wholly owned technology when in fact the technology is blended. The standard problems arise, and the foreign party threatens to take the prototype away for manufacturing at a different factory. In this situation, the China factory will often say something like the following: “We agree that you [foreign developer] own the newly developed IP and you can do what you want with that IP. However, this is blended technology and we own the underlying technology in the prototype. For that reason, you cannot take your prototype and have it made by another factory, so you are stuck with us.

This result can be a disaster when the business and quality issues discussed above arise and cannot be resolved.

In Part 4 of this series, I will address how best to handle blended IP situations when encountered in developing your hardware or your Internet of Things 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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