How to form a China joint venture (Part 3): Is it all just to steal your IP?

By Dan Harris

This is Part Three of our new series laying out the issues companies typically face and the steps our China company lawyers typically go through when forming a China Joint Venture. In Part One, we talked about how despite the increasing difficulties with doing business in China (or perhaps because of those difficulties), our China corporate lawyers are seeing an increase in foreign companies looking to do joint ventures in China. We then discussed how the first thing we do is try to determine whether going into China via a joint venture makes both business and legal sense for the foreign company that has retained us.

In Part Two, we discussed how once both our lawyers and and our client are satisfied that doing a China Joint Venture actually makes sense generally, we see our next task as helping our client determine whether the Chinese company with which they are looking to form the joint venture is the right company for a China joint venture. In that post, we set out the questions to pose to your potential Chinese JV partner to tease out an answer to this.

In this Part Three, we talk about what our China corporate lawyers do to try to determine early whether the Chinese side is truly interested in doing a Joint Venture deal with our client, or just feigning interest as a way of gaining access to our client’s intellectual property.

With China’s economy declining (particularly the portion that most interacts with foreigners), our China lawyers have for the last year or so been seeing a massive increase in all sorts of foreign company problems including (but certainly not limited to) the following:

1. IP theft. See China Trademark Theft. It’s Baaaaaack in a Big Way.
2. Manufacturing quality control problems. See China Factory Disputes: The 101.
3. Sinosure problems. See China’s Sinosure: It’s Back and It Wants Your First Born
4. All sorts of disputes necessitating litigation or arbitration. See How to Sue a Chinese Company: The 101.
5. The Chinese government going after foreign companies (especially American companies) for not complying with all of China’s laws, more often and with greater ferocity than ever before in the last 20 years. See Want to Keep Your Business in China? Do These Things NOW and Doing Business in China Without a WFOE: Will the Defendant Please Rise.
6. Fake law firms. See China Lawyers: The Fakes and the Quasi-Fakes.
7. China employment law problems. See How to Avoid China Employment Law Problems, Part One, Part Two, Part 3 and Part 4, a series written by our lead China employment lawyer (Grace Yang) because, as she puts it, “now is not the time for employers in China (especially American companies) to be doing anything that does not fully comply with China’s employment laws.”
8. All sorts of sharp tactics and scams, old and new. See e.g., China Licensing Deals so Horrible They are Hard to Believe. See also our China Scam Week series, where In Part 1, we wrote about the scam of tricking someone to come to China to sign a deal. Part 2 was on the scam of getting money for supplying products and then supplying nothing or, more commonly, something that isn’t even close to what the foreign company bought and paid for. Part 3 was on the switched bank account, which is — by far — the most difficult to avoid scam. Part 4 was on the scam where a Chinese company gets you to provide it work or services (or perhaps even product) in return for stock or stock options you can never really own because you are a foreigner. Part 5 involved a fairly recent, increasingly common, and highly sophisticated scam whereby a Chinese company claims to be interested in investing in your foreign company to steal your IP. Part 6 was on fake joint ventures.

On the Joint Venture front, we are seeing a big increase in Chinese companies seeking to do a joint venture solely to steal the foreign company’s intellectual property. This ruse has been common in China for 30+ years but its use has accelerated (again) in the last year or so. One of our China lawyers long ago worked on a project that nicely illustrates how this ruse often works.

A U.S. company developed an advanced and expensive aquaculture technique ideally suited for species and conditions along China’s coast. The original plan was to sell six of these systems to a state owned fish grower in Shandong province. The Chinese company agreed to purchase the systems at a bargain price. After all the terms were agreed upon, our lawyer drafted the contracts and joined the U.S. company in Shandong to finalize and execute the contract. The day before the signing ceremony, the local government officials in charge of the project called us all in and stated that the price for the six as yet untested systems was just too high. They then explained how they had instructed the Chinese company not to execute the contracts, proposing the following as an alternative:

• Form a 51/49 joint venture company, with the U.S. company owning the majority interest. See Chinese Joint Ventures — The Information The Chinese Government Does Not Want You To Know as to why owning a majority interest in a Chinese Joint Venture does NOT mean that you control it.

• The U.S. side would contribute one aquaculture system as its capital contribution. The Chinese side would contribute the space for the system in the local bay, together with all other infrastructure required for six systems.

• The JV entity would commit to purchase five additional systems after the first system was up and running.

Our China lawyer told our client why this was a bad deal and did everything he could to try to convince it to stick with the straight sale deal. Against our lawyer’s strong advice to the contrary, the client chose to move forward with the JV, on their own and without our help.

The U.S. company later told our lawyer how the deal went down. The U.S. company delivered and installed the first system. The Chinese side claimed the system was no good. The JV then refused to purchase the five additional systems. The JV then went bankrupt and disappeared. Undaunted, the U.S. company then explored selling its aquaculture systems to an unrelated Chinese company elsewhere in China. However, when the U.S. company went on its first visit to this other Chinese company, it found ten copies of its original system up and running. The only thing this other Chinese company wanted from the U.S. company was consulting advice on how to fine-tune its ten systems. The U.S. company was permanently closed out of the China market while clones of its systems being used up and down the China coast.

This is the classic technique for using a Chinese joint venture to steal foreign intellectual property. This technique has though been refined a bit since then and the current standard technique works as follows:

• Foreign company offers to sell complex and expensive technology on a standard technology licensing basis.

• After much discussion, the Chinese side indicates the price is too high for untested technology. The Chinese side then offers to establish a joint venture company where the foreign side will own some percentage of the to be formed China Joint Venture.

• The foreign side contributes one unit of its technical system in exchange for its ownership interest. The Chinese side contributes the rest. The contribution of means that the JV now owns the technology for China. The JV agrees to the purchase a number of units at full price after the first unit is up and running properly.

• The foreign company then delivers and fully trains the Chinese side on how to operate the foreign company’s technology.

• The Joint Venture never purchases any additional units, claiming the foreign company’s technology does not work properly. The foreign company eventually discovers its technology has been cloned and is being actively utilized by an unrelated (usually state owned) company in China. Since the JV owns the technology, this unauthorized use infringes upon the JV’s intellectual property. The JV must therefor sue to defend its rights. But, the JV is controlled by the Chinese side and the JV management refuses to take any legal action.

• The JV then disappears. Normally, the Chinese side simply buys out the foreign side at a substantial discount.

This system in various forms is still being actively used in China. A variant of this system was used to extract high speed rail technology from foreign companies and to extract jet fighter technology from the Russians. There are various ways to prevent this from happening to you, but one of the keys is usually to license your technology to the JV if it will be using it at all and to do so in such a way as to heighten your protections. If your potential JV partner insists on the JV taking ownership of IP, you almost certainly should walk. There are various other things our China lawyers look at and do to protect our clients from thieving JVs, but we are reluctant to reveal everything for fear that doing so will give the Chinese side an edge the next time. Let’s just say you have been warned.

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Dan Harris is founder of the Harris Bricken law firm, a boutique international law firm focusing on small and medium sized businesses that operate internationally. China is the fastest growing area for the firm. Dan writes ChinaLawBlog.com as a source of China legal and business information.