GUIDE TO OUTSOURCING
Due Diligence and Risk Assessment
Device manufacturers should take into account certain considerations when performing due diligence and risk assessment.
What IP Will You Share? Various types of IP can come into play in an outsourcing relationship. They include trade secrets, patents, trademarks, copyrights, know-how, designs, and other confidential information. In most cases, IP due diligence begins with identifying and documenting all of the IP assets associated with the outsourced task. For example, if the outsourcing partner will use a proprietary manufacturing process, all IP related to the manufacturing process should be included. It is especially important to identify all of the trade secrets and proprietary know-how associated with the process. These types of IP often go unrecognized during an IP survey because, unlike patents or trademarks, they may not yet be reduced to a tangible form. It is also important to specifically identify any IP that is owned by a third party and to determine whether there are any restrictions on its use.
As part of an IP management strategy, some companies already have a system in place for routinely taking stock of their IP assets. However, there is a higher level of scrutiny required in offshore IP management. So even with such a system, the task may call for a team of business and engineering personnel. Guidance from an in-house legal counsel who is knowledgeable about IP laws may also be helpful in focusing the firm's efforts.
Carefully Review Third-Party IP. There are other considerations if the outsourcing arrangement will involve the sharing of IP that is jointly owned with or that is being licensed from a third party. In those cases, the licensing or joint-ownership agreement should be examined for any restrictions on use, limitations on transfers, or confidentiality provisions that are pertinent. For example, the IP licensing agreement may require obtaining consent from the third-party owner or making additional payments before giving an outsourcing partner access to the IP. It is also critical to ensure that an outsourcing partner is aware of the terms of the third-party license agreement. An OEM should get an assurance that its partner will comply with the terms of the agreement. In some cases, an outsourcing partner may need to obtain its own license from the joint IP owner.
IP Protection in Foreign Jurisdictions. IP rights are useless if they are insufficiently protected or cannot be enforced. Therefore, a firm's risk-benefit analysis should include an assessment of how well the legal infrastructure in the foreign country will protect its IP rights. Despite the efforts to harmonize IP laws worldwide through the World Trade Organization's Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) in 1994, the legal regimes protecting IP vary considerably around the globe.
But the international scene is not only chaotic—it is also dynamic. Many developing countries, in their desire to become innovation-based economies, are rapidly developing a body of modernized IP laws. For the most up-to-date information about regional IP issues, companies can consult with both U.S. and foreign counsel.
For example, in 1993, China implemented its laws on unfair competition. The laws recognize and protect trade secrets, and the country is continuing to make changes to its legal framework to promote IP protection. But China also struggles with enforcement. Compared with the United States, the judicial and administrative systems in China have a relatively short history in dealing with IP issues, making predictability difficult. It is important to recognize, however, that China is rapidly becoming more adept at dealing with IP issues. There is reason for optimism as Chinese companies share a growing interest in protecting their own IP rights.
Recent victories in Chinese civil courts by U.S. companies highlight China's commitment to improving IP protection. In April 2006, 3M successfully sued a Shanghai-based manufacturer for infringement of 3M's Chinese patents for respirator masks. The following June, a Chinese court upheld the validity of Pfizer's Chinese patent for Viagra and issued an injunction against two infringers.
Reducing the Risk of Loss
Being mindful of the challenges of enforcing IP rights in foreign countries, a diligent investigation of a potential outsourcing partner may be a firm's best protection. For an initial background check, some basic information can be obtained via the Internet (e.g., the Chinese Medical Device Information Network at www.cmdi.gov.cn). However, investing in third-party inspections or visiting a potential outsourcing partner should be the next step. The inspections should confirm that the outsourcing company has an institutionalized program for protecting IP and that it is reasonably comprehensive in its view of the IP at risk. In some cases, periodic site inspections or an on-site liaison to monitor the activities of the outsourcing company may be warranted.
But there are no foolproof ways to protect IP in global outsourcing, and even the most carefully executed outsourcing plan can fail. So if things should ever go bad, having a solid, well-drafted outsourcing contract that specifically addresses the protection of IP will mitigate any loss. In fact, in some countries (India, for example), trade secrets are protected only through contractual obligations. There, unless a firm has some contractual agreements to establish remedies for loss or misuse of its IP, it may be left with virtually no protection at all.
Nondisclosure and Noncompete Agreements. In any business transaction involving confidential information, a nondisclosure agreement should be in place before any trade secrets are shared. The laws of most developed or developing countries recognize the contractual obligations of a nondisclosure agreement. In general, nondisclosure agreements are most effective when they specifically list the proprietary information that is considered confidential. They should describe the scope of the confidentiality obligation (e.g., how the information is to be used), who is allowed to have access to it, and the length of time the confidentiality obligation is being imposed.
Under Chinese trade secret law, confidential information must be protected by a nondisclosure agreement or various other safeguarding measures to be considered a trade secret. When bound by a nondisclosure agreement, most reputable Chinese business entities will not wrongfully use trade secrets. In practice, however, most trade secrets are misappropriated when a key employee departs to another company, taking the trade secrets with them. As such, any noncompete agreements that an outsourcing partner has with its employees who will have access to a firm's IP will provide even better protection. In China, noncompete agreements are generally enforceable. A nondisclosure agreement can impose a confidentiality obligation for an indefinite time period. However, the obligations in an employee noncompete agreement cannot exceed three years in most cases.
Mandatory Arbitration Clause. As an alternative to the local judicial process, many offshore outsourcing agreements contain a mechanism for dispute resolution, such as arbitration. These mechanisms offer neutrality in choice-of-law, procedure, and venue. Arbitration is particularly beneficial in the context of IP disputes. One advantage is that firms can agree to have people with appropriate industry or technical expertise included in the arbitration panel. Also, the privacy and confidentiality offered by arbitration is a significant advantage for resolving trade secret disputes.
The parties can agree to refer disputes to any of a number of well-regarded arbitration institutions around the world. One such institution is the World Intellectual Property Organization, which is best known for handling Web domain name disputes. The China International Economic and Trade Arbitration Commission is also growing in influence in that region. Also, many countries, including China and India, are parties to the New York Convention on Enforcement of Arbitral Awards. Its members have agreed to enforce arbitration decisions made by recognized arbitration bodies.
It should be noted, however, that mandatory arbitration could pose a problem if a firm is seeking an injunction through the local courts while the arbitration decision is pending. In such cases, the defendant may try to stay the injunction proceedings, arguing that arbitration is the only recourse. To prevent this, an arbitration clause can include a provision allowing a firm to seek an injunction through the local judicial process, pending the arbitration decision.
Registration of IP. Understandably, many countries will not recognize a firm's IP rights unless the firm is properly registered in that country. In China, trademark registration nearly always makes sense because it is inexpensive and relatively well-enforced.
Table I. (click to enlarge) The number of patent applications filed in China has almost tripled since 2001. Source: State Intellectual Property Office (China).
Figure 1. (click to enlarge) The top 20 patent offices, according to the total number of patent filings in 2004. Of the three types of patent applications in China, only the invention type is represented here. Source: World Intellectual Property Organization Patent Report 2006.
The transfer of IP created within a foreign country may also be subject to local laws regulating the cross-border transfer of technology. These laws can include the assignment and licensing of patents and patent applications as well as proprietary technology or trade secrets. In the past, many countries had severe restrictions on technology transfer agreements and required government approval of any such contracts. Now, many of the most onerous rules have been repealed or relaxed. For example, in 2002, China repealed its long-standing regulations limiting technology licenses to a maximum term of 10 years, with the licensee having automatic rights to royalty-free use afterwards. However, policies change from time to time. Therefore, firms should seek appropriate advice from foreign counsel to ensure compliance with the legal requirements when transferring title to new IP. Failure to properly follow the rules could result in the forfeiture of a firm's rights to the new IP.
Local laws may also require the registration of IP created within their borders. Chinese patent law requires that patents for inventions created in China by a Chinese entity must first be filed in China. Furthermore, technology transfer regulations require that any licensing or assignment agreement that involves a Chinese patent must be registered with the State Intellectual Property Office within three months of the contract's effective date.
Given the complexities of offshore outsourcing transactions, many other IP-related issues that need to be addressed are outside the scope of this article. Although there is no guarantee against the loss of IP in an outsourcing transaction, proper security and adequate due diligence are the keys to protecting IP offshore. Strong contractual provisions provide another layer of protection by serving as a deterrent and establishing remedies in case a firm's IP is misused.
Steven Yu is a physician and a patent attorney at Kenyon & Kenyon LLP in Washington, DC. He can be reached at [email protected]. John Flock is a patent attorney at Kenyon & Kenyon's New York City office and is chair of the firm's Asian Practice Group. He can be reached at [email protected].