Header graphic for print
China Law Blog China Law for Business

Doing Business In China Safely. The Due Diligence Basics.

Posted in China Business

The below comes from an article I wrote a couple years ago for a manufacturing magazine.  I am reprising it today after having just communicated with a company that could sorely have stood to have read it.  The point here is that it is possible to do business in China safely, simply by following some basic due diligence rules.

Whether it is cynicism or realism, I am becoming 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, 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):

  • 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. One of my law partners suggested to this investor that he instead use the money to fly himself and my law partner to Vegas (this was before Macao got so big) and put the money on red.  As my partner put it, the chances of the client recovering his money there were much greater 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.
  • The guy who bought a million-dollar condo in Shanghai under his girlfriend’s name because he believed that 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 that he had put the condo in his girlfriend’s name so as to avoid (what he believed was) Chinese law.  And here’s the kicker. When he bought this condo for his girlfriend, he could have purchased it in his own name, no problem! His girlfriend had lied to him about Chinese real property ownership laws
  • 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.
  • The US company that used its joint venture partner’s local Chinese lawyer (what was this company thinking?). The Chinese lawyer drafted up agreements that involved the American company giving its critical technology to the joint venture permanently, without getting any real influence or control in the venture.  This is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in. You can find out more regarding this sort of Chinese joint venture deal in When in China Trust Everyone.

I could easily go on and on.

So what can a foreign investor do?

A lot.

In Seven Rules Of China Due Diligence we set out the following seven rules to analyze 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 is 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.
  • 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 addition) 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 the DigiCha blog did a great post entitled, Do You Know Where Your China Stock CFO Lives? setting out China company (mostly publicly traded) warning signs. The post talks about two Chinese companies, Longtop Financial and Sino-Forest, that publicly trade in the United States and have 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 dissimilar 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 neither inexpensive nor easy, it can be incredibly enlightening  in that it usually 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 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. It is our understanding that the Chinese companies investigated through the SAIC will know they are being investigated.

These SAIC forays usually give us massive amounts of documents in Chinese, which we then either translate for our clients or, more typically, summarize. They usually contain all sorts of key economic data on the company as well.

For more on these issues, check out the following:

What do you do to keep your company safe?

  • Harland

    “look to see how the Chinese company with whom you are interested is treated by other Chinese companies.”

    How would this be done, exactly? It’s one thing to state that it should be done but I’m at a total loss regarding how to execute.

  • Sadri

    Hello Dan,

    I am a big fan of your blog I’ve been reading for 2 years now. For my first comment, I’d like to ask what is to be found in the AIC file of a chinese company? I remember a few months ago, Bloomberg found out about GU Kailai’s holdings in searching her ID in the AIC archives.

    But to bring this to the level of most western and chinese business people, let’s consider a SME is under scrutiny. Let’s assume it is established in Zhejiang, has 50 employees, manufactures car accessories for the domestic and export market, with a registered capital of 500k and the turnover is about 5m / year.

    I know one will find the CVR, articles of association, probably a copy of the business licence and application forms for creating and altering items in the company’s registration, also some share transfer agreements (but do they show the real purchase consideration for a company’s share?)

    Would we find all of the shareholer’s resolutions such as the dividends resolutions, those appointing the general manager, the CFO, the upper management team?

    You said: “They usually contain all sorts of key economic data on the company as well.”

    Are you referring to the financial statements submitted on a yearly basis during the annual review? Are there to be found other economic data such as the existing corporate bank accounts or anything else?

    Wouldn’t the average Chinese entrepreneur be willing to conceal the true extent of the profitability of their business? I remember reading you and many others say chinese companies have 3 sets of books.

    Some comments of yours in helping us understand corporate disclosure practices to the government, in China, would be greatly appreciated.