Due diligence in China

For Canadian companies looking to do business in China, no matter the business model, whether through trading, investment or joint research, the key is to find the right partner.

While China’s legal system has made great progress in becoming more business friendly, legal and regulatory enforcement in China can still be unsatisfactory. As a result, prevention and preparation is key to success in the Chinese market. Due diligence is a prerequisite for any transaction with Chinese parties. Canadian companies involved in problematic cases could have avoided or minimized their issues through thorough and extensive due diligence at the front end of their business planning.

The following contains some situations that careful due diligence can help you avoid: Frauds and Scams in China.

On this page

• A checklist for conducting due diligence
• Best practices
• Watch our YouTube videos
• Where can you get assistance with due diligence?

A checklist for conducting due diligence

Operational due diligence to confirm the identity and legitimacy of business partners

It is ultimately your responsibility to make sure that you are dealing with a legitimate company. It is mandatory for a Chinese company to register with State Administration of Industry and Commerce (SAIC) or local SAICs, the government agency in charge of all business registrations. The registration information is accessible on most local SAICs’ websites. This provides an effective way for you to verify the information with what you have been told by the local company, such as the registered capital (indicating the amount of legal limited liability), registered legal person, registered address, scope of activity as permitted, and license expiry date.

Compliance with the business license can be an indicator of the reliability and longevity of the company.

Furthermore, it is relatively common to not be dealing with the person listed on the business license. That said it is still important to confirm whether the person you are dealing with is who they claim to be or whether he/she has the negotiation/decision-making power in the company they represent.

Financial due diligence when considering joint ventures or mergers and acquisitions

Once you are confident that you are dealing with a lawful entity, you should consider the Chinese company’s financial accountability, especially before significant transactions. Below are some recommended areas where you can begin your investigation.

For a listed company, look into the equity structure, percentage of shares, capital availability ratio, forms of investment, major shareholders, etc.

Financial statements and cash flow statements are hard to access in China. But balance sheets, which provide useful information on current assets, current debts and long-term liabilities etc., can be obtained through certain channels.

Other financial information you should consider include bank statements, bank loans or credits with any financial institutions or private lenders, real estate mortgage records (either the company's or a founder's), debt records, promissory notes, letters of credit, government grants, subsidies, etc.

It is worthwhile involving a professional service provider to conduct financial due diligence due to the limited open channels to the public for accessing financial information in China.

Reference Check and Third-Party Evaluation

A well-established company should always be open and ready to provide references. The company’s suppliers, customers, even competitors, are all good references. A company with a single supplier or limited market may entail more risk. Depending on the nature of the potential transaction, it would be useful to learn about the company’s:

• procurement policy, quality and frequency, and payment status from its suppliers;
• sales channel, sales markets, market segments, numbers of customers; and
• relationships with customers, etc.

You should also obtain a description of their business with foreign companies, request names of coordinators, and if possible speak to references that speak the same language as you.

Best practices

Take nothing for granted

You put your business at risk by making any assumptions with potential business partners. Even though the majority of Chinese businesses want to act in good-faith, proper due diligence will help weed out the problematic cases. Even for vetted partners, due diligence can offer additional intelligence for your negotiations and strategy.

Pre-due diligence and post-due diligence are equally important

Due diligence is not a one-time task. It is worthwhile to conduct due diligence throughout your time in the market. Trusted partners today may be less reliable in the future and you need to be prepared. Maintain ongoing due diligence as an integral part of your business.

Email address and English website

In China, it is not uncommon for Chinese business people to use public domain emails (e.g. sina.com, 163.com) rather than a company email address. While a public email address should not be an immediate red flag, more work should be done to verify the identity and claims of your potential business partner. Also, if a company only provides an English version of its website, then you should be aware that it could be a phishing scam.

On-site inspection is useful

Due to geographical distance, it is difficult to know your partner’s background, capability, credibility, and performance. For sizable deals, on-site inspection or on-the-ground presence is important. If your situation does not allow you to travel, find a trusted local associate to pay a prearranged or surprise visit to your partner.

Considering the legitimacy of company seals

In China, company seals (also known as chops) are key components in controlling the company. All legally registered companies in China are required to apply for official company chops from the local Public Security Bureau (PSB). The PSB will keep specimen chops for any future dispute or fraud verification. The company chop is used on all official documents such as contracts, memos, bank account applications, labour contracts, etc. It is round-shaped. Aside from the official company chop, there are other kinds of chops such as financial chop, contract chop, and legal representative chop. A key part of due diligence in China is to ensure that the chop is legitimate and being used in an authorized manner by an authorized person.

You should visit the company or local authorities and ask whether the person holding the seal is the authorized person to sign and stamp the documents in question. Since local authorities rarely open their files to private individuals, you can hire a local service provider, a licensed lawyer or a due diligence company to investigate on your behalf.

Quality control and quality assurance

The key to sourcing from China is to minimize defects and obtain products that meet your standards. To ensure proper quality control, your due diligence must continue even after you have struck an agreement. Ask for qualification certificates and samples beforehand. Understand that flawless samples will not translate to flawless mass production. Obtain references from your partner and speak with them. If a supplier offers an incredibly low price compared to others, be confident that quality is likely to be unacceptably inferior. Having a quality control inspector of your own in the factory who checks regularly on production is important. Provide specific penalty terms on your purchase orders if the products are defects.

Furthermore, you should:

• make sure your product design is manufacturing friendly;
• audit and approve factories based on a relevant checklist;
• obtain the manufacturer’s approval of the quality control plan;
• write down detailed product specification;
• perform quality control at several points of mass production;
• follow up with a corrective/preventive action plan when necessary;
• be on guard against the supplier re-engineering your production process; and
• revisit product specification for the next production batch.

Pay pennies to avoid heaps

You can start the due diligence process by conducting some initial checks based on your own network and knowledge. But given the complexity of the China market and the difficulties in gaining access to information, you may need the services of a professional service provider to conduct due diligence or quality control on your behalf. Compared to the potential losses as a result of conducting insufficient due diligence, paying up front can be a worthwhile investment.

Watch our YouTube videos

Where can you get assistance with due diligence?

• The Canadian Trade Commissioner Service in China can do preliminary research on a local company from public sources. In order to perform our research, we need to know the Chinese name and phone number of a local company. We can then investigate:
  • whether or not the company has registered with their local State Administration of Industry and Commerce (SAIC)
  • how much registered capital the company has
  • who the chief representative is
  • how long the company has been registered
  • what type of phone listing they have (mobile only as opposed to a landline, which would indicate in some ways the reliability and longevity of the firm)
• As we are not mandated to conduct a thorough background check on a local company, we can provide you with a list of firms that perform company background checks.

In addition to the above points, there are other effective ways that Canadian companies aim to mitigate problems when entering into any business relationships in China, for example, preparing a good contract/agreement, and registration of your intellectual property in China.

If you have any questions or would like to learn more about the services offered by the Trade Commissioner Service in China, please feel free to contact us.