Managing the Challenges of Conducting
Business in China
Jason Wright, Managing Director
September 12, 2014
Agenda
Environment and Challenges in China
Conducting Due Diligence in China
Detecting fraud: Knowing the red flags
Case study of fraud: MNCs in China
Managing your asset in China
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A challenging environment in China
Many commentators have detected increased hostility to foreign investors recently in mainland China; others see the potential for economic reforms that will eventually improve the prospects for foreign investors
High-profile fraud investigations into MNCs on the part of the Chinese authorities
Antitrust probes and fines for foreign companies
Anti-corruption campaign stepped up
SOE partners also targeted
Economic slowdown
Credit squeeze in certain sectors (e.g. real estate)
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Challenges of Doing Business in China
Lack of transparency
Corruption
Unlimited trust in local CEO
Lack of compliance culture
Professional relationships are reliant on personal relationships and favors
Existing local laws are often broad, ambiguous and subject to interpretation by authorities
No right of privacy against the state
» Turns attorney-client privileged communications on its head
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Regulatory Landscape in China
Impact to both local and international companies in China
» Both bribe giver and recipient are now penalized
» Clamping down on violations of Anti-Money Laundering and Anti-Trust
» Risk of violating state secrets law
– How does this impact your due diligence and investigation?
» Impact of international regulations
– Need for a “China” approach to compliance
» Is increased enforcement positive? Is China simply moving towards a situation analogous to that in the US or Europe?
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No dramatic changes in legislation, but enforcement has increased!
Fraudsters are getting smarter
» Large scale and increased complexity of fraud schemes. Some in high positions or by shareholders.
» Collusion across departments and functions – enables the fraudsters to stay undetected and reap illicit profits
» Conflicts of interest
» Use of external accomplices/ third party intermediaries to distance the fraudsters from the entities
» Use of offshore entities to cover fraudster’s traces
Fraud trends in China: common schemes
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The Art of Due Diligence – what do Greek statues and
Chinese businesses have in common?
In September 1983 the J.Paul Getty Museum was offered a statue, an ancient Greek kouros, for almost USD 10 million.
The Getty was cautious and commissioned some scientific tests which seemed to suggest that it was at least genuinely antique.
Yet experts who looked at the statue were able to tell instinctively and immediately that it was a fake.
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Instinct and Analysis
Why is it that the experts could decide so quickly, without even being able to explain their decision?
Why were the buyers at the Getty unable to see the problem?
Why were the scientific methods used unable to resolve the issue?
What did later investigation reveal?
How does this relate to the wider question of buying assets?
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Instinct and Analysis
“We will never succeed in evaluating works of art, choosing candidates, managing risk, without the skills that can be acquired only through experience; but that experience can always be enhanced by the power of data analysis and the implementation of scientific techniques.
True expertise can never provide a full objective justification of the judgments that emerge; to believe that it could is to misunderstand the nature of true expertise.”
(John Kay)
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Why clients often already know the answer…
Asset management firm retained Kroll to undertake due diligence on an investment proposition.
The two potential investors were supposedly Indonesian and Saudi, but appeared to be being represented by a Chinese law firm via its Beijing office. The Indonesian investor claimed to have USD 20 billion in a HSBC account in Jakarta ready to invest.
Subsequent investigation showed that the supposed address of the Beijing office of the law firm was in one of the most deprived areas of the city and also listed as the address of a rather dubious looking accountancy firm.
The individual supposedly representing the law firm in Beijing turned out to be based in small estate in the North of China and to be connected to a series of insolvent companies.
Numerous other discrepancies were uncovered but we knew as soon as we saw the original request that this wasn’t genuine – and I think the client did too, even if he wasn’t admitting it to himself.
And … we didn’t charge the client for this case!
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Trust your Instincts!
The absence of information
Unsatisfactory explanations
No one knows the principals
“It sounds too good to be true”
“It just doesn’t make sense”
BUT, do beware of the fact that these “instincts” are rooted in our native cultures. US investors, for example, fall for scams in China that they would never fall for in the US.
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Detecting fraud: Red flags
Company culture without accountability
Change in auditors
Delay in publication of financial results
Allegation reports
Frequent change in senior management
M&A transactions unrelated to core business
Unbelievable growth story
Company with high levels of debt
High number of related parties
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Conducting Due Diligence in China – the Issues
When entering or investing in China, it is important to understand the mind-set and reputation of the Chinese entrepreneur you are planning to do business with.
For example:
Understand the relationship between the Chinese partner and government
Identify family relationships and any potential conflicts of interest
How did the Chinese partner make their first pot of gold?
How trustworthy is the potential partner? Is he associated with individuals of ill-repute?
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Conducting Due Diligence in China – the Process
Public records are available but are not centralized, chaotically-managed and seldom obtained using online databases
For a full picture of a subject, it is important to look at the subject’s related parties
Need to widen scope to third party relationships
Necessary reliance on source intelligence and unannounced site visits
Consideration of state secrets and data privacy legislation
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What might we find?
Individuals
Undisclosed business interests
– Competing interests, often held through
family. Other businesses in primary or
secondary jurisdictions in financial, legal,
regulatory difficulty.
Reputation issues
– Poor integrity, history of disputes,
connections to corrupt officials
Illegal activities or Fraud
– Media references to and/or rumors of illegal
activities, sector characterized by unethical
practices, large lawsuits
Political affiliations
– Major affiliations, government officials on
board
Ethics
– Ostentatious lifestyle, reputation
Companies
Questions over ownership and origin of wealth
– Complex ownership structure, undisclosed beneficial ownership, unknown sources of wealth
Frequent changes
– Unexplained withdrawal of firms from transactions, sudden/unexplained changes of shareholders, auditors and advisors
Illegal activities
– Media references to and/or rumors of illegal activities, sector characterized by unethical practices
Concerning affiliations
– Political: major affiliations, government officials on board
– Organized crime
– Vendors, customers with adverse reputation
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Increasing Scrutiny of FCPA Compliance
Regulators expect anti-corruption due diligence in high risk countries or emerging markets
Regulators expect anti-corruption due diligence will be a standard component of any transaction that involves a potential FCPA risk
FCPA transaction testing as part of the due diligence process
Newly acquired businesses should be brought into full FCPA compliance
Pre-closing due diligence may allow avoidance/limitation of successor liability
Self-reporting being taken into account by DOJ/SEC
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How Fraud is Uncovered Tips are by far the most common detection method
Source: ACFE – 2014 Report to the Nations
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Tip by whom?
Source: ACFE – 2014 Report to the Nations
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Small allegation made by an anonymous tipster may be a red flag for
a much wider, and more serious issue.
Case study of fraud: MNCs in China
BACKGROUND
An anonymous tip was received alleging that one of the client’s regional offices was making up revenue figures.
An initial review of documents by the company’s internal audit team did not reveal any irregularities and the transactions seemed to be substantiated by proper documentation.
Management requested an independent investigation to validate the allegation.
WHAT WE DID:
Investigation involved a thorough review of the regional office’s sales contracts, sales orders, commission payments, rebates and receipt records. Interviews with the sales and customer service teams were also conducted.
The review identified that some sales recorded in the accounting ledgers could not be vouched to genuine supporting documents. The sales contracts were found to be fictitious, with discrepancies noted between the regional office’s copies and the copies provided to the company’s headquarters.
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As a result, the investigation was expanded to review documents kept in other regional offices and compare the same with the headquarters’ records.
It was found that a large proportion of the contracts was not legitimate. The company was eventually ordered by the SEC to restate their revenue for the past three years due to unreliable reported financial performance.
Case study of fraud: MNCs in China
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Potential challenges we can expect during
internal investigations
Taking into account cultural differences and
attitudes to books and records
Internal disciplinary - company has already
terminated the employment of the suspect employee
Data protection – transporting cross-border and personal data on corporate device etc.
Do we need to report our findings to law enforcement or to any other regulator and if so under what circumstances?
Internal investigation relating to fraud or regulatory issue - wider reaching implications beyond the obligation to self-report or pursue actions for recoveries?
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Managing assets in China
Advice we give our clients
Mitigation/compliance measures put in place must be instituted by local personnel but originate from head office
Unannounced visits by someone from head office or with little advance. Often internal audits are pre-planned, making it easy for the local office to “prepare” documents to comply with auditors
Fraud training for internal auditors is critical in spotting red flags
Regular data analytics
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Jason Wright
Managing Director
Kroll
1701-02 Central Plaza
18 Harbour Road
Wanchai, Hong Kong
Tel: +852 2884 7705