Being the Change: Fonterra and the Milk Crisis

In the Hutong

Missing my nonfat latte

1933 hrs.

Better writers have covered the Melamine Milk Crisis at great depth already (check out Imagethief's article here as an example, or China Law Blog's coverage) so I won't belabor the story. I do, however, have two points to add, germane to what we've been writing here till now.

The Joint Venture and Ethical Rot

Fonterra, the large New Zealand food cooperative that partnered with Sanlu to manufacture the formula, will be remembered for a long time as a company that allegedly knew about the contamination some weeks prior to the kidney stone outbreak, that, justly or otherwise, reputedly did nothing to either stop the sale of the product or alert authorities. I cannot speak for the veracity of these claims, but they are circulating as if they are the truth.

In the Court of Public Opinion, what Fonterra did and did not know is now immaterial, and if the allegations of inaction are false, the company is going to face an epic and expensive effort in China and elsewhere to repair their reputation. I will not speculate on the cost to the company if the allegations are true.

The lesson of Fonterra is plain: foreign partners in joint ventures have three choices:

1. Pick a China partner of unquestionable operational integrity, and then watch over them like a hawk to ensure they continue to operate in an ethical manner, especially in crises;

2. Pick a China partner of imperfect operational integrity, then cram into every employee the importance of maintaining the public trust over any other consideration;

or my favorite

3. Avoid the joint-venture question entirely to ensure you can set and enforce ethical standards with ease.

Readers of this blog know that I am fond of saying that the Sino-foreign joint venture is a lawyer's dream and a manager's nightmare. Maintaining a semblance of control and a consistent strategy are difficult enough in a JV. In an environment where business ethics and corporate governance are no longer of mere academic importance, yet where moral relativism and the Eleventh Commandment ("thou shalt not get caught") frame individual and corporate codes of conduct, the joint-venture does not lend itself to the cultivation of ethical leadership.

My point is not to absolve Fonterra, Sanlu, or anyone else of any action or inaction because of their corporate structure. Rather it is to sound a warning to companies who are in or are considering a joint venture that these are easy places for ethical lapses to fester unless both partners are committed to setting - and enforcing - high ethical standards. Articulating those standards, training to them, and sticking by them even when there will be hell to pay for doing so is the only way to prepare for a crisis like this, and to have much hope of long-term recovery in its wake.

Quality is Free

When I was fresh out of graduate school, I was thrust into a production management role for which I was somewhat under-qualified. (I'm being charitable, here.) My job was to spend six days a week supervising the outsourced production of accessory furniture across 30 factories in greater China. I had trained in marketing and logistics.

Two things saved me: a deep affection for factories and line workers I gained working teen summers in my dad's investment casting foundry, and Philip B. Crosby's book Quality Is Free: The Art of Making Quality Certain. In the space of less than three hundred readable pages, Crosby gave me a graduate course in managing quality. But what was important was his core point: ensuring quality - and the considerable time, attention, and costs associated with the effort - is where profits come from. Until you stop seeing quality control as a cost center, you will never have passable quality.

Or, as cookie-madam Debbie Fields once said, "good enough never is."

The end result of this upheaval (once the children are healed and the accused have done the perp walk) will be that a few smart companies across China's food sector will see this as an opportunity, and will make major investments in quality assurance, both human and technical. These companies will realize that if nothing else, making investments in inspectors and equipment will be cheaper than regularly yanking product off the shelves.

As Mattel and hundreds of toy retailers learned last year, though, you can't trust quality to the last guy up the supply chain. There has been far too much "trust" and not enough "verify" in handling quality issues out of The World's Factory of late. When I was inspecting furniture in Taiwan, I frequently did it alongside third-party inspectors and buyers from some of my company's largest customers - American retailers. It pissed me off, it was costly for the buyers, but it was the only way to ensure that nothing slipped through.

It would be easy to throw this whole issue on the government, but this crisis has proved once again that business cannot wait for government action. The real lesson of the Melamine Milk Crisis is that quality is everybody's problem, from the farmer to the retailer.

Nota Bene

If you haven't already, you have got to read what David Dayton over at the Silk Road blog is writing about all of this. David is a longtime China and Thailand factory guy. He knows the ugliness around the quality control business, including what it is like to go into a factory and get accused of racism (or worse) for rejecting a critical shipment for quality lapses. In his writing, he's pretty merciless about the issues, but he's absolutely right. I am a certified pollyanna when it comes to China, but not when it comes to quality control.

The price of quality is eternal vigilance. And it is really clear there are lots of people asleep at their posts - or just looking the other way.

Comments

[Chris Devonshire-Ellis]

Hi David;

I think you'll find that Fronterra acted in good faith over the issue. Yes, they knew about the contaminated products, and urged Sanlu to recall product. However, as the majority partner in the JV, Sanlu refused. Fronterra then went to local government, who did nothing. It was only in desperation that Fronterra went to Helen Clark, the New Zealand Prime Ministers office for diplomatic and government assistance to get the products recalled that anything happened - Clark ran Beijing directly, and Beijing acted.

It's a difficult one isn't it, to call legally. You can't legislate for your JV partner behaving in such a manner no matter what the contract said. It's a higher, moral obligation to act responsibly. That should be a given. Sanlu let not just their JV partner down, but their own people. No contract can or should attempt to insist on morality as a legally binding obligation. That path leads directly to the attempting to define the legal definition of good and evil, and it can't be done.

Chris

[David]

Hi Chris,

Thank you for the background on the Fronterra involvement in all of this. I suspected as much, which is why I did not try to pillory the company in absentia. In light of your input, it is all the more discouraging to watch the company and its leaders burned in electronic effigy.

I agree that it is impractical to use a legal tool like a contract to address a moral challenge. Moral absolutist that I am, I agree that any attempt to create social morality via legislative or legal action is misguided at best.

This brings up three issues.

First, that there is a dimension of due diligence with regards joint ventures, mergers, and acquisitions in China that would evaluate the ethical practices of a prospective partner and his or her employees. You may not be able to build ethical behavior into a contract, but you can build it into your evaluation process.

Second, this underscores another reason that the equity JV remains inferior to a WFOE: it is difficult if not impossible to handle these hard ethical issues with any kind of speed or effectiveness. All it takes is one partner to say "eh, let's just let it go and see what happens," and you're shot.

Third, it demonstrates that our much-vaunted rule-of-law is meaningless unless underpinned with a moral code - or "law of rules" to which individuals and institutions adhere to one degree or another. Despite the protests of ethical humanists, China is yet one more example that we are not by default moral beings, and that both relativism and rationalism are slippery slopes.

Law was not meant to function in a moral vacuum. The longer we ask it to, the more we demonstrate its shortcomings.

David

[David Oliver]

David,

Firstly its spelt Fonterra, as a kiwi I should know that.

I think Fonterra have tried to do the right thing and are getting some unfair criticism. Its likely that a JV seemed like a good idea at the time but I'm sure they would do a WFOE now. Sanlu JV is only part of their business, they also bring in a lot of NZ product such as Anlene milk powder and Anchor butter.

I hope that this doesn't lead them to pull out of the market. China needs world class dairy companies to help it build a modern dairy industry.

[David]

Thanks David,

As noted, I have no trouble believing Fonterra tried to do the right thing. As you and Chris point out, it appears they did.

The issue in this case is that as much as they wanted and tried to do the right thing, they COULD not. And that is the problem.

It demonstrates three problems: the weakness of the joint venture as a Sino-foreign business structure; the failure of businesses in China to anticipate and address quality fade at all stages of the supply chain; and the absence of adequate moral and ethical standards among business leaders.

These are the problems that need to be fixed. It is not a lot of fun talking about them - it is much more gratifying to hunt down a responsible executive, tack his hide to the shed, and walk away. That is what has happened before, and it did little good.

The good news is that most of these issues can be addressed and managed - if perhaps not solved - at the enterprise level.

The bad news is that it isn't happening. And that's why I'm crowing.

[Chris Devonshire-Ellis]

I think the Sanlu case is only partially to do with it being a JV, although if the Chinese had been the minority partner it's true to say this wouldn't have occured. The issue goes rather further and into the realms of sheer greed and a remarkable lack of concern over the health aspects. There is perhaps a deeper issue here over the role of the State and the lack of religious education in China - it's an atheist society, and the Party is the Church. Clearly, not having any fundamental religious education creates a society where the lines between right and wrong become increasingly blurred. The Chinese are not necessarily immoral as amoral - a fundamental inability to know right from wrong. THAT is a major issue to appreciate when dealing with China, and as David points out, requires an understanding of the basic level of honesty and integrity of the people you are dealing with. Ethical due diligence, if you will, on the potential management incumbents.

JV's can still be and are very successful in China - we have many JV clients both prosperous and happy. In any event, a partner makes perfect sense in many situations, regulatory or financial. It's a knee-jerk reaction to blame the JV structure for a scandal of this type. It is more to do with the personal moral integrity of the members of the board. It was the human aspect to this, and the amorality of the Chinese partners that created this terrible event, not the legal structuring of the business per se.

[Roger Barrett]

"The Party is the Church" is an astute comment. Now we hear lawyers in China are being warned off accepting cases on behalf of parents whose children have been affected, and that a media ban on reporting on the issue is in force. For reasons of 'public security'. With the party as the only church, when the people get upset there is only one government to blame. So China's Church is preventing both coverage and redress. Big Brother exists and is very much alive and well. The Thought Police anyone?

[David]

Chris, I agree - it is not the joint venture that is to blame here, but the amoral behavior of the decision makers.

I don't mean to lay a blanket condemnation on all joint-ventures, but to point out that it played a significant supporting role in this drama. One merely needs to accept Fonterra's self-defense at face value to grant as much.

I have seen a few well-structured equity joint ventures work quite well, but I have seen plenty end in tears. Even you must grant that a critical reason for the success of Dezan-Shira's clients within joint-ventures has been your ability to pilot them through the hazards lurking beneath the surface of the JV structure. Not all companies have been as well guided, and the history of business in China over the past two decades is spotted with the wrecks of joint ventures gone bad.

(Okay, I think I've milked that metaphor.)

My point on joint ventures is that they are fundamentally weaker structure than the WFOE, and that they are usually entered into when the foreign party is prohibited other options. When you MUST have a JV, they CAN be made stronger when fortified with foresight and a clear-eyed appreciation for all of the implicit challenges, and going forward I think all of us advising clients need to include the moral-ethical dimension as a part of our vetting process.

[David]

Roger, without taking issue with your comments, let's take another angle on this (keeping in mind that I am not a trained attorney.)

Take a hypothetical case where a government restricts or prohibits tort claims against a company or an industry, either generally or for a specific event. Hypothetically, let's call that event "widespread product contamination."

Because of the government restriction, corporate counsel should not fear that any voluntary action the company takes to redress damages suffered by the victims would be a de facto admission of liability.

Does this not then place a greater moral burden on the affected company to voluntarily provide some form of redress to the victims?

Purely hypothetical, of course.