Risks Faced by China-based Toy Manufacturers

The three most common reasons for recalls are design defects, loose magnets, and excessive lead paint.

Design defect

According to a report printed in a local Hong Kong newspaper on September 11 2007, more than three-quarters of toys recalled in recent years were triggered by design defects instead of
manufacturing faults. Examples of design defects included small detachable parts, sharp edges or long strings that could pose a risk of strangulation to children. In fact, only 10% of the 550 recalls in the past 20 years by US government quality-control authorities were due to manufacturing problems such as excessive lead paint and overheating batteries.¹

Loose magnets

Some plastic figurine toys, like the Polly Pocket Playset, Batman, and Barbie dolls have small loose magnet components. When these loose magnets fall off and more than one magnet are swallowed, the magnets can attract to each other and cause intestinal perforation, infection or blockage particularly for children, which can be fatal.

Excessive Lead

Lead paint is used in various products because it is bright, durable, fast-drying and cheap. In 1978, the US Consumer Product Safety Commission (the CPSC) made it illegal to use any paint containing more than 0.06% lead for children's products. Such products are subject to recall in the US If an excessive amount of lead is ingested, it may cause brain damage, learning disabilities, seizure and death.

On September 27 2007, the CPSC announced seven separate recalls of Chinese-manufactured toys and children's jewelry for containing unlawful levels of lead. These seven recalls, totaling more than 600,000 units, brought the total excessive lead-based recalls in 2007 to 50, which is more than double the highest number of recalls in any single previous year in the CPSC's history.²

US CONSUMER CLASS ACTIONS

Although class actions are unheard of in Hong Kong or other parts of the world, they are common in the US, especially when consumer products are involved because the affected class of plaintiffs can be very large. Class actions in the US will determine the rights and remedies for a large number of people whose cases involve common questions of law and/or fact. The defendants are often multinational institutions with "deep pockets" that can afford to pay potentially huge judgments.

On August 20 2007, a class action lawsuit was filed in a Los Angeles County Superior Court against Mattel, which imports millions of Chinese-made toys that have been recalled recently due to excessive lead paint. This lawsuit asked Mattel to set up a fund where concerned parents could have access to have their children tested for lead poisoning. The medical cost for testing one person for lead poisoning is around US$50. The class size will likely reach millions of plaintiffs because according to public statements made by Mattel, 1.22 million units of children toys that it sold were manufactured with surface lead paint.³

Similarly, on September 27 2007, a class action lawsuit was filed against Mattel in the United States District Court, Central District of California. The plaintiffs of this class action sought damages for injuries suffered from swallowing tiny magnets that became loose or fell out from certain dolls and accessories of certain magnetic play sets.

PUNITIVE DAMAGES

In addition to damages claimed for medical costs regarding lead poisoning tests, US toy retailers might be ordered to pay punitive damages. The purpose of punitive damages is to punish a defendant and to deter such a defendant (and others in the future) from engaging in similar conduct or making similar omissions.

Generally speaking, punitive damages are not available in contractual actions, but are available in tort actions. Typically, the amount of punitive damages is determined by the trier of fact - in this case, US juries, which are known to be very generous. The amount awarded is usually based on a number of factors, including the nature of the defendant's actions, the extent of harm caused by the defendant, and the defendant's financial circumstances. For punitive damages to be upheld constitutionally, they must not be grossly disproportional to the actual damages that have been awarded.

INDEMNITY AND CONTRACT CLAIMS BY TOY RETAILERS

In addition to possible termination of future business with Chinese toy manufacturers, US retailers may make indemnity claims against Chinese toy manufacturers to recover:

(i) compensatory payments that they have made to consumers;

(ii) legal costs for defending consumer claims; and

(iii) costs of the recall programs.⁴

Whether or not these indemnity claims will succeed will depend on the interpretation of the indemnity clauses in the contracts between the two parties.

Chinese toy manufacturers may also be sued by US retailers under contract law for other reasons, including misrepresentation, breach of warranties, and breach of promises regarding safety and quality of their products.

ENFORCEMENT OF US LAWSUITS

Against Assets in the US

A US judgment can be enforced against assets of a Chinese toy manufacturer that are based in the US, which may include contractual rights that the toy manufacturer has with other companies. For example, if a Chinese toy manufacturer has accounts receivables in the US from a US buyer, those receivables can be subject to execution of a US judgment.

New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards

With respect to the enforceability of arbitral awards, China is a party to the "New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards" This means that an arbitration award issued in the US, or in a third country, can be enforced in Chinese Courts.

Minimum contacts

Although US Courts do not have jurisdictional power over companies incorporated outside the US and not conducting business there, a Chinese toy company that is systematically tapping the US market, such as sending representatives to US trade shows, visiting companies in the US and sending electronic messages may be found to have sufficient "minimum contacts"with the US such that a US Court can exercise jurisdiction over it. A foreign defendant does not need to have an office or hire employees in the US to fall under the jurisdiction of US Courts.

US REGULATORY ISSUES FOR CHINESE TOY MANUFACTURERS

The two US governmental regulatory bodies involved in monitoring the quality and safety of toys in the US are the CPSC and US Customs & Border Protection (the CBP).

The CPSC is in charge of protecting the public from unreasonable risks of serious injury or death from consumer products, whereas one of the CBP's responsibilities is to ensure that the goods entering the US from foreign countries are safe for US consumers to use. Both agencies work closely together. The CBP has the authority to detain and exclude any products, such as toys, based on instructions from the CPSC.

CONSUMER PRODUCT SAFETY ACT 1972

One piece of US legislation that gives the CPSC its power is the Consumer Product Safety Act 1972. Under this Act, every manufacturer, distributor and retailer of a consumer product is required to inform the CPSC within 24 hours when they obtain information which reasonably supports the conclusion that a product:

(1) fails to comply with an applicable consumer product safety rule;

(2) contains a defect which could create a substantial product hazard; or

(3) creates an unreasonable risk of serious injury or death.

On September 4 2007, the CPSC stated that it was investigating whether Mattel "knowingly" withheld information regarding potential safety risks associated with its toys that were involved in a major recall in August 2007. If the CPSC decides that Mattel did breach provisions of the above Act, then it has the power to issue fines on Mattel for up to US$2 million.⁵

With respect to Chinese toy manufacturers, the CPSC may initiate seizure and condemnation proceedings if the products are determined to be hazardous. After the CPSC has designated a product as a substantial hazard, it may require the manufacturer to give public notice of the product's defect and either make repairs, replace the product, or give refunds to consumers. Also, a manufacturer who knowingly violates any rule and whose product subsequently injures any person may be subject to civil fines and criminal penalties.

CHINA'S GENERAL ADMINISTRATION OF QUALITY SUPERVISION, INSPECTION AND QUARANTINE

China's General Administration of Quality Supervision, Inspection & Quarantine (the AQSIQ) is a governmental department in China in charge of the quality of goods being imported into and exported out of China.

Currently, the CPSC is working closely with the AQSIQ, which means that if the CPSC is interested in investigating a particular manufacturer in China, the AQSIQ may help the CPSC to carry out an investigation, or it may decide on its own to do a follow-up of the CPSC's investigation.

On September 12 2007, a Consumer Product Safety Summit was held between the CPSC and the AQSIQ. At the conclusion of this summit, an agreement was reached between both parties where the AQSIQ agreed to:

(i) increase its inspections of consumer products destined for the US;

(ii) assist the CPSC in tracing hazardous products to the manufacturers, distributors and exporters in China; and

(iii) stop and prohibit manufacturers in China from using lead paint in its manufacture of all toys exported to the US immediately.

In addition, both agencies agreed upon?plans for future cooperation in the toy industry, including a roadmap?for?bilateral efforts to improve their safety. The two agencies?expect to?review the plans' effectiveness within one year to identify possible areas for improvement.

REBUILDING THE IMAGE OF CHINESE PRODUCTS

In early October 2007, the Chinese government tried to help Chinese toy manufacturers to improve the quality and safety of their products by running a two-day training workshop in Guangdong province. During this workshop, various government officials and executives of multinational firms gave lectures on toy certification systems, and export test regulations and standards in China, the US, and Europe. More than one thousand industry leaders, including owners and managers from Chinese toy manufacturers and state officials, attended this workshop. This is another step taken by the Chinese government to rebuild and improve the tarnished image of "made-in-China"products.

NEW PROPOSALS FROM US TOY RETAILERS

On September 6 2007, a large toy retailer in the US took an unusual step by asking the US federal government to impose a mandatory safety testing system for all toys sold in the US. This proposal, which was approved by the board of the US Toy Industry Association at a private meeting, did not envision a broad federal inspection program. Instead, the US toy retailers are calling for a federal mandate requiring all toy companies to hire independent laboratories to check a certain portion of their toys, whether made in the US or overseas, before these toys reach the US market. Currently, there is no uniform standard for testing, and the quality and safety of the toys are tested only after they have reached the US market.

Also, the proposal seeks to improve the following:

(i) frequency of testing;

(ii) determining at what point during the production should that tests be conducted; and

(iii) what specific hazards should be checked for.

By imposing such a system, US toy retailers would have a more reliable method of testing and detecting products with defects before they reach US consumers.

One reason why the US toy retailers have made such a proposal is because "if the consumer is aware that the government has some responsibility and is holding companies responsible, it will set their minds at ease as to the products they are buying off the shelves" according to Jeff Holtzman, chief executive of the Goldberger Company, a toy maker.

If the proposal is accepted by the US federal government, the government would need to increase its manpower at the CPSC because the CPSC would be involved in helping to set the testing standards. The CPSC will also continue its role in testing the toys after they have reached the US market to ensure that the proposed system is working effectively.

LIMITING POTENTIAL LIABILITIES FOR CHINESE TOY MANUFACTURERS

Contractual terms

A Chinese toy manufacturer can protect itself through contracts. It is advisable for a toy manufacturer to perform a "risk audit" so that it is aware of its potential liabilities, and it is vital that any contract between a US retailer and Chinese toy manufacturer be drafted carefully and thoroughly, allocating risks fairly. Every term and provision in a contract can have legal ramifications and needs to be reviewed and revised by experienced international lawyers.

Indemnification provisions

Both parties should have a clear understanding regarding indemnification. When something goes wrong, like the recent toy recalls, should the manufacturer be liable for all the costs of recall? If so, for how much? Who should bear liability for design faults? These issues should be considered before entering into a contract. A clear allocation of risks is desired.

Incorporation of safety standards

The degree of quality and safety standards required for the products should be stated in detail in the contract. This will avoid US retailers from claiming that the products do not meet the required standards. A Chinese manufacturer should have documentary proof that its production has complied with such detailed safety standards.

Dispute resolution, choice of law and choice of forum

When a dispute arises between parties, in which country should it be resolved? Which country's law or court's procedures should be followed? This may decide whether a class action is possible against a Chinese toy manufacturer. Is there a designated neutral third party (i.e. mediator or arbitrator) that can help to resolve the dispute? Details on all of these issues should also be stated in the contract.

Design

A Chinese toy manufacturer should pay extra attention to the designs of any products that it is asked to produce. Most of the time, it is the design of the product that has created the problem. Even if a toy manufacturer produces a product that fits the retailer's requested specifications exactly, that product might have problems because its design did not meet the required standard of safety or quality in the US

Even Mattel has acknowledged and admitted that its design defects were the main reason for most of these recalls. On September 21 2007, Thomas A. Debrowski, Mattel's executive vice president for worldwide operations, apologized to China for harming the reputation of Chinese manufacturers. In particular, he said that "the vast majority of those products that were recalled were the result of a design flaw in Mattel's design, not through a manufacturing flaw in China's manufacturers:"⁶

Liability insurance

Both retailers and manufacturers should purchase product liability insurance to cover themselves.

On-going inspection

There should be on-going inspections between US retailers and Chinese manufacturers to ensure good quality of toy products. Also, the supply chains, i.e. where the components of each part of the product come from, should be transparent, recorded and tested. By doing so, the quality of the products can be controlled and maintained.

With better cooperation among Chinese toy manufacturers and US retailers and better allocation of risks among these parties, a Chinese toy manufacturer can understand its potential risks better and can minimize the negative consequences of the current toy recalls.

Simon Luk is Partner and Chairman of the Hong Kong Practice of Heller Ehrman, and Honorary Legal Advisor to the Chamber of Listed Hong Kong Companies and the Toy Manufacturers Association of Hong Kong. Eric Wong is a Trainee Solicitor at Heller Ehrman. An abridged version of this article has been previously published in the newsletter of the Hong Kong General Chamber of Commerce.

Endnotes

1 The "easy-Bake Oven"is an example of a popular toy made in China with design defects. This electrical toy is a purple and pink plastic oven that resembles a kitchen range, with four burners on top and a front-loading oven. It produces heat to resemble a real kitchen burner. There were 29 reports of children getting their hands or fingers caught in the oven's opening, including five reports of burns.

2 Among the products recalled were "Happy Giddy Gardening Tools" "Toby & Me Jewelry Sets" and "Thomas & Friends Wooden Railway Toys"

3 On August 14 2007, a similar lawsuit was filed against Fisher-Price, a wholly-owned subsidiary of Mattel Inc., in New York.

4 According to news reports, one of Mattel's recent recalls involving 967,000 product units was expected to cost the company around US$30 million.

5 In 2007, Fisher-Price had to pay a fine of US$975,000 for failing to give a timely report on a potential choking hazard with a toy set called "little People Animal Sounds Farm" The danger with this toy was that the two small metal screws that held the toy "Stall door" in place could come off, posing an aspiration or choking hazard to young children.

6 "Should Mattel have said sorry to China" , September 21 2007.