Last year a couple of people from the Risk Advisory Group’s Asia Group stopped by my office and we spent quite a bit of time discussing risks in China. Risk Advisory Group And of course we also discussed various ways of mitigating those risks and of course, conducting one’s due diligence figured prominently. One of the things that has always bothered me about due diligence is that just about everyone knows it should be done but very few people know what exactly it is that should or even can be done. And because it can vary so much from deal to deal, I have always found it difficult to write about. I mean, if you are buying a $2,000 item from someone in China over the internet, your due diligence is obviously going to be a lot different than if you are buying a Chinese company for USD$2 billion.
So I did what I love to do when faced with something difficult: outsource it to the experts. I asked the Risk Advisory Group to do a guest post on China due diligence. Risk Advisory Group describes itself on its website as follows:
Risk Advisory is a leading, independent global risk management consultancy. We provide intelligence, investigation and security services to clients that include many of the world’s leading corporate entities, financial institutions and law firms. We help our clients to navigate increasingly complex regulatory, compliance and security environments in some of the most challenging jurisdictions.
Most importantly they do a lot of work involving China. The following is their guest post, and as I told them in my response to it, I could not be happier with it.
– Can you do effective due diligence in China?
A lot of companies, funds and other investors ask us about doing due diligence in China. They have heard many stories about business deals that have gone horribly wrong, particularly those very public deals which have made the front pages of the international financial press. They have been told that getting information in China is difficult, particularly if you want to stay on the right side of the law. They have also heard that accessing accurate data about the business they are buying, learning how a company secured its lucrative contract with a State Owned Enterprise (SOE), or understanding more about the background of the favoured candidate to run their joint venture is impossible.
That is not strictly true. Yes, it can be challenging: the press is heavily monitored, self-censors and, at times, is actively controlled; company records can be difficult (if not impossible) to access legally; and we all know that every company keeps at least three sets of accounts and you may never see the real figures. But China is just like every other country: the people who understand how it works can help you to unearth information that will help shape your decisions.
– The black, the white and the grey
First, a word on the law with the caveat that this should not in any way be construed as legal advice. I will leave that to the blog hosts.
On occasion we get asked by our clients if we can tell them how much money the company has in the bank, obtain individuals’ personal and family details from copies of their household registration files (hukou), details of telephone calls, text messages or some other equally illegal information. The answer is no. There are laws which protect certain classes of information in most countries in the world and China is no different. I would be wary of anyone who offers access to information not generally available elsewhere in the world. The issue in China is one of interpretation. While in all markets laws are subject to interpretation, in China the interpretation is inconsistent and changes regularly and without warning.
By way of illustration, last year, there were tens, possibly hundreds of newspaper articles published about increasingly limited access to corporate filings across the country. There were no known changes to the law. Yet, a year or so ago, access would be given to full corporate files by the Administrations of Industry and Commerce (AIC) bureaus. But in 2012, access to financial information and any personal data in the records became much more heavily restricted. The clampdown has not been uniform across China. Access has been far more restricted in Beijing than anywhere else. That is probably no surprise. Civil servants working so close to the seat of power are likely to err on the side of caution, and particularly so in the year of the transition. Today, some AIC bureaus simply refuse any access to the file at all.
But why has there been a clampdown? The answer is far from clear. Many draw a direct line between external events that have damaged China’s reputation and that of its companies over the last 12 months, citing events such as the publication of Muddy Waters Research into Sino Forest, and similar reports by short-sellers. Others suggest that investigative articles detailing the wealth of senior politicians published by The New York Times, the Wall Street Journal and Bloomberg, all of which drew heavily on detailed analysis of corporate and regulatory filings, were the root cause. It could well be either of those things, or it may be something entirely different. Nobody really knows because China is not a transparent place.
– So what does (good) due diligence get you in China?
As with everything in life – that depends. We regularly look at a broad spectrum of industries and people, and in many different provinces in China, and it surprises me how little investors know (or are willing to pass on) about the company in which they are proposing to invest. The more you, the client, share about the deal, your concerns and what you already know – as well as the more time and resources you invest – the more value due diligence is likely to add.
For example, one of our clients was considering funding a small business in northeast China. They had its name and that of the company’s founder – in Chinese characters, fortunately, because transliteration from English can cause a lot of false hits and a lot of wasted time – and very little else. In this case it was enough. Open sources revealed little about the businessman, but through the contacts we have in that part of China, we were able to uncover the businessman’s colourful past. He had started out in construction and applied some heavy-handed tactics to grow his business. This meant he had plenty of enemies and a few friends in high places who were responsible for sorting out the resulting mess without sullying his name. For some, this alone would have been enough to put them off the deal. But we found more, not related to the reputation of the entrepreneur, but more importantly perhaps, through the conversations we had with people who knew the business, there were serious questions raised over the quality of the food products his company sold and therefore the long-term sustainability of the business in which our client wanted to invest.
All of this information gave our client a much better understanding of the challenges it would face if it went ahead with its investment and for skilled researchers who know their way around China it was not too challenging to find.
In some cases, you can find a gold mine of information. During the course of an investigation into an SOE we unearthed reams of legal documents. Those filings detailed allegations of fraud, misuse of company funds and the illegal transfer of assets from the SOE to private companies controlled by some of its directors. Such revelations about SOEs are normally closely guarded secrets and not necessarily made public. That may be changing. Many have interpreted the reference by Chinese leader Xi Jinping to corruption during his first speech to the Politburo as a signal that he will take steps to tackle the issue.
– Keeping FCPA lawyers up at night
One of the biggest potential risks for US companies doing business with China is the extent of state involvement in the economy. Key industry sectors are dominated by powerful SOEs; there is considerable red tape involved in acquiring licences and permits across the board, all of which are handled by state departments; and as a result of extensive membership of the CCP, many people in private business could still be regarded as government officials. When Liu Zhijun, the former minister of railways, was investigated for ‘serious violations of discipline’ (generally speaking, a euphemism for corruption) by the CCDI, one of our clients became concerned about its dealings with a subsidiary which came under the Ministry’s control. They wanted to understand if the subsidiary had been associated with any wrongdoing, either in relation to Liu’s apparent transgressions or any other matter. It is often difficult to ask questions about SOEs and their operations or indeed powerful people within China. Officials are more likely to deny requests for information and people are less open in giving you their views. But in this case, our enquiries established that Liu’s influence over the subsidiary was slight and not controversial.
We worked with a client on a project in northwest China, a place with patchy public records and – even in the context of China – particularly tight control of the media and access to information. However, through a combination of open sources and conversations with people that live and work in the area we were able to map out a large and complex group of companies, as well as gather sufficient data to piece together the track record and reputation of its founder. His businesses created jobs and brought money into the local economy through tax revenue, but there were rumours circulating that he was corrupt. All of these allegations were published in anti-government publications from abroad and when we probed further, we found them to be baseless.
It is always worth identifying the source of any reported wrong-doing properly. Not everything is what it first appears. Because of censorship and state monitoring of the press in China, the Chinese are avid users of blogs and social media. While undoubtedly a great – and sometimes the only – source of information, posts cannot always be relied upon. Wildly inaccurate claims can be made by one blogger with an agenda so many times that they appear to have substance. Knowing your blogs, looking for tell-tale signs that posts were penned by the same writer, and doing your own fact-checking are crucial if you are going to be able to add any value in your analysis.
– Do more not less
In any country where information can be difficult to access and even more difficult to interpret, it really is worth spending more time – and money – doing your due diligence. China is no exception. It has long been under the spotlight of the US authorities responsible for enforcing anti-corruption laws and that focus shows no signs of dimming. The costs of emerging on the radar of the SEC are far higher than any fees you will pay to accountants, lawyers or investigators. More importantly, as I said at a recent conference, even leaving aside the regulatory reasons, it makes good business sense to know as much as possible about the people you are doing business with; the more you know the more likely the venture is to be successful.