March 30, 2017

Protecting Trade Secrets in Supply Chains

In today’s global economy many corporations must turn to outsourcing production of key components to compete and to expand their business in lower cost markets. Doing so can increase the risk of loss valuable trade secrets and confidential data. Indeed, the theft of trade secrets in countries in which the work is often outsourced, especially China, is pervasive. It is essential, therefore, for companies involved in outsourcing to be aware of these risks and implement a range of best practices to reduce the risk of theft of trade secrets in their supply chains.

The danger of theft of trade secrets from U.S. businesses by foreign actors is greatly increasing regardless of the extent that the company outsources all or part of production. The increased risk is caused by a number of factors. First, U.S. companies remain the leader in innovation in a number of areas and the economic value of intellectual property has never been greater. Approximately 70% of the value of publicly traded corporations is estimated to be in “intangible assets,” such as trade secrets.[i] Valuable trade secrets are not just high-tech in nature, but can include any type of information so long as the information is secret and has economic value. According to a recent study of EEA prosecutions, the type of trade secrets that were misappropriated, for example, not only includes the formula used in the manufacture of solar cells or the design of car parts, but also “starter” tobacco, which is used to manufacture various tobacco products, and advance copies of a Nike catalogue. [ii]

Second, it is far easier to steal trade secrets today than ever before. Almost all information is stored digitally which means that not only can it be possibly stolen remotely over the Internet, but employees can easily also make copies which can then be transmitted off-site. In addition, trade secrets also continue to be misappropriated the old-fashioned way, such as by bribing employees or planting spies in companies.

Third, the actors involved in theft of trade secrets have become far more sophisticated in recent years. The evidence indicates that foreign companies and governments are actively seeking U.S. corporations’ trade secrets. According to the same study, more than 30 percent of all of the EEA prosecutions to date involved Chinese citizens or naturalized U.S. citizens originally from China.[iii] In addition, the defendant, in slightly less than 30 percent of the total EEA prosecutions, misappropriated the trade secrets to benefit the Chinese government, an existing Chinese company or to start a company there.

Finally, in the case of China, there is evidence that the Chinese government or at-least state owned enterprises are actively involved in the theft of trade secrets. For example, the government in February 2012, for the first time, indicted a state owned Chinese company for economic espionage for allegedly stealing DuPont’s trade secrets relating to production technology for titanium dioxide, which is a white pigment used in the manufacture of a large number of materials ranging from paints to paper.

While difficult to quantify, the combination of these factors has led to annual losses to U.S. companies of over $300 billion per year that is comparable to the current annual level of U.S. exports to Asia.[iv] Non-monetary losses can include loss of reputation, image and/or goodwill. Regardless of how measured, theft of trade secrets is costing the U.S. economy millions of jobs and is a drag on the country’s gross domestic product.[v]

The risk of theft of trade secrets greatly increases for U.S. companies which outsource their operations since such outsourcing will invariably involve sharing their expertise and know-how with their foreign partner. There are, in general, three major categories of outsourcing and each provides, varying degrees of risk to trade secret owners. First, “captive-outsourcing,” which is where a company will use a wholly owned foreign subsidiary. This provides greater control over day-to-day operations and poses less of a risk to the loss of intellectual property. However, captive sourcing is not completely without risk. Indeed, there have been a number of reports of companies losing control of their off-shore operations without the protection of local law enforcement authorities. For example, U.S. chemical maker SI Group Inc. opened a factory in China in 2004 to produce rubber-bonding resin used in the manufacture of tires. In 2007, a Chinese competitor of SI hired SI’s Chinese plant manager to operate it’s own plant and began producing a product that SI claims is identical to the product manufactured at its Chinese plant. SI then filed a complaint with the Shanghai police who dropped their investigation 2009, citing a lack of evidence.

The second type of outsourcing is where a U.S. company hires a foreign company to perform part of its operations. This type of outsourcing presents the greatest risk to trade secret owners, especially if steps are not taken to reduce the risks. This type of outsourcing offers may benefits including low pricing, rapid implementation and greater flexibility in growth and termination. In many cases, however, the company must give up some degree of control over the intellectual property involved in the transaction. The company also becomes dependent on the foreign country’s law to protect its intellectual property, which may not be as protective of intellectual property as in the United States. For example, Singapore, Malaysia and Hong Kong, do not provide statutory protection for trade secrets or confidential information, and India and Brazil only provide for protection under limited circumstances.

The third type of outsourcing, in general, involves a joint venture between the foreign corporation and a local company. There are obvious business advantages to this arrangement. It allows the parties to share costs and risks and can reduce startup time. On the other hand, it can create complicated structural and operational issues that may be subject to the jurisdiction of the local company, and which may be unfriendly to a U.S. company. For example, under the Chinese law, the company creating improvements to existing technology owns the intellectual property to the improvements outright, which, in essence, means that a Chinese partner may be able to claim ownership and develop those rights independently without the U.S. company’s involvement or claim to joint ownership.

Given the rise in the value of intellectual property as a whole, and trade secrets, in particular, it is critically important for companies to strong measures to protect their trade secrets. In the case of outsourcing this is especially true. First, before entering into any type of outsourcing, companies should undertake an analysis to determine what specific technology actually needs to be transferred. This analysis should include not only an evaluation of the sensitivity of the technology, but also should take into account the type of legal protections in the jurisdiction where the technology is to be transferred and whether claims of theft of the intellectual property are fairly considered. A company may conclude that the trade secrets are simply too valuable or the legal protections too weak to justify outsourcing to that particular country.

Second, regardless of the value of the trade secrets and the legal protections companies should determine how to best structure the transaction and operations to minimize access to the technology. One possible way to do this is by compartmentalizing or separating different parts of the manufacturing process among different locations. This ensures that a particular outsourcing partner only has access or knowledge about one distinct area of the process, which limits its value.

Third, it is critically important for the U.S. company to conduct extensive due diligence about its proposed partner. This should include, as a minimum, the financial condition of the supplier, whether the supplier has a record for respecting intellectual property rights, whether the supplier has written employment and nondisclosure agreements in place with its employees and third parties, and the identity of any subcontractors that the supplier intends to use. Of course, the same level of due diligence should be performed on any subcontractors identified by the supplier.

Fourth, all contracts between the U.S. company and the supplier must clearly set forth in detail all of the information that the company considers confidential, all intellectual property and derivative works is owned by the company, prohibit the unauthorized disclosure and misappropriation by the supplier and specify that the company has the right to conduct a compliance audit. The supplier must also be obligated to return all trade secrets and continue to honor the contract’s obligations after termination of the agreement. The contract should also include that the company has the right to obtain damages for breach, and to seek injunctive relief for violations of the contract. Finally, to the extent possible, the contract should mandate the application of U.S. law of breach and the supplier should agree to U.S. jurisdiction or arbitration in a more neutral jurisdiction rather than litigation in local courts. The same sort of safeguards should also be included in contracts with subcontractors.

Fifth, the U.S. company should ensure that the supplier’s employees understand their obligations to protect trade secrets. This should include training the employees on the importance of protecting the trade secrets and the supplier’s employees should be required to agree to the same code of conduct and policies regarding the handling of trade secrets as U.S. employees.

Sixth, the supplier should be required to treat trade secrets and confidential information in the same manner that such information is treated by the company. This should include that the documents are appropriately designated as “Confidential,” and that the information is encrypted and accessible on a need to know basis.

Finally, the supplier should conduct exit interviews of all departing employees and the former employees should required to acknowledge in writing that they have returned all documents to the supplier and reaffirm that they will not disclose or use any trade secrets or confidential information. Particular attention should be given to those employees who are intending to go to work for a competitor.

Outsourcing provides real business advantages, however, these advantages may become outweighed if the outsourcing results in the theft or disclosure of trade secrets or confidential information. It is vitally important that companies evaluate the benefits and risks of such an arrangement before agreeing to such an arrangement.

[i] President’s 2006 Economic Report to Congress.

[ii] See Peter J. Toren, An Analysis of Economic Espionage Act Prosecutions: What Companies Can Learn From It and What the Government Should Be Doing About It, Bloomberg BNA Patent, Copyright and Trademark Law Journal, Vol. 84, No. 2081, Sept. 21, 2012.

[iii] Id.

[iv] Report of the Commission on the Theft of American Intellectual Property (“Commission Report”) at 2.

[v] Id.

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