Chinese Red Alert

Business ethics and business law do sometimes collide. But such problems are especially acute in China, where managers' interests are closely aligned to local Party bosses. Chinese managers' job performance is often based on how many jobs they create and how many widgets they churn out, not something as intangible as consumer protection, let alone "brand reputation."

Nor is there any self-correcting mechanism at work in China. Local health regulators often report to local government officials -- the same officials who own the companies that inspectors are supposed to be monitoring. Tort claims can't be brought by customers because the judiciary isn't independent. The state-owned press isn't free to ferret out corruption.

That leaves foreign JV partners as the last line of defense for their customers. Smart foreign firms have either installed their own people in China to supervise production or ditched minority stakeholdings altogether in favor of wholly owned operations. Mattel, for instance, owns many of its factories in China. That didn't avert a problem with lead paint in toys, but when problems were discovered, Mattel could move quickly to initiate a recall and regain its customers' trust. Fonterra, on the other hand, shared its safety-monitoring expertise with Sanlu and trusted it was being followed. It wasn't.

The Chinese government is making a show of its "justice," firing the local Party bosses and Sanlu's management team. National-level officials are scrambling to show that they're in control so people don't riot in the streets and demand their heads. Meanwhile the scandal spreads: In the past week, authorities have turned up contamination problems at as many as 21 other dairy companies. In the wake of disasters, as in the Sanlu case, Beijing usually tightens enforcement and introduces new regulations. But regulation can only accomplish so much.

It's the system itself, not just the company or the dairy industry, that's broken. Until the government -- and the Communist Party -- break their ties with business, managers' incentives will always be aligned with those of their political bosses, not their customers. In the meantime, made-in-China products will come under increasing scrutiny from foreign companies that make them there, and from consumers who buy them. None of this will begin to compensate the families who have lost their children.