What Chinese Businesses Need to Know About Establishing an R&D Center in the United States

September 23, 2013 Practice Group(s): Corporate/M&A Intellectual Property Labor and Employment What Chinese Businesses Need to Know About Establishing an R&D Center in the United States By Britt L. Anderson, Fred M. Greguras, Charles D. Holland, Linda L. Usoz, Yuki S. Ku There is increasing interest from Chinese businesses in establishing an R&D center in the Silicon Valley and other technology centers in the United States. For example, the world s largest mobile phone operator, China Mobile, has a research center in Milpitas, California; Lenovo, the Chinese computer manufacturer, operates a research center in North Carolina; and Changan Automobile Co. opened a research center in Plymouth, Michigan. The R&D center strategy is complemented by the general trend of increasing acquisition of and investment in U.S. technology companies by Chinese businesses, especially in the energy and software sectors, and by the desire in China to design and produce innovative, leading edge products rather than just manufacture them for others. The Chinese business can both improve technology and intellectual property (IP) it already owns as well as develop completely new technology and IP at a U.S. R&D center (Center). The U.S. has cutting edge technology, skilled engineers, creative entrepreneurs and is the home of leading universities where innovation is fostered. The U.S. is also a major market for the computer, software, telecommunications, biotech, renewable energy and other technology sectors. The U.S. has a well known legal system for employment, tax and IP matters and is a member of most international treaties and trade organizations in which China is a member. A Center in the U.S. can tap into all of these resources and improve the likelihood of successful development of innovation and commercialization. Action Steps A Chinese business setting up a Center in the United States should follow these steps: 1. As an initial step, determine the U.S. export control restrictions on the types of technology that will be developed. The basic viability of the Center may be limited if the research area is too restricted under the export controls. 2. Determine the best structure for the Center for tax and limitation of liability purposes. Generally, this will result in forming a U.S. entity with limited liability, either a corporation or limited liability company (LLC). This entity will be a wholly-owned subsidiary of the Chinese business or a wholly-owned subsidiary of an intermediate subsidiary of the Chinese parent. An intermediate subsidiary is sometimes used for tax planning purposes. Generally a corporation is used to minimize the risk of the foreign parent being taxed in the U.S. 3. Obtain a Federal Employer Identification Number (FEIN) for the Center from the Internal Revenue Service. A FEIN will be required to open a U.S. bank account. It is generally more practical to work with a bank that has operations in both the U.S. and China in order to facilitate financial transactions.

4. Determine the initial staffing for the Center. It will generally be faster to hire talent locally than to bring staff in from China. Apply for immigration visas for any key persons from China who will be managing or otherwise working in the Center. Consult with legal counsel on applicable employment laws and implement the operational and compliance process for employee payments, federal and state tax withholding, FICA and related items before hiring employees. Arrange for employee health insurance and other benefits which are competitive with other businesses in the area. Offering low salaries and minimal benefits will reduce the quality of the talent you are able to recruit. Employment matters are discussed in more detail below. 5. Obtain office and/or laboratory space for the Center. The office space needs to be zoned by local government for research purposes particularly if a laboratory is involved. Sign a written lease for office space only after review by legal counsel. 6. Have employees execute Employee Invention Assignment and Confidentiality Agreements that comply with local law as part of the hiring process. Have consultants and other independent contractors sign corresponding agreements. The purpose of these agreements is to assure that the Center owns the IP and other results produced by the employee or consultant. Generally a written assignment of ownership is required from consultants and other independent contractors or the Center will not own the results of their research. 7. Develop an IP strategy and implement IP protection for the results of the R&D. The purpose of the IP strategy is to protect and support the Chinese business. The R&D results should usually be owned by the company at the top of the group of companies since that is where value is concentrated for financing and exit purposes. IP Strategy is discussed in more detail below. U.S. Export Controls as a Threshold Factor The U.S. export control laws restrict the disclosure and transfer of sensitive technology and technical information to other countries. These laws need to be carefully reviewed prior to establishing a Center to determine compliance obligations. There is still sensitivity applicable to exports to China under these laws in a number of sectors such as telecommunications and information security, biotechnology materials and nuclear materials, facilities and equipment. The Bureau of Industry and Security (BIS) of the U.S. Department of Commerce regulates the export and re-export of dual use items and technologies on the Commerce Control List in accordance with the Export Administration Regulations. Depending on the circumstances, the export of controlled items may require an export license from BIS. In addition, under the International Traffic in Arms Regulations, the Department of State s Directorate of Defense Trade Control restricts the exports of military items, services and technology listed on the U.S. Munitions List. The definition of export is broad. Foreign access to technology and technical information may be deemed an export requiring U.S. government approval. Improvements or products made by a foreign company that incorporate U.S. technology are subject to export control laws as well. Digital information that is controlled by export laws must be strictly monitored. The ability to access controlled digital information overseas can be a violation even if the information was not actually accessed. 2

Forming the U.S. Entity for the Center The first step is filing articles of incorporation but there is more to forming a legal entity for the Center than simply filing articles. The formation needs to be completed in order to have the benefit of being a separate entity. The Center entity needs to be separate from the parent company for tax and liability reasons. The following documents are usually adopted at the formation stage of the entity in order to establish a separate entity. 1. Resignation of the Incorporator. Once the articles of incorporation are filed, the incorporator s job is completed. He or she will then resign and appoint the initial board of directors (Board) who will have the responsibility for the affairs of the Center. In a wholly-owned subsidiary, the initial size of the Board may be one person who does not need to be present in the U.S. or an employee of the corporation. A Board member who is not also an employee of the Center is not required to have a U.S. work visa. 2. Organizational Board Consent. The Board makes decisions by taking corporate actions at a meeting or by a written consent signed by all directors. Certain corporate actions must be authorized by the Board such as the appointment of the president, secretary and treasurer of the corporation, office leases and the sale of equity or borrowing for the capitalization of the entity. The officers of the corporation are delegated the responsibility of day-to-day management of the Center. 3. Bylaws/Operating Agreement. A corporation s bylaws and an LLC s operating agreement provide the guiding rules for the Center s decision making and internal affairs. 4. Stock Purchase Agreement. While there is usually no statutory minimum capital as in China, the Center needs to be capitalized with equity and/or debt adequate for operations. A stock purchase agreement or investment representation letter is used for the purchase of equity and a promissory note in the event the Center is partially capitalized with debt. 5. Qualification to do Business. If the Center is incorporated under the laws of one state and has offices in a second state, it must file qualification documents in the second state. For example, if the Center is incorporated in Delaware but has an office in the Silicon Valley and Austin, it would have to qualify to do business in California and Texas. 6. Intercompany Agreement. The basic purpose of an intercompany agreement is to assure that ownership of the technology and IP developed at the Center is owned in the right place in the company group to maximize value for the Chinese business. As indicated, the R&D results should usually be owned by the company at the top of the group of companies since that is where value is concentrated for financing and exit purposes. Other intercompany agreements such as a license agreement for base technology and agreements for services of various types such as market research should also be considered. Employment Matters Recruiting, training and employing individuals are not simple tasks in the U.S. There are numerous federal and state laws which must be followed in recruiting and hiring, in employing, in paying and in disciplining and terminating employees. Legal counsel needs to be involved in all aspects of the planning and implementation of U.S. employment. Following is a summary of the most important issues in connection with employing individuals in the U.S.: 3

1. Using Independent Contractors instead of Employees: This is risky and very scrutinized under federal and state law. While the practice may still be common to use independent contractors to try to avoid employment-related overhead (such as payroll taxes, workers compensation insurance and similar expenses), the federal government and numerous state governments have implemented audit programs for employers who engage individuals or sole proprietorships as independent contractors. Under such audits, the Center would have the burden of demonstrating the individual meets complex multi-factor tests in order to be an independent contractor and not a misclassified employee. The tests are very difficult to meet and failure to meet all tests can result in substantial penalties, taxes, interest, and legal expenses, as well as conversion of the contractors to employees. 2. Hiring non-u.s. Citizens without Work Status: The right to hire and employ persons who are not U.S. citizens, do not have a green card or who do not have certain types of visas is restricted. The Center needs to be advised by immigration counsel before making any commitments to a foreign worker without the proper status. 3. Hiring Local People: Employment laws vary from state to state and impose requirements on the recruitment and hiring process, calculation and payment of wages, discipline and termination and many other aspects of employment. The Center should have a basic understanding of what it can ask or consider in making hiring decisions before hiring its first employee. Federal and most state laws (including California) impose restrictions on the scope of background and credit checks of applicants for employment and employees, as well as how the information obtained may be used in making hiring and other employment decisions. Upon hiring employees, there are many notices and brochures and other information which must be posted in the workplace and/or provided to each newly hired employee. In addition, many employers find it useful to have employees sign an offer letter accompanied by a short employee handbook outlining the terms of their employment (such as pay rate, list of any benefits provided, policies on discipline and termination and other terms). Many benefits are optional (meaning the Center is not obligated to provide them), while some are not. Further, different states and often different cities impose obligations to provide certain kinds of benefits. For example, San Francisco imposes an obligation on employers to provide a certain amount of paid sick time to all employees who work in the city. 4. Compliance with Non-discrimination Laws: Both federal and state non-discrimination laws impose duties on employers to make all employment-related decisions without regard to certain characteristics (such as, by way of example only, race, color, national origin, ancestry, age, gender, sexual orientation, gender identity or expression, marital condition, veteran status, and certain other characteristics). Training management in various aspects of these laws is needed to reduce the risk the Center will face lawsuits. 5. Employee Compensation: Both federal and state wage and hour laws apply to all employees. The Center may not simply decide to pay all employees on a salary basis (as opposed to an hourly basis) and assume it has complied with its obligations. The manner in which, amounts and frequency with which companies pay employees is subject to complex federal and state regulation. Certain employees are entitled to overtime pay when they work in excess of certain hours during a work day or work week. Further, the laws impose numerous record-keeping requirements as well as reporting requirements concerning the compensation earned and paid to employees. 6. Employment Lawsuits and Claims: The U.S. is generally a litigious society and lawsuits and claims over alleged violations of employment laws are very common. Employees are permitted to sue their employers or former employers even where it appears that the business fulfilled its obligations, complied with law, or at least tried very hard to do everything correctly. In addition, certain claims may be made to a government agency and need not be filed in court. For example, 4

employees or former employees in California who claim they have not been paid all of their wages may file a complaint with the California Labor Commissioner s office. The process is generally fast and inexpensive for the employee because the employee need not hire a lawyer. Generally, it will take at least 2-4 months to recruit and hire employees, set up payroll, obtain all the necessary insurance, ensure all employee postings and notices are in place, ensure all offer letters and other agreements with employees are drafted in compliance with applicable federal, state and local laws and other necessary tasks are completed. Below is a checklist of the basic steps that should be completed before the Center s first employee starts work. This is a guideline only and the Chinese business should consult legal counsel to confirm its employment plans and to assist with the steps below: Register with the state tax authorities (in California, the agency is the Employment Development Department) after receiving its FEIN. Obtain all required workers compensation insurance. Ensure the Center posts all required federal and state employment postings. Engage a qualified vendor (such as ADP, Administaff, Paychex, TriNet) or accounting person with significant payroll experience to prepare and process payroll. Prepare forms of offer letters, employee handbooks, confidential information and invention assignment agreements and other agreements. Obtain guidance and assistance on proper interview questions, background checks, required consent and notification forms and reference checks. Engage immigration counsel before making any offers or promises of employment to individuals without work status in the U.S. Prepare job descriptions which will be useful in determining whether the position is exempt or non-exempt from overtime and certain other legal requirements. Ensure that compensation rates, methods and related record-keeping comply with applicable wage and hour law and that management is trained on requirements for overtime pay, meal and rest breaks and other wage and hour issues. Comply with federal, state and local law requirements to provide any paid sick time, health insurance or health benefits, any minimum wage which might be higher than the federal minimum wage along with any local posting requirements. Intellectual Property Strategy The purpose of an IP strategy is to protect and support the Chinese company s business. The strategy should help maximize the value derived from research and development at the Center. Most of the Center s results may be protected under one or more types of IP law such as patent, trade secret, copyright or trademark law. Both federal and state laws will typically apply to each type of IP protection. IP developed at the Center will be subject to U.S. law initially, since the Center resides in the U.S. The IP strategy includes an evaluation of R&D results, case-by-case, to determine what type of IP protection is more appropriate, given the company s goals. Maximizing IP value requires an understanding of these various laws as well as the international treaties affecting IP rights. 5

U.S. Patent Law Patents are the strongest form of protection, since patentees obtain the right to stop others from utilizing the patented invention in exchange for disclosing certain information about the invention. While various treaties such as the Patent Cooperation Treaty (PCT) and the Paris Convention for the Protection of Industrial Property (Paris Convention) affect various rights for technology developed in the U.S., technology developed at the Center will be subject to U.S. law in the first instance. Therefore, it is important to understand certain U.S. patent law requirements in order to obtain valid IP rights. It is also important to understand how patent laws differ between countries in order to have an IP strategy that can maximize IP value in all important markets. Contracts related to Patent Ownership U.S. state law governs contracts related to assignments of inventions made by Center employees and contractors.1 Because of differences in state law, an invention that is owned by a Center in one state under that state s law might be owned by the inventor if the Center resides in another state. The assignment provisions in the Center s employment and consulting agreements must comply with the law of the state in which the Center is located and should assign invention rights to the Center to the fullest extent possible under that state s law. Foreign Filing License China requires the inventors or owner of technology developed in China to file a patent application in China or obtain the State Intellectual Property Office s review for state secrets prior to filing a patent application outside of China. U.S. patent law similarly requires the inventors or owner of technology developed in the U.S. to file a patent application in the U.S. or obtain a foreign filing license before filing for patent protection outside the U.S. A U.S. patent may be invalid if the applicant files an initial application outside the U.S. without obtaining a foreign filing license and later files for and obtains a U.S. patent.2 This is also true for a PCT application that contains significant new information about the invention. A foreign filing license is advisable if the PCT application is to be submitted to a receiving office other than the U.S. Patent and Trademark Office (USPTO). Filing PCT Application in the Correct Receiving Office The PCT requires the patent applicant (in most cases, the company to which the invention has been assigned) to file its international application with the receiving office designated for the applicant s residence or nationality.3 If the application is filed with the wrong receiving office, that office will advise the applicant to correct the application or may forward the application to the International Bureau in Switzerland4 to process. The application s filing date in this instance is the date that the applicant files corrected papers or the date that the International Bureau processes the application. This process can delay application filing to a date later than the date that the application was submitted to the wrong receiving office. If the application has been filed with the wrong receiving office on the 1 A number of cases in California have considered whether an invention was owned by an inventor or a company where there was no agreement between them. California Labor Code 2870 specifies the broadest scope of inventions that an employer may require an employee to assign to the employer. 2 A patent is invalid under 35 U.S.C. 185 unless the failure to obtain a foreign filing license was through error. 35 U.S.C. 184 provides a way to obtain a foreign filing license if a patent application has erroneously not obtained a foreign filing license before filing a first foreign patent application. 3 See Patent Cooperation Treaty Articles 10 and 11 and Implementing Regulations Rules 18, 19 (2011). 4 The International Bureau is part of the World Intellectual Property Organization, which is responsible for administering PCT applications. 6

last day before priority applications are abandoned, the applicant may lose the benefit of priority to earlier patent applications. Consequently, PCT applications need to be filed with the correct receiving office. 1. U.S. Company Applicant. The designated receiving office for a U.S. applicant is the USPTO or the International Bureau. If the applicant will be the Center, a PCT application may be filed with the PCT branch of the USPTO. The USPTO will process the application and also review whether to grant a foreign filing license. 2. Chinese Company Applicant. a) U.S. Inventors Not Named as Applicants If the sole applicant named in the PCT application is the Chinese company, the receiving office for the PCT application is the Chinese patent office. The Center should obtain a foreign filing license for the application before the Chinese company files the PCT application. Therefore, the PCT application needs to be prepared with adequate time to have the foreign filing license granted before filing. b) U.S. Inventors Named as Applicants The USPTO may be an authorized receiving office if one or more inventors who are U.S. residents or U.S. nationals are designated as co-applicants. The recent changes to U.S. patent law under the America Invents Act (AIA)5 provide the option to designate inventors in the U.S. as inventors only or as applicants. The PCT application has the option of naming inventors as applicants for the U.S. only. Consequently, the PCT application may be filed with the USPTO if one or more of the U.S. inventors is named as an applicant. Prior Art Differences The changes in U.S. patent law under AIA were reported as a step toward harmonizing U.S. patent law with the laws of other countries, but significant differences remain. One difference is what qualifies as prior art. An inventor s public disclosure of the invention is not prior art to the U.S. patent application if the application is filed one year or less after the inventor s first public disclosure of the invention. China s patent law does not have a similar provision. China s patent law has a different set of exceptions for inventor disclosures that qualify as prior art.6 Other countries require absolute novelty. Therefore, the Center should control public disclosure of inventions to maintain the ability to pursue valid patents in China and many other countries. Another difference between U.S. and Chinese law is the standard used to assess obviousness of an invention where the prior art was filed before but published after the filing date of the Center s application ( secret prior art ). In China, the Center s invention must be substantially different from the invention discussed in the secret prior art. This standard is lower than China s obviousness assessment used for published prior art. In the U.S., the Center s invention must be new and not obvious in view of the secret prior art. U.S. law is stricter than Chinese law in these circumstances, and an invention that is patentable under Chinese law may not be patentable under U.S. law. Patent applications should generally be filed aggressively since early application submission is important in these circumstances. Even if an application is later determined not to be patentable in the 5 Leahy-Smith America Invents Act, Public Law 112-29, 125 Stat. 284-341 (2011). 6 See Patent Law of the People s Republic of China Article 24 (as amended through 2008). 7

U.S., applicants that file early may still use that early filing date as priority for applications around the world where the patenting standards may be less stringent. Written Description Differences China s law and regulations require almost literal support for subject matter that is claimed in a patent. The specification must directly and unambiguously describe what is claimed.7 U.S. law is less strict. A patent application must describe subject matter sufficiently that a person of ordinary skill understands the inventor was in possession of what is claimed. Patent applications should be prepared so that the text provides ways to amend claims during prosecution that do not require adding unwanted limitations into the claims. Otherwise, amended patent claims in China could be narrower and therefore easier to design around than amended claims in the U.S., allowing competitors to develop products in China that are very similar to the Chinese company s products. Patentable Subject Matter Another difference is the type of subject matter that may be patented in the U.S. as opposed to in China and other countries. The USPTO has historically granted patents to certain software and methods that may not be patented under China s law, which requires solution of a technical problem by a technical measure to provide a technical effect. In addition, plant and animal varieties, methods of diagnosing disease, and methods of treating disease are patentable under U.S. law but not under Chinese law. Trade Secrets Trade secret law provides the owner the right to stop others who obtained the trade secrets illegally. It can be used to protect valuable assets such as manufacturing processes, customer lists and other information that provides a competitive advantage. The owner must take reasonable steps to protect the confidentiality of the information. Trade secret protection in the U.S. is primarily based on state law. California law also provides for third party liability for trade secret theft under the California Uniform Trade Secrets Act (UTSA). Independent development is a defense to a claim of theft of a trade secret. Patent law grants the right to exclude others from practicing the patented invention even if others independently develop the invention, but trade secret law does not. Some types of technologies may not be protected effectively as a trade secret. For example, a mass marketed product may be reverse engineered by anyone who buys the product. Copyright Law If the Center s R&D result includes creation of original works, such as software, or other works, or use of copyrightable material from the Chinese business, a U.S. copyright protection program should be implemented. Copyright protection is easier to obtain than patent protection in the case of software, but may provide more limited protection because it encompasses only the actual expression and not the ideas or inventions covered in a work. In addition to software, copyright may be used for protection of web site content, advertising communications, audiovisual content, and other works of authorship. U.S. copyright protection is provided exclusively under federal law based on the U.S. Copyright Act. Independent development is a defense to a claim of infringement. Clean room 7 See State Intellectual Property Office s Guidelines for Examination, Part II, Chapter 8, 5.2.1.1 (2010). 8

procedures are commonly practiced in software development to preserve the originality requirement of copyright. Both the U.S. and China are parties to the Berne Convention, which is the most important international treaty affecting the rights of copyright owners. In some instances, the Center s R&D activities may benefit from the Berne Convention if software, for example, as used by the Center is considered to be a Chinese work, and the Chinese business that owns the work has complied with any applicable copyright formalities in China. Even in the case of a registered foreign work, however, compliance with U.S. copyright registration formalities brings critical statutory benefits. Specifically, the U.S. Copyright Act makes statutory damages, which can range up to $150,000 per work infringed, and attorneys fees available only to parties including foreign copyright owners who have complied with U.S. registration formalities. Registration prior to initiation of the infringement is also essential to claim these remedies. These statutory damages and attorneys fees available under U.S. copyright law are often the most important enforcement tools for a copyright owner given the difficulty of proving actual damages, such as lost sales or a defendant s profits. Accordingly, a formalized U.S. copyright registration program for protecting software and other works is essential for maximizing protection. For software owners concerned about public disclosure of proprietary information, the U.S. Copyright Office provides procedures permitting redaction of trade secret material from software deposit copies in the registration process so that confidential material does not appear in the public record due to the registration process. Trademark Law Trademarks can be of great value to the commercialization of the results of the Center s R&D. Registration of trademarks provides important evidentiary presumptions in court proceedings, entitles the owner to affix the symbol, and enhances the ability to police confusingly similar marks adopted by third parties. Registration also is mandatory for U.S. anti-counterfeiting efforts. Enforcement efforts and proper licensing are critical in preventing erosion of rights. Accordingly, a Center should develop a U.S. trademark program that maximizes registered protection, enforces against infringing uses and controls use by licensees. Trademark law in the U.S. is governed by the Lanham Act at the federal level as well as by various state laws. Under the Lanham Act, infringement may be found in the case of use of an identical or similar mark based upon a likelihood of confusion as to affiliation, sponsorship or source. Trademark protection in the U.S. may extend to related goods, not just the exact goods under a registration. Unlike in China, superior rights in the U.S. are determined based upon the party that is first to use a trademark at common law, rather than the first to file or register. As a result, before initiating use of a trademark, the Center should have trademark searches conducted that investigate prior users of the same or similar marks as well as potentially conflicting trademark applicants and registrants with the USPTO. Also differently than under Chinese law, full enforceability of a registered trademark under U.S. law requires that a trademark owner prove actual use of a trademark in the U.S. prior to the grant of registration. However, under the provisions of international treaties to which the U.S. is a party, a trademark previously registered in another country such as China may be able to obtain a more limited defensive protection in the U.S. without proof of use. The Center should consult with a U.S. trademark attorney to determine the best strategy for utilizing foreign trademark registrations as bases for initiation of U.S. trademark rights. For Chinese businesses planning a future U.S. market launch, the Lanham Act also has provisions for intent-to-use applications that permit a trademark owner to obtain nationwide priority as of the original filing date once registration has issued. These intent-to- 9

use applications can be used to clear and select trademarks up to several years in advance with reasonable certainty that the preferred name will be available for product launch. Both the U.S. and China are parties to the Paris Convention, which allows a trademark owner making a filing in either the U.S. or China to make a subsequent filing in the other country within six months and claim the priority of the original filing. Thus a subsequent U.S. trademark filing may relate back to the date of Chinese trademark filing for purposes of priority during the first six months following the Chinese filing date, and vice versa. This ability to claim priority based on a foreign filing can assist in rapidly orchestrating a brand launch or a defense to infringement covering both the U.S. and Chinese markets. ******************************************************* An R&D center in the U.S. provides access to cutting edge technology, skilled engineers and universities where innovation is fostered. The U.S. is also a major market for commercialization of the results of R&D. A Center in the U.S. can help accelerate the pace as well as the likelihood of successful development of innovation and commercialization. Forming and operating the legal entity properly, planning for and implementing the right employment practices and having an IP strategy that maximizes the value of the results for the Chinese business are all important to a successful Center. Authors: Britt L. Anderson britt.anderson@klgates.com +1.650.798.6746 Fred M. Greguras fred.greguras@klgates.com +1.650.798.6708 Charles D. Holland chuck.holland@klgates.com +1.650.798.6710 Linda L. Usoz linda.usoz@klgates.com +1.650.798.6702 Yuki S. Ku yuki.ku@klgates.com +1.650.798.6731 Contact: Linda Zhou linda.zhou @klgates.com +1.650.798.6751 10

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