Fraud and Corporate Governance in Foreign Invested Enterprises in China

By Klaus Koehler, Managing Director, Klako Group

Many small to medium-sized companies come to China with the idea that establishing their Representative Office, Wholly Foreign Owned Enterprise or even Joint Venture will be an easy and quick process. However, after going through the establishment process, hiring local employees, whether it be managerial staff or lower levels and during the startup period, foreign investors are finding that in China "everything takes much longer than expected and nothing ever turns out the way one imagines."

Problems in Foreign Invested Enterprises (FIEs) can vary from outright criminal activity to serious non-compliance issues. Many of these problems are foreseeable but due to a lack of poor management and lack of control from the foreign investors, these issues are frequent and can cause not only monetary punishments but also jail time.

Many problems in FIEs can be traced back to their initial establishment and the project's structure. There will often be a disconnection between the reality and the great expectations of the foreign investor. The incoming management will often be placed under additional pressure to meet the unrealistic expectations. It is recommended that when establishing your entity in China, a detailed business plan is created in order to make the procedure more smooth. Be prepared for unexpected occurrences and delays in the startup period.

Factors that contribute to Fraud and Corporate Governance

Lack of control and communication
Many foreign companies feel they only need to send a company representative from overseas to China once or twice a year. The majority of clients let this happen. They rarely conduct visits and the majority of the time they let the office run freely, giving complete control to the General Managers. Due to the language barriers, emails or phone calls are rarely made to check on the office. At the same time, financial reports are usually only provided for in Chinese making it impossible for the foreign investor to understand the figures being presented to him.

Turning a blind eye
Many companies before deciding to establish an entity will hire a local manager to take care of this for them. Many companies end up realizing after three or four years that in fact their company had never been established legally in the first place and they had been hiring local employees illegally. Many foreign companies fail to make an investigation as to what the Chinese legal requirements are or how to implement some form of corporate governance into their Chinese entities so as to prevent this.

Ethical Situations
Many foreign companies feel that it is appropriate to promote business activities that they themselves would never conduct in their home country, but because its China they believe they can get away with it. This is a wrong perception of China. There are numerous foreign investors who employ local staff illegally. Representative Offices do not declare their staff to the government agencies under which local staff must be employed. They pay employees in cash so that the staff does not have to pay Individual Income Taxes. This may save costs but if at any point the investor dismisses a staff member or a staff member resigns, the local employee (more often then not) will report the investor to the authorities and ask for more compensation than is required by law. The costs will be more than if the investor had followed the law.

Inexperienced Foreign Staff
It is very common in China to find young foreign professionals, straight out of university being assigned to move to China and start up the business due to their lower salary compensation wishes compared to the more experienced managers, who complain that China is a hardship living experience. There is no doubt; China is not an easy assignment. Complications arise in every business deal, and although the young professional may learn by hands on experience it is a good opportunity for him rather than the investor who is looking to expand quickly. Negotiating contracts for expatriates can also be time consuming and can deter from training and explaining the responsibilities of the China entity.

Common Types of Fraud and Non-Compliance in Foreign Invested Enterprises

Company Registration Documents

Normally the foreign investor will painstakingly negotiate or discuss the documents associated with establishing the company. Investors will often involve lawyers from both China and their home country in the negotiations of the signing of the Joint Venture contracts or the formulation of the Articles of Association. This is very good that the time is spent formulating these documents however, the same investors will often fail to conduct any follow up to see which version of their negotiated contract gets approved or what articles have been permitted by the government bureaus. The majority of the time they will put the contract or Articles of Association into a drawer. It is important for a foreign company to follow step by step the registration procedure of the entity so as to make sure no changes have been made and to make sure that registration has been completed.

If a foreign investor is establishing an entity in China, it is important to note that searches at the State Administration of Industry and Commerce can be made (without the knowledge of the Chinese partner or Chinese managers) to confirm which set of transaction documents have actually been approved and registered.

Background of Chinese partners / managers

For the establishment of any Joint Venture, internal audits should be conducted into the company of the Chinese Partner in order for the foreign investor to be aware of the company's immediate status in terms of any debts or loans that may be outstanding. The audit can also confirm who is the legal owner of the land and buildings, if there are any trademarks, who is the proper/registered owner/user and what are the fixed assets of the company.

Whether doing an internal audit into the Chinese partners company or into his personal background (as should be checked for all General Managers), it is also advisable for foreign investors to conduct internal audits into their newly established entity through an external company (outside perspective) regularly in a year, for example on a quarterly basis before tax filing occurs. It is common for foreign investors to find out through these internal checks that their Chinese counterparts have been declaring false amounts on invoices in order to pay less taxes or in some cases changing balance sheets and cash flow statements in order to have a Profit and Loss that is suitable for their needs rather the needs of the foreign investor. Internal audits often discovers anomalies which lead to further discoveries. However, it is impossible to guarantee that all secrets will be found through an audit.

Corporate Governance

Overview of the Organs of the FIE

Board of Directors or Executive Director - The Board of Directors is the supreme power of authority, however if the company, such as a WFOE is being invested by a sole proprietor, he has the option of being the Executive Director which also means he will be the General Manager. There is no legal requirement for the General Manager to sit in the Board of Directors. Indeed, it is better to have the functions separated.

Option of an Independent Director - It is rare but perhaps useful to have an independent person familiar with China in the Board. This person is not independent completely, but is able during the startup period to provide an objective viewpoint of what is normal practice in China. It should be noted that the majority of consultants, lawyers or independent parties will tell a different story of how China operates. It is advised to obtain second opinions but always remember that if the opinions do not match, this is not out of the ordinary. Choose a consultant or lawyer or independent party that makes you feel comfortable in handling in your China plans.

Board Meetings - It is shown that with regular Board Meetings, less fraud-related problems occur. Although a Board should not have necessarily operational control of the entity, they should exercise their supervisory function. It is recommended in the initial startup period to have Board Meetings three to four times a year rather than the required one time a year. It is also important to send people from the foreign investors company to China in order to do spot-checks. This will keep the Chinese partner or General Manager on their toes.

Chairman - He is important because he is the legal representative of the company, which is default by law. In the eyes of the authorities he holds a the highest and most powerful position within a Joint Venture and WFOE. In the case of a crisis the role of Chairman becomes crucial.

General Manager - The General Manager is responsible to the Board. Unlike many other countries the General Manager is not the legal representative of the Joint Venture or the WFOE, despite being responsible for the daily operation of the company. It is more frequent that frauds take place in WFOEs compared to Joint Ventures because the Chinese partner will monitor the activities of the foreign appointed General Manager much more closely. Typically Chinese General Manager's will want to be legal representative of the company so that they hold some power and authority in the company as the legal representative is mentioned on the Business License of the company.

Chief Representative - This is the position of "legal representative" , but in a Representative Office. The same guidelines should be noted as above.

Management - Check the background of each personnel as most resumes are embellished. Virtually everyone working in China appears to be a General Manager, Division Manager or Department Manager. It is important to not only check the resume and references but also to contact the previous employer (who are normally more forthcoming by phone) for more details. This should particularly be done for the General Manager or Chief Representative position.

Set Guidelines for Employees - Many of the problems FIEs meet with is due to a lack of clarity in what is authorized and what procedures are to be followed. It is recommended to prepare internal guidelines / management directives (typically known as management by-laws). The employment contract is important for the overall security of the company. However as usual one cannot always rely on contracts alone. Contracts should include confidentiality and non-competition clauses and it is recommended that they be drafted by China law firms. An employee handbook should be provided to all employees. Foreign managers should learn what the relevant laws are for employees in China. Implement these laws together with the company policies.

Meet all the Employees - Every case of incompetence, fraud or deliberate non-compliance is known by someone within the company who is willing to tell. It is important for the foreign investors to maintain contact with persons other than the General Manager or Division Heads. Naturally the authority of the General Manager should not be undermined but it is also reasonable for the headquarters to be exposed to skeptical or critical voices within its subsidiaries. Naturally, not all rumors or critical statements can be accepted at face value. However, such information will provide headquarters with guidance as to which areas should be investigated in particular during the internal audits.

Conclusion

It is a mistake for foreign investors to either become extremely nervous about their China operations or to be excessively complacent. Fraud and non-compliance issues for many FIEs are serious issues and in the majority of cases these companies already have their suspicions. Common indicators are abnormal transactions, high turnover of staff (in some cases no turnover at all), fluctuating bookkeeping records and possibly no profit-making for overly long periods of time.

It would be wrong to second guess every decision by the management in China. It would be wrong to expect everything in China to operate like back home. However, it is equally wrong to place blind trust in management and accept any problem which arises in being "that's China".

If you require assistance with the above subject, please contact us at info@klako.com with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.