China: Due diligence the Chinese way

Last Updated: 25 November 2015
Article by Rogier Van Bijnen

When I open the door of our conference room, I meet the counterparty for the first time - an older American gentleman and his Chinese (female) business partner. He has built a very successful global business, and has given her a carte blanche to run operations in China. Our client intends to buy all his non-Chinese activities and expressed interest in the China business as well, but only wants to decide after thorough due diligence. We're not even five minutes into the meeting when she suddenly starts shouting at her business partner that she hasn't seen any money yet, so she doesn't understand why he wants to give our client all kind of information about their business.

Once things have calmed down, we walk them through our bilingual due diligence questionnaire: 'Audited accounts over the past three years?' 'We don't have this.' 'Labor contracts?' 'All verbal.' 'Contracts with your customers?' Sometimes in writing, but usually all done over the phone. By the way, we won't disclose the identity of our customers until you have paid.' While we cover other topics in a similar way, I'm more and more relieved that our client only intends to buy their assets (primarily client relationships) in China, and not the equity in the company (which would come with a whole range of potential unknown liabilities).

Once the counterparty has left, I explain to the client that I can already predict the outcome of our due diligence: we will receive a shoe box with some random documents and there will be no such thing as a real "company", which is what his management in Europe believes there to be. The most important question in this case - whether the customer relationships at the heart of this transaction really exist - can probably only be answered by verifying the purported revenue received from these customers on the basis of bank statements and VAT payments. We will literally look over the shoulder of the target company's management when they log onto their bank account and the online tax registration system.

This story is not unique - even though our clients tend to focus on somewhat more sophisticated targets, the issues we generally encounter do not differ that much. Chinese companies are often quite reluctant to provide information or to fully cooperate with our due diligence. They quickly come to the view that information is commercially too sensitive to share and the Western style due diligence questionnaires are way too detailed and serve no clear purpose.

The result is that important information is often not disclosed, or if it is, only very late in the process. It is not unheard of for Chinese counterparties to deliberately withhold information that is unfavourable to them. Sometimes this is done by senior management who does not want to jeopardize the transaction, and sometimes by individual employees who made a mistake and don't want to lose face. One step further, intentionally providing incorrect or misleading information, is unfortunately not an exception either.

A recent eye-catching example is Caterpillar, which was forced to write off USD600m on a Chinese acquisition after inventory listed on the target's balance sheet turned out not to exist. In another case Deloitte had to let a listed client go after discovering that this client falsified bank statements to claim non-existing cash reserves, which reserves were independently confirmed by some of their bankers who were also part of the scheme.

Why do so many cases go wrong? In my view, an important reason is that it is far from easy to find good acquisition targets in China. Many of our clients face heavy competition - whenever there is a good target, the whole world jumps onto it - and often there is pressure from headquarters to push that China deal through. When, after months of lengthy negotiations, there is finally agreement on the commercial issues, nobody wants to hear that there are still outstanding issues from the due diligence.

Another reason seems to be that Western companies are much less prepared for fraud. In Europe or the U.S. one often starts with the assumption that a document is genuine unless there is an indication to the contrary, but in China I always take the exact opposite approach. When the other side is intentionally deceiving you, it often takes a full, multi-disciplinary due diligence to unravel this. Another good method is to imagine various ways of how the other side could defraud you, and then systematically rule these scenarios out during due diligence.

Whenever we start a due diligence exercise, we identify the key line items on the target's balance sheet and P&L and then try to verify each of them bottom-up during our investigation. This requires close cooperation between the various teams - if we take the target's annual sales volume for example, we lawyers need to confirm that this is backed up by written contracts, while the financial team needs to check that the payments have been actually received, and the technical/commercial team should confirm that it is likely that the target indeed physically produced such volume. It is quite difficult for the target to manipulate all these data points at the same time.

Such extensive due diligence is of course more costly than a high-level due diligence as is often seen in the West these days, but trust me, being scammed will turn out to be way more expensive.

In case you wonder what happened to the case at the beginning of this article: while we are still in the midst of our due diligence, I receive a phone call from the client that their board has approved the transaction and requires the purchase agreement to be signed as soon as possible. 'How about the due diligence?' I ask. 'Oh, almost forgot about that, just send me a summary or something. I trust them, it will all be ok.'

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Rogier Van Bijnen
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions