China Operational Due Diligence

Part Two in a four part series

Op-Ed Commentary: Chris Devonshire-Ellis

Feb. 4 – Operational due diligence is an important tool to utilize when examining Chinese companies, either for confirmation of production capabilities, or potentially as an M&A target. Chinese enterprises often lack useful and reliable operational information, however, and some transactions have not lived up to acquirers’ expectations after discovery of operational surprises or weaknesses. The likelihood of buyers being disappointed by the performance of the target company can be reduced by conducting operational due diligence (ODD). ODD can be a highly effective tool in helping the buyer understand exactly how the target company works, which in turn leads to a trouble-free transition after the consummation of the acquisition. It can also prove effective at assisting the buyer in evaluating how well the target’s current operations support future strategic objectives.

ODD should include a detailed assessment of:

• The functional operations of the target and the processes and systems supporting it
• The interconnectedness of these operations
• The likely impact of operations on the future financial value of the company

ODD can be used at variety of stages in the acquisition process, but it is typically used to achieve one or more of the following outcomes:

Target Assessment
Identifying potential enhancement opportunities for operations, along with the key commercial issues associated with the deal—such as the unforeseen opportunities that might deliver an extra US$10 million to the bottom line. When factored into a valuation of, say, ten times cash flow, such an uplift translates into an sizeable US$100 million of additional value. That can be the edge a buyer needs to place a deal-winning bid in a competitive bidding process.

Bid Evaluation
Reviewing management structures and controls and providing an assessment of operational effectiveness and benchmarking the business against similar firms. Identification and validation of any assumed operational improvement initiatives that underpin the target’s business plan and assessment of the business’s capability to deliver each initiative. ODD will identify the deal killers—aggressive management plans that simply won’t fly.

Post Deal
Highlight operational areas where improvements can be made to enhance productivity and profitability and work with the management team to accelerate the improvement process.

Key Operational Functions
A company’s operational capabilities can be the basis of a deal and specific auditing tests must be devised to measure the value chain. The steps involved in this will vary depending on the company being considered for investment, but it should involve an on-site of the target’s daily business processes and of the systems supporting the business’ operations. This analysis should involve an evaluation of production capacity, raw material flows, inventory levels and all other factors that are necessary for the business to conduct normal operations.

The Key To Value
ODD completes the view of the target company in areas not fully addressed by financial due diligence and can often be a very important tool in identifying the real value of the transaction. Financial due diligence typically merely verifies the target company’s financial statement and attempts to opine on the potential future sales and profitability, but chiefly using historic patterns and trends as its base point. ODD goes much deeper to assess the target company’s functional operations and the interactions between them. The insights gained in this process can often determine a significant amount of the transaction’s value, or lack thereof.

The Chinese Limited Liability Status Grand Misrepresentation Technique
A commonly misunderstood area by foreign investors when assessing the creditworthiness of a Chinese business is the aspect of “Limited Liability Status.” Usually, in the West, this is issued in the form of a cash injection into the business, and can be checked via the public records office. Extending credit then, say of US$1 million, to a company with a limited liability of just US$25,000 may then start to flag up red with your accounts department. It’s a good way of protecting yourself against providing over-credit to customers likely to default, and also a proven method of assessing risk when providing credit in the form of cash or sales.

All well and good. In China however, there is very limited access to any public records, and those pesky China business licenses that state “the amount of registered capital” are prone to inaccuracies as well. As is always the case in China, the devil is in the details.

The registered capital amount as displayed on a Chinese business license also fulfills the same criteria as the limited liability status. So if a business has RMB1 million as its registered capital, the shareholders are also responsible for that amount of liability. If you want to send product worth US$1 million to a Chinese company, you’d better start assessing the amount of risk in the published registered capital amount shown on the license.

But it doesn’t stop there. When setting up a Chinese domestic company, before applying for the business license, the investors are required to contribute the registered capital required. Accordingly, a further check is needed to verify the registered capital amount was in fact paid. This document, a “Capital Verification Report,” has to be issued by a third party Chinese CPA firm cross checking bank statements showing the amount was injected. The false production of such a certificate means the CPA firm can also be liable for fraud.

If a capital verification report has been issued, then the business has a legal limited liability status and it was, at time of incorporation, capitalized in accordance with the law.

It’s these simple checks that can separate a good sale to China from a delinquent sale to China, and they are easy to carry out.

Mergers & Acquisitions: Joint Ventures
A JV in China is a type of investment that creates a legal entity owned by the partners based on pre-defined terms. The regulatory regime over ownership and the equity varies according to the type of JV, but essentially it is common for the foreign investor to contribute cash, and the Chinese land and buildings as part of the deal. Consequently, attention must be paid to land, as a lack of knowledge about Chinese law provides a relatively easy way for the Chinese party to deceive an unwary partner.

Land Use Rights
These relate to the status of the land on which your Chinese partner has his premises. Land use is heavily monitored in China; with specific permission for appropriate commercial and industrial use being granted and only able to be altered by the central government, especially when it comes to the protection of the state’s agricultural resources.

China possesses 20 percent of the world’s population, but only 5 percent of its arable land. Accordingly such land is precious to the government and cannot be used for commercial or development use without state-level approval.

Regrettably, there have been many examples of corruption, even at the provincial government level, misleading foreign investors over the status of the land. You must ensure the land you have, or that will be injected as an asset into the JV has the pertinent land use rights. If not, you can lose your entire investment if the state becomes aware inappropriate land has been used for development purposes. It is a very real and very common problem.

Checks can be conducted at the local land bureau over title and the given land use permission to ensure all is in order. State-owned enterprises do not possess land use rights certificates, so they must be asked specifically to obtain one and present it to you. If you do not ask for it, they will not provide it and your investment will be in immediate danger of being compromised.

How do you determine if they own the land? Two types of land use rights exist:

Allocated rights
These are issued to a venture for a period of years (check the timeframe) but only give the right to use the land. This is fine, but means any development (i.e. buildings) that are erected on it will ultimately benefit the landowner, not your company. Additionally, if the agreement over the land is between the Chinese partner and the landlord directly, what happens if your Chinese partner defaults on the rental? You can be thrown off the land. Check this out and ensure you have agreements in place, such as letters of intent from the landlord directly to circumnavigate this eventuality. It’s also important to ascertain whether or not your intended Chinese JV partner actually owns the land he is ”injecting” as part of his capital in any potential JV. One client we had who was setting up a JV in Suzhou was quite happy until we pointed out that his Chinese partner didn’t own the land—valued at US$4 million—that he was ”injecting” into the JV. You can be sure that our client returned to the negotiating table pretty quickly! A powerful Chinese partner may be able to obtain a guarantee from local government; however, this guarantee is useless and can be overridden by the law or the central government. A foreign client cannot use a guarantee against an order from the central government because, by asking for the guarantee, the foreign investor has shown they recognized that the structure was not entirely within the boundaries of the regulatory process.

Granted rights
Again, these are issued for a period of years, but give title to the land during the timeframe. From a legal point of view, you may want to consider having granted rights, especially if significant investment is taking place onsite. Yes, of course it costs more to ”buy the land,” but if such rights are issued in your JV name, you may use them to raise loans in China (giving the granted rights as security) and even profit from any sale of the rights later on. For long-term strategy, this secures your China future.

Management Due Diligence
There are two aspects to this that affect JVs or mergers with Chinese companies.

Existing Managerial Habits
Chinese companies, especially state-owned enterprises, tend to have archaic attitudes to management that extend way back to China’s iron rice bowl period. This, coupled with the rude fact that, as SOEs, they are representatives of the government itself and therefore often above scrutiny, can often lead to polar opposites when it comes to business management and good corporate practice. Chinese executives may never have had to be scrutinized before, or subjected to checks and balances. Yet as soon as a foreign investment is made, be aware that the Chinese authorities will render special attention to the business at a far higher level of attention to which the Chinese have ever been exposed. Naturally, as the new-to-China foreign investor, any difficulties in compliance will be your fault. The reality may be far different, and you need to be open to the conducting of an HR assessment of the capabilities of managerial staff to work in the corporate environment you require.

Inheriting Staff from Chinese Companies
If staff are transferred from a state-owned enterprise to a new JV, or are inherited via merger, you need to conduct checks on who you will inherit and their pension/welfare obligations. Many new investors have found themselves unwittingly crushed by the sheer weight of taking on not just staff, but also long-term social costs as well. Make sure you do your due diligence on the financial aspect of HR and do not just willy-nilly accept whatever staff you are given. If layoffs need to be conducted, make sure the Chinese side does this as part of their responsibility instead of just passing it off on an unsuspecting new foreign partner. This is particularly true when an acquisition is made for just part of a Chinese SOE.

Listings overseas
To comply with regulatory regimes elsewhere, auditors will need to ascertain that the company is clean and that all assets and liabilities have been correctly stated. Yet it is also common for Chinese companies to have potential debts running into millions of dollars. Due diligence, as well as a statement, needs to be made to the auditors to convey the true position of the company.

As mentioned earlier, Chinese companies are not monitored as diligently as foreign invested enterprises in China. This can lead to issues with the internal accounts, as well as a skimping on other major sources of mandatory expenditure. One issue I recall we were asked to be involved in related to a Chinese company scheduled to be listed in Hong Kong. But with 17 retail outlets nationally, there was a discrepancy in the mandatory welfare payments it had been making.

These mandatory payments—the social payments businesses in China are obliged to make to various funds on the employees behalf, pension, medical insurance and so on—differ regionally in China and are also updated every year, making them notoriously awkward to keep track of. Nonetheless, the company had been underpaying these, and the potential liability ran into millions of dollars. How to uncover how much of this could be considered as a liability and if there was any room for local negotiation to improve upon what is termed as a “mandatory” payment was an interesting question of Chinese central government versus the provincial authorities.

Due diligence then can also reach into the very heart of Chinese law and the responsible authority, which in this case is a legal opinion on whether the collection and managing of mandatory welfare for staff is a state or provincial responsibility. If provincial, then the governments are prepared to negotiate; if state, they would not.

Due diligence on matters affecting national businesses therefore will require trips to Beijing to examine such questions with central government officials, as well as a presence in the city concerned.

Anti-Monopoly Law and Considerations
It is also important to note that with the passing of China’s anti-monopoly law on August 30, mergers and acquisitions where foreign investment is involved, including equity joint ventures and cooperative joint ventures, now fall under a new regulatory system. The anti-monopoly law prohibits three kinds of monopoly acts: reaching monopolizing agreements; abusing a dominant market position; and concentration of business operations that which may exclude or restrict competition. Conduct subject to an anti-monopoly inspection includes mergers and acquisitions, JVs, as well as licensing and technology transfer. While the most of the provisions of the anti-monopoly law apply to both domestic and foreign-funded companies, there is a mandatory security inspection provision on mergers and acquisitions by foreign investors on any merger or acquisition that may have an impact of state security. The foreign investor must go through a state security inspection before they are allowed to proceed with the merger or acquisition.

China Governmental Due Diligence
Unlike many other countries, China can additionally be in conflict between various levels of government. Firstly, because there is conflict between different government ministries and their responsibilities, and secondly, because there can be differences in where the actual China legal responsibility lies. In a country with no independent judiciary, it can be vital on occasion to know which level of government has the authority. I discuss this inter-governmental conflicts and the implications as follows:

Conflict Between Ministries and their local Agencies
A common conflict that arises is between the Ministry of Commerce and the Tax Bureau. Applied on a local basis, it can manifest itself in the MOC and other related government officials being out of compliance in their statements to foreign investors, especially when it comes to some areas of tax and customs administration. Keen to secure foreign investment, they can be prone to “oversell” the attractiveness of the investment and omit to recognize the authority of the tax bureau post incorporation. This is dangerous as by then the investment has been realized and the funds transferred. The foreign investor is then left with little option but to swallow the pain.

Examples can be in situations we have come across when an investment has been structured and approved in a free trade zone, however with the actual processing taking place externally in a secondary location. We have come across situations where the licensing for this arrangement has been approved by the local MOC, the business license issued, and the investment made. However, when the tax bureau wishes to inspect the new operation, they find there is a discrepancy between the legal registered address (in a free trade zone, with a lower tax rate) and the actual location (in a higher tax location). Accordingly the tax bureau insists all activities take place in the free trade zone if they are to obtain the lower tax break. But the investor has already put up his factory in the secondary location…

Government officials are subject to targets related to the attracting of foreign direct investment, and often, as mentioned, they can act as little more than “salesmen.” Odd as it may seem therefore, it is important to obtain professional advice, especially in the tax structuring area, of your investment and to check that the local government have been providing accurate, and not misleading advice.

Identifying levels of governmental legal responsibilities when assessing liabilities
Earlier we discussed the case of the national retail outlet with large unpaid statutory welfare amounts as liabilities. In order to satisfy the auditor responsible for assessing the risk of debt, a case had to be discussed as to whether it was the remit of the local government to possess authority to negotiate this amount, and whether the State would be able to challenge this. It’s a classic China conundrum—State vs. local government. In this type of instance, legal counsel needs to be sought to provide a valid opinion on the issue. Millions of dollars were at stake, as was the potential performance of the prospectus for listing the business in Hong Kong. On this occasion, it was successfully argued that the local government did have the right to negotiate the amount of unpaid “mandatory” welfare payments owed to Chinese nationals within its local region. Consequently, a lower figure of liabilities, based on previously discussed guidelines with the various governments concerned, resulted an overall reduction in the total welfare liability of some 40 percent. This was not a small sum, and affected the prospectus. The auditors accepted the argument, and accordingly reduced the amount of liabilities the company showed in its balance sheet. On this occasion then, due diligence was backed by a valid legal opinion and accepted as such by the auditor.

Discussing the levels of authority in China government has long been a guessing game played by China journalists, however when large amounts of investors money are at stake it is important to obtain opinions from credible firms and to use their China experience to take stock of the true level of risk.

M&A Environmental Issues
As Chinese government becomes more and more concerned about the environmental issues in China and the damages the polluting causes, it is taking decisive steps to regulate and to ensure the compliance with the environmental standards. As a result, M&A require very conscientious due diligence on the environmental liabilities. For example, a factory that has been polluting the local rivers for some twenty years may one day get prosecuted for massive damages. To avoid the risk of getting involved in M&A activities that might end up in a disaster, in the due diligence context, attention should be paid to the following information:

What is the current environmental situation of the company?

● Has it had any environmental problems in the past or might it get any environmental problems in the future after the take-over?

● If yes, then what kind of counter-measures have been taken and what are the results?

● Has the company stored or used any hazardous substances, raw materials, objects etc. or as it been/is it involved in any hazardous procedures?

● Has the company paid any pollutant discharge fees over the last years?

●  What is the company’s policy regarding the environmental issues?

● Can the company provide any documentary evidence regarding this information such as environmental impact assessments, licenses, approvals, permits, permissions, certificates, applications, registrations and notifications?

●  Can the company provide any reports on its environmental situation produced by (private and governmental) third parties over the last five years?

Such matters need to be attended to, and if necessary, professional advice needs to be taken. Soil samples can be processed in Hong Kong at labs there from experts in this field.

Due diligence therefore is an expanding issue, depending upon the complexity of the company and the size of risk involved. For substantial investments, detailed analysis should be undertaken, and if necessary, additional expert professional opinions brought in.

This is part two of a four part series. Part three—Financial Due Diligence—follows on Monday.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates. The practice assists foreign investors in the China market, providing legal, tax, and due diligence services from ten offices throughout China. For more information, please email the firm at info@dezshira.comor download the practice’s brochure here.

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