Manufacturing Beyond Shores

This report draws on the Taiwanese experience of working with Chinese firms and focuses on nonlegal measures for Intellectual property (IP) protection in light of declining predictability in the Chinese legal system. For U.S. small and medium businesses, the legal dimension of IP protection is accessible, and authoritative guidelines exist; however, if the legal system itself is unreliable, then more attention should be paid to practical tactics so as to avoid the use of Chinese courts. This report highlights the IP protection practices of Taiwanese companies in a checklist format to fill the gaps in understanding IP vulnerability in China.

Executive Summary

U.S. leadership in technology innovation is being challenged by China’s rise. Concerns over intellectual property (IP) rights protection in China continue to heighten as innovation increasingly becomes a key area of strategic competition. The United States needs to strengthen the development of nonlegal IP protection approaches so that U.S. firms are not vulnerable in relying on foreign legal systems to secure intellectual assets overseas. China’s role a strategic competitor should not deter the United States from harnessing Chinese talent, resources, and innovations.

The risk of losing U.S. IP and technology can be mitigated, as Taiwan’s experience demonstrates. This report lays the foundation for nonlegal measures structured on a practical checklist derived from Acer Group founder Stan Shih’s “Smiling Curve,” which charts the value added by each step along the production process. Mirroring the lip’s upward curl, Shih’s curve proposes that value is higher at the beginning and end of production. Specifically, product concept, research and development (R&D), prototype, at the start of production plus branding, sales and service at the end account for the majority of value production. The checklist focuses attention on four critical areas with high risk of unauthorized IP transfer: personnel, local partners, suppliers, and factories. The handful of actionable items for each category serves as the beginnings of a checklist that should be customized to fit unique companies and situations.

The checklist of nonlegal courses of action can help U.S. firms operating in foreign jurisdictions preserve agency despite unfriendly legal or political environments. If, however, the United States continues to fixate on legal reforms abroad, U.S. firms will become increasingly fragile in expecting the same legal predictability in allied and rival countries. This path is counterproductive to maintaining the leading innovator position because developing markets with emerging opportunities in technologies are often weakly governed by the rule of law.

When the massacre in Tiananmen Square frightened Western investors in 1989, Taiwanese businesses and policymakers grasped the opportunity to gain market share and influence in China. Amid today’s tensions, Taiwan has continued to invest in China because they have built an IP approach that protects their interests, despite open hostility and little assurance of legal protection. The same approach is available to the United States once leaders acknowledge that learning self-protection via nonlegal means is equal in importance to influencing the international rule of law to meet the exceptional U.S. standards.

Introduction

Science and technology innovation is a key area for strategic competition with China. As part of this, influence in the legal protection of intellectual property (IP) is a critical front of contestation. Although both U.S. and Chinese policymakers have tightened access to their technology assets via export bans, the respective markets remain attractive for the talent pool and consumer power. As a result, only one in five Western companies want complete decoupling from China. However, concerns over IP theft are widely publicized, as seen in statements by heads of the Federal Bureau of Investigation and MI5. In addition, Xi Jinping’s recent remarks were uncharacteristically direct in naming the United States as a hostile force that seeks to “contain, encircle and suppress” China. Therefore, escalating political tensions may heighten U.S. wariness toward Chinese courts, which are no longer reliable for protecting IP, despite continued efforts for judicial reform.

This report draws on the Taiwanese experience and focuses on nonlegal measures for IP protection in light of declining predictability in the Chinese legal system. For U.S. small and medium businesses, the legal dimension of IP protection is accessible, and authoritative guidelines exist. However, if the legal system itself is unreliable, then more attention should be paid to practical tactics so as to avoid the use of Chinese courts. To fill the gap in understanding IP vulnerability in China, this paper highlights the IP protection practices of Taiwanese companies in a checklist format. Taiwanese businesses have long operated in China during political turmoil and have a strong record of safeguarding IP. Notable examples include Foxconn and Taiwan Semiconductor Manufacturing Company Limited (TSMC), both of which own highly sensitive IP for secretive clients such as Apple. Therefore, Taiwanese businesses are a rich resource in formulating China-based operations that are effective against IP loss.

The nonlegal checklist of IP preventative measures is not limited to application in China. As experts such as Singaporean diplomat Kishore Mahbubani and businessmen such as TSMC founder Morris Chang brace for a multipolar world, the United States need to reassess the reliance on law for protecting its innovations overseas. Instead of urging foreign nations to improve their intellectual property rights (IPR) regimes, this may be a moment for the United States to retool and innovate by building expertise to protect IP outside of legal means. By taking important lessons from Taiwan on building internal systems to manage IP, U.S. firms can design their coupling with global markets to be selective and precise. This report leverages the Taiwanese conception of an interconnected value chain and highlights actionable measures in four areas critical to IP loss prevention: personnel, local partners, suppliers, and factories.

Reorienting the focus on legal reform toward improving resilience among U.S. firms operating overseas improves the United States’ ability to engage diverse international markets and to continue being a global leader in innovation. Especially as reshoring proves to be more difficult than expected due to work culture differences, the ability to manage IP flows outside of the United States will shape the future of U.S. influence.

Untenable Reliance on Law in Global Innovation

On February 3, 2023, the Chinese Ministry of Foreign Affairs published the article “The U.S. Willful Practice of Long-Arm Jurisdiction and its Perils,” accusing the United States of enforcing its domestic law in extraterritorial jurisdictions. Less than a month later, the Wall Street Journal published “China’s Newest Weapon to Nab Western Technology—Its Courts,” detailing instances where the Chinese legal system coerced foreign companies to relinquish their technology. However, the debate around U.S. influence on global IP is not new, and U.S. legal scholars have challenged the claims of unfairness in Chinese courts meagerly substantiated by anecdotes. U.S. demands for legal reform as a method to protect U.S. IP is becoming increasingly untenable as Chinese leadership hardens its stance against U.S. influence.

This report steps above the skirmish for legal influence to question the paradigm of reliance on the rule of law to secure U.S. innovation abroad. Recent research shows that U.S. federal and state courts struggle to understand the principles that guide illiberal legal systems, including in China. In addition, the rapid pace of technological development makes legal response a defensive reaction with lagging international reach. Therefore, it is questionable whether legal reform should be the primary focus of foreign policy to sustain the United States as the leading innovator globally. For IPR reform, the 2022 Special 301 Report released by the Office of the United States Trade Representative (USTR) is critical for establishing new rules to protect U.S. interests. Unfortunately, it relies on “voluntary” change from target countries, which leaves U.S. companies passive when U.S.-led change is rejected, as in the case of China.

Even though Special 301’s aggressive unilateralism yielded moderate success in changing foreign markets—such as during Japan’s rise in the 1980s—China’s strategic challenge to U.S. global leadership should be treated differently. The Special 301 report identifies countries with IP protection or enforcement issues that are detrimental to innovation worldwide. Unsurprisingly, China was named in the Priority Watch List (along with 6 others), while close partners such as Canada and Mexico appeared on the Watch List with 18 others.14 According to this USTR perspective, IP appears to be under threat in many countries with substantial trade and manufacturing relations with the United States (Figure 1). However, unlike other countries on the list, China’s ambition to displace the United States is backed by long-term plans to (1) blunt U.S. power, (2) build Chinese regional power, and (3) expand Chinese reach globally.15 U.S. innovation globally may suffer as China presents an alternate market and partnership model for nations unable or unwilling to oblige U.S. demands, such as France.

▲ Figure 1: Visualization of USTR Special 301 Report Watch List Countries. Source: Data from Office of the United States Trade Representative, 2022 Special 301 Report (Washington, DC: Executive Office of the President of the United States, 2022). Author’s own creation using mapchart.net.

The United States has encouraged global markets to adopt U.S. domestic legal standards with some success; however, the high level of legal predictability does not exist in most of the world. U.S. firms should not be misled by the USTR to expect uniform legal enforcement globally. Instead, preventative IP protection measures should become common knowledge in order to circumvent the use of foreign legal systems. The advantages of a strong rule of law domestically that shelter U.S. firms should not translate into crippling naiveté in navigating diverse legal systems abroad. In fact, weaker IP regimes present opportunities to harness knowledge spillover that Taiwanese firms have maneuvered to their advantage, and partially (not universally) strong IPR can improve global welfare. Learning from the case of Taiwan, innovators can move past the reliance on law-anchored IP protection when manufacturing beyond U.S. shores.

The Taiwanese Experience

Taiwan’s economy depends on safeguarding the IP of foreign partners, yet it continues to invest in risky markets such as China. Taiwanese firms are contracted as original equipment manufacturers (OEM) and original design manufacturers (ODM) by clients such as Apple, Tesla, Peloton, Microsoft, and Amazon. Notable examples of Taiwanese OEMs and ODMs include Foxconn, Wistron, Pegatron, and TSMC, all of which have operations in China. TSMC is often spotlighted for its global dominance in the semiconductor industry because 92 percent of advanced chips are manufactured in Taiwan. As a result, TSMC is a key partner for both the United States and China, as both seek to become self-sufficient for critical goods such as chips in order to lead in science and technology innovation. China announced the “National Semiconductor Industry Development Guidelines” in 2014 and Made in China 2025 in 2015. Despite the threat of competition, TSMC applied to the Taiwanese government in 2015 for permission to build a 12-inch wafer foundry in Nanjing, China, which would be cutting-edge by Chinese standards.

The ability to manage risks allows Taiwanese firms to capture market advantages that contribute to its dominance. Following the 1989 Tiananmen Square crackdown and subsequent drop in foreign investment, Taiwanese businesses patched the gaping wound of China’s economy, and Taipei began to permit and document indirect investments into China. In 1991, Taiwan overtook the United States and Japan as the largest contributor of foreign direct investment (FDI) to China, surpassed only by Hong Kong (Figure 2). By 1992, foreign businesses returned and China’s GDP was revitalized from a growth rate of 4 percent in 1990 to 14 percent. On the one hand, Taiwan became adept at navigating precarious political environments, and on the other, it tightened its grip on advanced technology and manufacturing capabilities that forced others to be reliant. Similar to the post-Tiananmen response, Taiwanese companies post-Covid-19 continue to invest in the Chinese market, as discussed in the next section.

▲ Figure 2: Contracted FDI in China by Source Country (USD, millions). Source: Yun-Wing Sung, “Subregional Economic Integration: Hong Kong, Taiwan, South China and Beyond,” in Corporate Links and Foreign Direct Investment in Asia and the Pacific, eds. Eduard K.Y. Chen, Peter Drysdale, James H. Davidson, and Liz Siemensen (New York: Routledge, 1995), 62.

This report draws on the experiences and research of Taiwanese academics and businesses. Since the first direct presidential election in 1995, Taiwan has posed a threat to the Chinese Communist Party because it embodies an alternative governance model. As a result, the self-ruled island is subjected to elaborate disinformation campaigns and cyber warfare from China. Because of this, other countries have taken lessons from Taiwan on combating disinformation and cybersecurity. In the same vein, the Taiwanese experience of safeguarding IP in Chinese jurisdiction can offer insights and best practices for U.S. audiences. Due to the lack of stability and guarantee in cross-strait relations, Taiwanese firms have evolved to protect the IP entrusted to them by foreign partners through nonlegal measures.

Nonlegal Approach to Intellectual Property Protection

When Covid-19 struck, the drawbacks of offshoring the manufacturing sector set off alarms for Western firms, but Taiwanese companies continued to enter the Chinese market. The pandemic highlighted the widening gap of manufacturing capabilities and supply chain control. Augmented by the Made in China 2025 strategic challenge, the vulnerability of global dependence on China prompted foreign policy analysts to take up concepts such as nearshoring, friend-shoring, reshoring, and decoupling. However, a 2020 survey showed that just under 20 percent of thought leaders from the United States, Europe, and Asia want complete decoupling. Echoing the sentiment, USTR Katherine Tai has explicitly opposed the use of “decoupling” and “deglobalization” and instead borrowed the European term “de-risking” as her preferred approach. Another survey focused on 525 Taiwanese executives found that among the 331 respondents with business in China, 31 percent planned to stay and 33 percent were considering moving. Notably, among the 177 Taiwanese firms with plans to relocate capacity out of Taiwan, mainland China was chosen as a destination by 21 percent of the respondents, even in the face of recent tumultuous market trends. Their willingness to move into China is aided by a familiar understanding that risk management and value creation go hand in hand.

The Chinese market remains attractive for both the size of its economy and its talented workforce, despite fears of dependence and the risks of losing cutting-edge technology. The Chinese policy of “trading market access for technology” began as early as the 1980s, and Taiwanese firms have learned to selectively utilize China’s strength in technological development while keeping critical IP safe. On the other hand, the United States continues to focus on legal measures. For example, the U.S.-China Business Council began its IP protection best practice guide by recommending that U.S. parties understand the legal landscape and register patents and trademarks as preventative measures. Although the advice is not wrong, the Taiwanese approach relies less on legal systems and instead focuses on securing key areas of value via nonlegal means.

The founder of Taiwanese conglomerate Acer Group, Stan Shih, coined the “Smiling Curve,” which is the foundation for this report’s approach. Shih’s curve charted the value added by each step in the production process. Based on Shih’s concept, Shin-Horng Chen of the Taiwanese Chung-Hua Institution for Economic Research expanded the curve to dispel the binary approach of “high-end” and “low-end” tasks in the production chain so that value added in the cross-strait production network can be viewed holistically. In an interview for this project, Chen noted that his newest research focuses on “market-centric segmentation of global value chains” to reflect the bifurcation of production processes that separately serve Chinese and U.S. markets. This report contends that IP protection can be similarly deconstructed across the production chain so that U.S. firms entering China can selectively engage and manage IP loss risks.

Although IP protection has been negotiated between the United States and China since 1979, enforcement issues persist. Some scholars have attributed the issue to China’s inter-bureaucratic competition, while others have argued Confucian values “militated against thinking of the fruits of intellectual endeavor as private property.” Regardless of the origin of ineffective IPR enforcement, foreign businesses continue to focus on legal mechanisms for the protection of their IP. Unlike the United States, the consistent application of law is not found in most countries. However, legal unpredictability can be advantageous. Counterintuitively, Taiwanese firms prefer to set up research and development in countries with weak IPR protection because of benefits from knowledge spillover. Therefore, destinations for manufacturing partnerships should not be determined solely on the ability to defend IP through litigation, but instead nonlegal measures should receive more attention. In fact, TSMC’s portfolio of IP includes 90 percent trade secrets and 10 percent patents. A retired Acer R&D executive, Louis Lu, commented:

I was at Acer for 18 years . . . we only considered filing patents if infringement is easy to prove in court, especially when infringement is visible and obvious. If not, the best way to keep the knowledge safe is as a trade secret. For example, our chemical processing method for a component is not conspicuous, so we keep it as a trade secret. Coca Cola’s recipe is another example.

Therefore, IP enforcement must take the local market characteristics into account and supplement the use of publicly filed patents, along with privately secured trade secrets.

Despite the usefulness of trade secrets, the research on IP is skewed toward publicly filed patents, copyrights, and trademarks. The cause is multifaceted. Firstly, academic research on trade secrets is difficult because it requires industry experience to grasp the practical constraints of manufacturing. Conversely, publicly filed IP is innately accessible, and years of data can be used to characterize historical activity and forecast trends. Secondly, industry experience is difficult to come by, as employed personnel cannot divulge the protective measures used because it will be rendered less effective once revealed. Retired personnel may be interviewed, but the knowledge may be dated and will likely be protected by confidentiality agreements. Lastly, as the manufacturing sector moved abroad, factory operations became foreign and inaccessible to corporate managers based in the United States. This report aims to draw from Taiwanese expertise in protecting IP beyond conventional advice to counter legal unpredictability, diplomatic uncertainty, and apparent IP asset vulnerability outside U.S. jurisdiction.

Building off Shih’s “Smiling Curve,” the curve in this report traces the relative amount of value added through the same 10 steps, but instead of demarcating Taiwan, China, and foreign brands as the critical parties, this “Secret Smiling Curve” accounts for embedded trade secrets and disaggregates personnel, local partners, suppliers, and factories (Figure 4). The four categories are selected because they trigger critical “pause points” when hiring and firing personnel, surveying and enlisting local partners, sourcing and selecting suppliers, and designing and building factories. Rooted in the China context, the checklist aims to be useful in jurisdictions with “weak” IP protection from the legal system.

▲ Figure 4: “Secret Smiling Curve” of Embedded Intellectual Property. Source: Author’s own creation.

The Checklist Manifesto

IP audits became a common practice in the 1990s as governments, corporations, and intergovernmental organizations such as the World Intellectual Property Organization published best practice guidelines. Large corporations may use IP audits to visualize “technology heat maps” to evaluate mergers and acquisitions for strategic decisions. However, for small and medium firms, comprehensive IP management tools and expensive lawyers may not be accessible, and guides with exhaustive lists of questions are inefficient. Due to the costly maintenance of systematic IP audits, this report proposes a checklist approach (see “The Checklist” section). Inspired by Atul Gawande’s The Checklist Manifesto, this report’s checklist is developed to be terse and focused on “pause points” before critical steps are taken. The condensed checklist is not a replacement for comprehensive surveys that should be conducted with lawyers, as legal professionals are better equipped to identify, classify, document, and validate a firm’s IP through exhaustive checklists. In addition, though the checklist focuses on the Taiwanese offshoring context in China, it can be expanded for use in other jurisdictions.

Atul Gawande, a surgeon and the assistant administrator for global health at the United States Agency for International Development, authored The Checklist Manifesto to build a system that addresses the gray area between ignorance and ineptitude in the healthcare sector. A checklist seems ill-suited to capture the overwhelming web of knowledge required to mitigate risks of IP loss. However, Gawande argues that checklists anchor routines to optimize the balance of “freedom and discipline, craft and protocol, specialized ability and group collaboration.” A pilot’s engine failure checklist includes “Fly the Plane” to redirect attention back to the basics despite overwhelming distress from the threat of death. For companies on the brink of inking potentially momentous expansion plans, a similar rush of adrenaline may cloud judgment so that seemingly obvious steps to protect their IP are forgotten. Therefore, a checklist catches similar gaps between ignorance and ineptitude in IP protection abroad.

Unlike comprehensive reports and guidelines that require a break from normal routine, checklists are designed as a final inspection to catch common but critical lapses. As opposed to centralized knowledge and decisionmaking at headquarters, checklists facilitate standardization without removing power and responsibility at the periphery where managers are executing contracts and plans. The list is designed around four categories of “pause points” for foreign firms when key decisions are made along the “Secret Smiling Curve” (Figure 4) related to personnel, local partners, suppliers, and factories in China. Therefore, the manager with purview that encompasses all four functions should activate the checklist and track its progress. Typically, the most suitable candidate will be the country or regional director in a corporation.

Personnel

In China, 87 percent of trade secret misappropriations are conducted by employees or ex- employees as opposed to external personnel. The trend is similar for most of the world, including the United States. Although noncompete clauses are being debated for their damage to employees and competition, the clauses are generally permitted in China. However, an interviewee remarked: “Employment contracts and confidentiality agreements are mostly deterrents—they are a necessary preventative measure. But in reality, enforcement is weak in China.” Therefore, Taiwanese firms have learned to leverage organization design, training, and task allocation as techniques to minimize IP leakage due to labor mobility. The pre-Covid-19 worldwide employee turnover rate was 10.9 percent across all industries, with technology (software) suffering the highest rate of employees voluntarily leaving, at 13.2 percent. For China, the average employee turnover rate across industries is 20.8 percent, while the technology (internet) sector sees nearly triple the global average, at 36.0 percent. In other words, you can expect one in 7.5 employees to leave each year at global technology companies, compared to one in 2.8 employees in China. Therefore, designing the organization to retain IP despite the mobile workforce is critical.

• Use a cleanroom design between teams. The concept of cleanrooms is now part of popular consciousness due to Covid-19. For Taiwanese companies, cleanroom organization designs hamper IP theft and challenge claims of IP infringement from competitors. Taking software development as an example, instead of the incoming R&D requests going directly to the coding execution team, an added intermediary person creates a “cleanroom” so that the team physically and virtually keeps the inputs and outputs apart (Figure 5).

• Spread key tasks across time and space. Large corporations spread subsidiaries throughout China to avoid consolidated knowledge. For smaller companies with limited budgets, an accepted practice is to break up knowledge between day and night shift teams. In addition, newly established teams should be time tested by starting with nonsensitive tasks to build competence before proprietary projects should be considered.

▲ Figure 5: Information Flow in Standard and Cleanroom Team Structures. Source: Author’s own research and analysis.

• Modularize product during conception. Leverage the innate characteristics of products to modularize the product. For example, splitting hardware and software development enforces barriers to IP theft on two fronts so that one will not work without the other, effectively creating a lock and key system when taken as a whole.

• Conduct design and development (D&D), not R&D. Taiwanese companies typically perform basic research on the island, while development work to bring the innovation to market can be performed within China. In addition to development, designs for the local market may be differentiated from international market products, as the Chinese market is typically sufficiently large to warrant a separate localized version. Some localization efforts have failed, but an added layer of product differentiation may shield the international market from copycats.

• Disperse tasks to fragment knowledge. With the cleanroom design in mind, team leaders should allocate tasks so that knowledge around a key function or component is not aggregated within one employee. For example, if a commonly found equipment is used, the engineer inputting the parameters will aggregate significant know-how that should be fragmented. In the chipmaking context, ASML is the only equipment supplier for extreme ultraviolet (EUV) photolithography machines; therefore, experienced engineers are a storage of competitive advantages.

• Restrict access to prototypes and key components. Many underestimate the speed of Chinese copycats that release new features and “good enough” innovations ahead of multinationals as shanzhai (guerilla) products. Accidental or intentional early access to a new product innovation may lose its value if nimble copycats release it before the original. Key components may be physically secured by suppliers, but employees with knowledge of where to procure them may create vulnerabilities if competitors buy off the proprietary information or hire away employees.

• Train all employees on IP and confidentiality and document the training. Perhaps the most important point in this section: employee awareness of what constitutes IP leak vulnerability should be continually reinforced. In addition, documentation of training and confidentiality agreements should be kept as future evidence if IP theft is suspected. Leverage the sales and marketing teams as competitor surveillance mechanisms to report potential IP infringement.

A company’s personnel represents the greatest vulnerability and is linked to local partner selection. Poor choice of partners may create future competitors that absorb sufficient know-how to displace and replace the original innovator. However, strong local partners can be pivotal. For example, even though TSMC is the key target for poaching talent for Chinese state-backed competitors such as Hongxin Semiconductor Manufacturing Company and Quanxin Integrated Circuit Manufacturing, it maintains a low total turnover rate of 4.9 percent. Even after TSMC’s former chief operating officer, Chiang Shang-yi, made the “foolish” mistake of joining Semiconductor Manufacturing International Corporation, TSMC continued to be trusted by its clients for exceptional reliability and trustworthiness. Therefore, selecting a partner that can withstand the onslaught of competitors and temptation to take over the entire value chain is key.

Local Partners

Common partnership approaches include technology licensing, joint venture, product reseller, and contract manufacturer. In general, higher dependency on a local partner warrants more profit or technology sharing to ensure the agreement can be sustained (Figure 6). Depending on the specific design and sourcing of the final product, several subcategories of partnerships can be created. For example, tangible products manufactured outside of China can enter the market with reseller agreements that are subcategorized as exclusive or authorized resellers. Exclusive reseller agreements increase the profits gained by the sole local partner, as well as the dependency on their performance. However, the risk of high dependency is typically balanced by selecting a sizable partner that has market advantages in sales channels or brand recognition. On the other hand, nonexclusive authorized reseller agreements allow foreign brands to engage several resellers and mitigate dependency on a single partner. In another example, technology licensing can be subcategorized as cutting-edge or older-generation technology licenses. Although cutting-edge technology may confer first-mover advantages, older-generation technology often has a proven track record in sales and performance; therefore, local partners may be amenable to less profit in exchange for calculable returns on investment. For example, older-generation medical devices that are proven to work reliably will have more transparent pricing and therefore smaller margins. On the other hand, cutting-edge technology depends on the quality of the local partner to make inroads with new customers and use cases; therefore, more profits are shared with the local partner, but local market success will also depend heavily on the quality of the local partner.

▲ Figure 6: Dependency-Profit Sharing Paradigm of Partnerships. Source: Author’s research and analysis.

For a large market such as China, partners are enticed to eventually cut out the foreign brand or technology licensor in order to retain more profit because marginal gains are enormous. Therefore, tension in the relationship increases as Chinese partners become more successful. Specifically, foreign partners increase dependency on Chinese partners because they hold growing shares of global profits. Smaller Chinese firms will perceive a risk of being replaced by larger or more notable local partners. On the other hand, larger Chinese firms have the capability to invest in developing their own product once the market opportunity is proven. The tension of successful partnerships is lessened in smaller markets, such as Taiwan or Singapore. The limits of the domestic market force companies to grow by trading with global partners via trust and reputation. Therefore, the risk-reward calculus difference in China inevitably increases the propensity for partners to seek larger rewards by breaking away from the foreign partner. Using the “Secret Smiling Curve” (Figure 4), the below items warrant dedicated attention to manage the risks associated with relying on local partners.

• Conduct product R&D with suitable partner type and size. Chinese firms that have exceptionally strong R&D capabilities have fewer barriers to reverse engineer products, which is legal. Other than visiting the facilities to meet the R&D team, their patent portfolio should also be examined to avoid nurturing potential competitors. Further, it is helpful to use enterprise databases such a Qi Cha Cha to review the shareholder structure, paying particular attention to competing companies holding shares. The National Enterprise Credit Information Publicity System is also useful for providing a history of irregular activity or lawsuits.

• Delay sharing prototypes and process design. Lead time to market is an advantage that can counter shanzhai copycats. An interviewee mentioned that they saw a competitor’s early prototype while passing through the facilities of a shared partner. Therefore, partners such as labs or contract manufacturers may inadvertently expose early designs to competitors out of negligence.

• Exclude details on key components and parts. Local partners may request typically proprietary information, but there are usually workarounds available. For example, medical equipment certification requires submitting information to the governing body, and local partners may request more information than necessary, including details on key components. A workaround is to find a third-party agency that can complete the registration on behalf of both parties.

• Withhold global profit and sales data. Maintain an information advantage in partnerships that expect renegotiation of terms by withholding profit and sales data. External parties have less ground to stand on to increase their share of profits without data. Data on profit margin and sales can be roughly derived from procurement or service orders, so the relative standing of a particular partner among other geographies should be occluded whenever possible. As the Chinese saying goes: “no comparison, no harm.”

• Transfer technology that is one or two generations behind. As discussed earlier, older technology can be positioned as a less risky option for partners. In addition, it provides valuable lead time for U.S. firms to establish a firm hold on global markets and prevents Chinese local partners with strong absorptive capacity from replacing the original U.S. innovator. This is particularly relevant for fast-evolving products, such as consumer goods and electronics.

Suppliers

For the purposes of this report, suppliers are companies and partners that provide intermediate goods, whereas contract manufacturers in the previous section produce finished or near-finished goods. Intermediate goods include physical products, such as phone casings or liquid preservatives, but may also include software. Although suppliers have the ability to move up or down the supply chain, the final product is difficult to innovate for parts suppliers, according to the Taiwanese experience. On the other hand, competitors present a threat if Chinese suppliers are willing to sell intermediate goods that have embedded IP, especially for key parts and components. Therefore, the critical items to account for in the checklist are deterrent measures to guard against the threat to IP from competitors.

• Set penalties for suppliers of proprietary parts. Supplier agreements for key components and parts should include clear conditions to punish with penalties if proprietary products are sold to competitors. An interviewee mentioned that competitors may offer double the standard price to purchase cutting-edge parts; therefore, it is necessary to set strong deterrents, such as charging 100 times the product price.

• Avoid sharing suppliers with key competitors for ordinary components and parts. Check the client list of suppliers, even for commonly found parts or components. Although it may be difficult to avoid sharing suppliers—especially for commodified goods where economies of scale make the leading supplier an attractive choice—the execution of daily activities can be separated. For example, leading suppliers may have several factories, warehouses, and project management teams to choose from. An interviewee remarked that a factory visit revealed the next-generation product of a competitor because the shared supplier was not conscious of IP that can be gleaned visually, such as design and physical specification.

• Preassemble imported key intermediate goods. Avoid disclosing raw materials to downstream suppliers by preassembling. For example, solvents used in medical devices may use specialized raw materials that can be proprietary knowledge. To prevent leaking the recipe for assembling the ingredients, the “half-baked” intermediate goods can be imported instead of the raw materials to protect not only the supplier list and ingredient list but also the method of assembly.

Factories

The physical design of a factory managed by U.S. executives can integrate IP protection safeguards. To prove theft of trade secrets, observable steps need to be taken to show the courts that effort was made to preserve confidentiality. Examples of measures that Chinese courts use to judge sufficiency of protective action include password restricted access to information, confidential watermarks on documents, and confidentiality agreements with employees and partners. Therefore, factories should be set up to optimize the surveillance and documentation of personnel activities so as to deter and counter unwanted knowledge transfer.

In addition, healthy relationships should be maintained with local government officials because their incentives are not necessarily aligned with national plans for domestic innovation. Specifically, national efforts for technological self-sufficiency may be in tension with local government incentives focused on economic growth. For example, in 2010, the Taiwanese flat-panel technological resources were “conspicuously targeted” by the Chinese national central government due to fear of dependency, but local-level governments rely on exports to foreign markets, which will not accept inferior products made with locally sourced parts. Therefore, in practice, local governments need to maneuver between national plans and regional commercial interests by creating protection for foreign innovation suppliers to sustain economic growth. That said, recent expansions of China’s counterespionage law allow state officials to inspect and seize “electronic equipment, facilities, and related programs and tools of relevant individuals and organizations” that threaten national security. Precautionary measures below can be taken to preempt any internal or external threats to IP.

• Obscure equipment configuration in assembly lines and manufacturing processes. Many industries rely on equipment that is manufactured by a handful of companies, which makes knowledge on equipment settings transferable to competitors. For example, the semiconductor industry relies on ASML, Applied Materials, Lam Research, and Tokyo Electron as key equipment suppliers. In particular, cutting-edge EUV lithography systems are only produced by ASML. Therefore, equipment configuration should be protected because it can become sensitive proprietary information that engineers may leave with and bring to competitors.

• Document and mark confidential materials, even in transit. Sensitive information and equipment should be marked confidential, and access should be restricted to select personnel. A timestamped record of who accessed sensitive material should be kept, even during logistical transitions between factory locations or teams. The record of activity will be valuable in court and is a physical reminder to personnel that they are accountable for confidentiality.

• Demarcate restricted areas. Proprietary materials (e.g., ingredients, parts, and documents) should be stored in areas with restricted access. Unintentional trespassing can be intercepted with clear signage and access checkpoints. Checkpoints may request guests or employees to leave electronics with cameras (e.g., phones and laptops) outside, which is a standard practice at TSMC facilities.

Moving Forward

The checklist approach based on Taiwanese experience is a starting point for U.S. firms engaging with China and other markets with weaker IP protection enforcement. Taiwanese experiences show that weaker IP regimes can be an opportunity to enhance innovation potential by capturing knowledge spillover. In addition, critical IP can be protected through nonlegal measures that do not depend on the fairness of foreign courts and governments.

This report focused on personnel, local partners, suppliers, and factories as critical “pause points” that have higher risk of IP and value loss. The foundation of the checklist is built on Stan Shih’s “Smiling Curve,” which was further developed by Shin-Horng Chen at the Chung-Hua Institution for Economic Research. Through a condensed list, the checklist aims to orient attention toward high-impact measures that are actionable. However, the checklist is not a substitute for legal counsel, and it can be further customized to fit each company and market.

In starting this checklist, this report aims to draw more attention to nonlegal and practical approaches to IP protection that U.S. companies can implement globally. U.S. innovators need to exchange experience with Taiwanese partners that have familiarity with the Chinese landscape and beyond. This requires the cohesive efforts of researchers, company executives, and policymakers due to the proprietary nature of IP protection strategies. The United States needs to work transparently with its partners to frame the sharing of nonlegal best practices as a coordinated effort to jointly safeguard and capture the global innovation potential.

The Checklist

---

Emma Hsu is an adjunct fellow (non-resident) with the Renewing American Innovation Project at the Center for Strategic and International Studies. She is an Asian market entry analyst with a master’s degree from the University of Hawaii at Manoa and a bachelor’s degree in biochemistry from McGill University.