Chinese Companies' Legal Approach

Welcome everyone to another edition of my China Tech Law Newsletter, where I talk about the legal issues foreign technology companies face in China.?The first three editions of the blog have been fairly technical - on ICP licenses, VIE structures, and data privacy regulations.?

This time I’m going to switch gears a bit and talk less on practice points and more generally about working with Chinese clients, specifically in the semiconductor design industry.?Hopefully its relevant to you, the reader, if you do business with Chinese technology companies and want to know more how they operate.

I'm familiar with the semiconductor industry here from my time as Asia Pacific General Counsel for 6 years at Cadence Design Systems, a NASDAQ listed provider of advanced software tools used to design semiconductor chips.??

Cadence, at least to the outside world, was a very boring company when I joined over 10 years ago.?Today, its anything but boring.?Cadence and its competitor Synopsys are key players in the semiconductor industry value chain, a value chain which has now been placed at the frontline of the economic competition between China and the US.? For better or worse (yeah, definitely better), this really became the case only after I left Cadence and went back to private practice.?

My practice at our firm today includes advising some of the younger, up-and-coming Chinese semiconductor design companies on the employment, IP and licensing issues they face day-to-day.?These companies do encounter US export control issues which are difficult and highly specialized. We have our clients work with partner law firms in the US when these questions come up.

THE SEMICONDUCTOR INDUSTRY 101

I thoroughly enjoy working with these companies and their young in-house counsel.?To understand the environment they are operating in, let me give you a sense of the industry.?

At a very high level, putting together a semiconductor chip involves a lot of design work on the front end before it finally gets manufactured at?what we refer to as?a “fab”. And on the very, very?front end, the starting point is design work using eDA tools of the type Cadence offers.?

This is computer aided design on steroids - the software tools that help you align?at a very microscopic level, lots of transistors?in the most efficient way possible.?And because of the numbers and complexity involved at that microscopic level, the actual design output has to be automated - the “A” in eDA.?

Some design firms are massive (think Qualcomm) and are "fabless" design houses that use?eDA design tools to?design chips for third parties. Fabless because they don’t have their own manufacturing facilities.?The designs are sent to?places like TSMC?(Taiwan Semiconductor Manufacturing Corporation), or Semiconductor Manufacturing International Corporation (SMIC)?here in Shanghai, also known as foundries.?The foundries, through a modern day miracle using some of the most advanced engineering in the world, manufacture chips out of silicon which then eventually go into a device, integrated into a laptop, phone,?and now more and more automobiles.?

The work for designers and manufacturers alike continues to get more complicated as the upper limits of?Moore's law?set in and the physics make it difficult?to?squeeze more and more transistors into a finite space. Getting the chips smaller and smaller in size is requiring ever more capital for the foundries to manufacture. And here is where the scale of someone like TSMC as a contract manufacturing giant, has been able to pull ahead of every other foundry in the world, including Intel.

As you can probably imagine, to make all this magic work and to continually optimize?the traditional tradeoffs between?chip size, speed,?and power consumption,?the?different parts of the value chain – eDA companies, design houses, foundries and others all have?to seamlessly work together?on compatibility and ongoing support years ahead of rolling out a new fabrication standard.

FUNDING AND TALENT IN CHINA

Now back to China and its indigenous semiconductor ecosystem.?A?large number of Chinese design houses and now eDA companies have started in the last few years to take up demand and help the Chinese industry become more self-sufficient. In addition to government subsidies, venture capital has flooded the system, perhaps too much so, with some distortion effects on allocation of talent and market opportunities among winners and losers.?

Venture capital investment tripled in?the industry in?2020 compared 2019.?The draw of course is a huge growing market and potential exit for the investments on local exchanges, especially with the opening of the?NASDAQ-like?Star Market,?where 32 chip companies went public on China’s A-share market in 2020 compared to 18 in 2019.

Even with money falling from the sky, like any industry, you still need enough of a talent pool to draw on to make things work.?China for sure has an exceptional reserve of electrical engineering talent (which I worked with every day at Cadence Design Systems) which have cut its teeth for many years for the international semiconductor eDA and design companies here.?

Nevertheless, to show you the growth here, the?China Semiconductor Industry Association still?estimates there is a?talent shortfall of?300,000 engineers.?That may be changing as more graduates come back to hard tech such as semiconductor with the internet companies finally cooling and laying people off a bit in the last few months.?Of course its not just a raw numbers game.?What is most lacking is actual advanced project management (tapeout) experience. Most engineers at the leading global semiconductor companies here have worked in R&D, but as part of a larger global team with the most senior engineering leadership back at company HQ.

LEGAL DEPARMENTS

As you can see, the semiconductor industry is not an easy industry for a non-engineer to wrap their head around, myself included (especially that first year on the job).?Even the sales teams and certainly most senior leadership all have electrical engineering backgrounds.?You have to in order to truly understand how the products work.?

For the supporting teams like legal functions, at the moment, the industry is growing quite fast, and so are the requirements both on understanding global export control rules and the need to protect IP.?

New eDA and design companies are not typical startups.?They are well-funded and have legal counsel basically from day one, because they have to.?Unlike other startups which might build a minimum viable product and figure out their business model as they go, these companies have specific big customers they are born to try to serve and must be operating at those companies’ standards from the get-go on licensing, IP protection, global compliance, etc.?

But given the supply of legal talent not keeping up with demand, these companies typically have to hire very smart but young in-house counsel who are still getting experience in the industry.?The pay packages are attractive and include stock as the companies looks for that IPO 3 or 4 years down the road.?These are the people I work with every day as clients.?

Things have changed quite a bit from when I was in their shoes.?When I first started negotiating contracts with some of the largest mainland Chinese customers, we had our standard template license agreements which I had been used to fighting over with clients in Korea and Taiwan.?When it came to clients in mainland China, I was ready to roll-up my sleeves.?We had 30 years anticipating every argument our customers would make.?It was going to be a totally unfair fight!

To my (na?ve) surprise at the time, many contracts were never negotiated at all.??A large contract with a customer in Korea might be a matter of months to iron out the license agreement, in China it might not be reviewed at all and signed by an engineering director without legal review.?

Today, these companies from big to small, as embodied by their legal departments, have tremendous respect for IP and most definitely read and negotiate every major contract they sign.?Source code, know-how, and patents, are the lifeblood of these companies.?These companies have so much more of their own valuable IP than 10 years ago, and they’re protecting it from other Chinese competitors.?

Legal contracts matter, and the environment to enforce those agreements has also improved dramatically especially in the large cities like Shanghai, Beijing, and Shenzhen. And the improving environment benefits everyone - Chinese and foreign companies alike.

PRACTICE POINTS

I mentioned up top, this blog entry is lighter on practice points than previous editions.?

The issues that Chinese eDA companies face with their customers are the same that (semiconductor industry) software licensors face around the world.?What differs perhaps is the bargaining power and trade-offs made in getting a deal done.?

Here is how a typical conversation might go, exaggerated a bit for humor and dramatic effect.

Warranty

Customer: Where is the product warranty in the license agreement?

Software vendor: Uh, there is no warranty.?

Customer: No warranty??Don’t you stand behind your products?

Software vendor: We do stand behind our products, that’s why we sell you maintenance and software updates.

Customer: Wait, can I license the software without buying the maintenance?

Software vendor: Uh, no.?Its a bundled deal.

Customer: So let me get this straight, you’re charging me to fix your own bugs?

Software vendor: Uh, yes.

Ok this is an over-simplification.?No software is error or bug-free.?The warranty is also about more than just bugs.?There is no warranty that the software will meet customer’s requirements.?Each customer’s requirements will be different, we’re selling a tool here like Microsoft Excel, we’re not making customized spreadsheets for you.

Could you as the customer interpret it to mean that the software may not even work at all?? Well you could, but no one does and in reality if there are problems with the software, you don’t look to a vendor’s warranty, you look to a vendor’s reputation in this kind of niche industry to care enough to make all efforts to fix things.

Rounding out the warranty subject, there is no warranty that the software won’t infringe on a third party’s IP.?If there is an IP infringement issue, your remedy is to invoke the IP indemnification clause for us to defend you, thank you very much!

IP Indemnity

Most indemnities work like this.?When a third party sues a customer for using software that violates their IP, we need the option to defend the case directly?or we let them defend and we reimburse them for damages and reasonable legal costs.?The customer being sued cannot settle without our approval.?If we don’t win, we have to either (1) get the proper IP rights from the 3rd?party, (2) replace or modify so the software is not infringing anymore, or (3) terminate the license to customer and refund them the license fees.?

Picking up the exaggerated conversation again, honing in on (3) above:

Customer: You’re telling me I could be sued by a third party because of your IP infringement and you’re potentially going to leave me hanging here?

Software vendor: Uh, well, it's not likely but we have to cover that bet-the-company contingency.?In that case, we’ll try to procure a license to avoid infringement. But the other party may be unreasonable.?We have an amazing (but small) engineering team that will try to come up with a workaround (but we can’t make Herculean efforts if its not practical given our resources).

In the face of an intransigent third party with no work-around, the only option could be a refund of the license fees.?Hey, knowing we can do this with our customers actually helps give us negotiating power with the third party to find a settlement as they can't essentially blackmail us!?But otherwise, worst case scenario, uh yeah you’re going to be hanging there and have to switch tools in mid-design cycle (cue audible "gulp" sound)...?

All extremely hypothetical and unlikely, but us lawyers are trained to think of unlikely worst-case scenarios.?It’s what gets us out of bed in the morning.

Limitation of Liability

Our liability under the contract is capped at the license fee amount.?We don’t give any compensation for business interruption or lost profits (i.e. consequential damages).?

Customer: If you believe in your product, you should not cap liability at the fees.? That's also just...unfair...

Software vendor: We shouldn’t be exposed to more than we earn on the deal. We can't make exceptions either, we would have to make exceptions for all our customers then and if we had a problem with one product that all our customers used.....

Customer: That’s great, that’s a problem for those customers to deal with.?I’m a big player here, don’t you want my business??You know your competitor didn’t cap liability right? I’m not asking you to make an exception for all your customers, just me.

Software vendor?(scratching her head a bit): Uh, can I ask you something??

Customer: Fire away.

Software vendor: You license your own designs to your own customers under a license agreement.?So you give uncapped liability to your customers, right??

Customer: Hey, hey, hey stop trying to change the subject my friend.

OK, wrapping up - its been a pleasure to work with these young semiconductor companies.?They are well funded and pay for good advice.?Even though, ironically, I may be teaching their in-house counsel to eventually put myself out of a job (or at least out of a client), its in all honestly a thoroughly rewarding experience to work with sharp people eager to learn.?

Without getting into value judgments here, these young counsel have an incredibly challenging job of learning to become semiconductor lawyers in a high-speed, complicated industry where they face relatively obscure international regulatory issues from Day 1.? These are talented lawyers working for companies that together want to do the right thing and be in (international) compliance with all laws and regulations, while aggressively protecting their own IP.? Its a story all lawyers can appreciate.

That's it for this edition. Thanks again for all the support reading, commenting on, and sharing this blog with others. If you haven't already, please hit that "Subscribe" button here on Linkedin to stay up on new entries I publish here. And see you again in two weeks!