Investors Should Be Cautious With China’s IP Theft Promise

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On a business trip to Long Island, New York, last autumn I was taking a shortcut to evade some mall traffic when I literally had to stop my car and make sure my eyes weren&s;t deceiving me. At an equipment dealer in an industrial park were rows of&a;nbsp;forklifts&a;nbsp;built by &l;a href=&q;; target=&q;_blank&q;&g;Chery&l;/a&g;. Chery began life in mainland China in the 1990s as a car maker with a&a;nbsp;name remarkably similar to General Motors&s; Chevy. The state-owned Chery then produced cars so similar to Chevy that at times parts were &l;a href=&q;; target=&q;_blank&q;&g;interchangeable&l;/a&g;. In the U.S., Chery doesn&s;t sell cars, instead primarily offering industrial equipment. And in fairness, a decade or is a long-time in business and may not reflect Chery today. But it&s;s hard to argue that Chery, now China&s;s &l;a href=&q;; target=&q;_blank&q;&g;largest&l;/a&g; vehicle exporter, paid much of a price for its questionable practices of the past. It&s;s a cautionary example that U.S. businesses and their investors need to be wary of, even as the Chinese communist party pledges IP theft reform, as &l;a href=&q;; target=&q;_blank&q;&g;Reuters reports&l;/a&g; today.

There&s;s no denying foreign brands and products have had a difficult time balancing the lure of the massive mainland China market with all the trouble that comes with it from weak trademark protectionm, from Chery to knock-off products that have even included&l;a href=&q;;&g; Canadian ice wine&l;/a&g;. Regardless of the apparent progress this week by the Chinese government in discouraging IP theft, investors would do well to continue to consider weighing the risks of operating in China against the possibly great rewards. And they can be great &a;ndash; Starbucks&s; success in tapping into Chinese burgeoning middle class is one &l;a href=&q;; target=&q;_blank&q;&g;example&l;/a&g; of how the market can reinvigorate slowing growth.

If you think these risks of losing control over IP is minor, consider the example of &l;a href=&q;; target=&q;_blank&q;&g;American Superconductor&l;/a&g;.&a;nbsp;If you had to choose a poster company for the danger of intellectual property theft and China, American Superconductor would be among your finalists. The Massachusetts-based maker of highly efficient conducting wire and associated designs for wind turbine and grid management systems was one of the apparent winners of the renewable energy sector boom of the mid 2000s, especially as the central planners of mainland China put in plans for a wide expansion of the country&a;rsquo;s renewable energy base. American Superconductor quickly became a key supplier of turbine design and technology to China&a;rsquo;s Sinovel, expecting to receive hundreds of millions of dollars annually in orders to feed Sinovel&a;rsquo;s wind&a;nbsp;farm plans. In an interview for &l;em&g;Forbes&l;/em&g; (for a story which never ran), I met with AMSC founder and then-CEO Greg Yurek in March 2011. IP theft, he said, wasn&s;t much of an issue, because the algorithms protecting the software running the market&s;s best turbine systems were uncrackable. Unfortunately, the algorithms mightn&s;t have been crackable, but employees were. Mainland Chinese managers and an Austrian employee illegally sold the turbine control software secrets to Sinovel that year, leading to a breakdown in the relationship between the companies. Shares cratered, falling from a 10-year high of $430 (adjusted for a reverse split of 1-for-10 in 2016), to a low of $2.97 in mid-2017. Revenues from China fell from $241 million&a;nbsp;in 2010 to $679,000 in 2017. Shareholders literally lost billions of dollars of equity. American Superconductor isn&s;t the only example. The political advocacy group Coalition for a Prosperous America has an interesting&a;nbsp;&l;a href=&q;; target=&q;_blank&q;&g;top 10 lis&l;/a&g;t.

&l;img class=&q;size-medium wp-image-1534&q; src=&q;×181.jpg?width=960&q; alt=&q;&q; data-height=&q;181&q; data-width=&q;300&q;&g; IP theft sent American Superconductor shares off a cliff in 2011.

It&s;s taken a decade for American Superconductor to recover as it refocused its business in the U.S. and international&a;nbsp;sales to&a;nbsp;India and Korea. Somewhat ironically, the turning point for shares came about a year ago when&a;nbsp;a court in Wisconsin found Sinovel guilty of stealing AMSC&a;rsquo;s technology. On news of the victory,&a;nbsp;the stock saw the heaviest one-day volume ever. The companies settled for about a tenth of what the court said Sinovel cost AMSC, with Sinovel paying $32.5 million to AMSC in July with the remaining $25 million in December.

Outright theft like with AMSC can happen anywhere &a;ndash; this isn&s;t solely a mainland China problem. But more formally, the Chinese government has long had a requirement that foreign companies need to transfer technology to the country through joint ventures with domestic firms. It&s;s been a wildly successful requirement for China &a;ndash; the country amassed more than half of its intellectual property from foreign companies this way, the Minneapolis Federal Reserve Bank noted in a 2015 &l;a href=&q;; target=&q;_blank&q;&g;report&l;/a&g;. This week&s;s proposal, which would go into effect in China starting next year if approved, would start to dismantle that formal technology transfer requirement. That&s;s a good start and could be long-term bullish for U.S. companies selling into China. But it&s;s far too early to think your stocks with heavy China exposure are less risky than they really are.&l;/p&g;

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