Hong Kong: Toto, We’re Not in Mainland China anymore

In an effort to reduce the challenge of manufacturing in Mainland China, many foreign companies decide not to go direct. They instead make use of intermediary companies that act as the sellers in the transaction. These intermediaries deal with the buyer, but the messy business of manufacturing is done in the PRC. These intermediary companies are often located in Hong Kong. We have seen that most foreign buyers do not understand the risks involved in dealing with Hong Kong companies and this too often causes them to unknowingly take on significant risks. One of those significant risks arises in the area of intellectual property protection.

From the standpoint of legal jurisdiction, Hong Kong and the PRC are two entirely different countries. The most important result of this legal distinction is that foreign investment in the PRC by Hong Kong companies and individuals is restricted in the same way it is restricted for American and European and Australian companies. This means Hong Kong companies cannot operate directly in the PRC. To operate legally in the PRC, a Hong Kong company must form a WFOE or an Equity Joint Venture, in the same way as for any other foreign entity. See How to Form a WFOE in China, Part 3: What’s Hong Kong Got to Do With It?

What does this mean in the manufacturing setting? The foreign buyer enters that enters into a contract with a Hong Kong company is (999 times out of 1000) not entering into a contract with the actual manufacturer because the actual manufacturer is a company located in the PRC. The actual manufacturer is a legal entity entirely separate from the Hong Kong company. To make this clear, in the manufacturing contracts drafted by the China lawyers at my firm, we call the Hong Kong company the “Seller” and the PRC manufacturer the “Factory.”

Now consider what all of this means from the standpoint of intellectual property protection. The foreign buyer provides its proprietary design to the Hong Kong seller. Complicated molds embodying the proprietary design are fabricated. Extensive engineering and production design work is conducted to develop a working product prototype. But, none of this work is done by the Hong Kong-based Seller because all of this work is being done by the factory in the PRC. This work is almost always being done by entities unknown to the buyer and with which the buyer has no contractual relationship. The molds and tooling and product prototypes are physically located in the PRC.

The result is that the buyer has given away its most valuable intellectual property to persons and entities it both does not know and cannot control. So what happens if something goes wrong? What happens if the buyer wants access to the molds to transfer production to another factory. What happens if the buyer learns the molds are being used to make “knock off” products? What happens if the buyer learns the product prototype is being used in the PRC to manufacture a competing product? These are not trivial questions as these things happen every single day in the PRC. The answer is that the buyer has no recourse at all in the PRC. The only legal action the buyer can take is against the Seller in Hong Kong. In the intellectual property area, this means the only thing the buyer can do is to sue for damages. The buyer can take no direct action against the infringer nor does it usually have any good legal basis to prevent the infringement happening in the PRC.

Now add to this that in most cases (at least most instances — by far — where companies have retained my law firm to investigate the above sort of situations), the Hong Kong Seller has no real assets. The Seller is no more than a small office with a phone and computer and sometimes a small sales staff. All the productive assets are located in the PRC, in the hands of companies and individuals with no direct legal relationship to the Hong Kong entity. Cash received by the Hong Kong entity is regularly swept into separate accounts with no direct relationship to the Hong Kong entity. In litigation terms, the Hong Kong entity is judgement proof.

What this all means is that the foreign buyer has essentially given away its intellectual property. The intellectual property is in the hands of a company in China and nothing can be done in China if the intellectual property is misused in some way. For physical items like molds, tooling, and prototypes, the items are gone forever. The PRC entity may refuse to return the items. The PRC entity may pass the items on to its subcontractors, who then further pass the items on to a subcontractor or family friend. In the end, it is not unusual to find that no one knows the ultimate fate of the items. But what is known is that the items are located in the PRC and the buyer has no legal recourse in the PRC. The buyer has nothing more than a claim for monetary damages against a Hong Kong entity likely to be judgment proof.

A foreign buyer that fully understands the risks may make the business decision to incur the risk. However, in our own work in Asia, we pretty much never encounter U.S. or European buyers that understand the situation. Most simply assume that when they contract with a Hong Kong entity, their legal situation is no different than if they were contracting with a PRC entity. They have already decided to incur the risk of manufacturing in the PRC and they see working with a Hong Kong entity as a way to reduce that risk, not increase it. They assume the Hong Kong entity will be easier to communicate with and that because Hong Kong’s legal system is better, they and their IP will be better protected this way.

But in reality, the foreign buyer has not reduced its risk. It has instead dramatically increased it. If the increase in risk is intended, that is part of the commercial calculation. But when the increase in risk is based on a fundamentally incorrect understanding of the law and the facts, it is nothing more than a mistake.

For more on why it is important to distinguish Mainland China from Hong Kong, check out the following:

• China Contracts and Hong Kong Jurisdiction: No, No, No
• China And Hong Kong Trademarks. Think Puerto Rico.
• How to Form a WFOE in China, Part 3: What’s Hong Kong Got to Do With It?

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.