Stop Your IP and Key Information from Leaking when Manufacturing Overseas

This post focuses on protecting against intellectual property losses arise from what we call leakage — the situation where a company has a contract preventing its foreign counter-party (usually a foreign manufacturer) from using its proprietary information, but fails to prevent that information from leaking to third parties not bound by such a contract.

When our international manufacturing lawyers draft a manufacturing contract with an overseas factory, one of the main things we engage in is “contract plumbing.” This involves us working to make sure the contract is thoroughly sealed so as to prevent leakage of proprietary information to third parties outside the contract.

What do we mean by leakage? Most foreign buyers are concerned about the owner of their factory appropriating their product design and making that product for its own use. Since most contract manufacturers are direct competitors of the product buyer, this is a realistic concern. So we draft the manufacturing contract to prevent this sort of direct appropriation of the product design.

However, our experience shows that just preventing direct appropriation by the contract manufacturing company is not nearly enough. If you block just your factory owning company  from appropriating  proprietary information, they will almost inevitably find ways to provide your propriety information to other parties who will make use of the information. Since the factory owner did not commit the deed directly, it will then claim it is off the hook and “not responsible for any misappropriation that may have occurred.”

Sometimes the factory owner sincerely seeks to maintain control over the product design because its contract with its foreign buyer is valuable and it makes better economic sense for it to maintain good relations with its foreign buyer than to go to the trouble and expense of marketing the appropriated product in the United States and/or Europe. In this case, however, there are still other parties involved in the manufacturing process that will benefit from stealing the product design from both the product buyer and the factory owner. In this sort of situation, proprietary product information “leaked” away from the factory owner to a third party in a way that benefits the third party, not the factory owner.

No matter the cause of the leakage though, the effect is the same on the product buyer; the product buyer has lost its proprietary information to a foreign company. In our experience, the losses from this sort of third party leakage roughly match the losses from direct appropriation by factory owners. For this reason, we focus on preventing such leakage in any contract manufacturing arrangement, even when our clients insist “my relationship with the factory is so good there is no way this it would ever take our proprietary information.”

The Most Common Forms of IP Leakage

The list of common ways leakage of proprietary information/intellectual property occurs is long, with the following the most common:

Related parties. When an overseas factory intentionally seeks to appropriate proprietary information from a foreign party, leaking that information to a related third party company is the most common technique it will employ to achieve that.

Many manufacturing companies — particularly in Asia — are organized as part of a large group company. Many of these group companies consist of many separate companies ultimately owned by a single shareholder or shareholder group. In the classic scheme, the group company will form a special purpose entity that then enters into the contract manufacturing contract with the product buying company. This special purpose entity then leaks the proprietary information to a different company which, though a separate legal entity, is actually a member of the same group. The product buying company has no contract with the entity that actually manufactures the infringing product. The factory that entered into the contract with the product buying company then asserts that it is free from liability because it is not the offending manufacturer.

Employees. You should assume many employees of your contract manufacturer are on the look out for a new idea (i.e., your idea) that will give them their start as a factory owner rather than wage slave. Appropriating confidential information revealed by a foreign customer is a convenient way to get this kind of head start. Employees are quite enterprising: they will not only run off with your design, they will also run off with your customer list. In just a few months, they will be contacting your customers with offers to sell your product at 30% below your wholesale price.

Subcontractors. Our clients are often surprised by the number of subcontractors involved in manufacturing their products and in some cases, their “factory” does not actually manufacture the product. All production is actually done in a different factory down the street. In other cases, when their factory has too much work, it subcontracts out its excess production. Complex products nearly always require subcontractors. Take Internet of Things products (IoT) as an example. Such products are usually a mix of a main product with numerous subassemblies and the contract manufacturer will often subcontract out production of subassemblies and related components, acting as little more than a assembler. These subassemblies and components often embody the truly innovative portion of the product. To get production done, the main factory is generally quite free in disseminating the foreign buyer’s confidential information through a large group of loosely related factories, none of which have any contractual obligation to protect the confidential information or refrain from using it to directly compete with both the foreign buyer and the contract manufacturer.

Molds and tooling. The key step in contract manufacturing is often designing and production of the molds and tooling used in the manufacturing process. The molds are often the primary repository of the unique design of a product and the tooling often embodies years of manufacturing know-how on the part of the foreign party. Product buying companies often take great care in specifying the ownership of the molds and tooling without realizing that molds and tooling are rarely made by their contract manufacturer. Instead, that factory hires third parties to do the mold design and tooling manufacture. As a part of this process, the factory discloses the product buyer’s confidential information related to those designs to a mold or tooling manufacturer that can (and often does) freely sell the design to a third party or use it for its own purposes. Consider the case of a foreign product buyer that has not obtained a design patent on its basic product look and feel: its molds are likely the most important element of its product value. If its mold design leaks away, the value of its product design can be destroyed.

Third party programmers and designers. Few small or start up companies have their own product designers, graphic artists or software programmers and so most contract these tasks to third party shops. Product buyers frequently leave these tasks to their factory, which takes us back to the standard situation: to get the work done, the factory must disclose the product buyer’s  proprietary information. Often, no one in the process pays much attention to who really has the rights to the work product of these third parties. Consider an example: say the GUI for the interface for your smartphone app that controls your IoT product becomes popular and is identified with your company and you want to use that GUI design as part of your branding. Do you own the copyright? Does your China factory own the copyright? Does the third party designer own the copyright? Does anyone know? Did anyone clarify this from the start? Do you know what the law of the manufacturing country says about this? What about your own country’s laws? Third party “shops” have become a significant source of IP leakage.

How to Stop the Leakage

The first step to preventing your information from leaking is to have contract provisions written to prevent this. If your contract with your manufacturer does not cover the issue, you have little hope. This is why a contract is required and why a simple purchase order is virtually never adequate. But what sort of contract provisions are appropriate? The key is to deal with related parties (See above for a list of the riskiest related parties) by stating all disclosures to related parties are prohibited and your factory will be liable for all improper use of the information by a related party.

In dealing with third parties other than related parties, the situation is more difficult. An absolute prohibition will not work. Your manufacturer must disclose your key information to its employees. And in the modern manufacturing world, few factories are wholly self contained, so sharing of information with other companies is virtually always required as part of the manufacturing process.

There are two ways to deal with the situation. The approach we previously took was to require the factory to identify each individual entity that would receive our client’s confidential information and our client would then enter into a separate NNN Agreement with each of these individuals or entities. Under this approach, the factory would be liable only for damages caused to our client that arose from disclosures to persons or entities the factory never identified. But as manufacturing practices evolved, and especially as  factories began manufacturing increasingly complex products (such as Internet of Things devices) that require a whole slew of different companies, this careful system (that worked great for socks and rubber duckies) has become less and less workable. The factory will seldom identify every involved party and those that have been identified are becoming increasingly unwilling to execute their own NNN agreements, and the fact that the factory ends up “off the hook” means the factory becomes careless with information.

So our most common approach today is to allow the factory to disclose information as necessary, but to make it liable for all damages caused to our client from misuse of the confidential information. If a key employee steals the information, the factory is liable. If a subcontractor steals the information, the factory is liable. If a mold manufacturer steals the information, the factory is liable. This approach allows the factory the flexibility to get its job done but also giving it a strong incentive to impose its own mechanisms to maintain the confidentiality of the information provided to it by our product buyer client. Factories often complain about our seeking to load the liability on them. Our response to this is that “if you cannot trust the persons to whom you disclose our client’s information, you should not make the disclosure.” Our record in getting these sorts of agreements signed is shockingly good.

When you manufacture overseas, your goal must be to stop leaks of your IP and key information. This is not an easy job, but it is doable.

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.