Caution Marks Outsourcing in China

By Stan Gibson  |  Posted 08-29-2005

Caution Marks Outsourcing in China

Lured by a skilled work force and rock-bottom wages, IT customers are eyeing China's outsourcers longingly, with one major misgiving: the risk of losing intellectual property.

To take advantage of the opportunity while still protecting sensitive data—customer records, proprietary business practices, patents, copyrights and trade secrets—some U.S. companies are taking a slow and careful approach to dealing with Chinese outsourcers.

The resulting rewards are modest, but the developing knowledge and trusted relationships promise bigger gains in the future.

Ozburn-Hessey Logistics, a transportation and storage management company in Nashville, Tenn., needed a labor productivity management tool for its warehouses. Six months ago, the company contracted with Chinese software developer Powerise International Software Co. Ltd. to write the software.

"It's an add-on to our warehousing software that shows individual and team productivity," said Bob Spieth, CIO at Ozburn-Hessey.

In connecting with Powerise, personal connections between a Chinese-American Ozburn-Hessey IT staffer and Powerise personnel were key. Since the project is small and does not include trade secrets or other critical corporate data, Spieth said he's not concerned about security risks.

However, if the project is successful, Ozburn-Hessey may want to invest in more strategically significant, and potentially riskier, work.

Another executive at a U.S. cosmetics maker also vouched for the virtues of starting small and relying on personal contacts. In setting up a manufacturing facility in China, he hired a trusted individual with nine years of experience working in China and 20 years in the cosmetics business to handle his company's operations on the ground.

Powell urges China to address intellectual property violations. Read more here.

"It's difficult to sue people, to have an SLA [service-level agreement] and to enforce it. So reputation is critical, and you have to have a great relationship with the people that refer you and the people you're dealing with," said the executive, who asked not to be named. "We're not going through outsourcing companies but going into the country itself."

In another project, the executive is working through a U.S.-based Chinese national to set up an office in China to test server security. While initially small, the project could be expanded into a help desk or other IT support facility.

Chinese outsourcers know that protection of IP is perceived to be an Achilles' heel of their country and their business, so they are ready with the right answers.

"It's probably the most overhyped issue. I have never had that problem, but perception is reality," said Walter Fang, vice president and chief technology officer of Neusoft Group Ltd., a software house based in Shenyang, China.

Founded in 1991, with annual revenues in 2003 of $270 million and 6,000 employees, Neusoft is among the more established Chinese software developers. Specializing in software for medical equipment such as MRI (magnetic resonance imaging), CT (computerized tomography) scan and ultrasound machines, the company has also co-developed human resources application software with Hewitt Associates LLC, of Lincolnshire, Ill.

"We cannot afford to be sued. That gives us a very good motivation," said Fang. To avoid a legal confrontation, Neusoft takes copious precautions, including maintaining a geographically separate development center for each client project and welcoming on-site liaison managers from client companies.

"Only employees on a given project can go to a given center," said Fang, adding that printers and USB drives are prohibited. Employees must sign a nondisclosure agreement in order to begin work and must sign another NDA should they depart the company. Fang also pointed out that U.S. and Chinese laws govern the contracts, which typically include Singapore as a site for independent arbitration in case of disputes.

William Bierce, a partner at Bierce & Kenerson P.C., in New York, said that Sweden is also a popular destination for dispute resolution.

"The Chinese are concerned that things will be slanted toward a Western point of view. Sweden is near Russia and has historically been neutral," Bierce said. Sweden became popular as a mediation zone during the early years of détente between the United States and the former Soviet Union, noted Bierce.

China's history has led the country to adopt a unique outlook on business, said another attorney. "They did away with property in terms of Communist theory. Now they're trying to establish the recognition of intangible property rights in a country that is pretty poor," said David Weild, a partner at Fross Zelnick Lehrman & Zissu PC, a New York law firm specializing in IP.

Next Page: China's Communist legacy affects IP laws.


's Communist Legacy Affects IP Laws">

China's Communist legacy means that the state permeates many activities.

This influence could affect whether a company receives sufficient backing to carry through on its obligations, Weild said.

A turning point for China was its joining the World Trade Organization in 2001, which meant that companies could approach Chinese partnerships with a greater sense of assurance—up to a point.

"Chinese laws today are actually quite good. They conform with WTO standards. Where the problem comes in is on the enforcement side," said Michael Mensik, a partner at Baker & McKenzie LLP, in Chicago.

With enforcement still largely untested, a U.S. company might do well to set up a captive operation, Mensik said in August at the China IT Service Summit in New York.

In addition to IP concerns, there is a host of other areas IT pros should be aware of before dealing with partners in China. For example, Mensik said, foreign investment is regulated in China and requires government approval and registration.

In addition, there are equity restrictions by industry, such as call centers, or so-called value-added telecommunications services, which may be only 50 percent foreign-equity controlled.

Further, businesses typically have a narrow, defined scope; foreign exchange is regulated; and loans must be registered within a certain time. Technology transfers are also regulated—approval is needed, and registration cannot be done online.

If that weren't enough, labor laws must be taken into account. Some notable differences, according to Mensik: There is no employment at will; written employee agreements preclude termination without cause and without severance or prior notice to the employee and to the labor union; disputes are subject to local arbitration with the right to appeal.

Further, Mensik noted, when an invention is created in the course of a worker's employment, the employer is liable to pay a certain percentage of profits to the employee.

In addition, said Mensik, public security and government employees have the right to examine employee communications. Bierce pointed out that this capability raises the question as to whether the government could be seizing information to create its own data repository. The danger is similar to that of industrial espionage, Bierce said.

Mensik stressed the need for a solid contract once all these considerations are taken into account.

"The IP is going to land in China; the work is going to be done in China. So you should get a master IP agreement," said Mensik. But perhaps more important than the agreement itself is simple trust. "It's the trust you develop during the negotiation process that will carry you over the bumps," Mensik said.

But, he added, China is becoming more adept at dealing with IP questions. "Companies that have had IP issues have found ways of dealing with it through civil actions [and] local police enforcement. It has changed dramatically in recent years," said Mensik.

One reason for such change may be that, after China became a WTO member in 2001, the Chinese government established the State Intellectual Property Office and State Copyright Bureau for the protection of IP, said Yu Cisheng, deputy director-general of the IT office of Beijing Municipality, which promotes the technology industry in the Beijing area.

Spurred by WTO directives, the Chinese government has also vowed to purchase "original software and bring along the whole society to employ original software," Cisheng told the New York conference audience.

For Chinese software companies, much is at stake. Powerise, which was founded in 1992 and had revenue of $50 million last year, has been listed on the Shenzhen, China, Stock Exchange but aspires to be listed on the Nasdaq.

With $20 million in U.S. sales at present, the Beijing-based company aims to build on that presence to achieve $100 million in sales within three years, Huichun Lin, CEO of Powerise, told the China IT Summit audience in New York.

"We are seeking to take advantage of money markets and management in the U.S.A. and use the advantage of training, expertise and cost in China," Lin said. "Our goal is becoming the best international software company in China."

So far, things are going smoothly in Powerise's relationship with Ozburn-Hessey. "If we didn't have a Chinese-speaking developer on staff, I think it would be a much different proposition," said Ozburn-Hessey's Spieth. And is he satisfied with the quality of work?

"I am, and we are," Spieth said.

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