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How to do Safe Business in China: Due Diligence of Chinese Partners

13 July 2012

Chinese trading companies and factories are adept at raising smokescreens to hide their true circumstances, for example by use of Western perceptions on the differences in business culture and the importance of relationships (Guanxi) rather than documentation and contracts.

The original Dutch version of this article was written for, and first appeared in Fenedex Press magazine, no. 367 / June 2012.

How valuable a due diligence can be when doing business in China is strikingly shown by a recent case: a Dutch company that has been doing business with its Chinese counterpart for almost 10 years discovered that the counterpart was in fact not a Chinese registered company after all. The name of the company matched a Hong Kong-registered company, while the bank account to which payments were remitted  belonged to another (Chinese) company operated by the same managers. The stamp on the contract was faked. In these circumstances, there was insufficient legal basis to sue the counterpart in court for failure to deliver goods valued at approximately USD 500,000, after a deposit of USD 300,000 was already made.

There are many examples of cases where foreign companies take losses because they failed to sufficiently understand the Chinese company they were dealing with. Chinese trading companies and factories are adept at raising smokescreens to hide their true circumstances, for example by use of Western perceptions on the differences in business culture and the importance of relationships (Guanxi) rather than documentation and contracts. On the other hand, international companies that fall for such tricks are not blameless. Many fail to consider even the most basic steps in due diligence when doing business with a Chinese company or individual.

Due diligences are necessary in all kinds of business situations; the complexity and size of the transaction should determine how thorough the investigation should be. This article will discuss company investigations recommended in commercial transactions (i.e. of purchase and sale of goods), and due diligences for joint ventures or acquisitions. It will also briefly focus on another kind of due diligence: that of the Chinese legal environment related to investments.

Company investigations

The priority in a commercial transaction of purchase and sale is for the buyer to receive the goods at the agreed terms (quality, quantity, timing), and the seller to get paid. Some of the risk in such a transaction can be mitigated by negotiating favorable contractual terms: for example, the buyer will try to insist that it makes payment only upon receipt and inspection of the goods. But even then there is risk: what if defects are found at later stage? Even with a duly executed contract and clear evidence of the breach, there are situations in which enforcement is impossible – these are the situations to avoid at all cost.

Existence of the Company

Surprisingly often, business partners discover that the company that they have been doing business with does not actually exist. Existence of a company in China can be checked, online or through the search of its company file with the local company registry. In addition, one should focus on whether the bank account is a business account linked to the company, and email addresses have the same domain name as the company or are of public domain (e.g. 163.com or sino.com). The company can also be asked to provide a copy of its business license. Note that the only registered name of the company is its Chinese name, and so the contract should include this name, or alternatively specifics such as the business license number and registered address which – as opposed to the English name – are unambiguous. If you are not sure, re-confirm details from an independent source before transferring funds!

Trading vs. Manufacturing

Often goods are purchased from China through a trading company, but this raises a problem. If the trading company enters into the contract and receives the funds from the foreign party, it is this trading company – and not the factory – that is responsible for the delivery of the goods. These trading companies are typically small and have limited assets. In case of a claim, these companies are often liquidated, leaving the claimant with empty hands. Unless one can prove fraud, the shareholders and managers of these limited companies cannot be held responsible, so it is always better to do business directly with the asset-heavy manufacturer than an asset-light trader; or at least ensure that the manufacturer is jointly liable for the trader’s obligations. Similarly, foreign companies should avoid to do business with Hong Kong trading companies, which are usually just a postbox without office and assets.

If a dispute arises with a smaller company, the first step is to check whether the company has assets. This may be in the form of real estate, bank accounts or even vehicles. If assets are found, and there is a risk that they may vanish once a lawsuit is filed, one can immediately apply to preserve (i.e. freeze) these assets pending the outcome of the lawsuit. This way one is not only sure that a favorable judgment is enforced; it will also put pressure on the opponent to settle the lawsuit.

Due Diligence Investigations for Joint Ventures or Acquisitions

It is a well-known fact that many (most?) Chinese companies have more than one set of accounting books: one for the owners, one for the tax authorities, and one for the foreign partner. This does not mean that foreign investors should never consider acquiring a Chinese target company or its assets. The value of legal due diligence is to reveal all key issues, and then advise which can be accepted, which can be resolved and how, and what issues are true deal-breakers. Simply stated, due diligence is used to avoid that foreign companies end up partnering up with or acquiring a Chinese company that turns out to be far from what they thought (or hoped!).

Organizing a due diligence investigation

In China, it is often not easy to convince a target company to fully cooperate. Companies are not used to opening up to third parties, and are afraid that discoveries will have a negative impact on the deal. In some cases, the target company’s manager may have no interest in the deal, and will therefor purposely try to hinder the investigation. However, given the fact that data rooms are rare, convincing local management to cooperate is a key to a successful legal due diligence.

In addition, it is very important to double-check information with independent sources, such as relevant government departments, which can clarify the company’s registration information and preferential tax policies, offer insight on the company’s international trade activities and on land-use rights and building ownership.

Common Problem Areas

Despite the fact that during the establishment of a company and the obtaining of licenses in China many things can go wrong, checking these items generally does not uncover the biggest issues. In practice, the following areas reveal a lot more issues:

  • Land & buildings: Land in China is either state-owned or collectively-owned, but individuals and companies can own land-use rights and the buildings on this land. Often however, land-use rights are acquired and factories are built without the right approvals, which creates a high risk to a potential acquirer, since the land-use rights may be withdrawn.
  • Employment: Chinese employment law is relatively strict, requiring all employees to have a written employment contract, and requiring the company to withhold and pay social insurance contributions and individual income tax based on real salaries. In practice, many companies pay out part of the salary under the table, creating potential liabilities not only for employees but also for the company. In case no employment contracts are present, the acquirer of a company may face substantial claims in arrears from employees.
  • Taxes: Across China, companies have been offered benefits to invest in certain areas. In recent years, the national government has gradually abolished many of these benefits, however local governments have continued to offer incentives to lure investment. Oftentimes there is no basis for these incentives, which means that a change of policy could cancel them overnight – and could even lead to penalties and demands for taxes in arrears. Thus it is important to understand whether preferential policies have a basis in law, or have been offered at the whim of an official.

Investigating China’s Legal Environment

Some companies expand into China through M&A, but setting up a new company – a representative office, a joint venture (JV) or a wholly foreign-owned enterprise (WFOE) is still the most common means to establish a presence. However the Chinese legal environment is still developing, which creates very different challenges to companies that are used to operating in Western countries. The attraction of China as a market sometimes blind international companies to the difficulties that they will face – companies are advised to understand these difficulties before finalizing their decision to invest in China.

Bureaucracy & Licensing

Establishing a company involves almost 20 steps – including name pre-approval, project approval, company registration, and registration with secondary authorities such as the local and national tax bureau’s, Customs, and the State Administration for Foreign Exchange, carving the company’s stamps and opening its bank accounts. It takes patience to deal and negotiate with officials at different departments, and experience to anticipate to their requirements. An experience law firm or agent can assist a company to overcome hurdles quickly and efficiently.

Court system

China’s court system has a poor reputation abroad – stories of corruption and local protectionism, as well as inexperience and incompetence of local courts, are common. Even though the system is improving rapidly, these complaints are sometimes justified. The best way to avoid such challenges is to ensure that contracts include dispute resolution clauses which send disputes to a competent, fair court or arbitration tribunal in China.

Investment Restrictions

Since China’s accession to the WTO in 2001, most sectors have been opened to foreign investment. With some notable exceptions such as recruitment and publication, foreign investors can now establish wholly-owned subsidiaries in almost every industry. This does not mean, however, that China does not set conditions for foreign investment. First, local authorities may set a minimum registered capital which is higher than the legal minimum of CNY 100,000 (one shareholder) or CNY 30,000 (more than one shareholder). Also, business scopes – the activities that a company may legally engage in – should be formulated according to certain guidelines. Companies must have a physical registered address (no virtual offices allowed, though exceptions exist), and must have employees, file for taxes, and pass annual inspection each year.

Manager’s liabilities

If a foreign manager is sent abroad to lead an office, factory or facility in China, he/she is generally not familiar with the risks and liabilities of taking on this position in China. Unfortunately also in China, a management position comes with certain risks. Managers should understand in what way they are responsible for taxes, insufficient company funds, bribery, working conditions, and commercial disputes, which in some cases may lead to being restrained from leaving China.