A friend emailed me a post the other day and asked me if I agreed with him that it was the “most helpful post your blog has done for helping foreign companies doing business with China.” My response was that I wasn’t sure, but that it certainly ranked up there and that it had been so long since we did that post (more than seven years), I would run it again. Certainly though the advice in that post holds equally true (or more so) today as it did way back then.

Here is that post:

If you are doing business in or with China, you have to check out ChinaSolved. It is operated by my friend Andrew Hupert, who also operates DiligenceChina, [link no longer exists] which is one of the best China business blogs. ChinaSolved is shaping up as a terrific resource on doing business in China. It is already chock-full of useful business advice.

Its article, “Ten Commandments for Westerners In China,” [link no longer exists] is typical of the site’s excellent and straightforward advice for foreign companies doing business in China. And I found myself agreeing with nine out of ten. Here goes:

  1. “Know what you don’t know” (for many westerners, this is by far the most difficult challenge.). Any similarities between China and “back home” are purely accidental. This is a completely different culture. Do not be fooled by surface similarities or by local people who “seem to get it.” Sources of reliable information are your #1 asset.
  2. China is still a communist country – and there is absolutely zero chance of that changing any time soon.
  3. You have to show up to win. You must be physically present and put in the “face time.” There is no “autopilot” in China business. If you feel that you are too busy to learn about China, then you are certainly too busy to be successful here.
  4. If things worked well here in China, then there would be significantly fewer opportunities for competent westerners. Try not to get too frustrated by the challenges you face.
  5. Time does not mean money here. Chinese business people do not believe in “opportunity cost.” Even simple negotiations can drag on for a long time. Avoid getting sucked into an endless cycle of meetings that don’t accomplish anything.
  6. Truth, honesty, good-will and long-term benefit are all culturally-specific concepts. Don’t expect your western standards to carry over here. Win-Win is not standard operating procedure here. Do not fool yourself that your long-term relationship with a local partner means anything.
  7. Don’t check your brains in at the border. You wouldn’t hand over your company’s money, intellectual property or trademarks to a virtual stranger in Sydney, London or San Francisco and expect to make a windfall. Don’t do it in China. The people that are offering to open doors for you are the same ones that can lock you out. Beware of people who peddle their “powerful friends and great connections.” They can use them to hurt you as well as help you.
  8. Due Diligence becomes more important when the language and systems are unclear, not less important. Don’t settle for the “least worst” deal or partner. Partners don’t get more honest and relationships don’t improve as the amount of money involved increases.
  9. China will still be here next year, and in 5 years. Don’t be pressured into signing a contract or making a deal because you are afraid of “missing the boat.” The boat has been here for 4,000+ years.
  10. Having a sense of humor helps. Having a Plan B helps even more.

I agree with all but number 6.  I understand why ChinaSolved felt it necessary to put it in here, but I think it is wrong.

Truth, honesty, good-will and long term benefit are not culturally specific concepts and long term relationships with local partners mean a lot. I think ChinaSolved felt the need to put this in here to make up for the common mistake of Westerners equating a week of good businesses meetings and friendly dinners in China with being set for life. All of us (China consultants, China accountants, and China lawyers alike) who represent Western companies that are doing business with China could fill a book with stories of China deals gone bad. So let us just take it as a given that Western companies constantly make the mistake of trusting too much, too soon.

But, I personally have also have seen enough to fill a book about excellent, mutually beneficial relationships between Chinese companies and Western companies.  And, at least as far as I know, every one of those successful long term relationships was based on trust and mutual long term benefit.

So I say we downsize to just nine commandments.

What do you think?

Last December, in a post entitled, Payment Fraud In China. This Season’s Edition, we wrote of how it has “become somewhat of a December tradition to write about China payment scams in December because history shows this is the biggest month for those.  Last December, it was Ancient China Business Scam. Back With A Vengeance This Season.”

This year it seems that China fraud season has started earlier than usual for those doing business with China and, near as I can tell from my completely unscientific non-survey, it seems that the diversity and ingenuity and number of scams is way up as well.  In other words, don’t say we didn’t warn you.

We are seeing the following old scams in quantity this year:

1.  “The come to China to celebrate our deal scam”  In this scam an alleged Chinese company emails a foreign company to express a desire to buy a few million dollars of the foreign company’s product or service.  The terms of the deal are quickly worked out and the Chinese company suggests the foreign company come to China to sign the contract and to celebrate the two parties having cooperated so well in inking their deal.   The foreigner(s) gets to China (usually some fairly out of the way city in China) and is treated to what appears to the foreigner to be a really expensive meal at which the contract is signed. At which point, the foreign company is told that Chinese custom requires that the foreigner buy the Chinese CEO an expensive gift and pay the notarization fee. The foreigner is then either taken to purchase a nice piece of jade and requested to pay a couple of thousand dollars for the notarization fee. Oftentimes the foreigner just gives the Chinese company people cash to go off and buy the CEO gift on the foreign company’s behalf.

It isn’t until weeks later that the foreigner learns that there is no deal and, in fact, there is no Chinese company either. The big lure of this scam is that nobody wants to fly all the way to China, have a great meal at someone else’s expense, and then be too cheap to spend USD$3,000 to $8,000 more to seal the deal.

I keep getting emails from people asking me if “their” deal looks real to me.  My answer is always the same: I have no idea but before getting on a plane, I would do some due diligence on the company AND if the company shows up as real, I would contact them to make sure that they are really the ones with whom you are dealing.  Sometimes just one email to the company that is purportedly behind the deal is enough to determine that a scam is being perpetrated.
It should go without saying, but real Chinese companies are a heckuva lot less likely to perpetrate this sort of scam than someone posing as a real Chinese company.

2.  “The new bank account to pay us scam.”  This is the scam on which we focused last year and it is still around and scary as ever.  I really really hate this scam because I have seen far too many smart companies fall for it and I view it as maybe the most difficult to detect.

This scam is usually employed against a foreign company that has been making purchases from a Chinese company for an extended period. The foreign company has been making its payments pursuant to purchase orders that specify the company bank account to which payment should be made. Suddenly, the “Chinese company” (note the quote marks here) sends an email to the foreign company requesting funds for outstanding POs be made to a new bank account. Often, the name on the bank account is not the same as the name of the Chinese company. Often, the bank account is in a different city or even in a different country. Often it is for Hong Kong.

What is the scheme here?  Well, it is always possible that the Chinese company has changed its bank account, but you had better be quite certain of this before you switch your payment.  In the old days, the scheme was either that the Chinese company had hit hard times and was seeking a double payment or an employee at the Chinese company was seeking to get your payment instead of the company.  The Chinese company would get the money in Hong Kong and then claim that you had never paid and that you still owed them money because it was completely your fault for having made the payment to someone other than to them.

Then last year this scam became even more sophisticated when computer hackers started hacking into Chinese companies’ computers and sending out invoices that purported to be on behalf of the Chinese company.

How can you avoid getting caught up in this type of fraud?  Take note of the following:

  • The computer networks of many Chinese companies are not secure. The networks are subject to abuse by employees of the Chinese company and by outsiders. This means that you can NEVER trust an email communication from a Chinese company. Email is inherently insecure in China and you never know with whom you are really dealing when engaging in electronic communication with Chinese companies.
  • Chinese companies tend to be very loyal to their banks and so you should view with extreme suspicion any request to make a change in the payment bank. You should not even consider following such a request unless the request is made in writing on a revised purchase order stamped with the company seal. Even in that case, it is important to contact someone you know in the company with supervisory authority to ensure that the request is valid. Email requests to make a change should be ignored, but the request should be forwarded to your trusted Chinese company contact for an explanation.
  • Carefully review all bank account information. Monitor both the name of the payee and the location of the bank. Where the payee is even slightly incorrect, do not pay. Where the location of the bank is in the wrong city or country, do not pay. I have seen cases where foreign buyers paid to bank accounts outside of China to payees with no connection to the seller. These cases were all obvious frauds and the buyers lost their entire payment. I have seen millions of dollars vanish into thin air with this sort of scam.  The Chinese parties committing the fraud will explain the need for this irregular payment as part of a plan to hold foreign currency outside of China. This kind of arrangement is no longer required in China. Explanations of this kind are indicia of fraud and should be ignored.
My law firm recently drafted a settlement agreement between an American company that had been tricked by someone (presumably outside the Chinese company) into sending a six figure payment to a “new” Hong Kong bank account. The Chinese company continued to seek payment from the American company for product the Chinese company had produced and delivered to the American company.  Initially, the Chinese company sought full payment, but it agreed to compromise both because we noted that it had been  negligent in allowing its computers to get hacked and because it wanted to maintain its relationship with the American company.

3.  “The fake company scam.’  This is a tried and true favorite and it comes back in new forms every year.  My personal favorite is the fake law firm or fake trademark/copyright/patent agent scam.  Under that scam, a website appears proclaiming really cheap trademark, copyright and patent registrations in China.  Foreign company sends some money and nothing ever gets filed.  There are two variations on this one, one much more sophisticated and harmful than the other.

The first and more simple version is for the fake China law firm or China IP agent to get a one-time payment and then do absolutely nothing further.  Under this scenario, the foreign company quickly realizes it has been scammed and, more importantly, knows that it still needs to register its IP in China.

Under the more sophisticated version, however, the fake Chinese law firm or IP agent keeps updating the foreign company and keeps requesting more money along the way.  Many (probably even most) legitimate law firms and IP agents charge for registrations in stages so even savvy foreign companies see nothing wrong in this.  The smartest of these sophisticated scammers even eventually send the foreign company a fake trademark registration certificate or copyright registration certificate (I am personally not aware of this having gone so far with a patent registration, but I would not doubt that it has).  The foreign company then thinks it is covered for its China IP registrations and does not learn for many years later that it is not. By that point, of course, there are no further traces that might lead to the scammers.

This years most popular edition of the fake company scam seems to be that of fake freight forwarders.  I did some research on this scam  after getting my second email on it in a month and came across this article, Forwarders put on alert over new Chinese freight scam.   One version of this scam is not all that different from the fake IP registration scam in that both involve gaining trust, getting money, and then disappearing:

Fraudulent forwarders pose as legitimate companies with spare capacity. They arrive on-time to collect loads and then disappear.

Another frequently seen scam involves organized gangs creating their own websites and advertising themselves as freight forwarders. These sites are characterized by very basic information, freemail accounts, and mobile phone or Skype contacts only, Mr Yarwood warned.

A third type of fraud commonly seen is where criminal organizations buy failing operators and continue to trade under their name in a state of virtual insolvency. They are able to identify and accept cargo which is subsequently stolen in transit.

Many years ago, a company came to us after its multi-million dollar cargo had disappeared.  All we had to do was look at the shipper’s business license to know that it was a complete fake.

What is the best way to prevent falling victim to this scam?  Pretty much the same as with most other scams.  Make sure that you know with whom you are doing business.  In other words, do your due diligence.  For more on what that means, check out the following:

One of our China lawyers is about ¼ the way through what is appearing to be a very thorough and systematic book on China Due Diligence, called, Due Diligence in China.  We will be posting a review of that book soon.

What are you-all seeing out there?

With so much foreign attention focused on the possibilities for drama in China it is easy at times to overlook the nation’s thirst for foreign-produced or foreign-formatted factual content. The recent announcement of BBC Worldwide’s deal with CCTV is a timely reminder that factual content can succeed in an environment where reality and elimination formats are considered undesirable television viewing by the authorities. When I ran all this past Kristian Kender, a Beijing-based media consultant with whom we regularly work, he agreed that there were many openings for factual content in China. According to Kristian, “with the success of CCTV-9 there do exist quite a lot of opportunities for international factual producers in China. What they need to bring to the table is experience, some funding and an international broadcaster.”

So, it is great to see that a bunch of factual producers will be touring Beijing and Chengdu November 12 through 18 this year as part of the “Enterprise Asia Screen Industry Delegation.”  The event is already attracting media analysis; for example Screen Hub’s recent article “Chinese Factual: initial fears before a long haul” [link no longer exists].

We have devoted more than a few posts to legal issues around feature films produced with Chinese partners or imported into China from abroad , with the following being just some of them:

Though many of these issues we discussed in the posts above apply to all types of content, television tends to present its own challenges for foreigner producers and distributors. In the face of these challenges, preventative or protective measures include
  • Obtaining some level of protection for a series format by employing a non-disclosure agreement that is appropriate for the Chinese context
  • Filing for registration of program titles as trademarks in China
  • Taking practical steps to increase the likelihood of receiving payment from Chinese agents
  • Doing some due diligence on buying agents to ensure that they have the necessary capacity and authority

I will be writing more about these issues in the context of China factual content when this group hits town.

 

Buying a Chinese company?  Looking to do a China Joint Venture?  Looking to use a Chinese company to distribute your product in China?  Licensing your technology?  Just want some good widgets from a reliable China supplier?  Everyone will tell you that before agreeing to anything you should do your due diligence to make sure that your Chinese co-party measures up.

But how do you do that, especially now when it has become clearer than ever that much private investigatory due diligence in China is illegal?

The first thing we do, because it is so easy and so cheap, is to conduct an internet search of the company in English and, more especially, in Chinese.  Doing this sort of search will virtually never be enough to feel good about going forward with a $10 million deal, but it is sometimes enough to persuade you not to do so.

Then do your due diligence the old fashioned way.  Ask your potential Chinese counter-party for relevant documents showing its various registrations and financial condition.  In particular, get its tax returns.

And if your potential counter-party will not turn over what you reasonably seek?  Seriously consider walking away. In our experience, legitimate Chinese companies do not balk at providing documents that reinforce that they are who they say they are.

And if your potential counter-party does turn over the documents you reasonably seek?  Then get someone who truly knows what he or she is doing to thoroughly review those documents.

It is that simple.

What do you think?

UPDATE:  I should have mentioned that it is even more important than ever that you hire the right firms to conduct your due diligence in China.  This means hiring a company with experience in China and, most especially, a company that knows China’s investigatory laws and follows them.

I am tired of feeling bad for people/companies who call or email me to say that they just bought this or that from China and they did not receive it or what they received is not even close to what they ordered and paid for.  Happened to me twice yesterday:

  • Restaurant owner in the Midwest bought two kitchen machines from China for about $15,000 for the two of them.  Why?  Because according to him, the same machines cost around $30,000 each in the United States.  The machines he received did not work at all.  Not at all.  Neither of them.  His requests to the seller to fix them or to accept a return were completely ignored and he wanted to know what my law firm could do to help.  I told him pretty much nothing other than to write a letter in Chinese threatening to sue the offending company in China, which letter would almost certainly be ignored.  He asked about suing in China and I told him that to do so, he would need to find a Chinese lawyer to take the case in the somewhat remote city in which the Chinese company is based and then he would need to pay that lawyer, along with the court filing fees, and who is to say that he would win in any event?  And then if he does win, how will he actually collect on the judgment?  He asked whether there is some sort of law in China mandating that companies accept returns.  I told him that I was not aware of such a law, but that even if there were such a law, why should his Chinese manufacturer follow it? We ended the conversation with him saying that it would have been cheaper in the long run for him to have just bought the machines in the United States and with my agreeing with him.
  • Retailer in the Midwest (pure coincidence) bought $23,000 of allegedly ceramic dish-ware, only half of which ever came and all of which was low grade plastic.  Again, I had to tell the caller that it would not make sense to pay my firm anything to assist in what would almost certainly be a fruitless exercise.  This person ended the call by saying she would never buy from China again.  My reaction to that was to remain silent.

If you are going to be doing a one-time China product purchase (really not just from China, but from anywhere) without due diligence and a contract, you should know that what happened to these two companies could very well happen to you and that your recourse will be limited, at best.  And if you are going to be doing a one time product purchase from China of an amount that does not warrant your engaging in at least some due diligence regarding your seller and/or in having an enforceable contract drafted, well then maybe you should reconsider.

Cause if the deal goes bad and you call me, I won’t have much to tell you.

Just saying….

Just got a PR email touting a podcast by John Jullens, a Partner at Booz & Company based in Shanghai.  The podcast sets out eight “best practices” for partnering with a Chinese business and though none of the eight should be the least bit earth shattering for anyone doing business in China or with China, they do all make good sense.  Here they are as set out in my email, with my comments in italics.  

  • Focus on filling capabilities gaps by selecting a partner who is demonstrably able to provide the organizational capabilities a business needs to be successful in China.  In other words, partner with a Chinese company that actually understands China.
  • Don’t be fooled by guanxi, the importance of which is often overestimated and can deter focus from the goal of filling capabilities gaps.  I agree.  For most industries, there are many things more important than guanxi.  For more on the overvaluing of guanxi, check out How We Really Feel About China, Part I: Guanxi
  • Drop the marriage metaphor. This is consistent with Chinese antitrust laws, which allow for “non-monogamous” arrangements, such as joint ventures with more than one partner, including companies that are direct competitors.  My advice here is merely to be flexible.  Set up your deal so that the legal side serves the business side, not vice-versa. 
  • Keep on triangulating to fill data gaps. Because much data is simply not available or transparent in China, foreign businesses must create and constantly maintain their own information base by interviewing officials, friends and business leaders.  Put more simply, make sure that you know your Chinese partner and to know your Chinese partner you must conduct due diligence that goes beyond just documents.  For more on China due diligence, check out Doing Business In China Safely. The Due Diligence Basics.
  • Conduct a thorough stakeholder analysis before signing a deal to identify your Chinese partner’s key decision-makers and influencers, whose identities, interests and roles may not be clear initially. This is particularly important when dealing with Chinese businesses, where the key decision-maker(s) is oftentimes not clear.  
  • Clarify decisions rights up front to prevent unexpected actions by a Chinese partner.  For example, the Chinese partner of a western business once exchanged its entire management team with that of a direct competitor.  This definitely makes good sense. The thing I would add here is that you should not assume anything and, in particularly, you should not assume that your Chinese partner does business even remotely the same way that you do.  
  • Go easy on the integration so as not to impose your business’ processes and standards on a Chinese partner to the point of destroying its unique capabilities and value.  I agree and I think this is important.  I have seen too many deals in the United States where company A buys company B because of what company B has to offer and then goes in and completely remakes company B in company A’s own image, literally stripping off all of what caused company A to buy company B in the first place.  I think this tendency is even greater in transnational deals.  
  • Find ways to earn trust by stressing your long-term commitment, empowering the local deal team and showing respect for your Chinese counterparts. Sure.  Why not?  
What do you think?   What else do you recommend for succeeding at China M&A?

China is evolving and certain things that were “no big deal” five years ago are a big deal now. Dealing with China customs law is a prime example of that.

My law firm does not generally handle routine customs matters, believing that they are better left to non-lawyers who specialize in that; it just usually does not make economic sense to pay lawyers rates to have someone figure out custom codes and tariffs.  This is true for China as elsewhere around the world.  However, we gladly represent foreign companies that are being asked to explain something to China customs at risk of a major fine or going to jail.  In fact, we pretty much think any company that fails to use an attorney for that ought to have their collective heads examined.  Until a few years ago, we averaged maybe one or two such matters a year, but in the last couple years, our average is closer to one a month and we attribute that change solely to stepped up enforcement by China customs.

So if you are a foreign company doing business in China that involves importing products into China (or exporting, but less so), it behooves you now more than ever to get things right.  You can make sure to get things right regarding China customs and avoid having to pay for a lawyer or you can get into trouble with China and have to deal with the attendant risks that go along with that and pay a lawyer to try to fix your problem.  I know some lawyers don’t like my analogy here, but it really is no different from changing the oil in your car’s engine.  You can do that regularly at a relatively low cost or you can fix the engine every few years when it blows.

This is part one of a four part series of posts on import trade compliance in China that is designed to help you figure out how to avoid the huge cost of having to fix your China “engine.”  I asked my friend Shawn Mahoney to write this series of posts because Shawn (a non-lawyer) just flat out knows China trade compliance because he has been living and breathing it for nearly a decade.  Here’s part I of Shawn’s series:

 

There are thousands of stories, many of which we’ve read here at China Law Blog, of companies attempting to sell into China before understanding the legal and regulatory environment for their product. Importing into China is one of these often-overlooked areas, specifically, the rules and regulations as they apply to individual products. In my experience, the importation process creates more issues and lost revenue over time than any other day-to-day activity involved with selling into China.

From the inception of your idea to enter the China market, to the daily grind of fulfillment and sales, there are three keys to getting your goods into the commerce of the PRC.

First, understand the importation process and how it should be performed for your specific product before you ship anything (even samples). DUE DILIGENCE.

Second, if you are importing your own products into China, your relationship with China’s importation regulatory institutions is vital to your success. If you are not the importer of record for your product, see point one.

Third, always make sure your paperwork is correct before you ship, especially with samples and new products. This includes keeping up to date with new laws, regulations and enforcement rules for your industry.

The rest of this post will focus on the core concepts vital to understanding the Chinese importation regime. The next post will concentrate on understanding the ins and outs of the actual importation process, with the final two posts looking at the why and how of creating strong relationships with The General Administration of Customs (GACC) and The General Administration of Quality Supervision, Inspection and Quarantine (AQSIQ).

When first selling your products to China there are a few core concepts, that if understood, will make speed bumps out of potential mountains.

1)    All products brought into China require an import license. The importer of record is not necessarily your customer, but the entity that has the import license (like a trading company).

2)    Many products require additional paperwork or special licenses to be imported.

3)    There is an actual list of products that require compulsory inspection (Import and Export Commodity Compulsory Inspection Catalogue).

4)    You cannot abdicate your responsibility to understand import regulations to the importer of record. Even if you have no operations in China and sell Inco Terms this side of the Water (or even CFR/CIF China port), your company is still liable and can be punished if your products are imported illegally or incorrectly.

5)    The law in China is always written to allow extensive leeway for Ministries and departments to enact their own regulations and enforcement mechanisms.

6)    There is an assumption behind all enforcement that you must prove your stated content or claims. For example, you cannot simply send an MSDS sheet with no testing to verify your claim of content.

7)    GACC and AQSIQ are the front lines of enforcement, many other agencies, departments and Ministries allow these two entities considerable freedom in how they enforce specific regulations at the border.

I am constantly giving speeches on protecting intellectual property from China.  I used to start that talk with something like the following:

If you are doing business with or in China, you have to plan on someone in China making a play for your Intellectual Property.  It’s not a matter of if, but when. It may be your partner, your distributer, your manufacturer, your sales manager, your top scientist, your supplier, or your customer who seeks to take and then use your IP.

Big Chinese companies steal IP.  Small Chinese companies steal IP.  State owned Chinese companies steal IP.  Privately owned Chinese companies steal IP.  And despite the beliefs of many Americans just starting out in China, Chinese companies with people who speak great English and invite you to their family weddings also steal IP.

I have since added something along the lines of the following to it:

The reason Chinese companies are going to be so quick to steal your IP is because if you haven’t done what you should be doing to protect your own IP, they figure that they will get away with it.  They’ve done the cost-benefit analysis and the benefits of stealing your IP outweigh the costs.  It’s as simple as that.  US companies do the same analysis but because of the likelihood of getting caught and punished here their decisions tend to be different.  It isn’t so much that American companies have higher morals, it is just that our system is better for preventing IP theft.

And if it’s a really long talk, I might even add something about how the US was known as one of the worst IP scofflaws back in the late 1800s.

All of this is a preface to a delightful guest piece we received from David Woronov, a Boston based international business and IP lawyer with the Posternak Law Firm.  David’s piece is on a Chinese company scammed by a US company.  Trust me when I tell you that this sort of “reverse” scam is not uncommon and is bound to increase as more Chinese companies come to America believing American companies don’t cheat.  I saw a lot of this sort of thing with Korean companies fifteen years ago and with Russian companies ten years ago.  Eventually, foreign companies coming to the US come to realize that we too have our fair share of bad apples and that due diligence is important everywhere.  In other words, the “China scam” can easily go both ways.

Here’s David’s take:

 

Early Due Diligence and Security for Payment—They’re Just as Crucial for Chinese Trying to Do Business in the West

Okay, it’s in vogue in the Western media to warn readers to be suspect of Chinese pirates, hackers, thieves and other ne’er-do-wells, as if they (and their government) have a virtual monopoly on such practices.  This may be paranoid, ignorant, racist, and dangerous at any number of levels, including as some might be lulled into “letting down their guard” when dealing with dangerous situations in other countries, or even in their own backyards.

At China Law Blog, perhaps the message should be that Chinese businesses also need to conduct their own due diligence, and act with care, prior to and when dealing with business counterparts from or in the West.  Many in China still believe that if they are dealing with an American or European company, they do not need to worry about whether or how they will be paid, and they do not need to devote time or energy to obtaining security or collateral in advance.  That is not a safe manner for them to proceed in China, the US, or anywhere else!

In a recent case here in the United States, my firm represented a Chinese company as a plaintiff, that had acted as Chinese sales representative for a defendant high tech manufacturer based in the US, just prior to the 2006 Olympics in Beijing.  The US company was a small public company, whose stock had once been listed on the American Stock Exchange, and is now only traded “Over the Counter” (and as of this writing was trading for just under $1.00 per share).  As a publicly registered company, the plaintiff could have accessed the defendant’s financial filings with the Securities and Trade Commission before it agreed to the arrangement, and if it had, it would have learned that virtually all of the defendant company’s assets (including all of its intellectual property, equipment, etc.) had been pledged as collateral for small, short-term loans by a venture fund. Such a review would also have revealed that the lender had constantly had to extend the loans (each time, on a short-term basis) and would then increase the amounts of the loans each time they had come due, while also ratcheting up interest rates and adding tougher covenants and terms.  This most basic review would have revealed that the defendant company was being held in a tight and spiraling cash corset.

Ignorant of all this, our Chinese client agreed to facilitate selling a fair number of the defendant’s products for the 2006 Beijing Olympics.  In fact, our client was relying on a cash commission payable on each sale, but it had not thought it necessary to arrange for an enforceable “master contract” (in either Mandarin or in English) with the defendant US manufacturer — which at least would have opened up the possibility for a law suit against the US manufacturer under Chinese law … but no such luck.

Back when they started fulfilling the original sales orders they had received through our client in China, the US company unilaterally listed our client in its other contracts as an “authorized repair station” in China. The US Company also listed our client as an authorized repair station on its product materials distributed in Chinese, and even sent emails telling purchasers that our client could train their staff, calibrate their machines, and handle their repairs–none of which was true.  Early on, our client did attempt to go out of its way to help, to the point where it had rented (with its own money) some large tracts of land in Beijing, for a period of a few days, that could be used for training purposes. As part of our lawsuit, I visited our client’s offices in Beijing, and immediately saw that although it is definitely a very “real company” — it was a busy, carpeted office complete with cubicles, conference rooms and reception areas, in a tall tower in Chaoyang — it definitely was NOT a warehouse, nor a calibration laboratory, a training facility or an electronic repair shop.

So when our client finally become aware of what was going on, and flat-out refused to its being listed as a servicer (for which it was not qualified, had no resources, and most significantly, was not being paid or  trained), and also demanded to be paid what it was owed for commissions, there was the crucial breakdown between the two parties. The US company then promptly sent an email unilaterally “terminating” the arrangement with our client but conveniently neglected to send notices to the customers themselves, who continued to bombard our client with calls and demands.

Our client in China was owed a pretty hefty amount in commissions and other fees for what it had done, but not enough to justify the potential costs of a full blown US law suit.  We tried to negotiate with the US company, but when it became apparent that we would have to initiate a lawsuit to toll the statute of limitations and to get the defendant US company to focus on this.

After we filed the suit, the defendant hired litigation counsel, and out came the defendant company’s defenses.  They claimed that our client had intentionally tampered with their products (despite that all of the products had been shipped directly to the end users in China) and that somehow our client had tortiously interfered with and damaged the US company in China.  Ordinarily, this all might have been quickly (but never cheaply) dealt with in litigation, but under these circumstances it was all too much.  At the end of the day, there would have to be enormous direct expenses (as well as indirect opportunity costs) for our client’s staff and other witnesses to fly back and forth from China to the US to attend depositions and hearings, as well as the costs of having to hire numerous interpreters and translators.  Most importantly, we were concerned about the ultimate creditworthiness of the US company defendant. Our client might win all the battles, but it would still lose the war if it could not collect from a defendant that appeared to be teetering near insolvency.

We ultimately reached a cash settlement, leveraged on the liability disclosures that ultimately had to be reflected in the US company’s publicly disseminated financials (it had repeatedly delayed releasing its financials, well past the times required under applicable federal law, but as things dragged on, and investors began to clamor, finally it HAD to disclose this case in its footnotes), and the fact that the defendant had “suddenly” realized that it “might” need our client’s assistance cleaning up some export control issues.  So after a number of years, our client received a fraction of what it was owed, especially after all the costs were netted out.

As our client now knows (having learned it the hard way), just because one is working with a Western company, that alone does not mean that it should let down its guard and ignore proper due diligence processes and its common business sense and practices.  China may be perilous, but so is most of the business world.  And an ounce of prevention is much better than many pounds of cure — no matter what the currency.

What do you think?

 

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 milliondollar 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?

Once my law firm brought on a lawyer from Kansas (who loves to say that she followed the yellow brick road to the Emerald City), I felt compelled to stop with the “you aren’t in Kansas anymore” tropes.  But I just couldn’t resist just this one time.
A loyal reader emailed me a link the other day to an article by Dorsey lawyers Peter Corne and Robin Weir on a recently decided Delaware Chancery Court case In Re Puda Coal, Inc. Stockholders Litigation, C.A. No. 6476-CS (Del. Ch. Feb. 6, 2013), involving “highly questionable” due diligence. Along with the link, the reader had this to say:
Thought you might be interested in seeing this as it serves as a pretty strong refutation to those who persist in believing that the problems you write about on your blog are rare due only to the fact that they seem to involve large doses of stupidity.
He said it, not me.

Anyway, it is an interesting article because it is such an interesting case. In the Puda case, plaintiff shareholders alleged that the company’s independent directors were liable for having failed to detect the unauthorized sale of the company’s assets by its chairman, who was based in China.  The directors seemed to have argued that they could not be responsible for what went on in China, but the court very clearly felt otherwise:

Chancellor Strine bluntly reminded independent directors that they must be capable of fulfilling their fiduciary duty of oversight, no matter where the company’s assets or operations are located. Among his many forthright comments:

  • “[I]f you’re going to have a company domiciled for purposes of its relations with its investors in Delaware and the assets and operations of that company are situated in China … in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot. You better have in place a system of controls to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company.”
  • “Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors … [I]f the assets are in Russia, if they’re in Nigeria, if they’re in the Middle East, if they’re in China, that you’re not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won’t cut it.”
  • “There’s no such thing as being a dummy director in Delaware, a shill, someone who just puts themselves up and represents to the investing public that they’re a monitor.”

The court went on to stress that if the information directors need to monitor their company is in a language they do not understand, “in a culture where the legal and ethical standards may be different from in the U.S., this could be ‘very difficult… You better be careful there. You have a duty to think. You can’t just go on this [board] and act like this was an S&L regulated by the federal government in Iowa and you live in Iowa.'”

Iowa. Kansas. The whole point of the case and of this post is that there is no justification for not doing the requisite due diligence.  Oh, and if you think being in China is like being in Kansas (or Iowa), you are cruisin for a bruisin.

What do you think?