Conducting due diligence in China has never been an easy task. But expansion of privacy laws and high-profile investigations of due diligence firms has made assessing business risks in China even more difficult.

Acquiring information before entering into major business transactions is a standard part of American business culture. The term “due diligence” originated in the United States as part of the Securities Act of 1933 and refers to “an assessment of the legal risk, evaluation of the viability of the target, and a review of disclosure obligations.”

American companies doing business in China or with Chinese entities have long struggled with the relative scarcity of information compared to that available in the United States. Even when records and government filings are publicly available, Chinese companies often maintain multiple sets of books, leading potential investors to distrust much of the information provided by Chinese companies. Additionally, the valuation methodology used by Chinese companies may differ from internationally accepted methodologies.

Gathering business information in China

Due diligence investigation companies in the United States use publicly available and commercial databases to ferret out every detail of the people and entities involved in potential transactions. Simple database checks in the United States yield asset information, credit history, and individual background information. More sophisticated companies can track down additional detailed non-public information so that potential partners or acquirers of the business have a virtually unlimited pool of information to use in their decision-making process.

Many of the databases and processes available in the United States to investigate businesses do not exist in China, but due diligence remains an important aspect of conducting business there. Fear of getting involved with unscrupulous business partners or suppliers created a major niche for due diligence services with local Chinese experience. A slew of foreign companies opened up shop in China to provide services to this market by offering private investigation services to multinational corporations (MNCs). These companies advertised their services as “work-arounds” to the difficulty of accessing information. Clients, often lawyers from corporate law firms, saw working with investigative due diligence firms as a way to provide their clients with business information without getting their hands dirty.

Foremost among these companies was ChinaWhys, operated in Shanghai by Briton Peter Humphrey and his American wife Yu Yingzeng, which  billed itself as a premier service for multinational companies (MNCs) seeking to protect themselves before entering into transactions in China. Humphrey wrote and spoke extensively about the need for MNCs to take measures to thoroughly vet Chinese transaction partners in order to avoid fraud.

As anti-corruption efforts increased in the United States with the expanded enforcement of the Foreign Corrupt Practices Act (FCPA), the stakes became even higher for US companies to ensure that they had sufficient information to effectively monitor their foreign operations and transactions. ChinaWhys and its competitors used a combination of investigative and forensic accounting tools to speak with people, uncover asset information and company connections, and close the loop on potential fraud both before companies entered into transactions and while China operations were ongoing.

Article 253 and the expansion of Chinese privacy laws

In the summer of 2013, Humphrey and Yu were arrested for illegally gathering personal information on Chinese citizens in conjunction with an investigation ChinaWhys was handling for British pharmaceutical company GlaxoSmithKline. This arrest crippled ChinaWhys and shocked the expatriate community and the investigative industry. Humphrey and his wife appeared on CCTV and publicly apologized for using illegal means to obtain information.

What changed that could have led to Humphrey and Yu’s arrest? One of the major sources of information due diligence investigation companies like ChinaWhys relied on was records kept by the State Administration of Industry and Commerce (SAIC). SAIC is the agency responsible for registering, incorporating, inspecting, and regulating companies in China. Prior to 2012, SAIC records relating to the formation and status of a company were accessible in full. Information including the status of a company, names and personal details of shareholders, annual financial data and annual audit reports, was available via AIC records. In the summer of 2012, China cut off access to the wide array of information that had been available via SAIC.

Moreover, China’s laws on personal data protection and the use of personal information have been expanding in the past few years. In February 2009, Article 253 of the PRC Criminal Law was amended by the National People’s Congress to make working personnel of state agencies and organizations in the fields of finance, telecom, transportation, education or healthcare, potentially subject to criminal liability if they sell or illegally provide to others, the personal information of citizens obtained during the course of such organization’s performance of their official duties or provision of services.

In early 2012, investigative firm Dun & Bradstreet was investigated by Shanghai authorities for violations of Chinese consumer privacy protection laws. The government investigated practices in the Shanghai Roadway D&B unit. State television reported that Dun & Bradstreet had obtained private information from banks, insurance companies, and real estate agents including income levels, jobs and addresses for some 150 million Chinese residents and had sold individuals’ details to marketing companies. As a consequence, Dun & Bradstreet shut down the troubled unit a few months after the investigation.

After Humphrey’s arrest, due diligence and investigative companies have continued to operate throughout China, but their actions have gone further underground. While ChinaWhys employees published articles and spoke publicly about their tactics and strategy considerations, the investigative companies that remain in China have stopped sharing such information about their services and instead have kept a lower profile.

Consequences of the information gap

Making a wrong decision based on incorrect information and subsequent assumptions can have dire and immediate consequences. The sense among investors that some Chinese companies do not provide accurate information can lead to a drop in value and, ultimately, to a delisting of public companies. According to McKinsey Quarterly, “the aggregate market capitalization of US-listed Chinese companies fell in 2011 and 2012 by 72 percent—and around one in five was delisted.” A major factor in the delisting of Chinese companies is the widespread perception that the information available on these companies is incomplete and unreliable.

The Chinese government and MNCs have a shared interest in reforming the recording and accessibility of information. The expansion of laws governing personal information and the restriction of SAIC records has constrained foreign investment and created a riskier market for prospective investors.

China will need to find a balance between protecting personal information and allowing investors to make informed decisions. Expanding external access to registration and shareholder information and ensuring that companies accurately report such information will reduce the demand for underground investigative services to perform standard due diligence functions. Once a higher level of mutual trust has been established between the Chinese government and foreign investors, the level of confidence in Chinese companies listed abroad will also increase, and the stated Third Plenum goals of economic expansion and a decrease in corruption will be advanced.

In the interim, while reform of access to information is still pending, companies are left with limited options in pursuing transactions with Chinese parties. Rather than safely relying on accessible information databases or on underground investigative services, businesses must tap into existing informal networks of information. Leaning on information obtained via contacts operating in China (or contacts of contacts) is one potential source of reliable, if not systematic or quantifiable, information on the trustworthiness of potential transactional partners.  Additionally, companies can directly ask their prospective business partners to provide them with accurate financial documents including tax filings and registrations as a condition of entering into transactions. By hobbling together the sparse existing sources of official information with word-of-mouth information garnered from contacts and self-provided information, some companies will be able to obtain satisfactory results and approach deals with a measure of confidence. However, this approach requires constant diligence and an element of blind luck that may detract some potential investors or dealmakers from entering the Chinese market or working with Chinese companies.

[author] Pooja Nair is an associate at Foley & Lardner LLP, where her practice focuses on e-discovery, business litigation, and white collar criminal defense. She can be reached at [email protected]. [/author]

(Photo by Jonathan Poh via Flickr)

Posted by Christina Nelson