Counterfeiting: Faked in China

The world's biggest factory is also a fake goods hotbed. Here are 13 ways to protect your company. The second in a CSO series on counterfeiting.

There are a thousand stories of counterfeit goods coming from China. Here's one:

Four years ago a Chinese company, Shenzhen Superway, approached The Will-Burt Co., 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 headquarters in Orrville, Ohio.

"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 $140 million in goods that violated intellectual property rights; goods from China (and Hong Kong) made up almost 70 percent of the haul.
  • In 2003, Brooklyn prosecutors charged six men with importing up to 35 million counterfeit brand cigarettes from China. The smugglers allegedly hid the goods in shipping containers behind kitchen pots.
  • 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 CSOs 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.

Byproduct 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 sizeit's home to 1.3 billion people (by comparison, the United States has 296 million; the European Union has 457 million. "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 involvedwrapping 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 U.S. 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 $47,000, and a dealer can sell it on the street for $94,000; that same $47,000 can purchase 1,500 bootleg versions of Microsoft Office 2000, which can be sold for $423,000. Although an unscientific example, the point is clearcounterfeiting 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 $600 on a box of software that they could buy for $5? They can't afford $600; 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 licenses 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 sneakers 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 cigarettesand in some cases, investigators find they are literally underground facilities. Authorities can raid a building, squeeze their way through a 3-by-3-foot 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 wallsit's a David Copperfieldworthy 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 40-foot 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. (See "Drug Busters," November 2005, for a profile of how pharmaceutical giant Novartis takes on the counterfeit drug problem.)

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 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 $6,100 worth of counterfeit goods on hand; for companies, the amount is $18,000. 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.

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