Sinogie Consulting Limited - Sinogie in the press

Business malfeasance in China is a concern for anybody wishing to tap the market. Bruce McLaughlin of Sinogie Consulting Ltd explains how to weed out the ne’er-do-wells from the genuine opportunities.

“China’s a very difficult place to do business. You can’t do any sort of due diligence. That’s why we got ripped off.”

“It’s very hard to find any information on the people that you’re planning on working with in China.”

“It’s just not like working in America or Europe. You can’t get information on anything.”

Most readers will have heard comments like these from fellow conference delegates, business associates, or even their own staff and potential business partners. These comments do have their uses. Dishonest business people and fake corporations in China plant these ideas in the heads of naïve potential foreign investors. And China managers at foreign companies bring them out as excuses when trying to explain to their bosses at home how they have managed to lose tens of millions of dollars doing business with a company that did not exist.

Useful or not, though, these claims are far from true. Of course there are differences between doing business in China and working in other countries. Every country has its own systems, its own regulations, and its own regulatory authorities. Investors into most jurisdictions make the effort to understand local company regulations and conduct appropriate levels of due diligence before making investments or entering into major transactions.

For some reason, this is not the case for foreign investors in China. Many of them seem to assume that it is impossible to find information on the companies that they plan to do business with. Companies fail to check whether the valuable company that they are about to buy really exists; whether their potential distributor really has the distribution network it claims to have; or whether their potential joint venture partner is allowed to go into business with them.

There is little excuse for this. China has a long-standing and rigid system of company regulation and registration. With its strong central planning and obsessive licensing and statistic collection, the central government has a wealth of information on all legitimate, properly-registered Chinese companies. Much of this information is available to anyone who knows where to look. More in-depth information on a target company’s operations, reputation and management is available from specialist investigation and research companies. Even a quick search for the most basic information can save investors from making disastrous mistakes.

What are the risks?

Doing business in China will almost invariably involve dealing with a local company at some point. It could be a distributor or agent; a joint venture partner; an acquisition or investment target; a customer; or a supplier.

The foreign company can find the local party in any number of ways. One would like to think that most local business partners are found through relatively scientific means, finding a variety of potential partners or acquisition targets, screening them for suitability, and choosing the most appropriate one, after getting references from other reputable companies which have dealt with the Chinese party in the past.

Unfortunately, this is not the way things generally work. Stories abound of even the largest multinationals finding a business partner run by someone who is a friend of a friend of someone a manager once met in a hotel in Hong Kong. Other foreign managers go into business with companies which approach them on spec, run by people they have never met, based in cities they have never visited. Of course, business partners found through this route could be perfectly respectable companies. But to enter into large deals with companies like this without even the most basic background check seems foolhardy.

Some of the risks companies face include the following:

The company does not exist – Foreign companies might transfer huge amounts of money, or send valuable merchandise, to a company that does not exist at all. This has happened many times in the past, in China and throughout the world.

The company is not everything it claims to be – This can be down to anything from dishonesty to overconfidence on the part of the Chinese party, or careless assumptions by the foreign investor. A supplier may not have the production capability it claims to have; a distributor may not have the distribution network and experience it boasts of; or a joint venture partner or acquisition target may not be as financially sound as the investor thinks.

There are hidden traps which the investor will find later – This is of particular concern to foreign investors entering into joint ventures with local partners or acquiring Chinese companies. As well as the obvious risk of massive debts, the investor could find itself saddled with outdated equipment, a huge payroll of staff who cannot be laid off, an appalling local reputation, or any number of other problems. The company may not be properly licensed to engage in the type of business that the foreign investor hopes to enter into.

You have been talking to the wrong person all along – Through dishonesty, overconfidence, or innocent stupidity, someone could come to an agreement on behalf of the Chinese party without the authority to do so. It could be someone who is making deals without proper authorization, or someone trying to defraud the foreign investor and the Chinese party.

Even the basics help

Checking government records on the target company can give foreign traders and investors a degree of assurance about the legitimacy of the company. Predatory Chinese parties might assure naïve foreign investors that it is impossible to check on the background of Chinese companies. This is not true, and investors should walk away from anyone who claims that it is impossible to do such checks, or makes an excuse for why their company is not registered where it should be.

Legitimate companies in China should be registered with their local Administration for Industry and Commerce (“AIC”). By carrying out a search of the AIC’s records, it is possible to find the following information on the target company:

●	Confirmation that the company exists, along with its full name and registered address.
●	Registered capital and ownership of shares.
●	Name of the company’s legal representative (information on the company’s senior manager and other personnel may also be available).
●	Type of enterprise (State-owned, collective enterprise, private limited company, Sino-foreign equity joint venture, etc).
●	Business scope (A Chinese company is only permitted to engage in businesses covered by the registered business scope outlined on the company’s business licence).
●	Limited financial information: the company’s balance sheet and profit and loss as reported to the local AIC and tax authorities.

Points to look out for

The basic information set out above can be very useful. Most crucially, it assures the foreign company that the local company does actually exist, and that it has been legitimately established.

It also gives a registered address (and usually a business address if different) and a contact name, allowing the investor to check that the person it is dealing with really is a representative of the company.

It is also important to check the company’s registered business scope, to ensure that the company is allowed to engage in the business or transaction the investor plans to work in. Otherwise there is a risk that a joint venture could be closed down or a transaction cancelled without warning.

The financial information available from the AIC is not especially reliable. The target company could have any number of reasons for making false reports to the AIC and the tax authorities. Many companies under-report their income in order to reduce their tax liabilities; some companies – especially failing State-owned enterprises – choose to inflate their income in order to ensure that the government does not close them down. If the financial information on the company looks disastrous, the investor should obviously walk away, but positive financial information from the AIC should not be taken at face value.

Companies are required to undergo annual inspections by the tax authorities every year, and to renew their filings with the local AIC every year. It is important to ensure that the records are up to date. If the target company has failed to make filings for the most recent date that they were due, it could be in financial trouble, or have ceased operations. Companies should de-register with the local AIC if they cease operations, but in the upheaval and chaos this involves, their managers often forget to do so. If the target company’s records are not up to date and there is no acceptable information, the investor should not consider doing business with the company.

Getting the information

The records mentioned above are stored at the target company’s local AIC office, and can generally be viewed by anyone. AIC records are not stored centrally, and very few AIC offices have made their records available on line. It is therefore necessary to physically visit the local AIC in the county or municipality in which the target company is based. This is, in many cases, impractical, especially for companies planning to trade remotely with the target company. Fortunately, specialist corporate investigation companies can do this for clients for a small fee. Sinogie Consulting, for example, has a network of specialists who can visit any local AIC to retrieve records.

Most AICs do not allow the public to take away or photocopy the records. However, it is possible to write down all the relevant information. Reports from corporate investigation companies therefore contain all relevant information but no copies of official documents.

Depending on the nature of the foreign company’s relationship with the target company, it can also be worth asking for a copy of its business licence. While it is of course easy to forge a business licence, it will at least allow the investor to check the official name of the target company and its business scope before starting a more formal company search.

Finding out more

In some cases, it may be necessary to find more in-depth information than that available from AIC records. An investor may need to know more about the target company’s operations, reputation, and management.

Engaging the services of a specialist corporate investigation company is usually the best way to find this information without fear of offending the target company’s management. The investigation companies use a variety of methods, including database searches; enquiries on a no-name basis with the target company’s suppliers, clients and rivals; pretext-based contacts with the target company itself and other methods. A good corporate investigation firm will find valuable in-depth information on the target company, without the target company ever knowing it is being investigated.

The only area in which corporate investigation companies cannot help is in finding verifiable financial information. Without actually going into the target company and conducting formal due diligence, it is impossible to verify whether the information the target company has submitted to the local authorities accurately reflects the truth. However, the investigation firm can find out from the other sources mentioned above whether the target company’s claimed sales figures sound realistic, and whether there are any rumours that the target company might be in financial trouble.

Is this enough?

In the case of large joint ventures, mergers, and acquisitions, the information available from these investigation companies is certainly useful, but it is unlikely to be enough: the investor should really engage an accounting firm to conduct formal due diligence as well. However, the investigation companies can give information on the target company’s operation and reputation – which in many cases are as important as its finances – and rule out unsuitable companies before the foreign investor invests in an expensive financial due diligence exercise.

In some cases – such as where the foreign party is engaged in a small sale contract with the Chinese party – the basic information available from AIC records is all an investor might need. Getting this information is relatively inexpensive, and it can be delivered in just a few days.

For larger investments and transactions, the foreign party would generally be well advised to engage an investigation company to undertake more in-depth research. The investigation company will know what potential pitfalls to look out for, and can help assure the investor that the Chinese party is everything it claims to be.

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