Mondaq Article By RP Lawyers:China: Due diligence the Chinese way

China: Due diligence the Chinese way
Last Updated: 13 May 2015
Article by Rogier Van Bijnen
R&P China Lawyers

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.’

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