China Comes To Nixon (Texas): Contract Issues In Outsourcing's Next Wave

Thursday, December 1, 2005 - 01:00

After having endured a seemingly endless yearlong stream of articles, editorials and assorted "special reports" on China's new and growing role in the global economy, 2006 stands to be the first year in which mainstream Corporate America includes China-based technology service companies in its discussion of viable outsourcing destinations.

If the overload of commentary is to be believed, China's emergence as a true engine of global commerce has been happening slowly but deliberately over the last decade, with the most significant activity occurring since 2001, the year in which China was admitted to the World Intellectual Property Organization (WIPO). And, while the importance of this single event in promoting China as a safe and trusted business partner is undeniable, U.S. companies considering outsourcing to China still face numerous legal and practical challenges.

State Of The Industry

Without question, China is a country of perplexing contrasts. By one measure - purchasing power parity - China is the world's second largest economy (behind the U.S.), and is in the midst of an extended period of tremendous growth, with gross domestic product having quadrupled since 1978. Between 1997 and 2003 alone, China's annual manufacturing exports to the U.S. rose from $66 billion to $163 billion.1 And, China is already the largest software outsourcing base for Japan. However, on a per-capita basis, China is still a desperately poor nation, and the government continues to maintain a tight grip on many businesses and industry sectors, reminding westerners that despite its emergence on the global stage, it remains a communist state under authoritarian rule.

In contrast to the rapid pace of China's manufacturing gains, U.S. companies have been slow to acknowledge China as a potential destination for technology-based outsourcing projects. This despite a Chinese workforce of approximately 500,000 professionals in the IT industry (with at least 80,000 expected to be added each year for the foreseeable future),2 and labor rates that are approximately 10 to 15% below those found in India.3 But, even with outsourcing to India and other overseas destinations in full tilt in the U.S., the notion of outsourcing technology-related services and processes to China has historically been a tough pill to swallow for many U.S. companies for a variety of obvious and not-so-obvious reasons.

Factors commonly cited by industry professionals and commentators for the slow acceptance of outsourcing to China include: (i) the limited availability of professionals with management experience; (ii) a lack of process maturity, especially in non-repetitive business processes; (iii) a severe lack of English-speaking professionals; and (iv) cultural disconnects that range from the absence of a traditional western marketing philosophy to the tradition of relying on trusted, personal connections (known as "guanxi") as the primary basis for developing business relationships.

But, perhaps the most well-publicized and - at least from corporate counsel's perspective - greatest risk factor in outsourcing to China has been inadequate and unpredictable protection and enforcement of intellectual property rights. The concerns on this point are diverse and unavoidable. At the core of the problem is a legal and judicial system that has historically had much difficulty enforcing western-style intellectual property laws and regulations. The Chinese have traditionally viewed intellectual property as community property, and domestic competitors have frequently copied each other's products and ideas with impunity. In addition, as Chinese markets have opened up in the last three decades, foreign companies have often been expected to exchange their intellectual property and know-how for market access, something that U.S. companies who value their intellectual property rights are simply unwilling to do.

China also lacks significant laws that would discourage trade secret theft. And, from a patent perspective, China's adoption and implementation of the "first to file" rule (instead of "first to use" in the U.S.), enables unscrupulous companies to obtain Chinese patents on U.S. companies' intellectual property by doing nothing more than copying these proprietary inventions and racing to the State Intellectual Property Office (SIPO) to file their claims.

Considering the foregoing, it is clear that the reticent attitudes of many U.S. companies toward outsourcing to China are not driven by perception vs. reality regarding substandard protection of intellectual property rights. There are, however, discrete strategies that U.S. companies can and should adopt in order to minimize and manage the risks associated with such endeavors.

Intellectual Property Contract Strategies: Establishing Rights In China

When contracting for outsourcing work to be performed in China, it is critical for a company to use its pre-contract leverage and take all prophylactic measures to secure as much protection as possible for its intellectual property. Given the current state of the Chinese legal system, it is not advisable for a foreign company to depend on Chinese intellectual property laws for such protection.

Prior to engaging a Chinese provider, a company must take a broad view of the intellectual property it wishes to protect that goes beyond simply taking inventory of relevant technologies and processes. The company's internal due diligence should include an examination of all sources of competitive advantage in its product or service, and the unique features, processes, technologies (both proprietary and licensed), and relationships that define the company's "brand." This process should be approached from both a current and forward-looking perspective, as the company's ability to assist its Chinese service provider in influencing the development and enforcement of standards relevant to the company's products and services is a critical, yet underappreciated aspect of establishing ongoing intellectual property protection.

A U.S. company must register its patents and trademarks with the appropriate Chinese agencies and authorities for those rights to be enforceable in China. And, although not required, registration of copyrights with China's National Copyright Administration is advisable, especially should an enforcement action become necessary. In addition, under Chinese copyright laws, copyrightable work performed by Chinese employees that is not within the specific employment relationship may belong to the employee. Thus, the outsourcing contract should expressly designate all work performed by the Chinese provider and its employees (as well as any agents and subcontractors), including any derivative works based upon or improvements to the outsourcing customer's existing intellectual property, as "work made for hire," and include a separate provision irrevocably assigning to the company all associated copyrights and other intellectual property rights.

Intellectual Property Contract Strategies: Implementation And Enforcement

With respect to enforcement of intellectual property rights, there are several provisions that a U.S. company should include in the outsourcing contract to ensure adequate enforcement of intellectual property rights by the Chinese legal system, regardless of whether the provider is an independent Chinese company or the Chinese operations of a foreign company (including the outsourcing customer's own affiliates and subsidiaries). Primary among these provisions is a requirement that the outsourcing contract itself be registered with the Ministry of Commerce (MOFCOM), especially where the contract involves the import or export of technology ( e.g., software licenses, technical services or consulting, and patent licenses). While not a blanket requirement for validity, registration with MOFCOM is recommended, if for no other reason than that a failure to register may limit a foreign company's ability to enforce the contract, as well as the Chinese provider's ability to perform specific financial transactions using the subject technology.

A second provision that should be included in the outsourcing contract concerns the practical aspects of the service provider's day-to-day access to and use of the customer's or any third party's information and technology under the contract. China's data security and privacy laws are limited at best, and far less protective than U.S. laws such as the Gramm-Leach Bliley Act and HIPAA. Thus, there must be clear, strict requirements of confidentiality for the provider itself, as well as a requirement that all persons having access to the information or technology (including agents and subcontractors) execute confidentiality agreements, with copies of such agreements required to be provided to the customer. In this respect, the contract should also contain restrictions on who can access the customer's information or technology, as well as clear logical and physical security requirements (e.g., segregation and securing of equipment, restrictions on items permitted into, and information that may be removed from, the facility, and logs that show who accessed the customer's materials, for what purpose, and for how long).

In addition, the contract must deal with dispute resolution in an intelligent and practical manner. As a matter of course, U.S. law should always govern the contract. The reasons for this are many, but in short, the Chinese justice system remains decentralized and unpredictable, especially in the area of intellectual property enforcement, where complaints may be filed either with local administrative agencies (the most prevalent approach) or with intellectual property panels in the civil court system. Determining which agency has jurisdiction over infringement cases requires the claimant to navigate a confusing maze of geographic and subject-matter limitations. On the other hand, within the judicial system there are Intellectual Property Tribunals in the Intermediate and Higher People's Courts throughout the country; however, corruption, local protectionism, and limited resources, coupled with burdensome evidentiary requirements, and extremely slow administration, are reasons enough to avoid entering into this labyrinth.

Regardless, in the event a U.S. company chooses or is required to bring an intellectual property enforcement action in China, it is advisable for the company to report the action to the U.S. State Department, through the U.S. Embassy in Beijing and/or the Department of Commerce's Trade Compliance Center. Although the U.S. government cannot intervene in the matter, it will monitor the case and, where necessary, contact Chinese officials regarding the status of the action and other concerns the U.S. company may have.

Even when a contract is governed by U.S. law, certain Chinese laws, including those regarding ownership of developments and import/export of technologies, remain enforceable in the eyes of the Chinese authorities. One way to limit exposure in this respect is to have the contract provide for binding arbitration in the event of a dispute. China is a signatory to the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, with the result that arbitration awards are enforceable in China. A caveat to this is that binding arbitration should be clearly and unequivocally identified as the sole manner of enforcing the contract. If the dispute resolution provision may be construed as allowing the parties to select the method of dispute resolution ( i.e., binding arbitration or litigation), the parties run the risk of having the provision deemed to be a non-binding arbitration clause and the dispute remitted to the jurisdiction of the Chinese courts.

Conclusion

Lest the message be unclear, while the need for caution still remains, all is not "doom and gloom" when it comes to evaluating outsourcing to China. As 2005 draws to a close, there is encouraging news regarding the Chinese government's efforts to lure foreign investments and create a more "western-friendly" legal infrastructure to protect intellectual property rights. In Beijing's Haidian District, a special court has been established to prosecute software copyright violations, which are considered criminal offenses under Chinese law. And, to bolster enforcement efforts in the face of global pressures, China has lowered the threshold for punishable offenses to $6,000 (down from a range of approximately $12,000 to $24,000), and increased prison sentences from three to seven years. Also, one of China's highest-ranking government officials, Vice-Premiere Wu Yi, is now responsible for the enforcement of software copyrights and prosecution for piracy crimes.

Only the passage of time will tell whether these developments are viewed by U.S. companies as effective in protecting their intellectual property assets. Until that time arrives, companies outsourcing to China must take deliberate, defensive steps in both the structuring and performance of their outsourcing contracts, to protect their business and assets and provide for enforcement of their rights in a predictable and balanced manner.

1 "A World of Work: A Survey of Outsourcing," The Economist (November 13, 2004).

2 Source: The China Software Industry Association, 2003.

3 Source: "The China Reality Check," neoIT, June 2005.

Kevin E. Colangelo is a Senior Associate at Kramer Levin Naftalis & Frankel LLP and a member of its Outsourcing and Technology Transactions Group.

Please email the author at kcolangelo@kramerlevin.com with questions about this article.