Protecting Intellectual Property in China

Multinational corporations can’t afford to stay away from China. But to remain competitive they must develop mechanisms that allow them to minimize the risk of losing critical know-how.

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Intellectual property (IP) protection is the No. 1 challenge for multinational corporations operating in China. According to the U.S. government, China accounted for nearly 80% of all IP thefts from U.S.-headquartered organizations in 2013,1 amounting to an estimated $300 billion in lost business. Among European manufacturers, the loss of IP in China reduced potential profits by 20%.2 Although multinational corporations can’t afford to stay away from China, in order to remain competitive they must develop mechanisms that enable them to shift some of their innovation capabilities to China safely, without losing critical know-how.3

The effects from IP leakage in China are ubiquitous. They are visible in counterfeited items including toys, luxury goods, automotive and aircraft parts, pharmaceuticals and other complex high-tech products.4 But IP violations go beyond products. They extend to pirated operational processes and the replication of entire business and service models. For many multinational corporations, IP leakage frequently becomes a barrier to Chinese sites becoming fully integrated partners in global innovation activities.

IP leakage often occurs through staff transfers or shared practices from foreign multinational corporations to local joint ventures or supply chain partners.5 For individual multinationals, this type of IP leakage is often a calculated risk worth taking in exchange for greater access to local markets through a partner’s channels or better quality parts from local suppliers. However, unintended IP leakage can affect a company’s reputation and profitability; in the worst case, it can create powerful local or even global competitors.6

Most of the executives we interviewed said that managing IP leakage is the most critical day-to-day activity when doing business in China. A senior executive from a Fortune 100 company commented:

When I moved to China from the U.S.A., I never imagined that I would have to include IP protection management in almost all of our business processes. I think about the issue actively every day. Yet, we are still not able to prevent all IP leakages entirely.

To learn about how companies are managing the China IP protection challenge, we studied more than 50 multinational corporations. (See “About the Research.”) We identified nine IP protection practices that can be used as a web of protection. These practices allow corporations to (1) expand faster within China and across other emerging markets; (2) improve performance; and (3) enhance local and global innovativeness.7

Understanding the Drivers of IP Leakage

The challenge of protecting IP in China is influenced by three factors: the state, the global market and sociocultural factors. Senior managers need to understand how to manage each of them as well as how to apply critical protection mechanisms.

The Role of the State

China aspires to be a technology powerhouse by 2020 and a global technology leader by 2050. Its ambitious indigenous innovation policy goals and explicit desire to shore up its relatively weak innovative capacity form the strategic foundation of this objective. Such goals present a major competitive threat to foreign companies. The Chinese government’s plan for the development of science and technology defines indigenous innovation as “enhancing original innovation through co-innovation and re-innovation based on the assimilation of imported technologies.” The goal is to transform foreign technology into Chinese technology with a “by China for China” tagline. Although Chinese managers see this as adaptation, the U.S. Chamber of Commerce noted that many multinational technology companies view it as a “blueprint for technology theft on a scale the world has never seen before.”8

The Role of the Global Market

Over the past decade, foreign direct investment in China has changed significantly, from low-cost manufacturing to a proliferation of high-tech manufacturing and advanced services. The trend is expected to accelerate, particularly in areas such as renewable energy and information technology. In China, industry development is asymmetric, with rapid increases at the bottom and at the top — often driven by leapfrogging of certain development stages based on substantial rather than incremental advances in know-how. The foundation for this asymmetric development is partly based on existing voids that characterize the Chinese legal system. The quandary is that multinationals can no longer compete in China with products and services based on a previous generation of know-how. Today, the Chinese market is more sophisticated than it was even 10 years ago. Staying on the leading edge is essential to survival for local companies. Imitating proven high-tech know-how from foreign companies, with a limited chance of punishment, is not only the most profitable but also the least risky strategy for many Chinese companies.

The Role of Sociocultural Factors

IP leakage is also a direct consequence of sociocultural conditions that are deeply rooted in Chinese history. During the Mao Zedong era (1949-1976), characterized by Communism and widespread poverty, property rights were stifled. This legacy continues to shape attitudes toward IP protection.9 China’s approach to education, which includes an emphasis on rote memorization and a bias for exact copies of works by experts or masters, also plays a role.10 In addition, there is a very high turnover rate for well-educated middle managers and engineers, who are the stewards of a company’s IP. According to a McKinsey & Co. study, annual staff turnover rates in high-tech industries in China exceed 20%.11 This results in a constant bleeding of talent and a loss of IP.

Creating an IP Protection Web

Much of today’s discussion about IP protection in China takes a legal perspective and focuses on patent protection strategies.12 We found that executives at multinational companies strongly agree that current protection practices derived from developed countries are not as effective or do not work fast enough to protect from the fallout of IP violations, and that real solutions are not at all apparent. Enforcement is weak, and complaints take years to work their way through the legal system. Indeed, by the time a multinational company succeeds in a Chinese court, the damage may already have been done. Pfizer Inc.’s experience in China with Viagra offers a case in point. After 15 years of complicated litigation, Pfizer now owns the Viagra patent in China. But the drug generates meager sales, because of the large number of counterfeiters and a Chinese 12-company consortium that produces a legal generic equivalent of the drug.

The IP Protection Web

View Exhibit

The IP protection web consists of three interconnected layers. Strategic clarity forms the first layer, followed by legal fundamentals and business intelligence as the second layer. The inner layer consists of six operational practices that should be woven through the entire company.
The IP Protection Web

Successful IP protection in China requires an assortment of internally and externally focused practices that are integrated, dynamic and mutually reinforcing. We identified nine specific protection practices that address strategic, legal and business intelligence issues. The first four practices are defensive and externally focused; the other five are proactive and internal. The layering and combining of these practices creates what we call the IP protection web. (See “The IP Protection Web.”)

Externally Focused Defensive Practices

The externally focused practices provide the initial elements corporations can use in protecting IP in China.

Practice 1: Develop strategic clarity.

Executives need to have a clear business strategy that is aligned with their objectives for operating in China.13 Too often, companies enter the Chinese market without being clear about what they are doing and why. Strategic clarity includes identifying the specific IP that allows the company to execute its strategic plan. The strategic plan should include detailed operational, management and contingency processes to guide implementation; it should also include selecting the individuals who will lead the China effort. Emerson Electric Co., an electronics manufacturer headquartered in St. Louis, Missouri, has more than 40 locations and produces thousands of products in China. As Lee Swee Chee, president of Emerson Process Management, commented:

We are in China to make money. We transfer enough technology to meet market needs, but we do not move sensitive material into China. We produce to global standards and are aggressive in pursuing counterfeiters and putting them out of business. We plan, execute and integrate IP protection globally and locally.

IP leakage often occurs when foreign multinationals bring too much IP to China or when they share it too broadly with unvetted partners. Incorporating IP protection practices during the development of the business strategy provides the critical foundation upon which corporations can build a robust IP protection strategy.

Practice 2: Collect business intelligence.

Executives and managers must also develop deep knowledge about the Chinese operating environment prior to entry. This should include understanding location choice trade-offs and awareness of the regional differences within China. Each business location offers a range of opportunities and threats, including how IP is viewed locally and how IP infringements are handled. Beth Epstein, director of fraud prevention and integrity risk at Hill & Associates, a risk protection company based in Hong Kong and Singapore and with extensive experience in China, explained:

The reality is that you have many different Chinas and no unified way of dealing with intellectual property protection everywhere. For example, in poorer regions, government officials will not shut down a plant producing counterfeit products until they have an alternative source of employment for local workers.

Business intelligence enables executives to learn about local customer values, needs and expectations, local labor market dynamics, supply chain threats and locations where IP protection may be most effective. There are formal and informal ways to collect business intelligence, ranging from using in-house experts (only recommended for the most China-experienced companies) to hiring outside professionals. Rather than relying on mitigation activities after IP has been leaked, companies should make IP protection an integral part of the due diligence process.

Practice 3: Follow legal fundamentals.

Formal patent filings and trademark protection are important in China, but unfortunately, they can create an IP leakage threat of their own. Too often, multinationals base their IP management activities on their understanding of the legal systems in their home countries. Under China’s patent protection system, which is based on the “first-to-file” principle, the detailed patent application is published within a relatively short time period after the patent is filed.14 As a result, filing for a patent in China can signal a counterfeiting opportunity for would-be imitators.

There are also problems of representation. One problem for foreign multinationals is that they often rely on local law firms that know the Chinese legal system but lack specific industry or product expertise. This can lead to filing mistakes and IP leakage. Alternatively, multinationals use lawyers from outside China — often headquarters-based corporate counsel — who don’t know the Chinese legal system well.

Practice 4: Create interest alignment.

Doing business in China involves managing a complex set of relationships with customers, employees, communities, government officials, supply chain partners and others. Interest alignment is an essential practice that relies on social capital to function.15 The Chinese term guanxi, which emphasizes the importance of reciprocity and social capital, is understood both inside and outside China.16 The social capital developed through positive local relationships means that companies recognized as good citizens may enjoy favorable treatment in IP protection enforcement.

In China, different groups see IP leakage differently. Multinationals have to be explicit and proactive in managing interest alignment. They need to be aware that understanding the perception of a win-win situation from the Chinese perspective is essential. Interest alignment can be an effective substitute for what a more mature legal system would provide. Kent Kedl, a managing director based in Shanghai for Control Risks, a consulting firm specializing in political, integrity and security risk, described a client he worked with while setting up a factory in a small city in China:

The client worked closely with the local government, and they both understood the importance of the factory for the city. Nine months after the factory opened, an employee left and set up a shadow factory across town where they sold the same product at half the price. The foreign firm brought in “big name” lawyers to no effect. Some time later a middle manager indicated to a government official that the shadow factory was greatly hampering their desire to contribute to the local economy. Shortly thereafter the local government shut down the shadow factory.

Internally Focused Practices

Companies that begin with a clear China strategy, a deep understanding of the rules of the game, an interest alignment mindset and sound legal fundamentals are able to prevent a certain amount of IP leakage. For these companies, IP protection efforts shift from defensive activities to proactive activities aimed at encouraging complex social and organizational behaviors that create barriers that are difficult for would-be IP copiers to crack.

Practice 5: Disaggregate processes.

Counterintuitive to traditional efficiency logics, which would suggest centralization, physically separating manufacturing and R&D processes, disaggregating proprietary components and compartmentalizing critical know-how are essential for effective IP protection in China. Eric Nelson, former general manager of DelStar Technologies Inc., a maker of plastic components based in Middletown, Delaware, described the company’s manufacturing process:

None of the process capabilities that we had were patented. Processes were broken down into those elements critical to the business so that no one single individual had access to all of them. As general manager, I was the only one who knew the entire manufacturing process. Extrusion dies, for example, were critical to the manufacturing process. These were kept overnight in a separate vault that could only be opened by one person, me, using a lock and key. Other staff members were never allowed to put the dies into the extrusion machine.

The logic of disaggregation is that if would-be IP imitators are only able to access a “piece” of your IP, they rarely can access all that’s needed to replicate products or processes. In addition to disaggregating processes, IP protection can be achieved by moving highly skilled talent to locations like the United States, Europe or Singapore, where more favorable IP protection enforcement is possible, even though the work is China-related.

Practice 6: Implement a controls discipline.

When employees are surrounded by practices that emphasize the importance of internal IP protection, they are more likely to pay attention to the issue and act in ways that support protection. Beth Epstein of Hill & Associates explained:

Do not assume that your Chinese workers are familiar with your home country standards regarding IP or integrity issues. Unless they have significant experience with other foreign employers, they are not likely to understand your perspective.

Many foreign executives think that their local employees are aware of the differences and will automatically honor corporate rules that are based on sociocultural rules from abroad.17 However, that may not be the case, and controls discipline needs to go beyond providing codes of conduct manuals. Several executives highlighted specific managerial practices that reinforced controls discipline involving finance controls, IP handling practices and behavioral controls. Chinese multinational computer company Lenovo Group Ltd., for example, conducts the full spectrum of its R&D activities — everything from market conceptualization to product deployment — in proprietary labs. According to Leo Curtis, a senior executive consultant at Lenovo’s Beijing Innovation Center, not even a picture of a product leaves the Lenovo campus until the product is ready to hit the market. Any breach by an employee leads to full and immediate prosecution and dismissal. Curtis explained:

The likelihood of being hired at another technology firm if you have been found to play a part in counterfeit activities is small. Lenovo wants the employees at any given time to consider if a breach of the security policy is worth the employee’s career or next job.

One effective and relatively straightforward way to implement controls involves mandatory bag checks for everyone, including the most senior executives — regardless of whether they are locals or expatriates. Another effective practice is always having at least two people sign off when accessing IP-critical information; the best approach is to have the people come from different backgrounds or different parts of the company. In addition, it’s important that leaders have a regular physical presence on the manufacturing floor or in the R&D laboratory.

The combination of internal visible controls discipline and the extension of that discipline to external supply chain partner operations can add important layers to the IP protection. James Boyle, managing partner of financial advisory firm Expat-CFO Services Ltd. in Shanghai, contends that there are three important questions to ask foreign partners: “Who is the local partner really?” “Who is behind the company name?” and “What will and what could they be doing with the your technology?” Controls discipline extends to enforcement. In the case of violations — even minor ones — punishment should be immediate and without exception.

Practice 7: Create dynamism.

The continuing socioeconomic transformation of China makes it essential for multinationals to embrace a dynamic stance toward IP while developing new protection solutions continuously. In 2005, UTStarcom Inc., a global telecom infrastructure provider based in San Jose, California, decided that it was necessary to move some of its global research and development activities to China in order to keep pace with the development of the local market. Like other companies, it faced an uphill battle with imitators. Fear of exposing itself even more to potential IP leakage led UTStarcom to seriously consider canceling the China R&D project, recalled UTStarcom cofounder Hong Lu:

China became so important to us in terms of volume and growth that we simply had to commit more. IP management became an executive task and agenda point in every management meeting. It became an active driver of our business strategy. We changed from a focus on building barriers to dynamically identifying and managing leakage threats. With this move, we essentially developed the capability to stay at the leading edge of IP protection. We changed from a focus on mitigation and protecting finished products to protecting innovation capabilities while simultaneously bringing new products to market at a much faster pace.

Practice 8: Manage human resources strategically.

In China, protecting IP is closely linked with the company’s people management systems. The most prevalent cause of IP leakage in China is widely seen as staff turnover. Strategic human resource practices are aimed at mitigating IP leakage. The first step is selecting employees with integrity and compatible ethical values. In addition, executives need to understand local labor market dynamics and what drives turnover. Developing reward systems that resonate with local talent can help reinforce desired behaviors.18

One reward talented employees in China often value highly is training and development, especially when it focuses on improving technical skills. External training and development opportunities are not readily available in China or are very expensive. To address this gap, Briggs & Stratton, a leading manufacturer of gasoline engines based in Wauwatosa, Wisconsin, developed a yearlong management training program. It provides MBA-level marketing, finance, operations, strategy and leadership skills training to high-potential employees to upgrade their skills and, more importantly, to retain them. According to Mark Plum, former Briggs & Stratton-Asia president, this program resulted in the promotion of several participants to executive levels in China as well as a significant decrease in turnover among high-potential employees.

Practice 9: Engage in focused corporate social responsibility activities.

In China, focused corporate social responsibility can build legitimacy that can help insulate companies against IP leakage. This is one layer of IP protection that we did not anticipate when we designed our research. Executives interviewed stated that a positive corporate social reputation is attractive to employees, especially younger knowledge workers, and helps recruit good talent. SPX Corp., based in Charlotte, North Carolina, which designs, manufactures and markets engineered solutions and products, has benefited from this interest. Nina Liu, president and managing director of its Asia Pacific business, commented:

Integrity is critical at SPX, and a clear understanding of how much SPX values integrity provides employees and prospective employees an attractive work culture. We think it makes us stand out as an employer.

Corporate social responsibility serves to bind some individuals from the millennial talent generation to the organization. In addition, the company’s reputation has a positive impact on the community in which it operates. Most companies departmentalize corporate social responsibility activities and leave them strategically detached from operations. Executives we interviewed found that integration of corporate social responsibility into the planning process produced positive results. As Richard Brubaker, founder and managing director of Collective Responsibility, a Shanghai-based organization focused on corporate social responsibility, told us:

Do good and talk about it! For example, if you support a local school or kindergarten, you need to emphasize to the local officials, your employees and the community at large that you can only do so if your company’s assets, including its IP, are being protected and respected.

Promoting this linkage actively might not be comfortable from a Western managerial perspective, but it is key in China, where “doing good” and talking about it are important for developing local embeddedness.

Cisco System Inc.’s experience following the 2008 earthquake in China’s Sichuan Province demonstrates this point. In the wake of the disaster, Cisco made a significant donation for earthquake recovery. Subsequently it was selected to install an IT system linking hospitals and rural clinics in Chengdu, a major city in the affected province. Although no one questioned the quality and suitability of Cisco’s products, the relationships the company built after the earthquake also signaled to the local decision-makers that Cisco was a good corporate citizen.

Reconfiguring IP Protection Practices

Protecting IP in China requires a dynamic, multilayered configuration of defensive and proactive practices that provide barriers against both external attacks and leakage from within the organization. Companies need to make their own choices about which objectives, structures and capabilities are most applicable to their specific operations in China. The ability to interlock and revamp protection practices as needed may be one of the most important organizational capabilities companies can have to succeed in China. The business opportunities in China are well documented. Although pursuing opportunities typically involves risks, we have identified processes and practices that can reduce those risks by forming a web of protection against IP leakage.

Most of the companies we studied learned to protect their IP through trial and error — there is no one single “best” process or practice. Each company relies on its own combination of practices to form a defense. However, the changing composition of IP risk creates a need for ongoing reconfiguration. Indeed, as Chinese companies become more skillful at absorbing leaked IP from those employees that used to work for international rivals, international companies must develop more sophisticated responses and find new ways to engender loyalty. The lessons learned from this study can be applied to other emerging markets with transitional institutional environments. The more interlinked the practices are, the more effective IP protection can be.

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References

1. J. Parker, “Indigenous Innovation Remains Key Feature of New Development Policies,” The U.S. China Business Council, Nov. 12, 2013, www.uschina.org.

2. Ihrcke, J. Ihrcke and K. Becker, “Study on the Future Opportunities and Challenges of EU-China Trade and Investment Relations,” EU-China Trade and Investment Relations - Study 1 of 12: Machinery, www.development-solutions.eu, accessed January 15, 2014.

3. R. Ong, “Tackling Intellectual Property Infringement in China,” China Business Review 36, no. 2 (March-April 2009): 17-21.

4. D. Wagner, “International Perspectives on Counterfeit Trade,” MIT Sloan Management Review 49, no. 4 (summer 2008): 9-10.

5. H. Chesbrough, S. Ahern, M. Finn and S. Guerraz, “Business Models for Technology in the Developing World: The Role of Non-Governmental Organizations,” California Management Review 48, no. 3 (spring 2006): 48-61.

6. W. Shih and J-C Wang, “Will Our Partner Steal Our IP?” Harvard Business Review 91, no.1 (January-February 2013): 137-141.

7. Related research: A. Schotter and M.B. Teagarden, “Protecting Intellectual Property in China: A View from the Field,” in “Global Strategies for Emerging Asia,” eds. A.K. Gupta, T. Wakayama and U. Srinivasa Rangan (San Francisco: John Wiley & Sons, 2012): 235-264.

8. J. McGregor, “China’s Drive for ‘Indigenous Innovation’ — A Web of Industrial Policies,” July 27, 2010, www.uschamber.com.

9. M.M. Keupp, A. Beckenbauer and O. Gassmann, “How Managers Protect Intellectual Property Rights in China Using De Facto Strategies,” R&D Management 39 no. 2 (March 2009): 211-224.

10. I. Harvey, “Intellectual Property: China in the Global Economy - Myth and Reality,” briefing note, International IP Strategists Association (September 2011) 1: 1-8.

11. “Insights China: The China Context,” Sept. 22, 2012, www.solutions.mckinsey.com.

12. D. Somaya, D. Teece and S. Wakeman, “Innovation in Multi-Invention Contexts: Mapping Solutions to Technological and Intellectual Property Complexity” California Management Review 53, no. 4 (summer 2011): 47-79.

13. J. Palfrey, “Intellectual Property Strategy” (Cambridge, Massachusetts: MIT Press, 2011).

14. W. Jaeschke, Z. Lu and P. Crawford, “Comparison of Chinese and US Patent Reform Legislation: Which, If Either, Got It Right?” The John Marshall Review of Intellectual Property Law 11, no. 3 (special 2012) 567-601.

15. M.B. Teagarden and A. Schotter, “Favor Prevalence in Emerging Markets: A Multi-level Analysis,” Asia Pacific Journal of Management 30, no. 2 (June 2013): 447-460.

16. Keupp, Beckenbauer and Gassmann, “How Managers Protect Intellectual Property Rights.”

17. M. Reitzig, “How Executives Can Enhance IP Strategy and Performance,” MIT Sloan Management Review 49, no. 1 (fall 2007): 37-43.

18. C.B. Bhattacharya, S. Sen and D. Korschun, “Using Corporate Social Responsibility to Win the War for Talent,” MIT Sloan Management Review 49, no. 2 (winter 2008): 37-44.

i. M.M. Keupp, A. Beckenbauer and O. Gassmann, “Enforcing Intellectual Property Rights in Weak Appropriability Regimes,” Management International Review 50, no. 1 (February 2010): 109-130.

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Comment (1)
Rabindranath Bhattacharya
Dr. Rabindranath Bhattacharya, India

I congratulate the author for writing an article on a topic which is so relevant, There is a saying that behind every challenge there is an opportunity and it is so true! I agree with the author that we cannot ignore China but doing business there with IP risks dangling like a sword on your head requires tremendous amount of courage, foresightedness and patience. Probably HR Management of a company will have a tough time to design totally new methodology and incentives exclusively for  operations in China to help protect IP.  For example, learning of Chinese language by foreign staffs is a must to mix with the local people and read their minds.
I would also like to know from the authors whether it is possible to build up an index for IP protection zone wise in China and extend the same to country wise subsequently.