in the file everything you need

Lesson 3 Overview•
This week we address the issue of Consumer Protection in our reading of Chapter 24 of The Legal
Environment of Business (10th Ed.).
The federal agencies discussed in Chapter 24 “Consumer Protection: are the Federal Trade Commission, The
Food and Drug Administration, and the Consumer Product safety Commission. There are significant sanctions
these agencies can bring down on offenders who fail in their duty to treat consumers fairly in the marketplace.
These agencies enforce and publish regulations concerning statues such as the Federal Trade Commission Act,
The Food, Drug and Cosmetics Act, and the Consumer Product Safety Act.
The Mandatory Assignment 24-3 “Spotlight on McDonald’s -Food Labeling” in the Business Case Problems at
the end of Chapter 24 is a good segue into your consideration of how management, Chinese regulatory
authorities, the Chinese judiciary, consumers and the international community reacted and dealt with a lifethreatening health issue from contaminated milk in the Sanlu Case.. Note the tension between management and
Chinese government officials and the consumers.
First MANDATORY ASSIGNMENT
MANDATORY ASSIGNMENT — Briefly answer the questions in 24.3 “Spotlight on McDonald’s – Food
Labeling” (p. 530) based on your reading. Post your answers in the Discussion Thread. with your opinion on
whether the Nutrition Labeling and Education Act is an appropriate response to the issue of food labeling for
children? If not, how should it respond? Also answer the questions asked on the Mandatory Assignment
Template: Should the law be amended to improve it? If yes, how? Is theh law satisfactory? If yes, briefly
explain why you think it is satisfactory.
Your second Mandatory Assignment is to write an analysis of the Sanlu Case. The Sanlu Case is posted
below along with guidance on how you should write your analysis.
Read the Sanlu case at least twice. First, get the overall situation and read again to become more
familiar with the facts.
Each time you read the case, take notes and identify in a time line the facts, the decisions that were
made, and by whom.
Use the template in Law Assignments for your answer. Discuss the following:
(1) How the Chinese government and judicial system responded to the situation and the
response of the international community; and
(2) Give your opinion on whether you believe the Chinese government’s regulatory and
judicial responses were adequate to protect the consuming public in China and
consequently buyers of the milk product in other countries.
S
w
9B09M077
SANLU GROUP AND THE TAINTED MILK CRISIS1
Francis Sun wrote this case under the supervision of Professor Shih-Fen Chen solely to provide material for class discussion. The
authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised
certain names and other identifying information to protect confidentiality.
Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of
this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to
reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of
Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca.
Copyright © 2009, Ivey Management Services
Version: (A)2009-10-07
The government said Sanlu was to blame; Sanlu said the cow farmers were to blame; the
cow farmers said the cows were to blame; the cows said the grass was to blame; and the
grass said its mother was to blame. . . .
— Black humor circulated widely in China in the wake of the tainted milk scandal.
In late summer of 2008, a tainted milk scandal unfolded in China and shocked the world. Lethally high
levels of melamine, an industrial chemical that could cause kidney failure, were detected in infant formula
being sold in the market. Sanlu Group Inc. (Sanlu), the core firm in the scandal, had manufactured a
product containing melamine that was 5,125 times higher than the European Union (EU) safety limits. The
scandal swept through the Chinese dairy industry, which was valued at RMB122 billion (US$18 billion) in
2007. All over the world, Chinese dairy products were recalled and banned. By December 2008, the
official numbers of victims included more than 290,000 infants sickened, 51,900 hospitalized, 11 suspected
deaths and three officially confirmed deaths.
On January 22, 2009, the Intermediate People’s Court of Shijiazhuang city, Hebei province, sentenced two
managers of Sanlu’s raw milk suppliers to death. Four Sanlu executives — Chief Executive Officer (CEO)
and Chairwoman Tian Wenhua, Vice Presidents (VPs) Wang Yuliang, Hang Zhiqi and Wu Jusheng —
were charged with producing and selling fake or substandard products. Tian was sentenced to life
imprisonment, and the others received sentences of five to 15 years. Tian was ordered to pay a fine of
RMB24.7million (US$3.6 million). Despite the bankruptcy of the company as a legal entity, Sanlu was
also fined RMB49.4 million (US$7.3 million).2
1
This case has been written on the basis of published sources only. Consequently, the interpretations and perspectives
presented are not necessarily those of Sanlu Group or any of its employees.
2
“Sanlu Group Criminal Cases Reached Verdict,” Xinhuanet, January 23, 2009, http://news.xinhuanet.com/legal/200901/23/content_10705325.htm, accessed on January 23, 2009.
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9B09M077
SANLU GROUP
The Road to Becoming the Top Dairy Producer
On February 16, 1956, 18 farmers in suburban Shijiazhuang city pooled 32 milk cows and 170 milk goats
to form a collective milk plant for handling milk storage and basic milk processing. They named their
3
group “Happiness Dairy Production Collective.” This collective was the predecessor of Sanlu Group.
Thanks to several generations of hard-working employees, the company successfully survived the political
turmoil (i.e. the Cultural Revolution) and steered itself into the reform era in China. Since the early 1980s,
and throughout China’s rapid economic growth that created a huge consumer market, Sanlu had continued
to diversify its dairy products. Sanlu employed nearly 10,000 people, and was one of the largest employers
in Shijiazhuang, the capital of Hebei province.
Sanlu’s success was inseparable from one particular individual, CEO and Chairwoman Tian Wenhua. In
1986, Tian first initiated the program of combining cow ownership and cow raising to solve the problem of
raw milk shortage. At the time, China had just started its economic reform, and the shortage economy
dating back to the planning era still prevailed. Because any activities other than pure farming were
considered a “capitalist tail,” raising cows were prohibited in rural areas. By combining cow raising and
milk processing in its daily operations, Sanlu assumed the roles of both a farmer and an industrial
producer.
As consumer demand for dairy products increased along with economic growth and improved living
standards, Sanlu’s integrated model couldn’t catch up with the ever-growing market. Raw milk supply
became a bottleneck for expanding output capacity. Tian was often embarrassed by not being able to
4
satisfy a friend’s request for a 500-gram milk quota.
Tian revolutionized the industry by convincing villagers to raise cows and sell raw milk back to Sanlu, as
epitomized by the slogan “cows going to villages, and milk coming back to cities.” She nicknamed those
villages as the first section on Sanlu’s production line. By 2003, Sanlu’s raw milk supply was relying on
more than 160,000 heads of cows being raised by villagers.
From the very beginning, some questioned whether these ill-managed and less-monitored “first sections”
would supply substandard raw milk to Sanlu. What happened later proved that such worries were not
unwarranted. Due to misalignments of interest between Sanlu and the cow raisers, disputes frequently
erupted regarding the milk quality and the price. Because these villagers supplied a large portion of raw
milk that was necessary for Sanlu’s expansion, the company could fill the supply gap only by sacrificing
quality in exchange for quantity.
Since the 1990s, Tian had launched multiple rounds of successful acquisitions, labeled as “low-cost
expansions.” Three of those major acquisitions were made in 2006 alone. In February 2006, the group
opened a dairy plant in Tangshan (a city in Hebei, near Beijing) with an annual output capacity of 200,000
tons of formula milk powder. In April 2006, Sanlu acquired a liquid milk production base in Weifang, in
Shandong province, which was capable of producing 300,000 tons of liquid milk every year. In October of
the same year, the company invested in production facilities with an annual capacity of 100,000 tons of
5
lactic acid bacteria drink and yogurt in Xinxiang, Henan province.
3
Diyi Caijing Daily, Oct. 10, 2008, http://news.sina.com.cn/c/2008-10-10/012716425723.shtml, accessed on Oct. 10, 2008.
“Reinvestigating Tian Wenhua and Her Sanlu Model,” Sanlian Life Weekly, November 3, 2008, pp. 82–87.
5
Ibid.
4
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9B09M077
Powdered milk had been Sanlu’s strongest product line since 1983, when it introduced the first infant
formula product in China. By 2007, Sanlu had been exceeding all other competitors for 15 consecutive
years, with a market share of more than 18 per cent. Its market share ranked second for yogurt and third for
6
liquid milk. In 2007, Sanlu’s total sales reached the benchmark of more than RMB10 billion (US$1.36
billion), a 5.3 per cent growth over the previous year (see Exhibit 1). Tian was considered one of the most
successful entrepreneurs in China for her role in building up the company. She was named deputy chair of
the China Dairy Industry Association and elected to the National Committee of the Chinese People’s
7
Political Consultative Conference.
Sanlu prided itself on its stringent quality control by boasting extremely rigorous test procedures for its
products. On September 2, 2007, Sanlu was featured in “Made-in-China,” a special episode of the CCTV
program Quality Reports Weekly. In the program, Sanlu claimed that it carried out more than 1,000 tests
before sending a product to the market. Numerous Sanlu products passed regulatory standards three times
8
in a row and were thus exempted from routine inspections from the government.
In 2007, the Chinese Ministry of Commerce awarded Sanlu the titles of “the Most Competitive Brand” and
“the Renowned Brand in China.” Forbes ranked Sanlu number one on its list of top Chinese dairy
enterprises. The China Brand Asset Assessment Center estimated that Sanlu’s brand assets were valued at
approximately RMB15 billion (US$2.19 billion). In the same year, China’s State Council bestowed the
prestigious “2007 National Science and Technology Progress Award” on Sanlu for its innovative infant
formula and related techniques. In August 2008, one month before Sanlu was shut down for criminal
charges, CCTV and dozens of other media promoted Sanlu as “the national brand that had changed
9
Chinese people’s life in the past 30 years.”
Partnership with Fonterra Co-operative Group
In December 2005, Sanlu signed a joint-venture agreement with the New Zealand dairy firm Fonterra Cooperative Group (Fonterra). The joint operation was formally launched on June 15, 2006. In this
partnership, Fonterra acquired a 43 percent stake in Sanlu at the price of RMB864 million (US$107
million), allowing Sanlu to control the majority equity (56 per cent). Under the agreement, a senior
Fonterra manager joined Sanlu’s senior executive team, and three Fonterra representatives also joined the
seven-member board of directors.
Fonterra was the largest marketer of dairy ingredients in the world, exporting dairy ingredients to 120
countries. Fonterra had total revenues of NZ$12.3 billion (US$8.5 billion) in 2005 and was worldrenowned for its production, processing and sales of dairy products. Fonterra exported more than 90 per
10
cent of its total production.
The joint-venture deal represented the largest investment by a foreign dairy company in China. At the time
of signing the joint venture contract with Fonterra, Sanlu declared it would invest RMB3 billion (US$439
million) in further expansions over the following three years, with the aim of forming a national industrial
network.
6
Sanlu Group website, http://www.sanlu.com, accessed on Nov. 19, 2008.
Ibid.
8
Ibid.
9
“Special Focus”, China Dairy, Issue 9, 2008, pp. 3 –7.
10
“Media Release”, Fonterra Company website, www.fonterra.com, accessed on Nov. 20, 2008.
7
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9B09M077
The significance of the joint venture was best captured by remarks made by executives of both parties
11
during an earlier signing ceremony at the prestigious Diaoyutai State Guest House in Beijing. According
to Tian:
Sanlu has become a famous Chinese brand. We have accumulated extensive experience in
new product research and development (R&D), operational management, sales and
marketing, and maintained a robust and sustainable growth momentum for many years.
Fonterra is an acknowledged leader in dairy production with extensive management
experience, world-class R&D teams, and advanced marketing skills.
I believe the co-operation between Sanlu and Fonterra is significant to the development of
the Chinese and global dairy industry. It signals that Sanlu has taken the first crucial step
towards the objectives of reaching the world-class level and developing Sanlu into a global
leader in the dairy industry.
Fonterra CEO Andrew Ferrier emphasized that the investment reflected Fonterra’s confidence in the future
of the dairy industry in China:
Over the past 20 years, Fonterra has been the number one exporter of dairy ingredients to
China. We have been impressed by the spectacular growth in consumer demand for dairy
products in China and the way Sanlu has grown strongly to meet this demand.
From a marketing perspective, Fonterra Brands Managing Director Sanjay Khosla said that the investment
was the logical marketing strategy for Fonterra in China:
We will complement our existing importing and consumer businesses in China by
partnering with a successful local company that has access to local fresh milk supplies.
The joint venture would draw on the respective strengths of Fonterra and Sanlu. It is a
professionally managed company that has a good track record for growth. It has an
established sales and distribution network reaching more than 600 cities in China.
The partnership did not affect the operational structure of Sanlu. The business scope of the joint venture
continued to be manufacturing, marketing and distribution of consumer dairy products within China.
Throughout 2006 and 2007, as expected by both parties, the joint venture had been on the track with its
original goal of achieving a high level of competitiveness and profitability.
THE SCANDAL
In late 2007, sporadic consumer complaints and media reports began to emerge, blaming tainted baby
powder milk for a number of cases of infant kidney failure12 (see Exhibit 2). Some of these cases had a
confirmed link to products from Sanlu, which had been China’s number one seller of baby formula for 15
11
All citations are from Fonterra Co-operative Group Ltd., “Fonterra and Sanlu Reach Joint Venture Agreement”, press
release, December 2, 2005, assessed on Nov. 20, 2008.
12
“Sanlu Received Consumer Complaints as Early as End of 2007,” Hebei Youth Daily, September 23, 2008,
http://news.sjzcity.com/2008/6131.shtml, retrieved on June 20, 2009.
Page 5
9B09M077
consecutive years and had accounted for more than 18 per cent of the Chinese baby formula market in
2007.
In response to more and more similar consumer complaints, on July 1, 2008, Sanlu launched an
investigation into infant kidney failures that were allegedly linked to its infant formula. The company sent
16 batches of samples to the local governmental food safety regulator for testing of the ingredients. The
results showed that all of the 16 samples contained melamine.13
Melamine is a chemical often used to manufacture a type of flame-retardant plastic, which is commonly
used in the manufacture of countertops and dry-erase boards. Melamine is nitrogen-rich and is sometimes
illegally added to food products to increase their protein level. Melamine is also used in cattle feed.
Melamine is known to cause renal and urinary problems in humans and animals when it reacts with
cyanotic acid in the body. If taken by humans or animals in a large quantity or over a prolonged period,
melamine can damage urinary and reproductive systems. The common symptoms of melamine poisoning
14
are kidney stones and kidney failure. The use of melamine in food production is universally banned.
On August 1, 2008, Sanlu’s board of directors, led by Tian, held its first meeting to discuss the
contamination of baby formula and dairy products.15 The board decided to cover up the incident and to
check the products in stock for melamine content. The board decided not to halt production. The firm filed
a report to inform the local government that its products were contaminated with melamine and asked the
government to help investigate possible contaminations of the raw milk sources. On the same day, some
government officials visited Sanlu and applauded its decision. They did not ask the company to stop
production.16
After the government officials’ visit, Sanlu held another board meeting on August 13, 2008, deciding that
the company would (1) continue to sell products in stock with a melamine level of less than 10 milligram
per kilogram (mg/kg), (2) withhold temporarily inventories with a melamine level of more than 10 mg/kg
and (3) replace items in the market that had high melamine levels with products that contained
approximately 20 mg/kg.17
On September 11, 2008, the Health Ministry of China announced that a lethally high level of melamine
was detected in infant formulas being sold in the market, including those made by Sanlu. The following
day, the government ordered Sanlu to halt production and to recall and destroy all unsold products. The
authorities reportedly seized 2,176 tons of Sanlu’s inventory and ordered the firm to recall another 9,000
tons from the market.18 On September 15, local police arrested four individuals and detained 22 suspects
for adulterating melamine into the milk source. In the follow-up moves, Tian and three other executives
were arrested and a number of government officials at the central and local levels were removed from their
office (see Exhibit 2).19
Court investigations indicated that, from October 2007 to March 2008, the dairy industry faced extreme
shortages of raw milk. Dairy firms started a new round of fierce competition for raw milk that drove the
13
“Tracing the Sanlu Poisonous Milk Powder Case,” Xinhua Net, January 4, 2009, accessed on Feb. 22, 2009.
World Health Organization, “Q & A on Melamine,” http://www.who.int/csr/media/faq/QAmelamine/en/, accessed on April
25, 2009.
15
Fonterra Media Release, “Statement by Fonterra CEO Andrew Ferrier to Media Conference,” September 15, 2008.
Source: www.fonterra.com, accessed on Nov. 20, 2008.
16
The Melamine in Court. By Tian Lei. Nanfengchuang Magazine, Issue 2, 2009, pp. 56-58.
17
“Tracing the Sanlu Poisonous Milk Powder Case, Xinhua Net, January 4, 2009, accessed on Feb. 22, 2009.
18
“China to Destroy 10,000 Tons of Tainted Baby Formula,” Xinhua, September 15, 2008.
19
Yanzhao Dushi Bao, September 23, 2009, pp. 1.
14
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9B09M077
price as high as RMB3.6 (US$0.51) per kilogram. When the price reached RMB3 yuan (US$0.43), Sanlu
found that it could not afford to pay for the raw milk, yet its major suppliers insisted on a higher price. To
keep production running, Sanlu agreed that its suppliers could adulterate the raw milk with water under the
condition that the protein level be maintained at 2.8 grams per 100 grams level.20 Geng Jinping, a supplier
who was later executed in the Sanlu case, added approximately 434 kg melamine-rich “protein powder” to
some 900 tons of raw milk at his milk station.21
On September 16, 2008, China’s General Administration of Quality Supervision, Inspection, and
Quarantine (GAQSIQ), which was the Chinese equivalent to the U.S. Food and Drug Administration
(FDA), released test results based on 491 samples of baby milk powder sold by 109 companies. The results
indicated that all 11 samples from Sanlu failed the melamine test, and one recorded the highest level of
contamination among all samples, at 2,563 mg/kg or parts per million (ppm), despite the EU safety limit of
only 0.5 ppm melamine content in food. Samples obtained from 21 other companies were also found to be
tainted (with concentrations ranging from 0.09 to 619 ppm), including samples from all top five dairy
22
brands in China, such as Mengniu, Yili and Bright Dairy.
China’s top dairy firm that survived the scandal impeccably was Beijing-based Sanyuan Dairy (Sanyuan),
which later acquired the bankrupted Sanlu. Sanyuan owned and operated 27 large-scale farms in Beijing
and their more than 35,000 heads of milk cows. This integrated model accounted for more than 80 per cent
23
of its raw milk and guaranteed the quality of raw milk supply.
The number of tainted milk victims soared. On September 17, 2008, Health Minister Chen Zhu stated that
tainted formula had sickened more than 6,200 children, and 1,300 newborns remained hospitalized due to
24
kidney failure. In early December 2008, Xinhua reported that the Ministry of Health revised the numbers
to more than 290,000 sickened, 51,900 hospitalized, 11 suspected deaths and three officially confirmed
deaths.
The official figures were likely to be understated because deaths without an official verdict might not be
counted. For example, the eight-month-old daughter of Li Xinquan, a peasant from Runan County, Henan,
died on September 10, 2008, as the result of long-term intake of Sanlu’s baby formula, but was not counted
as a victim. The family was denied compensation because she died one day before “9-11,” the official date
25
on which the government labeled the Sanlu scandal as a criminal case.
Sanlu’s joint-venture partner, Fonterra, played a significant role in uncovering the scandal. During Sanlu’s
August 1, 2008 board meeting, Fonterra representatives Bob Major, Mark Wilson and Patrick Kwok
reportedly disagreed with the decision to cover up the incident, but their minority position on the board
failed to stop the decision. On September 5, 2008, these representatives notified the New Zealand
government about Sanlu’s decision and asked for help in dealing with it. Three days later, the prime
minister of New Zealand, Helen Clark, deputized Tony Brown, New Zealand’s ambassador to China, to
26
alert Beijing directly. The series of actions was believed to have prompted the Chinese government to
investigate and thereafter disclose the scandal.
20
“Investigation into Sanlu’s Poisonous Milk Powder,” Xinhua, January 4, 2009.
“Sanlu Criminal Cases Reached Verdict,” By Zhang Jingyong. Xinhua, January 23, 2009.
22
“Products from 22 Dairy Firms Contain Melamine”, Yanzhao Dushi Bao, September 17, 2009, pp. 4.
23
“Credit, Quality, and Trust”, by Niu Liping. China Dairy, October 2008, pp. 15-16.
24
“Twelve More Arrested in China’s Tainted Milk Scandal,” Associated Press, September 18, 2008.
25
“The Melamine in Court”, by Tian Lei. Nanfengchuang Magazine, Issue 2, 2009, pp. 56-58.
26
“New Zealand Alerted China to Tainted Milk, PM Says,” South China Morning Post, September 16, 2008, pp.A4.
21
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9B09M077
REACTIONS TO THE SCANDAL
Domestic Reactions
The tainted milk scandal had directed the Chinese public’s fury and resentment toward the involved dairy
firms. Long queues of consumers formed outside the offices of Sanlu and other dairy firms, demanding
product returns and refunds. Hundreds of thousands of consumers filed law suits against Sanlu. Most
interesting were the consumer reactions on the Internet.
Internet hackers broke into the Sanlu website and, using a play on words, changed the name “Sanlu Group”
to “Melamine Group,” which was made easier because Sanlu Group (三鹿集团) and “Melamine Group”
(三聚氰胺) both started with the same Chinese character (三). To Sanlu’s list of “famous products,”
hackers added “Melamine.” Internet users also vented their anger with hundreds of millions of messages
on bulletin boards and blogs.
Celebrities who had endorsed dairy products in media advertisements were also mocked in images to
which digitally modified words had been added. For example, the words of actress Deng Jie in an
advertisement were paraphrased from something like “Sanlu, trustworthy and smart choice” into “Sanlu,
step-mother’s choice,” and her profile was changed to a petrified statue (symbolizing a kidney stone). Text
messages expressing anger and black humor, such as the blame game cited in the opening to this case,
were widely circulated among cellular phone users.
In late September 2008, the disclosure of an official’s speech diverted the public anger toward political
leaders. In a speech reportedly delivered in August 2008, Zhu Yonglan, the director of the Special Food
Supply Centre at the State Council and Central Government Offices, disclosed that her office was set up in
27
2004 to source high-quality organic food for top political leaders. The existence of Zhu’s office stirred up
growing resentments that the country’s leaders were not even troubled by the food security turmoil faced
by Chinese citizens. Ordinary consumers started to question whether the government ever intended to be
serious about the food safety issue.
International Reactions
As expected, the melamine scandal led to worldwide bans on Chinese dairy products from China’s
28
neighboring Asian countries, and from Africa, Europe and the Americas. In Canada, for example, the
four largest manufacturers of infant formula testified to the federal government that they did not source
milk ingredients from China. Mengniu strawberry yogurt, the only Chinese dairy product on Canadian
market, which was distributed only in Alberta and Saskatchewan (and without English or French
29
trademarks), was recalled by its importers for possible melamine contamination.
On September 25, 2008, the EU announced a ban on all imports of baby food containing Chinese milk and
called for tighter checks on other Chinese food imports. Netherlands and the French authorities ordered all
27
“Amid Milk Scare, China’s Elite Get Special Food,” by Anita Chang, CNBC, September 24, 2008,
http://www.cnbc.com/id/26873844/for/cnbc, retrieved on September 23, 2009.
28
“China Tainted Milk Crisis Triggers Global Recalls,” USA Today, September 23, 2008,
http://www.usatoday.com/news/world/2008-09-23-3519812911_x.htm, retrieved on September, 23, 2008.
29
“Mengniu Strawberry Flavour Sour Milk Beverage May Contain Melamine”,
http://www.inspection.gc.ca/english/corpaffr/recarapp/2008/20081015e.shtml, accessed on September 22, 2009.
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30
Chinese dairy products to be removed from store shelves. Meanwhile, the European Food Safety
Authority (EFSA) warned that children who consumed large quantities of biscuits with high milk content
could theoretically be consuming melamine at more than three times the prescribed EU safety limits (0.5
mg/kg of body weight).
In the United States, the FDA issued an advisory on September 12, 2008, regarding the possibility of
contaminated milk powder being sold in specialty markets serving the Asian community in the United
States, while assuring consumers that no formula approved for sale in the United States was made in
China. Later, the FDA issued a general alert against all finished food products from China, noting that
official information from a number of nations indicated a wide range of melamine contamination in many
31
products. To further cope with the surge of contaminated food incidents in China, the FDA set up, for the
32
first time, overseas inspection bureaus in Beijing, Guangzhou and Shanghai in November 2008.
The World Health Organization (WHO) referred to the incident as one of the largest food safety events it
had dealt with in recent years. The WHO decried that such deliberate contamination of foods intended for
vulnerable infants was deplorable. In a press conference, WHO official Peter Ben Embarek said that the
milk contamination was clearly not an isolated accident; instead, it was a large-scale activity intended to
33
deceive consumers purely for short-term profits.
BACKGROUND OF THE SCANDAL
Chinese firms did not operate in a vacuum. Their activities were affected by both the industries to which
the firm belonged and the larger community in which it resided. Sanlu alone could not have caused a
scandal with such a magnitude. Apart from the mistakes and wrongdoings within Sanlu, numerous other
factors had also play a facilitating role in the scandal, including the structure of the dairy industry,
government regulations on food safety, the political climate and all the social and cultural transformations
that had accompanied China’s recent economic development.
The Chinese Dairy Industry
When the People’s Republic of China (PRC) was established in 1949, the dairy industry in China was
relatively small, with an annual total output of more than 200 metric tons. The first three decades of
economic development raised the dairy industry’s output to almost 1,000 metric tons. However, in the next
three decades that followed China’s massive economic reform in 1978, the economy grew by more than 10
per cent annually. The growing affluence of Chinese consumers, their rising awareness of and demand for
nutritional intake and rapidly expanding commodity distribution channels together created a huge market
for dairy products. Strong demand stimulated more investments in the industry, making China one of the
major dairy producers in the world (see Exhibits 3, 4 and 5).
Unlike most other countries where dairy farming occupied vast prairie lands, China’s very conventional
farming sector used a unique operational chain (see Exhibit 6). Due to the lack of prairie lands, more than
30
“EU Bans Baby Food with Chinese Milk,” CNN News, September 25, 2008.
“FDA Import Alert,” November 12, 2008. http://ftn.fedex.com/news/NewsBulletinDisplay.jsp?url=111808&lang=en,
retrieved on September 22, 2009.
32
“U.S. Opens Food Safety Office in China after Scares,” CNN.com, November 19, 2008. Retrieved on April 28, 2009.
33
“China’s Melamine Milk Crisis Creates Crisis of Confidence,” VOA, September 26, 2008,
http://www.voanews.com/english/2008-09-26-voa45.cfm, accessed on September 22, 2009.
31
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9B09M077
80 per cent of the dairy cows in China were raised by small farmers in their backyard (see Exhibit 7). Each
herd typically comprised fewer than 20 cows. Average milk production per cow was 30 per cent lower than
the world average.34
One media report painted an even murkier picture.35 According to this source, most Chinese dairy farmers
were poor and did not eat well — neither did their cows. The average herd of just three to five cows was
often kept in substandard and filthy conditions. The two major dairy firms in the Inner Mongolia region,
Mengniu and Yili, relied on small-scale farms for more than 90 per cent of their raw milk supplies and
constantly paid two-thirds of the normal price to purchase milk that failed quality tests.36 These two firms
purchased substandard milk despite having invested millions in state-of-the-art facilities in a region that
prided itself on its vast grasslands and produced more than one-quarter of China’s milk.
Chinese safety standards required that fresh raw milk be processed immediately after being extracted from
cows and then be kept at a prescribed low temperature. Due to lack of capital and operational scale, most
backyard farmers had neither the necessary processing and refrigeration equipment, nor access to modern
and large-scale processing facilities, which were concentrated in the major cities. After years of fierce
competition, processing facilities became even more concentrated, making it virtually impossible for
dispersed backyard farmers to send fresh milk directly and immediately to dairy plants.
This dilemma was seen as a lucrative opportunity by some villagers who had easy access to funding and
established “milk stations” to connect the supply chain. As shown by the picture in Exhibit 8, a small
vehicle was used by farmers to transport fresh milk to the bigger tank truck owned by a milk station. The
truck traveled to individual cow farmers to collect unprocessed raw milk for delivery to a station equipped
with rudimentary processing facilities (i.e. refrigerators).
More often than not, raw milk was transported to multiple milk stations before arriving at a dairy plant
because some milk stations lacked all the necessary equipment to run their operations. For example, a milk
station might have refrigerating equipment but lack the tank truck equipped with a cooling system to safely
transport milk to dairy plants. Instead, the milk was recollected by a larger milk station that owned the tank
truck. As illustrated in Exhibit 6, the supply chain between cow farmers and final processors often included
one or more milk stations.
The supply chain was further strained by an imbalance between supply and demand. On one hand, the
dairy industry was expanding rapidly to meet the strong demand for dairy products. On the other hand, the
lack of modern and large-scale operations made it impossible for cow farmers to raise their output to the
level that was necessary to support the rapid growth of the industry. As a consequence, dairy plants were
scrambling for scarce milk sources.
All these factors together triggered round after round of mergers and acquisitions in the dairy industry.
Because of their abundant capital and advanced technology, large dairy enterprises were grabbing the
market share of small producers, which faced funding and equipment constraints. Smaller firms were
fading out of the competitive landscape, and several large brands emerged (e.g. Sanlu, Yili, Mengniu and
Bright Dairy). Powered by heavy investment in product development and brand building, major players
accounted for more than 70 per cent of the dairy market in China.37
34
“PR. China Dairy Products”, GAIN Report by USDA Foreign Agricultural Service, October 12, 2007.
“Why China’s Milk Industry Went Sour,” BBC, September 29, 2008.
36
“Dirty Secrets of Milk-faking Capital,” by Al Guo, South China Morning Post, September 22, 2008, pp. A5.
37
”The Foreseeable Dairy Industry Change in 2009”, by Li Wei, Beijing Shangbao, Feb. 20, 2009,
http://www.cnyf.gov.cn/news/details.jsp?cid=0&itemid=39157, retrieved on September 22, 2009.
35
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Although the dairy industry was experiencing rapid growth, all parties along the supply chain had
experienced their fair share of hardship. The dairy plants, for example, had to secure a continuous supply
of raw milk and compete with each other for market share. Milk stations had to compete not only with each
other but also with those dairy plants that collected raw milk directly from farmers.
The backyard farmers were probably hit hardest. Their first foe was the rising production costs, especially
feed costs. From January to August 2007, the average price of corn increased 18 per cent, and the average
price of alfalfa increased more than 20 per cent in the first half of 2007. Higher operation costs (e.g. labor,
water, electricity, and transportation) further cut into the farmers’ profits, which dropped from RMB3,000
to 4,000 (US$400 to $533) per cow/year in 2006 to RMB1,000 (US$133) in 2007. Banking credit for
farmers had also been tightened, when the interest rate increased from 6.1 per cent at the end of 2006 to
7.29 per cent in September 2007.38
The price of raw milk, however, had changed very little. Fierce competition in the consumer market had
driven down the retail prices of dairy products, which in turn prevented dairy farmers from raising the price
of their raw milk. The lack of refrigeration equipment left dairy farmers with little bargaining power: they
either accepted low prices or allowed their raw milk to go sour. Choosing the lesser of the two evils, some
farmers accepted the low prices offered by the closest milk station or dairy plant. Others chose to pour
extra milk into a river or to kill their cows and sell them as beef.39 As a result, 40 per cent of small
backyard dairy farms were losing money in 2007.40
The entry of foreign dairy enterprises further complicated the competitive landscape. Foreign producers
were usually brought into China by local partners who sought capital and technology support. Foreign
brands were also facilitated in their expansion in China by the lack of consumer confidence in domestic
brands, due to a series of food safety incidents that preceded the large-scale contamination of dairy
products (see Exhibit 3). Chinese consumers believed that imported products or foreign brands had better
quality assurance than their domestic counterparts. Foreign brands, such as Nestlé, Mead Johnson and
Abbott Labs, were popular among consumers, particularly in the lucrative infant formula market, which
was contested by both major domestic and international players.
Food Safety Regulations in China
Food safety regulations in China were complex, and its monitoring system was unresponsive. The agencies
that oversaw and enforced food safety policies had ambiguous and usually overlapping duties. For
example, both the State Council and its affiliated departments could issue regulations and directives
concerning food safety standards. The last major regulatory revision had been made in 1995, through the
Food Hygiene Law, which had laid out general food safety principles. Apart from the lack of regulations,
law enforcement was problematic under the current system. The responsibility to ensure food safety, for
example, was shared among approximately 10 government departments at the national level, plus
numerous provincial and local agencies.
Among various institutions, the General Administration of Quality Supervision, Inspection, and Quarantine
(GAQSIQ) functioned as an enforcement agency that regulated food imports at the national and local
levels. Of the 19 agencies under GAQSIQ, the Department of Supervision on Animal and Plant
Quarantine, the Bureau of Import and Export Food Safety and the Department of Supervision of Food
38
USDA Foreign Agriculture Service, GAIN Report, October 12, 2007.
Ibid.
40
“China’s Animal Feed Tainted with Melamine,” Associated Press, October 31, 2008.
39
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Production all fulfilled the duty of monitoring food safety. In 2001, the GAQSIQ was made a ministry to
raise its profile and enhance its authority in addressing the increasingly challenging issue of food safety.41
GAQSIQ ran a program that exempted food processors from routine inspections once a product had been
proved safe. For example, Sanlu was one of 2,152 companies that had been granted a three-year exemption
on the grounds that its quality control was sufficient to meet regulatory standards.42 In practice, however,
corrupt officials often abused this program by seeking private payments from the companies that they
regulated. Unsafe food could easily reach the market without proper inspection and, as a result, cause
widespread health hazards.
Insufficient regulations on food safety could be attributed, at least partially, to the ecological and historical
contexts in China. Relative to China’s large population, the country had less arable land than most
countries. The agricultural system was composed mostly of small land-holding farmers and subsistence
agriculture. To feed their families, farmers used fertilizers and pesticides intensively in an effort to raise
their output. Food products that were not consumed by farmers themselves were sold in open-air markets
or urban supermarkets, where consumer safety awareness was low, government-imposed standards were
absent and quality inspections were rare.
As urban consumers’ incomes increased, their awareness of and demand for safety foods also increased.
Product contaminations in urban areas attracted more attention from local and national media, further
exacerbating the growing unrest over food safety in China. The often retarded legislative system, however,
could not catch up. Public concerns about food safety had prompted the government to enact an
overarching basic law on food safety and to initiate urgent reforms to strengthen and streamline interagency coordination.
However, no big moves were made until the 2000s, when China became more interconnected with the
worldwide markets. In March 2007, the U.S. Food and Drug Administration declared that melamine had
been found in imported Chinese pet food that had killed hundreds of cats and dogs. Along with other
product recalls (e.g. tires, toys and toothpaste), this pet-food scandal evoked worldwide public anger and
hurt the reputation of the made-in-China label. The national image of China was badly damaged, and the
competency and legitimacy of the Communist government was questioned.
Humiliated and frustrated by such product scandals, the Chinese government decided to overhaul its safety
inspection system. After rounds of investigations, the authorities found that Zheng Xiaoyu, the head of
China’s national drug administration, had accepted bribes from various firms in exchange for government
endorsements of product safety. In May 2007, Zheng was convicted and sentenced to death for approving
unsafe medicines made by eight pharmaceutical companies that paid him a total of more than RMB6.49
million (US$850,000). His corrupt practices resulted in hundreds or thousands of patient deaths.43 Yet, the
execution of the corrupt officials did not solve the product safety problems. As shown in Exhibit 2, food
contamination remained a serious issue in China after the execution of Zheng.
41
W. Tam and D. Yang, “Food Safety and the Development of Regulatory Institutions in China,” Asian Perspective, 29 (4),
pp. 5–36.
42
Ibid.
43
“China Ex-regulator Gets Death Penalty,” CBS News, May 29, 2007.
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Political Climate in China
Economic activities in China often served political purposes and therefore were conditioned to be
politically correct. As reflected in corporate governance, a party secretary was installed in most Chinese
firms to counterbalance the CEO and to assure political correctness of daily business activities and longterm corporate strategies. Tian Wenhua, the CEO and Chairwoman of Sanlu, also served as the company’s
communist party secretary and was a member of the National Committee of the Chinese People’s Political
Consultative Conference.
Media control and the lack of transparency were the two aspects of the Chinese political system that
received the most criticism from the West. For example, some Western media speculated that the Chinese
government delayed the recall of Sanlu’s tainted baby formula in an effort to avoid disrupting China’s
44
hosting of the summer Olympic Games. It was also widely believed that the Chinese government had the
tendency and ability to cover up unfavorable incidents that might disrupt political stability, such as food
contaminations, industrial and mining accidents, outbreaks of contagious diseases and natural disasters that
caused heavy human casualty and property damage.
One of the most publicly exposed incidents was the recent outbreak of SARS (Severe Acute Respiratory
Syndrome). SARS is a contagious decease transmitted through droplets sprayed by coughing, sneezing or
spitting. When SARS first emerged in 2003, the disease had no known cure. According to the World
Health Organization (WHO), the SARS epidemic killed more than 200 people and infected approximately
3,800 others worldwide, with approximately half the cases occurring in China. Since its first appearance in
China in November 2002, the disease had spread to more than 20 nations on five continents. In the United
States, approximately 220 cases were confirmed without fatalities, but the disease killed 29 people in
Canada, mostly in the Toronto area.45
Despite the threat of SARS to public health, Chinese officials originally tried to cover up the disease for
political reasons and asserted that the country was safe for work and travel. The cover-up likely caused
heavier casualties because it delayed the necessary actions taken by the international community to fight
the epidemic. When the cover-up became impossible to continue, the Chinese government pacified the
public by firing its top public health official and the mayor of Beijing.46
The SARS case could be seen as a turning point for the Chinese government’s handling of public incidents,
partly because the central government had realized it could no longer cover up public incidents in this
Internet age. Indeed, prompt confirmation and proper handling of public incidents were more beneficial
than covering them up and letting rumors run wild. Local officials were still motivated, however, to cover
things up, which was a direct result of the design flaws in the current Chinese political system.
The flawed method used by the Chinese government to evaluate local officials might have contributed to
these cover-ups. Under the current Chinese political system, performance of local officials was evaluated
on the basis of two criteria. First, local political leaders needed to ensure that no major incidents or social
unrest occurred during their tenure. Second, economic targets on gross domestic product and growth
needed to be achieved in their jurisdiction. Failing to keep up with either of these two criteria would result
44
“Was China’s Milk Scandal Hushed Up?” by Stephen Hutcheon, New Zealand Herald, September 15, 2008,
http://www.smh.com.au/news/world/was-chinas-contaminated-milk-scandal-hushed-up/2008/09/15/1221330732015.html,
accessed on April 25, 2009.
45
“SARS Cases Continue to Rise in Toronto”, CNN, May 29, 2003,
http://transcripts.cnn.com/TRANSCRIPTS/0305/29/se.12.html, accessed on September 22, 2009.
46
“Beijing Mayor Fired over Handling of SARS”, PBS, April 21, 2003,
http://www.pbs.org/newshour/updates/sars_04-21-03.html, accessed on September 22, 2009.
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in a dismissal. Under the current system, dismissing officials from their posts meant the demise of their
political careers.
The two-fold evaluation system motivated local officials to cheat. On the one hand, they tended to cover up
any incidents that might generate negative news and harm their political career. On the other hand, they
tended to relax regulations on enterprises that generated tax income and contributed to economic growth in
their jurisdiction. In the coal mining industry, for example, local officials might allow mining companies to
lower their safety standards and put miners’ life at risk. Then, if an accident should occur that caused heavy
casualties, local officials tended to cover it up.
A State Council investigation revealed that Sanlu began receiving complaints about sick infants as early as
December 2007, but did not test its products until June 2008. Leading government officials in Shijiazhuang
had reportedly failed to report the contamination to provincial and state authorities until September 2008.47
This cover-up allegation was also confirmed elsewhere. According to media reports, Sanlu tried to buy off
critics and cover up the contamination. In a memo dated August 11, 2008, Sanlu’s Beijing-based public
relations agency, Teller International, advised the company to seek cooperation from a major search
engine, Baidu, to censor negative information. The agency had reportedly contacted key staff at Baidu
repeatedly and proposed a RMB3 million (US$440,000) budget to screen out all negative news.48 After the
memo appeared on the Internet on September 13, 2008, Baidu denounced it in a communiqué, by saying
that the proposal had been firmly rejected because it violated Baidu’s corporate principles of unbiased and
transparent reporting.49
Knowing the dilemma in the political evaluation system, businesses could easily hold local officials
hostage and, thus, knowingly violated safety standards to maximize profit. Such businesses believed that
the local officials would always rescue them should unfavorable incidents occur. For example, Sanlu,
which — at RMB330 million, or US$48 million in 2007 — was considered a major tax contributor to the
city government in Shijiazhuang, certainly had long received favorable treatment from local authorities.
Social and Cultural Transformations
Traditional Chinese culture had valued virtues and righteousness over personal gains. The great
philosopher Confucius said more than 2,500 years ago that “riches and honors are what men desire; yet a
decent man will not obtain them in an improper way.” He further said that “the mind of a decent man is
50
conversant with righteousness; the mind of a mean man is conversant with personal gains.” These
doctrines had been the moral principles upholding the Chinese value systems and guiding generation after
generation of Chinese people’s lives up to 1949.
When the Chinese Communist Party took power in 1949, Mao and his colleagues abolished the Confucian
value system through implementation of the Cultural Revolution, which built a new value system based on
Chinese-style communism by emphasizing collective interests over personal gains and advocating
individual sacrifice for the community good. To curb materialism, Mao launched political campaigns to
denounce private ownership, referring to his movements as “cutting capitalist tails.” One of Mao’s political
47
“Probe Finds Producer Knew of Toxic Milk for Months,” China Daily, September 22, 2008,
http://www.chinadaily.com.cn/china/2008-09/22/content_7048712.html, accessed on September 22, 2009.
48
“Leaked Memo Alleges $640,000 Cover-up over Scandal,” by Tim Hume, Sunday Star Times (NZ), September 28, 2008,
http://www.stuff.co.nz/sundaystartimes/4708283a6005.html, accessed on April 25, 2009.
49
“Baidu Declares: We Never Agreed to Bury Sanlu Negative News,” Sino.com, September 13, 2008, accessed on June 5,
2009.
50
Analects of Confucius. 2001. Beijing, China: Renmin Wenxue Chubanshe.
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opponents in these campaigns was Deng Xiaoping, who was referred to as the capitalist representative
lurking within the party and a diehard capitalist agent that must be purged.
History showed that Mao was right regarding Deng’s capitalist beliefs. Not long after Mao’s death, Deng
resumed power and became the paramount leader of China. According to Deng, poverty was not socialism
or communism, and the Chinese people needed to get rich. He allowed that some people would get rich
before others. His famous utilitarian and materialistic analogy for economic development was that “no
matter white or black, a cat is a good cat as long as it catches mice.”
Deng’s guidelines have proved to be the roots of many social problems in today’s China. The cat analogy
encouraged people to consider the end over the means when seeking economic gains. However, allowing
some people (mostly communist elites) to get rich first led to extreme disparity in income distribution. In
this moral and value vacuum, the demons of greed, selfishness and opportunism were released from after
30 years of stern communist suppression.
In this freestyle gold rush, the economic exploitations found in Karl Marx’s treatise (Das Kapital; in
English, Capital), reappeared in communist China. The social vices of materialism affected all aspects of
people’s daily life in China. In the years before Deng’s influence was felt, people didn’t lock their doors at
night; now they needed to fortify their residences with iron fences and cages. People once could host a
stranger for a couple of days at their home; they were now reluctant to take care of their own parents or
siblings.
When newly rich elites married their capital to power to accumulate even more wealth, those at the
grassroots level also found capitalistic opportunities. They pried away utility hole covers on backstreets to
sell them as waste iron or cut off telecommunication wires to sell them as waste copper. Business persons
in the city traveled to rural areas to sell fake drugs and substandard industrial products. Farmers
reciprocated by supplying poison-soaked vegetables, hormone-fed fish and adulterated milk, only to
wonder why city dwellers were so resilient.
The old tricks of painting a yellow cow as a milk cow to raise its price or mixing urine with milk to
increase its weight now seemed outdated. New traps were invented to take advantage of advancements in
technology. Adulterating melamine into milk was one of the high-tech cheating schemes. Other traps were
set up through the Internet, cellular phone text messages and electronic banking cards, to name a few.
IMPACTS OF THE SCANDAL
Sanlu Group
The value of the company plunged as a result of the scandal. On February 12, 2009, the court declared
Sanlu bankrupt. By then, the company’s total assets were RMB1.56 billion (US$228 million), but its total
debt to 274 creditors amounted to RMB1.76 billion (US$257 million). Sanlu’s net assets plunged to
negative RMB201 million (US$29 million).
In addition, the Sanlu faced hundreds of lawsuits from victims’ families. Sanlu needed to borrow another
RMB902 million (US$132 million) to pay for victims’ treatment and compensation. The total payments
were expected to exceed RMB700 million (US$102 million). In all, Sanlu faced a net debt of RMB1.1
billion (US$161 million).51
51
“Court Declared Bankruptcy to Sanlu,” Xinhua, February 12, 2009.
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On March 4, 2009, in a court auction, Sanyuan Dairy, one of Sanlu’s competitors and one of the few dairy
firms that had survived the scandal, bought Sanlu’s core assets for RMB617 million (US$90 million). The
Sanlu brand, once valued at RBM15 billion (US$2.19 billion), was acquired for RMB7.3 million (US$1.1
million) by an anonymous bidder in a court auction in April 2009.52
Sanlu’s bankruptcy was disastrous to its foreign partner, Fonterra. On September 24, 2008, Fonterra
announced that it had written down two-thirds of the carrying value of its investment in Sanlu by NZ$139
million, the costs of product recall and the impairment of the Sanlu brand from criminal charges.53 Fonterra
suffered from heavy write-offs, a ruined business and public condemnation.
Government Regulators
The scandal prompted the Chinese government to step up inspections on food quality and safety. On
September 18, 2008, GAQSIQ announced the termination of the safety inspection exemption program for
all products and companies. One week later, China’s newly appointed GAQSIQ director, Wang Yong
(who had replaced Li Changjiang who resigned earlier) stated that the government would enforce stricter
measures to deal with food contamination and that inspectors had, to date, removed 7,000 tons of
54
melamine-contaminated dairy products from shops throughout China.
On October 4, 2008, the Ministry of Agriculture announced that it had sent 150,000 officials to overhaul
the supply chain from cattle feed to milk collection, and 18,803 milk-collecting stations had been checked
and registered by these officials. The ministry was reported to have investigated 98 dairy producers and
farms, banned 151 illegal companies and indicted three manufacturers for using feed containing melamine.
During an investigation into melamine contamination at Yili and Mengniu in Hohhot, Inner Mongolia,
55
local police arrested six people for allegedly selling and mixing melamine into raw milk.
The Ministry of Health and five other government agencies also issued a joint statement on October 9,
2008, setting the legally acceptable level of melamine content in infant formula at 1 ppm (1 mg/kg), and at
2.5 ppm in other dairy products (including liquid milk). The Chinese Center for Disease Control and
Prevention said that any amount exceeding 1 ppm would give reason to suspect that its presence was
56
intentional.
The Dairy Industry
The scandal resulted in dairy firms worldwide being forced to check the safety of their products. In late
November 2008, infant products made by Nestlé and Mead Johnson were also found to contain traces of
melamine; yet the FDA concluded that melamine or cyanuric acid alone at or below 1 ppm in infant
57
formula raised no public health concerns and, thus, did not issue recalls for these products.
52
“Sanlu Brand Sold at 7.3 Million,” by Wang Xiaoyue, Beijing Shangbao, May 13, 2009,
http://www.globrand.com/2009/248834.shtml, accessed on June 5, 2009.
53
“Sanlu Asset Sales Plan Taking Shape,” New Zealand National Business Review, November 19, 2008,
http://www.nbr.co.nz/article/sanlu-asset-sales-plan-taking-shape-37990, accessed on April 25, 2009.
54
“Governance after Chaos”, China Dairy, Issue 10, 2008, pp. 6-19.
55
“Six More Detained over Melamine,” China Daily, October 7, 2008.
56
“Limits Set on Melamine Levels,” People’s Daily, October 9, 2008.
57
“FDA: Trace Levels of Melamine Allowed in Infant Formula,” CNN news, November 28, 2008.
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The Tokyo-headquartered snacks maker Lotte Group recalled its Koala’s March cookies in Hong Kong
and Macau because of contamination. The company then promised to look deeply into all the details of the
manufacturing process to win back customer confidence.
On September 29, 2008, British confectionery group Cadbury withdrew all its 11 chocolate products made
58
in its three Beijing factories, on suspicion of melamine contamination. On September 30, 2008, Unilever
recalled its Lipton milk tea powder after internal checks found traces of melamine in the Chinese milk
59
powder that the company used as an ingredient.
60
Elsewhere, Heinz recalled cases of baby cereal in Hong Kong after discovering they contained melamine.
Six Neslac and KLIM products made in Nestlé’s factory in Heilongjiang were delisted by the Taiwanese
61
Department of Health for containing traces of melamine. Starbucks and KFC both suspended the selling
62
of Mengniu milk.
The deadliest blow from the scandal was received by the Chinese dairy industry, which had been valued at
RMB122 billion (US$18 billion) in 2007. Since the scandal erupted, sales had plummeted by 30 to 40 per
cent, according to the Chinese Dairy Association. In the raw milk bases of Mengniu, Sanlu and Bright
Dairy alone, daily losses from dumping raw milk were estimated to be RMB45 million (US$6.6 million).
If the reduction in cow productivity was included, daily losses of RMB18 million (US$2.6 million) were
63
also incurred.
As a result of the discovery of contamination, three other major dairy producers, Yili, Mengniu and Bright
Dairy, were all stripped of their status as Chinese national brands. The three producers recalled the tainted
milk powders and apologized to the public in separate statements. Mengniu’s chief financial officer (CFO),
Yao Tongshan, attempted to reassure consumers by offering a no-quibble refund on all products. Mengniu
also recalled all its baby formula, and trading on its shares on the Hong Kong Stock Exchange was
64
suspended on September 17, 2008. Shares of other dairy companies fell sharply the next day.
Chinese consumers had lost their confidence in the dairy industry. They no longer trusted small shops and
instead turned to larger stores for their dairy products. The distribution network that the dairy industry had
established in past decades had been entirely dismantled. Even in some large supermarkets, shelves that
once were designated for dairy products had been swept bare as a consequence of the product recalls.
Shops in Hong Kong experienced a rush for imported formula from cross-border shoppers, and in response
65
some retailers reportedly rationed their stock.
Consumer panic resulting from the contaminated milk had reduced demand for dairy products in general,
causing hardship to more than 2 million Chinese farmers who had nowhere to sell their milk and no means
58
“Tainted Milk Crisis Hits More Global Companies,” International Herald Tribune, September 26, 2008,
http://www.iht.com/articles/ap/2008/09/26/business/AS-China-Tainted-Milk-Quality-Control.php, retrieved on Sept. 26, 2008.
59
“Lipton Milk Tea Powder Recalled in Asia,” USA Today, September 30, 2008,
http://www.usatoday.com/money/industries/food/2008-09-30-liptontea-hongkong_N.htm?csp=34, retrieved on Sept. 22,
2009.
60
“Heinz to Stop Using Chinese Milk in Its Products,” Business Weekly, September 30, 2008,
http://www.bizjournals.com/albuquerque/stories/2008/09/29/daily13.html. Retrieved on September 30, 2008.
61
“Taiwan Minister Allegedly Attacked over Tainted Milk,” AFP, October 3, 2008.
62
“Soy: Starbucks in China Opts for Milk Substitutes,” China CSA, September 26, 2008.
63
“Governance after Chaos”, China Dairy, Issue 10, 2008, pp. 6-19.
64
“Mengniu Hong Kong Shares Plummeted over 60%”, by Liu Xiaoqing, Daily Economic News, September 24, 2008,
http://finance.sdnews.com.cn/2008/9/24/665185.html, retrieved on September 22, 2009.
65
“Mainlanders Strain Powder Supply in HK,” by Peter So, South China Morning Post, September 18, 2008, pp. A2.
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to support their dairy cows. In Hebei alone, in three days from September 14 to 16, 2008, nearly 6,000 tons
66
of raw milk were dumped into rivers. One farmer lamented that when he was young he was told that
capitalists in the West poured milk into the river without giving it to poor people, so how could this happen
67
in a communist country like China?
The “Made in China” Label
In recent years, China had been criticized for exporting poisonous pet food, toxic beans and dumplings,
substandard tires and poorly designed toys. The label “Made-in-China” was tarnished worldwide. In this
melamine incident, China shocked the world by sickening and, in some cases, even killing its own infants
with poisonous milk! As commented by Wall Street Journal columnist Joseph Sternberg, China’s failure to
introduce food-safety legislation was much more pernicious and disgraceful than it had first appeared. He
said that the milk poisoned not only thousands of infants with melamine, but also the society at large with
68
fear.
Facing criticism around the world amid the tainted milk scandal, in late September 2008, the Chinese
government scrambled to salvage its reputation and announced an ambitious program to improve food
safety. However, no matter how much effort the regulators were determined to exert, considerable damage
had been inflicted on the “Made in China” label, especially because the milk scandal had followed in the
69
wake of other scares over unsafe products originating from the world’s major exporting nation. Among
the messages posted on the Internet, some suggested that PRC should be denoted as the People’s Republic
of Cheating or the People’s Republic of Copycats. China had a long way to go in clearing her notoriety as a
cheater and low-quality producer.
CONCLUSION
On February 1, 2009, Tian and the other three Sanlu executives each filed an appeal to the Higher People’s
Court of Hebei Province, pleading innocence and requesting to revoke the Intermediate Court’s January 22
70
verdict. The Higher Court rejected their appeals and upheld the original verdict. Like similar incidents in
the past, the rejection by the Higher Court could be seen as the final nail for the Sanlu scandal because the
culprits’ sentences, and thus their guilt, had been finalized, although these individuals themselves didn’t
believe so.
Around the time of the trial, a blogger named Wu Qing, claiming to be Tian’s daughter, posted four widely
71 72
circulated essays on the Internet, insisting that her mother was not to blame. , Up until that point,
consumers and the society at large did not view as a major concern whether her mother was to blame, or
whether the grass’s mother was to blame. The concern and worry instead regarded whether the conviction
of those individuals would solve the food and product safety issue in China. If not, what could be done —
and what should be done — to prevent similar incidents in the future?
66
“Special Focus”, China Dairy, Issue 9, 2008, pp. 3-7.
“From Cow to Milk,” by Wang Hongliang, Sanlian Life Weekly, September 29, 2008, pp. 70-74.
68
Joseph Sternberg, “Notes on a Milk Scandal,” Wall Street Journal, October 10, 2008,
http://online.wsj.com/article/SB122358125053920083.html?mod=googlenews_wsj, retrieved on September 22, 2009.
69
“China Scrambles to Salvage Reputation amid Milk Scandal,” AFP, September 24, 2008,
http://afp.google.com/article/ALeqM5iCQFgtK5OTblOceDxmbdN7BcRguQ, accessed on September 22, 2009.
70
“China Court Rejects Appeal of Former Sanlu Chairwoman,” Xinhua, March 26, 2009.
71
http://www.legaldaily.com.cn, January 20, 2009, accessed on June 15, 2009.
72
“In China, Tainted Milk Trial Kept under Wraps,” by Barbara Demick, Los Angeles Times, January 1, 2009,
http://articles.latimes.com/2009/jan/01/world/fg-china-milk1, retrieved on September 22, 2009.
67
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Exhibit 1
SANLU’S MARKET SHARE IN CHINA’S DAIRY INDUSTRY, 2003–2007
(Sales in billions of RMB*)
Industry Total Sales
Sanlu Group Total Sales
Sanlu Group’s Share
2003
47.8
5.2
10.9%
2004
62.5
6.0
9.6%
2005
85
7.5
8.8%
2006
104.1
8.6
8.3%
2007
119.9
10
8.3%
* Between 2003 and 2007, the exchange rate between the Chinese renminbi and the U.S. dollar fluctuated between 8.28
yuan and 7.38 yuan per U.S. dollar.
Source: USDA GAIN Report 2007 and Sanlu Group Company website at www.sanlu.com, accessed on Nov. 20, 2008.
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9B09M077
Exhibit 2
CHRONICLES OF THE SANLU SCANDAL
AND RECENT FOOD SAFETY RELATED INCIDENTS IN CHINA
June 2004
July 5, 2005
March 30, 2007
July 10, 2007
September 2, 2007
December 2007
January 8, 2008
February 2, 2008
March 1, 2008
May 17, 2008
May 27, 2008
July 01, 2008
July 16, 2008
July 23, 2008
Sanlu was involved in a nationwide “Big Head Baby” scandal in which
hundreds of thousands of babies fell sick and 13 babies died after drinking lowcost powdered milk containing low to no nutritional content.
Tianjin health authorities confiscated 900 packages of Sanlu yogurt for postdating the production date.
U.S. Food and Drug Administration (FDA) reported melamine was detected in
pet food imported from China. Hundreds of cats and dogs became sick and died
after eating these imported pet foods.
The Director of China State Food and Drug Administration, Zheng Xiaoyu, was
executed for charges of failing to oversee food safety following a series of food
safety incidents, including the scandal that pet food from China had poisoned
American cats and dogs.
The CCTV extolled Sanlu as the most reliable dairy product with the highest
quality in its weekly Quality of Made-in-China program.
Sanlu received numerous consumer complaints that children who ate Sanlu dairy
products had red sediments observed in their urine.
Sanlu infant formula received the National Award of Science and Technology
Progress, the only dairy product ever to receive this top national science and
technology award.
A Zhejiang consumer contacted Sanlu and local health authorities when he
believed that Sanlu powdered milk might have caused his daughter to have
difficulty urinating. Later, without knowing the seriousness of the issue, the
consumer accepted four boxes of Sanlu powdered milk as remedy. He posted his
story on a popular Internet blog site. This was the first documented exposure of
the Sanlu scandal.
Reports of mass infant kidney failure started arriving at Sanlu. Sanlu asked
government agency for help in testing the dairy products. No defects were
identified.
The customer service department at Sanlu submitted a written report to Sanlu
TMT regarding customer complaints of infant kidney failure after consumption
of Sanlu products.
Sanlu TMT members held a meeting regarding customer complaints and made
the decision to coordinate media reports and deal with customer complaints.
Sanlu launched investigation into kidney failures observed in infants who had
consumed Sanlu infant formula. The company sent samples of 16 batches of
products to the local governmental food safety regulator for testing. The results
indicated that all 16 samples contained melamine.
Health officials in Gansu province reported that 16 infants who had consumed
powdered milk were suffering from kidney problems.
Hunan TV reported a sudden rise in infant kidney stones cases and hinted that
use of the same brand of powder milk might be the cause.
Page 20
9B09M077
Exhibit 2 (continued)
August 1, 2008
August 2, 2008
August 13, 2008
August 20, 2008
Sanlu TMT members decided to keep details of the incident secret and to check
its products in stock. The company decided not to cease production.
Sanlu filed a written report to the local government, informing that its products
were contaminated with melamine. The company asked the government to help
investigate the milk sources. The same day, government officials visited Sanlu
and applauded the company’s earlier decisions about maintaining secrecy and
checking products in stock. The officials did not ask the company to stop
production.
Sanlu TMT members decided that the company would 1) continue to sell
products in stock with melamine levels less than 10 mg/1 kg; 2) withhold
temporarily those products with melamine levels greater than 10 mg/1 kg; and
3) exchange higher melamine level products from the market for products with
melamine levels of approximately 20 mg/kg.
Sanlu CEO and Chairwoman Tian Wenhua filed an oral report to the local
government and requested to report the incident to the provincial and central
governments.
August 24, 2008
CCTV and dozens of other media promoted Sanlu as the “national brand that
has changed Chinese people’s life in the past 30 years.”
September 11, 2008
The Health Ministry of China announced that overdosed melamine, which can
cause kidney problems in infants, was detected in infant formula sold in China
market, including Sanlu’s products.
September 12, 2008
The government ordered Sanlu to halt production and to destroy all unsold and
recalled products. Authorities reportedly seized 10,000 tons of Sanlu products.
September 13, 2008
Baidu announced in a communiqué that it had firmly rejected a proposal by
Sanlu’s public relations agent in early August regarding accepting a RMB3
million (US$440,000) payoff in exchange for screening all negative news.
September 15, 2008
Local police arrested four people and detained 22 suspects who were involved
in adding melamine to milk.
September 16, 2008
Tian Wenhua was removed from her positions as the CPC party head, and as
CEO and Chairwoman at Sanlu.
September 16, 2008
The newly installed Sanlu CEO, Zhang Zhenling, on behalf of Sanlu,
apologized to consumers for contaminated milk powder.
Page 21
9B09M077
Exhibit 2 (continued)
September 17, 2008
September 17, 2008
September 18, 2008
September 23, 2008
September 24, 2008
January 22, 2009
In a State Council meeting, the Chinese premier, Wen Jiabao ordered a thorough
investigation into the matter.
The General Administration of Quality Supervision, Inspection, and Quarantine
(GAQSIQ) announced that 22 dairy firms’ baby formulas contained melamine.
Famous brands, such as Mengniu and Yili, were included in the list. Among
them, Sanlu’s baby formula contained 2,563 mg melamine per 1 kilogram body
weight (European Union [EU] safety limit was 0.5 mg/kg of body weight).
The General Administration of Quality Supervision, Inspection, and Quarantine
(GAQSIQ) announced that 24 brands of liquid milk contained melamine. It also
ordered an end to the safety inspection exemption program for all products and
all companies.
Li Changjiang, head of the General Administration of Quality Supervision,
Inspection, and Quarantine (GAQSIQ), resigned office; seven local officials,
including Wu Xianguo and Ji Chuntang, respectively the Communist Party of
China (CPC) head and mayor of Shijiazhang city, where Sanlu was located,
were removed from office by the central government of China.
Fonterra announced that it had written down the carrying value of its
investments in Sanlu by NZ$139 million (two-thirds of its value) to reflect the
costs of product recall and the impairment of the Sanlu brand “as a direct
consequence of the criminal contamination of milk in China.”
Sanlu’s former CEO and Chairwoman Tian Wenhua sentenced to life
imprisonment; three other members of the top management team and 18
suppliers sentenced to terms that ranged from the death penalty to 2 to 15 years
of imprisonment.
February 12, 2009
The court declared Sanlu to be bankrupt.
February 28, 2009
The Chinese People’s Congress passed China’s first Food Safety Act.
Sources: Various Chinese media reports.
Page 22
9B09M077
Exhibit 3
WORLD LEADERS OF FLUID MILK PRODUCTION AND CONSUMPTION, 2007
(COUNTRIES AND REGIONS)
(in thousands)
Fluid Milk
Production
Fluid Milk
Consumption
(in thousands of
metric tons)
(in thousands of metric
tons)
European Union
(EU)
24,344
132,600
34,000
United States
9,150
84,095
27,393
India
38,000
42,140
41,130
China
8,700
35,000
14,820
Russia
9,910
32,000
12,000
Brazil
15,925
26,750
14,582
Oceania
(Australia and New
Zealand)
5,963
25,465
2,583
Ukraine
3,200
13,100
5,075
Argentina
2,150
9,400
2,000
Canada
1,005
8,145
3,060
Country/Region
Milk Cows
Source: Compiled from 2007 U.S. Department of Agriculture (USDA) GAIN Report.
Page 23
9B09M077
Exhibit 4
CHINA: DAIRY PRODUCTS OUTPUT, IMPORT, AND EXPORT, 1949–2007
(In thousands of metric tons)
Total Output
Total Imports
Total Exports
1949
217
–
–
1978
971
–
–
2001
11,226
183.1
16.2
2002
14,004
257.4
23.1
2003
18,486
311.7
21.4
2004
23,684
343.6
28.7
2005
28,648
315.7
35.3
2006
33,663
343.3
35.2
2007
36,500
264.7
119.7
2008
(First 8 months)
12,673
303.4
114.3
Source: China Nutrition Industry Development Report, 2006, Beijing: China Economic Publishing House; China Dairy,
Issues 2, 10, 2007; Issues 1, 2, 2008; Issue 1, 2009.
Page 24
9B09M077
Exhibit 5
ANNUAL PER CAPITA MILK CONSUMPTION IN CHINA, 1995–2007
(In kilograms)
Urban Area
Rural Area
Overall
1995
16.0
0.64
5.1
1996
16.0
0.8
5.4
1997
14.7
0.95
5.4
1998
15.5
0.93
5.8
1999
17.3
0.96
6.7
2000
19.8
1.06
7.8
2001
22.1
1.2
9.1
2002
28.4
1.19
11.8
2003
34.5
1.7
15.1
2004
–
–
17.4
2005
–
–
19.99
2006
–
–
25.59
2007
–
–
24.96
Sources: China Statistics Yearbook (1996–2004), Beijing: China Statistics Press; China Nutrition Industry Development
Report, 2006, Beijing: China Economic Publishing House; China Dairy, Issue 1, 2008.
Page 25
9B09M077
Exhibit 6
MILK SUPPLY CHAIN IN CHINA
Farmer
Farmer
Smaller
Milk
Station
Larger
Milk
Station
Dairy Plant
Processing
Final Products
Farmer
Dairy Plant-Owned Farms
Page 26
9B09M077
Exhibit 7
BACKYARD DAIRY FARMS IN CHINA
Photos taken by Francis Sun in May 2009.
Page 27
9B09M077
Exhibit 8
A TYPICAL SMALL-SCALE MILK STATION
Photo taken by Francis Sun in May 2009.
CHAPTER 18
Corporations
413
Reviewing: Corporations
David Brock was on the board of directors of Firm Body Fitness, Inc., which owned a string of fitness clubs in New
Mexico. Brock owned 15 percent of the Firm Body stock and was also employed as a tanning technician at one of the
fitness clubs. After the January financial report showed that Firm Body’s tanning division was operating at a substantial
net loss, the board of directors, led by Marty Levinson, discussed terminating the tanning operations. Brock successfully convinced a majority of the board that the tanning division was necessary to market the clubs’ overall fitness
package. By April, the tanning division’s financial losses had risen. The board hired a business analyst, who conducted
surveys and determined that the tanning operations did not significantly increase membership.
A shareholder, Diego Peñada, discovered that Brock owned stock in Sunglow, Inc., the company from which Firm
Body purchased its tanning equipment. Peñada notified Levinson, who privately reprimanded Brock. Shortly thereafter, Brock and Mandy Vail, who owned 37 percent of the Firm Body stock and also held shares of Sunglow, voted
to replace Levinson on the board of directors. Using the information presented in the chapter, answer the following
questions.
1. What duties did Brock, as a director, owe to Firm Body?
2. Does the fact that Brock owned shares in Sunglow establish a conflict of interest? Why or why not?
3. Suppose that Firm Body brought an action against Brock claiming that he had breached the duty of loyalty by not
disclosing his interest in Sunglow to the other directors. What theory might Brock use in his defense?
4. Now suppose that Firm Body did not bring an action against Brock. What type of lawsuit might Peñada be able to
bring based on these facts?
Debate This . . .
The sole shareholder of an S corporation should not be able to avoid liability for the torts of her or his
employees.
Terms and Concepts
alien corporation 389
articles of incorporation 394
benefit corporation 394
bond 396
business judgment rule 403
bylaws 395
close corporation 392
commingle 399
common stock 396
crowdfunding 397
dividends 389
domestic corporation 389
foreign corporation 389
holding company 389
inside director 401
outside director 401
pierce the corporate veil 399
preemptive rights 408
preferred stock 396
private equity capital 397
proxy 406
public corporation 391
publicly held corporation 391
quorum 401
retained earnings 389
S corporation 393
securities 396
shareholder agreement 393
shareholder’s derivative suit 410
stock 396
stock certificate 408
stock warrant 408
ultra vires 398
venture capital 397
voting trust 407
watered stock 410
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414
U N I T F OU R
The Business and Employment Environment
Issue Spotters
1. Northwest Brands, Inc., is a small business incorpo-
rated in Minnesota. Its one class of stock is owned by
twelve members of a single family. Ordinarily, corporate
income is taxed at the corporate and shareholder levels. Is there a way for Northwest Brands to avoid this
double taxation? Explain your answer. (See Nature and
Classification.)
2. Nico is Omega Corporation’s majority shareholder. He
owns enough stock in Omega that if he were to sell it,
the sale would be a transfer of control of the firm. Discuss whether Nico owes a duty to Omega or the minority
shareholders in selling his shares. (See Shareholders.)
• Check your answers to the Issue Spotters against the
answers provided in Appendix D at the end of this text.
Business Scenarios
18–1. Preincorporation. Cummings, Okawa, and Taft are
recent college graduates who want to form a corporation to
manufacture and sell digital tablets. Peterson tells them he will
set in motion the formation of their corporation. First, Peterson makes a contract with Owens for the purchase of a piece
of land for $20,000. Owens does not know of the prospective
corporate formation at the time the contract is signed. Second,
Peterson makes a contract with Babcock to build a small plant
on the property being purchased. Babcock’s contract is conditional on the corporation’s formation. Peterson secures all
necessary subscription agreements and capitalization, and he
files the articles of incorporation. (See Formation and Powers.)
(a) Discuss whether the newly formed corporation, Peterson, or
both are liable on the contracts with Owens and Babcock.
(b) Discuss whether the corporation is automatically liable to
Babcock on formation.
18–2. Conflicts of Interest. Oxy Corp. is negotiating
with Wick Construction Co. for the renovation of Oxy’s corporate headquarters. Wick, the owner of Wick Construction
Co., is also one of the five members of Oxy’s board of directors. The contract terms are standard for this type of contract.
Wick has previously informed two of the other directors of his
interest in the construction company. Oxy’s board approves
the contract by a three-to-two vote, with Wick voting with
the majority. Discuss whether this contract is binding on the
corporation. (See Directors and Officers.)
Business Case Problems
18–3. Spotlight on Smart Inventions—Piercing the
Corporate Veil. Thomas Persson and Jon Nokes founded
Smart Inventions, Inc., to market household consumer products. The success of their first product,
the Smart Mop, continued with later products,
which were sold through infomercials and other
means. Persson and Nokes were the firm’s officers and equal
shareholders. Persson was responsible for product development, and Nokes was in charge of day-to-day operations. In
time, they became dissatisfied with each other’s efforts. Nokes
represented the firm as financially “dying,” “in a grim state,
. . . worse than ever,” and offered to buy all of Persson’s shares
for $1.6 million. Persson accepted.
On the day that they signed the agreement to transfer the
shares, Smart Inventions began marketing a new product—
the Tap Light. It was an instant success, generating millions
of dollars in revenues. In negotiating with Persson, Nokes
had intentionally kept the Tap Light a secret. Persson sued
Smart Inventions, asserting fraud and other claims. Under
what principle might Smart Inventions be liable for Nokes’s
fraud? Is Smart Inventions liable in this case? Explain. [Persson v. Smart Inventions, Inc., 125 Cal.App.4th 1141, 23 Cal.
Rptr.3d 335 (2 Dist. 2005)] (See Piercing the Corporate Veil.)
18–4. Duty of Loyalty. Kids International Corp. produced
children’s wear for Walmart and other retailers. Gila Dweck
was a Kids director and its chief executive officer. Because she
felt that she was not paid enough, she started Success Apparel
to compete with Kids. Success operated out of Kids’ premises,
used its employees, borrowed on its credit, took advantage
of its business opportunities, and capitalized on its customer
relationships. As an “administrative fee,” Dweck paid Kids
1 percent of Success’s total sales. Did Dweck breach any fiduciary duties? Explain. [Dweck v. Nasser, 2012 WL 3194069
(Del.Ch. 2012)] (See Directors and Off
Officers.)
18–5. Business Case Problem with Sample Answer—
Piercing the Corporate Veil. Scott Snapp contracted with
Castlebrook Builders, Inc., which was owned by
Stephen Kappeler, to remodel a house. Kappeler
estimated that the remodeling would cost around
$500,000. Eventually, however, Snapp paid Kappeler more than $1.3 million. Snapp filed a suit in an Ohio
state court against Castlebrook, alleging breach of contract
and fraud, among other things. During the trial, it was
revealed that Castlebrook had issued no shares of stock and
that personal and corporate funds had been commingled. The
minutes of the corporate meetings all looked exactly the same.
In addition, Kappeler could not provide an accounting for the
Snapp project. In particular, he could not explain evidence of
double and triple billing nor demonstrate that the amount
Snapp paid had actually been spent on the remodeling project.
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
CHAPTER 18
Are these sufficient grounds to pierce the corporate veil?
Explain. [Snapp v. Castlebrook Builders, Inc., 2014 -Ohio- 163,
7 N.E.3d 574 (2014)] (See Formation and Powers.)
• For a sample answer to Problem 18–5, go to Appendix E at
the end of this text.
18–6. Business Judgment Rule. Country Contractors,
Inc., contracted to provide excavation services for A Westside Storage of Indianapolis, Inc., but did not complete the
job and later filed for bankruptcy. Stephen Songer and Jahn
Songer were Country’s sole shareholders. The Songers had
not misused the corporate form to engage in fraud. The firm
had not been undercapitalized, personal and corporate funds
had not been commingled, and Country had kept accounting records and minutes of its annual board meetings. Are the
Songers personally liable for Country’s failure to complete its
contract? Explain. [Country Contractors, Inc. v. A Westside Storage of Indianapolis, Inc., 4 N.E.3d 677 (Ind.App. 2014)] (See
Directors and Off
Officers.)
18–7. Torts. Jennifer Hoffman took her cell phone to a store
owned by R&K Trading, Inc., for repairs. Later, Hoffman filed
a suit in a New York state court against R&K, Verizon Wireless, Inc., and others. Hoffman sought to recover damages for
a variety of torts, including infliction of emotional distress and
negligent hiring and supervision. She alleged that an R&K
employee, Keith Press, had examined her phone in a back
room, accessed private photos of her stored on her phone, and
disseminated the photos to the public. Hoffman testified that
“after the incident, she learned from another R&K employee
that personal information and pictures had been removed
from the phones of other customers.” Can R&K be held liable
for the torts of its employees? Explain. [Hoffman v. Verizon
Wireless, Inc., 5 N.Y.S.3d 123, 125 A.D.3d 806 (2015)] (See
Nature and Classification.)
18–8. Rights of Shareholders. FCR Realty, LLC, and
Clifford B. Green & Sons, Inc., were co-owned by three
brothers—Frederick, Clifford Jr., and Richard Green. Each
brother was a shareholder of the corporation. Frederick was
Corporations
415
a controlling shareholder, as well as president. Each brother
owned a one-third interest in the LLC. Clifford believed that
Frederick had misused LLC and corporate funds to pay nonexistent debts and liabilities and had diverted LLC assets to
the corporation. He also contended that Frederick had disbursed about $1.8 million in corporate funds to Frederick’s
own separate business. Clifford hired an attorney and filed
an action on behalf of the two companies against Frederick
for breach of fiduciary duty. Frederick argued that Clifford
lacked the knowledge necessary to adequately represent the
companies’ interest because he did not understand financial
statements. Can Clifford maintain the action against Frederick? If so, and if the suit is successful, who recovers the damages? Explain. [FCR Realty, LLC v. Green, __ Conn.Supp. __,
__ Conn.L.Rptr. __, 2016 WL 571449 (Super. 2016)] (See
Shareholders.)
18–9. A Question of Ethics—Piercing the Corporate
Veil. In New York City, 2406-12 Amsterdam Associates LLC
brought an action in a New York state court against
Alianza Dominicana and Alianza LLC to recover
unpaid rent. The plaintiff asserted cause to pierce
the corporate veil, alleging that Alianza Dominicana had made promises to pay its rent while discreetly forming
Alianza LLC to avoid liability for it. According to 2406-12,
Alianza LLC was 90 percent owned by Alianza Dominicana,
had no employees, and had no function but to hold Alianza
Dominicana’s assets away from its creditors. The defendants
filed a motion to dismiss the plaintiff’s claim. [2406-12
[
Amsterdam Associates, LLC v. Alianza, LLC, 136 A.D.3d
512, 25 N.Y.S.2d 167 (1 Dept. 2016)] (See Piercing the Corporate Veil
Veil.)
(a) Assuming that 2406-12’s allegations are true, are there
sufficient grounds to pierce Alianza LLC’s corporate veil?
Discuss.
(b) Suppose that the parties to this dispute were small, close
corporations. How might that circumstance affect the
result in this case?
Legal Reasoning Group Activity
18–10. Corporate versus LLC Form of Business. The
limited liability company (LLC) may be the best organizational form for most businesses. For a significant number of firms, however, the corporate form or some other
form of organization may be better. (See Nature and
Classification.)
(a) The first group will outline several reasons why a firm
might be better off as a corporation than as an LLC.
(b) The second group will discuss the differences between
corporations and LLCs in terms of their management
structures.
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
C H A P T E R 19
Agency Relationships
O
ne of the most common, important, and pervasive legal relationships is that of agency. In
an agency relationship involving two
parties, one of the parties, called the
agent, agrees to represent or act for
the other, called the principal. The
principal has the right to control the
agent’s conduct in matters entrusted
to the agent.
Agency relationships are crucial in
the business world. By using agents,
a principal can conduct multiple
business operations at the same time
in different locations. Indeed, the only
way that certain business entities can
function is through their agents. For
instance, a corporate officer is an
agent who serves in a representative
capacity for the corporation. The officer has the authority to bind the corporation to a contract. Only through
its officers can corporations enter into
contracts.
Most employees are also considered to be agents of their employers.
19–1 Agency Law
Section 1(1) of the Restatement (Third) of Agency1 defines
agency as “the fiduciary relation [that] results from the
manifestation of consent by one person to another that
the other shall act in his [or her] behalf and subject to his
[or her] control, and consent by the other so to act.” In
other words, in a principal-agent relationship, the parties
have agreed that the agent will act on behalf and instead
of the principal in negotiating and transacting business
with third parties.
The term fiduciary is at the heart of agency law.
When this term is used as a noun, it refers to a person
having a duty created by his or her undertaking to act
primarily for another’s benefit in matters connected with
the undertaking. When used as an adjective, as in the
phrase fiduciary relationship, it means that the relationship involves trust and confidence.
Agency relationships commonly exist between employers and employees. Agency relationships may sometimes
1. The Restatement (Third) of Agency is an authoritative summary of the
law of agency and is often referred to by judges in their decisions and
opinions.
416
Today, however, the United States is
experiencing a trend toward a socalled gig economy, which centers
on short-term, independent workers
who are not employees. Companies
like Uber and Lyft (discussed in this
chapter’s feature) provide evidence
of this trend. This type of on-demand
employment raises questions related
to agency, making agency an increasingly important topic for students of
business law and the legal environment to understand.
also exist between employers and independent contractors who are hired to perform special tasks or services.
19–1a Employer-Employee Relationships
Normally, all employees who deal with third parties are
deemed to be agents. A salesperson in a department store,
for instance, is an agent of the store’s owner (the principal) and acts on the owner’s behalf. Any sale of goods
made by the salesperson to a customer is binding on the
principal. Similarly, most representations of fact made by
the salesperson with respect to the goods sold are binding
on the principal.
Because employees who deal with third parties generally are deemed to be agents of their employers, agency
law and employment law overlap considerably. Agency
relationships, however, can exist outside an employeremployee relationship, so agency law has a broader reach
than employment law. Additionally, agency law is based
on the common law, whereas much employment law is
statutory law.
Employment laws (state and federal) apply only to
the employer-employee relationship. Statutes governing
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
CHAPTER 19
Social Security, withholding taxes, workers’ compensation, unemployment compensation, workplace safety,
and employment discrimination apply only if an
employer-employee relationship exists. These laws do not
apply to independent contractors.
19–1b Employer–Independent
Contractor Relationships
Independent contractors are not employees because, by
definition, those who hire them have no control over
the details of their work performance. Section 2 of the
Restatement (Third) of Agency defines an independent
contractor as follows:
[An independent contractor is] a person who contracts
with another to do something for him [or her] but who
is not controlled by the other nor subject to the other’s
right to control with respect to his [or her] physical conduct in the performance of the undertaking. He [or she]
may or may not be an agent.
Building contractors and subcontractors are independent contractors. A property owner who hires a contractor and subcontractors to complete a project does not
control the details of the way they perform their work.
Truck drivers who own their vehicles and hire out on a
per-job basis are independent contractors, but truck drivers who drive company trucks on a regular basis usually
are employees. See this chapter’s Ethics Today feature for a
discussion of disputes involving the classification of drivers working for Uber and Lyft.
The relationship between a principal and an independent contractor may or may not involve an agency
relationship. To illustrate: A homeowner who hires a real
estate broker to sell her house has contracted with an
independent contractor (the broker). The homeowner
has also established an agency relationship with the broker
for the specific purpose of selling the property. Another
example is an insurance agent, who is both an independent contractor and an agent of the insurance company
for which he sells policies. (Note that an insurance broker,
in contrast, normally is an agent of the person obtaining
insurance and not of the insurance company.)
19–1c Determination of Employee Status
The courts are frequently asked to determine whether
a particular worker is an employee or an independent
contractor. How a court decides this issue can have a significant effect on the rights and liabilities of the parties.
Agency Relationships
417
Employers are required to pay certain taxes, such as Social
Security and unemployment taxes, for employees but not
for independent contractors. Therefore, workers may benefit from obtaining employee status in some situations.
Criteria Used by the Courts In deciding whether a
worker is categorized as an employee or an independent
contractor, courts often consider the following questions:
1. How much control does the employer exercise over the
2.
3.
4.
5.
6.
7.
details of the work? If the employer exercises considerable control over the details of the work and the
day-to-day activities of the worker, this indicates
employee status. This is perhaps the most important factor weighed by the courts in determining
employee status.
Is the worker engaged in an occupation or business distinct from that of the employer? If so, this points to
independent-contractor, not employee, status.
Is the work usually done under the employer’s direction
or by a specialist without supervision? If the work is
usually done under the employer’s direction, this
indicates employee status.
Does the employer supply the tools at the place of work?
If so, this indicates employee status.
For how long is the person employed? If the person is
employed for a long period of time, this indicates
employee status.
What is the method of payment—by time period or at
the completion of the job? Payment by time period,
such as once every two weeks or once a month, indicates employee status.
What degree of skill is required of the worker? If a great
degree of skill is required, this may indicate that the
person is an independent contractor hired for a specialized job and not an employee.
Whether a worker is an employee or an independent contractor can affect the employer’s liability for the
worker’s actions. An employer normally is not responsible for the actions of an independent contractor. ■ CASE
IN POINT 19.1 Terence Pershad was a tow truck driver
for Five Star Auto Service. Five Star had contracted to
perform towing and auto repair services for AAA North
Jersey, Inc. After one of its customers was involved in a
car accident, AAA called Five Star for assistance, and Five
Star sent a truck driven by Pershad. Pershad got into a
fight with Nicholas Coker, a passenger in the car, and
assaulted Coker with a knife.
Coker filed a suit in a New Jersey state court against
Pershad, Five Star, and AAA. The court determined that
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418
U N I T F OUR
ETHICS
TODAY
The Business and Employment Environment
Is It Fair to Classify Uber and
Lyft Drivers as Independent Contractors?
The transportation-for-hire world has changed
dramatically since Uber, Lyft, and other
transportation-sharing companies came onto
the scene. Uber started in San Francisco in
2009. Today, its services are available in one
form or another in about 60 countries and
more than 300 cities worldwide. Its main
competitor, Lyft, was launched in 2012 and
operates in more than 200 U.S. cities. The growth in
transportation sharing has not been without its setbacks, though. Most of them involve laws that have
prohibited Uber and Lyft from operating in certain
cities, as well as lawsuits by drivers claiming that they
were misclassified.
Classification of Workers
Workers in the United States generally fall into two
categories: employees and independent contractors.
Employment laws, including minimum wage and antidiscrimination statutes, cover employees. Such laws
do not cover most independent contractors. Enter
the digital age of on-demand workers who obtain job
assignments via apps.
Workers for Lyft, Uber, and similar companies
choose when and where they will perform their duties.
They do not choose how much they will be paid,
however. For them, employment is a take-it-or-leave-it
proposition. They electronically accept the platform
terms of the apps, or they obtain no work assignments.
Some critics of this contractual system argue that
there should be a new category of workers with
“dependent-contractor” status who receive some of the
protections traditionally given only to employees. Certain aspects of current labor law would be attached to
the relationships between dependent contractors and
their employers.
Worker Misclassification Lawsuits
A number of former or current Uber and Lyft drivers have pursued legal remedies to change their
job classification and to obtain better benefits. In
California, for instance, two federal court judges
…