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Katherine Peavy

In Due Time: China’s business environment makes the case for due diligence

2014: Volume 13, Number 1
1. The Development of China’s Developmental State: Environmental Challenges and Stages of Growth
2. In Due Time: China’s business environment makes the case for due diligence
3. China’s Currency Reforms from a Banker’s Perspective
4. China and the Ukraine Crisis
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The South China Morning Post headline jumped out at me: Steel Princessstrading company in liquidation. I leaned a little closer to my neighbor on Hong Kong’s Star Ferry to read over his shoulder. The article claimed that liquidators were looking for about US$500 million that the company should have had in the bank. “Yes!”I mentally fist-pumped. Some people might view a missing half-a-billion as a failure, for me the headline meant success. I had investigated the CEO of Pioneer Iron and Steel, dubbed the “Steel Princess”by the press, on behalf of a client.

Fortunately, occasions when front-page headlines support the analysis in a due diligence report remain rare. On this occasion, the bankruptcy of Pioneer Iron and Steel leading to transfers of company assets from the trading company to other entities owned by the Pioneer Metals Group fulfilled the worst-case risk scenario in a due diligence report I’d given to a client a few years before. The largest risk, depending on what business the client planned to do with Pioneer, was that the corporate structure allowed for undocumented asset transfers. I never expected to see the exact risk we’d documented on the front page of a newspaper.

I noticed the client’s name was not on the list of creditors, so it was likely they had put measures in place to protect their company from the financial losses and potential reputation issues that headlines about deals gone bad can bring.

For most companies, due diligence focuses on protecting a company’s reputation and finances through understanding business partners better. To highlight the importance of due diligence on investment partners or supply chain partners in China, let me provide examples of successes and failures companies have experienced in their China business and show how robust — or superficial — due diligence affected the outcome.

Deals go bad all over the world and in one’s own backyard. Yet, it is often the lure of China, the promise of increasing revenues, the exciting focus on guanxi (networking and relationships), and the mystique of the potential in this huge market that make executives overlook risks they might not ignore in a domestic market or one without as much perceived upside potential. I’ve been involved in numerous situations in which executives with the stars of market potential in their eyes ignored the necessity of deep due diligence on a pre-transaction project. The dealmakers stuck to a fig leaf compliance approach, wanting to cover up the full picture of a risky investment. They would check a compliance box to satisfy a board prior to pushing through a lightly vetted deal. The investment team may have received their bonuses that year, but down the road the fig leaf would fall and companies would often suffer financial and reputation losses. Those types of clients are the best for consultants, public relations firms, and lawyers because we know that these types of deals will probably result in lucrative investigations once the deal goes bad.

A basic principle of any partnership is understanding the identity and experience of a partner. Most people wouldn’t get married without knowing their future spouse’s background, but companies regularly don’t take the time to learn about the companies and executives they do business with, paying them millions of dollars and often losing millions.

The first step of any due diligence is to verify the company’s registration details with China’s Administration for Industry and Commerce (AIC) or Hong Kong’s company registrar. In this case, the AIC records showed the Steel Princess set up a network of companies, ultimately owned by her and her mother, through which she held shares in iron and steel producers in China. The parent company also had holdings and links to Hong Kong companies that in turn had interests in entities in the British Virgin Islands, providing an easy route for transferring money out of China or Hong Kong and causing large risks to investors.

Either the Steel Princess or her mother were the legal representatives of each of the companies in the Pioneer Group. In China, the AIC registration file shows the name of the company’s legal representative, the person responsible for any of the company’s legal obligations such as paying bills or transferring funds. The legal representative is the ultimate controller of the company. The legal representative must sign any contract a company in China enters into. The Steel Princess set up her companies well. She was clearly the boss. By contrast, we often come across scenarios where clients are negotiating with people who are not the company’s legal representatives. Deals are not valid until the legal representative signs off.

The CEO of Pioneer Metals, called by China’s press the Steel Princess because her grandfather was the Minister of Metallurgy in the 1970s, did have connections in the metals industry in the country as a princeling, a child or grandchild of government or party official in China. However, during our research for the client’s due diligence report, we interviewed industry insiders and did not find any history of the Steel Princess having worked in government steel producers or in the Ministry of Metallurgy. The structure of her company and cash infusions appeared to be her main contribution to the industry.

Another risk I pointed out to the client was that the CEO’s grandfather was a policymaker more than 30 years ago. As such, it was unlikely she or her family had any influence with current policymakers. For the client, the risk could be that they were paying a person for a pedigree without any evidence the person had practical skills to get the job done. If the client wanted her to lobby for or against regulations or gain connections in the current government, they might find her connections dated and irrelevant. If they were looking for practical industry knowledge, they might consider someone with different experience.

Restrictions in the metals industry required multinationals to deal with domestic Chinese companies, and Pioneer Metals had a high profile. The CEO was one of the richest women in China, according to various annually published lists. The Forbes or Hurun “rich lists” often attract investors or business partners for those on the lists on the assumption that connections with perceived money and power will help them do business in China. But in our experience, a spot on the rich list is often short-lived. Many former rich list stars have experienced meteor-like falls from grace as a result of high-profile investigations by China’s Economic Crime Bureau. By 2010, China’s richest man in 2006, Huang Guangyu, CEO of Gome Electrical Appliances, was serving a 14-year prison sentence on a fraud and corruption conviction. Another 2006 rich list rising star, Wu Ying of Bense Group, later received a commuted death sentence for the allegedly fraudulent activity that got her onto the rich list.

A quick Internet search will identify high-profile individuals such as the Steel Princess or Huang Guangyu, but a few times, clients provided only the English name of a Chinese person they saw as the key to success of their China business based on a dinner or business meeting. That’s how one due diligence report started on a Shanghai-based gentleman applying for a high net worth account with a multinational bank in New York. The client sent us the individual’s English name and China bank account number. First, like most countries, privacy laws protect bank accounts in China. Second, a Chinese bank account must be registered with the individual’s Chinese name as it appears on his or her Chinese identity card or passport. Obviously, the English name could have been made up. We asked the client for better identifying information, such as a Chinese name and copy of a passport. Fortunately, they sent a business card and passport copy the next day, so we had a proper Chinese name and a company name and address.

The AIC records showed that the gentleman in question was indeed the legal representative of the investment firm he claimed to own, but a visit to the offices in Shanghai’s Pudong district found an office with a locked door. The management of the high-end office building was not familiar with the company or the legal representative, but confirmed the company did rent the office space and pay its bills. Media searches found no record of the investment firm or the firm’s CEO. Industry contacts had never heard of the firm, which according to the client had about US$300 million in assets.

With most companies or individuals in China, it is possible to research and find information on track records within an industry and trace a CEO’s “first bucket of gold,”as many rags to riches stories of Chinese entrepreneurs are documented in profiles of executives for business magazines, known by industry insiders or by current and former employers. But the assets and seed money of our client’s potential client were untraceable. It was as if he had created the money out of thin air.

We had to issue a report stating that we couldn’t find the source of funds or any business profile for the executive and concluded that any transaction with him would be high risk. Fortunately, anti-money laundering regulations require banks to prove the source of their clients’ funds. A few months later, the executive’s name was all over China’s front pages, but not connected to our client. The executive and his investment firm reportedly were the cover for a corrupt government official attempting to siphon off millions of dollars from the Shanghai municipal pension fund and hide the money abroad.

Another scenario where due diligence plays an important role involves compliance with laws in the client’s home country. The U.S. and U.K. both have anti-corruption statutes that apply to multinationals in their home markets as well as international markets. In the U.S., they are the Foreign Corrupt Practices Act and Sarbanes-Oxley acts. In the U.K., it is the Anti-Bribery Act. Companies must have transparent programs in place to show they understand the identities of their suppliers, vendors, and distributors.

Consider cases in which companies applied a fig leaf compliance approach, determining only whether the company is registered with the AIC, for example, rather than verifying any government connections or reputation issues:

  • By 2010, Siemens AG paid more than US$ 1 billion in fines to U.S. and German government agencies for overlooking the fact that subsidiaries in foreign countries, including China, used consultants or marketing firms to pay bribes to government officials to obtain contracts. Most of the consulting firms were owned by friends and relatives of government officials. (See for a full article.)
  • Also in 2010, telecommunications company Alcatel-Lucent paid US$135 million to the Securities and Exchange Commission for similar payments to government officials made via consultants acting as agents for telecommunications bids. (See for plenty of examples of similar cases).
  • And British pharmaceutical giant GlaxoSmithKline has been involved for the past year in a corruption scandal that began in China where sales and marketing vendors are said to have paid bribes in the forms of airplane tickets, vacations, and cash to doctors to get the company’s drugs in Chinese hospitals, which are state-owned and thus government entities for purposes of the U.K. Anti-Bribery Act and U.S. Foreign Corrupt Practices Act. It should be noted that while fines have not been set, a number of GlaxoSmithKline executives and business partners in China have been imprisoned as the case came about through investigation by China’s Ministry of Public Security. (For a thorough article on this case see:

For industries such as telecommunications, pharmaceuticals, and real estate, government restrictions on participation by foreign companies, project bidding, and a high level of government ownership in domestic China assets creates risk for many forms of corruption in the downstream supply chain.

One telecommunications multinational wanted to get ahead of the game and start a due diligence program for its existing sales and marketing vendors. These vendors were assigned to participate in bids for government projects, and their task was to understand the technical requirements, outline technical specifications for the client, and manage the bid process. They thought that by keeping this kind of arm’s-length approach, they would protect themselves from any situations in which their staff would be in a position to bribe government officials during the bid.

We were assigned to conduct due diligence on hundreds of these agents. The client maintained a few agents in every province in China. The main objective was to determine whether any of the agents were linked to government officials.

We initially identified a few agents either linked to government officials or entities, or linked to the client’s own employees. Unfortunately, the client put its employees in a difficult position requiring sales staff to find the agents, brief them, and sign contracts with them. They had no front-end due diligence process in place to check agents prior to signing contracts. In other words, they had no substantial controls in place. The sales team was, of course, under pressure to win bids and make money. Without any initial controls, the sales team found whomever they thought could win the bid, which included companies with close government connections.

The client also had a substantial base of agents with a track record for working on telecommunications bids and no obvious government connections, so they were not in danger of losing too many of their agents.

The vice president of sales in charge of our project, who reported findings to corporate legal counsel, came to me one day with a report that raised red flags about an agent. The AIC records showed the agent’s company had a connection to an employee and a government official as a minor shareholder. He said, “Are you sure about the findings on this company?”I explained to him that the AIC records were very clear. “But this is my top agent and my top salesperson here. What am I going to do?”

The vice president of sales did not flinch when it came to cutting out a few of the initial agents with unwanted connections, but he balked in this instance. Taking action against this agent could hit sales figures. Shortly thereafter, the system I had set up to compare agent company AIC filings to sales staff names and known government official names was taken back for the sales and marketing team to handle.

It is not uncommon for companies like this one to find themselves a few years down the road caught between over-reliance on guanxi and the vagaries of fig leaf compliance. Executives are often fearful of dropping the fig leaf because of what might be revealed.

From a slightly different perspective, the real estate industry in China has been the source of the most exciting and scandalous due diligence reports and fraud investigations I’ve been involved in. The combination of government ownership of land and skyrocketing land and housing prices over the last 15 years has created interesting bedfellows and motivations.

A U.S. based multinational investment bank requested a due diligence report on a Chinese-owned real estate development company that approached them for funding of a five-star hotel in a prime location of a major Chinese city.

The client felt comfortable with the Chinese real estate company through the CEO, a man born in China who had immigrated to a European country in his 20s after making his first “bucket of gold.” A few years after returning from abroad, the CEO had a thriving real estate development company and planned to list it on the Hong Kong stock exchange. It was not surprising when the investment bankers and the legal counsel requested a conference call to discuss the findings of our report.

With many companies and people involved in the hot real estate market, industry insiders were easy to track down. They led us to other industry insiders and even family members of the CEO. We discovered that the CEO made his first “bucket of gold”through working with the Triads (Chinese mafia) in southern China, and sometimes still used them to threaten business partners. Additionally, the CEO had close connections with the Communist Party secretary of the city involved in granting the land use rights for the hotel, and in the past the developer had received some deals that simply could not have happened without under-the-table government support.

On the phone, the client said, “I just can’t believe these findings. This sounds like a mafia organization, but when we go to their office everyone speaks fluent English. They’re very professional. I mean, the staff are all wearing khakis and Polo shirts.”

To which his colleague (the legal counsel, I presume) replied, “The 9/11 terrorists were also wearing khakis.”

I explained to the investment team that the findings were definitely unusual, and because of that we made sure that we corroborated the most serious allegations with three or more sources that included former and current employees, business partners and even a family member. The client did not go through with the deal, but the developer found other investors. When I’m in China, I go to the bar of the luxury hotel the developer built and wonder whether the story will ever hit the headlines.

For me, China is still one of the most interesting markets for due diligence because of the competition between a market potentially teeming with deals and profits and a very opaque business and legal environment. In that context, many companies have gotten burned financially or their reputations have taken a beating merely due to not taking the time or spending the money to understand their business partners.

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