The gloves are off. Tensions over recent weeks between China's major Internet players have been rising precariously. As interactive entertainment provider Shanda accused search engine giant Baidu of copyright infringement, Tencent's instant-messaging provider QQ and anti-virus company Qihoo 360 blocked each other's online products and services amid allegations of users' privacy being violated. But as attention grabbing as these run-ins might be because of the sheer size of the firms involved, they are pedestrian in a sector in which intellectual property (IP) and copyright infringements and other underhandedness are commonplace.
For an analogy, some might consider the lawless days of California's Gold Rush back in the 1800s. Internet entrepreneurs are the modern-day prospectors staking claims in a vast and wild frontier, where sheriffs are few and far between. "China is an extremely rapidly developing economy that has undergone tremendous change in the past 20 years, you could almost say that there hasn't been time to establish universally accepted ethics or business practices," says Mark Natkin, managing director of Marbridge Consulting in Beijing. "There is a certain Gold Rush or 'land grab' mentality in China."
The mentality, he argues, is partly driven by an uncertain regulatory environment. Online video, blogging or social media businesses can change overnight from being unregulated opportunities to services subjected to rigid regulation. "Some people have seen rule changes where there may have been an opportunity yesterday, but it is gone today because the government changed a regulation overnight," he says. "This fosters a very short-term outlook to making profits, and because it's short term, people are looking for short cuts."
The number of Internet users in China has already overtaken that of the U.S., although in terms of revenue the market is still relatively small. Nevertheless, with growing take-home salaries and a steadily increasing Internet user base, the country is a gold mine where businesses aggressively fight to gain turf and defend it.
Tim Smith, a Beijing-based IP lawyer for international law firm Rouse, has a similar take. "What principally motivates companies in China is a 'land grab.' It's a brutal commercial environment and they will do whatever they need to gain commercial territory." Smith, who has represented recording industry clients in lawsuits against China's leading search engine Baidu and Yahoo China, says, "They will seek to — as any company would if faced with the same situation — filibuster, slow down, defend as vigorously as they can any proceedings that suggest that their business model is infringing on anybody [else's] rights."
For foreign companies trying to break into China's market, this creates rough and unforgiving terrain. Big Western names such as eBay, Amazon and Yahoo have failed. Others — including Google and MSN — struggle against local competitors and YouTube, Twitter and Facebook are among those that have been shut out by domestic restrictions and China's "Great Firewall." While some may have grievances about the operating environment, they also might be partly to blame for their struggles if they're inflexible and incapable of adapting their business to China.
If a company's philosophy "is one in which you just migrate the rules and systems that apply in [another] market to China, you will most likely fail," says Edward Yu, president of Beijing-based consultancy Analysys International. "But if you adapt to the market a little bit, you still can improve your investment return in some way."
Part of the Action
In spite of the challenges, there is no shortage of investors willing to join the Gold Rush. "Everybody bites their lip and jumps into the pool," says Natkin. "We consult for a variety of hedge funds and venture capital firms and we are constantly highlighting the various risks involved – which is not meant to deter them from coming into the market, but just to make them aware of what may happen. The potential rewards are just too high. They can't bear not to participate."
William Bao Bean, managing director of SingTel Innov8, a Singapore Telecommunications-backed venture capital fund, notes that investors see China as a big pool of profitability, even though innovation may be lacking. "China is the place where the services are being created, perhaps not the high-level tech, but the services," says Bean. "Talking about regulation and lack of enforcement probably made sense five years ago … but these days the real focus is on where the value is. For us, we're looking for game-changing technologies out of the U.S., and we are looking for money-making services out of China."
And money-making doesn't necessarily mean innovative. In a market that is to a large degree virgin territory — both in terms of economic development and customers — services that have been successful elsewhere but are new to China are easy targets for local copycats. As Yu of Analysys notes, the outright copying of a product or service is often blatant in China.
At the moment, investors are happy to back companies that are outright copycats or that copy a business based on a foreign model, says Yu. "Baidu is actually a similar model to Google, with a bit of local adaptation. CTrip is actually a mirror [image] of Travelocity and Expedia…. You can take advantage of this from a pure investment return point of view. But from an ethical point of view, it's a different story."
Yu notes that there are "hundreds" of start-ups copying the likes of Facebook, Twitter, and other social media and entertainment sites, often right down to the page design. But there is innovation at a "macro" level. According to Yu, "Some companies are really genuine copycats, but some have done what we call macro-innovation and adapted products and services to be more acceptable to the Chinese market."
For investors like Bean, whose fund seeks to discover products and services that SingTel can bring to other markets, what's being created for China can be ideal. "When a U.S. company comes into China, it tries to take a developed-market service and modify it to become a developing-market service. Whereas [Chinese companies] are developing services based on … mobile, short messaging and SMS as opposed to e-mail." These services, he says, are easier to transfer to Southeast Asia and Africa, parts of the world where SingTel is present.
A major complaint – and perhaps excuse – among Western firms is the country's weak or underdeveloped regulatory system, particularly in areas such as IP and copyright protection. Analysys's Yu notes that while China's Internet sector lacks solid regulations, "enforcement is a bigger issue…. In some cases, everyone knows something is in violation of a law, but from a legal point of view, it is very hard to prove an infringement or copying of an innovation … and to do so, may take months or years."
While that may be true, Dan Harris, founding partner of Harris & Moure, a boutique law firm specializing in U.S. investments in China,says the entire system needs to be put into context. "Americans are always complaining about the lack of enforcement in China," he says. "But what they really mean by that is, 'The government is not doing enough to stop someone from manufacturing fake Adidas.' Well, in the U.S. the government is not that active either."
Rouse's Smith adds that a lot of the challenge is just a reflection of the sector's immaturity, as was once the case in the U.S. In the early days of Internet technology, he notes, many top U.S. firms grew their businesses through similar tactics. "YouTube arguably could not have gotten to where it is today without allowing commercial videos to be made available," before there was a big supply of self-generated content, and now YouTube has both licenses for commercial content in place and technology to identify copyright material when it is uploaded."
Smith points out that in the West today, making money using stolen IP or infringing copyright always carries the risk of a lawsuit or even a priso sentence. Not so in China. "In the U.K., if a court issues an order for a company to do something and it doesn't do it, the director of that company … could wind up in prison," he says. "That is very unlikely to happen in China. The courts simply don't have the same force as court systems do in the West."
Other experts agree. Harris says the Chinese legal system – while generally good at dealing with complaints in a fair manner — is not as effective at penalizing bad behavior. "The reality is that Chinese courts do not have the same power to enforce judgments as courts in the U.S. do. In the U.S., if you get a judgment for US$5,000 against a U.S. company and they don't pay, you can bring in the sheriff and start seizing furniture and bank accounts," says Harris. "You can do that in China too, but it's a lot more difficult and the court just isn't as strong a body."
In spite of imperfections, Smith notes that the legal system is increasingly used for conflict resolution in China and proving capable of handling an increased caseload. "There were 30,000 intellectual property claims filed last year in China. It's the most litigious IP jurisdiction in the world … but the system is quick. You expect to get a decision in the first instance within six months and on appeal within a year," he says.
After the Gold Rush
But how long can cut-throat competition among China's Internet players last? Observers expect the chase for market share and quick money to subside as companies gain scale, innovate, and establish better – and more marketable — brands. "Ideally, once a lot of the larger companies have killed off most of the smaller ones, or the smaller ones have died off because they can't compete, [government officials] will step in and regulate 10 companies instead of 300 or 200 companies," says Marbridge's Natkin, because "it's easier to regulate a small number of large companies that have a lot to lose than to regulate a slew of smaller companies that have very little to lose." Additionally, he notes, with more and more Chinese-to-Chinese lawsuits involving larger companies, "you should start to see the legal system being a better tool and things will begin to settle down."
Harris, speaking from Seattle, broadly concurs. "My strong sense is that the wealthier a country is, the better their IP protection will be, to a certain point," he says. "Once a country has a lot of big, strong powerful companies that have their own IP that needs protecting, they don't view it as 'carrying water' for foreigners. Protection really starts improving. China is starting to get some of those companies."
As more Chinese Internet companies break free of the Gold Rush mentality and begin investing more in R&D and innovation, it is argued that they will seek legal protection for their own IP. The government may encourage this, Smith notes, since the development of both innovation and a larger domestic consumer market will likely be central pillars of the next five-year plan. "Both are fundamental to China's continued progress … over the next decade. To me, as an IP lawyer, achieving those is fundamentally [dependent] on the development of technology and the protection of technology."