Risks Faced by China-based Toy Manufacturers
The Bulletin, Hong Kong General Chamber of Commerce,
Nov 2007.
Recent concerns over safety in the toy industry should
prompt foreign investors and
PRC manufacturers to be aware of legal ramifications.
This article explores ways of
limiting potential liabilities when exporting goods to
the US.
Issue: November 2007
BACKGROUND
As China has become the world's factory, trade friction
between China and the US has escalated as China's exports to the US continue to
rise. Recently, China-made toys have made the headlines after a number of
safety concerns were raised by the US government and numerous major recalls of
toys were made by US toy retailers. China is one of the largest sources of US
imports for many products. In 2006, China was the number one supplier for toys,
with a staggering 86% of total US imports of toys coming from China. In recent
months, millions of toys have been recalled in the US For example, in August
2007, Mattel Inc., the world's biggest toymaker, recalled over 20 million
pieces of Chinese-made toy products due to excessive lead paint and loose
magnets. Such recalls will cause financial ruin for many Chinese toy
manufacturers because they have to bear the huge costs of recalls as well as
the potential loss of business with US retailers. In addition, they may be
exposed to massive indemnity claims from US retailers as a result of recently
filed class actions in the US.
REASONS FOR RECALLS
The three most common reasons for recalls are design
defects, loose magnets, and excessive lead paint.
Design defect
According to a report printed in a local Hong Kong newspaper
on September 11 2007, more
than three-quarters of toys recalled in recent years were
triggered by design defects instead of manufacturing faults. Examples of design
defects included small detachable parts, sharp edges or long strings that could
pose a risk of strangulation to children. In fact, only 10% of the 550 recalls
in the past 20 years by US government quality-control authorities were due to
manufacturing problems such as excessive lead paint and overheating batteries.1
Loose magnets
Some plastic figurine toys, like the Polly Pocket Playset,
Batman, and Barbie dolls have small loose magnet components. When these loose
magnets fall off and more than one magnet are swallowed, the magnets can
attract to each other and cause intestinal perforation, infection or blockage
particularly for children, which can be fatal.
Excessive Lead
Lead paint is used in various products because it is bright,
durable, fast-drying and cheap. In 1978, the US Consumer Product Safety
Commission (the CPSC) made it illegal to use any paint containing more than
0.06% lead for children's products. Such products are subject to recall in the
US If an excessive amount of lead is ingested, it may cause brain damage,
learning disabilities, seizure and death.
On September 27 2007, the CPSC announced seven separate
recalls of Chinese manufactured toys and children's jewelry for containing
unlawful levels of lead. These seven recalls, totaling more than 600,000 units,
brought the total excessive lead-based recalls in 2007 to 50, which is more
than double the highest number of recalls in any single previous year in the
CPSC's history.2
US CONSUMER CLASS ACTIONS
Although class actions are unheard of in Hong Kong or other
parts of the world, they are common in the US, especially when consumer
products are involved because the affected class of plaintiffs can be very
large. Class actions in the US will determine the rights and remedies for a
large number of people whose cases involve common questions of law and/or fact.
The defendants are often multinational institutions with "deep
pockets" that can afford to pay potentially huge judgments.
On August 20 2007, a class action lawsuit was filed in a Los
Angeles County Superior Court against Mattel, which imports millions of
Chinese-made toys that have been recalled recently due to excessive lead paint.
This lawsuit asked Mattel to set up a fund where concerned parents could have
access to have their children tested for lead poisoning. The medical cost for
testing one person for lead poisoning is around US$50. The class size will
likely reach millions of plaintiffs because according to public statements made
by Mattel, 1.22 million units of children toys that it sold were manufactured
with surface lead paint.3
Similarly, on September 27 2007, a class action lawsuit was
filed against Mattel in the United States District Court, Central District of
California. The plaintiffs of this class action sought damages for injuries
suffered from swallowing tiny magnets that became loose or fell out from certain
dolls and accessories of certain magnetic play sets.
PUNITIVE DAMAGES
In addition to damages claimed for medical costs regarding
lead poisoning tests, US toy retailers might be ordered to pay punitive
damages. The purpose of punitive damages is to punish a defendant and to deter
such a defendant (and others in the future) from engaging in similar conduct or
making similar omissions.
Generally speaking, punitive damages are not available in
contractual actions, but are available in tort actions. Typically, the amount
of punitive damages is determined by the trier of fact - in this case, US
juries, which are known to be very generous. The amount awarded is usually
based on a number of factors, including the nature of the defendant's actions,
the extent of harm caused by the defendant, and the defendant's financial
circumstances. For punitive damages to be upheld constitutionally, they must
not be grossly disproportional to the actual damages that have been awarded.
INDEMNITY AND CONTRACT CLAIMS BY TOY RETAILERS
In addition to possible termination of future business with
Chinese toy manufacturers, US retailers may make indemnity claims against
Chinese toy manufacturers to recover:
(i)
compensatory payments that they have made to
consumers;
(ii)
legal costs for defending consumer claims; and
(iii)
costs of the recall programs.4
Whether or not these indemnity claims will succeed will
depend on the interpretation of the indemnity clauses in the contracts between
the two parties.
Chinese toy manufacturers may also be sued by US retailers
under contract law for other reasons, including misrepresentation, breach of
warranties, and breach of promises regarding safety and quality of their
products.
ENFORCEMENT OF US LAWSUITS
Against Assets in the US
A US judgment can be enforced against assets of a Chinese
toy manufacturer that are based in the US, which may include contractual rights
that the toy manufacturer has with other companies. For example, if a Chinese
toy manufacturer has accounts receivables in the US from a US buyer, those
receivables can be subject to execution of a US judgment.
New York Convention on the Recognition and Enforcement of
Foreign Arbitral Awards
With respect to the enforceability of arbitral awards, China
is a party to the "New York Convention on the Recognition and Enforcement
of Foreign Arbitral Awards" This means that an arbitration award issued in
the US, or in a third country, can be enforced in Chinese Courts.
Minimum contacts
Although US Courts do not have jurisdictional power over
companies incorporated outside the US and not conducting business there, a
Chinese toy company that is systematically tapping the US market, such as
sending representatives to US trade shows, visiting companies in the US and
sending electronic messages may be found to have sufficient "minimum
contacts"with the US such that a US Court can exercise jurisdiction over
it. A foreign defendant does not need to have an office or hire employees in
the US to fall under the jurisdiction of US Courts.
US REGULATORY ISSUES FOR CHINESE TOY MANUFACTURERS
The two US governmental regulatory bodies involved in
monitoring the quality and safety of toys in the US are the CPSC and US Customs
& Border Protection (the CBP). The CPSC is in charge of protecting the public
from unreasonable risks of serious injury or death from consumer products,
whereas one of the CBP's responsibilities is to ensure that the goods entering
the US from foreign countries are safe for US consumers to use. Both agencies
work closely together. The CBP has the authority to detain and exclude any
products, such as toys, based on instructions from the CPSC.
CONSUMER PRODUCT SAFETY ACT 1972
One piece of US legislation that gives the CPSC its power is
the Consumer Product Safety
Act 1972. Under this Act, every manufacturer,
distributor and retailer of a consumer product
is required to inform the CPSC within 24 hours when they
obtain information which
reasonably supports the conclusion that a product:
(1)
fails to comply with an applicable consumer
product safety rule;
(2)
contains a defect which could create a
substantial product hazard; or
(3)
creates an unreasonable risk of serious injury
or death.
On September 4 2007, the CPSC stated that it was
investigating whether Mattel "knowingly" withheld information
regarding potential safety risks associated with its toys that were involved in
a major recall in August 2007. If the CPSC decides that Mattel did breach
provisions of the above Act, then it has the power to issue fines on Mattel for
up to US$2 million.5
With respect to Chinese toy manufacturers, the CPSC may
initiate seizure and condemnation proceedings if the products are determined to
be hazardous. After the CPSC has designated a product as a substantial hazard,
it may require the manufacturer to give public notice of the product's defect
and either make repairs, replace the product, or give refunds to consumers.
Also, a manufacturer who knowingly violates any rule and whose product
subsequently injures any person may be subject to civil fines and criminal
penalties.
CHINA'S GENERAL ADMINISTRATION OF QUALITY SUPERVISION,
INSPECTION AND
QUARANTINE
China's General Administration of Quality Supervision,
Inspection & Quarantine (the AQSIQ) is a governmental department in China
in charge of the quality of goods being imported into and exported out of
China.
Currently, the CPSC is working closely with the AQSIQ, which
means that if the CPSC is interested in investigating a particular manufacturer
in China, the AQSIQ may help the CPSC to carry out an investigation, or it may
decide on its own to do a follow-up of the CPSC's investigation.
On September 12 2007, a Consumer Product Safety Summit was
held between the CPSC and the AQSIQ. At the conclusion of this summit, an agreement
was reached between both parties where the AQSIQ agreed to:
(i)
increase its inspections of consumer products
destined for the US;
(ii)
assist the CPSC in tracing hazardous products to
the manufacturers, distributors and exporters in China; and
(iii)
stop and prohibit manufacturers in China from
using lead paint in its manufacture of all toys exported to the US immediately.
In addition, both agencies agreed upon plans for future
cooperation in the toy industry, including a roadmap for bilateral efforts to
improve their safety. The two agencies expect to review the plans'
effectiveness within one year to identify possible areas for improvement.
REBUILDING THE IMAGE OF CHINESE PRODUCTS
In early October 2007, the Chinese government tried to help
Chinese toy manufacturers to improve the quality and safety of their products
by running a two-day training workshop in Guangdong province. During this
workshop, various government officials and executives of multinational firms
gave lectures on toy certification systems, and export test regulations and
standards in China, the US, and Europe. More than one thousand industry
leaders, including owners and managers from Chinese toy manufacturers and state
officials, attended this workshop. This is another step taken by the Chinese
government to rebuild and improve the tarnished image of “made-in-China”
products.
NEW PROPOSALS FROM US TOY RETAILERS
On September 6 2007, a large toy retailer in the US took an
unusual step by asking the US federal government to impose a mandatory safety
testing system for all toys sold in the US. This proposal, which was approved
by the board of the US Toy Industry Association at a private meeting, did not
envision a broad federal inspection program. Instead, the US toy retailers are
calling for a federal mandate requiring all toy companies to hire independent
laboratories to check a certain portion of their toys, whether made in the US
or overseas, before these toys reach the US market. Currently, there is no
uniform standard for testing, and the quality and safety of the toys are tested
only after they have reached the US market.
Also, the proposal seeks to improve the following:
(i)
frequency of testing;
(ii)
determining at what point during the production
should that tests be conducted; and
(iii)
what specific hazards should be checked for.
By imposing such a system, US toy retailers would have a
more reliable method of testing and detecting products with defects before they
reach US consumers. One reason why the US toy retailers have made such a
proposal is because "if the consumer is aware that the government has some
responsibility and is holding companies responsible, it will set their minds at
ease as to the products they are buying off the shelves" according to Jeff
Holtzman, chief executive of the Goldberger Company, a toy maker.
If the proposal is accepted by the US federal government,
the government would need to increase its manpower at the CPSC because the CPSC
would be involved in helping to set the testing standards. The CPSC will also
continue its role in testing the toys after they have reached the US market to
ensure that the proposed system is working effectively.
LIMITING POTENTIAL LIABILITIES FOR CHINESE TOY
MANUFACTURERS
Contractual terms
A Chinese toy manufacturer can protect itself through
contracts. It is advisable for a toy manufacturer to perform a "risk
audit" so that it is aware of its potential liabilities, and it is vital
that any contract between a US retailer and Chinese toy manufacturer be drafted
carefully and thoroughly, allocating risks fairly. Every term and provision in
a contract can have legal ramifications and needs to be reviewed and revised by
experienced international lawyers.
Indemnification provisions
Both parties should have a clear understanding regarding
indemnification. When something goes wrong, like the recent toy recalls, should
the manufacturer be liable for all the costs of recall? If so, for how much?
Who should bear liability for design faults? These issues should be considered
before entering into a contract. A clear allocation of risks is desired.
Incorporation of safety standards
The degree of quality and safety standards required for the
products should be stated in detail in the contract. This will avoid US
retailers from claiming that the products do not meet the required standards. A
Chinese manufacturer should have documentary proof that its production has
complied with such detailed safety standards.
Dispute resolution, choice of law and choice of forum
When a dispute arises between parties, in which country
should it be resolved? Which country's law or court's procedures should be
followed? This may decide whether a class action is possible against a Chinese
toy manufacturer. Is there a designated neutral third party (i.e. mediator or
arbitrator) that can help to resolve the dispute? Details on all of these
issues should also be stated in the contract.
Design
A Chinese toy manufacturer should pay extra attention to the
designs of any products that it is asked to produce. Most of the time, it is
the design of the product that has created the problem. Even if a toy
manufacturer produces a product that fits the retailer's requested
specifications exactly, that product might have problems because its design did
not meet the required standard of safety or quality in the US.
Even Mattel has acknowledged and admitted that its design
defects were the main reason for most of these recalls. On September 21 2007, Thomas
A. Debrowski, Mattel's executive vice president for worldwide operations,
apologized to China for harming the reputation of Chinese manufacturers. In
particular, he said that "the vast majority of those products that were
recalled were the result of a design flaw in Mattel's design, not through a
manufacturing flaw in China's manufacturers:"6
Liability insurance
Both retailers and manufacturers should purchase product
liability insurance to cover themselves.
On-going inspection
There should be on-going inspections between US retailers
and Chinese manufacturers to ensure good quality of toy products. Also, the
supply chains, i.e. where the components of each part of the product come from,
should be transparent, recorded and tested. By doing so, the quality of the
products can be controlled and maintained.
With better cooperation among Chinese toy manufacturers and
US retailers and better allocation of risks among these parties, a Chinese toy
manufacturer can understand its potential risks better and can minimize the
negative consequences of the current toy recalls.
Simon Luk is Partner and Chairman of the Hong Kong
Practice of Heller Ehrman, and Honorary Legal Advisor to the Chamber of Listed
Hong Kong Companies and the Toy Manufacturers Association of Hong Kong. Eric
Wong is a Trainee Solicitor at Heller Ehrman. An abridged version of this
article has been previously published in the newsletter of the Hong Kong
General Chamber of Commerce.
Endnotes
- The "easy-Bake
Oven"is an example of a popular toy made in China with design
defects. This electrical toy is a purple and pink plastic oven that
resembles a kitchen range, with four burners on top and a front-loading
oven. It produces heat to resemble a real kitchen burner. There were 29
reports of children getting their hands or fingers caught in the oven's
opening, including five reports of burns.
- Among the products
recalled were "Happy Giddy Gardening Tools" "Toby & Me
Jewelry Sets" and "Thomas & Friends Wooden Railway
Toys"
- On August 14 2007, a
similar lawsuit was filed against Fisher-Price, a wholly-owned subsidiary
of Mattel Inc., in New York.
- According to news reports,
one of Mattel's recent recalls involving 967,000 product units was
expected to cost the company around US$30 million.
- In 2007, Fisher-Price had
to pay a fine of US$975,000 for failing to give a timely report on a
potential choking hazard with a toy set called "little People Animal
Sounds Farm" The danger with this toy was that the two small metal
screws that held the toy "Stall door" in place could come off,
posing an aspiration or choking hazard to young children.
- "Should Mattel
have said sorry to China" , September 21 2007.
