One of our recurring themes is the need for due diligence when working on any business matters in China. Most foreign companies think of due diligence only when they are planning to make an investment. Most companies are not aware that due diligence is required whenever you do any kind of business with a Chinese company. If you do not already know the Chinese company with which you will be conducting business, you must confirm that the company really does exit and that you are dealing with the actual  company and not an impostor.

I want to share a conversation I had yesterday with some young lawyers who work for the one of the largest and best law firms in Shandong province. I was discussing with them the question of whether or not the company seal on a particular document was valid or not. It seemed like a simple matter. The resulting conversation was not so simple.

When asked how they go about confirming the validity of a seal, the lawyers told me that “you have to go the town where the company is located.” Once there, you then have to determine if the seal is registered. Often the seal is not registered as registration of seals is not mandatory in China. Then you inspect various documents filed with the local authorities to determine if the same seal was used on those documents. If the seal is registered, or if the same seal was used on all company documents filed with the local authorities, you know that the seal is valid.

Even this is not enough. Even though the seal is valid, you still have to determine if the seal is being used in an authorized manner. Just on the surface, there are two possible issues. First, an impostor may have created a fake company seal. Second, someone within the company may be using the seal in an unauthorized manner. The only way to resolve these issues is to actually visit the company at its headquarters and to ask: is the person who stamped this document employed at your company? If the answer to this is yes, you then must ask whether the person is authorized to do this particular business.

An affirmative answer to both these questions is the only way you can be assured that the signature and the seal on your document are valid and will effectively bind the company. There is no other way to do it: a visit to the relevant  government office and to the company office is required. There is no service available to do the work. You have to hire a Chinese licensed attorney to do it. A Chinese attorney is normally required because local governments rarely open their files to a private person and they certainly will not open their files to a foreigner.

My first response to all of this was to say that this is far too expensive a procedure for normal commercial transactions. The Chinese lawyers looked at me with a mixture of amusement and contempt. They said that they understand my response since it is typical of their North American and European clients. They further stated that they are amazed at the naïveté of their foreign clients on the need for basic due diligence in commercial transactions. One lawyer looked at me and said: “What do you think we do all day at this law firm. Most of our young lawyers and legal assistants are primarily engaged in basic due diligence about potential business partners of our Chinese clients. We travel to the local offices and we charge for the expense. Our Chinese clients willingly pay the fee because they know the risk is too great to act in any other way. We constantly see foreign companies enter into contracts without doing any such investigation and it continues to surprise us. You say that our form of due diligence is too expensive. We say that being cheated is far more expensive. Given that the chance of being cheated in China is extremely high, it makes no sense to us to take the risk. Our Chinese clients would never enter into an important contract without a personal investigation of the other side and we find it very strange that these foreign clients who know even less about China will willingly take a risk that virtually no Chinese company would take.”

It makes sense to take seriously what these young Chinese lawyers are saying. Let me give you just one example of what can go wrong in China. Say you are dealing with a large and well established Chinese company. There is no question that this company exists and that it makes the product that you wish to purchase. Now ask yourself this: are you really dealing with that big company? Or are you dealing with an impostor? How do you know?

It is easy in China to fake company seals, business cards, bank accounts and even a website. The unsuspecting foreigner makes a deal with the impostor and sends funds to the bank account. Product never arrives. The foreigner contacts the well established Chinese company and that company truthfully responds by saying “we have never heard of you.” It turns out the foreigner had been dealing with a fake, virtual company the entire time. This happens all the the time in China. Trust me when I tell you we see instances of this at least once a month.

Other standard scams are well known and I will not repeat them here. The point is this. In China, you never know if you are dealing with a legitimate company and a legitimate representative of that company unless and until you investigate on the ground in China. Any foreign company that enters into a contract in China without this knowledge in hand is taking a risk that the Chinese companies themselves will not take. Does that make sense to you?

For more on China due diligence, check out the following:

What do you think?

  • Mark

    Wow Steve…Thank you for this post. This is basic stuff and sometimes stating the obvious is so important.

  • Rayson

    Great article. This is exactly what I do now, having learned over time that nothing is ever as it initially seems in China.

  • I believe these lawyers are busy doing such investigations, but only a small proportion of Chinese transactions require this service. Most transactions are too small, or they are between parties that already know each other (same family/friends circle).
    Foreigners should do more due diligence, of course. Their transactions/deals are often large, and they are an easy prey.

  • DLW

    Steve, this is absolutely “spot on,” and as misery loves company, then I would only add that similar alarm bells should be sounded for real and proper due diligence in deals in other countries, as well (including ones that are almost universally deemed by most clients to be “fully developed”). It can be as basic as whether the other entity really exists, or ever existed or, as you note, if the counterparty is even really the entity it purports to be. But you are so right that it moves down to other levels, as well, as to a review of the entity’s due powers and authority for the actions in question, including both external (regulatory) and internal restrictions thereon, the authorized parties (officers and directors) for executing (and ratifying) contracts, and even the counterparty’s ownership structure (as but one example, one may learn that the counterparty is a former state owned enterprise, but is still in the early processes of privatization, and thus may have yet other restrictions).
    If “due diligence” is frequently regarded as a “dirty phrase” uttered in the early planning stages of many Western business deals, as Heaven knows that through time such processes have uncovered countless problems that have either negated proposed transactions, or made them far more costly for one or both of the parties, it is that much more essential in foreign cases where there are thousands (as opposed to hundreds?) of different ways that things could go terribly wrong. And my belief is that Chinese courts, much like those in most Western countries, won’t be particularly sympathetic to a foreign party who plunges blindly (and greedily) into a transaction, without taking reasonable steps to perform advance due diligence (and of course, obtaining a legal judgment against a nonexistent entity or one with no assets–even if it were to happen–would be of little comfort anyway). So there won’t be many ex post facto remedies available for those who had failed to heed the warnings.
    China still seems to bring out a sort of “steeple chase” mentality in some businesses, where their unrestrained desires to get into China, whether to source cheap products there (many days late and dollars short–no longer quite so cheap!) or to try to sell into China’s domestic markets (a verityable graveyard for unsophisticated foreign companies that lack adequate resources and well-developed strategic plans), lead them to abandon their senses.

  • DD is a problem when even the people who offer due diligence services often turn out to not be who they claim to be once you perform your DD on them.
    For myself, it amazes me how often I find out things that people who had been working with a certain company or person for years didn’t know by simply googling the name of the person or company.
    Totally fictional example:
    Guy: We worried that company X may be selling product Y which they developed for us and which we hold the copyright in to customer Z.
    Me: Wow, you guys did google the name of company X before you decided to give them the contract to develop product Y, didn’t you?
    Guy: No.
    Me: Well, if you had you would have seen that company X had a high-profile copyright infringement case some years back. Perhaps not the people you wanted to give that contract to.
    Guy: Oh.
    Yes, China’s a special case, but there’s no excuse not to just do a minimum amount of checking wherever you’re doing business.

  • Dan

    @FOARP,
    You could not have made a better comment if I were paying you.
    You are absolutely right. It is amazing how many times a simple Google search would reveal enough on a company to know not to do business with them. I find this to be particularly true of those companies that take money and then never provide the product. I would swear that at least half the time when I get a call about a case like that I can do a Google search while on the phone with the company that was scammed and within 15 seconds find plenty of information that would have told a reasonable person not to do business with the scammer company.

  • Andeli

    So true and for those who know a little Chinese http://www.123cha.com/ one can even check if the Shenfenzhen of the person you are dealing with is fake or not.

  • David Wood

    I’d be wary of using Google as a quasi due diligence service. How to use it in China for Chinese company due diligence? All info would be in Chinese which is useless for searching anything in English. If you want to do due diligence use a professional firm that can access Chinese company records. There are such services about.

  • Joe Zhou

    Note to FOARP and Dan – Google’s search engine is not active in the China market, as has been addressed in massive detail in the global media. 95% of all searches in China are conducted through Baidu. Google would be next to useless for finding information about China, and I’m surprised you even considered it .

  • Mandrake

    FOARP and Dan are absolutely right to encourage companies to do a Google search as a first pass method for finding out about a Chinese company. Of course Google is in English which means it misses a lot of what you can find on a Chinese company, but I think people would be surprised at how often you can find out information about Chinese companies in English through Google written by those who have been cheated by those Chinese companies. I use Google as my first pass when looking at buying from Chinese manufacturers and there have been many times where just Googling a company convinced me not to use them.

  • Matt Ryan

    Nobody said Google should be the first and last place to go for China due diligence. All people are saying is that it is a great first place and I completely agree with that.

  • Rayson

    Great article. It seems to me that there will always be people though who get so caught up in doing a China deal that they will not only not conduct due diligence, they view due diligence as an impediment to what they are trying to do. That can be their only reason for not even bothering to do a Google search on the company they are about to do business with. Oh, and I too always use Google first to find out about Chinese companies and it is a great tool for that because if your Chinese company shows up as “scam,” “cheat,” “crook” all over Google, you do not need to go any further and Google is much better than Baidu for that, especially if you can’t read Chinese.

  • Frederick Douglas

    What do you think of the standard disclaimer included in many due diligence reports prepared by international foreign law firms on China-related deals to the effect: “We assume that all documents reviewed in the preparation of this report are true, genuine and correct”?

  • Joel

    I disagree with Joe’s point on Baidu above. It generates far too much advertising and not enough real information. It is simply not as effective as Google.

  • I don’t know what these people are talking about. Google is a great way to quickly find out things about Chinese companies.

  • James G

    Google does Chinese language searches fairly well. I haven’t used Baidu much at all but I’d trust Google when doing a search in either Chinese or English. Googles results aren’t lacking, are they?

  • Guys, I know that Google doesn’t have everything on a company, that its coverage of China is less than that elsewhere, and companies can do SEO work so that any bad results are hidden on the 100th page of results. This doesn’t mean I don’t keep on finding things out about companies (even Chinese ones) by a quick Google search – Google is far from useless for this purpose, even in China. In fact, when you’re searching in English as a first pass, I think it may be more useful than Baidu since almost all Baidu searches are in Chinese.

  • Volker Müller

    I wonder how to fake a bank account in China. So much paperwork necessary to open a bank account for a legitimate company.
    And Chinese banks are extremely careful that only legal transactions are made.

  • Mi Fu

    the question that comes to my mind, what is the *real* problem of China? Is there more fraud than in other countries? Or are people simply more afraid of fraud?
    Next year will be my 25th aniversary in China. In all these years, did I encounter any fraud? Perhaps a peddlar on the peasant’s market wanted to overcharge me, but real fraud? None!
    Due diligence? Well, i would call it common sense. If I am establishing a cooperation with another company and the volume of sales/purchase is more than a few thousand RMB, I will visit them, talk with the responsible persons, will spend an evening together (don’t talk about business), drink a bear or two, become friends, make clear that the business relation will be a win-win relation (there are people who say most Chinese business people are not interested in a win-win relation. Wrong!)
    One of the main problems of nowadays China is a general lack of trust, often accompanied by a pathological fear of crime. I know intelligent people here in Beijing who are afraid to go out on the street at night because they are afraid of crimes. Ridiculous!
    In the same way many business people are pathologically afraid of being cheated. If the negative impact of fear (delay or abortion of a promising business relation) is more serious than possible risks, then the lack of trust becomes a problem for the development of a company.
    Of course, laywers see the black side of the society everyday. And due diligence (with a reasonable input of work / costs) is justified in most cases. But we should not see each business partner as a potential defrauder.
    This would harm business relations and have a negative impact on your company and on the society as a whole.

  • AC

    I think with so many readers endorsing google as a due diligence tool it’s no wonder there are QC and legal problems with Chinese suppliers.

  • @AC – Let’s put it like this – I COULD call them up, send people round to their addresses, check licenses and permits and registrations, obtain references etc. etc. etc., but what the hell’s the point of all that if the first page of results on Google includes (as in my totally fictional example) a prominent copyright infringement case in which the company concerned behaved in an untrustworthy fashion? This doesn’t mean that if nothing shows up I can rest easy, but as a first step it works very well.

  • bernini

    I am a Chinese lawyer, and I can say the words of those young Chinese lawyers cited by Steve are not fully correct: 1, the registered seal in government are not easy for attorney to check; 2, Not the truth that all young Chinese lawyers are busy in Due Dillegence for Chinese companies’ transactions. I agree the investigation of target company is necessary, to visit them, but the use of seal normally in China is normal, not so dangerous. The foreign companies can’t trust a Chinese company through website or phone, paying a visit is the minimum. Also a well-drafted agreement would protect the buyer’s interest and the payment scheduale is also an important element.

  • Darcy

    @FOARP – You make a good point as to how using Google can be a good way to screen out the worst of the Chinese companies. Or at least those that have already been written about by other companies they have scammed.

  • Don Clarke

    Steve: Fascinating post highlighting the gap between (agency) law on the books and law in practice. I just wrote a comment on this here: http://lawprofessors.typepad.com/china_law_prof_blog/2011/08/due-diligence-and-agency-law-in-china.html
    To summarize: the text of Chinese agency law is very favorable to people who are duped by people purporting to act on behalf of others, and not so favorable to purported principals. (Much more so than US law as contained in the Restatement of Agency.) Your post suggests that in practice it’s the other way around. Normally I would wonder if courts treat these issues differently as between foreign and domestic companies, but from your post it would seem not.

  • akbigdog

    Great article, but it raises a question: how do you perform due diligence on the Chinese law firm you engage to perform due diligence?