Kroll: Understanding the mind-set of the Chinese entrepreneur, how business is done in China, and recognizing the tell-tale signs of fraud

http://fraud.kroll.com/articles/pre-empting-fraud

Posted by Low Hwan Hong, Year 4 undergrad at the School of Business, Singapore Management University

Written by: Violet Ho

China: The Business Pearl of the Orient? While attractive, China has gained a reputation as a place where deals and contracts are often treated more like ideas than bona fide agreements. In recent years, however, the business climate and regulatory structure in China have improved, and many analysts predict that with a little effort and knowledge, launching a venture in China could be an effortless exercise. But to succeed, it is important to understand the Chinese culture of doing business and the mind-set of the Chinese entrepreneur.Chinese entrepreneurship has for centuries been built upon two important attributes:(1) familism and (2) guanxi, the premise of connections.Familism is the social structure by which the needs of the family are more important than any individual family member. Familism has great influence on business decisions in Chinese society, particularly since many of China’s companies are family-based. Foreign management may find it hard to penetrate this family circle of trust and secure loyalty, making it challenging to enforce corporate decisions.Guanxi refers to the personalized networks of influence these entrepreneurs possess. It is a central idea in Chinese society, which is tightly knit with informal ties and relationships, including relationships with the Chinese government in almost every aspect of social interaction. Guanxi for some companies may mean they are more likely than their competitors to be approved for loans, or they may receive relevant licenses sooner rather than later. These relationships may prove advantageous, but today’s political assets may very well turn out to be tomorrow’s political liabilities. It is essential to understand whether the Chinese partner’s strong relationship with its government counterparts is an institutional alliance based on operational strength and contributions to the local economy, or, more dubiously based on bribery.

Understanding the mind-set of a Chinese entrepreneur

First-generation Chinese entrepreneurs typically come from humble beginnings; they have tasted hardship, but in a growing economy also tasted the sweetness of wealth. As a result, they are highly ambitious and willing to take risks if they sense a maximum pay-out on their investments. This mind-set does not change when there is a transition from a private company to a listed company or from a private company to an international company, which could potentially create corporate governance challenges.

Recognizing the tell-tale signs of fraud

When investing in the “China story,” investors should not be consumed by an entrepreneur’s ambitious pitch until they can corroborate the story. When something sounds too good to be true, investors need to dig deeper.

Fraud channeled through third parties is very common in China; the complexity of schemes may be different, but the end result is the same. Investors must confirm the veracity of any intermediary contracts and acquisitions the Chinese entrepreneur is pursuing. What may come across as a legitimate revenue-generating acquisition often turns out to be an over-priced purchase of a relative’s business, which simply is a conduit to channel funds back into the entrepreneur’s pocket.

Similarly, sales revenue figures and relationships with distributors should be questioned. For example, a multinational client in the retail sector – who was once impressed by the double-digit sales growth of its China branch – appointed Kroll to investigate the reason behind large accounts receivable that were building up with distributors. Kroll found that the China branch was simply moving goods back and forth from its family-owned distributors. As per the small print in the contracts, the distributor could return all unsold goods with no penalty. The illusion of profitability boosted the company’s share price; however, reality quickly caught up and news of bad debt caused a significant drop in share price and angered investors.

In the West, many companies possess control mechanisms to limit such behavior. These include job rotations, authorization levels, segregation of duties, tendering processes for contracts and internal audits, and more importantly, regulatory requirements such as disclosure of conflicts of interest or external audits. In China, however, these measures may not be enough, especially since junior employees will rarely disagree with senior management, and internal authorization can be easily obtained when the entrepreneur’s family members are the other department heads.

Pre & Post-transaction checks

For foreign investors, conducting extensive and thorough reputation-focused due diligence before entering into a transaction is a priority. This must include a thorough background search on the partners, their business, and track record working with foreign investors. It is important to try and have a clear assessment of the entrepreneur’s true motivation, integrity, and business acumen.

The mistake many investors make is to rest on their laurels after the deal is done. Post-transaction, if possible, it is crucial to conduct an in-depth risk assessment of how the company mitigates or handles instances of fraud, bribery and corruption, money laundering, related-party transactions, and conflicts of interest. Based on the findings, appropriate anti-fraud, anti-corruption measures can be put in place, but given the challenges mentioned above; these will only be of value if managed by a local team put in place by the head office.

Where satisfactory due diligence cannot be conducted before an acquisition, regulators now expect effective post-acquisition due diligence to identify the risks in a relatively short time after the deal. The primary objective of the forensic due diligence is to evaluate the potential future loss in value resulting from inappropriate or unethical business practices of the target. This analysis generally concentrates on specific areas – inventory and supply chain management, consultancy and agency fees, travel and entertainment expenses, political and charitable donations, and cash transactions.

China should not be a place that investors shirk in trepidation; rather, it is a vibrant place where intrepid investors and entrepreneurs can do business for potentially a great reward, but only when done right.

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