China Due Diligence - Red Flags to Avoid Some of the Pitfalls
- 1. 1Credit Control China Due Diligence – Red Flags to Avoid Some of the Pitfalls John Besant-Jones and Marcel Wiedenbrugge Abstract China is full of wonderful investment opportunities but as many predecessors have found out, it is also full of fraud risks that could be avoided or at least minimized if appropriate due diligence steps are taken with proper awareness of the red flags. Frequently, these risks are not the same as those contained within Western companies. Lots of clues can be found on the ground and in the accounting financial statements of Chinese companies, providing useful leads for further investigation or the conclusion that it is simpler to just walk away. Spending just a small amount of resource on this critical process may itself be one of the best investments you ever make, because it could save you losing many millions at a later date. In this article, the authors give a whirlwind tour on what to look out for and include a mini case study as an example to start you off. Introduction It’s almost an irresistible opportunity. Your company has the chance to invest in a business located in a huge and fast growing economy. The target is an Analysis www.creditcontrol.co.uk Biography Marcel Wiedenbrugge is the principal and founder of WCMConsult (Netherlands). He combines knowledge and experience in account management/sales, credit management, service management and related software solutions. Marcel is an entrepreneur, consultant and writer on business process improvement, and aims to bring finance and commerce closer together by developing integrated business models. He develops and conducts trainings and workshops and undertakes credit management market research, with a focus on Asia Pacific, in particular China. He is the author of ‘The Customer Profit Maxim’ www.customerprofitmaxim.com and can be reached at: marcel.wiedenbrugge@wcmconsult.com or www.wcmconsult.com. John Besant-Jones is a special situations research analyst for Asian companies and owner of Red Flags Consulting LLC. He has worked for banks such as Credit Suisse, ABN and Barclays. John also holds an MBA in Chinese Business from the Chinese University of Hong Kong, an MA in Finance & Investment from the University of Exeter, and a Bachelor degree in Engineering. John is also a member of the Continuing Education Committee for the Hong Kong Society of Financial Analysts, which is the Hong Kong branch of the CFA. See website www.redflagsconsulting.com or contact John on jbesantjones@redflagsconsulting.com. John’s professional profile can be found on LinkedIn https://www.linkedin.com/pub/john-besant-jones/1b/5aa/865 Marcel Wiedenbrugge Founder WCMConsult Keywords Due diligence, Accounting, Fraud, China, Asia, Financial statements, Red flags Paper type Research, Case study John Besant-Jones Founder Red Flag Consulting
- 2. www.creditcontrol.co.uk operation similar to your own, so you have the familiarity for a successful business model. There are numerous areas where efficiencies can be made and growth stimulated. Better still, the price of entry looks great. Yet despite all this, many foreign companies and investors have traveled down the same path of thinking and run afoul. Why? The answer is lack of proper due diligence, or to phrase it better, not being aware of what can go wrong and how to avoid it. We address just a few essential issues to increase your chances of being one of China’s more successful foreign investors. Basic due diligence It is much more than just visiting operations on the ground. Rigorous checks in all areas are needed to make absolutely sure that you get what you are paying for, and avoid what you don’t want. Chinese companies sometimes have complicated ownership networks, and these need to be fully understood so you know where the profits are really generated and what you are really buying. Conducting business using personal relationships is very important in this region, yet that does not mean the seller will always truly be your new best friend. The due diligence process should be critical, but not so rude as to send insulting signals. You are also investing in something for the future, not just today, and the seller may have personal friends who are important suppliers and customers that you want to keep. Most of all, you want to make sure the seller and yourself have a common and continued interest to make the business successful in years to come. Without this common interest, there is a greater chance that something can go wrong. Very basic checks can be for: Basic financial due diligence Schemes that inflate revenues and profits, or make false claims to asset ownership are among the most common hazards. Forensic accountants can 2 Credit Control Analysis • • • • • • • The manufacturing and storage facilities for existence, ownership, condition, capacity and activity, as well as staff numbers to ensure that everything matches what is being portrayed on the books. A reality check with the competitor environment. If there are plans for expansion or radical changes, the relationship with local authorities and central government can be especially important. Inventory levels and product quality (preferably over a longer period of time). A sensible supply chain and verifiable customer/supplier relationships. Newly posted signs that may cover up facilities that could be owned by someone else. The company chops, which is the official seal used in business transactions.
- 3. 3Credit Control provide great value here, and their findings can be merged in with discoveries elsewhere to create a better overall picture of what is actually going on. The quality of record keeping can be variable, and may not match the standards of your own company. There can be two or even three sets of books – the books that you see, the books with the real numbers, and the books used for taxes. Written contracts can be less extensive and verbal agreements are common. Rural regions require an even greater level of scrutiny because of lower quality documentation. These factors may restrict the ability of forensic accountants, which is why other aspects of due diligence are important. Features to look out for are numbers that look unusual, and if there is an explanation for this, consider its veracity. Search for: Analysis www.creditcontrol.co.uk • • • • • • • • • • • • • Excessive account receivables or account payables relative to the income statement or balance sheet. Unrealistic asset values compared to industry and local norms. Mismatches between physical inventory and inventory valued on the books. Significant cash transactions that reduce the paper trail. Dominant customers may present a credit risk, while dominant suppliers may present a supply chain risk. In both cases, there is higher potential for collusion. Hidden liabilities, including the potential for much larger than expected funding requirements in the future. Fake bank statements and invoices. Bank statements should be verified at the central branch level, not the local branch. Falsified purchase orders, invoices, shipping documents and receipts. Original documents for asset ownership. An independent valuation report for property and buildings. Undisclosed side agreements and transaction documents that do not have genuine official seals. Staff members that have two or more different names. Weak internal controls. These are cited as a contributory factor in almost every post analysis of fraudulent activity of a company.
- 4. www.creditcontrol.co.uk Also take in to account cultural differences. For example, bad debt is an issue that some Chinese may not like to provide for because it is sometimes associated with losing face. It may also not be tax deductible. Hence the bad debt charge could be too low. In some instances, unwritten down bad debt can be shifted in to “Other Receivables” to make it appear that trade receivables from normal business activities have kept a good collection track record. Awareness and detecting more sophisticated fraud strategies Many fraud strategies are able to overcome basic due diligence checks for the more obvious red flags, such as excessive account receivables and fake bank cash balances. These are often assisted by third party networks that are close friends, family members or relatives. Sometimes a third party relationship can be hidden with the use of puppet nominees, such as low level staff members. Round tripping is a good example of that; sales, bank cash balances, receipts, operations and asset ownership can all appear real. The method typically tunnels out cash from the business to provide hidden forms of financing to customers, who in turn use these funds to purchase products from the company with the intention of artificially inflating revenues, profits and ultimately its value. Round trip financing to the customer can be achieved in a variety of ways, either directly such as payments cloaked in apparently legitimate transactions, or indirectly such as undisclosed loan guarantees. Other examples include rerouting products made by another business through the company’s own channels and claiming all the revenue as its own, or the company states it owns certain key assets that are really owned by another party. Participating third parties may ultimately be related via nominee ownership structures disguised by secrecy laws in offshore jurisdictions such as the Cayman or British Virgin Islands. These methods frequently adopt the tunneling and propping concept, a well-known fraud strategy in China. Tunneling is used to covertly get assets/cash out of the company or increase its liabilities, for example to misappropriate or round trip, and propping is used to inflate the sales, profits and asset values/ownership of the company –most often as a way to increase its value or credit worthiness. The strategy relies heavily on the abuse of guanxi, which are close business networks in China. More detailed checks to uncover these techniques may include: 4 Credit Control Analysis • Differences between accounting policies in China and that of your own organization. • • Extensive activity and ownership checks on the company, its customers, and its suppliers should be made all the way up to the ultimate ownership level. If possible, check the company’s and its counter parties’ tax records – no one wants to pay real tax on fake or round tripped transactions.
- 5. 5Credit Control Obey the law and use it as a great tool to find red flags It is not ok to only selectively adhere to corporate law in China, even if you think some domestic Chinese companies are getting away with it. PRC corporate law is often vague, complex, and open to interpretation, and may be applied more rigorously to foreign companies. Moreover, if a legal dispute arises, and there is discovery that your company was in breach of any law, related or unrelated to the dispute, the chances of a successful outcome in court may be drastically reduced. There is also the possibility of inadvertently violating laws in your home country, such as the Foreign Corrupt Practices Act for US companies, or laws on regulation and compliance if your company is a stock exchange listed corporation. Always conduct your due diligence within the bounds of PRC law. You are strongly advised to get a very good PRC corporate lawyer. PRC law should at least be considered at the asset, operating, and entity levels. Areas to watch out for include valid business licenses, restrictions on foreign ownership, taxation, and foreign exchange. For example, make sure you do not pay a deposit to buy a company operating in a foreign owned restricted sector – the deal will not happen, you have wasted your time, and have the uncertainty of getting your deposit back. There may be PRC law restrictions on the amount of foreign loans a company can borrow relative to its registered capital; this needs to be factored in to future financing requirements. Different types of foreign investment may have different applicable laws, such as Wholly Foreign Owned Entities, Equity Joint Ventures or Contractual/Co-operative Joint Ventures. Variable Interest Entity (VIE) type of structures are sometimes used to get round foreign ownership restrictions or to speed up Ministry of Finance and Commerce (MOFCOMM) approvals. These VIEs are contractual arrangements that give the recipient the right to future economic benefits of the business, but at best have precarious enforceability in PRC courts, may have substantial offshore cash flow repatriation limitations, and ultimately there is no direct equity Analysis www.creditcontrol.co.uk • • • • Verification that there are no assets or cash used for loan guarantees of any form, and if so, to who. A comparison to see if the company is performing inexplicably well compared to competitors is useful. Applying commercial and financial common sense can reveal a great many red flags. For example, a big red flag giveaway is the co-existence of large amounts of cash and debt on the balance sheet – it usually makes no sense to have both in sizable amounts, and could indicate that either the cash may be fake or it cannot be spent because it is locked up as security in an undisclosed financing deal-which also means there is a hidden liability.
- 6. www.creditcontrol.co.uk ownership in the target company. Moreover, there is a high risk that in the future such VIE arrangements may be outlawed if the ultimate contractual beneficiaries are non-Chinese nationals. Ownership documentation can be questionable, particularly for land use rights. If the target company does not have the original title to land use rights because there is an excuse such as it is waiting for them to be converted in to its own name, be very wary, even if a deposit has been paid. If the target company previously had the business practice of not fully paying all taxes, or making inadequate provisions for mandatory employee social benefits, statutory reserves, selling inferior goods, operating without licenses, paying “commission” or “consultant fees” to certain customer employees to get business, etc, do not assume that under foreign ownership the business can continue this, or that it will be as profitable if these practices are discontinued; this effectively means the acquisition target may be worth less than the historic books show. Beware of tax avoidance strategies such as transfer pricing – the Chinese are well aware of these schemes and they are deeply frowned upon. 6 Credit Control Analysis A Mini Case Study – Faking financials to gain bank acceptance notes Litigation releases from the SEC against a US stock market listed company provide an interesting case study on what to look out for. Fortunately, the company auditors were diligent enough to spot what was happening. The company, we shall call it “the purchasing company”, produced cellulose ether, primarily used in the PVC, cosmetics, foods, and paints industries. Although it was based in China, it was incorporated in Delaware, and was listed on the US OTC Bulletin Board. The case is relatively complex, but this is the minimum level of understanding needed to reach an appropriate level of due diligence awareness, and it incorporates many of the points made in this article. This was for a fully audited company to US Generally Accepted Auditing Standards (GAAS) by a relatively well-known auditor; many Chinese companies are audited with arguably lower auditing standards using less well-known local firms. The contested activity centres on the obtaining, use and disclosure of bank acceptance notes. A measure used to assess credit risk was faked. These bank acceptance notes were gained by creating fake purchase orders in collusion with a related third party supplier. In China, the scrutiny from banks issuing acceptance notes is often considered a less rigorous process than that used for standard bank loans, hence it is a vulnerable area. It should also be remembered that what may be considered as normal business practice in China could be interpreted as an invalid activity from the perspective of Western companies and regulators. The SEC alleged that in 2011, the purchasing company indirectly obtained bank financing by issuing fake purchase orders to one of its suppliers. This supplier was 100% owned by the CEO and President of the purchasing company, and thus was a related party. The fake purchase orders and accompanying invoices were presented by the supplier to banks so that bank acceptance notes could be issued. The subsequent funding received
- 7. 7Credit Control Analysis www.creditcontrol.co.uk by the supplier were either routed back to the purchasing company, or kept by the related party supplier for operational needs. In the context of tunneling and propping, the tunneling was the creation of a bank acceptance notes liability, whereas the propping was the subsequent cash received by the company. The SEC litigation release states it was the banks that paid respective cash to the supplier, however the supplier could also receive cash by selling these bank acceptance notes at a discount in to a secondary market. The SEC also infers that the bank acceptance notes were mischaracterized as notes payable owed to third parties but this may in fact be two transactions rolled in to one; the first being the undisclosed creation of a bank notes payable for purchasing company, and the second being the passing of cash from the supplier to the purchasing company, which was then classified as a inter- company loan from the supplier to the purchasing company. The chart above illustrates what happened: In the balance sheet of the purchasing company, a liability disclosure was made in the form of “Notes Payable – related party”, but there was no disclosure of the full amount of all notes payable to banks. In the cash flow statement, the related party notes payable were presented in the financing activity section as a cash inflow “Proceeds from loan from a related party”. As security for the notes, the purchasing company apparently deposited between 50% and 100% of its cash, which then became restricted cash. In some respects, this is an indirect form of round tripping using falsified orders to a supplier that was part of the purchasing company’s related party network, and is an alternative scenario to more well-known and direct round tripping schemes that use fake sales. In this particular situation, the purchasing company had an undisclosed liability to
- 8. www.creditcontrol.co.uk8 Credit Control Analysis banks, but only described a loan from a third party as part of the transaction chain. Moreover, financing had been obtained by means that may be considered illegal in China, hence exposing the purchasing company to potentially immediate demands for the funds to be returned to the bank. There were a number of red flags for this type of activity, many of which could be found by simply reviewing the purchasing company’s accounts, including: • • • • • • The related third party nature with its supplier increased the risk of collusion to obtain mutual benefit – In this case, the related party nature was disclosed, but in many cases it is undisclosed and investigation is needed to discover its true status. The size of the respective purchase order was disproportionately larger than the company’s business activity – According to the SEC allegations, the fake purchase orders totaled some US$40 million, which was over ten times higher than the estimated actual delivered orders from that particular supplier, and well over the company’s estimated annualized total cost of sales, for all related goods produced and sold in that year. There was an unusually large increase in restricted cash – During the period under investigation, standard short and long term bank loans remained virtually unchanged, and declared notes payable owed to banks fell substantially. But at the same time, there was a substantial rise in restricted cash (typically used as security for bank loans). This strong rise in restricted cash contradicts the direction of the company’s overall declared bank debt obligations. In contrast, there was a significant rise in notes payable to a third party. This leads to the suspicion that there may have been company cash used as security for undisclosed bank debt obligations, and that the money apparently borrowed from a third party used cash sourced from these undisclosed obligations. The purchasing company claimed it made restricted security deposit between 50% and 100% of the face amount for its disclosed bank acceptance notes. Using restricted cash as security for 100% of the face value for bank acceptance notes makes the effort of obtaining these notes seem a bit pointless. It is more likely that the restricted cash secured between 30% and 50% of the notes total face value, hence the total amount of notes were larger than disclosed. The purchasing company had serious underlying cash flow problems – Operating cash flow was very negative, and as a result the purchasing company had clear funding requirements from external sources. PRC banks tend to limit the amount they lend to non-State Owned Entity (SOE) companies, and often only accept certain types of assets as loan security. In the case of this purchasing company, the amount of standard bank debt the company had obtained already appeared high. It was a logical choice to use bank acceptance notes as further means of financing. Direct lending from one firm to another is illegal in the PRC – Unapproved non-financial institutions are not permitted to extend any direct loans to each other; an approved financial institution as an intermediary must be used. Yet the purchasing company accounts make clear statements such as “Proceeds from
- 9. 9Credit Control Conclusion It is often better to be safe than sorry. There is no doubt that China is a wonder- ful place to do business but if you have unanswered concerns then walk away. Legal recourse may be limited in a subsequent dispute, very expensive, and could take years to resolve. You might have lost money by spending on the due diligence, but by being cautious you prevent a much greater loss, and gain some great experience about what to look for next time. Analysis www.creditcontrol.co.uk loan from a related party”. While this suggests the potentially illegal activity of direct lending between two companies took place, it is possible that the management of the purchasing company directed their 100% owned supplier to “give” the purchasing company the cash without recourse instead of lending it, but chose to describe this event in its audited books as an intercompany borrowing transaction for the purpose of explaining the cash inflow in its US SEC filings. The footnotes in the purchasing company accounts curiously describe this “loan” as non-interest bearing with no fixed terms of repayment, which could create a gray enough area for the definition of an intercompany loan under PRC law. Moreover, it is possible that indirect lending can be made using an entrustment loan, which is legal in China. Questions also need to be asked about whether the 100% owned supplier should have been consolidated on to the purchasing company’s balance sheet. Although there is no suggestion of this by the SEC, the bank acceptance notes financing potentially gives the related third party supplier an extra ability to provide goods at discounted prices, which may temporarily boost profit margins and give a false impression of higher profitability for the purchaser. Moreover, there is the potential for the funding recipient to misappropriate the cash, or covertly pass it on to a customer of the company to enable round tripping in the form of purchases. There are numerous scenarios to consider.