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If you think it's just handbags and DVDs, think again. Chinese pirates these days are thinking big--really big.

The Chinese-built Chery QQ mini car, for instance, looks so much like GM's Chevrolet Spark that GM filed suit against China's state-owned Chery Automobile Co. Ltd. late last year, accusing it of violating its intellectual property rights.

"GM Daewoo alleges that Chery produced the QQ through copying and unauthorized use of GM Daewoo's trade secrets, while claiming that it had developed the vehicle on its own," the South Korean company said in a news release in December. Technology related to the Matiz had never been sold or licensed to Chery through authorized channels.

Automakers have expanded into China in a big way over the past few years, eager to win a share of a large, profitable and fast-growing market.

One factor that makes China so attractive is that it still has a relatively small personal vehicle population. China has just eight personal vehicles per 1,000 people of driving age population compared with 940 personal vehicles per 1,000 in the United States, GM says.

"China has the world's fastest-growing vehicle market and one of the largest," GM says. "GM's vision is to become a leading domestic player in China."

SUPPLY CHAIN VULNERABILITIES

But the move into China has not been without its risks.

The supply chain, for instance, spans thousands of miles and multiple time zones, which increases the risk of a possible business interruption.

In addition, because companies are sourcing more and more of their component parts from China, "they have compounded their risk of business interruption by transferring production of certain parts from plants in their control to a third-party operation in China," says Mike Stankard, managing director and automotive practice leader at broker Aon. "If you're an underwriter, you now have a greater challenge to understand what the true business interruption risks of this company are," he says.

There are other issues that come with operating in a rapidly developing country. In China, factories are also at risk of unscheduled shutdowns because of power shortages, says Mike Hanley, global director of automotive at consultant Ernst & Young.

Then there is political risk. Although the danger of outright confiscation of assets may not be high, China may not always have the best interests of foreign multinationals at heart. Sudden changes to the legal or regulatory landscape could create serious concerns for risk managers.

Part of the problem is that to operate in China, automakers must form a joint venture with a quasi-governmental partner.

"That typically comes with losing a degree of control that you're accustomed to having when it comes to making decisions about risk management and insurance placements," Stankard says. "A lot of times in these joint ventures, the local joint venture partner takes responsibility for that and you, as the seasoned, concerned risk manager, don't have that comfort level you would normally have."

But one of the biggest risks the automakers face as they expand in China is the danger of violations of their intellectual property rights. China is a culture known for rampant, enterprising knockoffs and lax enforcement of intellectual property rights.

"Intellectual property continues to be a very significant issue," Hanley says. "It is clear; the Chinese made no secret about this upfront. It was clear that part of their strategy in forming joint ventures was to begin to learn about the automotive industry and how they can produce cars."

Intellectual property typically includes copyrights, trademarks, patents and trade secrets. Companies invest a great deal of time and money into developing new products. A lack of protection for intellectual property could have a negative effect on research and innovation.

GM, for instance, says it spends billions of dollars each year developing new products and advanced technology. "We are committed to bringing much of our latest technology and products to the global market," GM says. "However, like other global companies, GM can only do this in an environment in which we are confident that our intellectual property rights will be respected and protected."

In a speech to the Asia Business Conference at Harvard University in February, Philip Murtaugh, GM's top executive in China, said one of the main challenges of doing business in China was piracy, according to a recent Reuters report.

Bogus products--from CDs, DVDs, software and watches to electronic equipment, clothing, processed foods, consumer products and auto parts--are estimated to account for up to 7 percent of global trade and cost legitimate rights holders around the world billions of dollars annually, according to a U.S. Commerce Department statement.

Illegal copycat products, including exports to the United States, cost American businesses $24 billion annually, the Commerce Department has said.

"We take any violation of our intellectual property rights very seriously," GM says. "Those of us who are working hard to develop a truly world-class automotive industry hope very much that intellectual property rights will be fully protected in China, the United States and around the world."

Ford Motor Co. also says counterfeiting is a serious concern, not just in China but in other global markets as well. Concerns include not just protection of its brand, but consumer safety and product durability and performance, says Ford spokesman Chris Vinyard.

SEEING GRAY

Counterfeiting is only one part of the problem. Automakers are also struggling to cope with a growing gray market. The gray market consists of products produced by a supplier that are genuine, but are being sold through illegal channels.

For instance, a factory may manufacture genuine auto parts from 8 a.m. to 5 p.m. and from 5 p.m. to 8 a.m., it may continue to manufacture the exact same genuine auto parts, but slip them out the back door to be sold through illegal distributors.

It is hard to estimate how large the gray market losses are, but they are extremely difficult for companies to fight because the part is genuine.

"I think people have trouble seeing the gray market as a problem and don't understand the potential impact it could cause," says Ray Wood, senior patent counsel at the law firm of Warner, Norcross & Judd in Grand Rapids, Mich., who gave a presentation recently to Aon clients. "You wouldn't believe how much management time can be spent with a gray market problem; it's amazing," he says.

"With black market goods, very few consumers are honestly fooled," he says. But with gray market goods, he says, "they're your products and you're not getting any money for it. If you've got a gray market problem, what are you going to do with the factory that's making the stuff? Are you going to shut them down?

While there are intellectual property laws on the books in China, Wood says they are rarely enforced.

"They have laws. The laws on the books are not the problem," Wood says. "The problem is the enforcement of the laws is so scattered and also their priorities are a little bit different than ours are," he says. "They only have a limited number of people to go out and enforce intellectual property problems."

GM, however, says the Chinese government is serious about intellectual property rights protection and the State Council has established a task force known as the Intellectual Property Executive Conference to look into intellectual property-related issues.

China's new auto policy released this year stresses the need to protect the intellectual rights of auto companies and bans the sale of auto products that violate these protections. "That is why we're pursuing this matter through the courts," GM says.

In a visit to China in January, before stepping down as Commerce secretary, Donald Evans said the trend of increasing piracy and counterfeiting and stealing must be reversed. In an interview with USA Today, Evans complained that China's commercial pirates must start serving time. He told the newspaper that those who are stealing, cheating, counterfeiting and pirating have got to go to jail.

PROTECTION STRATEGIES

For automaker risk managers, there are some things they can do to protect their company's intellectual property.

One strategy has been to use older technology in cars manufactured in China, Ernst & Young's Hanley says. Cutting edge technology is saved for developed markets in the Western world.

Companies also should do an intellectual property risk assessment. This means sitting down and taking inventory of intellectual property, trademarks, patents and copyrights, and identifying which ones need the most protection, Wood says.

Thorough due diligence of joint venture partners and suppliers also is important. Do background checks and discuss expectations. In many cases, partners and suppliers want to do business and want to do the right thing but do not understand expectations, Wood says.

Watermarks are also a helpful tool to help identify whether a part is genuine or a counterfeit. By embedding some sort of identifying mark in a product, a manufacturer can then more readily identify whether the part is genuine. If a part is counterfeit, then the company can take action.

In addition, manufacturers should conduct surprise spot inspections, Wood says. It is important to simply drop in and visit manufacturing plants and suppliers unannounced or on very short notice. Planned inspections are of little or no use.

Risk managers also can turn to insurance to help them manage their intellectual property risks. However, insurance for intellectual property may not always be available, or in some cases may be too expensive to make it worth the while, says John Brosnan, director of the intellectual property and media group with Aon Technology and Professional Risks.

For large multinationals concerned about the possibility of third-party liabilities, however, it is possible to build a large program with meaningful limits that would provide coverage in a multitude of countries and not just in China alone.

"What the carriers are always concerned about is the risk of being adversely selected," Brosnan says. "They would feel much more comfortable insuring a company in 10 countries including China, rather than only China, which is more risky," he says.

Expansion into new, emerging markets always involves risk. Auto manufacturers, however, can manage their intellectual property, supply chain and political risks through a combination of loss prevention strategies as well as insurance.

Piracy is a big problem for U.S. businesses, but it's not keeping foreign automakers out of China.

"The upside benefit offsets those risks," Hanley says. So far, they have wagered that it is better to do battle with the pirates and cope with all the other risks involved in an emerging market like China to win a share of an important new growth market.

PATRICIA VOWINKEL, a former Reuters journalist, is a frequent contributor to Risk & Insurance®.

May 1, 2005

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