Keeping Your Chinese Partners Honest

Posted by Reading Time: 4 minutes

By Chris Devonshire-Ellis

Jul. 31 – A Financial Times article published earlier this week told the story of how a German businessman was cheated out of his business in China. The story, written by Jamil Anderlini, deals with the tale of businessman Heinz Zuercher, who took up a position as CEO with the Frankfurt listed media company, Business Media China, established in China since 2004.

To cut the long story short, Zuercher finds local staff have set up a parallel company and have been siphoning off media contracts introduced to them by the parent and delivering them to their own company rather than Business Media China.

One intellectual property lawyer who has worked in China for nearly two decades told FT: “There is an attitude among many in the Chinese business community that foreigners are rich and stupid and therefore fair game; that deceiving them is somehow acceptable in a way it wouldn’t be if they were Chinese.”

Meanwhile, the founder of the company stated:“My management philosophy was one of mutual trust and harmony, a merging of European quality standards and discipline with Chinese drive and knowledge of the market.”

He added that: “I realize now that the key to everything in China is not harmony but control.”

The company’s shares have plunged from €20 in early 2008 to about €0.40 now. It seems unlikely that Business Media will be able to survive. The sad thing is none of this had to have happened. However, their tale is far from being unique.

I recall a similar episode a few years ago with a Canadian investor involved in pet drugs and food supply to the Chinese market. Trusted Chinese employees also set up a parallel company and orders from the parent company were siphoned off by the company owned by the Chinese managers.

My firm, Dezan Shira & Associates, had been called in to conduct some internal audit work for the WFOE managed by Chinese staff. The staff didn’t like the idea, but as the Canadian government was involved as investors, it was felt, reluctantly, that a quick “look at the books” wouldn’t do any harm. The company had been advised by its Chinese staff that an injection of US$1 million was needed to sustain the business because “orders were slow.”

Two of Dezan Shira’s staff were dispatched to review the operations.
What happened was that the books seemed ok, but somehow the financial modeling seemed off. Our internal auditors used business behavioral models to conduct tests on how performances should be. Curious, our staff then found an unusual item: documentation related to a Chinese website.

On looking at the site, suspicions were aroused that this was a parallel company. Further digging revealed this to be so. All hell broke loose when we informed the Canadian investor – who at first refused to believe the evidence of his own eyes. His Chinese staff then tried to defame my staff in various underhand ways. However, the cat was out of the bag.

The long term upshot was that the Chinese executives are now in prison, but the Canadian company pulled out of China. It’s a story very similar to the Business Media case, and one which sadly, at Dezan Shira & Associates we have seen occur on numerous occasions over the years. Being called in to deal with a suspected problem however is often too late to save the business, although it will prevent further fraud and accumulated losses.

To make investors aware of the risks and to prepare them for structures to prevent this type of deception, we have devoted several issues of China Briefing Magazine to the very subject over the years : China Risk and Due Diligence, Cultural Differences in Chinese Financial Reporting, China Operational Risks and Mitigation, Common Mistakes and Misperceptions in China and How To Avoid Them, Analyzing Chinese Financial Reporting, Conducting Due Diligence In China, Investing in China – Practical Financial, Tax and Accounting Issues for the International SME, Managing Your Joint Venture Partner and the latest issue Operating Overseas – Compliance Issues which takes in matters such as the Foreign Corrupt Practices Act and so on. Most of these issues are also been available in German, click here.

What has happened to Business Media China would appear to be bad management on behalf of the foreign investor. The lesson – and sadly, it seems to be one we have to preach over and over again – is that in China (or in any other country for that matter) it makes sense to engage a strategy to keep your staff honest. This means not putting temptation in their way.

There are a number of quick rules or methods that can be deployed to greatly reduce operational risk:

-financial systems should be put in place that works in conjunction with head office systems;

-monthly reporting to head office of accounts, forecasts and budget performance must be insisted upon;

-a monthly (or at least quarterly) third party overview of the business accounts and operations must be implemented and the provider chosen by the parent company, not the local staff;

-sales leads, actual revenues and receivables should be thoroughly checked against known business modeling and behavior;

-the manager being reported to must have a fluent command of Chinese as well as the parent company language

-one individual should not be in control of all aspects of the local business

-sales personnel should be kept separate from accounts, and each department should have separate reporting streams

These are simple, inexpensive guidelines that are not pertinent solely to China. This is simply mitigating against business risk. The real tragedy of the Business Media case is not that it happened in China. The real tragedy is the demise of what would have been an excellent business came down to serious failings of the incumbent management.

One of the roles of foreign executives in China is to keep your staff honest. Implementing the actions above, and taking professional advice to do so would cost less than if they exposed themselves to risk that would cost them millions in the long run. Business Media appear to have failed in their obligations to recognize risk, keep their staff honest, implement internal mechanisms to do so, and seem sadly to have paid the price.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and the publisher of China Briefing.

Foreign investors concerned about mitigating risk in China may contact the practice at China Briefing is available in English, German, French, Italian and Spanish on a complimentary basis. To subscribe, click here.