A view from the Eastern front
On 22 March 2018 the US Trade Representative (USTR) published its much-anticipated investigation report into China’s technology transfer, IP and innovation policies and practices. The investigation had been ordered by President Trump under Section 301 of the Trade Act, an order which had been an early warning shot in the threatened trade wars to come. The report paints a somewhat incomplete and misleading picture of China’s entire machinery of state geared towards systematic extraction of technology from the US, ranging from unfair technology transfer rules, blatantly protectionist industrial policies, and even allegations of cyber-espionage carried out by military units.
China promptly delivered its own tidy riposte. On the following day the China State Council issued the Measures on Work Relating to the Transfer of Intellectual Property to Overseas Parties (Trial Implementation) (IPR Guidelines). The IPR Guidelines clarify and strengthen the implementation of existing regulations governing the review and approval of technology transfers from within China to foreign entities. Taken together with the Draft Prohibited and Restricted Technology Exportation Catalogue 2017 (Catalogue), which expands the categories of technology that are restricted or prohibited for export to include artificial intelligence, aerospace, and telecommunications, the IPR Guidelines have heightened fears of significant impacts on R&D and merger activity for multinationals in China.
These developments fit into broader external narratives around China’s technology transfer and innovation policies, narratives which are at times incendiary and certainly prone to containing a mixed bag of valid objections and mischaracterised issues. These narratives gloss over the competing tensions at play as well as the opportunities they allow to successfully engage with the Chinese market. We examine below the technology transfer framework in context and consider how these latest developments fit into China’s innovation roadmap.
Overview of the regulatory framework
The overarching framework regulating all transfers of technology into and out of China, whether by acquisition/disposal, investment, or as a consequence of R&D collaboration (e.g. agreed ownership of technological achievements), is the Technology Import and Export Regulation (TIER). TIER is supplemented, amongst other things, by the Catalogue, which identifies the categories of technology that are prohibited or restricted from import or export. Restricted technologies can only be exported subject to the approval of the Ministry of Commerce (MOFCOM) or its branches.
Formalized approval process
The IPR Guidelines now refine and legally formalize the approval process for external transfers of restricted technologies involving IP, which is defined to include patent rights, exclusive rights to layout designs and integrated semiconductors, software copyrights, and rights to new plant varieties. An external IP transfer is broadly characterised to include technology export as well as the acquisition of a controlling interest in a Chinese domestic company by foreign investors, or the grant of an exclusive licence to a foreign entity.
Criteria for examination
The crux of the review and approval process under the IPR Guidelines is the impact of the proposed technology transfer on (i) China’s national security and (ii) China’s capacity to develop technological innovation within key sectors. ‘National security’ is a notoriously broad and vague concept in China. Under the National Security Law of the PRC 2015 national security concerns extend into matters of politics, economics, ecology, civil society, and culture, to name a few.
The review and approval of transfers of restricted technologies was previously primarily the domain of the Ministry of Commerce (MOFCOM). The IPR Guidelines now mandate the formal involvement in the review process of specific government agencies with greater expertise in the relevant IP. For instance, the State Intellectual Property Office (SIPO) will now examine external transfer requests for restricted technologies involving patents, and will ultimately issue an opinion in writing to MOFCOM or its local branch. MOFCOM will issue its examination decision based on this opinion.
The deployment of this expertise is presumably intended to bring added rigour to the approval review process amid concerns that the current absence of formalized consultation has allowed technology leakages in areas which may compromise China’s national security and strategic interests. It is also a move that in some ways may decentralize power in the approval process.
A complex backdrop
It goes without saying that these developments are embedded within a far broader and complex political and economic context. Beyond the turbulent backdrop of official statements, stump speeches, tariff announcements, and of course, tweets, there are long-term strategic concerns at play for China. This was put into sharp relief by the intrigues surrounding the Chinese telecommunications behemoth ZTE. Its apparent existential crisis following on from the US export ban and its overreliance on US manufactured components was a shock to many observers at home.
Chinese officials have reiterated the concerns driving the IPR Guidelines. SIPO official Zhang Zhicheng stated that “If China fails to strictly scrutinize core IPR transfers related to national security, China may lose control of indigenous innovation capacity on core technologies in important fields, and therefore incur huge economic losses and cause adverse impact on China's indigenous innovation capacity and international competitiveness”.
The intertwined themes of national security, self-sufficiency in core strategic areas, and homegrown innovation capacity also reflects the direction of policy and regulatory development. China is transitioning into an innovation-based economy with a strong R&D base under the roadmap set out by the 13th Five Year Plan and the “Made in China 2025” initiative. The directive from Beijing is to boost domestic innovation and production of core technologies, while also acquiring foreign expertise and technology in key areas where China lags too far behind. This unrelenting drive towards becoming a self-contained technology powerhouse has ignited fears of shattered global supply chains and rapacious acquisitions abroad.
Like many policy issues in China, technology transfer policy is marked by competing tensions. The openness required of an innovation ecosystem and its cross-border flows of innovation factors are at odds with the efforts to ringfence entire supply chains and the increasing scrutiny of technology transfers.
For instance, central and local governments recognize the benefits and ‘spillover effects’ of multinational advanced R&D being carried out locally, in turn helping to drive the development of local innovation ecosystems. They actively encourage foreign companies to increase R&D investment in China through tax breaks, subsidies, and trade facilitation measures. Yet according to a recent AmCham Shanghai survey foreign companies still remain reluctant to bring their most valuable R&D and IP to China, with the majority instead building lower priority China R&D functions focused primarily on adapting global products for the local market. The most concerning barriers cited in the survey were a lack of IP protection and market access restrictions.
There has indeed been a trend towards substantially liberalized business regulation and more robust IP protection. The recently developed specialised IP Courts are becoming increasingly sophisticated in handling complex IP disputes and are even becoming a venue of choice for some foreign litigants. Damages continue to grow and IP litigation filing numbers are increasing at a brisk pace. Yet at the same time the IPR Guidelines and the shift in focus to mandated domestic IP ownership exacerbates existing key concerns around market access and undermines advances already made.
It is likely that the majority of R&D arrangements and technology transfers in China by foreign entities will continue to be largely driven by commercial considerations and the relative negotiating positions of the parties involved rather than political imperatives or the ‘national security’ implications of the arrangement. Restricted sectors still represent a relatively small proportion of industries wanting to do business in China and therefore most deals are in sectors free from any ownership or transfer restrictions.
Nevertheless, although the IPR Guidelines are designed to clarify existing procedures for restricted technology exports, the vague mechanisms they introduce create new uncertainties and concerns.
National security as a ‘catch all’
The broad definition of ‘national security’ will leave room for interpretation and future evolution along with any policy shifts. No doubt that the concept will in practice assume some shape over time as economic priorities solidify. However, given the broadly defined nature of ’national security’ it will also in practice likely operate as a catch-all ground for refusal if there is some aspect of the transaction with which the decision maker is not comfortable.
External transfers of restricted or prohibited technologies under the Catalogue will become much more difficult to clear. After all, these technologies appear in the Catalogue in the first place because they have some bearing on the national interest. The new requirement for formal consultation and the issuance of a written opinion (rather than passive approval) may lead to a risk averse and overly cautious approach. Decision makers may be more inclined to reject requests in order to ‘future proof’ their decisions and limit their exposure to transfers that are negatively viewed in hindsight.
Of particular uncertainty is the extent to which acquisitions of Chinese domestic companies will be ensnared by the IPR Guidelines. While it is clear that only the outbound transfer of restricted technologies is subject to review, it is unclear which category of mergers and acquisitions by foreign companies will be scrutinized. There is no reference to restricted technology in this context, potentially exposing a very broad range of technology deals to delays and unexpected roadblocks.
Parties will need to engage earlier with the relevant agencies to gauge the prevailing attitudes towards the specific technology and domestic target. In addition, the risk of regulatory refusal will need to be re-priced and factored into the breakup fee and overall deal structure.
The IPR Guidelines will stymie foreign R&D and the development of an innovation ecosystem around restricted technologies in China. We anticipate a withdrawal of foreign companies and institutions cooperating with Chinese entities on technology and a re-examination of R&D inside China in the restricted areas, including in areas that are not traditionally understood to impact national security, such as medical devices.
In addition, the limited progress towards more advanced multinational R&D being carried out in China to produce technology designed for global exploitation will continue to be hindered, particularly in restricted technology areas. This will also bring into question the feasibility of existing relationships between foreign and local universities, start-ups and companies within the China innovation ecosystem.
It will be critical for multinationals to understand how they can balance satisfying the new regulatory and compliance procedures against securing the right levels of IP ownership and protection. This will likely mean increasingly capturing core technology developments through internal methods that do not require public disclosure rather than public registration mechanisms which trigger regulatory requirements and restrictions.
The competing tensions between openness and control are illustrated by China’s technology transfer policy. The majority of technology deals we have worked on have benefited from a trend towards improving IP protection and substantially liberalised business regulation in the past few years, moving from an active approval process to passive registration. This has maximised the number of win-win technology collaborations and contributed to the development of the innovation economy.
The crucial issue in most China technology deal making and collaborations has been the commercial negotiating power of the parties, not state interference. Of course, there have been situations where the existence of these rules and procedures can be exploited by the Chinese party to gain an unfair advantage if they are intent on doing so. We have also seen in a few sectors the clear ambition of the Chinese government to gain a technology advantage. These situations indeed involve risk, can be anticipated and, often, avoided.
This status quo is threatened by China’s drive to secure access to key technologies through ownership and restrictions on transfers, all in an effort to protect domestic innovation. These moves will undermine China’s domestic innovation ecosystem in the sectors that it has identified as strategically important yet currently lacks capability.
The IPR Guidelines are subject to further clarification by other government agencies. It is our hope that their real-world application will not cast a long shadow over cross-border technology deals by significantly tightening supervision in practice or reversing some of the recent liberalizations.
This article was first published on LexisNexis in July 2018.