The mirage of Due Diligence in China

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Richard Eller 2
ByRichard S. Ellert OnShore Advisory Group LLC

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One of the first questions I get from customers looking to establish a presence in China is 
“how do I conduct a proper Due Diligence exercise?”

The question implies that Due Diligence is the right tool to ferret out issues related to a company or individual operating in China. It implies that there are established and legal channels to conduct investigations such as background checks, fraud investigations, financial audits, trademark protection and legal searches.

Nothing could be further from the truth.

In an environment where public records are limited and faced with rampant corruption, conducting such investigations considered mundane in most western countries can be tricky and outright dangerous.

Most western-trained lawyers tasked with a due diligence exercise in China look to private investigators to explore corporate and personal records since the rules about access to these records are murky and uncertain. New laws have been enacted to crack down on due diligence companies as the government tries to limit public exposés that could harm social stability and cause trouble for corrupt officials and the social elite. These laws, such as Article 253’s vague wording, leave much to the interpretation of the individual judges who are appointed by the Party and are directed to protect social stability at all cost.

Just last year, Peter Humphrey and his wife Yu Yingzeng (a US citizen) were arrested under Article 253 for their efforts to conduct an investigation linked to a due diligence effort by GlaxoSmithKline. Although the facts behind the affair are murky, Peter Humphrey’s actions were completely mundane in terms of trying to uncover information about prospective business partners. In the West, his work would have simply entailed searching for public corporate records, credit files and interviews with past and present associates. Many other Due Diligence professionals have been arrested and prosecuted under this law.

Case in point, Peter Humphrey described the consequences of failing to conduct proper due diligence, and cited the disastrous acquisition of a Chinese company, Siwei Mechanical Electrical Engineering, by Caterpillar last year.

“If Caterpillar had done the kind of due diligence” combining accounting with background investigation, retrieval of corporate records and discreet supporting inquiries, “it might have spotted the fraud before doing the deal,” Mr. Humphrey wrote.

Oddly enough, in an environment where the government has launched a very public crackdown on corruption, the efforts to clamp down on corporate and individual information is at odds with our western understanding of access to critical information.

In China, most Western companies are forced to maintain several sets of accounting books in order to satisfy the disparity between the Generally Accepted Accounting Practices (GAAP) of China and their country of origin. If these companies operate with subsidiaries in Hong Kong for example, the need for different sets of books goes up accordingly. When conducting DD in China, the only books available maybe the China GAAP books and it is fair to assume that they reflect what the company exposes to the China Tax authorities and has no relation to the financial realities of that entity.

Issues related to transfer pricing, taxes, duty, currency exchange, etc. would suggest that examining all existing books, followed by exhaustive forensic accounting reviews by a qualified professional is the only viable way to obtain a clear financial picture of the company and its subsidiaries.

Beyond financial issues, any proper DD exercise should explore property rights, intellectual property, historical relationships with local and regional authorities, customer and supplier relationships, hidden treasury activities (read corruption), all of which are likely to impact the transactional decision.

None of these issues can be resolved by conducting what we would consider a proper DD exercise; there is an obligation to delve deeply into areas that are simply not accessible to an outsider, be it a local lawyer / accountant or representative of the prospective western business partner.

It is necessary to spend time with local officials – yes, that means very long, alcohol fueled dinners and parties – to have conversations with middle management and workers, meet with other property or industrial owners from the area, speak with competitors / partners / suppliers, and most importantly, trace the ownership of machinery, inventory and AP records to uncover any potential informal leans that may not show-up in the records.

In 2008 I led the acquisition of a manufacturing operation in China from one of the largest groups in Asia, I spent $250,000 on Due Diligence and legal activities to insure that we knew all there was to know about our target acquisition. By the time the exercise was done, we were confident we knew the vast majority of the issues and the lawyers signed off on the deal.

Reality is that we knew nothing.

What we had was a well orchestrated exercise to feed us what the selling party wanted us to know, and their insistence on secrecy during the process prevented us from exploring areas that would have revealed major (deal breaker) issues.

The bottom line is that, without a clear mandate to explore all areas of a business (or individual) in China, by all means necessary, it is best to walk away and never look back. It is also fair to say that what I describe here is largely applicable to all countries where corruption and lack of transparency is present. Unfortunately, this represents the large majority of what we like to call Low Cost Countries.

The intricate collusion between government officials and business is so prevalent, that this issue is not about to go away anytime soon, and anyone looking to either establish a presence in China, acquire a business, launch sourcing initiatives or purchase goods or services must be prepared to leave their Western sensitivities at the border.

I learned this lesson the hard way and I hope this short article will at the very least insure that you ask the right questions.

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