Protecting trade secrets in China: how CEOs must build intellectual property strategies.

Despite China's low wage rates and massive, fast-growing markets, many companies are cautious in setting up operations there because of a very real danger: China remains an intellectual property jungle, full of risks. It has virtually no trade secret laws. It also offers far less stringent protection of patents and licenses than companies enjoy in the United States and Europe. And it is keenly interested in acquiring intellectual property that it can leverage in global markets.

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If CEOs are not careful, the risks can out-weigh the benefits. The fact is that if you take your business to China--and even, in some cases, if you don't--your intellectual property could end up in the hands of potential competitors both in the Chinese market and in major markets outside of China.

In view of this risk, CEOs need to ask some critically important questions. For example, how much of your global revenues are you putting at risk? How vulnerable to duplication are your unique capabilities in products, operations and supply-chain management? And how much would it hurt you if your competitor had the same selling proposition you have?

Unfortunately, you cannot assume that the U.S. government will be able to persuade the Chinese government to adopt Western attitudes toward IP protection, or that U.S. agencies will necessarily take up the cudgel on your behalf if your rights are violated. Companies with enormous clout may be able to muster diplomatic negotiations on their behalf, but such efforts will not always be successful, and most companies will need to fend for themselves.

Of course, it may be worthwhile to give up some amount of intellectual property in exchange for dramatically lower costs and huge markets. The challenge is to reap the benefits of lower cost without destroying your advantage, both in China and in non-Chinese markets, by inadvertently creating a competitor with your own technology. The key question is, do you have intellectual property that a Chinese company could identify and use? And if so, have you properly protected and monetized that IP?

In our experience, managing IP in China consists of three basic activities:

* Monetizing value from your rights. This involves enforcing global property rights in China from competitors, managing technology transfers with local partners, and protecting yourself against IP leakage in your local R & D activities.

* Managing standards development. This includes monitoring the evolution of local standards and exerting influence where needed to affect its outcome.

* Managing the broader business context for IP. This entails keeping an eye on internal and external vested interests when addressing government relations and market access via partners and when working with suppliers and customers.

Every company should create a strong global IP strategy. Begin by identifying what is critical to your business, including your brand, processes, innovations and licensed technologies. This is what you need to protect. Now determine what must be kept at home, what must be kept in-house if done overseas, and what can be outsourced, taking into consideration such factors as importance to your business, role going forward, usefulness to competitors, ease of theft, and cost. Be sure to keep back and well-protected anything that would allow competitors to hurt you badly, regardless of whether or not you are operating or selling in China.

Once your IP strategy is in place, you need to set up a global and local organization that can monetize the value from your rights. Members of this organization will secure and monitor patents, administer licenses and see that you join or form suitable standards bodies and exert appropriate influence on evolving standards. Also, make sure that your entire organization--from marketing to production--is aware of the importance of IP and understands how to identify and report violations.

You don't have to be a giant multinational to be able to protect your secrets in China. The cost of setting up an IP organization, securing the necessary patents and then administering an effective IP program varies widely. For a relatively small company managing only a few patents, it may be as low as half a million dollars. But small companies that secure the right patents, at the right time, with the right strategies can be quite successful creating valuable Chinese partnerships based on this type of IP strategy. For larger firms concerned with positioning a range of intellectual properties at the intersection of technology and market trends, the costs run much higher. But leading companies such as IBM, Intel and Procter & Gamble, among many others, make this kind of investment because they understand that innovation is their lifeblood, and this is the way you protect your innovation while benefiting from the low-cost advantage of China.

Your IP organization should lose no time in registering your patents, both in China at the State Intellectual Property Office and globally. You can also use Hong Kong IP laws in China if you know how to go about it. Your IP staff will also license Chinese users of your IP and collect fees. They should routinely investigate your entire value chain to ensure that all sources of value are effectively protected and to prevent others from capturing rich parts of your business or violating any of your patents, licenses and contracts. Also, be sure to do your due diligence with outsourcers and licensees, checking their security processes, policies and training; employee retention rates; litigation history; finances; and insurance. Make sure that your contracts cover supplier and customer activity globally, as well as their interactions with all other parties, and that they allow you to monitor their activities thoroughly.

When you discover an obvious violation, you have a number of options. In some cases, you can negotiate with the violator, setting up licensing agreements or even trading IP. If that doesn't work, you can sometimes employ quasi-judicial solutions, such as arbitration. But if the violator proves truly recalcitrant, you may need to resort to lawsuits or border seizures. Unfortunately, these actions can be costly in time, money and your company's local image in China. It is far better to prevent violations through scrupulous protection and vigilant monitoring, as outlined above.

Another significant concern for high-technology businesses is the Chinese government's identification of interoperability standards as an effective "value gate" where it can try to gain IP leverage for its own companies. For example, the fight for cellular telephone standards control in China could and someday may fill volumes in the strategy books. Article after article has shown that Qualcomm's apparent decision to stick to what appears to be a well-thought-out and well-executed IP strategy will pay off, with the company's patented CDMA standard being one of the final standards available for Chinese cell manufacturers.

China's recent attempt to set its own standards for Wi-Fi, ignoring established world standards, is another case in point. If China had prevailed, the cost to global high-tech companies hoping to sell Wi-Fi-enabled computers into China would have been enormous. In this instance, intervention at the highest levels of government on behalf of a powerful company succeeded in persuading the Chinese to reverse their policy. Not all negotiations will necessarily end so positively. This is an excellent issue for CEOs to discuss with their representatives and trade agencies in Washington.

In the end, each company will need to do a meticulous analysis of the cost/benefit trade-offs involved in doing business in China--and weigh that analysis against similar analyses of India, Mexico and other low-cost countries. The goal is to make the trade-off decisions as deliberately and thoughtfully as possible, weighing all the relevant factors--including the risk to the underlying technology.

Withholding critical product technologies has been one approach that companies in the past, and even some today, have used to try to stop the technology IP drain in China. This tactic may have worked in the past but is becoming less effective in today's sophisticated competitive industries. To achieve the real low-cost benefits of China, along with worldwide distribution, the products have to be world class. How can your company afford not to ship cutting-edge products? In many cases, these products need to be produced using innovative manufacturing processes or possess key differentiating features to achieve competitive advantage. It may be impossible to do this without allowing Chinese companies access to your company's key technologies.

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A classic example is the manufacture of DVD players in China. Each DVD player needs the newest features to be competitive. A clever IP strategy, however, using patent pools, has protected some non-Chinese DVD innovators and ensured that Chinese-manufactured DVDs still pay for the innovations with substantial patent royalties.

Fortunately, IP is an endlessly renewable resource, fueled by innovation. But it is also, in this era of globalization, extremely fungible. So it must be carefully protected and leveraged to ensure that it continues to generate sustainable competitive advantage.

RELATED ARTICLE: SHIELDING KNOW-HOW

* File For Patent Protection. Even though China's laws are lax, it still probably makes sense to file with the State Intellectual Property Office in Beijing and also with the patent office in Hong Kong.

* Set Up An IP Organization. You need a unit within your company that monitors the use of your patents, administers licenses and monitors for violations.

* Take Due Dilegence Seriously. It's critically important to know who your outsourcers and licensees really are and whether they have procedures in place to protect IP.

* Shielding Some Know-How. The Chinese want the latest manufacturing technology, but you may be able to retain your most sensitive know-how in Hong Kong or Taiwan.

* When There Is A Violation. It's probably better to negotiate a cross-licensing arrangement or other settlements rather than to lawsuits.

* Watch the Standards. Several major U.S. companies such as Qualcomm and Intel have had to wage battles to make sure Chinese authorities did not devise technology standards that would discriminate against their products.

Kevin Rivette is an executive advisor to The Boston Consulting Group, based in San Francisco. David Michael is a vice president and director in the firm's Beijing office.