The billion dollar problem: chip counterfeiting

Then AMD took the evidence to the Chinese police. Together, they staged a raid on four different locations in Shenzhen, including a warehouse where they found boxes of ersatz chips. Criminal proceedings are under way in the case. AMD is helping to prosecute a similar case in the Philippines.

"We can't say how much value was there, but even one [microprocessor] is too many as far as we are concerned," said Mark Tyrell, director of worldwide security and corporate services at AMD (Sunnyvale, Calif.).

Counterfeiting is the dark side of the electronics industry, and the gloom is spreading. The problem affects virtually all companies along the supply chain, from component suppliers to distributors, EMS providers, ODMs, OEMs and their customers. Indeed, any electronics company that wants to take advantage of the low costs that come with globalization must realize that someone in the chain might be tempted to make extra profit by buying counterfeit goods and pawning them off as real.

The damage to a company's brand is incalculable if a consumer winds up buying a computer that doesn't work because it contains substandard parts, industry experts said. "If a deal sounds too good to be true, it probably is," said Daryl Hatano, an executive with the Semiconductor Industry Association.

But sometimes it's easy to be tempted into a trap, particularly at a time when the electronics industry is expanding. Shortages of parts force legitimate companies to look beyond authorized distributors to secondary, or "gray" markets, which can be a legitimate mechanism for trading excess components. Players include independent distributors and brokers, many of whom are honest middlemen. But since excess parts often move from broker to broker, even careful managers can have a hard time tracing a part's origin and determining whether the goods they're buying are counterfeit.

Not a minor problem

Solectron Corp., one of the largest global contract manufacturers, turned to secondary channels when shortages of some parts began last August, according to John Caltabiano, materials director at the Milpitas, Calif., company. About the same time, Solectron found handfuls of counterfeit components mixed in among good parts. The components affected were commodity items, such as capacitors, which are so small they're hard to inspect.

"We as well as other companies have had problems with counterfeiting over the last several years, and as we buy through alternative channels, it gets worse," said Caltabiano.

"It's an issue that has hit us in the last 18 months," added Dan Pleshko, vice president of global commodity management at Flextronics International Ltd., the world's largest EMS provider.

Recognizing how big counterfeiting has become is one of the first steps in tackling the problem. Observers believe the Chinese government is cracking down on counterfeiting. Authorities in China seized more than $10 million in counterfeit electronics in 2002, according to Jones.

AMD's Tyrell said he was pleased with the level of cooperation he had with the Chinese police in the company's case. "Our contacts in the local police carried off the sting to perfection," he said.

But in a society where pirating of everything from Microsoft Corp.'s Windows operating systems to DVD movies is rampant, cracking down isn't easy. As authorities in coastal cities move against counterfeiters, the operators retreat to the poorer, interior cities, where jobs are so scarce that counterfeiting operations are welcome, Jones said. And, as some countries get serious about enforcement, other countries such as Vietnam can easily offer havens to counterfeiters.

Small-time black marketeers and counterfeiters remark that chips aren't the only threats, said Jones. Some counterfeiters are more sophisticated and well-organized, including those who appear to operate from inside large Chinese electronics companies. Jones said some large Chinese companies appear to have "re-engineering departments," whose job is to study and copy competitors' designs.

Hatano said it is relatively easy for a counterfeiter with access to chip-making technology to scrape off each layer of a chip, "photocopy it" and then rebuild the chip layer by layer. The United States made this practice illegal in 1984, and the World Trade Organization required protection of chip designs in a measure adopted in 1997.

More often than not, the large chip makers are the victims. Among those that have reported counterfeiting in recent years are AMD, Analog Devices, Dallas Semiconductor, Hitachi, Hynix, Maxim, NEC and Philips. Target products range from DRAM to nonvolatile SRAM.

Enforcing the law

Analog Devices Inc. took the novel step of bringing charges in India against an alleged chip counterfeiter operating from China. ADI had an estimated 80 percent of the market a few years ago for chips used in electronic-metering systems, according to one published report. But sales began to plummet as cheap Chinese counterfeit chips hit the market. The company filed a copyright infringement suit against Shanghai Belling Co. and its Indian distributor, HiTek Electronics. The Indian courts ordered Shanghai Belling to stop selling the parts.

Part of the reason Analog Devices acted in India was the perceived lax enforcement of intellectual-property laws in China. The SIA's Hatano said that China enacted anti-counterfeiting and IP protection laws in 2001 as part of its effort to gain entry into the World Trade Organization.

China also has introduced regulations governing the registration of intellectual property and has outlined administrative enforcement measures. Basically, an aggrieved party has the right to file suit with the State Intellectual Property Office, which can order immediate injunctions against counterfeiters. Cases involving the theft of a layout design are handled centrally in Beijing, but Hatano believes that enforcement is somewhat lax.

"I spoke with a judge in China [who] showed me the log of cases involving counterfeiting," Hatano said. "It seemed to me the penalties weren't that severe."

Chips to printers

Chips are far from the only items that counterfeiters target. Counterfeiters operating in the printer market, for example, collect used inkjet cartridges, refill them and then resell them as new in fake packaging. Lou Ederer, an attorney at Torys LLP in New York, represented printer maker Lexmark in a lawsuit against an alleged counterfeiter selling fake inkjet printer cartridges. The factories producing the counterfeits had easily been established in the Czech Republic. "One case involved thousands of units, and since these were heavy-duty office printers, there were hundreds of thousands of dollars at stake," said Ederer.

Since there are legitimate remanufacturers that refill cartridges and sell them as used, it's easy for counterfeit goods to enter into the supply chain. "I've litigated in a lot of industries, and all of them have a soft underbelly in the legitimate market where counterfeiters enter into the stream of commerce," Ederer said. All it takes is for someone to buy products at low prices from an anonymous vendor. "The estimates of losses are in the hundreds of millions," Ederer said.

Manufacturers such as Intel Corp. say that buying from an authorized distributor is the best protection. A spokesman for the world's biggest chip maker said that it's much better to buy goods in their original packaging in order to minimize the risk of getting a remarked chip. But Intel (Santa Clara, Calif.) also welcomes any chance to verify information about chips that are moving through secondary channels. There are ways to reduce the risk of unwittingly buying counterfeit parts, said Caltabiano at Solectron. That company buys more than 90 percent of its parts directly from manufacturers; but for parts in short supply for which it must go to secondary markets, Solectron relies on only four brokers, according to Caltabiano. Those brokers were exhaustively qualified in terms of their trustworthiness, recordkeeping and supply sources. "Clamping down this way has almost eliminated the problem," Caltabiano said.

Similar measures have been put in place at Flextronics to weed out counterfeit goods, said Pleshko. "We have started to control and manage the secondary channels with the same exactness we do with the direct manufacturers," he said.

Detecting bad parts

Pleshko and others hope that technology can help prevent counterfeiting. Yet companies and counterfeiters are engaged in a game of one-upmanship in which the former keep improving their anti-counterfeiting techniques and the latter keep devising ways to crack them.

In the 1990s, Intel started marking its chips with laser-engraving machinery, replacing painted labels, which could be easily faked. Now the company puts identification into each chip so that a software utility can detect the speed at which it was designed to run. In the future, inventory-tracking technologies such as radio-frequency ID tags could prevent counterfeiters from penetrating supply chains because every product could be tracked (see related story, page 61).

More discreet identifiers, dubbed DNA markings, can be used to identify products in ways that the counterfeiters can't duplicate. Such approaches include identification marks that can be seen with microscopes.

But counterfeiters always seem to adapt to new technologies. That's why electronics companies are being encouraged to register their intellectual property even in places that don't appear to enforce IP laws.

"At various points in time, counterfeiting may be hard to do or easy to do," the SIA's Hatano said. "If you register your IP, it means that you eventually expect the enforcement to happen."

Ultimately, consumers have to realize the enormity of the problems associated with counterfeiting. In that way, the war against counterfeiting would resemble the war on illegal drugs, smuggling and other illicit behavior. Addressing the demand for counterfeit goods may help lessen their presence in the market.

"From the consumer view, you are getting an inferior product," Hatano said. "It just takes one bad part for an entire system to fail. If the consumers don't tolerate it, then counterfeiting won't be as profitable."

Dean Takahashi is a staff writer at the San Jose Mercury News. He can be reached at DTakahashi@mercurynews.com.