Gathering Storm

Chinese tech companies are growing patent savvy, and Shenzhen -based Netac leads the charge. This year the company sued Sony--the first foreign corporation sued for patent violations in China.

By Lisa Lerer (IP Law & Business, Dec.,2005)

Chinese software engineer Frank Deng never thought of himself as an IP expert. But in September 2002, he found himself teaching the basics of patent law to Chinese reporters.

"They'd ask, 'What is IP patent?' " recalls Deng, who was born in China and polished his English in Singapore, working as an engineer for Royal Phillips Electronics N.V. "In 2002 not many people know IP so we have to do a lot of education."

Deng fell into the teaching role when his fledgling company, Netac Technology Co, Ltd., launched one of China's first patent infringement lawsuits, bringing a popular Western corporate weapon to the East. In September 2002, Netac claimed that its competitor, Beijing Huaqi Information Technology Co., Ltd., infringed the core technology of Netac's best-known product, OnlyDisc, a USB (universal serial bus) flash storage drive. Deng says that Netac invented the USB flash drive in 1999, before any other company. The company received its first Chinese patent on the technology in 2002.

Netac's case made headlines in the local press, and at first, it seemed like a public relations disaster. Commentators accused Netac of being overly litigious, says Deng. More than half of the visitors to a popular Chinese search engine, Sina.com, surveyed in a 2002 poll, said that they believed that Netac's behavior was monopolistic. But three years later, Deng is over the bad press.

"That's OK," he says, "it doesn't matter because we won." In June 2004, the Intermediate People's Court of Shenzhen ruled that Huaqi was infringing Netac's patents, awarded Netac damages, and prohibited Huaqi from selling the infringing product. Huaqi is fighting back--appealing the case and asking the Chinese patent office to reexamine the USB patent. The appeal has been stayed, pending the results of the reexamination.

As more Chinese tech companies like Netac get savvy about patents, suits against Westerners are certain to grow. And fighting a Chinese company on its home turf is like scaling the Great Wall--with one hand tied behind your back.

Netac's aggressive patent use--and its win against Huaqi--has made it into a top brand, and has turned the 37-year-old Deng into another millionaire member of China's new tech elite. Deng has become a technology-savvy general, overpowering his competitors with an army of lawyers and an arsenal of patents. Most Chinese companies focus on manufacturing, offering cheap outsourced labor to larger multinationals. "We don't think that's the right way," says Deng. Rather than simply offering the China price--based on cheap labor and goods--Netac develops and patents technology, leveraging those inventions into manufacturing deals with technology giants like IBM Corporation, Dell Inc., Samsung Corporation, and Toshiba Corporation. If competitors aren't agreeable, Netac threatens litigation, a standard Western practice that is relatively new in China.

Even before Netac went to court, the company was ahead of the IP curve. "Most [Chinese] companies have heard about IP and will say that it's is very important," says Tony Chen, a litigation partner in Paul Hastings's Shanghai office, "but they don't actually do anything with it." Netac is different, in part, because of Deng's experiences in Singapore in the mid-1990s. Working outside China teaches sea turtles--the Chinese nickname for Western-educated, or -employed, citizens--how to take full advantage of IP portfolios, says Chen.

At Phillips, Deng and Cheng, who was a hardware engineer at the company, began to design a product based around the new USB 1.1 standard, which allowed USB ports to support more advanced software. That product became OnlyDisc. In 1999 the pair returned to China, and founded Netac with their invention and just $35,000.

At a time when few Chinese companies held patents and even fewer had in-house IP counsel, Netac's first hires were two lawyers, a general counsel and an IP counsel, who immediately filed for a Chinese patent on OnlyDisc's core technology. Two years later--before the patent issued--Huaqi unveiled a new USB flash drive, similar to Netac's. Netac approached, offering licensing and manufacturing deals but, according to Deng, Huaqi refused to work with the company. "They don't think IP is a big deal," says Deng, "but we think our IP will work for us." Huaqi couldn't be reached for comment.

As soon as the State Intellectual Property Office (SIPO) awarded Netac a patent in 2002, the company filed suit in the Intermediate People's Court of Shenzhen against Huaqi, its distributors, and Taiwanese manufacturers Beijing Acer Information Co., Ltd., and Tai Guen Enterprise Co., claiming $490,000 in damages. Acer and TGE soon settled, agreeing to pay an undisclosed amount and cease production of the infringing drive. But Huaqi and its distributors kept fighting, and because of the case's technical complexity, the litigation dragged on significantly longer than the average six months. Finally, after two years, the court ordered the defendants to pay $125,000 and stop the manufacturing and distribution of the infringing flash drive. Huaqi appealed to the Guangdong High People's Court, which heard the case last year. A decision is pending.

Even with the reexamination hanging over Netac's head, the trial win against Huaqi established the company's brand, says Deng. In a country that counterfeits everything from toothpaste to cars, being officially declared real--with a patent case--can be great for business. Since the win, Netac's raised its prices 10?0 percent, while still winning lucrative government contracts, including one with the army. According to Deng, the suit forced Huaqi to scale back its operations and propelled five multinationals into licensing deals with Netac. The company has also gotten larger government research grants, allowing Netac to invest over $12 million in R&D. Last year the 350-employee company had sales revenue of more than $62.5 million.

With Netac leading the charge, Chinese companies are slowly starting to take on foreigners in Chinese courts. Last year 4 percent of 8,332 civil IP court cases featured foreign parties, an increase from 1.3 percent in 2003. Most of those cases involved a foreign company suing a Chinese manufacturer. But lawyers practicing in China expect those numbers to eventually flip as more Chinese companies receive patents. "I've been telling clients here, 訨ust get ready. Like it or not you are going to get sued in China,' " says Jones Day's Bai. A handful of these cases have already begun. In July 2004 regulators overturned Pfizer Inc.'s Viagra patent after a group a Chinese companies complained to the State Intellectual Property Office, arguing that the patent violated the novelty requirement. (Pfizer has appealed.) In April, Chinese networking company Beijing Donjin Xianda Technology Co. Ltd sued Intel Corporation for violating unfair competition laws.

A growth in patent litigation may be an inevitable result of a rise in Chinese patents. From 1985 to 2000, SIPO handled about one million patent applications. By 2004, that number had doubled. Most of these new applicants work in Netac's Shenzhen neighborhood, a once sleepy fishing village now bursting with gleaming skyscrapers, office parks, multi-story shopping malls, and a young, often-Western educated tech elite. Netac's headquarters are surrounded by IP-savvy compatriots, including the networking company Huawei Technologies Co., Ltd.--well-known for its (now settled) U.S. patent litigation with Cisco Systems, Inc. Huawei holds over 8,000 patent applications worldwide.

At press time, Netac's patent portfolio had ballooned to 200 Chinese patents and 50 international patents. Building an IP portfolio is important for Chinese companies, says Deng, because China won't always be able to offer the cheapest goods. "Someday Vietnam or India or Sri Lanka could get cheaper labor and then a cheaper price," says Deng, "so a lot of companies think IP technology is more and more important."

Last December, Netac was awarded its first U.S. patent, which Pan claims is almost identical to the reexamined Chinese patent. Before the U.S. Patent and Trademark Office granted Netac's patent, Pan says that examiners reviewed all the evidence submitted by M-Systems and Huaqi to the Chinese Patent Reexamination Committee.

With a U.S. patent in its arsenal, Netac is now considering international attacks. According to Pan, other multinationals produce and sell Flash memory drives without Netac's permission. In March, Deng told the English-language newspaper China Daily that Netac was investigating SanDisk Corporation, Dell Inc., Hewlett-Packard Company, and Apple Computer, Inc., claiming that the iPod Shuffle infringed Netac's flash drive patent. But invading the U.S. may not be that easy, warns Bai. Few Chinese lawyers knew how to draft overseas patents three or five years ago. So, says Bai, they wrote claims too narrowly for effective American-style legal warfare. "The patent applications I have seen so far are all a half-assed job," he says. "They're worthless." Rather than enter the U.S. legal system, Bai thinks Chinese companies should capitalize on their home court advantage and countersue American companies in China. "What a great way to level the playing field," he says.

(Reshipment and little deletion by Netac)