Differences in business and legal practices can expose companies to corruption risk
As consulting professionals who regularly practice in the FCPA arena, Forensic Risk Alliance recently spent several weeks in Shanghai for an anti-corruption and bribery audit of a major energy company. While we have previously lived and worked in the People’s Republic of China, we continue to make new observations with each visit with respect to how business is conducted there and what some of the red flags are for companies and individuals doing business in the country. Here we share just some of our observations and collective insights from our experience in China.
China, the second-largest (and most dynamic) economy in the world, continues to experience chart-topping numbers of cross-border mergers and acquisitions, and an increasing number of US and UK companies are looking to the East for expansion. Unfortunately, differences in culture, business and legal practices can expose foreign companies to significant corruption risk, which can potentially result in losses, fines and penalties, ultimately eroding shareholder value. For example, Watts Water acquired a Chinese company called Changsha Valve in 2002, which had a policy and practice of paying bribes to obtain contracts. This failed to come to light during the M&A due diligence, and seven years later Watts Water settled an action with the SEC to disgorge over $3.5 million in profit and pay a civil penalty of $200,000, on top of the investigation and legal costs.
Most businesses understand that working across different territories presents cultural, legal and business challenges, and doing business in China or working with a Chinese agent or partner poses its own set of difficulties. Corruption risk in China remains high due to certain Chinese business practices, weak law enforcement, strong government involvement in certain areas (such as land permits, business licenses, quotas for foreign movies, and foreign exchange restrictions) and a high percentage of state-owned or state-controlled companies in the oil and gas, mining, infrastructure, banking and healthcare sectors. Ensuring that robust anti-corruption due diligence is carried out can help companies to establish the realistic value of a Chinese acquisition target or identify the potential corruption risk of a Chinese subsidiary.
No guan xi? No good!
The building of relationships (guan xi in Chinese, pronounced ‘gwan she’) drives successful business development in China. This is absolutely key to getting things done in the country and is built on the exchange of gifts, meals, entertainment and favors. This includes providing moon cakes during the Mid-Autumn Festival, as well as small gifts and client entertainment (commonly karaoke or spa treatments). The giving of moon cakes is frequently cited as an example of corruption risk in China, although it is more likely that the cakes are simply what people are nibbling on when they are discussing the real bribes. Although it is almost impossible nowadays in China for a decision-maker to decide contracts purely on the basis of a box of moon cakes or a free spa treatment, these exchanges of gifts, as common as handshakes in the West, are seen as quite necessary in the business relationship-building process.
It is well known that in China, business generally gets done at the dinner table and the lavishness of these dinners is considered a mark of your respect for the client. What is less commonly known is that Chinese businessmen love a good drink just as much as their UK counterparts. One client tells us her stories of nightly drinking sessions with her clients, involving the purchase of high-priced beers, wines and liquors – the more expensive the beverage, the more respect and ‘face’ for the client.
In China, face is not an asset that can be held onto – rather, it must be given to others. ‘Giving face’ essentially means doing what the client asks for, regardless of legality or moral or ethical standards. This gives salespeople strong motives to test the boundaries of law and regulation, which can be easy or impossible to achieve, depending on their guan xi. The extent of business that is reliant on guan xi and face will be critical in identifying risks in a company’s practices and corporate governance.
Because Chinese business practices and culture weigh heavily on relationships and networks, handshake deals and oral agreements can be deemed more binding than contracts by some companies. Not surprisingly, on more than one occasion we have come across a multi-million-dollar business without any written agreements with its key clients. This can create a myriad of legal issues and may expose companies to increased corruption risk and potential erosion of business upon key persons leaving or the business being acquired by a new owner.
Potential areas of high risk
Conducting effective anti-corruption due diligence is particularly difficult in China due to management’s unwillingness to cooperate, incomplete books, high employee turnover, weak internal control and lack of public information and resources. Nevertheless, there are ways to overcome or mitigate these challenges. One of the first steps in effective anti-corruption due diligence is to conduct an initial risk assessment of the company in question in order to identify high-risk areas where corruption is more likely to occur. During our engagements in China, we have noted several areas of business that frequently expose foreign companies to high risk.
1.3 billion foreign officials? The Chinese government is thought to own more than 70 percent of the country’s productive wealth, and it is the majority shareholder of approximately 30 percent of publicly listed companies. According to one observer, the Chinese government ‘wields power through the allocation of massive state resources and effective control of large-scale state-owned enterprises, which continue to dominate key sectors of the economy.’ The Chinese government’s broad ownership and control of commercial enterprises qualifies a significant percentage of the country’s workforce as ‘foreign officials’ as defined under the FCPA, which magnifies US companies’ compliance challenges. Many companies we have spoken with take the approach of ‘everyone in China is a government official unless proven otherwise’.
Multiple sets of books. Accounting records are sometimes manipulated, and often, different versions of accounting books are kept for different purposes. In one case, a real estate company had five versions of its accounting books: one version for the auditors, one for the taxman, another for the banks, one for the shareholders, and a fifth that recorded every payment made and received for the CEO and CFO’s own control purposes. In addition, we have noted that excessive amounts of cash are kept secretively off balance sheet, such that illegal payments can easily remain undetected. Also, in some cases, personal bank accounts are used instead of company bank accounts in order to hide questionable transactions.
Lack of legitimate accounting supporting documents. Supporting documents such as contracts, invoices and receipts are often falsified. A fa piao is an official government receipt that any legitimate business registered with the tax office is expected to produce when a sales transaction is completed. Fa piao should be provided as supporting documents for bookkeeping, as they give the highest level of legitimate evidence for expenses and are also required by the tax office for sales tax and corporate tax purposes. A poorly controlled company might have falsified invoices or missing fa piao. Fraud and illegal payments can easily be hidden, and there is also a high risk of being charged heavy fines and penalties for tax evasion.
Tax evasion. We have heard it said that ‘everyone and every company in China is avoiding tax’. While it is impossible to prove this statement, we regularly observe certain tax-evading practices, such as when the majority of an employee’s remuneration is arranged through tax-deductible ‘allowances’ without legitimate supporting documents, revenue is hidden or expenses are fraudulently inflated. This apparently common practice among Chinese companies will expose foreign investors to a risk of heavy fines and penalties, especially given the Chinese tax authorities’ particular attention to foreign companies and joint ventures.
Weak control and accounting manipulation. State-owned enterprises and family-controlled conglomerates dominate the Chinese corporate landscape, where business structure and corporate governance can be weak. Lack of independent boards, checks and balances, segregation of duties, transparency and separation of senior management or shareholders’ personal wealth from company assets is likely to result in fraud and bribes, including transactions with related parties, payroll-related fraud, ghost employees, personal bank accounts and so on. In addition, in Chinese culture people traditionally treat their superiors and leaders with enormous respect: they always give them ‘face’, and are reluctant to disagree with or challenge them. This increases the risk of illegal payments remaining undetected or unquestioned. In some cases, Chinese management run companies as if they own them, and the CFO often becomes the CEO’s own personal bookkeeper and must act exactly as instructed. Inevitably, manipulated or totally fictitious revenues can evaporate overnight or after an acquisition, making an effective due diligence process even more crucial.
Kickbacks and ‘grey income’. Some Chinese companies obtain business through bribes, gifts, commissions or kickbacks, and it is not unusual for employees interacting with vendors to receive something, however nominal. This is known as ‘grey income’ for those receiving it. In some cases, this grey income is exploited throughout a company at all levels, from receptionists and secretaries to sales teams and, most prevalently, senior management. This often amounts to a significant value and is considered an acceptable – even normal – stream of income or benefits. This expectation is well known and accepted by many people in China, and some graduates will even fight for low-paying but highly influential jobs within the government, with the intention of maximizing their grey income in the future.
Unapproved land use rights. China has a system of public ownership to all land. As a general rule, land in urban areas is owned by the state, and land in rural areas is owned by collectives (rural collective economic organizations). In theory, individuals or companies can only obtain or purchase land use rights from either the local governments or collectives. Bearing in mind that the People’s Republic of China only has a history of about 60 years, the laws and regulations on land use rights and ownership have not had much time to evolve. Many companies claiming they have land use rights obtained ten years ago will not be able to provide legitimate documents; worse still, some companies obtained their rights through bribery of government officials. Thus, even land use rights that have been certified by the government can be challenged and easily lost, causing large, unexpected and significant losses for those without guan xi.