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ICG Risk Blog - [ Low cost is not low risk: realities of IP Loss ]

Low cost is not low risk: realities of IP Loss


Previous: Trends in Intellectual Property IP transfer to China

This note builds upon the Intellectual Property (IP) protection series. Readers are encouraged to review:

The US supply base is undeniably concerned about IP loss in China; trade issues, protection of intellectual property and the opening of China's market to foreign products were high on the US agenda during Chinese president Hu Jintao's recent visit to North America. While certain assets are likely targets inside China, the key is to think "asset" instead of "country". Risk cannot be based on countries or "risky areas" but rather wherever a sufficiently valuable asset is accessible at any tier in any country - as the collector will move to the least defended point that contains the IP. We currently see, for example, collection efforts on the US west coast against electronics assets long before they are transferred to a presumably risky country in Asia. Commercial and dual-use technologies are high on the collection list.

The idea of trying to isolate "risky countries" with respect to IP migration remains unworkable due to the revenue loss and market share erosion that occurs when IP is withheld plus the fact that nations such as China demand that you be there in order with competent products in order to do business.

The three key areas of vulnerabilities remain the same: Pricing model compromise (supplier outsourcing, subcontracting, etc.), Data citadel attack (R&D hives and data warehouses), and Human resources (HR) churn. All three are critical, yet we find that HR too often gets scant attention even though collection effectiveness is high while risk and cost are low.

Yes, all technology migrates over time but most firms assume risk by default in (a) not identifying what is already compromised, (b) identifying what assets need to be protected and (c) the amount of dollars and effort needed to realistically protect those assets - wherever they occur in the supply chain. If a collector obtains a critical IP asset, the owner's entire ROI justification collapses along with the expected revenue stream. And when the IP asset is the core of a system or subsystem that often contains more mature, less competitive technology, the entire system revenue stream truncates.

Many of the risks to suppliers as well as OEMs were inadvertently demonstrated in a recent 2006 SAE World seminar, Lessons Learned in China: The Automotive Supplier Perspective distilled from "more than 50 interviews and surveys with executives of global automotive suppliers located in the U.S."

A firm expert in supply chain analysis and logistics, PRTM, had surveyed these global suppliers, distilling the collective supplier wisdom on attempts at IP protection as "To protect critical IP, choose components wisely, break up assemblies, select partners carefully and exploit all legal options." Unfortunately, all are ineffective in protecting IP as none of the four offer protection against even modest collection efforts. They are even less effective against an Asian style method of collection.

It validated our assessment that commercial supply bases have no effective protection whatsoever and whatever attempts that are being made at a 'solution' to IP risk are only lulling the targets into a false sense of security. Following is the text of the original PRTM IP protection slide from their survey followed by our commentary pointing out the weaknesses of each approach. (I hasten to note that PRTM was only presenting a collated supplier response, but I fear that the longer those efforts are allowed to stand without challenge, the more likely it is that PRTM will be associated with these de facto "best practices.") PRTM text is in italics and was transcribed from PRTM handouts:

Choose components wisely

  • Only source components which have reached maturity in marketplace
  • Only source basic components with little "design know-how"
  • Make IP protection a priority of your make/buy strategy
  • Or build your own plant in China

COMMENT: The market value of an asset trends downward from high value design to low value commodity. Such progressive value loss can often be mitigated if mature IP is integrated into systems led by a high value asset. It is difficult if not impossible to isolate the newer asset(s) from the older in the production of integrated systems. (In the case of electronics, for example, the asset will appear in three overlapping tiers: logic design, embedment in firmware and test.)

The damage from IP loss moves progressively up the value chain, to newer and more vital IP, in terms of future growth, because collectors are re-tasked to target and acquire more valuable IP.

Compromise of the high value asset compromises both the value of the lead asset as well as the maturing and mature technology components in the system. When there is an IP loss, it is most likely that the discovery will show that the damage to the business is not isolated and broader than anticipated.

There is no "build your own plant" option. Regardless of whether your firm moves into an existing structure or contracts its own, someone else will erect the building, install HVAC, electricals, electronics and contract the security function, guards included.

A local option that delivers protective control is feasible only with a complete IP asset protection program (including asset vulnerability assessments), and significant preparation in selecting and developing local supply chain relationships.

Break up the puzzle

  • Do not source too many components from one supplier
  • Piece out assembly to multiple suppliers in different regions - protect integration IP
  • Avoid giving unnecessary specification & drawing details

COMMENT: Location-specific IP protection is a partial approach - and too often a red herring - that rarely if ever adds much protective value for a global asset. Conversely, location-specific approaches often creates a false sense of comfort on the protective side. The accessibility of the asset to hostile IP collectors at any tier, at any location, is the key question.

Asset-specific protection, by contrast, is global, or requires a comprehensive view of asset accessibility in the supply chain. It almost always becomes optimally effective on the basis of a complete asset (value chain) exposure assessment to be effective.

Choose integrity tested partners

  • Check integrity history with current customers
  • Choose strategic partner with a vested interest in protecting your IP - heavily dependent upon both yours and his business success

COMMENT: Even under ideal conditions, partnering merely shares the risk of IP loss but does not control it. Under typical conditions, partnering is not controlled and generates additional risk. (Note the levels of IP transfer that already occur in any joint venture.)

Education and a clear delineation of joint interests is usually required, but frequently hard to affect and enforce.

Customers may not pre-disposed to cooperate with supplier IP protection efforts.

Invest in legal protection of IP

  • Ensure strong legal contract and non-disclosure agreement… but still proceed with extreme caution
  • Use Chinese lawyers to write detailed "contracts" - jointly signed in person
  • Prosecute offenders relentlessly

COMMENT: Unfortunately, legal remedies come after the economic damage is done or is underway, i.e., the ROI and revenue loss are unrecoverable.

Legal remedies are ineffective outside the US, parts of the EU and Australia, and may in fact be damaging to the litigating party.

A legal strategy may be useful for asset sales or portfolio management (disposition), and will likely be a necessary part of US-based due-diligence for Sarbanes Oxley compliance. It will have limited deterrent value at best for clandestine IP asset collectors.

Above these risks to IP, PRTM found that "the majority of North American automotive suppliers sourcing from China are not realizing great savings," that "over half the participants in [the PRTM] study achieved less than 40% of their savings goals" for their Chinese operations:

PRTM concluded that China sourcing requires a minimum savings of 20% to outweigh such negatives as costs associated with logistics, quality and intellectual property (IP) risks… [PRTM cautioned] suppliers not to get too excited about the low price of a Chinese-made component. "Premium freight is the most basic risk" [of] the hidden costs of doing business in China… [Suppliers] wishing to save money by producing in China need to factor in the cost of insurance [and] the cost of lawyers and investigative teams to enforce IP rights and allocate funds to cover quality-related risks associated with doing business with one of the country’s relatively new suppliers… Suppliers should carefully select their business partner in China by doing local research and networking, not flipping open the Yellow Pages

Given the substantive IP transfers inherent in joint ventures, it was interesting to note the ebbing of JVs:

As far as suppliers wanting to establish a China strategy, PRTM finds joint ventures are becoming a thing of the past, with 21% of respondents in a JV with a Chinese company in 2005 but just 14% expected to be in one by 2010. The growth in China sourcing will come in the form of greenfield plants [with] 28% of respondents taking this approach last year and 44% expected to in 2010. "Joint ventures are out"

Even these brief comments does not do the problem justice. We see otherwise skilled firms adopting an IP protection posture involving amateurish methods and unimplementable good intentions, often buttressed by the erroneous belief that US legal remedies are applicable on a global basis. Other firms violate the rule of "Absence of evidence is not evidence of absence." When no legitimate Vulnerability Assessment has been carried out, it is tenuous at best to claim that no penetrations have been made, or that no threats of collection exist.

Leave it to the English to be candid:

There is an almost suicidal rush now to transfer research and development operations to China lock, stock and barrel. Financial consultants have advised firms about the tax advantages of relocating R&D to China; you can hire researchers with PhDs very cheaply compared to the more advanced countries. All this raises the risk of loss and abuse of intellectual assets in a country where copycatting and intellectual property piracy have long been a national sport.

US and EU IP is being harvested at an intense rate by a hierarchy of collectors. In the case of China, Chinese firms are being pressured for increased margins while Chinese scientists and researchers are being pressured for national breakthroughs that create native Chinese advances not subject to foreign control and/or royalty payments.

Edward Tse's China's Five Surprises offers a fine structural analysis of points that most, if not a wide majority, of US and EU firms are not taking into account in planning their response to China. Even this aggressive posture as outlined by Tse is not enough to satisfy CCP goals for growth, thus the pressure on Chinese scientists to acquire foreign technology as part of their research.

In heated competitive atmospheres such as this, it is all too easy to view foreign IP as harvestable assets. Changes in Chinese law are reducing even the modest IP protection for foreign firms save for the efforts offered up to redress audio and film piracy. We have reason to believe that there is also an assumed feeling of impunity on the part of collectors in the face of feeble or ineffectual responses from targets.

We expect visibility of offshoring, outsourcing and IP theft to rise in the US 2006 and 2008 elections. It is a basic tenet of attack strategy that the attacker (collector) will step up activities in progress if they feel that a heightened security posture is imminent. What is belated good practice and awareness on the target side will be met with accelerated collection on the adversary side.

We recommend early adoption of prudent, non-adversarial business practices now to identify current exposure and to combat the forthcoming surge in collection efforts. Beware ineffectual IP protection tools and processes such as the mechanisms flagged above or IP protection pyramids that, while desirable, are fuzzy and leave the client without the tools to achieve its IP goals. We have achieved success with strategies drawn from proven Counterterrorism (CT) practices applied to Intellectual Property risk evaluation and remediation. We know from experience that these processes can be taught and that they are easy to embed as company best practices performed by its employees instead of an outside consultant. Properly done, IP protection becomes a crucial business attribute, like quality, lean manufacturing or robustness.

Next: Persistent limitations and deficiencies among the 'guardian class' of business advisors charged with protecting their clients' interests in China

Piracy in China Remains Concern For U.S. Firms
Cui Rong
Wall Street Journal
May 16, 2006

Bank of China's $9.9 Billion IPO Plan Vexed by Bad Loan Legacy
Luo Jun
May 16, 2006

In a Scientist's Fall, China Feels Robbed of Glory
New York Times
May 15, 2006

Chip fraud in China becomes embarrassing setback
Faked development of digital signal processors unravled
By Sumner Lemon
IDG News Service
May 15, 2006

Automotive Sourcing in China & Cost Savings [Title from weblog - may not be the paid subscriber title]
By Christie Schweinsberg
April 6, 2006
Mirror from
Manufacturing Forum, Practical Machinist

Study Reveals: Auto Suppliers Find No Cost Guarantee in China Sourcing
April 3, 2006
Mirror at China Supply Chain Council

Study Reveals: Auto Suppliers Find No Cost Guarantee in China Sourcing; OESA and PRTM Management Consultants' Survey: More Than Half of Companies Studied Achieved Less Than 40 Percent of China Sourcing Targets
Business Wire
April 3, 2006

Enter the Dragon? - Lessons Learned in China Sourcing
Executive summary [Handout obtained at SAE session presentation]
Andreas Mai and Stephen Pillsbury, PRTM Management Consultants
Findings from a study based on more than 50 automotive supplier executive team interviews and surveys of supplier experiences and best practices in China
Lessons Learned in China: The Automotive Supplier Perspective
SAE 2006 World Congress, Detroit, MI
April 3, 2006
NOTE: Best online summaries immediately above

Competition and trade in the U.S. auto parts sector
by Thomas H. Klier, senior economist, and James M. Rubenstein, Miami University of Ohio
Chicago Fed Letter
Research Department of the Federal Reserve Bank of Chicago
January 2006

Don't jump in without testing the water
Peter Humphrey, ChinaWhys
China-Britain Business Council (CBBC)

China’s Five Surprises
by Edward Tse
Strategy + Business
Winter 2005

GM Eyes Asia for Cost Cuts
Asian suppliers could help automaker trim costs
by Joseph Szczesny
Car Connection
Sept 12, 2005

Serial No. 109–34
MAY 17, 2005
Mildly indexable HTLM version

OE Auto Parts Supplier Strategy for the Next Ten Years
Marc Santucci
May 2, 2005

A "China Price" For Toyota
The auto giant is taking its cost-slashing drive to a new level. Can its suppliers match China's cheaper parts?
By Chester Dawson in Toyota City, with Karen Nickel Anhalt in Berlin
Business Week Online
FEBRUARY 21, 2005

Sourcing in China not a sure bet
By strategy + business
Special to CNET
February 7, 2005, 10:00 AM PST

Gordon Housworth

InfoT Public  Intellectual Property Theft Public  Risk Containment and Pricing Public  Strategic Risk Public  


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