The One China Supreme Court Decision that Could Complicate the World’s Supply Chain

The following article was first published on IPWATCHDOG on June 9, 2020; click here to access the article.

By Amy Hsiao & Tyler King

For months now, the news has been plastered with updates on COVID-19, the novel coronavirus that has upended lives and trickled into near every facet of the modern experience. Across the political aisle, consumers and producers are questioning the current level of reliance on Chinese production for drugs, ventilators, and masks. Despite these concerns, most manufacturing alternatives, including India, are still working to reestablish normalcy, making China even more indispensable. Realistically, China is and will remain the dominant player for outsourcing production for at least the next five years. Now that Chinese factories are producing close to their full capacity, foreign investors should refocus their attention to newfound legal issues that may complicate the supply chain.

In the Original Equipment Manufacturer (OEM) supply chain, Western companies outsource product manufacturing to China and sell the goods back to the United States at a high margin. This process has triggered a spike in consumption, fueled by a steady decline in prices for everyday products. Interestingly, China has also gradually shifted from being the “World’s Factory” to a retail giant, second only to the United States (2019). The Chinese government has made it clear through national policies, like the “Belt & Road” and “Made in China 2025” initiatives, that its goal is not to serve as the back-door factory for global brands, but to create brands of its own and produce high-value products and services. As such, the OEM industry is falling out of the government’s political favor; this is also reflected on its legal status. The Chinese Supreme People’s Court (“SPC”) has reneged on OEM precedents, exposing OEM arrangements to new legal risks and scrutiny.

The Key Question:

As an example, let’s say a U.S. company (Cooper Inc.) is the owner of a successful pet toy brand called “CHESTER”; it has long engaged a Chinese company (Mr. Wang) in Shenzhen to manufacture and export the pet toys back to the US. Cooper Inc. does not own any trademarks in China. In fact, a third party (Ms. Piper) owns the trademark “CHESTER” covering the pet toy category. This Ms. Piper can be anyone: Someone who used to work at Mr. Wang’s factory, or someone who simply watched Shark Tank one day and loved Cooper CEO’s pitch and decided to register the brand in China.

• Question (1): Can Ms. Piper successfully bring a trademark infringement claim against Cooper Inc.’s manufacturing and shipping activities involving the affixing of CHESTER trademark on pet toys when Piper is the owner of the trademark in China?
• Question (2): Can Cooper Inc. defend the infringement claim by pointing out although it doesn’t own the trademark in China, it owns the trademark in the U.S.A. where the shipment is bound?
• Question (3): Now, assuming Ms. Piper simply created the CHESTER mark herself without having any prior exposure to Cooper’s brand or company, can she still stop Cooper Inc. from making the products in China bearing her trademark?

China, like most Asian countries, is a first to file country. Simply put, this means the IP ownership of a trademark belongs to the party that registers the trademark first with the China Trademark Office. The law is clear-cut, but the major flaw is that it also disregards some prior “rights,” like the rights of a company that created and used a brand for years but simply does not register the brand’s mark in China. This also means there are a lot of opportunistic bad-faith players in China who are not the parties first inventing or using the brand, but are able to hold the real brand owners hostage because, under the Chinese law, these brand owners are the infringers to their own brand. If happens, the bad actor can put the entire OEM factory and hundreds of jobs at risk simply because he or she beats everyone else and registers the mark in China. To prevent this, the SPC made an exception in the PRETUL and the DONG FENG cases to shield the OEM industry.

The PRETUL Case (2015) and the DONG FENG Case (2017)

Under the standard given in Pujiang Yahuan Lock Co Ltd v Focker Security Products International Limited ((2014) MinTiZi No 38) (the “PRETUL case”), the act of affixing a mark to goods, without any intent to distribute or sell the goods in the domestic China market, did not constitute use of a trademark. Put simply, this OEM activity is not trademark use because it is merely attaching a physical mark and the resulting product will be tightly sealed and immediately bound for markets outside China. Such use cannot take on the function of identifying the source of goods and there is little possibility to cause consumer confusion in the Chinese market. Accordingly, in this context, it is not possible to infringe the Chinese owner’s trademark rights.

In December 2017, the SPC held a retrial of Jiangsu Chang Jia Jin Feng Power Machinery Co., Ltd v. Shanghai Diesel Engine Co. Ltd ((2016) Zui Gao Fa Min Zai No 339) (the “DONG FENG case”), affirming the PRETUL principle by applying the same standards discussed in the case. Once again, the SPC noted that the mere act of affixing a mark did not rise to the level of trademark infringement, as it would not affect the normal identification and distinguishing function of the Chinese owner’s trademark rights.

Under the twin standards of PRETUL and DONG FENG, OEM factories could safely affix the trademarks of their clients to goods for export without concern of violating Chinese law (or bowing too much or paying the ransom to the third party who happens to be the first to register the trademark). Following these two cases, the Chinese manufacturing factories and plants were satisfied because there was little risk of infringement litigation or shipment detentions at customs. If questioned, they could simply produce the OEM order or the registration certificate from the destination country (be it from the United States, Indonesia or anywhere in the world). The Western brand owners were happy as well, though it was frustrating their trademarks were taken in China, they could still get the products made and shipped out of China. The unspoken reality is that most Western brands are already taken and registered by a bad-faith third party in China; unless some drastic (and usually expensive) measures are taken, it is almost impossible to get the trademark back soon enough to meet business timelines. The SPC created a clever solution: so long as the business activities in China were limited to OEM (i.e., no marketing or selling the products to the domestic Chinese consumers), brand owners could operate without a China- registered trademark.

The HONDA Case (2019)

However, things took a different turn in 2019, leading into 2020. In September 2019, the SPC decided Honda Motor Co Ltd v Chongqing Hengsheng Xintai Trading Co Ltd ((2019) Zui Gao Fa Min Zai No 138) (the HONDA case), which departed from the prior jurisprudence in the PRETUL and DONG FENG cases. Here are the basic facts in the HONDA case:

• Honda, the famous Japanese car company, owns various HONDA trademark registrations in China.
• Two companies in China were commissioned by a third company (called Burmese Meihua Company Limited) to manufacture and export motorcycle parts to Myanmar. These products will bear the trademark: “HONDAKIT & Design”. Meihua owns a Burmese trademark registration for “HONDAKIT”.
• In 2016, the production was completed but the goods were stopped at the customs in China, suspecting infringement to Honda’s trademark rights. The shipment was released because the customs, upon showing of the Burmese trademark, was not able to determine if this case was indeed a trademark infringement case.
• In 2016, Honda filed a trademark infringement lawsuit against the two companies in China who oversaw manufacturing and exporting. While the first court that heard the case found in favor of Honda for $43,000, a second court dismissed an infringement claim, pointing out this was an OEM case and therefore was under the PRETUL and the DONG FENG standards (no possible trademark infringement). In 2019, SPC issued a shocking retrial judgment, confirming that, although the facts in the case fit squarely in the OEM context, infringement could still be possible, and was indeed present in the case at bar.

There are several factors in the Honda case that support an infringement finding: (1) HONDA is an extremely popular and well-known trademark in China; (2) there are bad-faith factors present in this case. For example, although the defendant did indeed own the trademark in the destination country, its trademark did not match the mark in use. Based on the above, although SPC did agree the relation between Meihua and the defendants was indeed an OEM arrangement, SPC went on to find infringement. In the Honda case, SPC pointed out that consumer confusion is still likely because the resulting products from the OEM relationship could still be “accessed” by the relevant public, e.g. the operators of goods transportation, the Chinese consumers travelling abroad or making cross-border online shopping. Note that there is no discussion about actual confusion; when SPC is determined not to protect a bad-faith actor, the hypothetical possibility of a confusion will do.

The HONDA case rips apart the presumption of OEM immunity. A party is able to successfully bring a lawsuit and cause shipments to be detained at the Chinese border, as long as one owns the registered trademark in China can point to a few more factors that tip the scale to its favor.

The HONDA decision made it clear that a trademark infringement is no longer black and white in the OEM context; OEM’s are no longer insulated from China’s trademark law. Implicit in the decision and consistent with China’s national policies is the determination that China is no longer interested in being merely the World’s Factory; given OEM is no longer the main pillar of China’s economy, it is subject to scrutiny, just like every other commercial activity.

What’s Next?

China’s trademark system is still full of bad-faith filings, where bad actors own multiple third parties’ trademarks, including some of the world’s most famous brands. Now, with the PRETUL-DONG FENG protection gone, Western companies manufacturing their products in China will face new scrutiny; everything is now in a “gray area”, with no guarantee of protection from China’s top court.

In 2020, despite multiple amendments to the Trademark Law, including the newly issued standards in determining infringements, little guidance has been given from SPC or China’s regulatory bodies on this OME issue. Chinese rightsholders are now encouraged to file for infringement lawsuits and to register “their” marks with the customs to trigger shipment seizure/detainment. Some of these cases are justified, just like the HONDA case, but others may be motivated by bad faith to hold a legitimate brandowners hostage. Following HONDA, a bad-faith trademark owner can now cause real business disruption by delaying a U.S.-bound shipment at the Chinese customs, unless the rightsholder is either willing to pay a ransom or spend six plus months in court. For example, a shipment valued at $2.5 million is detained at the customs port at Guangzhou; the U.S. brand owner does not have a Chinese trademark because the mark has long been taken by a Chinese individual named Linda Lin. Linda demands a payment of $200,000. The cost of a Chinese litigation is approximately $150,000; although there is certainly hope in winning the litigation, six months can mean delivery deadlines missed and business opportunities lost. OEM is a vital lifeline for the Western world and particularly for small businesses. Although OEM-infringement litigations will likely increase in China, the immediate threat is at the customs level which controls the ability to get products out of China; the lack of clarify in this process and assurance from the Chinese courts can literally and easily destroy small businesses. With the HONDA decision, the SPC has thrown out the clear rules that previously guided foreign direct investment, trade, and manufacturing choices.

If drawn into a trademark dispute, Western brand owners should establish whether there is an OEM arrangement; if there is no OEM arrangement and the trademark is taken by an aggressive third party, the brand owners have little remedy and are unlikely to prevail. If the arrangement is OEM, the trademark is well-known, and the used mark is more similar to the foreign trademark registration than to the Chinese registration, there could be a good case to overcome the dispute raised by the Chinese mark owner or questions from the customs, or both. The HONDA case has highlighted the importance of (1) exploring trademarks in China for both OEM and non-OEM purposes, (2) ensuring confidentiality throughout the OEM process to prevent exposure of the goods to the Chinese market, and (3) conducting trademark monitoring and risk assessment in advance. After all, this process directly implicates the global supply chain.

While the HONDA case precedent may be concerning, it is also subject to later reevaluation or discretionary regional enforcement. It remains to be seen what impact the HONDA case will have on OEM the OEM process but suffice it to say that China is moving beyond OEM.