5-Hour Energy maker raids major counterfeit operation

November 19, 2012, 11:09 PM UTC

FORTUNE — Already under scrutiny about the safety of its products, the manufacturer of 5-Hour Energy drinks has uncovered and is shutting down an illegal counterfeiting network that flooded the nation with millions of bottles of fake versions of the high caffeine energy drink.

Every week, Living Essentials sells more than nine million genuine bottles of the over-the-counter 5-Hour Energy drinks through more than 100,000 retail outlets in the United States. The company insists its products are not harmful, although the New York Times reported last week that 13 deaths in the last four years, allegedly linked to the drink, are being investigated by the U.S. Food and Drug Administration.

Court documents unsealed Monday reveal that the company, which says its sales are more than $1 billion a year, has seized more than 1.8 million bottles of counterfeit products during raids secretly authorized in late October by U.S. District Judge Kiyo Matsumoto in Brooklyn, N.Y. and U.S. District Judge William Alsup in San Francisco, Calif.

Except to call the fakes “potentially dangerous,” the court papers filed by Living Essentials make no mention of possible health hazards from the counterfeit versions, which were discovered in three flavors: Berry, extra strength Berry and Orange. The drinks sell for $2 to $4 a bottle and are often sold in 12-packs. The counterfeiters used lot numbers found on real products.

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In its request for authorization to conduct the raids, the company said: “Living Essentials is not aware of serious adverse consequences associated with the counterfeits. However, Living Essentials cannot vouch for their safety or purity. The counterfeits have been manufactured by unknown criminals…”

The company did not immediately respond to a request for comment, but according to the complaints filed by Geoffrey Potter, of Patterson, Belknap, Webb & Tyler, the attorney for Living Essentials, the fake products were traced back to a San Diego factory, which was raided last Thursday. [Update: In a statement released to Fortune, Scott Henderson, president of 5-hour Energy, said: “We are extremely upset that a group of alleged criminals preyed upon and profited from the loyal, hardworking customers who have come to rely on us to provide them with a high-quality product and the world’s leading energy shot.” This press release tells customers how to identify counterfeits.]

There, the company’s investigators found ingredients used to make the fake drinks, which were put into counterfeit bottles and packages for shipment around the country. Investigators believe the ingredients were imported from Mexico.

That raid followed a series of investigations and document seizures that began in retail stores, including CVS drug stores, Valero (VLO) gasoline stations and 7-Eleven shops, and traced their supply chains back to the source of the fake products. In the last month, nearly 100 outside investigators from Kroll, Inc., armed with secret subpoenas authorizing raids to seize documents, computers, illegal manufacturing equipment and counterfeit products, had fanned across the country to trace the supply lines back from retail outlets through middlemen to wholesale warehouses and to the manufacturing facility. They found the product in a majority of the states and at wholesale distributors in California, Florida, Illinois, Michigan, New York, Pennsylvania and Texas.

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Accompanied by local law enforcement authorities, the investigators located and raided the manufacturing facility in San Diego, which was unmanned, but contained records leading the investigators to the alleged bosses of the operation.

The court documents say that genuine 5-Hour Energy is made only at two plants in Wabash, Ind.

Potter says that people with distribution operations in California and Michigan are believed to be the masterminds of the scheme. Records seized in the raids show the counterfeiting may have been going on for at least two years. The complaints, charging violations of trademarks and other civil violations, ask for $25 million in damages and recovery of all lost profits, which could be millions of dollars more from dozens of defendants. The fake products allegedly were being sold wholesale for $1.25 to $1.75 a bottle.

The hunt was triggered in late September when the company learned from an independent salesman that he had obtained products from a broker that appeared to be substandard and possibly defective. By examining those product samples, Living Essentials discovered they were counterfeit — they did not consist of the authorized ingredients, were not the pale pink color of the real products and smelled funny, the filings show. Other customers who had bought fakes also had complained they were getting “no energy” from the drinks they had bought.

Among the differences, according to court documents, the real drink contains 8,333% of the minimum Recommended Daily Intake of vitamin B-12, no sugar, and caffeine roughly equal to the amount in a 12-ounce cup of coffee. The counterfeits had sugar, no B-12, varying amounts of caffeine, and were different colors. While the packaging of the counterfeits closely resembled the real products, some bottles did not contain a dimple on the top of the plastic bottle, which is left by the manufacturing process for the real product.

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Manoj Bhargava, owner of Innovation Ventures of Farmington Hills, Mich., the parent company of Living Essentials, is a new member of the Forbes Billionaire’s list, thanks to sales of 5-Hour Energy. Since Living Essentials began manufacturing the drinks in 2004, the company says it has sold more than 1.5 billion bottles of what it calls its “dietary supplementary” products.

Bhargava has repeatedly insisted his product is not a safety risk. So far, no health incident has been reported to the company or the USDA from products that match the lot numbers of the fake goods.

Potter told U.S. District Judge William Alsup that Quality King, a multi-billion dollar a year wholesale distributor based in Ronkonkoma, Long Island New York, had more than 600,000 bottles of fake 5-Hour Energy drinks in its warehouses, according to information Quality King provided to Living Essentials, the court documents say. Quality King and another large wholesale distributor, Victory Wholesale Grocers, both sold counterfeit energy drinks to the drug store chain, CVS Caremark (CVS), the documents say.

The companies did not immediately respond to requests for comment.

Between August 6, 2012 and Nov. 1, 2012, Quality King said it had bought more than 870,000 bottles of the drinks from a California-based company called Dan-Dee Company, which was the “national distribution hub” for the conspiracy, and got the products directly from the San Diego factory, according to the court documents. Dan-Dee shipped the products through Baja distributors, a company controlled by Joseph and Justin Shayota, who are accused by Living Essentials of being “among the kingpins of the nationwide counterfeiting conspiracy.” The documents say Dan-Dee paid more than $3.8 million for nearly 15,000 cases containing more than 3 million bottles of the counterfeit products to Midwest Wholesale Distributors, a company controlled by Shayota and another alleged “kingpin,” Walid Jamil.

None of the accused or their attorneys had any immediate comment.