by Dan Harris in 'China Law Blog'
Not sure if it is cynicism or realism, but I am getting 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 (that includes in or with China) 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):
I could easily go on and on.
So what can a foreign investor do?
In Seven Rules Of China Due Diligence, I 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 in 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's 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.
Always 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 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 multimillion dollar account at a nonexistent 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 DigiCha just did a post entitled, "Do You Know Where Your China Stock CFO Lives?" setting out China company (mostly publicly traded) warning signs. The post talks about how two Chinese companies Longtop Financial and Sino-Forest, that publicly trade in the United States and have recently 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:
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 disimilar 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 not at all 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 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. So far, no Chinese licensed attorney with whom we have worked has ever been denied access. It is our understanding that the Chinese companies investigated through the SAIC will know they are being investigated. Like I said, we have so far always been able to get the file, but there could come a day when a local SAIC in an outlying province will block access to the file of a powerful company within its purview.
These SAIC forays usually give us a massive amounts of documents in Chinese, which we then either translate for our clients or, more typically, summarize.
The hot topic in this arena right now is this: the parent company does an IPO in Hong Kong or the U.S. The parent claims the IPO proceeds were injected into a WFOE in China. Was the money injected into the WFOE or not. If so, when? 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 SAIC 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.
For more on these issues, check out the following:
What do you think?
Dan Harris is founder of the Harris & Moure law firm, a boutique international law firm focusing on small and medium sized businesses that operate internationally. China is the fastest growing area for the firm. Dan writes ChinaLawBlog.com as a source of China legal and business information.