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China factory problems: Always YOUR fault?

by Dan Harris  

China Product Outsourcing Problems

The title is somewhat of a stab at humor. It stems from my blaming most (but certainly not all) China factory problems on the foreign buyer. We have written countless times of what is required to secure good product from Chinese factories:

 

We have also written how our China lawyers constantly get calls or emails from American and European companies that have received bad product from their Chinese factory suppliers and how there is nothing we can do for them. We wrote about this just last week in How To Get Bad Product From China With No Legal Recourse. To a certain extent, we like being able to blame the victim in these situations because that way we as lawyers can comfortably sit back and tell ourselves that had they only contacted us BEFORE they started having problems, we could have prevented all of their problems.

But what about where the Chinese company just up and suddenly shuts down. How can the American or European buyer be blamed for that? Well guess what, they can and in Doing Business In China Safely. The Due Diligence Basics, I explain the following situations where blaming the victim is really pretty easy:

  • The guy who “invested” $500,000 into a China business because the owner of the Chinese business was allegedly the son of a five-star general. One of my law partners suggested to this investor that he instead use the money to fly himself and my law partner to Vegas (this was before Macao got so big) and put the money on red.  As my partner put it, the chances of the client recovering his money there were much greater and it would be a lot more enjoyable. This guy went ahead and invested the $500,000 and lost every bit of it. He then wanted us to sue the “son of the general” on a contingency fee basis, but we would not have taken on that case for a 150% contingency.
  • The guy who bought a million-dollar condo in Shanghai under his girlfriend’s name because he believed that foreigners were not allowed to own real property in China. His girlfriend then left him and claimed he had given her the condo as a gift. The guy wanted us to sue the girlfriend but we demurred, saying that we just did not like a case where our client would need to stand in front of a Chinese judge and explain that he had put the condo in his girlfriend’s name so as to avoid (what he believed was) Chinese law.  And here’s the kicker. When he bought this condo for his girlfriend, he could have purchased it in his own name, no problem! His girlfriend had lied to him about Chinese real property ownership laws
  • The countless people who call my firm after having sent tens of thousands of dollars (sometimes hundreds of thousands of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. We have never taken one of these cases because we deem them pretty much hopeless.
  • The US company that used its joint venture partner’s local Chinese lawyer (what was this company thinking?). The Chinese lawyer drafted up agreements that involved the American company giving its critical technology to the joint venture permanently, without getting any real influence or control in the venture.  This is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in. You can find out more regarding this sort of Chinese joint venture deal in When in China Trust Everyone.

I then listed out the following seven things that American and European companies should do before doing business with China:

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.

Okay, but what about the situation where the American or European company has done everything set forth above and its Chinese factory just suddenly and without any warning shuts down and its owners disappear into the night? Doing the above will not help at all with that situation, right? Wrong. In fact a couple of times that has happened to clients of ours and both times because they had a really good contracts they were able to go their China factories and take away the already produced product for which they had paid, while other product was being held by the Government to be used to pay employees. Okay, so far so good.

But I have to admit that even in the above two situations our clients were not made whole because in both instances the Chinese factory had only produced about half of the product for which our clients had paid and so our clients ended up losing some money on the other half and, more importantly, they were left short-handed in terms of product inventory — and in both instances, at the exact wrong time. Could even this have been prevented?

When asked this sort of question (and I have been asked this question a couple of times at speaking engagements) I usually give a fairly pat answer along the lines of how about all that companies can do is to consistently monitor their Chinese factories for any signs of problems. That sort of answer is fine at a seminar, but what does it mean in real life? I think I now have a good answer, thanks to the post, 3 Telltale Signs of a Bankrupt Factory at the Intouch Manufacturing Services Blog.

This post starts out saying that for all sorts of reasons “more and more factories in China are shutting their doors.” I agree. It then explains why Chinese factories always seem to be open one day and then shut down the next, virtually always without any sort of notice. Most importantly, it then lays out the following three key indicators that your China factory is in deep trouble:

  1. Unused floor space/clear overcapacity.
  2. Increasingly poor product lead-times.
  3. Staff Strikes, Walkouts, and Layoffs

All three make sense to us and I urge you to read the whole article. I will also add one more thing against which you should always be on the lookout: changing laws and changing market forces. We had one client who came to us because it had heard a rumor that its not so small China factory was going to get shut down because it had been operating illegally in its location. We researched the matter, determined that it was true and our client ceased its purchasing. Maybe 4-5 months later, the factory was closed. Another time one of our clients had heard that its Chinese factory had been or was going to be bought as it was in the line of a planned highway. Very quick research revealed that this was the case and gave our client plenty of time to find a new supplier.

Bottom Line: Outsourcing your product to China will never be without risks, but the more proactive you are in seeking to reduce those risks, the better your odds will be of preventing problems.

Does anyone disagree with this?


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.

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