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Monday, February 13, 2006 - Page updated at 01:14 PM

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Businesses scramble to outfox the fakes

Seattle Times business reporter

Second of two parts

From a small rented booth inside an electronics megastore, Wang Gongwei sells sleek, Chinese-made Tsinghua Tongfang computers with built-in CD burners, wireless networking and Pentium chips.

What's not inside these computers is any Windows software. That's because Chinese consumers prefer to buy their new PCs piracy-ready, and China's third-largest computer maker obliges them.

"Definitely, 100 percent of the customers would not buy computers with software inside," the young salesman said. "There's no need to buy the real software."

In the same store, they can purchase counterfeit Windows and virtually any other kind of software for less than $1 a copy and install it themselves. Buying the machine with the real Windows inside would cost $100 more, Wang said.

Instead of just going after the pirates, Microsoft went looking for a partner. In November, it signed a deal with top Chinese PC maker Lenovo, which last year bought IBM's PC business. Lenovo agreed to preinstall legitimate Windows software on its machines in China for the first time.

"This is a big step and one we've never seen previously," said Fengming Liu, general manager of corporate and government affairs for Microsoft China.

While global companies such as Microsoft are drawn to China's billion-plus consumers, the persistence of piracy has forced them to change how they do business.

China's legal system is gradually improving to offer better protection for intellectual property, but companies say enforcement still takes too long and penalties are too soft to deter abusers. For now, the sale of counterfeit products goes on largely unfettered within the country, and fake products are increasingly making their way outside to the U.S. and Europe.

As a result, many foreign companies are recasting their business models. Some are experimenting with sharply lower prices in China to encourage people to buy legitimate goods. Others are offering popular, easy-to-pirate products such as computer games in China for free, while selling accessories that are less expensive and harder to counterfeit. Still others, deciding it's not worth the risk, are forgoing any investment in China.

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Rules get tougher

Twenty years ago, intellectual property was practically an unknown concept in China. Liu, a Chinese citizen who has worked at Microsoft nine years, remembers that at Peking University's law school in the 1970s he and fellow students copied foreign textbooks.

"We debated whether it should be done," he said. "We decided there was no other way we could learn because we couldn't afford to buy the books."

Since then, two decades of freewheeling economic growth have spawned copies of nearly every kind of foreign brand name on the market.

"When you get down to the anthropology of it, it's because a Western product carries a social cachet," said David Mycroft, who spent 12 years investigating counterfeiting cases in Asia for a U.S.-based risk-consulting firm. "If you are eating Del Monte canned corn, you might be one step up from your neighbor who can't afford it."

China began overhauling its laws protecting patents, copyrights and trademarks in 2001 as it prepared to join the World Trade Organization. And some courts have started to apply and strengthen those laws.

Last year, China's highest court issued a ruling that lowered the threshold for criminal copyright infringement, so violators can be punished after a minimum of $3,600 in illegal gains. Illegal sales of more than $30,000 could result in jail sentences up to seven years.

Another significant ruling came down in December when a Beijing court penalized a market's owner for allowing vendors there to sell knockoff handbags. Landlords had never been held responsible before.

Many observers say the legal framework has been improving, but until Chinese authorities apply swifter and more serious penalties, brazen pirates won't be deterred.

"I believe the law is more than adequate to punish the culprits," said Joseph Tsang, a Hong Kong private investigator who has worked on the counterfeiting issue for 25 years. "The question is how much time and resources the government in various cities will put in."

Foreign and Chinese companies in 2004 filed more trademark applications in China than ever before, said attorney Nelson Dong, a partner at Dorsey & Whitney in Seattle, who represents technology companies doing business in China.

"If they didn't fundamentally believe in the system, they wouldn't bother to file," he said.

Part of the reason is that U.S. companies learned the hard way that their rights at home didn't apply overseas, said Ron Cai, a partner at the law firm Davis Wright Tremaine in Shanghai.

"You may own a patent or trademark in the U.S., but it doesn't mean you have the same right in China," he said. "If you don't register, tough."

Now at least some of those companies have prevailed in Chinese courts. In December, Starbucks won a trademark suit it filed in 2003 against a Shanghai coffee company that had copied its Chinese name.

Yet just as China's legal system is gaining a few teeth, the pirates are growing fangs.

"We release software on a weekly basis, and it's all copied within days," said Microsoft's Liu. The fake software comes with a certificate of authenticity and the same paper, CD and box material as the real product. "Even people in the industry can't tell the difference," he said.

Microsoft's upcoming product Office 12 isn't even on the market yet, but counterfeits are already circulating in China.

Chinese manufacturers of DVD and CD players make the most of the widespread counterfeiting by advertising that their machines can defeat the region-by-region global-coding system designed to deter piracy, and can overcome CD-read errors caused by fakes of shoddy quality.

In 2004, 67 percent of all piracy-related seizures at U.S. borders originated in China, according to the Office of the U.S. Trade Representative, which estimates U.S. companies lose more than $3 billion a year to Chinese copyright piracy alone.

Shifting strategies

Rather than rely solely on the law to protect them, more nimble companies are coming up with their own strategies to outfox the pirates.

Many newcomers to China made the mistake of trying to sell their products the same way they did at home.

Selling a $30 computer game in a box just doesn't work because it's too expensive and too easy to copy and because Chinese gamers prefer to play online in Internet cafes, said James Gwertzman, director of business development at Seattle's PopCap Games. A better strategy would be to sell playing time over the Web, or break down what is now a single product into smaller, more affordable parts.

For some companies, finding a strong local partner has helped. Since China aims to develop its domestic software industry, the government may be more inclined to enforce the rules when local companies are involved. Microsoft, which first tried to tackle China on its own, began creating joint ventures with strategic partners a few years ago.

"It's important for China not to see us as a foreign company ready to take away money," Liu said.

Other companies, such as Adobe Systems, have slashed prices by as much as 80 percent to put authentic software within customers' reach. The company is testing China-specific prices for popular products such as Adobe Creative Suite 2 in an effort to curb piracy.

Inside Beijing's 24-story Kemao electronics superstore, where competition is fierce and margins are thin, it's easy to see why price is an issue.

Tsinghua Tongfang's high-end notebook computers cost $1,000, and desktops are as low as $300. Customers would balk at paying another $100 for preinstalled software, said manager Zhang Bin.

"It's not that we don't want to buy the real thing," Zhang said. "We can't afford it."

Microsoft has held firm on prices in China, saying it's impossible to compete with pirates who have virtually no costs.

"It's not a matter of affordability. People can afford a lot more expensive things," Liu said. "Many people in China have better hardware than I do."

Rather than worry about consumers, Microsoft is pressing Chinese companies to buy licenses for the software they're already using. Companies with bigger bank accounts can't make the same price argument as consumers, Liu said. "We're talking about enterprises that spend millions of dollars on information technology."

At least in theory, the recent court ruling lowering the criteria for criminal prosecution should make it easier for companies to apply such pressure.

Lessons from Harry

Harry Potter offers some lessons about counterfeiting and the Chinese consumer.

Hawkers were selling counterfeit DVDs of "Harry Potter and the Goblet of Fire" on Beijing's streets within days of the movie's theater debut. By contrast, the latest book, "Harry Potter and the Half-blood Prince," is a bestseller at Shanghai's popular Jifeng Books — and it's the real thing.

Why the difference?

A Chinese publishing house bought the rights and translated the book to sell in China at the same time the English version appeared in bookstores in other parts of the world. It costs 58 yuan, or about $7 — about five days' minimum wage. While that's not cheap to average Chinese consumers, it's still within reach.

Giving people more of what they want at a price they can afford has helped cut down on piracy, said bookstore owner Yan Bofei. People's incomes have gone up, so they can afford to buy legitimately published books. And they have access to more of those books than before, Yan says.

The result is that counterfeit books, so common in China 10 years ago, are now scarcer.

That's not the situation with most foreign films. One movie ticket in Beijing or Shanghai costs more than the Harry Potter book. And the Chinese government limits imports of foreign movies to about 20 titles a year. Yet audiences crave many more.

"The only way you can watch these movies is by buying the fake copies," Yan said.

Though Yan's bookstore doesn't sell pirated books, he reflects the mixed attitudes that prevail in China. He said the free circulation of ideas has social benefits in China, where many people are still hungry to learn about the outside world. And, said Yan, protecting intellectual property, or IP, helps rich countries at the expense of poorer ones.

In the modern world, ideas often come with a price tag, but that wasn't always the case.

"Marco Polo came to China and took a lot of things back," Yan said. "They were not seen as IP."

Paying for the past

When Chinese companies want to go global, it often requires coming clean on their intellectual-property violations.

Lenovo, now the world's third largest PC maker, is on a drive to expand its business internationally. Committing in November to install genuine software from Microsoft as well as Chinese companies in its computers was a significant step toward that goal, the company said.

Likewise, said David Chao, partner and co-founder of Doll Capital Management in Silicon Valley, one of the Chinese start-ups his firm backed had to make good on years of unpaid licensing fees to Microsoft before it could carry out an initial public offering of stock in the United States.

Chinese banks, telecom companies and technology leaders "are all looking for opportunities to become real global players, so expect them to come very clean on the intellectual-property rights front," said Microsoft's Liu.

At the same time, Chinese technology companies have become more aggressive about filing patents and protecting their own intellectual property. In one high-profile case last year, a Shanghai record agency sued China's leading search engine, Baidu, for copyright infringement because it provided links to download songs. In another case, Chinese telecom-equipment giant Huawei struck out against three former employees it accused of taking trade secrets to a competitor.

Chinese officials have also shown they can prevent piracy when the government's own interests are threatened. A week after introducing new mascots, called Friendlies, for the 2008 Beijing Olympics, Chinese authorities in November announced a crackdown on phony Olympic products and threatened strict penalties for those caught counterfeiting. At Beijing markets stocked with other counterfeit goods, there was no sign of the fake Friendlies.

Tough fight ahead

Hosting the Olympics and helping Chinese companies become global players are good reasons for Beijing authorities to escalate their fight against piracy. It still won't be easy, said Philip Cunningham, a Beijing-based writer and political commentator who has lived in China for more than 10 years.

"Trying to solve the piracy problem in China is like trying to solve the drug problem in the United States," he said.

A more realistic goal for China, said Cunningham, is "to be somewhere between complete compliance and everything for free."

Liu, Microsoft's top lawyer in Beijing, said laws alone are not enough. Foreign companies and governments need to show how China itself will benefit from stronger IP protection.

Without it, the country of such early inventions as the compass, paper and gunpowder will lag in developing the 21st century's innovations, he said.

Tsang, the private investigator, said he is confident the problem will shrink in China as it did in other countries.

After all, Japan, Korea, Taiwan and the United States have had problems with piracy at one time.

"China is getting stronger every day economically," he said. "After World War II, Japan copied the USA, but now you can hardly find any counterfeiters there.

"They are advanced and rich enough they don't need to copy other people."

Seattle Times business reporter Kristi Heim, who conducted many of the interviews for this story in Mandarin, traveled to China on a World Affairs Journalism Fellowship from the International Center for Journalists. Kristi Heim: 206-464-2718 or kheim@seattletimes.com

Seattle Times photographer Alan Berner : 206-464-8133 or aberner@seattletimes.com

Copyright © 2006 The Seattle Times Company

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