The day before yesterday, I wrote a long post (with a long title), China, The World, Greed, Cognitive Dissonance, The Best and the Brightest, and Why People Seem to Encourage/Almost Enjoy Getting Scammed, on why people are so susceptible to getting scammed. My thesis is that once someone has convinced themselves that the deal is lucrative, they have a hard time convincing themselves that it might be a scam. I concluded that post by promising a part two describing how to avoid getting scammed. This is that part two and it too is going to be quite long, so please bear with me.
The first thing to avoid getting scammed is to have the right attitude, and that means you must question and doubt EVERYTHING. Why would a legitimate Chinese company in Shenzhen contact you for an oil and gas deal when you are just a school teacher in Vermont? And why would an oil and gas company be located in Shenzhen anyway (it’s possible, but not likely)? Why is a Chinese company contacting me out of the blue to make a $3 million purchase of my widgets when there are 3,000 other widget companies and when we’ve never previously made a sale for more than $30,000? How can this Chinese company charge $11 per widget when everyone else is charging at least $22? And after you have compiled your list of questions and doubts, do not pay a penny (other than perhaps to your own investigator) to anyone until you truly have compelling answers to all of your questions.
One of the classic tactics of a scammer when asked tough questions is to give complicated and convoluted answers. And then when you even hint at wanting an answer you can understand, the scammer seeks to paint you as an idiot and/or a bad person for not trusting them. Do not fall for either. Chinese companies spend weeks, sometimes months, conducting due diligence on their potential counter-parties and your doing the same will be viewed by legitimate Chinese companies as a sign of your savvy and your intelligence, not as a sign of any moral failings. As for your being made out to be an idiot, well just remember how you will feel like much more of an idiot after you are scammed than if you prevent a scam. Oh, and if you don’t understand how the business or the deal is going to operate, that, standing alone — fraud or no fraud — is a great reason for you to just walk away.
The second key to not getting scammed when dealing with a China company is to make sure you are actually dealing with a China company. Though our percentage estimates vary, all of the China lawyers in my firm estimate that at least half the time when a Western company is scammed by a “Chinese company,” the company is either not Chinese at all (oftentimes they are from Nigeria) or they are not a company at all because they have never actually registered with the Chinese corporate authorities. This means that just confirming you are dealing with a real registered Chinese company will lower your chances of getting scammed.
In China Due Diligence. The Most Basic Things To Do. I set out the following basics for how you can determine whether you are dealing with a legitimate Chinese company.
The first thing you do is ask the Chinese company to send you a copy of its business license. Do not be afraid to do this. Chinese companies do this all the time. If the Chinese company refuses to send this to you, walk away.
You then have someone fluent in Chinese and with knowledge about Chinese business licenses examine the one that you have been sent.
Our China attorneys typically look for the following:
To determine whether it is real or not. This is done by comparing the information on the business license provided with the corresponding information on the relevant Chinese government website — usually the local State Administration for Industry and Commerce (SAIC). If the business license you have been provided is fake, you walk away.
To see when the company was formed. We like to compare what the real business license says against what we were told (by email or whatever) and also what the Chinese company says on its English language and its Chinese language website. If different years are given in different places, we get suspicious and we ask more questions.
To see where the company is located. We like to compare this against both what we were told (by email or whatever) and also against what the Chinese company says its English language and its Chinese language website. If there are different addresses in different places, we get suspicious and we ask more questions.
To see what the scope of the Chinese business is, as listed on its registration. If the scope is “consulting” and our client thinks it will be ordering five million dollars of widgets from a factory, we get really suspicious. Looking at the scope is a good (though not always fool-proof) way to determine whether you are dealing with a manufacturer or a broker.
To see the amount of registered capital. If the amount is too low, the odds are good that it is not a manufacturer. If the amount is really high, the odds are good that this is a big company. Note that this information is not going to be as commonly listed in the future.
Lastly, you should go visit the Chinese company or send someone you truly trust to do so.
Doing the above is not nearly enough due diligence for big deals, but it is a relatively fast, relatively cheap way to at least get some sense about the Chinese company with which you are thinking of doing business and it oftentimes will be enough to let you know whether or not you even wish to conduct additional due diligence or just walk away.
In China Business Due Diligence, I went into a bit more depth on some of the basics that should be undertaken to prevent fraud, and I listed out the following:
Construct your own fraud scenario. Ask yourself how the Chinese company could have staged everything it has shown you. Did it switch the factory signs before you arrived, so that it looks like it owns the factory, rather than someone else? Did it paint the old machinery to look new? Is the person with whom you are speaking really a PwC accountant, or just someone paid $100 to pose as one? We have encountered fake factories, fake Chinese lawyers, fake documents, fake accountants, fake foreigners, fake owners….
Focus on the operations. Look carefully at the Chinese company’s operations. Why does the company have only 100 boxes in storage when it claims to be selling 5,000 widgets a week? How can the company make 5,000 widgets a week with only enough of x material to make 100 total? Why did the company have a completely different set of employees on the same day and time two weeks apart? It pays to visit two or three (or more) times — a good fraudster can put on a show, but they are unlikely to be able to do it the same way each time. Watch for the subtle differences.
Get the official records yourself. Use your own people to get the Chinese company’s official corporate records from the official Chinese government sources. Though doing this is neither inexpensive nor easy, information gleaned from the official government records can often be helpful. Then compare the official records with the documents the Chinese company gave you. This is key.
Take company-provided introductions with a grain of salt. Speak with your target Chinese company’s vendors, neighbors, employees, and customers, especially those you find on your own. When talking with people to whom your target Chinese company has introduced you, take everything that is said with a grain of salt. It is not difficult for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or a phone call and this sort of thing goes on all the time. And again, do you really know whether these people are as claimed? We love sending our own people to just hang out around the Chinese company for a week or two as it is amazing what they can learn just by watching and by talking with employees and others in the vicinity.
Speak with the Chinese company’s competitors. Competitors with real businesses can and usually will tell you about their competitors, but, of course, any information gleaned this way should be taken with at least a bit of salt as well.
Do not delegate. Use your own trusted network to gather information on your potential Chinese counter-party. If you don’t have such a network, get one. If you can’t get one, don’t do the deal.
Co-blogger, Steve Dickinson, wrote a post, entitled, Three Keys to Spotting a Fraudulent Chinese Company, describing some of the things he looks for to determine the legitimacy of a Chinese companies listed on foreign stock exchanges for investors that have retained Steve because they are concerned about the value of their investment. Steve’s first step in these situations is to determine whether the Chinese entity is an empty shell. If the Chinese entity is an empty shell, then there is no value in China to protect and further analysis of the company is a waste of time. Steve describes this analysis as follows:
I have done this research so many times that I have developed a three step test to determine whether a Chinese company is a fraud. I take a look at the annual or quarterly report of the Chinese company and if it meets these three tests, it is virtually certain to be a complete fraud, with no operations, no assets and no funds in the bank.
The three indicia of fraud are as follows:
1. The company has a large amount of cash in the bank. I often see supposed cash holdings greater than 50% of the company’s annual gross revenues. Interest rates at Chinese banks are very low and legitimate Chinese companies do not usually keep large amounts of their cash in interest bearing bank accounts. Usually the supposed large cash account is accompanied by bogus explanations explaining why the Chinese entity is unable to repatriate the funds to its investors as dividends. Later investigation usually reveals that these funds were never actually deposited in the bank. That is, these large deposit accounts are simply falsified. The odd thing is that auditors will normally verify that the accounts are real. Once the fraud has been exposed, I have asked auditors what they did to verify the account. They usually state that they relied on reports from the management of the company. In China, the only way to verify the authenticity of a bank account is to arrive at the bank unannounced and look at the computer screen while standing BEHIND the counter as the clerk makes an unplanned query. Virtually no bank in China will allow this, which means that audit verifications of Chinese bank accounts are typically of no value.
2. The company reports profit margins in excess of 30%. I often see fake companies report profit margins of 50%. Doing business in China is difficult and I have never seen a legitimate Chinese company with profit margins even approaching this level, not even state owned monopoly companies. These high margins are then the explanation for why the company has so much free cash; they are so profitable they are printing money. The claim is that they have some unique product or some technical monopoly. In my experience, these claims are never true, as just a few minutes of careful thought would reveal.
3. The company is formed as a VIE (variable interest entity) when it is operating in a business sector where foreign investment is not restricted and the VIE structure is not required. A VIE is required only when a foreign invested company intends to operate in a restricted sector such as the Internet. This is why Baidu, Sina, and AliBaba are organized as VIEs. But most Chinese business sectors are open to foreign investment. When a company that operates in manufacturing or retail sales chooses to organize as a VIE, there is typically only one reason: the organizers are planning to commit fraud against the foreign investors.
I cannot resist closing out this post by talking about how to avoid getting caught in what I see as perhaps the most common, most insidious scam of all: The China bank switch scam. This is the scam where someone hacks into either your computer or that of your Chinese counter-party and then sends you an invoice (and you actually do owe the money) directing you to make payment to a bank account held by the scammer, not by your Chinese counter-party. In How to Conquer China Payment Scams I discuss this scam in more detail and advocate engaging in the following actions to prevent it from happening to you:
1. Get to know your suppliers who speak English (if you don’t speak Chinese) and get your supplier’s landline phone numbers as that cannot be hacked. Call if you have any concerns.
2. Get your supplier’s bank account information in advance and ask them to refer to “bank account information document” on their invoices, rather than listing out full bank details every time.
3. Ask your suppliers to fax you their invoice and make sure the sending fax number belongs to your supplier’s company.
4. Do a first small wire to confirm the account.
5. Have a special procedure for confirming the company name. Note also “that paying a Chinese company in mainland China is safer for you” than paying them overseas, be it Hong Kong, Taiwan or anywhere else.
6. Have a special procedure for confirming bank account changes. “Follow the same procedure as point 5, but also call several people in the company. They will understand your attitude if you tell them you are worried about the “different bank account scam” — they are also a victim when it happens to their customers.
7. Have an internal procedure for confirming all payments over a certain amount.
Anyone have any additional scam prevention tips? If so, please share them in your comments below.