5 Essential Steps to Acquiring IP in China

As international investors scour China for acquisition targets, many are finding opportunities to purchase not only local management or distribution capabilities, but also locally developed technologies. Thanks to China's commitment to scientific innovation and development there will be even more acquisitions of Chinese technology in 2010, and smart investors will need to know how to secure the rights to this intellectual property when buying into the China market.

Despite the many stories of pirated technologies and other horror stories, finding technological innovations at Chinese companies should not be surprising. With China’s large and highly skilled research and scientific community, low costs for research and manufacturing, and government incentives for creation and innovation, the pace of China’s climb up the technological ladder should only increase. What is surprising, however, is the fact that many of these technologies are for sale. In China’s case, there may still be some Rembrandts in the attic.

Commitment to Technology and Innovation

China has long been committed to the development of innovative technologies. Its laws and regulations, promote technology creation, and national programs like the Major Science and Technology Projects of the 11th Five Year Plan (2006-10) and the National High-Tech Research & Development Program, also known as the 8-6-3 Program, are designed to encourage development in technological fields. To implement these and other plans, several PRC ministries and agencies in July 2006 issued an opinion to encourage innovation and technology transfers into China. The Opinion on Methods for Promoting Technology Transfers and Innovation and Encouraging Changes in Foreign Trade Growth focuses on biotech, telecom, petrochemicals, civil aviation and aerospace, environmental protection, and renewable energy. Among other things, the Opinion encourages foreign companies to partner with local companies, R&D centers, and universities in their research endeavours.

China’s R&D Starts to Catch Up

Statistics compiled by the PRC Ministry of Science and Technology show that the number of full-time personnel engaged in basic research in China rose from 78,800 in 2001 to 115,400 in 2005, a 46.5 percent increase. The country now has roughly 200 national labs in operation and an expanding network of satellite field research stations. Government funding for science and technology has also significantly increased. Apart from financial support, the government encourages the patenting of new technologies from both government and university R&D centers, as well as from state-owned and private enterprises. Statistics from the PRC State Intellectual Property Office (SIPO) suggest that these efforts may be paying off (see Table).Although China’s R&D strength may not yet match that of Western economies, it is clear that the government is making technological development a national priority.

R&D Centers in China

Encouraged by tax incentives, investment authorities, Chinese consumers, and the globalization of technological development, many foreign enterprises in China have set up R&D centers.

According to the PRC Ministry of Commerce, about 46 percent of multinational corporations operating in China established R&D centers by 2005, and China reportedly has more than 750 foreign-invested R&D centers, up from about 400 in 2003, mainly concentrated in technology-intensive industries, such as information technology, electrical motors, telecom, and pharmaceuticals.

The Essential Steps to Acquisition

When Chinese technology is being acquired, companies should conduct due diligence on that technology to verify several key issues. First, a company should identify the technology to a degree sufficient to confirm that it fits its needs. Second, the company should confirm that the seller owns the technology and whether any state funds were used in its development. Third, the company should ensure that the technology does not infringe upon any third party’s intellectual property (IP) rights.

Due diligence on registered IP (normally patents and designs, but occasionally trademarks and copyrights) is generally straightforward, but unregistered IP (normally in the form of trade secrets or confidential information) can be trickier. Comprehensive due diligence should also analyze previous transactions and other relevant agreements that may affect what can be done with the target IP.

1. Identifying the Technology

A Chinese seller should be able to describe the technology in enough detail for a buyer to understand the technology fully. This can be a simple step if the target technology is a product, but if it is a process, then the description may be more complicated, especially if the process is a trade secret kept in the heads of a small reference group or in an operator’s manual that the seller may not want to share until the deal is completed. The parties to a transaction can address this problem with a nondisclosure agreement.

Identification is also critical to determine whether the technology falls within certain categories of “prohibited,” “restricted,” or “free” technologies as set out in the 2002 Regulations for the Administration of Technology Import and Export, the principal guide for foreign acquisition, use, and export of Chinese technology. If the technology belongs to the prohibited or restricted category, it may not be transferable at all, or only with government approval.

2. Confirming Ownership

Determining whether the seller actually owns the technology normally requires several meetings with relevant technicians to understand how the technology was developed. If no longer with the company, where are those technicians now? Were any state funds involved in the development? If external subcontracted testing and development were involved, to what degree might input give rise to third-party inventorship rights to the technology? It is crucial for a prospective buyer to know how the technology was developed, by whom, when, and with whose funds.

Additionally, a prospective buyer should thoroughly review the employment agreements of the employees who assisted in the development to confirm that the seller owns the employees’ contributions, whether the seller has imposed and enforced confidentiality restrictions, and whether the employees have been “reasonably remunerated” for their contribution to the technology, as required under PRC law. These steps will allow a buyer to avoid future claims by the employees responsible for its development.

Prospective buyers also should ensure that legal due diligence includes a complete review of all licenses, rights to acquire, liens or other forms of security over the technology and the like. In particular, buyers should investigate whether the technology’s licensees have been involved in counterfeiting or breach of agreement actions, have IP protection measures in place, produce for competing brands, or have third party or subcontractor involvement in the licensed IP. Buyers should also perform a “brand hygiene check” to ensure the licensees’ ethical, regulatory, and environmental compliance. Last but not least, buyers should investigate the licensee’s tooling and equipment used in manufacturing. Buyers should also review copies of any executed powers of attorney into which the seller has entered.

3. Assuring Non-infringement

To address the possibility of infringement, a buyer should normally begin with a “novelty search” at SIPO to obtain an authoritative opinion on whether the technology is new and inventive, two of the three criteria for patent ability. This search could aid a buyer if the seller has not made the technology public and if the technology is still suitable for patenting.

The novelty search also identifies patents, patent applications, and publications, which can help the buyer determine whether a seller may have infringed upon third-party IP rights.

4. Obtaining Further Assurances

If, after the due diligence is completed, questions remain unanswered, a buyer may want to obtain statements from the seller and, if necessary, from the relevant technicians. Such statements would confirm that all disclosures made during the course of the due diligence are true and would indemnify the buyer against liability for infringement of IP rights if such an infringement stems from something that was not disclosed or disclosed incorrectly. After obtaining these statements, the parties can draft an acquisition agreement to keep the deal alive, though, in the case of restricted technology, such an agreement does not take effect until the government approves it.

5. Government Approval

The Regulations for the Administration of Technology Import and Export specify the procedures for government review and approval of technology acquisition deals in China. Technology in the prohibited category may not be exported, so agreements involving this kind of technology is illegal.

Restricted technology can be exported, but only after obtaining an export license from the government. Agreements relating to free technology, which constitute the bulk of technology acquired from PRC entities, only needs to be registered. The process involves an online application and approval by the local authority in charge of foreign trade, who issues a registration certificate. Agreements that involve free technology takes effect when it is executed.

Judicial Scrutiny of Technology Acquisition Deals

Although China encourages Sino-foreign collaborations in technology creation and use, the government is concerned about potential foreign misuse of Chinese technology, and there has been a growing policy emphasis on this in judicial interpretation of technology acquisition contracts. As a result, prospective buyers should exercise extreme caution and remember that assignment-back provisions normally acceptable in the West, whereby local innovations are assigned back to the licensor of the original technology, bear risks.

One sign of the growing emphasis on local technological innovations is the anticipated toughening of China’s “first filing” rule. Currently, inventions “made” in China by a PRC entity or individual should be “first filed in China,” but there is no penalty for failing to comply. A draft amendment to the Patent Law, however, would subject the inventions of all entities and individuals in China to the first filing requirement, including inventions developed by Sino-foreign joint ventures and wholly foreign-owned enterprises. SIPO would then reject patent applications that do not meet this first filing requirement and invalidate patents discovered to have been developed in China but first filed overseas. If adopted, foreign companies interested in acquiring Chinese technology would have to ensure that the technology is filed first for patent protection in China to ensure protection.

Prospects

According to the Organization for Economic Cooperation and Development, China spent an estimated $136 billion (adjusted for PPP) on R&D in 2006, more than Japan and second only to the United States. This reflects China’s desire to enter the realm of innovative economies and, for foreign companies, presents opportunities to acquire new technologies for commercialization in China and abroad. A savvy buyer knows that technology acquisitions in China must be approached with the same care and due diligence one would require of similar deals in other countries. The government’s expanded support for technological development should lead to a wealth of choices for those hoping to acquire technologies in China.

Alan Adcock is Deputy Director, Intellectual Property at Tilleke & Gibbins International Ltd., a prominent law firm in Thailand with offices in Hanoi and Ho Chi Minh City, Vietnam. Alan is the co-author of China IP Challenges & Solutions An Essential Business Guide (ISBN: 978-0-470- 82275-3), John Wiley & Sons, 2008. He can be contacted at Alan.A@tillekeandgibbins.com

First publication on Britcham Guangzhou Chamber Eye Magazine.