Four Pillars: Digital rights and wrongs: “IP leakage”

I was reading the print edition of the latest issue of Fortune, and chanced across this article: Not Exactly Counterfeit. [That feels so good, to be able to link to a new story that I read as a paying subscriber, and then finding I can actually link to it and share it with others for free, without a digital barrier in sight. No sarcasm intended. That’s how it should be, and for this relief much thanks].

The story is all about ” a bug in the outsourced economy”, referring to unauthorised production cycles and “third shifts” that sell cheap excess into otherwise protected markets.

To me, the heart of the story is apparently about a guy named Horace Chang and his dealings with New Balance. We pick up the action in the early 1990s: the italics below represent direct quotes from the article, and the bold straight bits are mine:

New Balance began outsourcing in the early 1980s, using factories in Japan, then South Korea, then Taiwan. In the early 1990s its Taiwanese suppliers began moving their factories to mainland China. One of those contractors was Horace Chang, now 59, a tough, keen businessman. (Chang declined to be interviewed for this article, citing New Balance’s legal proceedings against him.)

At this stage God’s in His Heaven and All’s Well with the (Friedmanian Flat) World.

In 1990, Chang built a factory in Yang Jiang City, in Guangdong province near Hong Kong. At first his factory, which can employ up to 4,000 workers, made New Balance shoes only for export. But in January 1995, at Chang’s request, New Balance licensed him to also distribute its shoes to the Chinese domestic market.

Everything’s copacetic. After all, who wouldn’t want to go after the Chinese domestic market as a by-product of what was an export-only factory? Everybody wins.

Chang’s sales were initially modest, according to Ed Haddad, 57, New Balance’s vice president for intellectual property. But soon he had success with an inexpensive style known as a “classic.” It’s a colorful fashion shoe with “no technology,” Haddad explains – meaning none of the fancy midsole engineering that defines a high-performance shoe.

Now let me understand this. Sales aren’t too good, then suddenly Horace breaks through with a simple inexpensive style. So far so good. Not an IP leak in sight. Implied or otherwise.

In June 1999, Chang stunned New Balance executives at a meeting in Boston by announcing that he was projecting sales of 250,000 pairs that year – quadruple what he’d sold the year before.

“We were amazed,” recalls Haddad. But not pleased. New Balance executives feared that the company’s name was becoming associated in China with a fashion shoe, jeopardizing its reputation as a performance brand. They told Chang to pull back from selling classics.

“He was dumbfounded,” Haddad recalls. “He came here thinking he was doing a great thing – like the cat that brings you the dead mouse – and we slapped him on the hand.”

Now it gets interesting. The guy comes to Boston and says “I’m going to sell your socks off. Because the customer wants the Classic and I intend to give it to him”. A quarter of a million times. NO discounting. And his management rap his knuckles. Silly Boy. Give the customer what he wants? You’ll be wanting to run a charity next.

Chang didn’t pull back. Rather, he ordered materials to produce 450,000 pairs, as the New Balance sourcing department reported to its alarmed management later that year. Soon Chang’s inexpensive shoe was seeping out of China into premium markets like Japan. Licensed New Balance distributors there were furious.

Now we have something to talk about. A local manufacturer and distributor, a legitimate part of the global supply chain, wants to increase sales of a product that he produces legally and distributes effectively. His global management don’t agree, they would like to see the premium market protected. He feels he knows what his customers want, in terms of spec and price.

Houston, we have a problem. But as far as I can make out, not an IP issue. But things aren’t as copacetic any more, with inexpensive grey product seeping across borders into premium markets and all that jazz.

In August 1999, New Balance notified Chang that it was terminating his license to make and distribute classics, effective Dec. 31, 1999.

“What happened then is when everything went crazy,” Haddad recounts. Upon termination, the contract called for Chang to return to New Balance all its confidential technical, production, sales, and marketing information, including molds, specifications, signs, labels, packages, wrappers, and ads. He didn’t.

“He continued to sell,” says Haddad, “and was actively trying to sell product outside the country: in Taiwan, Hong Kong, Italy, Germany.” (It’s unclear whether Chang continued to make classics after 1999 or sold stockpiled inventory. Chang told the Wall Street Journal in late 2002, when it wrote about the situation, that he still considered himself entitled to make New Balance shoes.)

At New Balance’s request, the provincial divisions of China’s Administration of Industry and Commerce (AIC) seized about 100,000 pairs of Chang’s shoes from his stores and factories. During one raid New Balance made an alarming discovery: Chang had launched a competing line of classic-style sneakers under his own brand.

These he called Henkees (a meaningless word in Chinese), and he marked them with a logo on the saddle that purported to be a distortion of “Hi.” At a glance it looked a lot like New Balance’s block N saddle design. Chang had obtained a Chinese trademark on the Hi logo without New Balance’s noticing.

They said tomayto he said tomahto. And their ways parted. And we get the first taste of something to do with IP. He didn’t send back the specs, and may have (not sure here) kept on producing shoes to the classic spec. May have.

His crime? To produce and sell shoes they weren’t planning to sell, to people who weren’t planning to buy what they wanted to sell them in the first place. They wanted to control the product and its price and its placement and its promotion and however many other Ps you want to add. He wanted to sell his customers what they wanted at a price they were happy with.

Very intriguing. Maybe my perspective’s warped. But as far as I can make out, he did not change the design or the price.

Just the quantity. Upwards.

Like most Western companies doing business in Asia, New Balance had inserted arbitration clauses in its contracts so that it wouldn’t have to deal with foreign courts. Disputes were to be heard by an international arbiter applying Massachusetts law.

But while an arbiter could assess damages, he could not provide New Balance what it needed in this crisis: an injunction stopping Chang from selling New Balance classics. To get that, the company had to sue in the Shenzhen Intermediate People’s Court for Guangdong province. In late 2000 it did.

By this time I was not worried about IP leakage any more. I was worried about IP lobotomy.

I really don’t get it.

This is not about IP. It is about using tenuous arguments related to IP to try and lock customers in to products they don’t want at prices they don’t like.

It’s not going to work. IP or no IP. This is not really about New Balance or for that matter Horace Chang.

It’s about the customer.


It’s the customer who owns the customer. It’s the customer who selects the product. And the price.

And I think there’s a lesson here for all of us, particularly in positioning mainstream and luxury products in India and China.

The Innovator’s Dilemma appears to have mutated and grown. And we need to prevent this particular strain from getting traction.

Let me know what you think

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