Header graphic for print
China Law Blog China Law for Business

How To Really Really Investigate A Chinese Company.

Posted in China Business, Legal News

Not sure if it is cynicism or realism, but I am getting increasingly willing to blame “the victim” of China business problems. I am convinced that nine times out of ten when bad things happen to good people who do business internationally (that includes in or with China) it is the “good person’s” fault. Like all lawyers who work with China, I have a ready set of horror stories, which I rotate depending on the occasion, but usually include one or more of the following (modified slightly to protect the guilty):

1. The guy who “invested” $500,000 into a China business because the owner of the Chinese business was allegedly the son of a five star general. Co-blogger Steve Dickinson suggested to this investor that instead of investing this money into the Chinese company, that he use the money to fly him and Steve to Vegas (this was before Macao got so big) and put the money on red because, as Steve put it, the chances of his not losing his money were much greater this way and it would be a lot more enjoyable. This guy went ahead and invested the $500,000 and lost every bit of it. He then wanted us to sue the “son of the general” on a contingency fee basis, but we would not have taken on that case for a 150% contingency.

2. The guy who bought a million dollar condo in Shanghai in the name of his girlfriend because he believed foreigners were not allowed to own real property in China. His girlfriend then left him and claimed he had given her the condo as a gift. The guy wanted us to sue the girlfriend but we demurred, saying that we just did not like a case where our client would need to stand in front of a Chinese judge and explain the deal by starting out saying that he had put the condo in his girlfriend’s name so as to avoid the Chinese law that says…. And here’s the kicker. When he bought this condo for his girlfriend, he could have purchased it in his name, no problem! His girlfriend had lied to him about Chinese real property ownership laws.

3. The countless people who call my firm after having sent tens of thousands of dollars (sometimes hundreds of thousands of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. We have never taken one of these cases because we deem them pretty much hopeless. 

4. The US company that used the local Chinese lawyer of its joint venture partner (what was this company thinking?) who drafted up agreements that involved the American company giving its critical technology to the joint venture permenantly without getting any real influence or control in it (this is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in). For more on this type of joint venture deal, check out, When in China Trust Everyone.

I could easily go on and on.

So what can a foreign investor do?

A lot.

Here goes.

In Seven Rules Of China Due Diligence, I set out the following seven rules to analzye a Chinese company with which you are doing business, taking the first six from an article by Muddy Waters entitled, “The Six Rules of China Due Diligence“: 

Approach the company as a potential customer does. “You want to see what the China side customers see. Fraudulent companies have far less confidence that they can fool a Chinese company in their industry than they do about fooling a starched shirt analyst. Moreover, they’re usually less willing to take legal risks in their home market (China) than they are in the United States.” In other words, look to see how the Chinese company with whom you are interested is treated by other Chinese companies.

Take all company-provided introductions with a grain of salt. “When companies set up meetings or conversations between you and their suppliers or customers, take them with a grain of salt….In a country where a lot of managers earn less than $500 per month, it’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.” I completely agree. 

Try to construct your own fraud scenario. “At some point in evaluating every investment, you should stop and ask yourself how you could have staged everything you’ve been shown or done with the company. It’s good for American investors to practice this mentality because it makes us less credulous. More importantly, this kind of thinking makes clear how surprisingly simple measures (e.g., switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous investor.” I absolutely love this advice and I urge everyone to follow it.

Forget about the paper. Focus on the operations. “In today’s world where you can buy a competent color printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value….Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times – a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences. Ultimately if you cannot find a good way to measure the company’s sales or productivity (as in the case of a service company), you should think carefully about proceeding with the investment.” I completely agree with the advice to put the Chinese company’s operations under a microscope, but I completely disagree with the advice to ignore the paper, as I discuss more fully below. I advocate putting the paper under a microscope as well. 

Always speak with competitors. “Competitors with real businesses can usually tell you one of two things about a fraudulent competitor – either that it’s obscure (sometimes the “competitor” is hearing about the company for the first time); or, that they know it’s a fraud. Many competitors will be reluctant to speak openly at first about a fraudulent competitor if they know you’re a potential investor in the fraudulent company. However, if you’re a potential customer who is shopping around for a vendor, it can be a different story.” This is excellent advice, but one should also take the views of competitors with at least a bit of salt.

Do not delegate. “A lot of experienced China investors have stories about subordinates who colluded with a target company to attempt (and sometimes succeed) to defraud the investor. Be attuned to the dichotomy between the investment funds at stake and the income/wealth of the people on whom you rely for judgment.” Very true. At least half the time when my firm has been brought into a fraud situation, we have to ask ourselves whether the “trusted subordinate” was incredibly stupid or in on the fraud.

The seventh rule (my added rule) is to put the documents you receive under a microscope because the fraudulent company will nearly always make some mistake in its documents. In my career, I have caught the following, all of which threw up massive red flags:

Company claimed to have a multi-million dollar account at a non-existent bank;

Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary;

Company claimed to have a branch office in a particular city, yet its documents on that branch office (including supposed government documents) put that city in the wrong province;

Company claimed to be bringing in twice as much product as physically possible on a particular ship;

Company claimed to have been shipping out product on a particular ship that did not exist during the first few years when the product was allegedly being shipped;

Company claimed to have won an IP lawsuit in a country’s Supreme Court (they produced the Supreme Court’s decision and everything), but there had never been such a case.

Bill Bishop at DigiCha just did a post entitled, “Do You Know Where Your China Stock CFO Lives?” setting out China company (mostly publicly traded) warning signs. The post talks about how two Chinese companies Longtop Financial and Sino-Forest, that publicly trade in the United States and have recently been under scrutiny for alleged improprieties both have Canada-based CFOs even though the bulk of their operations are in China. Bishop posits that these companies may have hired foreign-based CFOs as “China fraud beards.” 

Bishop then goes on to quote from an iChinaStock post, entitled, 5 Warning Signs That A Chinese Stock May Be a Fraud, listing out the following warning signs:

  1. Company went public through an OTCBB Transfer or other ways of back-door listing;
  2. Company name starts with “China” [unless they are state-owned they can not register a company in China starting the word "China"];
  3. The products are sold in China, but there is minimal Chinese-language information about those products;
  4. The business defies common sense;
  5. The underwriter, audit firm and accounting firm are second tier and/or have a track record of missing frauds (like Deloitte China).

Bishop adds a sixth item to the list, that “the CFO does not live in the same city as corporate HQ and is not a regular presence there.”

I like Bishop’s admonition not to invest in a business that defies common sense. Yes, that is pretty basic, but in many ways it is the key. It is not too disimilar from the advice I gave in the When in China Trust Everyone post mentioned above:

First off, THINK. That’s right, think. Secondly, do not do anything you would not do in any other country. Just because your Chinese partner and/or your Chinese partner’s lawyer tell you this is how things are in China does not mean you have to believe them and it certainly does not mean you have to abandon your common sense.

One more thing to do before you invest or, in some cases, even do business with a Chinese company: get their official corporate records from the official Chinese government sources. We have of late been doing this rather frequently for our clients and though it is not at all inexpensive or easy, it can be incredibly enlightening and it goes far beyond the information provided by the basic company search firms. 

The China company search firms typically provide only a fairly basic list of information, such as the names, and addresses of those involved with the company and its registered capital. in addition to not being terribly complete, the information from these search firms is of dubious provenance. How did they get the information? Can we be sure they looked at the entire file? We know the files are only supposed to be open to lawyers. How did they obtain access? When did they review review the documents? Last year’s documents may be of no help at all.

We strongly suggest that you seek out the full SAIC (State Administration for Industry and Commerce) file on the Chinese company about whom you are seeking information.

In our experience, the SAIC only opens its file to licensed Chinese attorneys. Everyone else is turned down. The Chinese licensed attorney must go in person to the SAIC office, review the file, and make copies in the office. So far, no Chinese licensed attorney with whom we have worked has ever been denied access. It is our understanding that the Chinese companies investigated through the SAIC will know they are being investigated. Like I said, we have so far always been able to get the file, but there could come a day when a local SAIC in an outlying province will block access to the file of a powerful company within its purview.

These SAIC forays usually give us a massive amounts of documents in Chinese, which we then either translate for our clients or, more typically, summarize.

The hot topic in this arena right now is this: the parent company does an IPO in Hong Kong or the U.S. The parent claims the IPO proceeds were injected into a WFOE in China. Was the money injected into the WFOE or not. If so, when? If not, what is the most recent record on the registered capital status of the WFOE. For a WFOE that receives an injection of capital from an IPO, there is typically at least six months of advance work in increasing the registered capital amount. All of this is public and can normally be found in the SAIC file. In addition, the annual audit will show an injection of capital. But the audit is of the previous year. So for recent injections of capital, we have to rely on the approval for the increase in the registered capital.

For more on these issues, check out the following:

What do you think?

  • http://solongandthanx.blogspot.com/ Mark

    Thank you so much for this information! With China slowly but surely becoming a superpower in the world, this knowledge about China’s business mentality is extremely useful. I personally feel that learning the language is also very important. I know that lot of people, myself included, do not want to learn the language as a matter of pride to their own language. But I think in pursuit of self-preservation and survival in the future, knowing the Chinese language is important.

  • http://jlizamavera.blogspot.com Jaime

    Great blog! I found some really good posts.
    Best regards.
    Jaime.

  • Ollumi

    Cripes, reminds me of how tiring it is because you have to practice this with everything in this country (including haircuts, fruit and general food vendors, cigarette vendors, etc.)
    A few things:
    1) Why do you put so much faith in company facility presentation(i.e. “hive of activity, number of employees” when you yourself have stated that it is ridiculously common to set up false meetings? How hard is it really to call in a number of stand-ins? In this country especially, where most people evaluate a company via how much hardware it has – factory space, equipment, number of employees with so and so degrees, never mind how much of that has anything to do with why you’d actually be interested in the company – that local professionals of a certain trade are trained professionals at giving impressive presentations. There’s a number of companies I know off the top of my head that easily pass themselves off as 三产单位 of some reputable, or at least renowned state company or another when in reality they’re a group of sales people who were former employees or have some network leverage in these companies that rent office space right in the middle of the plant facilities of said companies. Then they take their Chinese customers and their foreign potential investors to an impressive tour of the facilities and equipment( which they don’t own) and employees(which don’t work for them).
    2)I think at least a part of your clientele probably aren’t investing in China for the local facilities or equipment, which makes investigating the market critical. I think, however, Muddy Waters skimmed over(perhaps intentionally) how to get that information in a few quick sentences. It’s understandable, given first hand information isn’t exactly reliable here, even from “victims”, because of the zero reward for risk taking and gigantic hammer for responsibility taking that is so prevalent in the private industry here, not to mention state company customers. Seeing what the customers think, like everything else in China, needs to be a process of interpretation and interpolation and could do with a bit of salt as well.
    3)Do not delegate – I wholeheartedly agree with this. While it is somewhat frustrating to converse with a parachute executive with no immersive experience in China and rightful confidence in the way he or she has always done things, it is downright annoying to deal with a regional manager or even worse, some rep from hk/malaysia/singapore/local with conflicting interests motivating them, because these things then become sabotaged from the get-go and a complete waste of time.

  • Inveterate trader

    Nice. I am going to send this on to all of my clients who seem not to believe me when I tell them that I am very wary of investing in any Chinese company and for all of the reasons you have set forth in your article.

  • danjyu

    Sadly, people who buy into stories like LongTop, CCME, and SinoForest, seem to require ‘market discipline’ (or a regulator catalyzing an investigation, which then ultimately leads to ‘market discipline’)…
    I wonder if reading something like the above will make a difference. I suspect that psychological/cognitive biases or too strong, such that, even with resources like the above, they need to be burned in order to learn.
    I guess they say experience is the best teacher, for a reason…

  • PC

    You need more dealing with how to examine the finances here.

  • http://www.melnyks.com Serge Melnyk

    Very useful information. Thank you for such great insights!

  • BD

    I agree with your suggestions, but if you need to do all of this, is it really even worth it in the end?

  • P. Saville

    To really really investigate a Chinese company you need experienced auditors and forensic accountants. I think you should have mentioned this.

  • John Bird

    I have been approaching the China issue from the standpoint of a short seller in the stock market and your blog has been very enlightening over the last year. My experience in obtaining the SAIC files has been that China based credit bureaus can also obtain the complete files. I have regularly used Qingdao Inter-Credit and they are both affordable and responsive.
    It is imperative for a outsider looking at the public filings to appreciate the differences between a WFOE and a domestic entity, which you have previously explained. It is also important to recognize some of the basic Chinese regulations. These include a prohibition of consolidated filings, the use calendar year for reporting, accruals, capital and equity accounting variations, and limitations on dividends. My confidence in the SAIC filings stems from the fact that WFOE’s must file annually and include an audited financial statement with that filing. The audit must be preformed by a Chinese audit firm and that financial statement is commonly also used with tax reporting.
    Any one foolish enough to ignore this readily available source of information deserves the predictable disasters that await the reckless.
    John

  • Mosey wales

    Back in the late 1990s in china a legal contemporary of mine would always comment that if you ever wanted to achieve things in China and obtain a favorable result or if there was a perceived injustice or aspect of doing business which wasn’t fair usually due to government interference one was always better off bringing this to the attention of US commentators who would then kick up a song and dance about the unfairness of it all to the Chinese authorities? This would then have the desired effect of achieving absolutely nothing as far as US business interests were concerned while enabling our clients from other jurisdictions to get concessions from the Chinese almost as if this was done to spite those US interests. All this reminds me also of those totally interminable White Papers that various foreign government chambers trot out each year with little or no effect.
    To achieve business progress in China a. You don’t make a song and dance about things. b. You ensure you keep your profile as low as possible. c. You determine what the regulatory authorities want in return for the concessions you are trying to obtain.
    It is for these obvious reasons that I post my comments on an anonymous basis. However those that are trying to achieve results in this China market can always send myself an email.

  • Elemental

    Funny, I just said to a friend of mine that I was waiting for a CLB post on all this to put it all in perspective. This does that and more.

  • aaron

    Bottomline:
    Don’t buy a bridge in Brooklyn.
    No country is a bank vault. You can’t just throw money into it and expect it to be safe investment. (Heck, even putting money into US banks are not that safe any more).

  • Neil

    Well, this certainly puts sourcing on Alibaba into perspective!

  • http://blog.theepochtimes.com/1/china Matthew Robertson

    This is an excellent post, Dan. Tell me: is there any explanation about why a Chinese attorney needs to go to SAIC, why anyone else can’t go? And what are the rules for filings there–can offenders simply not file things that, if uncovered, were incriminating? The explanation of the nitty-gritty elements involved into digging into Chinese companies and checking out potential frauds is the most interesting part of this.
    Another observation I’d make is that I don’t think it’s wrong for Americans to be trusting. It is wrong of the Chinese to be so unscrupulous, ripping people off who pay for goods when it all looks legitimate. It is right to warn of the precautions that should be made when dealing with China, but the tone of the post seems to normalise what should not be normal: skulduggery, deception, and so on. Just a thought. I’ve met several businessmen who found themselves in such predicaments. They’re sorry stories, and it’s all because they simply assumed that other people would behave decently.

  • Twofish

    Robertson: Another observation I’d make is that I don’t think it’s wrong for Americans to be trusting. It is wrong of the Chinese to be so unscrupulous, ripping people off who pay for goods when it all looks legitimate.
    I’ve known of equally messy tales of Chinese doing business in the US. The problem is that if you have been somewhere, you know a lot of the basic information that you need to avoid getting ripped off. In particular, you likely have a “trust network” of people that you know you can trust. If you are new to a place, then things that are obvious scams to the locals are non-obvious to you, and you really have no clue who to trust and who not to.
    Of course, the people that are less than honest know this, and so you have this big target on your back. What’s worse is that the honest people are likely to make less extravagant claims, and if they don’t have anything to offer, then they aren’t going to bother you.
    Robertson: They’re sorry stories, and it’s all because they simply assumed that other people would behave decently.
    Most people will behave decently, but if you are in a foreign land, then the odds are that you are going to be more likely than a local to run into people that won’t.

  • http://www.shanghaiscrap.com Adam Minter

    Dan – Great post. I’ve just sent it off to a bunch of scrap industry folks, and one response I just received reads: “Why the hell didn’t you send this to me before the markets tanked in 2008???” He’s referring, of course, to the epidemic of broken contracts that hit the industry in the wake of the economic crisis. Anyway, this is broadly applicable to more than just investment. A real public service.

  • Scott Rogers

    I have printed this out and I promise never to do any sort of business with China again without looking this over first. In fact, I promise never to do any sort of business in any emerging market country without looking this over first. Great stuff!

  • G. Peters

    @Mathew Robertson – the reason that you need a Chinese lawyer to go to SAIC is because a lawyer is required to get certain official documents (is it all?) and that means only lawyers who are actually licensed lawyers in China. Foreign lawyers are not licensed in China and so this necessarily falls on Chinese licensed lawyers.

  • http://blog.sina.com.cn/u/1711714842 Ann Lee

    Thanks for the excellent article and just to add one point about the second case a foreign guy bought a millon dollar condo in the name of his girl friend may get his condo back if he has good evidence to support what he is saying and to prove he had paid all the money. If the girl friend claims to be a gift, such donation can also be revoked if the guy can prove to buy the condo as a token for marriage. Anyway, if it happens in Shanghai, I believe there will be some legal remedy.
    Also, I would like to say even a Chinese may have some difficulty to find out what the real target it will invest in since there is no good credit appraisal system in China and there is not so much access for you to know. However, to invest in a target just like to get married sometimes and make sure you understand well what the target want, the quick money, the management improvement or the real development with the help of the future investor. As Chinese has a idiom, one couple shares one bed but with different dreams. An investment with the investor and target having different purpose just like the couple with different dreams which may end up with divorce. So do as much as talk possible, with the employee, the manager and figure out what they want to achieve in the cooperation which may save a lot trouble in the future.

  • Dennis

    “You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.” I completely agree. ”
    So how should anyone do business in China, just through few trusted guys who somehow back in the mythical past managed to set up networks and now act as the gatekeepers? how convenient for them. Maybe they should form some sort of guild, you know, for the good of the consumer.