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Faked in China

Faked in China

Counterfeiting has been dubbed the crime of the 21st century, and nowhere is the problem more out-of-hand than in China.

The world's biggest factory is also a fake goods hotbed. Here are 13 ways to protect your company.

Four years ago a Chinese company, Shenzhen Superway, approached The Will-Burt Company, the Ohio-based maker of Night-Scan telescoping masts, which provide high-intensity lighting and sit atop military and public safety vehicles. Shenzhen said, We would like to be the sole distributor of your products in China. Ditch the multiple distributors you've been using - make them buy your product through us. We have a large marketing force eager to sell, and we have a great relationship with the Chinese Public Security Bureau (the national police department). The bottom line is, we'll sell more of your product.

CEO Jeff Evans was impressed. "They had done a lot of research and had put together what they thought was a pretty good sales and marketing plan for our product before they even talked to us," he recounts. Will-Burt agreed to the deal, but Evans sought to make sure his company was protected by including noncompete and confidentiality clauses in the agreement that Shenzhen wouldn't steal Will-Burt's product or compete against the company. "We felt pretty solid. We were concerned, but on the other hand, it was a strong offer. Their first order from us was for a large number of units," says Evans.

The good feelings flickered out as quickly as a firefly's glow. After the initial rise in sales, Shenzhen stopped buying the product, and for a simple reason: Almost immediately, Shenzhen had begun reverse engineering the Will-Burt masts and building them itself.

Will-Burt's sales plummeted. One of the company's former distributors reported that Shenzhen was knocking off its product. When the president of Will-Burt's mast division went to a trade show in China to find the fake product, there it was, complete with Will-Burt's name on it; Shenzhen's manual even used pictures from the real manual, including that of an Ohio state trooper examining a mast. The Shenzhen reps warmly greeted their Will-Burt visitor and proudly showed off their fake Night-Scan, seemingly oblivious to the fact that they had broken a contract and ripped off their former partner's product.

Will-Burt reconnected with a former distributor. But the pain remains. "Now we're trying to sell against ourselves in the market," Evans says, noting that his company is competing against a cheaper knock-off. The irony, he says, is that Will-Burt's main customer is the law enforcement officials at the Chinese Public Security Bureau, which as a purchaser would be choosing between the real Will-Burt deal and cheaper counterfeits. Another pain point: Will-Burt, which is employee-owned, now manufactures its masts for the Chinese market in that country, not at its Ohio headquarters.

"We lost three things," says Evans, pondering the ordeal. "We lost profits, we lost [future] jobs and we lost some innocence."

Counterfeiting has been dubbed the crime of the 21st century, and nowhere is the problem more out-of-hand than in China. New Balance sneakers, Callaway golf clubs, Foo Fighters CDs, Viagra tablets, Cisco routers, you name it: China is the world's Wal-Mart for fake goods. The evidence goes beyond the well-known 90 percent software piracy rate in China cited by the Business Software Alliance. For example: In the United States, in fiscal year 2004 the Department of Homeland Security seized almost $US140 million in goods that violated intellectual property rights; goods from China (and Hong Kong) made up almost 70 percent of the haul.

China's Shenzhen Evening News, a government-owned newspaper, wrote that some 192,000 people died in China in 2001 because they consumed counterfeit medicine.

"China is by far the leading problem for the vast majority of our members in terms of IP-infringing activities," says Steven D'Onofrio, executive director of the International AntiCounterfeiting Coalition.

What's a company trying to protect its IP, its brand, its good name, to do? Unfortunately, there's no easy answer. (And, given the nature of the problem and the difficulty of finding solutions, many companies prefer to keep their counterfeiting problems under wraps; thus, a number of CISOs contacted for this story did not respond to requests for interviews.) China's central government is making efforts to crack down on counterfeiting, but it faces obstructionists and powerful local officials who, for a variety of reasons, prefer the counterfeiting status quo. Companies that do business in China need to prepare for a long, drawn-out battle, knowing that every time they stamp out one counterfeiter, another may pop up in its place. But that's no reason not to muster the energy for the fight. Counterfeiting is a cancer upon global business, with consequences that include loss of jobs, tax revenue and brand integrity. And even death.

By-product of the Economic Juggernaut

Counterfeiting has proliferated in China for a wide variety of reasons. One has been China's ascendance as an economic superpower. Multinationals have made huge investments in the country, transferring technology and capital through outsourced manufacturing arrangements and partnerships, helping to fuel the country's growth. To the chagrin of those foreign companies, some of that money and technology has gone into copying their products.

Jeffrey Unger, CEO of GenuOne, a brand protection company, says outsourcing has been a huge facilitator. "The cost reduction was great, but companies were sending their IP all over the world to third parties they didn't know or own," he says.

Another factor is China's sheer size - it's home to 1.3 billion people. "China now has the technology and capital, and they definitely have the people to produce all kinds of counterfeit products," says Joe Simone, a Beijing-based lawyer at the law firm Baker & McKenzie and the vice chairman of the Quality Brands Protection Committee, a China-based group of more than 130 multinational companies that works with Chinese authorities on anticounterfeiting strategies.

China's economic evolution from communism to free markets has also contributed to a surge in illegal activity. "China is still a developed nation; you go through a period in which a country is in transition from a planned economy to a market economy and everyone's looking for a quick buck," says Phil Yang, who formerly led Gillette's anticounterfeiting efforts in China and is now general manager of paper and packaging company MeadWestvaco in China.

Financially, counterfeiting has proven itself to be a lucrative venture, making it attractive to organized crime. Yang says that in the past, producing fake goods in China was more of a Mom-and-Pop-type cottage industry. He says it now has become a much more organized activity. "Everything you see now is large-scale. You may see in rural areas a whole village involved - wrapping batteries, packaging razor blades. Whole villages will work on it, or several villages," Young says. "At the end, each person's contribution may be a few hundred goods, but it becomes millions when added up. And they're exported all over the world."

The return on investment can be eye-popping. A 2005 report from the National Chamber Foundation (a think tank affiliated with the US Chamber of Commerce) came up with an interesting comparison between counterfeiting and cocaine dealing. It goes something like this: A kilo of cocaine costs about $US47,000, and a dealer can sell it on the street for $US94,000; that same $US47,000 can purchase 1500 bootleg versions of Microsoft Office 2000, which can be sold for $US423,000. Although an unscientific example, the point is clear - counterfeiting pays well. "There's no marketing overhead, no taxes, and you're not paying workers normal rates," says Simone. Annoying expenses like R&D, advertising and other costs associated with turning an idea into a brand also conveniently disappear.

Yang and other security experts don't buy into the belief that copying is somehow inherent in Chinese culture. The simple fact is that counterfeit goods are cheaper than the genuine ones, and in developing nations like China, wages are low.

"The concept of copying things from the Internet or a CD, people just don't think there's anything wrong with that. It's not because of culture. In China, people don't make enough money to buy a [legitimate] CD," Simone says. "Why spend $850 on a box of software that they could buy for $5? They can't afford $850; that could be a month's pay for someone in China. It's an economic issue," says Unger.

Three Kinds of Counterfeit Operations

According to Yang, there are three major types of counterfeit operations in China. The first is legitimate factories that have licences to produce goods on behalf of brand-name companies. Some of those, particularly in remote areas, will produce fakes as well. It might be a handbag or battery or footwear factory that cranks out the genuine products for one or more labels, then runs a shift that turns sports shoes into a counterfeit brand by slapping, say, a Nike logo on products that aren't really Nike sneakers. "The workers have no idea; they may not even know what a Nike logo is," says Yang.

The second involves joint ventures between a multinational and a Chinese partner. The multinational may contract with the joint venture partner to make 100 widgets; instead, the manufacturer makes 200 and illegally sells the extras.

The third kind of operation is the underground facilities that make items such as cigarettes - and in some cases, investigators find they are literally underground facilities. Authorities can raid a building, squeeze their way through a 1-by-1-metre opening and come upon a large piece of equipment used to manufacture cigarettes located in the basement. How could that machine possibly have been moved into the building? "Sometimes they build a house around the equipment," says Simone. Dig a hole, pour some concrete, install the machine, then build the walls - it's a David Copperfield-worthy illusion. Simone also mentions fake doors, access points through cabinets and even times when authorities have had to follow electric wires in order to find a hidden factory.

Counterfeiters working underground also can make their fakes on the road. Yang says that some criminals put a 12- metre container on a truck to house a small piece of manufacturing equipment. "If you're mobile, who can track you down?" he asks.

National Action, Local Inaction

For years, Chinese authorities neglected the counterfeiting problem; after all, it was foreign companies' products that were being faked. That attitude has since changed. Thousands die every year from ingesting fake medicines, which has helped awaken the authorities to the sometimes deadly consequences of the crime.

Another factor spurring the central government into action: Chinese companies are watching their own brands get ripped off. For example, Li-Ning, the country's biggest indigenous footwear and apparel manufacturer, has assigned three full-time people to investigate counterfeiting.

China's membership in the World Trade Organization (WTO) also forced the country to beef up its observance of intellectual property rights. Last December, China hardened its anticounterfeiting laws by lowering the thresholds for criminal prosecutions. Now, an individual can be prosecuted for having $US6100 worth of counterfeit goods on hand; for companies, the amount is $US18,000. Those are drops of 50 percent and 70 percent, respectively, over the previous standards. The government also increased fines and toughened prison sentences for offenders. In addition, Chinese authorities are working more cooperatively with other countries on intellectual property issues.

However, while the stepped-up enforcement is encouraging, it sometimes seems like the government is shooting arrows at a Bradley fighting vehicle. For the counterfeiters, "usually the fine is just a cost of doing business", says Simone. "Administration authorities are active, but the problem is getting bigger and bigger."

And local authorities are in no hurry to lend a hand. This is a great paradox of counterfeiting. Simone believes it's the small and midsize company brands that suffer the worst from the growth in counterfeiting, both in China and abroad.

"The sales of counterfeits of famous brands mainly displace sales of local brands made by small and medium-sized entities," Simone says. "Small and medium brands and fakes normally compete on price, with the fakes normally winning out, since consumers would rather buy a cheap famous brand than a small or medium company brand for the same price."

And yet, while local brands can be victims of counterfeiting, experts say that a big obstacle national authorities face is that counterfeiting contributes to local economies.

"Counterfeit manufacturing operations at the local level provide jobs, and so [local officials] have an economic incentive not to crack down on counterfeiters," says Jack Holleran, who led the brand integrity department at Philip Morris USA from 2002 to 2005, and is now the company's senior VP of compliance and brand integrity. Local officials may also have financial ties with these operations. "You have the challenge that you're basically taking money out of the pocket of the local official who's involved in this process, so why would she or he be incentivized to stop making boxes of software or T-shirts or whatever the products may be?" asks Unger.

13 Anticounterfeiting Strategies

Not all is hopeless. You can take steps to reduce the chance, or at least the impact, of the heisting of your brand:

1. Do your due diligence. If you're considering a joint venture, make sure your partner has a clean bill of health. "If you don't have the right partner, you can lose your shirt," says Yang. "Find out whether the partner is a reputable company, not in financial trouble and not involved in any IP-related violations." Simone says to do the same research on service providers - for example, lawyers and investigators - as well. An investigator "may be a great guy, but he doesn't know northern China", he says.

2. Travel to China. Learn about Chinese culture and people. "If you have serious problems, don't just rely on e-mail and a prayer," says Simone. This advice is good not only for CISOs but also for lawyers, investigators and anyone involved in fighting counterfeiting.

3. Budget smartly. Don't assume working in China will be simple and easy. Simone says basic investigations cost between $US500 and $US1500. This is higher than elsewhere for a variety of reasons: The country is huge, making transportation more costly; experienced counterfeiters are good at evading detection, making investigations more time-consuming than they used to be.

4. Protect your IP. If you do business in China, register your trademarks with the Trademark Office there. But even if you don't sell there today, it's a good idea to register trademarks there now if you might do business there in the future, says Yang. Also, you can apply for patent protection by submitting patent applications through an officially designated patent agent, according to Baker & McKenzie's report "Intellectual Property Guide 2005: China".

5. Consult with government officials. That includes people in Canberra, the Australian embassy in Beijing and consulates in China. They should have IP experts on staff that can help answer questions about legal processes or other protection strategies.

6. Pursue criminal enforcement when necessary. "What you're going to hear from a lot of advisers is, oh, go ahead with administrative enforcement, it's cheap and easy. Better advice is to investigate deeply and do a criminal case," says Simone. (Administrative enforcement usually leads only to seizure of fake products and paying modest fines; criminal charges can bring jail time to infringers.) He adds that pursuing criminal cases requires more work from lawyers and investigators to make sure the courts properly handle the case.

7. Look at alternative enforcement strategies. Simone says civil strategies - in which the main objective is compensation - are worth pursuing sometimes, such as sending a trademark infringer warning letters and taking the case to court for damages and injunctions. "If an infringer has assets in a bank account, you can seize their assets before the case gets started," he says, adding that civil enforcement can be cost-effective. He cites a case in which a client wanted to take down a women's apparel counterfeiter. Simone advised the company that the raids, which would target the counterfeiter's operations in seven cities, wouldn't be cheap - the total cost might reach $US30,000 to $US40,000. "I said maybe we should do a civil action, take a few more weeks to get the documentation together. We'll go to court and freeze their assets at the same time we do the raids."

8. Have a notarized, legalized power of attorney available. Simone advises having someone on the ground in China with power of attorney to file court actions or authorize your licensee to file actions on its own behalf. When cases go to court, you'll need this local presence.

9. Show your presence. If you have manufacturing operations, make sure you have good supervision in place. That may mean assigning some of your people working in China to supervise the action. "If you assign only one expat to a [big] factory to save money, you're going to be in trouble," says Yang. Supervision also could entail putting counters on machines to know how many pieces are being produced. It's also important to make sure controls are in place to keep track of how much raw material you've sourced.

10. Have key people sign a noncompete agreement. "Let's say you start a mill and have a plant manager from home, but the deputy is a local guy. Two years later the local guy leaves. You have to find ways to protect the information about your operations that that ex-employee now has," says Yang. Noncompetes are one way to do that. He says noncompetes may not be easy to enforce (recall the Will-Burt case at the start of our story). But at least such agreements get employees who sign them to think twice before they jump ship.

11. CISOs can lead in retaining private investigators. There are security service providers, in China and Hong Kong, for example, that employ ex-police officers. "That's an opportunity for CISOs, who in many cases are former law enforcement officials, to talk in a meaningful way with other law enforcement officials who are just wearing a different hat now. That helps you get information, such as where the illegal manufacture is taking place or what the distribution network looks like or whether the product is being sold over the Internet or in a brick-and-mortar store. Once you've got the information, then you can take action," says Holleran, of Philip Morris USA.

12. Consider anticounterfeiting technologies for your products. Nick Tidd, VP of channel sales for computer network vendor 3Com, says his company is working with DuPont to develop a holographic label that will be affixed to products built in its Taiwan facility and then shipped from China. "It can't be removed, burned or scraped from the product," Tidd says, and will allow buyers to do a visual inspection to verify that it's a genuine 3Com product. RFID tags are also being deployed to prevent counterfeits. Purdue Pharma last year began shipping the painkiller OxyContin in bottles with RFID tags in the United States, and Pfizer planned on doing the same with Viagra by the end of 2005.

13. Look to industry associations, such as the Quality Brands Protection Committee, for help. These groups are great resources for information. Beijing-based Quality Brands, for example, has formed relationships with the authorities and lobbies Chinese officials directly. Paying middlemen to act in your interests can be less effective. "Very often we find good trademark agents who will want to work only with one particular trademark authority because they're beholden to them, when there could be three others to work with," says Simone.

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