China and The Internet of Things: Who Owns What?

China (Shenzhen mostly) remains the primary destination for manufacturing of small electronic consumer products. And since Internet of Things (IoT) products are red hot, this means our China lawyers are getting a steady diet of China IoT legal matters.

The issue we see on a day to day basis is this: the IoT product has now reached the mass production stage and is being produced in large quantities. Now that it has a commercial product, the U.S. buyer now seeks financing for its young company. The financier (be it angel, VC, private equity, or even someone’s father-in-law) then asks: who really owns the intellectual property in the product? Do you own it, does the Chinese factory own it, or does some third party own it? It is always awkward for the (usually) young entrepreneur to answer that question. However, with the rise of the Internet of Things (IoT), the question has become even more difficult to answer in a definitive way.

How did we get to this point? The process has worked its way through three general stages:

Stage One. In the good old days (say 1981 to 1995), the situation was simple. There were two possibilities. In the first, the Chinese manufacturer made a standard consumer product. The U.S. buyer merely purchased that existing product and perhaps required the manufacturer take the extra step of placing the U.S. buyer’s own trademark/logo on the product. In that setting, ownership of the intellectual property was clear: the Chinese manufacturer owned the product design and the U.S. buyer owned its trademark/logo. In the second, the product was a long standing, well developed product of the U.S. buyer. The buyer brought the completed product to the Chinese manufacturer and contracted with the manufacturer to make a copy. In that setting, ownership of the intellectual property was clear: the U.S. buyer owned all of the intellectual property and the Chinese manufacturer owned nothing.

The simplicity of the relationship encouraged the lazy practice of documenting the entire manufacturing relationship through simple purchase orders. NNN agreements, product development agreements and OEM agreements were seldom used, since the IP ownership was clear and the price and delivery terms were taken care of by the purchase order. This lazy approach then led to the subsequent disasters resulting from product defects. But that is an issue for another post.

Stage Two. In stage two (1995 to 2015), a new form of relationship developed. U.S buyers began coming to China with no completed project in mind. Instead, they came to China with a product idea or proposal. The buyer then worked with the manufacturer to co-develop the product. In some cases the role of the Chinese manufacturer was simply to take a completed prototype and then commercialize that prototype for mass production. In these cases, the U.S. buyer arrived with little more than a very basic idea, and the two sides worked to co-develop the product.

Normally, the Chinese manufacturer offered to perform all of the development work at its own expense, with the implied agreement that the manufacturer would be the exclusive manufacturer of the product. This co-development process typically proceeded using the same lazy “purchase order only” approach from stage one. This lazy approach then has led to the typical issues we see today that make answering the “who owns what” question so difficult. In order to do the co-development process properly, the parties must define their relationship with three agreements: 1) NNN Agreement, 2) Development Agreement and 3) OEM Agreement.

Where these agreements do not exist, as is common, a set of standard issues arises: Who owns the product design? Who owns the molds and other tooling? Who owns the manufacturing know-how and similar trade secrets? If the buyer decides to have the product made by a different factory, what compensation is owed to the manufacturer who co-developed the product? What is the obligation of the manufacturer to comply with price and quantity requirements of the buyer? If the manufacturer terminates its relationship with the buyer and manufacturers the product under the manufacturer’s own trademark/logo, is this a violation? Absent clear, written agreements, all of these questions have very unclear answers. In that unclear situation, the Chinese factory will generally be in the strongest position and in the event of a dispute the Chinese factory will typically prevail.

Stage Three. In stage three (2015 to today), we arrive at the IoT era. In the design, development and manufacture of consumer products for the IoT market, the already unclear and problem-filled relationships of the stage two era have now become magnified. In the IoT era we are now just entering, a whole new set of issues has arisen. In the stage two era, there was at least the simplicity of two entities designing and/or manufacturing a single product. In the IoT era, the situation is much more complex. In most of the IoT projects we have seen over the last six months, the development process has expanded to include the following:

1. Product “concept” from the U.S. buyer.

2. Product external design, from an international design firm.

3. Internal design and function, owned by:

a. The U.S. buyer;

b. The Chinese manufacturer;

c. The provider of sensors and other components required to connect the IoT product to an outside network.

4. Design of the IoT product “app” (usually for a smart phone). This then involves two completely separate sets of software: the communication sending software residing on the IoT product and the communication receiving software residing on the application in possibly multiple forms. In the same manner as the internal design, these software components may be written/designed by multiple parties: the U.S. buyer, the Chinese manufacturer and (quite often) third party software design firms.

So now consider: the product is complete, manufacturing is ready to start, and the U.S. buyer goes out for funding. The funding source then says: who owns this IoT product? Who owns its underlying IP? What we have found when we ask the U.S. buyers is that they usually don’t know. And their initial backers and sourcing companies don’t know either.

As you can imagine, the “we don’t know” response does not sit well with sources of serious financing. Even worse, when the U.S. buyer is now pushed to answer the question, they more often than not find out that the answer is that it is not clear who owns the new product, but what is clear is that the one entity that clearly does NOT own the rights to the product is the U.S. buyer. Even worse, it is often not possible to fix the situation when this stage is reached.

So the message is that as the manufacturing setting becomes more complex, it becomes even more important to enter into clear written agreements that answer the obvious questions in advance. It makes little sense to devote time, energy and money on developing an IoT product that someone else will own.

For more on the issues we are saying involving China and the Internet of Things, check out the following:

• China and the Internet of Things: A Love Story
• China and The Internet of Things and How to Destroy Your Own Company
• China and the Internet of Things, Part 3 of 228

The post China and The Internet of Things: Who Owns What? 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.