China due diligence lawyers
Good advice when doing business in or with China

In part 1 of this series, I talked about how fraud tends to increase when the economy is good, but revealed when the economy is bad. Or as Warren Buffet once, said, “Only when the tide goes out do you discover who’s been swimming naked.” I also mentioned how in the last few months our China lawyers have been called in to help on more suspected fraud cases than maybe any time in our law firm’s history and of how our goal with this series is to help arm you with information that will enable you to discern China-related frauds (really frauds anywhere) on your own, or at least get you to the point where you realize you need to do something to act on your suspicions.

I am convinced that nine out of ten times when bad things happen to good people who do business in or with China it is the “good person’s” fault. The victim’s failure to discern what was happening to it usually stemmed from one of three things:

  • They failed to account for how China is different from their home country.
  • They too much wanted to believe that their “good relationship would somehow insulate them from problems.
  • They saw issues that ordinarily would cause one to suspect problems, but they either explained each of these issues away on their own or they simply accepted the explanations of their Chinese counterpart, without conducting any investigation into their veracity.

Or as a China consultant friend of mine always likes to say, they “checked their brains at the airport gate.”

Like all attorneys 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” an “initial” $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 was so troubled by the wild and unsubstantiated claims this Chinese company was making that he suggested to this investor that instead of putting this $500,000 into the Chinese company, he instead use the money to fly him and Steve to Las Vegas 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. When your Chinese counterpart focuses more on its connections than on the inherent strength of its proposed deal, you should be doubly wary.

2. The guy who bought a million dollar condo in Shanghai in the name of his girlfriend because she had convinced him 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 our law firm to  bring on local litigation counsel to sue the girlfriend, but we demurred because we did not think he should throw more good money after bad by pursuing a case where he would need to stand before of a Chinese judge and explain the deal by starting out saying he had put the condo in his girlfriend’s name so as to avoid Chinese law. 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 and he had spent a million dollars without doing anything to confirm. They say love is blind, but we see this sort of thing all the time on the business front as well.

3. The countless people who call my firm after having sent hundreds of thousands of dollars (sometimes millions of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. Anatomy Of A China Scam. Part I. Just The Facts.

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 permanently 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 go on and on. Easily.

So what can you as a foreigner do? A lot.

The following rules to employ when analyzing 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. Dishonest companies have far less confidence that they can fool a Chinese company and far less ability to do so. They also will tend to be less willing to take risks with local companies than with foreign companies. Look at whether the Chinese company does business with other Chinese companies with whom you are interested is treated by other Chinese companies.

Take all company-provided introductions with a grain of salt. It’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should rely on your own networks to help you understand the company and industry. If you don’t have those networks, you should not be doing business with China yourself.

Try to construct your own fraud scenario. Ask yourself how everything you have seen could have been staged. This kind of thinking reveals how surprisingly simple measures (like switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous foreigner. Our firm’s China business specialists love regaling us lawyers with how different a facility is when they check it out for the first time at the company’s invitation as compared to what it looks like when they pop in unannounced one or two weeks later.

Forget about the paper. Focus on your China counter-party’s 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.”

Scrutinize the paper. Yes, you should be wary of every piece of paper provided to you by your Chinese counterpart, but you still should scrutinize it and hunt down and review even more. We love scrutinizing the paper (especially early on in a deal) provided to us by the Chinese company because so often their methods to obfuscate are so crude and obvious. And when we find that the Chinese side tried to trick our client, we suggest our client walk away from the deal. 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.

And these days, the Chinese government has a lot of “good paper” on its companies. That Chinese company with which you are looking to partner on an aerospace joint venture? Did you know that they are licensed only to bake cookies and cakes and they have been in business for all of 10 months? We frequently search Chinese corporate records for our clients and though it is not 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 you 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. Will they know how to interpret the information? Just as one example where knowledge on how to interpret is critical. Suppose a parent company does an IPO in Hong Kong or the U.S. and then claims the IPO proceeds were injected into the WFOE in China. Was the money injected into the WFOE or not. And if so, when? And 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 company’s official corporate 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.

Speak with competitors and speak with employees and speak with people in the neighborhood. We love sending one of our China business specialists out to speak with these sorts of people because it is amazing what you can learn.

Do not delegate. Be attuned to the dichotomy between the amount at stake with your investment/deal and the income/wealth of the people on whom you rely for judgment. In other words, you need to be able to trust the people on whom you are relying and if you cannot, you need new people. About half the time when my law 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.

Delegate. There are certain things that only you as a company should be doing and there are other things in which you absolutely positively must bring in the experts. There are no hard and fast rules on when and what is required because it varies with the company and the nature of the deal, but I can tell you that on the legal front there have been hundreds of times where our China lawyers have been brought in too late to help and there has pretty much never been a time where we were brought on too early.


And it is not just deals in China that require care and feeding. Deals with Chinese companies in your home country often do as well. Way back in September, 2011, I wrote about 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.

These days, the Chinese companies that are coming to America (and to Europe) have gotten considerably more sophisticated and we wrote about their newest foreign direct investment (FDI) tacts in The China Fake Investment Scam: Does that Chinese Company Want to Invest in Your Company or Steal Your Technology? and in The China Stock Option Scam.

I love writing about 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 finds it hard to believe anyone could have been so “easily” duped. And/or they just want to let us know that whomever it was who was duped was “incredibly stupid.”  I disagree. I do not see these things as hinging so much on one’s intelligence but on their inexperience with international business and especially with China. These are the people who “check their brains at the gate” when doing business with China.

I conclude this already overly long post with an admonition from a good friend of mine (and a true expert on doing business with China), Ben Shobert, effectively emphasizing the need for, and the benefits of, conducting due diligence:

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.

Be careful out there.

For more on avoiding China problems, check out the following: