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Technology Licensing Chris Neumeyer

Best Practices for Licensing Patents to Companies in China

Patent licensing generally is fraught with risks, but licen-sors who do business in China face special challenges. Common practices and contract provi-sions that may work elsewhere, often prove ineffective in China. Consequently, before entering into such an arrangement, the prudent lawyer will review some of the key issues faced by licen-sors in China.

Notably, foreign companies increasingly are being forced to defend their licensing terms before China’s antitrust regulator, the National Development and Reform Commission (NDRC). US patent-assertion entity InterDigital recently settled a dispute with the NDRC, by agreeing to lower its royalty rates in China and make other changes to its terms. The NDRC raided Qualcomm’s Beijing and Shanghai offices and launched an investigation into the US chip-maker’s licensing terms. When Microsoft announced plans to acquire Nokia’s business (but not its patents), several competi-tors demanded China’s govern-ment impose restrictions on the deal, prohibiting Microsoft and Nokia from raising their licensing rates in China.

But antitrust compliance is just one challenge faced by licen-sors in China; other challenges relate to restrictions on technology

imports, under-reporting of royal-ties, difficulties with audits, dis-pute resolution and more. This column summarizes a few rele-vant laws and challenges licensors should be aware of and best prac-tices for dealing with them.

Standard Precautions First, a distinction should be

made between companies that license patents into China only to generate licensing revenue and those that do so when transfer-ring technology to joint ventures, subsidiaries or others, in order to engage in R&D or manufacturing or develop qualified suppliers in China. With respect to the latter category, one should start with the following basic principles:

• Always assume your part-ner will attempt to steal your intellectual property and legal measures will not adequately protect you.

• Perform thorough due dili-gence and choose partners carefully, being especially wary of those with political power, influence, or potential competitive advantage. Be wary of joint ventures with government entities. Obtain a majority share, control of the board and install key executives.

• Never transfer crown jewels into China unless absolutely necessary. Instead, transfer only older or less valuable technology and keep critical technology offshore. Consider working with several partners

in China and transferring dif-ferent facets to each, so none will have the whole picture.

• Ensure that agreements clearly define the ownership of all intellectual property, both background and fore-ground. Deal appropriately with potential improvements. [This is discussed further below.]

Import and Export Restrictions

Before contemplating licens-ing technology to an entity in China, one should confirm that it will be permitted under China’s Regulations on Import and Export of Technology (the Technology Regulations).

The Technology Regulations define import and export as any cross-border transfer of technol-ogy, “by way of trade, investment, or economic and technical coop-eration,” a definition that encom-passes virtually any cross-border sale, assignment, or licensing of technology, patent rights, techni-cal secrets or know-how. The regu-lations divide imports and exports into three categories: (1)  prohib-ited, (2) restricted, and (3) freely transferable. Catalogues are pub-lished, from time to time, listing prohibited or restricted technolo-gies. Any technology not listed in the catalogues is deemed freely transferable.

Prohibited technologies may not be imported or exported. Restricted technologies may be imported or exported, subject to prior approval by the relevant agency. Until such approval is granted, the relevant licensing or transfer agreement is not legally binding in China. Freely transfer-able technologies may be imported or exported, but the agreement is still subject to other relevant laws and must be recorded with the

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State Intellectual Property Office (SIPO), as described below.

The Measures for Recording Patent License Contracts require the parties to record with SIPO a Chinese version of any patent license agreement within three months after the effective date of the agreement. Amendments also must be recorded. SIPO maintains a searchable public database that reveals the status of any recordings. The Measures previously prohibited royalty payments to be remitted out of China prior to recording the agreement, but that provision was deleted from the Measures in 2011.

Antitrust Compliance As noted above, foreign licensors

increasingly are being accused of violating China’s antitrust require-ments. The requirements are found in several sources, including the Technology Regulations, Article 329 of China’s Contract Law, a Supreme Court interpretation of Article 329, the Anti-Monopoly Law (AML) and regulations imple-menting the AML with respect to intellectual property rights.

Those authorities provide that any agreement that ille-gally monopolizes a technology, impedes technological progress, or infringes another’s technology shall be void. No party with a dominant market position may abuse its position to restrict or eliminate competition; dominant position is defined as capacity to control price, quantity, or other trading conditions in the relevant market, or deter others from entering the market. Ownership of IPR, by itself, does not create a presumption of dominant posi-tion, but may be a factor.

A contract potentially violates Article 329 when it:

• Restricts the transferee’s right to further develop the technology;

• Restricts the transferee’s pro-curement of similar or com-peting technology;

• Unreasonably restricts the transferee’s use of the tech-nology in the market, includ-ing with respect to quantity, variety, prices, or distribution channels;

• Unreasonably requires pur-chase of goods, or services that are not necessary for the technology;

• Unreasonably restricts the transferee’s channels for pro-curing parts, materials, or equipment; or

• Restricts the right to challenge the validity of the transferor’s intellectual property rights.

A party in a dominant position has potentially abused its position unlawfully when it:

• Sells goods at unreasonably high prices or buys at unrea-sonably low prices;

• Refuses to trade with another party without justifiable cause;

• Requires a party to trade exclu-sively with a designated party without justifiable cause;

• Ties products or imposes unreasonable trading condi-tions without justifiable cause;

• Applies dissimilar prices or terms to different parties with equal standing;

• Sends an obviously false notice of infringement; or

• Requires an exclusive grant-back of intellectual property rights.

Contract Provisions Parties : In any country, counsel

should confirm that contracts list the correct names and addresses of the parties. In China, one should go a step further, specifying the com-pany’s registered name, registered address, and registered number.

Ask the licensee to provide a copy of its business license and check with the local Administration for Industry and Commerce (AIC) office to confirm the licensee’s registered details, registered capi-tal, legal representative, and other matters.

Royalties : If possible, negotiate agreement for lump sum royal-ties, preferably up front, rather than volume or revenue-based, due to pervasive gamesmanship and under-reporting of royalties in China. If royalties must be based on net sales, carefully define allow-able deductions from gross sales, explicitly barring deductions for items such as sales commissions, marketing costs, or bad debts and provide a cap on deductions, such as 5 percent of gross sales. Make clear that royalties are based on sales prices to end-customers, not inter-company transfer prices, and are due upon shipment of goods, not receipt of payment. Due to fluctuating conversion rates, most foreign licensors require payment to be made in a foreign currency, such as US dollars.

Audits and Reports : Agreements should provide detailed requirements concerning royalty reports, specifying when reports are due and required con-tents, such as product description, model number, serial number, quantity, place of sale, name of purchaser, and net selling price of units manufactured and sold. A required form can be attached. The agreement also should con-tain a detailed audit provision, requiring the licensee and its par-ent, subsidiaries, and affiliates to keep all relevant accounting records for at least three years and allow unrestricted inspection and copying of records, with the licensee paying all audit costs, attorney fees, and a penalty in the event of under-reporting beyond a certain amount.

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Grant-Backs : Under China’s laws, any licensee who makes improvements to licensed technol-ogy owns the IPR in such improve-ments and any grant-back of an assignment or exclusive license to such IPR must be supported by rea-sonable compensation. The license may stipulate certain payments that shall be made in exchange for such grant-backs, but in the event the compensation is deemed inad-equate or any improvements are restricted or prohibited under the Technology Regulations a grant-back may not be possible.

Governing Law : Attempts to circumvent the above types of issues by having the agreement governed by laws of a country other than China may be inef-fective, because agreements that are contrary to China’s mandatory provisions may be unenforceable. However, rather than voiding the entire agreement, China’s courts will sometimes strike the offending provision or provide an appropri-ate remedy, so a sound severability provision is essential.

Dispute Resolution : If a Chinese licensee has substantial assets overseas, it might be accept-able to stipulate that disputes shall be resolved in particular foreign courts (such as US federal court); otherwise that would be a poor choice, as China does not rec-ognize most foreign court judg-ments and will not enforce them. Many foreigners perceive China’s courts as too biased or unreliable, so they select arbitration, particu-larly in Hong Kong or Singapore,

both of which are good choices. China is a party to the New York Convention, so foreign arbitral awards should be enforceable in China. However, if one may wish to seek injunctive relief in China, the courts of China or Hong Kong may be the best option, although one should not be overly optimis-tic about obtaining such relief.

Language: If the agreement will be in two languages, it should specify that one language is con-trolling and the other is for ref-erence only. If disputes will be resolved in China, the official lan-guage should be Mandarin; other-wise English is acceptable.

Signatures : Finally, no con-tract is complete without a sig-nature, or, in the case of China contracts, a correct signature and official company chop. A signa-ture alone may be binding, pro-vided it belongs to the company’s legal representative, as identified on its business license; a company chop alone may be binding, pro-vided it is the correct chop, as reg-istered with the Public Security Bureau. However, best practice is to require both and to examine other contracts the company has executed to confirm the signature and chop match up. Each page of the agreement should be initialed for good measure.

Conclusion With 1.3 billion people and

the world’s fastest-growing major economy, many foreign companies are intrigued by the opportunities of doing business

in China. Admittedly, there are plenty of challenges, including unscrupulous business practices, an unreliable justice system and zealous government officials protecting local interests. For licensors, those risks may lead to loss of valuable intellectual property  and technology, under-reporting  and  under- payment of royalties, and ineffective legal remedies.

Many licensors feel those dif-ficulties outweigh the benefits of doing business in China, but Winston Churchill said “A pes-simist sees the difficulty in every opportunity; an optimist sees the opportunity in every diffi-culty.” Indeed, foreign licensors who engage in careful planning, preparation and execution, will find they may mitigate the risks of licensing to China companies and the opportunities will often outweigh the difficulties.

Chris Neumeyer is Managing Partner of Asia Law, International Attorneys, a firm of international lawyers servicing the needs of companies doing business in Asia. Mr. Neumeyer’s work regularly involves intellectual property rights and technology, including LEDs, semiconductor chips, computers, monitors, power supplies, internet access devices, cell phones and camera modules. He has handled well over one-hundred licensing disputes and also advises and assists clients with respect to trademarks, trade secrets and copyrights.