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China Due Diligence. Cause It Really Really Really Matters.

By Dan Harris on Posted in China Business

As you can tell, I am a big fan of The Rule of Threes.

Back in September, 2011, I wrote a post regarding a China deal that appeared to have badly soured. The post was entitled, China FDI, Whatever Happened To Show Me? and it was on a China deal that went bad for the small Missouri town of Moberly. The point of my article was to emphasize the importance of conducting due diligence before entering a China (or any) deal:

So why am I writing about this and how is this relevant to you? 

I am writing about it because it appears (having only “seen” this from afar I do not know) that the government fell into three classic traps. First, it appears that various governments got overly excited about the possibility of getting Chinese money. It appears it fell prey to the classic “China is rich. We want money. Therefore this is a good deal” syndrome. Second, it appears nobody conducted adequate due diligence. Were the very valid suspicions of my e-mailer ever checked out? I doubt it. I have no idea if my e-mailer ever raised her/his suspicions with City Hall, but having dealt with governments, I can only imagine how they were treated. Can you say groupthink? Third, the deal was rushed. The Columbia paper noted how it all went through in “73 days, far less than the six months or more usually needed to conclude such a deal.” Rushing a deal does not mean it will fail, but it certainly increases the chances.

I had no idea our post would thrust me into a political firestorm half a country away.

Almost immediately after our post ran, I started getting phone calls and emails from the Missouri press and from individuals in that state, wanting to talk to me about Moberly’s deal and wanting to talk to me about a potential China Eastern Air Cargo terminal in St. Louis. It seems that those who opposed the St. Louis terminal were using my Moberly post as new ammunition for why that unrelated deal should be terminated (loose pun intended).  

I ended up giving an interview on St. Louis radio and to a few Missouri journalists and got quoted a few times (here and here) regarding the Moberly deal. I also ended up talking with a someone down there (whose name I cannot recall), who talked of flying me to St. Louis (which never happened) to explain how just because one Missouri town had been ripped off by mercurial “Chinese Investors,” that alone has absolutely no meaning when analyzing a completely separate deal involving a legitimate and well funded Chinese company like China Eastern.

I thought again of Moberly this week after reading an absolutely fascinating Business Week article by Susan Berfield recounting what happened there. The article is entitled,  “A Missouri Town’s Sweet Dreams Turn Sour” and appropriately subtitled, “Bruce Cole persuaded Moberly, Mo., to help him build a sucralose plant. The town’s sweet dreams of jobs and opportunity soon became a nightmare.” To sum up a long and detailed and thorough and fascinating (yes, I know I already used that word) article, it seems Moberly heard the words “Chinese Investors” and lost their heads after that. It appears Moberly got duped out of millions of dollars it did not have and now the town is going to be considerably poorer because of it. And all because of their lack of due diligence.

We love to write about the China scams because  they make great cautionary tales for our readers. Just about whenever we write such a post, we get a comment and/or email or two from someone who seems to find it hard to believe that anyone could so “easily” have been duped. And/or they just want to let us know that whomever it was who was duped was “incredibly stupid.”  I disagree. What usually has happened is what always happens and what appeared to have happened to Moberly. I do not see these things as hinging so much on one’s intelligence. I think these sorts of things happen when the “making money portion of our brains” (help me out here medical people) takes over and overwhelms the deep thinking part of the brain and thereby renders it fairly useless. I am just not sure this process happens any more often with “stupid” people. But I do think it happens more often to those new to international business and overly exicited about its prospects. These are the people who “check their brains at the gate” when arriving in China. 

Unfortunately, we have written so often on China scams and the need to conduct due diligence before doing business with anyone in China that I am beginning to fear we have nothing new to say about it — but being lawyers that is not going to stop us. So it was a breath of fresh air to see someone else talk about it, especially when that someone is not a lawyer, but a highly regarded expert on doing business with China. I actually came across the Business Week article in a post on the Cross the Rubicon Blog, entitled, “Misery in Moberly” and it was that post by Ben Shobert that spurred me to write this one. In his post, Ben so effectively emphasizes the need for, and the benefits of, conducting due diligence, that all I am going to do is quote him:

It is such a simple insight, but one that bears repeating:  you will never, ever regret spending money up-front vetting a potential partner or running a deeper due-diligence process on a particular fatal flaw in your international strategy.  In the case of this sort of vetting procedure in China, or other emerging economies for that matter, the process you need to go through isn’t as clear-cut as we experience in the developed West.  In emerging economies, you are looking for reputational, not just financial, information.  You might be able to get a D&B or S&P report on the company in question, but in an emerging economy, it probably doesn’t reflect the set of books that you care most about.

Due diligence. It’s mandatory.

Do you agree?

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

  • Lo Kok Kee

    Just wondered how do you explain experienced investors like John Paulson (re Sino Forest) and Maurice Greenberg (re China Express Media) got taken for expensive rides? They couldn’t have skimped on the due diligence bit, or at least, their in-house counsels shouldn’t have allowed it. Also, what about all the big name auditors who signed off on those accounts? How to do due diligence on this?

  • http://www.ridacto.com Max Mednik

    Really good advice and totally agree. I’m just now learning about doing business in China, but I have a close friend who has done multiple deals there with varying techniques and levels of success. Due diligence has been critical.
    i simply wanted to add 2 things. First of all, it seems like due diligence is important from the “scam prevention” standpoint, but as long as you’re not dealing with a scam, I’d say it’s still important. Due diligence furthers one’s understanding of all the parties and technicalities in a deal and uncovers a lot of data that can indicate things about the right price for the transaction or how to actually operate the deal once it’s in place.
    Secondly, besides the traditional due diligence on financials (3 sets of books in China), customers, supplier interviews, etc., what may be just as important is a strong understanding, confidence, and trust in one’s counterparties and partners. Since the right partnerships are critical (and often sine qua non in China), the people issues and motivations may trump the numbers or technical issues.
    Great blog and appreciate the advice! I’m working on a project called Ridacto which aims to use artificial intelligence techniques to help people create and negotiate better legal contracts, and a lot of your advice will definitely be helpful to those negotiating contracts on our platform. Thanks for sharing!

  • Steve Ng

    @Lo Kok Lee – This piece seems more about the legal stuff and licence checks on due diligence not the financials. The financial issues you need accounting boys to look at, not lawyers.

  • Charming Charlie

    I read that article in Businessweek and am surprised you feel there was enough China in the story to warrant a post; obviously you know more about the deal than I do. My takeaway from the article is that Bruce Cole miscalculated the amount of Chinese investors that would throw money into his coffers for a green card. Bruce Cole is an American. The design of the sucralose plant was purchased by him from a Chinese company, but that’s where the Chinese connection ends.

  • http://alexnstone.wordpress.com/ Alexandra

    Due diligence is key! I have only recently started working for a company who has an office in Hong Kong and uses Chinese manufacturers to assemble our products, but the first thing I learned and quite quickly was that due diligence is the only way to avoid issues. Due diligence and research is also essential for enforcing IPRs. Great post!

  • Bob Lewis

    Dan,
    Thanks for the great post and the insights from Ridacto.
    For anyone contemplating the purchase of goods and services from China I must recommend an article in to-day’s China Daily
    ( http://www.chinadaily.com.cn/cndy/2012-01/16/content_14449977.htm ) describing one company’s testing, inspection and certification services for a variety of Chinese industries.
    Let’s hope that someone at the bond rating institutions is also reading your blog.

  • Lo Kok Kee

    Hi Steve,
    The two cases I mentioned weren’t just financial issues. For Sino Forest, the allegation is that the company overstated the forest acreage owned and their carrying values. So due diligence would require checking on the title documents and the relevant land registries to ensure that firstly, the reported acreage is correct and secondly, but more importantly, they tally with the official records.
    For China Express Media, the allegation is that the company grossly over-inflated the number of buses that carried their advertising screens and hence their revenue. Proper due diligence would require checking on the counter-parties to verify that they actually own at least the number of buses that the agreements indicated. The short sellers who did the whistle blowing did a better job than the American investor. They went to the bus depots and actually counted the number of buses and the screens carried. In some cases, by riding on the buses, they can even claimed that the bus drivers can bypass the paid programming and select his own, so the screen may not even be contracted (most inter-city buses would already have a TV installed to entertain the passengers). I don’t think this would fall within the scope of the statutory audits.
    I personally am looking at a listed Chinese company that has negative enterprise value, i.e. the company’s cash on hand is higher than its market cap, with no borrowings or net liabilities. If only there is a fool proof way of doing due diligence to verify everything on its books (I already did the initial factory visit and can confirm that the production lines actually exist, haha), then it is really a too good to be true stock.