Due Diligence in China: Protecting Your Business from Fraud, Reputational Risks

Posted by Written by Thibaut Minot Reading Time: 6 minutes

China due diligence

Fraud can take many forms and may be perpetrated both internally by actors within an organization, or externally by third parties that interact with it.

In our final and third article in this series, we dig deeper on the most effective due diligence strategies to protect your China business. We also elaborate on establishing transparent standards for monitoring compliance to programs.

Due diligence in China: HR best practices

Internal fraud can be limited by performing a thorough background check on key personnel prior to onboarding them into the organization.

Prospective employers should pay close attention to fictitious credentials, undisclosed criminal records, or more commonly, a poor past performance record with previous employers.

In China, it may be difficult for expat managers or the overseas HR team to spot the red flags and identify a suspicious profile within a pile of CVs received.

To combat this, HR managers in China can verify the candidate’s criminal record, perform a face-to-face interview early-on in the interviewing process (or a video call if the recruiting manager cannot physically travel to China), ask to see the degrees and certificates, as well as request references from past employers – and actually contact these persons.

Once the staff is recruited into the organization, it is essential that their labor contract and the employee handbook make references to the corporate code of ethics and stipulate what forms of fraudulent behavior justifies a termination of employment.

Vetting third-party vendors in China

External fraud, on the other hand, takes place from outside the organization and is perpetrated by third-parties. A common example is where suppliers take advantage of lenient customers.

Indeed, it is not uncommon for foreign businesses to be deceived by their Chinese suppliers, such as in the non-delivery of goods upon purchase, the delivery of goods of unsatisfactory quality, or internet fraud from the part of fraudsters disguised as suppliers.

However, there are many ways a company can reduce their risk exposure to external fraud.

For example, they can conduct a discrete investigation of the perspective supplier, including a review of the Administration for Industry and Commerce (AIC) company records, a verification of the business’ financial performance, and asking for references from existing customers.

It is also advisable to go meet the potential supplier face-to-face prior to signing a deal and to visit the supplier’s factory, or otherwise appoint a trusted person or third-party agent to do so on your behalf.

Finally, it is always advisable to start with a minor purchase order to limit financial risk in the event of fraud, as well as to sign a robust supplier contract stipulating the supplier’s obligations and the clients’ rights and reparations in the event of breach of contract. The company’s code of ethics should also be imposed on suppliers through the contractual relationship.

Performing similar due diligence on other third-parties, such as prospective distributors or joint venture partners (JV), is also advisable.

Implementing robust China KYC policies

Foreign companies are often held accountable in their home country for their choice of business partner in China. For example, the U.S. Department of Justice is now vigorously enforcing the Foreign Corrupt Practices Act (FCPA) overseas and cracking down on corrupt practices perpetrated by American businesses and their affiliates in China.

Implementing robust Know Your Customer (KYC) policies may be particularly important for firms operating in the financial services space, and more generally for all the actors subject to anti-money laundering regulations both in China and at home.

Moreover, industrial espionage and IP infringement are still prevalent concerns in China, and the threat may very well come from customers – hence the need for a China KYC strategy. Failure to flag operational, financial, and legal problems when deliberating over a prospective JV partner or incoming investor can also prove extremely costly.

It is therefore vital for foreign companies to conduct a critical assessment of their resources and business practices at every stage.

Doing so ensures that the foreign company is in a position of strength to make informed decisions, for instance, at the deal signing stage and limits its exposure to financial and reputational risk that come with doing business with an incompliant partner or fraudulent customer.

Internal control at your China subsidiary

Internal control mechanisms are unlikely to be effective if fraudsters perceive that irregularities go unnoticed or unpunished within the company. Hence, fraud prevention programs must be coupled with monitoring systems and response strategies.

The company’s internal controls should be periodically reviewed to ensure that their effectiveness is maintained over time. One option available to monitor compliance at the local level could be to engage a third-party resource to perform periodic internal audits and fraud risk assessments on the Chinese subsidiary.

In this sense, it is important to work with a firm able to assess the strengths of fraud prevention mechanisms and investigate any irregularities observed, going beyond a high-level review of financial statements.

Many businesses in China still rely on a yearly statutory audit performed by a local CPA to assess the soundness of the accounting work and management practices; in reality, the yearly review work normally provides little guarantees against economic crimes.

Compliance can also be monitored by resources internal to the organization. When fraud is perpetrated within an organization on a recurring basis, the occurrence is likely to be noticed by other staff.

It is thus essential to provide employees with the tools to report any fraudulent behavior they observe, such as having whistleblower programs in place. Such programs must be localized to the China environment if they are to become effective.

For example, by offering a Chinese-language hotline as well as generating language- and culture-specific awareness on the programs within the China work environment.

If the data collected is to be efficiently analyzed, the forms need to accurately reflect the local company structure and contain questions likely to generate informative replies.

Conducting internal investigations in China

It is important to react quickly once fraud is suspected and gather evidence before it is destroyed. Evidence must be properly gathered through an investigation, so that it may be turned over to the police to be used in court later on.

Also, as is more commonly practiced in China, gathering key evidence provides the employer with ample bargaining power during the time that labor termination is negotiated.

Indeed, most foreign companies in China prefer not to resort to police or judicial proceedings, if possible.

These are often viewed as disruptive and costly, and the foreign party can sometimes feel at a disadvantage.

On the other hand, having gathered some evidence is helpful during the negotiation with the employee or at the labor arbitration phase, if any.

Many foreign companies would prefer to reach a mutual agreement with the employee early-on, without the case proceeding to a labor litigation or civil litigation.

Having electronic data protocols is vital to safeguard company data today – and is often the most vulnerable to fraud exposure.

One important step could be to mandate staff to use company proprietary IT software and hardware, instead of their own. Data privacy protection laws in China complicate the evidence-gathering process if that evidence is stored onto a personal laptop or mobile phone.

In China, where most business communication takes place through WeChat and financial transactions through Alipay, employees’ mobile phones are likely to be particularly rich in work-related information.

Foreign companies in China are sometimes reticent to deal with a fraud allegation to begin with, especially when the economic value of the crime is perceived to be low.

Indeed, responding to fraud could become quite disruptive for a business, especially if changes to key management personnel in China becomes necessary. The shareholders may stand to lose the management’s business relationships, informal connections, industry know-how, and much more.

As such, many investors would prefer not to react so as not to risk losing these valuable resources, especially if they see no short-term alternatives. Meanwhile, court proceedings can be lengthy and costly in China, which act as incentive for inaction.

However, this policy of leniency sets precedent for other staff. This should be considered alongside the immediate economic cost of the crime.

Tone from the top: Communicating core company values

A culture of compliance needs to be instigated by the local management, so that the tone from the top as valued by overseas stakeholders gets appropriately communicated to the employees working at the China office.

Compliance and work ethics could be included as KPIs set for local managers alongside those related to the financial performance of the Chinese subsidiary.

Additionally, local managers should be trained on local laws but also on the international compliance regulations that the overseas headquarters is subject to. This way they can understand the implications that economic crimes perpetrated in China has for the overall organization.

If the overseas shareholders can rely on the China management team to monitor and promote compliance to fraud prevention programs, they should be in much stronger position to mitigate their business risks in this jurisdiction.

This is Part 3 of a three-part series about fraud prevention in China. In Part 1, we examined what fraud looks like in China, and how to assess fraud risks. In Part 2, we highlighted five key strategies to combat against fraud in China.


About Us

China Briefing is produced by Dezan Shira & Associates. The firm assists foreign investors throughout Asia and maintains offices in ChinaHong KongIndonesiaSingaporeRussia, and Vietnam. Please contact info@dezshira.com or visit our website at www.dezshira.com.

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