China’s evolution from manufacturing to innovation

Erick Robinson examines how patents and the Anti-Monopoly Law are changing the rules in China and how companies can protect themselves.

Even five years ago, trying to protect any type of intellectual property in China was nearly impossible. The Chinese manufacturing economy was set up to produce – and copy – anything from purses to clothing to barely functioning electronics. But the Chinese government has now prioritised innovation rather than copying.

This evolution is similar to Japan’s transition in the latter half of the 20th century, from a reverse-engineering economy to a true innovation economy – except China is moving at light speed. Why all of a sudden does China care about protecting innovation? Simple: China now innovates and has an innovation market to protect. Before, there was little to protect other than the IP rights of foreign companies.

The Chinese government has issued a decree that innovation must now be a priority. Unlike in the US or other Western nations, once policies are decided by the Chinese government there is no debate. No one takes a poll, no one ‘tests the air’ and there is no period of discussion. The policy is implemented immediately.

Removing societal politics from economic policies is just one reason China has been able to move so quickly. Another is that unlike most countries or businesses today, China does not think ahead one quarter, or even one year. Rather, the government sets forth five-year plans and then sets about making sure the goals are reached. The most recent five-year plan sets innovation as China’s top priority. And unlike Western nations in which the execution of goals can be mired in protests and lack of support by differing political parties, China’s goals are generally achieved.

Sample problem: China’s semiconductor industry

China is a top consumer in almost every area. For instance, Chinese consumers purchase more smartphones than in any other country. And because all of these devices run on multiple chips, China uses more semiconductors than the rest of the world combined. See Figure 1.

 

But China severely lags in semiconductor production. Currently only 5% of the semiconductors used in China are produced in China. Relying so heavily on other countries, especially the US, to produce semiconductors necessary for electronic devices from cars to refrigerators to smartphones has been deemed a national security risk. Therefore, in 2015 the government set a target of producing 70% of the chips consumed by Chinese industry. China will go from producing 5% of the semiconductors it uses to 70%. This means that foreign companies will go from producing 95% of China’s semiconductors to only 30%. This may be a huge problem for companies such as Qualcomm, which makes 53% of its revenue from China, SK Hynix (24%) and Intel (20%).1 China will use two major weapons to achieve its goals: its patent system and its Anti-Monopoly Law.

 

Table 1: Enforcement of patents

  • High win rate (75% – 95%).
  • Foreign plaintiffs win more than Chinese plaintiffs (but must do their homework).
  • Virtually guaranteed injunctions (99%).
  • Short time from filing to trial/judgment (6-12 months).
  • Sparse discovery.
  • Low cost due to decreased time and discovery burdens.
  • alidity challenges are often not complete until after judgment (and injunction).
  • itigation generally not stayed pending validity challenges.
  • Dominant Chinese market for sales (largest worldwide for many electronics) and manufacturing (largest worldwide).
  • Forum shopping available (where infringement occurs).    
  • Specialised IP courts and judges that take pride in their skill and fairness (no discrimination against NPEs).
  • Although a civil law system, judges seek out and respect prior decisions.
  • Government has demanded that the courts be fair and create strong enforcement system.
  • Draft amendments to Patent Law may raise statutory damages and include punitive damages. Damages likely to rise significantly.
  • Pre-trial asset freezes available – freezing bank accounts and inventory a useful negotiating tactic.
  • System for blocking goods due for export at Customs is well developed.

 

Patent protection in China

Nothing in China has advanced faster than patent law. No patent law existed in China until 1985. Although China amended its patent law in 1992, 2000 and 2009, it is only in the past few years that the country has created an effective patent enforcement system. In November 2014, China instituted dedicated IP courts in Beijing, Shanghai and Guangzhou. Although China has a civil law system, the courts – particularly the IP courts – listen to each other. Further, the Supreme People’s Court, China’s highest court, regularly puts forth interpretations regarding IP law. These interpretations have the force of law and can be cited, just like a statute.

China is now, along with the US and Germany, one of the top three jurisdictions in which to enforce patents. Some of the key traits are listed in Table 1 above.

The biggest advantages are guaranteed injunctions, high win rates, quick time to trial and the huge Chinese sales and manufacturing market. Because technology companies around the world manufacture their products in China, it is possible to get an injunction that effectively prohibits worldwide sales in less than a year. This is because unlike most countries that only ban imports, China also bans exports of infringing articles. But don’t listen to me, listen to Apple. In a pleading in the Northern District of California,2Apple warned the court of the drastic consequences of a patent case against it:

“If BYD is not prevented immediately, and pending a final determination in the arbitration, from continuing the Chinese patent litigation, Apple and Apple’s supply chain may suffer serious disruption. Such disruption will irreparably harm Apple, Apple’s reputation and goodwill, and the millions of consumers and businesses who demand Apple’s high-end innovative product.”

Importantly for foreign companies with Chinese patents, the courts are generally quite fair. For example, foreign plaintiffs generally fare better against Chinese defendants than do Chinese plaintiffs. See Table 2.

 

The reasons for this likely include that foreign plaintiffs move forward with only their best cases. The take-home message, though, is that foreign patent owners can get a fair case in China. Although 95% of patent cases in China are between Chinese parties, approximately 11,000 cases were filed in 2015. See Figure 2 (p53).

 

 

Patent quality is generally poor. The national and local governments have provided financial incentives to file patent applications based on quantity, not quality. But even though a large percentage of Chinese patents are not of great quality, that is changing. The Chinese patent office is aggressively taking steps to improve quality. Plus, with such large numbers of patents issued, even a small percentage of quality patents is a lot.

China is undergoing an upswing in patent quality not unlike many technology companies. First, a company files patent applications on any and every idea, regardless of its merit, to get numbers. Once people are paying attention, the focus shifts to quality. The only difference in China is the amazing speed at which this is happening.

China’s Anti-Monopoly Law

China’s Anti-Monopoly Law (AML) was implemented in 2008. This complex and rapidly evolving law is currently enforced by three separate government agencies: the National Development and Reform Commission (NDRC), which is in charge of monopoly agreements and price-fixing; the State Administration for Industry and Commerce (SAIC), which is in charge of abuses of dominant position; and the Ministry of Commerce, which is in charge of merger review. Although there is considerable overlap between these agencies, the NDRC is likely to be the chief tool of the government as it pushes its innovation goals.

A good example of the power of the Chinese AML is what happened to Qualcomm. In December 2013, the NDRC announced it was investigating Qualcomm for violating the AML. Chinese companies had complained to the Chinese government about the licensing rates they were being charged by Qualcomm. After a year and a half of investigation, on 9 February 2015, the NDRC announced a settlement and that Qualcomm would be fined $975m to settle the case.

The real harm was not in the fine, but rather the effect of the other sanctions that drastically decreased the royalties Qualcomm receives from Chinese companies.4 The settlement affected only phones sold in China by companies based in China. What this means (in addition to large revenue losses for Qualcomm) is that Chinese handset makers such as Xiaomi and Huawei have a huge advantage in the Chinese market because the fees they pay for the same Qualcomm chips that run their competitors’ devices are significantly lower than their competitors’ costs.

Perhaps the biggest blow to Qualcomm, though, was that after the NDRC launched its investigation, other regulatory authorities started similar investigations in South Korea, Taiwan, the EU and even the US. What starts in China no longer stays in China.

Qualcomm’s largest failures were in not learning about the problem sooner and not accepting the problem and then working to come up with a solution. Had Qualcomm discovered the problem earlier, it might have avoided the issue becoming public and also circumvented ensuing investigations around the world. Further, Qualcomm fought the dispute  very hard. Only a year into the investigation when it respectfully acknowledged a problem did both sides begin to come together. This is a lesson for any company doing business in China.

What can companies do to protect themselves in China

As described, being on the wrong end of a patent lawsuit in China can be a huge problem. And being investigated under the AML can be even worse. So what can foreign companies do to protect themselves? The first thing to do is to realise that the rules for success in China for a foreign company are different than in other places. The good news is that the market is amazing and the government is doing good things to protect innovation. However, China is still quite nationalistic. Whether nationalism (for any country) is a net positive or negative is irrelevant: the rules are what they are. And in China, at least they are well known: do not do anything (long-term) that will adversely affect the Chinese people, government or economy. It really is that simple.

I look at China as a broad river with a swift current. So long as one swims with the current, extraordinary things can be accomplished is a very short time. But if one tries to swim upstream, then bad things happen quickly. Too many foreign companies insist on swimming upstream. Doing so is folly not only because of assured failure, but because there is so much ‘good’ river available. Companies should achieve the simple before they try to challenge the system. After a company does things right in China for a few years, it may have more leeway to test the current.

Many Chinese officials have put it another way: to succeed in China, you must be a friend of China. Being a friend to China can mean different things: investing in Chinese start-ups, setting up technology incubators, working with universities or anything that gives back to China. Contributions can be financial or strategic. China now has the minds and the money, but still lacks experience in IP and certain technologies. By building relationships with companies and schools that will foster the next stage of innovation in China, foreign companies can help China get to where it wants to be. And they can do the right thing: give back to a country that can deliver great success. Above all, though, be culturally respectful. Being aggressive, impolite or obnoxious is not acceptable.

One great example of a company managing China well is Intel. As mentioned, the semiconductor industry in China will soon be problematic for foreign companies. In 2014, Intel purchased a 20% stake in Tsinghua Unigroup as part of a plan to work together on chips for mobile devices. Tsinghua Unigroup, a company spun out of Tsinghua University in Beijing, has emerged in the past year or so as a champion among champions in the semi space. The company is controlled by Tsinghua University in Beijing, which counts President Xi Jinping among its alumni, and is backed by China’s central government. Through its stake in Tsinghua, Intel not only instantly became a China company, but also will receive information much more quickly through this conduit to the government. Being a friend to China is not rocket science. It just means creating a situation that is a win-win for the company and for China.

Regarding patents, as with most weapons, the best defence is a good offensive. The biggest challenge right now is obtaining Chinese patents, since until recently they had little value. Any company that does business in China – whether Chinese or foreign – should be filing for or acquiring Chinese patents. Chinese patents are relatively inexpensive right now, but the market is very opaque. The best way to acquire patents is to work with a Chinese company or someone on the ground who knows the market. Success in China is all about ‘guan xi’ – relationships. Forming strategic alliances with powerful partners is paramount to achieving long-term success.

Discussion

No longer satisfied to be the manufacturer to the world, China and its government and people are creating new technologies and improving existing ones. And now that China has a technology market to protect, it is has created one of the best patent enforcement systems in the world. Along with enforcement of its AML, China will use patent litigation to build up its domestic industry. This, by definition, means that foreign companies will have less market share. Such companies, instead of focusing on the negatives about which they can do little, should attempt to ‘grow the size of the pie’ by forming strategic partnerships with the government, companies and schools. Being a friend to China is a path to sure success while attacking or complaining about China does nothing but increase the chances of failure.

Businesses today cannot ignore the Chinese market. Although the rules may be less than ideal, foreign companies should simply accept what they cannot change and focus on those things they can. By doing so, China and the rest of the world can create an amazing engine for innovation that helps everyone.

Footnotes

1. Later I explain how companies like Intel have tried to insulate themselves.

2. Chinese company BYD, an Apple supplier, sued Apple in China for patent infringement. Apple asserted that BYD should not be able to do so based on a supply agreement between the parties, and filed a complaint in the Northern District of California (US) to compel arbitration and stop the Chinese lawsuit. The case was settled before adjudication of the issue. It would have been interesting to see, had the California judge told a Chinese court to stop the litigation, what would have happened. My guess is that Apple would not have liked it.

3. Note that the CIELA database contains only a fraction of the patent cases filed in China because not all are made public.

4. Qualcomm was required to implement multiple measures in order to satisfy their agreement with the NDRC which included offering 3G and 4G licences on standard-essential patents separately from other licences to other patents and would present a patent list during negotiation. Also, Qualcomm was required to offer separate licences for certain patents, with licensees paying 3.5% for devices using only its 4G technology and 5% for 3G-only devices or those that use both cellular technologies. Further, instead of applying the percentage to the wholesale price of the handset, Qualcomm would apply it to 65% of the net selling price of a device, a lower figure. Additionally, Qualcomm could not condition the sale of baseband chips based on the signing of a licence agreement with the terms that the NDRC found to be unreasonable.