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January 1, 2013

How to Take a Closer Look at China

Why due diligence is so tough and so crucial

Dan Harris is a partner at a Seattle law firm that, depending on the client, helps U.S. companies establish operations in China or find ways of picking up the pieces from botched deals. Or worse. Boy, has he seen stuff happen.

“It is easy in China to fake company seals, business cards, bank accounts and even a website,” Harris, quoting a partner, wrote in the China Law Blog of his firm, Harris & Moure, pllc. “The unsuspecting foreigner makes a deal with the impostor and sends funds to the bank account. The product never arrives. The foreigner contacts the well-established Chinese company and that company truthfully responds by saying, ‘We have never heard of you.’ It turns out the foreigner had been dealing with a fake, virtual company the entire time.”

“This happens all the time in China. Trust me when I tell you we see instances of this at least once a month,” he says.

Yet, despite the chicanery and difficulty obtaining accurate business information, the country remains an inviting opportunity for many U.S. manufacturers. By some estimates, operating costs (especially labor) are still a fraction of what they are in the United States. Production capacity and quality overall is considered satisfactory, and employees, if not their bosses, are generally hard working and honest. And even if its economy is going into the doldrums, China, with 1 billion residents, represents a huge sales market for those who can crack it by producing goods locally.

For U.S.-based companies with global operations, on balance the trade-offs seem to be acceptable. A major trick, then, is to do adequate due diligence so as to have the highest chance of a successful outcome and the least chance of running headlong into the Great Wall of China.

How, Harris was asked during an interview with Forward, does one do due diligence in China? “Very carefully,” he replies. “You assume absolutely nothing. You assume things that seem OK are fake.”

Harris’ view is supported by scores of horror stories from news accounts. Manufacturers colluding with a client’s rivals. Theft of intellectual property. Difficulty getting redress for production glitches. Then there are the obvious language barriers and cultural differences, including an opaque legal system not especially grounded in the rule of law that in any dispute is thought to favor the home team, and renders little in the way of justice. At the federal level, the Securities and Exchange Commission is investigating what it called “dozens” of Chinese firms that are publicly traded in the United States for allegedly deceiving investors with bookkeeping fraud. At press time, the investigation involved the Chinese affiliates of the four biggest accounting firms in the United States, Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PricewaterhouseCoopers, and China’s BDO China Dahua Co., Ltd.

How to Trust the Numbers

This comes atop continuing complaints about the overall inaccuracy of general macroeconomic statistics put out by Chinese officials. The most recent gripe is that governments at all levels in China have been issuing false data to mask the slowdown in the local economy. Such a decline certainly would be of interest to foreign outfits that see China as a fertile ground for sales growth.

“When you go to China, they’ll steal you blind,” says one American executive who has been involved in a number of operations there and who asked not to be identified because he is still doing business there. “If you don’t do your homework, you’re going to lose your shirt.”

Of course, this sense of caution is hardly limited to U.S. companies. “Performing due diligence in China can be a lot more difficult than in other countries,” begins a lengthy document on the official website of New Zealand Trade and Enterprise, a government agency in Wellington. “It is essential to research any Chinese companies or individuals you are considering doing business with to ensure that they are legitimate, creditworthy, reliable and can do what they say they can do. This includes independently verifying all important information that they provide you. A wrong move in China can later prove to be very costly in terms of time and money.”

Kicking a Lot of Tires

Clearly, due diligence in China involves many unique challenges. The use of fake factories or phony product samples is not so common in other countries. But certainly under-performers, over-promoters and outright scamsters are hardly unique to the Pacific Rim. From discussions with professionals who are paid to separate the frauds and phonies from the legitimate Chinese operators, they say the due diligence process conceptually isn’t all that dissimilar from moving manufacturing from a plant in, say, South Carolina, to one in Nebraska. You check out everything you can, using every means at your disposal, hire good people to help you and kick a lot of tires.

What’s different is the fact that China is an entirely strange environment. “The culture is different,” says Al Ernest, a partner in East West Associates, a Charlotte, North Carolina, consultancy that helps American outfits verify Chinese opportunities. “There’s a different set of laws.”

Pulling together a manageable shortlist of manufacturing prospects isn’t all that hard. Leads can come from many sources: trade shows, word of mouth, consultants and China-oriented business-to-business websites like Alibaba.com. Controlled by billionaire Jack Ma, and based in Zhejiang, China, Alibaba.com weathered a scandal that broke in 2011 involving fraudulent sellers who used the site to collect payments without delivering goods. As a result, Alibaba fired dozens of employees and several top executives.

Like Seattle lawyer Harris, Ernest says to watch out for individual websites. Concerning Chinese manufacturers, “Anyone can set up a good-looking website,” he says. “That doesn’t mean there’s an ability to deliver the product.”

“When we vet,” Ernest adds, a big question is whether the manufacturer “really makes the product and do they have the capacity.”

Alex Bryant, the president of East West Associates, figures a list of six prospects is the minimum necessary but that “I try to find 12.”

Different Levels of Disclosure

Then, the due diligence begins in earnest. By all accounts a surprising amount of this initially can be done over the Internet using search engines and other databases, like baidu.com, Alibaba.com and ca.yahoo.com. Someone fluent in Chinese and knowledgeable about local business has to be involved, of course. The idea is to look for third-party verifications and comments, as well as information from official sources. The level of disclosure won’t match, say, the filings U.S. public companies make with the U.S. Securities and Exchange Commission. Indications can be found that a given manufacturer is a registered business, an important signal of legitimacy. China hands say it is unregistered companies that account for a disproportionate share of the problems.

Even slick individual websites can be useful as a warning. See that pretty picture of “our new plant”? If you find the identical photo gracing some other manufacturer’s website, you’re onto a dodgy operation worth avoiding.

Harris says there are surprisingly inexpensive ways to get a leg up. “Hire a company that does initial due diligence in China,” he says. For $600 to $1,200, a dossier can be assembled to weed out the phonies and verify that a manufacturer is actually registered with authorities as a real company and who owns or controls it.

For example, the report may show that a company has been in business for only two years, meaning there’s no track record while raising questions of stability, structure and the ability to deliver over the long run. Or, it could show the Chinese company has been involved in disputes over the intellectual property rights of the U.S. client. For instance, in testimony to a U.S. congressional committee, Fellowes, the Itasca, Illinois, maker of paper shredders and other office equipment, has accused Jiangsu Shinri Machinery Co., the Chinese company with which it formed a joint venture, of stealing more than $100 million of assets and preparing to compete with Fellowes. Another American company thinking of outsourcing work to Shinri might want to know about this.

Such a report can also include corporate credit reports, which, perhaps surprisingly, are available in China.

Finding good help for the due diligence is crucial and not necessarily all that easy. Word-of-mouth recommendations from U.S. companies satisfied with their experiences seem to be the best way. A lot of this work goes to law firms staffed by Chinese lawyers educated in the United States or other countries following the rule of law.

A Google search for “China” and “due diligence” generates thousands of hits for outfits offering such services. Many seem extremely dubious, though. Expressions like “guarantee” and “risk-free offshore manufacturing,” always warnings since they really cannot be true, festooned some pages. Others contained bad grammar and misspellings. A person answering the phone, at what appeared to be a big operation in California advertising over the Web, offered to answer Forward’s emailed questions, but then refused to provide the email address.

Obviously, once a short list is developed, visiting factories in person and asking a lot of questions are musts. This is where Harris’ advice of not to take anything for granted kicks in. “Make sure the person you’re getting a tour from is a factory official,” he says, “and not someone who paid someone $20 for the right to take you around.” Harris has seen this.

Unlike in the United States, many companies in China are willing to disclose financial information and even open their books to potential vendors and partners, although whether they are the true accounting records may be questionable.

Be Wary of Product Samples

Obtaining product samples made by a factory is one traditional way of assessing quality. However, Al Ernest of East West Associates says it’s also necessary to make sure the samples come from the factory under review and not some other factory. “In the United States you ask for a sample, and you’ll get a valid sample 95% of the time,” he says. “In China, 33%.”

Much of the factory scrutiny process is what would be done for outsourcing anywhere in the United States: A close examination of machinery. Review of how the factory floor is organized, and whether the workflow makes sense. Pay attention to quality control checkpoints and how bad parts are handled.

Unlike most operations in the United States, workers in China frequently live in company-supplied dormitories at the factory. A number of published sources suggest checking out the quarters, if for no other reason than the proposition that happy, well-treated workers are more productive workers.

By all accounts, references often minimized in the United States play a key role in due diligence in China. This is partly due to the difficulty of getting solid information elsewhere. It’s considered acceptable to ask a factory for a list of the foreign companies it does work for. But it’s very important to check all references to make sure the relationships are valid and satisfactory.

The lack of good due diligence can have disastrous outcomes. Harris turns down far more cases than he accepts from U.S. companies claiming they were hosed in a China deal. The reason, he says, is that the U.S. company was responsible for the pickle it found itself in, often due to poor due diligence going in.

That’s not unique to China. You can find disputes like that between good old American companies in just about any courthouse in the United States. Whether it’s a U.S. firm outsourcing to another U.S. firm, or a U.S. firm outsourcing to a China firm, it’s still pretty much the same rule. Buyer beware.


 

William P. Barrett is a veteran journalist for national publications. He can be reached at wmpb@aol.com.