China leads the world in counterfeit and pirated products alleges the United States government, and they’re so successful because they use shell companies to evade enforcement at home. The shell company tactic works because China’s intellectual property law sets a high bar for the process of proving infringement in the courts, creating traps for the unwary. There is a solution to the problem, because Chinese companies have faced the same problem and defeated it in the courts relying on a blend of trademark law with intellectual property tort claims. In this article, we will look at case studies of local companies that dealt with this same problem, and offer solutions on how to shut them down.

Contents

How Infringement Evades Enforcement

Successful Enforcement Case Study

Failed Enforcement Case Study

Strategies to Defeat Shell Company Counterfeiters

How Infringers Evade Enforcement Mechanisms

A worryingly effective evasion tactic used by illegal counterfeiting schemes in China is to register several shell companies with which to perpetrate the infringement. This same tactic was used by a Chinese ring against Honeywell in New York, where a front company falsely used the Honeywell name to perpetrate counterfeiting. Chinese law does permit a solution, which requires first registering your mark in China and dealing with any trademark squatters there.

The numerous shell companies used in these schemes are set up for the sole purpose of selling the counterfeit products. Therefore, even if enforcement succeeds, these entities don’t have any assets, nor is the statutory representative usually the true beneficial owner, making it difficult to pursue personal liability against the true infringer.

The use of “fronts” and “front companies” represents sophisticated counterfeiting techniques that are illegal under Chinese law. To exercise your rights, you can take action under recourse under China Civil Code §1168, which allows pursuing joint and several liability in tort against the actual controllers of these companies. However, Chinese judges set a high bar for applying §1168 in such cases, requiring you to have done a thorough investigation into the infringer to prove that the individuals responsible are using a shell company in order to perpetrate infringement.

In the following sections, we’ll look at two cases where the trademark owner either succeeded, or failed, in bringing claims against an infringer using shell companies to evade enforcement.

Successful Enforcement Case Study

The Der Floorboards infringement case is one that that has gained some publicity and notoriety in the China intellectual property law practice. Der Floorboards obtained great commercial success after ten years of hard work in the business, but this attracted attention from counterfeiters.

 

Infringers  sold low quality knock-offs of Der under the company’s brand, profiting off of the company’s good reputation. These sophisticated counterfeiters also used shell companies to hide the identity of the beneficial owner, thus Der Floorboards was initially only to sue companies that had no assets and which were quickly abandoned by the counterfeiter.  To fight back in the courts, Der Floorboards closely monitored their activities, identified the connections between each entity, and strategically targeted the most egregious instances for lawsuits claiming personal liability.

Following the enactment of China Civil Code §1168 in 2021, Chinese courts have proven willing to pierce the veil and hold counterfeiters accountable for illegitimately using front companies as liability shields for their deceptive practices. The Der Floorboards enforcement action succeeded in court by proving that members of the counterfeiting ring were intentionally abusing the company’s independent legal personality, by showing that the only reason for registering the shell company was to evade imposing liability on the actual company perpetrating infringement.

In particular, a review of the stock ownership structure visible in China’s business registrar filings, showed common ownership among multiple different companies that were all infringing on Der. Moreover, while those owners filed registered capital in substantial amounts, corporate registrations revealed that funds were never actually transferred to the company. A second factor was that the infringer accidentally put their own name on trademark registrations, and additionally, the name of the actual operating entity on some of the packaging used in sales. These mistakes made it possible to connect the dots between each of the entities and people during litigation, and the court was persuaded that a half dozen shell companies were all acting as alter ego for the same person.

At the end of the case, Der Floorboards was able to obtain substantial damages personally against the very wealthy individual in China who owned these companies, even reclaiming profits that Der Floorboards should have rightfully earned. In this case, we can see that a litigation strategy that closely investigates what the infringer is doing on the ground, and identifying any suspicious activity, pays off in the end.

Before we explore how you can use Der Floorboard’s strategy to protect your intellectual property, let’s look at a cautionary tale of a case where the judge refused to take action against the counterfeiter.

Failed Enforcement Case Study

(Source: SMC)

The SMC case shows that the PRC Supreme Court will refuse to protect legitimate intellectual property rights if a very high burden of proof is not met. In the SMC case, an individual named Ni operated numerous shell companies with which to sell knock offs of SMC products throughout China. The plaintiff attorney argued this was abuse of control over the company, and sought the tort remedy joint infringement under §1168. The attorney’s litigation strategy focused on how the company was apparently formed for the sole purpose of selling copycat SMC products.

However, the Court declined to find the beneficial owner liable on a veil piercing theory. The Supreme Court reasoned that, regardless of whether infringement by the front company could be established, the plaintiff had failed to meet its burden of proof to show that the legal personality of the shell company sued was indeed an alter ego for Ni.

On the alter ego issue, the court found Ni had actual control of the shell company in China and that entity was indeed manufacturing, selling, and distributing counterfeits of SMC’s products. Moreover, since the products’ quality was low, it did not actually infringe on SMC’s patents, and thus the court proceeded under the trademarks theory, which requires piercing the corporate veil. However, SMC’s counsel made serious omissions when proving its case—it did not conduct an investigation into the corporate affairs at the business registrar with which to present evidence to the court.

In particular, facts that would have been relevant to the veil piercing claim are whether Ni had made capital contributions to the company and whether the certificate of incorporation showed that the company may not continue in business. Counsel did not investigate these corporate law issues at all, and the court stated it would have to make the rebuttable presumption that the company is adequately capitalized.  With the adequate capitalization presumption, the Supreme Court held that the shell company could independently satisfy any trademark infringement judgments to SMC.

An astonishing result of the SMC case—one that seems to have taken plaintiff’s attorney by surprise—in the interpretation of China Civil Code §1168 in intellectual property cases is the Chinese judicial doctrine that a company formed for the sole purpose of committing fraud, nonetheless has a separate legal personality from its owner. However, the result is not out of line with Chinese jurisprudence overall, which is relatively tolerant of fraud and deception, for example, China is perhaps the only jurisdiction with rules allowing a witness to lie to a judge under oath. However, Chinese jurisprudence is also very unwilling to allow people to avoid paying debts, and doesn’t even let people file bankruptcy at all.

A key lesson here is, the result in SMC is very much different from what might occur in other jurisdictions, where courts would be willing to pierce the corporate veil against fraud schemes. In China, special strategies are needed to defeat counterfeiters.

Strategies to Defeat Shell Company Counterfeiters

In cases like these, we can see there are three avenues are available to enforce trademark rights against infringers in China: joint infringement, aiding and abetting, and veil piercing doctrines. While providing a level playing field for parties, the Court’s jurisprudence intends to provide trademark owners with effective means to pursue trademark counterfeiters, while allowing judicial discretion to make appropriate decisions in tough cases.

Unlike SMC, Der Floorboards achieved enforcement against the counterfeiter in China because they focused on proving the related identity of several infringing entities, and demonstrated how an individual perpetrator used these legal entities as puppets to confuse the consuming public. When facing a sophisticated infringer like this, you can successfully enforce your trademark rights by mapping the network of relationships connecting the person with actual control to the web of front companies. These kinds of infringers typically use the same exact pattern of behavior and strategy to perpetrate infringement, with the following characteristics you can look out for:

• Real Name: Perpetrators will often use their real names in trademark filings, which are then licensed to front companies.
• Fronts: Front companies are used as the parties manufacturing, selling, and advertising the infringing items, with the name of the perpetrator not appearing on any listings.
• Complex Structure: Front companies will never use a single-owner equity structure, and thus avoid burden of proof disadvantages that come with such companies.
• Corporate Veiling: Perpetrators will always claim that the legal entities, i.e., the front companies, are solely liable for any unlawful conduct and will request the court apply shareholder limited liability.
• Manufacturer Denials: Real businesses producing infringing products will usually falsify manufacturing source information on product labels to avoid implicating their actual business. Alternatively, labels may include real information, and perpetrators will simply falsely claim that distributors misused their information to produce the sham labels on infringing products.

Judges among different jurisdictions in China apportion burden of proof differently, and how they do so can be dispositive as to whether trademark enforcement can succeed against the actual perpetrator. Therefore, we should take a closer look at the role of forum selection in resolving cases.

These regional differences in burden of proof requirements can often decide trademark infringement cases involving front companies in China. Therefore, a thorough investigation to prove the manner of control and close association that the individual infringer has in the front companies would be crucial in cases like Der Floorboards.

In trademark enforcement circumvention cases, counsel can file a motion under China Supreme Court Civil Procedure Rules §7, which allows a judge to determine the burden of proof in accordance with the principles of fairness. When there is already substantial evidence that companies are involved in bad faith sales and unfair dealings, judges are more likely to reduce the burden of proof.

A common fact pattern to look for is where the counterfeiter applies for what is called a “spurious trademark” — a mark that is so similar to an existing trademark that it is technically ineligible for approval and will likely be invalidated if approved.

If a front company is using a spurious trademark, the natural person behind the company should be required to testify as to what they authorized the front company to do with the mark, as well as to whether they own any equity in the company. Showing a close relationship that involves the registration of a spurious mark could establish joint infringement. Under Chinese law, trademarks must indicate the source of the goods or services. Thus, in cases involving spurious marks, this link can be used to trace control over the practices back to the actual infringer, thus facilitating enforcement.

In addition, investigating all the activities surrounding a spurious trademark and their connection to the natural person individual could reveal facts establishing that they authorized the practice. For example, in the Der Floorboards case reports, the counterfeiter applied for the trademark, website, and Taobao seller ID under their real name, which was seen as collusion with the company. Thus, the local court in China reasoned that the individual aided and abetted the infringement since all of these actions could have been completed in the name of the company, and therefore it would support enforcement against the natural person. In general, evidence of the individual’s actions will often be dispositive as to whether the judge will rule for joint infringement or aiding and abetting.

As noted above, proving this kind of infringement requires that the existence of a “spurious mark,” that is, one the Trademark Office refused to register or later invalidated. Approved marks are subject to the China Supreme Court’s Trademark Prior Rights Rules, which allows for trademark enforcement through administrative litigation for the protection of prior rights.

When taking this route, establishing the bad faith intentions of the infringing party is a strong strategy, and the invalidation of a spurious mark by an administrative agency can be used to support a finding that the individual acted in bad faith to register the trademark. The Shanghai Intellectual Property Court has also reaffirmed this holding in recent cases, with such findings helping to establish joint infringement and increase the potential damages awarded against the infringer.

Conclusion

As a legal system, Chinese intellectual property law is relatively lenient on fraud and deception, which has created fertile ground for counterfeiters. Nonetheless, these kinds of activities are strictly illegal, and the business that can navigate the several traps for the unwary can succeed in bringing legal claims against counterfeiters. In the above article, we’ve learned that identifying deliberate counterfeiting activities in itself is not enough. Rather, an investigation at China’s business registrars must be undertaken to identify corporate governance irregularities that will open the counterfeiter up to personal liability.

FURTHER READING

Get authoritative insights about Chinese foreign investment law from official government guidance in translation:

• Fighting Trademark Theft at the China IP Administration
• How China trademark infringement litigation actually works

For a general overview of this topic, see also CBL’s China Trademark Law FAQ.