Focus on China: Critical Issues Affecting U.S. Businesses Today

For U.S. companies today, it seems as if all eyes are on China. That country has vaulted past Japan to become the world's second largest economy and the United States' third largest trading partner ' and it's just getting warmed up. With over 1.3 billion consumers ' more and more of whom are middle class ' and a strong and rapidly growing economy, full and fair access to the Chinese market is critical to the future success of U.S. businesses and workers. Yet many companies find getting over the Great Wall and into the Chinese market to be fraught with challenge. This article highlights some of the recent developments in areas that most concern our clients with operations in China: the protection of intellectual property rights, the promulgation of national standard-setting provisions, and the adoption of a new antimonopoly law.

Intellectual Property

China is notorious for its weak intellectual property protections and rampant piracy ' a source of deep concern for U.S. high-tech and creative businesses whose newest products and innovations are often at risk. It is estimated that more than 90% of the 'digitized products' (software, music, and movies) purchased in China are pirated. Anti-counterfeiting laws, while they exist, often go un-enforced or provide penalties too small to offer any real deterrent.

The U.S. Chamber of Commerce, the U.S.-China Joint Commission on Commerce and Trade (JCCT), and other bodies have been working closely with the U.S. and Chinese governments to focus attention and action on reducing piracy and strengthening intellectual property rights in China. While there is still a long way to go, these efforts finally appear to be gaining momentum.

U.S. Customs seizures are up: In 2004, there were more than 7000 intellectual-property related seizures, of which China accounted for more than two-thirds (mostly imports of apparel, cigarettes and handbags, wallets and backpacks). China Customs seizures have also risen, from 756 in 2003 to 1051 in 2004. In addition, civil intellectual property litigation in China has rapidly increased: More than 8800 cases were filed in fiscal year 2004, a 45% rise from 2003.

Recent efforts to promote intellectual property protection have focused on stepping up enforcement, increasing the penalties for infringement and constantly reinforcing the importance of intellectual property protection through diplomatic contacts. Last July's JCCT meeting between cabinet-level officials from both the U.S. and China has resulted in commitments from China to increase the number of criminal enforcement actions taken, and resulted in the appointment of an IPR Ombudsman at the Chinese Embassy in Washington to help small- and medium-sized U.S. businesses with IPR issues and protection. China and the U.S. also established a bilateral IPR law-enforcement working group to bring U.S. and Chinese law enforcement officials together to reduce cross-border infringing activities. The U.S. has stationed additional IPR specialists at the U.S. Embassy in Beijing to enhance cooperation with the Chinese Government and bolster efforts to educate the Chinese populace on IPR.

In addition, the U.S. Trade Representative to the WTO ratcheted up the pressure on China by calling for a TRIPS Article 63.3 report on the measures China takes to protect intellectual property. The request was joined by Switzerland and Japan and is expected to take at least 3 months to complete. Upon issuance and review of the report, the U.S. (and other WTO members) will have the opportunity to challenge China at the WTO for any deficiencies in its IPR protections.

In the end, the greatest impetus for increased enforcement is likely to come from the many Chinese high-tech and industrial firms that are starting to acquire intellectual property rights and enter foreign markets. As Chinese firms begin to move up the value chain from simple manufacturing to innovation and creation, they have begun to see the benefit of protecting their own creations from infringement, at home as well as abroad. Stronger intellectual property protections are an inevitable part of economic development. Given China's rapid rate of growth, it hopefully will not be long before real improvements in intellectual property protections become visible.

Standard Setting

U.S. business is also keeping its eye on the proposed Interim Regulations for National Standards Involving Patents (Standards Provisions) currently being developed by the Standardization Administration of China (SAC). Unlike the antimonopoly law, the Standards Provisions are being drafted in secret, which has sparked enormous concern for U.S. intellectual property holders. Indeed, even the State Intellectual Property Office (SIPO), which is expected to promulgate the Standards Provisions jointly with SAC, has stated that it too has been largely excluded from the drafting process.

Recent comments by SAC officials make clear that the Standards Provisions will require the grant of irrevocable licenses to Chinese-based firms if a Chinese national standard incorporates the protected intellectual property. Such provision would go well beyond existing technology transfer regulations that provide for compulsory grants of technology licenses, but such provision does not expressly apply to standards and has never been enforced.

Given that U.S. companies hold much of today's key intellectual property, and are using it to develop tomorrow's new innovations, a compulsory licensing scheme would place U.S. businesses at a competitive disadvantage by allowing Chinese-based firms to acquire valuable intellectual property, without having to make any investment in research and development.

These concerns are not unfounded. Recent reports suggest that the Chinese government may consider compulsory licensing to be a strategy that will help Chinese companies to enter the market and get a leg up on the competition. The Ministry of Information Industry in particular has indicated its support for standard-setting groups to identify essential intellectual property and force patent holders to grant low-cost or royalty-free licenses. Meanwhile, other provisions of current technology transfer regulations affect ownership rights to improvements to licensed technologies.

In addition, Chinese standard-setting agencies have been pushing for the adoption of proprietary China-only standards in high-tech fields such as the Internet protocol, wireless Internet authentication and security (WAPI), 3G wireless communications (advanced mobile phone technology), audio-video capture and playback technologies (AVS), document and data protection, and radio frequency identification technology (RFID), and others. Unless China abandons mercantilism with respect to standard setting and becomes more willing to cooperate in the adoption of international standards and protocols, U.S. businesses ' especially high-tech industries ' are vulnerable to being 'locked-out' of the growing Chinese market.

The U.S. Chamber of Commerce and the American National Standards Institute (ANSI) have been active in highlighting U.S. companies' concerns with China's recent stance on standard setting and intellectual property. They have called for a more open, inclusive, and transparent process while remaining committed to enabling China's official participation in international standard setting organizations and decisions.

Antimonopoly Law

Another impending concern for U.S. companies doing business in China, especially those with significant intellectual property, is China's proposed Antimonopoly Law (AML). Although China has had various unfair competition and consumer-protection laws on the books since as early as 1978, there hasn't been much of a focus on the need for an antitrust law until recently. All of that is about to change. A draft AML is scheduled to be submitted to the Legislation Committee of the National People's Congress (NPC) last December and is expected to be enacted as early as this year.

The AML will totally redefine the competitive and regulatory landscape for both domestic and foreign businesses operating in and outside of China. Although facially neutral, the law is likely to affect domestic and foreign companies in different ways. There has been widespread speculation that the AML will be used as a tool to counter the 'dominance' of successful foreign brands, in an effort to protect Chinese competitors and consumers.

Unlike the Standards Provisions, the current draft of the AML has benefited from wide circulation and comment by groups both within and outside of China. The American Bar Association and U.S. Chamber of Commerce have formed working groups (in which the authors have participated) that have actively reached out to the Chinese drafters with suggestions that would bring the AML into alignment with existing international standards. Although receptive to our suggestions, not all of our proposals were adopted, and the AML as it now stands (and as it is likely to be enacted) still contains several areas of concern for U.S. businesses.

Merger Provisions

The draft AML contains pre-merger notification requirements similar in concept to the ECMR in Europe, or the HSR process in the United States. A sound pre-merger clearance policy can provide dealmakers with legal certainty and an opportunity to avoid or correct antitrust problems at an early stage, before a merger is consummated and capital has been committed.

Unfortunately, the draft AML's pre-merger clearance provisions still fall somewhat short of the mark. Article 19 purportedly explains when the mandatory pre-merger disclosure requirement is triggered, but the provisions are so vague (anything involving voting shares or 'substantial' assets of 'an adequate extent') that it is unclear when a pre-merger notification would not be required. This is likely to cause over-notification of small, innocuous deals that would add to the regulatory burden and expense of doing business in China. Since 2003, China has already had regulations governing mergers and acquisitions involving foreign investors, which have resulted in the filing of many notifications with respect to transactions having a negligible impact on China.

Furthermore, under the current draft of Article 20, pre-merger reporting obligations could be triggered anytime either the acquiring or acquired party has a substantial presence (more than $188 million at current exchange rates) in China-wide assets or revenues, irrespective of whether the deal even involves China. Working groups from the U.S. Chamber of Commerce and American Bar Association have warned that this approach is inconsistent with the International Competition Network's recommended best practices in merger review. The ICN recommends that a jurisdiction should require notification only when either the acquired party alone or both parties together have significant local assets or sales.

Dominance

Article 18 of the draft AML prohibits the abuse of a dominant position, similar in concept to Article 82 in the European Communities or section 2 of the Sherman Act in the United States. However unlike antitrust policies in the U.S. or Europe, the draft AML appears to trigger a finding of dominance based upon market share alone. Enterprises with at least a 50% share of a relevant market would be 'dominant' under Article 17, irrespective of the extent of actual competition in the marketplace. In addition, enterprises can also be 'dominant' through a theory of 'shared monopoly' when any two companies' market shares exceeds 66%, or any three companies' shares exceed 75%, irrespective of the extent of actual competition in the marketplace.

These theories of dominance are inconsistent with U.S. and European practices, and the concept of shared dominance seems unnecessary given the AML's other prohibitions on concerted action among horizontal competitors. There is a very real risk that U.S. businesses could be found 'dominant' even amidst vibrant and fierce competition, or where their technology or other IPR given them a legitimate head start in industries new to China.

The AML's Nexus With Standards
Provisions And Intellectual Property

Several provisions of the draft AML should be of particular concern to the U.S. high-tech industry and other holders of intellectual property. Article 18 contains a prohibition on conduct that could restrict the development of technology and proscribes 'unfair' pricing as well as refusals to deal 'without valid reasons.' Article 52 applies the AML to anything that could 'restrict market competition beyond the laws and administrative regulations on intellectual property rights.'

Given what appears to be a broad strategy to restrict the exercise of IPR in favor of development, these vague provisions could be interpreted to condemn almost any conduct relating to a U.S. company's protection, enforcement or licensing of its intellectual property, and could provide a justification for resorting to compulsory licensing under the Standards Provisions.

Although there are areas of serious concern for U.S. business, the AML prospects are not all grim. China's promulgation of a new AML will also open markets and encourage innovation, entrepreneurship and economic development, just as such laws did in Europe and the United States. Adoption of the AML is also likely to break down the internal ('administrative') barriers to trade between regions and provinces that have frustrated and fractured the Chinese market with local protectionism. In the long run, it will probably be the Chinese companies who will end up changing the most in order to bring themselves into compliance with the AML. U.S. and European businesses have largely already adopted procedures and cultures of antitrust compliance ' something that will take time for many domestic Chinese firms to develop.

Conclusion

There is a Chinese saying, 'Weiji chuangzao jihui', which means 'crisis creates opportunity' ' an apt description for the situation in China today. The Chinese market is one of the world's most promising growth opportunities for U.S. businesses, yet many companies are finding themselves increasingly behind the curve and in danger of being locked out of the market. With so many critical regulations in flux right now, the rules of the game are changing, and it is important to be informed.

The new AML, standards provisions and intellectual property challenges pose a crisis to those businesses without experienced, top-notch legal counsel who can help them to navigate the shoals and avoid the pitfalls that will await their less informed competitors. With sound advice, savvy U.S. businesses should be able to turn crisis into opportunity.

For U.S. companies today, it seems as if all eyes are on China. That country has vaulted past Japan to become the world's second largest economy and the United States' third largest trading partner ' and it's just getting warmed up. With over 1.3 billion consumers ' more and more of whom are middle class ' and a strong and rapidly growing economy, full and fair access to the Chinese market is critical to the future success of U.S. businesses and workers. Yet many companies find getting over the Great Wall and into the Chinese market to be fraught with challenge. This article highlights some of the recent developments in areas that most concern our clients with operations in China: the protection of intellectual property rights, the promulgation of national standard-setting provisions, and the adoption of a new antimonopoly law.

Intellectual Property

China is notorious for its weak intellectual property protections and rampant piracy ' a source of deep concern for U.S. high-tech and creative businesses whose newest products and innovations are often at risk. It is estimated that more than 90% of the 'digitized products' (software, music, and movies) purchased in China are pirated. Anti-counterfeiting laws, while they exist, often go un-enforced or provide penalties too small to offer any real deterrent.

The U.S. Chamber of Commerce, the U.S.-China Joint Commission on Commerce and Trade (JCCT), and other bodies have been working closely with the U.S. and Chinese governments to focus attention and action on reducing piracy and strengthening intellectual property rights in China. While there is still a long way to go, these efforts finally appear to be gaining momentum.

U.S. Customs seizures are up: In 2004, there were more than 7000 intellectual-property related seizures, of which China accounted for more than two-thirds (mostly imports of apparel, cigarettes and handbags, wallets and backpacks). China Customs seizures have also risen, from 756 in 2003 to 1051 in 2004. In addition, civil intellectual property litigation in China has rapidly increased: More than 8800 cases were filed in fiscal year 2004, a 45% rise from 2003.

Recent efforts to promote intellectual property protection have focused on stepping up enforcement, increasing the penalties for infringement and constantly reinforcing the importance of intellectual property protection through diplomatic contacts. Last July's JCCT meeting between cabinet-level officials from both the U.S. and China has resulted in commitments from China to increase the number of criminal enforcement actions taken, and resulted in the appointment of an IPR Ombudsman at the Chinese Embassy in Washington to help small- and medium-sized U.S. businesses with IPR issues and protection. China and the U.S. also established a bilateral IPR law-enforcement working group to bring U.S. and Chinese law enforcement officials together to reduce cross-border infringing activities. The U.S. has stationed additional IPR specialists at the U.S. Embassy in Beijing to enhance cooperation with the Chinese Government and bolster efforts to educate the Chinese populace on IPR.

In addition, the U.S. Trade Representative to the WTO ratcheted up the pressure on China by calling for a TRIPS Article 63.3 report on the measures China takes to protect intellectual property. The request was joined by Switzerland and Japan and is expected to take at least 3 months to complete. Upon issuance and review of the report, the U.S. (and other WTO members) will have the opportunity to challenge China at the WTO for any deficiencies in its IPR protections.

In the end, the greatest impetus for increased enforcement is likely to come from the many Chinese high-tech and industrial firms that are starting to acquire intellectual property rights and enter foreign markets. As Chinese firms begin to move up the value chain from simple manufacturing to innovation and creation, they have begun to see the benefit of protecting their own creations from infringement, at home as well as abroad. Stronger intellectual property protections are an inevitable part of economic development. Given China's rapid rate of growth, it hopefully will not be long before real improvements in intellectual property protections become visible.

Standard Setting

U.S. business is also keeping its eye on the proposed Interim Regulations for National Standards Involving Patents (Standards Provisions) currently being developed by the Standardization Administration of China (SAC). Unlike the antimonopoly law, the Standards Provisions are being drafted in secret, which has sparked enormous concern for U.S. intellectual property holders. Indeed, even the State Intellectual Property Office (SIPO), which is expected to promulgate the Standards Provisions jointly with SAC, has stated that it too has been largely excluded from the drafting process.

Recent comments by SAC officials make clear that the Standards Provisions will require the grant of irrevocable licenses to Chinese-based firms if a Chinese national standard incorporates the protected intellectual property. Such provision would go well beyond existing technology transfer regulations that provide for compulsory grants of technology licenses, but such provision does not expressly apply to standards and has never been enforced.

Given that U.S. companies hold much of today's key intellectual property, and are using it to develop tomorrow's new innovations, a compulsory licensing scheme would place U.S. businesses at a competitive disadvantage by allowing Chinese-based firms to acquire valuable intellectual property, without having to make any investment in research and development.

These concerns are not unfounded. Recent reports suggest that the Chinese government may consider compulsory licensing to be a strategy that will help Chinese companies to enter the market and get a leg up on the competition. The Ministry of Information Industry in particular has indicated its support for standard-setting groups to identify essential intellectual property and force patent holders to grant low-cost or royalty-free licenses. Meanwhile, other provisions of current technology transfer regulations affect ownership rights to improvements to licensed technologies.

In addition, Chinese standard-setting agencies have been pushing for the adoption of proprietary China-only standards in high-tech fields such as the Internet protocol, wireless Internet authentication and security (WAPI), 3G wireless communications (advanced mobile phone technology), audio-video capture and playback technologies (AVS), document and data protection, and radio frequency identification technology (RFID), and others. Unless China abandons mercantilism with respect to standard setting and becomes more willing to cooperate in the adoption of international standards and protocols, U.S. businesses ' especially high-tech industries ' are vulnerable to being 'locked-out' of the growing Chinese market.

The U.S. Chamber of Commerce and the American National Standards Institute (ANSI) have been active in highlighting U.S. companies' concerns with China's recent stance on standard setting and intellectual property. They have called for a more open, inclusive, and transparent process while remaining committed to enabling China's official participation in international standard setting organizations and decisions.

Antimonopoly Law

Another impending concern for U.S. companies doing business in China, especially those with significant intellectual property, is China's proposed Antimonopoly Law (AML). Although China has had various unfair competition and consumer-protection laws on the books since as early as 1978, there hasn't been much of a focus on the need for an antitrust law until recently. All of that is about to change. A draft AML is scheduled to be submitted to the Legislation Committee of the National People's Congress (NPC) last December and is expected to be enacted as early as this year.

The AML will totally redefine the competitive and regulatory landscape for both domestic and foreign businesses operating in and outside of China. Although facially neutral, the law is likely to affect domestic and foreign companies in different ways. There has been widespread speculation that the AML will be used as a tool to counter the 'dominance' of successful foreign brands, in an effort to protect Chinese competitors and consumers.

Unlike the Standards Provisions, the current draft of the AML has benefited from wide circulation and comment by groups both within and outside of China. The American Bar Association and U.S. Chamber of Commerce have formed working groups (in which the authors have participated) that have actively reached out to the Chinese drafters with suggestions that would bring the AML into alignment with existing international standards. Although receptive to our suggestions, not all of our proposals were adopted, and the AML as it now stands (and as it is likely to be enacted) still contains several areas of concern for U.S. businesses.

Merger Provisions

The draft AML contains pre-merger notification requirements similar in concept to the ECMR in Europe, or the HSR process in the United States. A sound pre-merger clearance policy can provide dealmakers with legal certainty and an opportunity to avoid or correct antitrust problems at an early stage, before a merger is consummated and capital has been committed.

Unfortunately, the draft AML's pre-merger clearance provisions still fall somewhat short of the mark. Article 19 purportedly explains when the mandatory pre-merger disclosure requirement is triggered, but the provisions are so vague (anything involving voting shares or 'substantial' assets of 'an adequate extent') that it is unclear when a pre-merger notification would not be required. This is likely to cause over-notification of small, innocuous deals that would add to the regulatory burden and expense of doing business in China. Since 2003, China has already had regulations governing mergers and acquisitions involving foreign investors, which have resulted in the filing of many notifications with respect to transactions having a negligible impact on China.

Furthermore, under the current draft of Article 20, pre-merger reporting obligations could be triggered anytime either the acquiring or acquired party has a substantial presence (more than $188 million at current exchange rates) in China-wide assets or revenues, irrespective of whether the deal even involves China. Working groups from the U.S. Chamber of Commerce and American Bar Association have warned that this approach is inconsistent with the International Competition Network's recommended best practices in merger review. The ICN recommends that a jurisdiction should require notification only when either the acquired party alone or both parties together have significant local assets or sales.

Dominance

Article 18 of the draft AML prohibits the abuse of a dominant position, similar in concept to Article 82 in the European Communities or section 2 of the Sherman Act in the United States. However unlike antitrust policies in the U.S. or Europe, the draft AML appears to trigger a finding of dominance based upon market share alone. Enterprises with at least a 50% share of a relevant market would be 'dominant' under Article 17, irrespective of the extent of actual competition in the marketplace. In addition, enterprises can also be 'dominant' through a theory of 'shared monopoly' when any two companies' market shares exceeds 66%, or any three companies' shares exceed 75%, irrespective of the extent of actual competition in the marketplace.

These theories of dominance are inconsistent with U.S. and European practices, and the concept of shared dominance seems unnecessary given the AML's other prohibitions on concerted action among horizontal competitors. There is a very real risk that U.S. businesses could be found 'dominant' even amidst vibrant and fierce competition, or where their technology or other IPR given them a legitimate head start in industries new to China.

The AML's Nexus With Standards
Provisions And Intellectual Property

Several provisions of the draft AML should be of particular concern to the U.S. high-tech industry and other holders of intellectual property. Article 18 contains a prohibition on conduct that could restrict the development of technology and proscribes 'unfair' pricing as well as refusals to deal 'without valid reasons.' Article 52 applies the AML to anything that could 'restrict market competition beyond the laws and administrative regulations on intellectual property rights.'

Given what appears to be a broad strategy to restrict the exercise of IPR in favor of development, these vague provisions could be interpreted to condemn almost any conduct relating to a U.S. company's protection, enforcement or licensing of its intellectual property, and could provide a justification for resorting to compulsory licensing under the Standards Provisions.

Although there are areas of serious concern for U.S. business, the AML prospects are not all grim. China's promulgation of a new AML will also open markets and encourage innovation, entrepreneurship and economic development, just as such laws did in Europe and the United States. Adoption of the AML is also likely to break down the internal ('administrative') barriers to trade between regions and provinces that have frustrated and fractured the Chinese market with local protectionism. In the long run, it will probably be the Chinese companies who will end up changing the most in order to bring themselves into compliance with the AML. U.S. and European businesses have largely already adopted procedures and cultures of antitrust compliance ' something that will take time for many domestic Chinese firms to develop.

Conclusion

There is a Chinese saying, 'Weiji chuangzao jihui', which means 'crisis creates opportunity' ' an apt description for the situation in China today. The Chinese market is one of the world's most promising growth opportunities for U.S. businesses, yet many companies are finding themselves increasingly behind the curve and in danger of being locked out of the market. With so many critical regulations in flux right now, the rules of the game are changing, and it is important to be informed.

The new AML, standards provisions and intellectual property challenges pose a crisis to those businesses without experienced, top-notch legal counsel who can help them to navigate the shoals and avoid the pitfalls that will await their less informed competitors. With sound advice, savvy U.S. businesses should be able to turn crisis into opportunity.