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Fraud
is fraud ... in anyone's philosophy!
Whether
it is a result of, as Xunzi argued, "All men being inherently evil",
or the more contemporary social pressures associated with the "to
get rich is glorious" mentality, however fraud
has become a widespread problem for many foreign firms
doing business in China.
Many western economies adhere to business operations and corporate
governance built upon stringent audit/accounting requirements and
certain legal disclosures. However, Chinese business has, for centuries,
been built upon connections (Guanxi) and verbal confirmations. It
is due to these differences and lack of
corporate transparency that
"Business Fraud" is one layer of the "Doing Business in China" onion
that is not so easy for foreign firms to peel, but often the most
costly!
Whilst
'fraud' inherently involves illegal activities, professional crimes
can involve a multitude of activities and deceitful behaviour that
is not necessarily captured through a strict legal definition of 'fraud'.
"Business
fraud" can basically be split into two categories -
direct and indirect. It
is this latter group that foreign companies find most difficult to
detect and resolve. Where as direct forms of professional crime may
include embezzlement of assets, ghosting of work hours, falsification
of financial statements or over payment of salary, indirect forms
are not so easy to detect. These may include, for example, various
forms of nepotism,
local joint venture (JV) partners establishing competing companies
to the JV itself, or even supplier contracts where the supplier is
in fact the JV partner's own private company or an employee's relative.
A
hypothetical example would be for an employee who orders all the firm's
printing requirements from a single supplier, which is in fact owned
by the employee's Uncle. However, this supplier actually does no printing
at all, but merely marks up the goods from another affiliate printing
company.
In
the West many companies, and indeed regulatory bodies, have
control mechanisms to
limit the extent of such behaviour. These include internal controls
such as authorisation levels, segregation of duties, job rotations,
tendering processes for contracts and internal audits, and more importantly
regulatory requirements such as "disclosure of conflicts of interest"
or external audits. The end result is a much tighter
corporate governance environment
and greater operational transparency.
In
China, however, many foreign investors seem to treat their mainland
Foreign Invested Enterprises (FIEs) as "outposts", essentially ignoring
all the management training and processes that have proven integral
in the more developed economies of the world. Whether it be due to
a lack of
"hands-on" management, language and cultural
differences, or simply a misunderstanding of the business environment,
there have been too many failed Joint Ventures
to simply blame on 'the difficult Chinese market'. All too often,
the real cause of an FIE's failure in China actually involves unscrupulous
behaviour and misinformation.
How
to limit your exposure
Due
Diligence:
With stringent statutory audits and other overseas reporting requirements
(such as to Stock Exchanges and other regulatory bodies) forming strong
financial corporate governance in many Western countries, financial
statements are generally considered to be "fair
and true". However in China, with
newly-developing accounting regulations, coupled with possible collusion
between JV partners and external auditors/financial advisors, company
financial reports may not be necessarily so reliable.
Many
potential JV partners simply present
fraudulent accounting books and financial
statements, false bank statements and even illegal contracts.
With this in mind, it is suggested that foreign
investors conduct thorough business due diligence (both legal and
financial) before entering into any business negotiation or contracts,
so as to first identify "who"
you are in fact really dealing with. Part
of this process should include a background and credit check on the
partners, their business and, depending on the industry, licenses
and solidity of standing with relevant local and state Government
departments.
Internal/External
Audits:
Many companies spend large budgets on backup data centres, software
virus protection and fireproof server rooms, yet are
not properly protected from Employee A,
the company Accounts Receivable clerk, who has
access to all the firm's billing and collection information.
This
is particularly important in China where many FIEs maintain only small
finance teams. In such cases, there may not be the personnel nor the
resources to adequately
ensure segregation of duties or audit trail
procedures. As a result, there are
many occasions where money has easily been siphoned off to individual
employee's and Chinese partners' bank accounts. This lack of control
actually ends up causing more damage to the company's financial position,
let alone reputation, than any worm virus could ever cause.
To
limit such exposure foreign investors should insist on having accounts
audited
by a reputable accounting firm with international standards
who can also provide constructive advice on
the internal controls. They should also insist on having the right
of access to the accounts at any time for monitoring purposes.
Whilst
external audits are statutory requirements and may uncover 'accounting
irregularities', internal audits are also an essential tool
to uncovering potential fraudulent activities and are just as important.
Internal audits and system audits
can uncover lack of internal controls and weaknesses,
areas for potential fraud and audit-trail compliance. This may help
to discover potential Employee A's before they bring down the whole
operation. After all, Mr. Nick Leeson brought down one of the oldest
established Merchant Banks in the world through a lack on internal
controls - what's to stop Employee
A in your China operation?
Management:
The
management team in many FIEs are often decided by JV partners or through
hiring of local staff who have the appropriate experience and education
to deal with both the Chinese business environment and Western management
principles.
Over
the past 5 years in particular there has been a trend for companies
to cutback on Expatriate packages and a push towards
localisation of staff.
However, whilst saving money and satisfying more appropriate resourcing
decisions, this trend often leaves many FIE head offices without hands-on
management exposure, and can effectively lead to a loss
of day-to-day operational and financial control.
This
loss of control may manifest itself in a multitude of problems, such
as a rogue JV project (as witnessed by one soft-drink company's manufacturing
plant being turned into a tanning factory by an unscrupulous JV partner),
misuse of company funds (such as the purchase of assets by the management
team to satisfy their own private company's fixed asset requirements,
or pledging assests to banks for loan approvals without the foriegn
partner's consent), and even the potential for the company to become
involved in illegal activities (such as trading in activities without
appropriate business licenses).
Though
there are advantages to localisation of staff and management teams,
a good measure to limit exposure to these problems is for the foreign
partner/firm to insist on the right to name
the Chief Financial Officer (CFO) to the FIE. This
ensures day-to-day control over both financial and operational policies.
It also allows the foreign party the ability to prepare separate financial
reports (for Head Office) under International Accounting Standards
or overseas accounting standards, and to appoint an independent accountant
for compliance purposes.
Whilst
there is obviously a cost-benefit payoff to be made in this decision,
acting in the
interests of shareholders is of the utmost
importance. This decision is illustrated
in one well-known example where a multinational decided to send a
CFO to its FIE in China, only after three years of operations. This
three year period allowed the JV partner to effectively run the company
for their own personal benefit and to extract all the technology and
knowledge they needed to first run the company into the ground and
then establish their own private company. In fact when the CFO finally
did arrive, all he was required to do was a few simple book entries
... to write off the entire multi-million
dollar operation!
Company
Structure:
Aside from the management team, the structure of the company and articles
of association, and internal control
procedures play an integral role in ensuring control of the company
and in limiting exposure to management fraud.
Faith
in partners is essential to any successful Joint Venture, however
the company's articles of association can protect parties when things
don't go to plan. Whether this be more control over the Board of Directors,
clauses requiring countersignature of major investment contracts,
competitive tendering obligations or remedies in case of fraudulent
activities, foreign investors need to ensure that they are
fully protected when
it comes to management control. Such measures also serve to dissuade
local management from fraudulent activities and set clear guidelines
and rules.
The
Company should also ensure that the articles provide a clean
route of exit should the firm wish
to pull out before the end of the JV's contracted life. Typically
this will be a lot longer than the length of time that the instigating
management will work for the company. Corporate strategies change,
company financial circumstances change and China's policies and legal
structure is changing daily. Thus, the FIE needs to be able to change
their business model to suit the Chinese market, regulatory requirements
and overall business strategy of all interested parties.
What
can you do if you are the victim of business fraud in China?
Whilst
the Chinese legal system does provide both criminal and civil remedies
for business fraud, there are many areas which still require further
legislation and consolidation. These
loopholes, for example, cover the indirect examples of fraud discussed
above, such as diversion of funds for the benefit of relatives/friends,
sale of corporate assets at unjustifiably low prices, culpable neglect
of directors and establishing companies in competition with the existing
entity.
Where
as such activities are covered in many Western countries through corporate
legislation, fiduciary duties, conflict of interest disclosures and
employment contract laws, the lack of legislation in China leaves
FIEs open to
large risks and potential difficulties in
prosecution.
The criminal
law essentially covers such crimes
as bribery, misappropriation of funds and conversion of funds and
property for personal use. If successfully prosecuted, criminal restitution
includes imprisonment, fines and/or confiscation and conversion of
stolen property for restitution.
Civil
legislation,
on the other hand, primarily covers misappropriation
of corporate funds or assets and remedies associated with bribery,
embezzlement and income derived from competing businesses. However,
it must be noted that whilst these remedies are available to corporation
itself, there are no such remedies
or derivative suits available to shareholders. This
ruling may cause difficulties for foreign investors who control minor
interests and/or are unable to exert Board of Director control when
pursuing fraudulent management or venture partners. After all, what
is to force a rogue JV chairman to file a civil action against himself
for embezzlement if he has majority control?
The
End Game
The
Chinese legal system is certainly rapidly changing to protect FIEs
from business fraud. At present though, the inconsistency in its application,
along with the time delays and costs associated with trials means
that prevention is certainly the safest option.
Through
conducting thorough business due diligence, undertaking annual internal
and external audits, instituting appropriate management controls and
implementing safe corporate structures, foreign
firms may be able to limit their exposure to business fraud in China.
With
so much at stake, it would appear that many foreign firms subscribe
to the Mencian teaching that "All men are inherently good". Whilst
this may certainly be implied in a safe corporate environment, it
only takes one bad onion to turn everything sour ... in anyone's philosophy.
Cameron
Hume , LehmanBrown - Beijing.
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