Countering Corruption in Intellectual Property Cases

Regaining rights to stolen intellectual property can be a perpetual nightmare for companies operating in China and other countries with similar governmental and law enforcement structures. The common raids-based approach to recovery can fail because of corruption and double-dealing. However, many companies are now using the more effective intelligence-based approach, which requires the skills of a CFE.

Mr. Xu, a consultant with an intellectual property (IP) protection firm in China, passed a crumpled sheet of paper across the desk to Mr. Smith, the security manger for a large, international cosmetics company manufacturing in China. The company was beginning to sell its products in the country for the first time. The words were in Chinese – a language Smith couldn’t read – on a barely legible carbon copy. However, Smith did notice the red stamp in the bottom right corner – the infamous “chop” without which nothing is considered official in China. The stamp had been placed on the paper by the local police bureau that had conducted a raid, with Xu’s help, on a factory that had been producing knock-off items infringing on IP belonging to Smith’s employer. Smith had employed Xu’s services to identify the counterfeiters and orchestrate the raid in conjunction with the local police.

“As you can see from this police seizure report,” Xu said, as he pointed to the crumpled paper, “we were able to capture more than 10,000 units of the counterfeit lipstick in that raid.”

“I suppose now that this counterfeit factory is out of business you have other prospects lined up that are producing the same product with our name on it?” Smith asked. Xu smiled and produced a list of nearly 20 company names and addresses. “Which one would you like us to hit next?” Xu asked. “We have a lot of work to do.”

Though this is a fictitious case, it shows a normal scenario for companies who use the common raid-based approach to IP protection in many developing parts of the world. However, it’s not a holistic, long-lasting solution for companies plagued with counterfeits in the market.

INTELLECTUAL PROPERTY RIGHTS BATTLES 

International companies with operations in the People’s Republic of China and other developing countries are in constant battles to protect their intellectual property rights (IPR). According to the “U. S. Customs and Border Protection and U.S. Immigration and Customs Enforcement’s 2009 Annual Report on Counterfeit Goods Seized,” mainland China was the origin of 79 percent of all of the goods seized in the United States by the two agencies in the fiscal year 2009.

Hong Kong S.A.R., a special administrative region under China, ranked second on the list with 10 percent of the goods seized during the same time period coming from there.

India ranked third, accounting for 1 percent of the goods seized.

In total, greater China (including Hong Kong and Taiwan) was the origin of nearly 90 percent of the counterfeit goods seized in the United States with a value amounting to US$233,997,415.¹ 

Chinese IPR infringement, however, is not solely a Chinese export-related problem. According to the Massachusetts Institute of Technology Center for International Studies and an intellectual property rights report for the Asia Business Council, counterfeit items in circulation in China account for up to 8 percent of the country’s gross domestic product, and counterfeit items make up approximately 15 percent to 20 percent of all items made in China.

Of course, China isn’t the only country in which foreign companies have IPR problems. But we’ll center on this country because of our professional experiences.

For years, companies active in China have been protecting their IPR by using a reactive raid-based approach that involves engaging third parties to seek out counterfeiters and coerce action from often less-than-enthusiastic or corrupt law enforcement agencies.

This method of IPR protection in China produces tangible items seized during raids, but it often leaves companies open to many unforeseen dangers and, in many cases, a never-ending cycle of grief.

For example, a company can end up being investigated or prosecuted for the bribery of government officials if third parties use monetary incentives to convince relevant law enforcement agencies to act. Moreover, the raids-based approach doesn’t strike at the root of the problem: the initial leak of the IP.

The reactive, raids-based approach to IPR protection merely treats symptoms. A holistic intelligence-based approach uses the analytical skills of CFEs to focus not only on seizing counterfeit items through raids but also identifying counterfeit syndicates’ operations, distribution channels and corporate structures and owners. It also locates the leak of the IP within an organization.

IPR PROTECTION IN CHINA 

A common misconception is that China doesn’t have developed IPR laws or relevant regulatory bodies. However, its real issue is the failure to enforce the existing laws. Companies are forced to rely on internal policies and procedures to prevent IP loss because of insufficient law enforcement. If they fail to protect their IPR in China, they might lose market share to cheaper, counterfeit competitors and risk potential damage to their brands’ reputations.

The lack of government-led IPR enforcement in China is further compounded by Chinese government bureaucracy. Each section of the government – both horizontally between divisions and vertically from national and provincial levels down to the local levels – has its motivations. Building the right mix of support across departments and jurisdictions is often as difficult a challenge to overcome as anything else in the process.

As a rule of thumb, the counterfeiting hot beds of China are located in industrial cities within Zhejiang, Fujian and Guangdong provinces. Counterfeiters usually work in jurisdictions where they’ve established local connections and in some areas where their operations are crucial to the success of the local economies. Local city subdistrict, and town- or even county- and city-district-level officials might be compromised by counterfeiting syndicates if they choose to accept kickbacks and other bribes offered to look the other way when investigating such activities.

City or prefecture-level government officials and agencies are usually more distant from counterfeiting syndicates and indeed might worry about the possible negative consequences of counterfeiting activities. However, in concentrated hot spots, officials at this level might be just as aware of the counterfeiters’ activities as the lower tiers of local government, yet are unwilling to act. The provincial-level governments are usually more concerned about the consequences of counterfeiting such as negative media coverage affecting the area’s investment environment.

Although companies need to work with local officials in both the raids-based and intelligence-based approaches, the former method relies much more on locals and often has conflicting motives, whereas the latter is able to circumvent some of the thornier issues.

THE RAIDS-BASED APPROACH 

Companies that are actively looking to protect their IPR find that the Chinese government generally offers little help. So these companies traditionally choose to enlist the services of third-party IPR protection firms that focus solely on seizing counterfeit items through raids, which they achieve by motivating and assisting local law enforcement agencies.

This approach leads to tangible results that grab headlines (“100,000 Fake Rolexes Recovered” or “More than US$1 million Worth of Counterfeit Medication Seized”), but it often fails to attack the reasons for the problem.

Counterfeit goods are merely the end products of IP theft. A raids-based approach never provides a picture of the overall counterfeit company’s size, scale, distribution or internal mechanics. Raids give counterfeiters time to adapt their operations and continue their activities long after the headlines fade.

The raids-based approach is often focused on small-scale retail and wholesale outfits rather than the actual counterfeit manufacturers or the possible IP leaks within the IP owner’s organization. This focus on lower-tier players in counterfeiting syndicates might simply cause counterfeiters to become more cautious, engage more government allies, or simply move their operations to other jurisdictions where they can start over.

Case Study: Raid-based Approach to IPR Protection  

During a regional sales conference, the Asia Pacific security manager of an international alcohol company became aware of extensive counterfeiting of his brands in China. The regional director instructed him to take action.

The counterfeiters were producing and distributing counterfeit alcohol. The bottles were identical to those that contained the alcohol company’s top-selling brand in the region, and it was being sold in China for nearly half the price. [Counterfeit alcohol is usually sold to bars, restaurants, and Karaoke (KTV) venues at lower prices than the real alcohol. It’s then re-sold to consumers in cocktails – and sometimes by the bottle – at the normal market rates.]

The security manager contracted a local IPR protection firm to find the source of the counterfeit liquor and carry out a series of raids with support from the local authorities so he could report the number of items seized to the regional director.

Within a few weeks the IPR protection firm had identified a number of distributors of the counterfeit liquor and discovered they were located in an impoverished province in China’s interior. The firm then began working to convince local officials to take action and encouraged them to intervene by giving them “facilitation payments” – normally in the form of fancy dinners and nights out on the town, but envelopes full of cash (usually amounting to about US$150) weren’t uncommon.

After successfully convincing the local officials, a raid was carried out on the counterfeiters’ warehouse and hundreds of bottles of the counterfeit alcohol were seized.

The IPR protection firm gave the security manager a copy of the official incident report for his reference to prove that the raiding company had completed its task. (The security manager couldn’t read the report because it was written in Chinese.) The authorities fined but didn’t detain the counterfeiters because the amount seized by the authorities wasn’t large enough to constitute a criminal action.

Even though the raid was successful, the problem persisted. The IPR protection firm continued to present the security manager with different distributors of the counterfeit alcohol. But the story was always similar: Payment was facilitated to the relevant government departments, a raid occurred and the counterfeiters received an administrative fine.

A CYCLE OF CORRUPTION 

Numbers-focused seizures have forced the firms conducting the raids to establish networks of questionable informants and law enforcement officials who are often only interested in lining their pockets. These resources have been known to tip off the counterfeiting syndicates about upcoming raids – playing both sides against each other and coming out richer for their efforts.

The raiding firms warn the counterfeiters of the upcoming raid, and the counterfeiters only give up token quantities of their goods to assuage the IP-owners and then move their operations elsewhere. In extreme cases, officials involved in raids have negotiated with the sellers to falsify documents by reporting lower quantities of goods seized than were actually taken to ensure the perpetrators only face administrative fines rather than criminal penalties, which perpetuates the cycle of IPR raids.

The raid-based approach to IPR protection in China can be carried out with integrity and produce tangible results, but the entire raiding methodology – from obtaining leads, to paying off law enforcement officials to carry out raids and then lobbying other officials to assess heavy fines – is open to manipulation by the many stakeholders in the process.

The actions of those conducting or organizing the raids on behalf of an IP owner in China could also possibly be criminal in nature (for example, the need to bribe officials) under Chinese law or in the IP-owner’s home jurisdiction.

THE INTELLIGENCE-BASED APPROACH 

The raids-based approach leaves most companies with no resolution and lots of fees. However, the intelligence-based approach to IPR protection in China offers a holistic solution that allows companies to strike at the heart of the counterfeiting problem.

A combination of investigative methods, such as controlled purchases from the sellers of IP-infringing goods and investigation of the counterfeiters’ corporate structures, produces an overall picture of a syndicate’s entire operation. Retailers, exporters, wholesale distributors, suppliers, and manufacturers can be identified and ultimately so can the original IP leaks.

Case Study: Intelligence-based Approach to IPR Protection  

A multinational pharmaceutical company discovered that one of its new medicines was prematurely available in local medicine markets within the Middle East and South Asia. After some initial research, they determined that the product wasn’t theirs, but its chemical makeup was identical to their product. The pharmaceutical company’s legal team retained an outside IPR protection company seasoned in the intelligence-based approach.

As a first step, the firm’s investigators went to the markets in the Middle East and South Asia to purchase the products and to try to identify the actual suppliers of the counterfeit medication. After the investigators reviewed the language on the product’s packaging and gathered information from local sellers, they discovered the source of the counterfeits was a company, or companies, based in China.

Next, the investigators conducted targeted market sweeps in China to identify the local sources of the counterfeits. The sweeps found more than 50 traders claiming to sell the product. The investigators purchased small samples from 20 of these targets. One of the companies boasted it was capable of selling large quantities.

Once the pharmaceutical company’s lab had confirmed that the counterfeit product’s chemical makeup exactly matched its own, the investigators conducted full background research – including an analysis of all media and corporate registry information – on the vendors of the counterfeit medicines.

They made controlled notarized purchases of the products to ensure the sale of the counterfeit products could eventually be entered as evidence in Chinese courts. The investigators then turned the evidence and information over to the multinational pharmaceutical company’s legal team in China to take action.

The multinational pharmaceutical company compiled and analyzed all the information and then began to search for possible leaks within its organization. The company identified an employee in its research and development department in London who had worked on the development of the product and had graduated from a university in the same town as that of the counterfeiters. The company analyzed the employee’s work computer and interviewed the individual. The employee had regularly discussed the development of the product with a former professor – a shareholder of the Chinese company – who was responsible for producing the counterfeit products.

In this intelligence-based approach, investigators (in-house or outside contractors) pose as potential clients and purchase the goods in question and gain the counterfeiters’ trust and slowly learn the inner mechanics of their syndicates. Investigators identify companies or individuals in these syndicates and then complete in-depth background checks on these entities or persons to confirm their true identities or corporate structures and to formulate an overall strategy on dealing with the syndicate’s illicit activities.

An investigator establishes relationships with key players in a counterfeiting syndicate by buying several products. Then the investigator arranges for an undercover licensed notary – a government-recognized professional, not a paid-off government official – to witness and document other purchases. Chinese notaries have extensive judicial powers; when they witness and notarize a purchase, that purchase is directly admissible as evidence in Chinese courts. The IP owner then can sue the perpetrators for patent and trademark infringement and other types of IP violation and unfair competition.

The intelligence-gathering IPR protection approach often reveals links among counterfeiting syndicates and the IP owner’s employees and suppliers. Therefore, the IP owner is able to also take action against these parties to root out key sources of a counterfeiting problem.

THE INTELLIGENT CHOICE 

Though the raids-based approach to IPR protection in China produces tangible results – seized goods – its fundamental shortcomings prevent it from ever truly solving the problem. The intelligence-based approach, which uses common investigative methods practiced by CFEs, offers IP owners an effective weapon in the battle against IPR infringement in China and other nations with low-cost labor, poor IPR laws and enforcement issues common in much of Southeast Asia and India.

¹ www.cbp.gov/linkhandler/cgov/trade/priority_trade/ipr/pubs/seizure/fy09_stats.ctt/fy09_stats.pdf; and www.cbp.gov/xp/cgov/newsroom/news_releases/archives/2009_news_releases/january_2009/01082009.xml 

[Original source inks no longer available. —Ed.]

Todd C. Lowe, CFE, CAMS, is a consultant in the Corporate Investigations Department of Control Risks in greater China.  

Benjamin Simar is the director of consulting for North Asia for Control Risks in Shanghai, China.

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