Reducing Criminal Liability with Chinese Imports

Problems with the Action Plan

Although the Action Plan purports to speak to “Prevention with Verification,” the main focus is on the creation of “mandatory and voluntary third-party certification programs for foreign producers that are based on product risk” and to “verify compliance with U.S. safety standards.” But there are few such third-party entities competent to perform the certifications. In fact, during a public conference call on the day the Action Plan was released, the Working Group could not identify a single such entity.

The Action Plan also discusses the development “of good importer practices” and the use of “strong penalties against bad actors.” Yet the prospect for prevention is not promising. As the Plan itself recognizes, “the importing community does not have available Good Importer Practices focused on ensuring product safety throughout the supply chain.”

A New Statute

The Consumer Product Safety Improvement Act of 2008, Pub. L. 110-314 (Aug. 14, 2008), was enacted largely in response to the import safety crisis. It substantially increased funding for the CPSC and provided for more personnel to monitor compliance. Like the Action Plan, it too calls for third-party certification of imported products.

The Act also increased maximum civil fines for safety violations from $1.25 million to $20 million, and increased some criminal penalties from misdemeanors to five-year felonies, with criminal forfeiture of assets tied to the offense conduct.

Compliance and Ethics for China-based Manufacturers

With thousands of miles and significant language and legal barriers between China-based factories and U.S. companies, legislative sticks and ad hoc monitoring and audits won't stem the tide of defective imported products or reduce clients' liability, which very often will be determined under strict liability standards. To minimize or eliminate criminal exposure in the new import safety environment, U.S. companies must move away from a system based on detection to a prevention-based system of compliance and ethics.

Compliance and ethics programs were born out of the U.S. government's recognition many years ago that intra-organizational systems designed to detect, resolve, and ' especially ' prevent violations of laws and regulations could reasonably be tailored to the size and nature of the organization without increasing costs ' in fact, often decreasing them.

Championed by the U.S. Sentencing Commission and endorsed by the Department of Justice and other executive-branch agencies, compliance and ethics programs have been adopted by every Fortune 500 company in the U.S. and thousands of others. They have been credited with reducing both criminal and civil liability in all types of organizations.

An Effective Program

Here are seven elements of an effective compliance and ethics program as defined by the U.S. Sentencing Commission, which we have annotated with specific suggestions regarding China-based manufacturers:

1. The organization shall establish standards and procedures to prevent and detect criminal conduct. Standards and procedures must be bilingual ' Chinese and English in China, Spanish and English here. U.S. importers should have bilingual vendor contracts requiring their China-based vendors to prove that they have ethics and compliance programs in place.

2. The organization's governing authority shall be knowledgeable about the content and operation of the compliance and ethics program and shall exercise reasonable oversight with respect to its implementation and effectiveness ' Periodic reports on the effectiveness of the compliance and ethics program shall be disseminated to high-level personnel. Your clients should meet with the principals of their factories, at their factories, at least annually. Larger clients should consider opening in China a representative office staffed by local citizens acting as liaisons and in-house quality control inspectors. These employees can help build a level of trust (guanxi) to ensure that the expected level of quality, performance and compliance is met by the vendor. Your clients should also develop “vendor scorecards” to quantify the effectiveness of the compliance program and make it better understood and maintained by the vendor's employees. Scorecards can be enormous carrots for China-based manufacturers if meeting or exceeding certain scores results in faster payment or larger orders.

3. The organization shall use reasonable efforts to vet those with substantial authority within the organization. Here, it is important to understand how your client's vendors hire their key employees and factory workers. What are the backgrounds of key employees? What is the rate of attrition among factory workers? Does the factory comply with relevant Chinese employment laws and regulations? Every January and February, the Chinese New Year brings the largest mass movement of humanity as workers return inland to their homes. Roughly 1/3 do not return. Pent-up demand brings a higher rate of defects as new employees are hired and trained by March ' a season particularly susceptible to unethical and non-compliant activities.

4. The organization shall take reasonable steps to communicate periodically its standards and procedures, and other aspects of the compliance and ethics program, by conducting effective training programs and otherwise disseminating information appropriate to such individuals' respective roles and responsibilities. China-based vendors should be required to supply bilingual manuals to their U.S. importers for review and modification pursuant to relevant changes in U.S. laws and regulations (and corporate counsel must stay abreast of these changes). Examples of training should be periodically forwarded to the importer and, if possible, principals from the importer should witness training in person during annual factory visits.

5. The organization shall take reasonable steps ' a) to ensure that the organization's compliance and ethics program is followed, including monitoring and auditing to detect criminal conduct; b) to evaluate periodically the effectiveness of the organization's compliance and ethics program; and c) to have and publicize a system, which may include mechanisms that allow for anonymity or confidentiality, whereby the organization's employees and agents may report or seek guidance regarding potential or actual criminal conduct without fear of retaliation. Since texting is ubiquitous in China, vendors should encourage factory workers to send anonymous texts or e-mails with their complaints or observations, and U.S. importers should have reasonable access to this documentary trail. This requirement can be negotiated in the vendor contract.

6. The organization's compliance and ethics program shall be promoted and enforced consistently throughout the organization through appropriate incentives to adhere to the strictures of the program, and disciplinary measures for engaging in criminal conduct and for failing to take reasonable steps to prevent or detect criminal conduct. Disciplinary records should be made available to U.S. importers as part of any vendor contract negotiations, at least with respect to egregious violations that pertain to the importer's products.

7. After criminal conduct has been detected, the organization shall take reasonable steps to respond appropriately to the criminal conduct and to prevent further similar criminal conduct, including making any necessary modifications to the organization's compliance and ethics program. The U.S. Embassy in Beijing and the many U.S. consulates in major Chinese cities have access to somewhat crude company financial profiles that may contain information about criminal conduct regarding a particular factory. These should be ordered at least semi-annually for major factories. The vendors' compliance manual should be revised periodically with an eye to preventing recurrences of past violations.

Conclusion

With the number of U.S. importers having grown from 732,000 in 2003 to 862,000 in 2007 (an increase of nearly 18%), prevention can only be achieved through heavy reliance on the import industry. Specifically, prevention can occur only through the relationship between the importers and their foreign factories.

Since compliance and ethics programs are proven systems to prevent violations of laws and regulations, the key is to make them optimally effective in foreign factories, with prevention a critical focus. U.S. importers must export our best compliance and ethics practices to Chinese manufacturers through on-site training and regular follow-up evaluations. The best entities for doing such are not government organizations but your clients themselves.

John R. Steer ([email protected]) is a senior partner with the law firm of Allenbaugh Samini LLP. He is a former Vice Chair to the U.S. Sentencing Commission and Counsel to the U.S. Senate Judiciary Committee. Mark H. Allenbaugh ([email protected]) is a managing partner and heads the firm's Federal Criminal Defense and China Trade & Risk Assessment Practice Groups.

China has quickly evolved into our second largest trading partner, and our pervasive reliance on China-made products has brought an increasing vulnerability to defective goods ' from poisoned pet food and lead-painted toys, to tainted heparin and melamine-laced milk-based products. Coupled with the near-depression in our economy, the China import safety crisis creates a perfect storm for driving importers and retailers out of business when faced with monumental product liabilities, both criminal and civil. Corporate counsel, therefore, must learn how to minimize or even eliminate their clients' increased criminal and civil exposure.

Background

According to the Consumer Product Safety Commission (CPSC), 61% of its 473 recalls in fiscal year 2007 were products made in China. In 2007, the President created a cabinet-level Interagency Working Group on Import Safety tasked with developing strategies to address this mounting problem. It released an Action Plan in November 2007.

Problems with the Action Plan

Although the Action Plan purports to speak to “Prevention with Verification,” the main focus is on the creation of “mandatory and voluntary third-party certification programs for foreign producers that are based on product risk” and to “verify compliance with U.S. safety standards.” But there are few such third-party entities competent to perform the certifications. In fact, during a public conference call on the day the Action Plan was released, the Working Group could not identify a single such entity.

The Action Plan also discusses the development “of good importer practices” and the use of “strong penalties against bad actors.” Yet the prospect for prevention is not promising. As the Plan itself recognizes, “the importing community does not have available Good Importer Practices focused on ensuring product safety throughout the supply chain.”

A New Statute

The Consumer Product Safety Improvement Act of 2008, Pub. L. 110-314 (Aug. 14, 2008), was enacted largely in response to the import safety crisis. It substantially increased funding for the CPSC and provided for more personnel to monitor compliance. Like the Action Plan, it too calls for third-party certification of imported products.

The Act also increased maximum civil fines for safety violations from $1.25 million to $20 million, and increased some criminal penalties from misdemeanors to five-year felonies, with criminal forfeiture of assets tied to the offense conduct.

Compliance and Ethics for China-based Manufacturers

With thousands of miles and significant language and legal barriers between China-based factories and U.S. companies, legislative sticks and ad hoc monitoring and audits won't stem the tide of defective imported products or reduce clients' liability, which very often will be determined under strict liability standards. To minimize or eliminate criminal exposure in the new import safety environment, U.S. companies must move away from a system based on detection to a prevention-based system of compliance and ethics.

Compliance and ethics programs were born out of the U.S. government's recognition many years ago that intra-organizational systems designed to detect, resolve, and ' especially ' prevent violations of laws and regulations could reasonably be tailored to the size and nature of the organization without increasing costs ' in fact, often decreasing them.

Championed by the U.S. Sentencing Commission and endorsed by the Department of Justice and other executive-branch agencies, compliance and ethics programs have been adopted by every Fortune 500 company in the U.S. and thousands of others. They have been credited with reducing both criminal and civil liability in all types of organizations.

An Effective Program

Here are seven elements of an effective compliance and ethics program as defined by the U.S. Sentencing Commission, which we have annotated with specific suggestions regarding China-based manufacturers:

1. The organization shall establish standards and procedures to prevent and detect criminal conduct. Standards and procedures must be bilingual ' Chinese and English in China, Spanish and English here. U.S. importers should have bilingual vendor contracts requiring their China-based vendors to prove that they have ethics and compliance programs in place.

2. The organization's governing authority shall be knowledgeable about the content and operation of the compliance and ethics program and shall exercise reasonable oversight with respect to its implementation and effectiveness ' Periodic reports on the effectiveness of the compliance and ethics program shall be disseminated to high-level personnel. Your clients should meet with the principals of their factories, at their factories, at least annually. Larger clients should consider opening in China a representative office staffed by local citizens acting as liaisons and in-house quality control inspectors. These employees can help build a level of trust (guanxi) to ensure that the expected level of quality, performance and compliance is met by the vendor. Your clients should also develop “vendor scorecards” to quantify the effectiveness of the compliance program and make it better understood and maintained by the vendor's employees. Scorecards can be enormous carrots for China-based manufacturers if meeting or exceeding certain scores results in faster payment or larger orders.

3. The organization shall use reasonable efforts to vet those with substantial authority within the organization. Here, it is important to understand how your client's vendors hire their key employees and factory workers. What are the backgrounds of key employees? What is the rate of attrition among factory workers? Does the factory comply with relevant Chinese employment laws and regulations? Every January and February, the Chinese New Year brings the largest mass movement of humanity as workers return inland to their homes. Roughly 1/3 do not return. Pent-up demand brings a higher rate of defects as new employees are hired and trained by March ' a season particularly susceptible to unethical and non-compliant activities.

4. The organization shall take reasonable steps to communicate periodically its standards and procedures, and other aspects of the compliance and ethics program, by conducting effective training programs and otherwise disseminating information appropriate to such individuals' respective roles and responsibilities. China-based vendors should be required to supply bilingual manuals to their U.S. importers for review and modification pursuant to relevant changes in U.S. laws and regulations (and corporate counsel must stay abreast of these changes). Examples of training should be periodically forwarded to the importer and, if possible, principals from the importer should witness training in person during annual factory visits.

5. The organization shall take reasonable steps ' a) to ensure that the organization's compliance and ethics program is followed, including monitoring and auditing to detect criminal conduct; b) to evaluate periodically the effectiveness of the organization's compliance and ethics program; and c) to have and publicize a system, which may include mechanisms that allow for anonymity or confidentiality, whereby the organization's employees and agents may report or seek guidance regarding potential or actual criminal conduct without fear of retaliation. Since texting is ubiquitous in China, vendors should encourage factory workers to send anonymous texts or e-mails with their complaints or observations, and U.S. importers should have reasonable access to this documentary trail. This requirement can be negotiated in the vendor contract.

6. The organization's compliance and ethics program shall be promoted and enforced consistently throughout the organization through appropriate incentives to adhere to the strictures of the program, and disciplinary measures for engaging in criminal conduct and for failing to take reasonable steps to prevent or detect criminal conduct. Disciplinary records should be made available to U.S. importers as part of any vendor contract negotiations, at least with respect to egregious violations that pertain to the importer's products.

7. After criminal conduct has been detected, the organization shall take reasonable steps to respond appropriately to the criminal conduct and to prevent further similar criminal conduct, including making any necessary modifications to the organization's compliance and ethics program. The U.S. Embassy in Beijing and the many U.S. consulates in major Chinese cities have access to somewhat crude company financial profiles that may contain information about criminal conduct regarding a particular factory. These should be ordered at least semi-annually for major factories. The vendors' compliance manual should be revised periodically with an eye to preventing recurrences of past violations.

Conclusion

With the number of U.S. importers having grown from 732,000 in 2003 to 862,000 in 2007 (an increase of nearly 18%), prevention can only be achieved through heavy reliance on the import industry. Specifically, prevention can occur only through the relationship between the importers and their foreign factories.

Since compliance and ethics programs are proven systems to prevent violations of laws and regulations, the key is to make them optimally effective in foreign factories, with prevention a critical focus. U.S. importers must export our best compliance and ethics practices to Chinese manufacturers through on-site training and regular follow-up evaluations. The best entities for doing such are not government organizations but your clients themselves.

John R. Steer ([email protected]) is a senior partner with the law firm of Allenbaugh Samini LLP. He is a former Vice Chair to the U.S. Sentencing Commission and Counsel to the U.S. Senate Judiciary Committee. Mark H. Allenbaugh ([email protected]) is a managing partner and heads the firm's Federal Criminal Defense and China Trade & Risk Assessment Practice Groups.