Law Blog

We have a phrase in Texas, something about the difference between a steer and a cow, I don’t remember how it goes, but it’s kind of like the British one – Pennywise and Pound Foolish.

This can be used to describe those who try to save a few dollars (used to be a penny back in the 1600′s) and it ends up costing them a lot more in the long term. Old Chinatex gets a lot of enquiries from people and companies that want to do business in Asia-Pacific. They think that just because factories makes stuff real cheap here in China, that things like quality legal counsel should also be cheap.

As many of you may know, Hong Kong and it’s neighbor city in China (Shenzhen) are two of the most expensive cities, as ranked by Mercer, in the world and that while making stuff is still cheap, helping those who make stuff keep their money is not.

Now, I know what you are thinking “those *#!% lawyers” – well that’s what you will be saying if you trust somebody who is not a lawyer or even worse, a local lawyer to handle your matter. Reminds me of one of the first legal matters I witnessed here in China. Foreign (U.S.) company comes to China to build a entertainment facility in a shopping mall. Against the advice of those who know better, they hire a local lawyer for numerous reasons – one of them being he is cheaper. Unbeknownst to them, the lawyer was good friends with the lawyer for the shopping mall and they had struck a deal where the savings to the shopping mall owner from the negotiations would be shared equally between the two lawyers and the mall owner. True story and I fear not a rare one.

Now, Old Frank has been helping people in Hong Kong and China who are in trouble and who don’t want to be in trouble and who want to make good money and keep it – for many years. I don’t want to see y’all be Pennywise and Pound Foolish when having somebody advise you on your business, which to many of you is your life. Better just be careful, make sure you get references if you have any doubt who you are hiring and expect to spend what you would spend in your country for similar quality services.

The New York Times recently posted an article bringing attention to one of the most common potential pitfalls of promising companies here in China. The article relates to the plight of Cathay Industrial Biotech.

Cathay’s founder, Mr. Liu Xiucai earned his Ph.D. in chemistry at the University of Wisconsin before returning to China to develop China’s domestic market for biotech innovation. In 1997, Mr. Liu developed a new and more efficient method of using microbe fermentation to produce diacid, an essential building block of nylon. After taking on Dow Chemical as its largest customer, Cathay attracted $120 million in investments structured by Goldman Sachs with a plan toward an IPO in the states in the summer of 2011.

While, today, Cathay produces half the world’s diacid, its prices, profits and margins have been slashed and the IPO postponed indefinitely. What happened, of course, is that the manager of Cathay’s diacid plant, Wang Zhizhou, quit and took 6 employees with him to start his own company to compete directly with Cathay in the production of diacid.

What made this interesting enough for the New York Times is that Wang’s coup was made possible by the financial and political support of the Chinese government. Wang’s new company, Hilead, secured $300 million in financing from the state owned China Development Bank, and his partners have known ties to the Shandong government.

Having a factory manager that runs off with secrets to start a competing firm is a well-known occurrence in China. Successful businesses here know that a great deal of resources need to be reserved for preventing the theft of whatever makes them profitable.

Employees leave with production methods, client lists, patents, trademarks, and other employees. Sometimes, legal action can be taken after the fact, but often, as in Cathay’s case, the prospects are quite grim.

Mr. Liu acted quickly, filed a lawsuit with the local government and sent the police to investigate Hilead’s factory. However, when they arrived, Beijing had declared diacid production a matter of national security, voiding any authority they had to gather evidence and build a case in Cathay’s defense.

Being up against the government is rarely a good idea in China. A legal win for Cathay would mean a loss for the Shandong government, making the matter nearly impossible.

What’s important to note, in this case, is that IP theft is not just committed against foreigners or the carelessly naïve. Foreigners often come with the expectation that Chinese competitors target foreign ideas but are less able to steal from each other. This mindset often leads to the wrong way of dealing with these type problems. A Chinese partner may know more about navigating local laws and politics, but as Cathay’s situation shows, its no guarantee of protection.

Seeing dollar signs, foreign investors in China often neglect to file the necessary patents and trademarks. We see many cases where long-term relationships with Chinese partners, based on blind trust, leads to poorly written contracts that are difficult to enforce.

We, also, see too many foreigner business operating in China not doing some good ole self-help by keeping trade secrets secret by implementing strategies and procedures to prohibit access to key data.

Cathay’s case has gained a lot of attention and commentary from various news sources. Some suggest that greater compensation or profit sharing could have persuaded Mr. Wang to stay with Cathay, but there is little evidence that loyalty can be purchased so easily.

It’s quite likely that financial independence may have only accelerated Mr. Wang’s plans to start out on his own. Anywhere in the world, the more there is at stake, the more must be done to protect it. Mr. Liu decided to produce diacid in China, like many of our non-Chinese clients, where production costs are lower, but in doing so he gave up many of the legal protections that would have protected him in the US.

His decision to raise money through Goldman Sachs was clearly better for his long-term plan of taking the company public in the US, but by neglecting the Shandong government and not protecting trade secrets, it seems his long-term plan may never come to be.

This is simply a typical case of the poor control of trade secrets, mismanagement of company employees, lack of understanding of the workings of Chinese local politics and, possibly, the poor structuring of a deal.