Management due diligence(0)
Existing managerial habits
Chinese companies, especially State-owned enterprises, tend to have archaic attitudes to management that extend way back to China?s iron rice bowl. This, coupled with the rude fact that as SOEs they are representatives of the government itself and often above scrutiny, can often lead to polar opposites when it comes to business management and good corporate practice. Chinese executives may never have had to be scrutinized before, or subjected to checks and balances. Yet as soon as a foreign investment is made, be aware that the Chinese authorities will render special attention to the business at a far higher level of attention the Chinese have ever been exposed to. Naturally, as the new-to-China foreign investor, any difficulties in compliance will be your fault. The reality may be far different, and you need to be open to the conducting of an HR assessment of the capabilities of managerial staff to work in the corporate environment you require.
Inheriting staff from chinese companies
If staff are transferred from a State-owned enterprise to a new JV, or are inherited via merger, you need to conduct checks on who you will inherit and their pension/welfare obligations. Many new investors have found themselves unwittingly crushed by the sheer weight of taking on not just staff, but also long term social costs as well. Make sure you do your due diligence on the financial aspect of HR and do not just willy-nilly accept whatever staff you are given. If layoffs need to be conducted make sure the Chinese side does this as part of their responsibility instead of just passing it off on an unsuspecting new foreign partner. This is particularly true when an acquisition is made for just part of a Chinese SOE.
The Chinese limited liability status grand misrepresentation technique(0)
Usually, in the West, this is issued in the form of a cash injection into the business, and can be checked via the public records office. Extending credit then, say of US$1 million, to a company with a limited liability of just US$25,000 may then start to flag up red with your accounts department. It?s a good way of protecting yourself against providing over-credit to customers more likely to default, and also a proven method of assessing risk when providing credit in the form of cash or sales.
All well and good. In China however, there is very limited access to any public records, and those pesky China business licenses that state ?the amount of registered capital? are prone to inaccuracies as well. As is always the case in China, the devil is in the details.
The registered capital amount as displayed on a Chinese business license also fulfills the same criteria as the limited liability status. So if a business has RMB1 million as its registered capital, the shareholders are also responsible for that amount of liability. If you want to send product worth US$1 million to a Chinese company, you?d better start assessing the amount of risk in the published registered capital amount shown on the license.
But it doesn?t stop there. When setting up a Chinese domestic company, before applying for the business license, the investors are required to contribute the registered capital required. Accordingly, a further check is needed to verify the registered capital amount was in fact paid. This document, a ?Capital Verification Report,? has to be issued by a third party Chinese CPA firm cross checking bank statements showing the amount was injected. The false production of such a certificate means the CPA firm can also be liable for fraud.
If a capital verification report has been issued, then the business has a legal limited liability status and it was, at time of incorporation, capitalized in accordance with the law.
It?s these simple checks that can separate a good sale to China from a delinquent sale to China, and they are easy to carry out.
Management due diligence
Operational due diligence overview(0)
The likelihood of buyers being disappointed by the performance of the target company can be reduced by conducting operational due diligence (ODD).
ODD can be a highly effective tool in helping the buyer understand exactly how the target company works, which in turn leads to a trouble free transition after the consummation of the acquisition. It can also prove effective at assisting the buyer in evaluating how well the target?s current operations support the future strategic objectives. ODD should include a detailed assessment of:
ODD can be used at variety of stages in the acquisition process, but is typically used to achieve one or more of the following outcomes:
The Chinese limited liability status grand misrepresentation technique
Purchasing product from China(0)
Many are very serious indeed; from tainted food, to toxic materials found in popular products. These can also lead to litigation from consumer groups or customers back home. Quality control is one issue of course, and being technically specific, I will not deal with it here other than to say that of course it is your responsibility as a buyer to ensure that the product you are purchasing meets the legal requirements of your own nation?s legal standards. But there are other issues that can and do affect the purchasing process and if understood and rectified, can reduce the risk.
With China joining the WTO, one effect has been to introduce increased competition into domestic industry. The Chinese tend to have a knee-jerk reaction to this and automatically reduce prices. It is also true to say that many international buyers perform highly aggressive negotiating and purchasing policies that are intended to get the best possible financial deal for the buying entity. Some indeed, are utterly rapacious. There is a link between aggressive purchasing and quality risks, and it has largely been ignored. But squeeze the manufacturers too much, with wafer thin or even no profit margin capabilities, and the pressure and incentive arises for the manufacturer or their supply chain to cut corners. I see it essentially as a moral issue ? you need to allow your supplier to make a reasonable dollar out of your business. If you do, it will keep them honest and more committed to you.
If not, there is a risk of the following equation occurring:
a) Aggressive Pricing x Reduced Profit Margins = Cost Cutting By Supplier
b) Reduction in Quality + Minimal QC Checks = Risk Of Contamination
a+b = c Toxic / Substandard Products
c = Risk of Litigation
Due diligence here can also be measured financially: the cost of litigation and award payouts set against purchasing costs. There are case studies, and if this hasn?t affected your business yet ? then you may well be wise to look at cases involving other unfortunate businesses who ignored this aspect.
Operational due diligence overview
Conducting due diligence in China(0)
Over the 15 years of working with Dezan Shira & Associates in China, we have seen many cases of troubled investors with problems in our dealings with foreign investors in the country. Some of these, regrettably, have proved terminal and the venture had to close. Contrary to popular belief, lawyers and accountants do not want to see businesses with problems. At Dezan Shira, clients who are profitable and on-track with their investment are a far greater source of sustainable income than those with problems. It?s also true to say that of the many trouble shooting cases we?ve been involved in, 90% could have been avoided by the deployment of due diligence at the front end of the investment planning. That initial work upfront would have almost certainly have thrown up red flags that would have altered the destiny of the investment and made it far less prone to inherent problems. In this article I begin by pointing out some of the areas and attitudes concerning investment into China that can hinder a sensible approach to due diligence. The process does not have to be expensive and there is much the savvy investor can do to limit the risk. We point out areas of basic due diligence an investor can conduct himself and also look at common technical due diligence mistakes and assumptions foreign investors can make in China. Due diligence, due diligence, due diligence. The six D?s foreign investors must carry with them in a box of things to do that need to be crossed off their investment check list. Not to do so is largely negligent, and those problems later on that so many expatriates like to tell horror stories about can usually be avoided.
To begin, I start with reasons why investors shy from due diligence, followed by basic checks, examples of hidden areas of risk, and more complex due diligence examples.
General poor attitude concerning due diligence
A tendency in China when it comes to due diligence is essentially a lack of professionalism, a desire to make a quick buck, a refusal to invest in any reasonable homework and an under-appreciation of how savvy the Chinese can be when it comes to the law.
Purchasing product from China
JV contracts and articles of association(0)
Both the JV Contract and Articles of Association are legally binding documents, meaning you may resort to the Contract to assert a right or claim damages against your partner, or your partner may make a claim against you. However, the legal binding effect of the JV Contract and Articles of Association is only between the partners who enter into this agreement, and the documents cannot serve as a defence against any third party or government authority. That is to say, if the agreement vested the compliance issue to one party in the JV, and non-compliance is detected later, both parties shall be jointly held legally liable. Nevertheless, it is arguable that the party who is specifically vested with the responsible for compliance issue should be liable for the whole responsibility.
Contractual JVs vs Equity JVs
There are two types of JVs in China, the Equity JV (EJV) and the Co-operative JV (CJV) (sometimes known as the Contractual JV). They may appear similar on the surface but have different implications for the structuring of your entity in China. Here we explore the differences, provide practical advice on structuring, tips on investment drawbacks, land use rights and profit distribution.
An EJV is a joint venture between Chinese and foreign partners where the profits and losses are distributed between the parties in proportion to their respective equity interests in the EJV, but the foreign partner shall hold more than 25% of the equity interest in the registered capital of the EJV. The company enjoys limited liability is a ?Chinese legal person?.
The CJV is a very flexible FIE where Chinese and foreign investors have more contractual freedom to structure cooperation. It is a joint venture between Chinese and foreign investors where the profits and losses are distributed between the parties in accordance with the specific provisions in the CJV contract, not necessarily in proportion to their respective equity interests in the CJV.
In the past, CJVs took one of two different forms – a true CJV which did not involve the creation of a legal person that was separate and distinct from the contracting parties; and a legal person CJV in which a separate business entity was established and the parties? liability was generally limited to their capital contributions.
In the case of a true CJV, each party was responsible for making its own contributions to the venture, paying its own taxes on profit derived from the venture and bearing its own liability for risks and losses. In contrast, a legal person CJV, the more prevalent form today, shares more of the characteristics of an EJV. The true CJV is rare today as few investors are willing to entertain the prospect of unlimited liability and the rest of this discussion only refers to legal person CJVs.
Legal and financial Due Diligence(0)
If you fail to do so, your entire China business may be at risk. Some of the basics you can actually do yourself ? other investigation may require professional assistance.
Due diligence can also extend to forensic accounting on a partners? books, as well as political risk and other issues, especially if the JV is sizable. However, this is unlikely to worry most SME JVs and may not be necessary for a simple production unit. Again, take advice.
Some potential partners may interpret such enquiries as intrusive, or infer that you do not believe them. If they are keen to close a deal quickly, they may try to skirt round such issues. This part of the negotiation process therefore needs to be handled with patience and some sensitivity. However, reliable and serious partners will understand your need, and that of your foreign parent, for these issues to be confirmed. Indeed, if they are doing their job properly, they should also require similar disclosure and transparency from you.
The bottom line here is ? take your time, know what you are getting into, and if you are uncomfortable, go elsewhere. Don?t be rushed.
Details of who is actually who in the Chinese company, and details of their limited liability must be obtained.
Ask for a copy of their business licence. It will list (in Chinese) details of the legally responsible person (Legal Representative), the registered address, the amount of registered capital (which is also the limited liability) and the period of the licence. This basic information should be checked off against what you know. If there are any discrepancies, ask the reasons why. Sometimes the answer may be quite reasonable ? on other occasions it may alert you to potential difficulties.
It is quite common for the actual legally responsible person not to even be the person you?re dealing with. Licence periods may not be consistent with liabilities – such as the case of the ten year projected JV with a Chinese partner whose licence was due to expire in three months time! Check this out and make sure you know with whom you are really dealing, and that they can deliver what they say they can.
Capital verification report
This is issued by a Chinese independent CPA firm, confirming the fact that the registered capital as identified on the business licence was in fact paid up. If the registered capital has not been paid, not only does this mean your partner has not actually capitalised his business, but it also means he has not complied with limited liability requirements. As a consequence he will also be in breach of his own articles of association ? which could cause serious problems in the event of a failure or other legal issues.
JV contracts and articles of association
Specific JV structural issues(0)
Many companies leave the entire operations up to the Chinese partner to run. This is a crucial mistake. A new business needs all the support it can get. You need to invest in a foreign manager to keep an eye on things, especially during the early stages. Correct systems, accounting and quality control issues all need to be taken care of. You have standards; ensure these are implemented and operational in your JV. The ideal solution is an expat manager – if not long term then certainly for the initial development stages. However, the General Manager is responsible for the operations of the business. It is wise to make this one of your personnel. Leaving both in the hands of the Chinese partner effectively hands them control of the business.
When negotiating the amount here do be sure that the Chinese side?s investment really is worth that amount of money. It is a pre-requisite to have asset and stock valuations. This means having proper valuations placed on machinery – the Chinese tend to quote the original purchase price with no depreciation – buildings often are valued at the price it would cost today to build and don?t actually reflect the fact that it may well be a 20 year old shack that cost US$10,000 to put up in 1987. Also, check the Land Use Rights certificate – if they can show these are granted rights, with no administrative or judicial enforcement measures such as sealing-up, seizure or freezing in connection with the asset, then they owns the land. If they are just allocated, they don?t and the right to use it should just be the rental value. See also the Due Diligence section below.
Legal and financial Due Diligence
Structuring your JV – General issues(0)
Some of the issues you need to consider apply to all types of foreign entities in China, while others relate specifically to JVs.
We will now explore these in more detail.
Having set up a limited company does not necessarily mean you can engage in any kind of business activity, as is the case in some Western countries. Like other entities in China, JVs can only be operated within the business scope approved by the authorities. Other activities are subject to further approval. So it is vital to determine what you want do right from the start.
Lazy, or deliberately disingenuous, business scopes, such as only using the phrase ?production of (product)?, will not necessarily qualify a JV as a production company. You will also fail to qualify for tax holidays, even if the local government approves it, as the tax bureau may require a more detailed and specific explanation. We have encountered numerous problems of this nature, all requiring a scope of business change on the licence before the tax bureau is satisfied with exemption status. You need to ensure your business scope is accurate. Attempts to fool the tax bureau into thinking you are one thing, while in fact you are another – even if you can get it past the approvals process – inevitably end in failure. Play the game and say what it is you are really doing.
Specific JV structural issues
The JV is back!(0)
Joint Ventures (JVs) were the first business entity opened to foreigners and for a long time have been an unpopular vehicle for international investors looking to China for lower production costs or for market access. Yet recently, we notice more than ever before, there are an increasing number of foreign investors wanting to set up a JV in China. JVs are coming back!
The Joint Venture often sounds like a warm and friendly way of doing business, a marriage made in heaven. You are likely to be offered many such wonderful sounding deals. Many Chinese factories are looking for long-term security in foreign sales via an overseas partner, or to get access to western technology. And because this structure has been around for a long time, many foreigners who have not yet done business here have heard about it. It sounds much more attractive conceptually than the main alternative, a Wholly Foreign Owned Enterprise.
But wait, China?s business history is littered with thousands of cases of unhappy partnerships and broken dreams ? the analogy with human marriage is a common one, with the popular Chinese idiom ?same bed, different dreams? often quoted. One major Western oil company once told us, only partly in jest, their JV was a win-win situation ? meaning the Chinese won twice. Business is not about being warm and friendly; it is about making profit and running a successful company. You may well end up becoming close friends with a commercial partner, but it is not the primary objective.
Structuring your JV – General issues