Risky Business in China

A Guide to Due Diligence

J. Gordon

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781137433213
• eBook ISBN: 9781137433237
• Topic: Social Sciences
• Subtopic: Business General
• Index: Social Sciences

Risk is a major reason that companies fail in, or fail to enter, China. Packed with case studies, this unique book demonstrates how correctly applied due diligence can not only reduce business risk in China, but also provide excellent business intelligence to support negotiations and business relationships.

chapter 3

Due Diligence in China

Due diligence approaches

Due diligence is a broad term, and a flexible tool. In China it is usually good to be flexible, and not to be bound by simple checklists and rigid rules. In the words of the famously flexible Bruce Lee¹: “the stiffest tree is most easily cracked, while the bamboo or willow survives by bending with the wind.”

The right timing, type, and amount of due diligence will vary depending on the type of driver (such as investment, M&A, sourcing or hiring), the project owner’s approach to risk, and on the nature of the risk, including its size, value, and potential impact. Managers will have to decide not only what type of due diligence to conduct, but also when and how to do it. Should it include a focus on businesses, individuals, assets, operations, processes, policies, regulations, and/or other risks? Should it be proactive or reactive? Overt or covert? In-house or out-sourced? The specifics will vary, but one thing is certain—due diligence is not optional! (See the Specialist Spotlight below).

In determining the risk factors that should be addressed, it is useful to consider which factors most often lead to failure, loss, and general pain in China businesses. Many of these things have as much to do with the principal as with the target, and many can be mitigated or avoided at the planning stage by being realistic, managing expectations, getting the right team in place, and setting down red lines that will not be crossed. Considerations include:

Aims—if long-term aims are not aligned, it will not end well.

Cultural fit—if it is not there, it will be hard to overcome obstacles.

Communications—it is complex enough without misunderstandings.

Information—if it is not there, or not accurate, it will not inform.

Standards—unless clearly defined, assumptions and expectations may differ.

Resources—are almost always tighter that predicted.

Schedules—rushed deadlines reduce negotiation leverage and increase errors.

Budgets—unexpected constraints can lead to cost and/or corner-cutting.

Change—of people, policies, and market conditions mean moving goalposts.

Optimism—is usually misplaced, and red flags should not be ignored!

Critically, the due diligence brief needs to fit the business aims and context. In some of the high-profile due diligence failures, the “right” answers may have been provided by the due diligence teams, but the wrong questions may have been asked of them. It is one thing to ask an accountant to review a set of accounts that has been provided by a prospective partner. It is quite another thing to ask if the accounts are consistent with the business operations, and whether there may be risks lurking around the corner. The former approach may work in some developed markets, where certain baseline assumptions can be made, but a more three-dimensional approach is needed in a market like China, where the numbers on the page may not add up in reality.

Some businesses recognize the need for due diligence but try to address it too narrowly as they don’t want to kill the deal, or as they want to save on fees. However it is important to look at a variety of risks, from internal operational issues to the potentially catastrophic external ones (think SARS²), and to ensure that the business can adapt. For some supply chains it is a process that could take years to plan and develop, and for some companies it has been happening slowly but surely since at least 2008, according to Katherine Peavy who also notes that it is important to have an exit strategy, in case the risks look like they could start to outweigh the rewards. She also points out that the cost of due diligence is easy to quantify and so can seem expensive in relation to the unquantifiable cost of the potential risk. Taking a long view, and with reference to reported cases of actual losses, companies would be well advised to put a figure on the risk cost, before trying to save money on preventative measures.

Kent Kedl believes too many people are too binary in their approach to due diligence in China, seeing only win and lose scenarios. In his experience less than five per cent of deals suffer death by due diligence, while those that pass the tests are able to move on with the benefit of business intelligence and confidence. The “third way” is the more usual outcome, with deals being restructured on the basis of due diligence findings in around 60 per cent of cases. A practical and positive approach to the brief, combined with flexibility in response to the results, is generally the best approach.

Proactive or reactive

Due diligence can, and should be, proactive. A proactive approach based on sound procedures can help to identify and address risks before they become a problem. The work can be budgeted, resourced, and scheduled for in good time, avoiding a last-minute squeeze and a rushed job. It can be deployed during pre-acquisition processes, pre-contract negotiations, or before new staff are signed. It can also be, and often is, reactive. This happens when responding to changes in the business or regulatory environment, assessing newly identified risks, when issues are brought to light by whistleblowers (as is increasingly the case), when scandals erupt in the media (or CCTV highlights failures of consumer protection at another major multinational), following failed audits, accidents, disastrous investments, or when people or things go missing.

Kedl refers to the “oh shit” moment as being a common trigger for managers to reactively call in some due diligence support. But it is often too late. Due diligence should also be applied from the strategy development stage in China, but very few give it sufficient, proactive consideration early on, when some external red-flag analysis could have a significant impact, and save a lot of problems, later. In general it is best to plan to be proactive but be ready to be reactive. China is a challenging place to do business, and even the best-laid plans sometimes need urgent, real-time rethinking.

SPECIALIST SPOTLIGHT: CHINADUE DILIGENCE NOT OPTIONAL

Dan Harris of Harris Moure/China Law Blog³

A US company goes to China and meets with a company there for manufacturing product. The two parties sign an agreement and US company sends over a large sum of money to build the tooling.

The Chinese company then says another large sum is needed to be ready to go as soon as the tooling is complete. Months pass. Nothing. More months pass. Nothing. It has now been a year and still nothing.

The US Company contacts my firm and wants to know about pursuing litigation against this Chinese manufacturer to recover the money paid. We determine that the US company has a very strong case, but suggest we first investigate the Chinese company to determine whether it has sufficient assets to pursue.

We conduct a fast and cheap investigation and get a comprehensive report on the Chinese company. From this report we learn the following: The company is not a manufacturer. It is a trader, with a tiny, rented office. It does not even have an export license. In other words, it gets its products from manufacturers and then has to bring on another company to ship them. It is just a middle-person. Its only asset is a small amount of inventory, which it may or may not own.

The US company then decides to order a comprehensive report on ALL of the Chinese companies with which it presently conducts business.

Perhaps you should too. China due diligence. Not optional.

Don’t ignore warning signs⁴

Overt or covert

Depending on the risk owner’s aims, the status of negotiations, and the relationship with a counterparty, the issue of due diligence may be considered a risk factor in itself. There is often a fear that the due diligence target might be offended by the idea, with loss of face, especially if a lot of time and effort (and food and drink) has already gone into establishing a friendly professional relationship.

A covert due diligence approach might be preferable in the early stages of project development, when working out a short list of targets, where plans are still confidential, or when initial contact has been made, but before serious commitments are in place. Covert due diligence can also be used later on in the process, for specific issues that present themselves as red flags. “Covert” does not necessarily imply a Bond-style thriller, or sneaky subterfuge. It just means that legitimate research and fact checking is done without the knowledge of the target. As a result, although the available information may be limited, the advantage is that as the target is not involved, the focus and process of information collection can be controlled by the principal, and the information received will include objective research and analysis of the situation on the ground, independent third-party opinions, and verified official information (such as that which can be obtained from the Administration of Industry and Commerce).

Overt, or open, due diligence is an equally important tool, especially where full disclosure of confidential company information is required, such as “hard” details of accounts, assets, liabilities, products, customers, and business plans. The core parts of the traditional legal and financial due diligence processes are, by necessity, open, as they require the target to provide access to commercially sensitive information. A covert attempt to obtain such details would involve not only moral hazard, but also legal risk of breaking laws around commercial secrets (or, in the case of State Owned Enterprises, even state secrets). The case of “The Rio Tinto Four,” in which four employees were imprisoned in China in 2010, is an example that got much attention at the time, and which pointed to tighter regulation of foreign firms’ ...

Table of contents

• Cover
• PALGRAVE POCKET CONSULTANTS
• Author
• Title
• Copyright
• Contents
• List of Figures and Tables
• List of Abbreviations and Acronyms Used
• Acknowledgments
• Introduction
• Chapter 01: Opportunity and Risk
• Chapter 02: How Risky Is Business in China?
• Chapter 03: Due Diligence in China
• Chapter 04: Putting Due Diligence on the Map
• Chapter 05: Survival Toolkit
• Chapter 06: Emergency Services
• Chapter 07: The Good, the Bad, and the Ugly
• Chapter 08: Conclusion: The New Reality
• Appendix: Resources and Reads
• Notes
• Index