How to Spot a Luckin Coffee Type Fraud in China

Implement internal due diligence to keep your China management honest.

Fraud can take many forms and may be perpetrated both internally by actors within an organization, or externally by third parties that interact with it. In the recent Luckin Coffee case, we have seen how executive management was corrupt from the start, deliberately inflating sales and building up the stock value on Nasdaq before selling off stock at prices far beyond the company’s reported capabilities.

Overseas stock markets – and those in Hong Kong – can often turn a blind eye to Chinese listings, with auditors often bending the rules to keep problems out of the portfolio. I know, I have seen it done. Our firm has also been involved in investigative work concerning fraudulent activities in China – I can assure you it can be most unpleasant when fingers start to be pointed and accusations made.

However, it can be so much easier to deal with if you conduct regular operational checks on your China business and “keep employees and managers honest”. But to ensure checks and balances are in place, and business tires regularly kicked, it helps to understand what a typical fraud looks like in China.

Typical China fraud: Mismatch between sales and inventory 

The CFO of a US automotive parts manufacturer receives an alarming email from a junior accountant working at the Group’s Chinese subsidiary. The employee claims to have witnessed fraudulent activity perpetrated by the local General Manager for months and has decided to speak up.

The employee mentions important sales orders not being properly invoiced or recorded in the books, and feels he is being pressured into performing accounting fraud. Unconvinced yet still inclined to follow up on the whistleblower’s tip, the CFO decides to engage a third-party auditing firm to perform a review of the Chinese company’s financials.

The audit report reveals important transactions taking place between the company and private bank accounts opened in the General Manager’s name. An investigation of inventory movements reveals a significant mismatch between the value of the products shipped out of the warehouse compared to the company’s sales figures.

After contacting a selection of clients serviced during the previous months, the auditors uncover that customers were offered enticing discounts if they were willing to forego a formal tax invoice and pay the company through Alipay.

The Alipay account in question was linked to personal bank accounts opened in the General Manager’s name, and it turns out that the General Manager would only partially transfer back the monies to the corporate bank account, thereby successfully embezzling several million RMB undetected.

While it may not be possible to have complete oversight and fully eliminate all probability of frauds occurring, such cash theft can be prevented if the relevant internal controls are put in place within the organization.

Here are three ways you can frame your fraud prevention strategy in light of your relative risks.

Assess specific risks, protect against fraudsters

Different companies are subject to different forms of fraud risks, depending on their industry, size, and business model. Companies need to make an assessment of their specific risks by identifying the areas where they are most exposed.

Small companies with a small China team should be concerned about the proper segregation of duties, for instance, with all things related to cash receipt and cash disbursement.

If the same person initiates and approves e-banking payments, or if one individual holds both the company chops and the corporate check book, there is a real risk of the occurrence of cash theft or fraudulent disbursements. Further, not separating the duties between the accounting and cashier functions opens the door for such economic crimes to go undetected.

Conversely, companies running large teams should carefully monitor the local payroll system, or otherwise risk being subject to fraudulent payroll and reimbursement schemes.

If the General Manager is colluding with or bypassing the HR team on payroll matters, he could conceive ‘ghost employees’ or fictitious bonuses to channel money to a personal bank account. If the headcount is large and payroll figures significant, it could be difficult to spot this form of fraud. Putting in place a digitized payroll system or bringing in an external firm to provide such services minimizes this risk. In fact, as a general rule of thumb, it is generally worth engaging a payroll practice in China purely for improving the cost of the service expense and increasing the professionalism, data availability and security.

If not, opportunistic employees can (and do) take advantage of low levels of supervision to utilize fraudulent reimbursement schemes: as one example; by overstating their work-related expenses, they increase their personal remuneration.

Trading and manufacturing companies performing sourcing activities in China should pay special attention to their supplier selection and management strategies. Indeed, such companies are prone to the collusion of their sourcing team with suppliers against the promise of bribes, or witness their local management select the companies of friends and relatives to act as suppliers. These examples of conflicts of interest are extremely common in China.

Companies that have not implemented IT systems to monitor and automate inventory management are most at risk. It then becomes extremely difficult to guarantee accurate consolidation between purchase orders received from customers, inventory movement records, and company accounting.

Get familiar with China’s regulatory environment

Depending on the industry of focus, different companies may be subject to varying levels of scrutiny from regulators and should take this into consideration when designing their fraud-prevention programs.

Companies operating in China’s healthcare sector, for example, are more likely to be held to the highest of standards and face tough repercussions in the event of non-compliance.

Pharmaceuticals giant GlaxoSmithKline found this out the hard way when they were fined US$490 million and saw several senior managers sentenced to prison – after the company was found guilty of bribing Chinese doctors and hospitals.

Likewise, the Chinese F&B market is closely watched by regulatory bodies and foreign companies are particularly advised to strive for compliance. The aftermath of the melamine in infant formula scandal showcased regulators’ intolerance of incompliance when public health and safety is involved, and the toughness of their sanctions when required.

Similarly, in recent years, many foreign food service outlets have realized the perils of operating without proper licenses, as illustrated by the large number of forced restaurant closures that have recently occurred in Shanghai and other large cities around China.

The financial services sector is another industry subject to considerable scrutiny in China.

While foreign fintech businesses rush into China lured by the promise of high rewards, many are reminded that PRC authorities intend to closely monitor how private firms are managing the savings of Chinese households. The crackdown on peer-to-peer lending platforms, as well as the recent fines levied on four major payment service platforms by the People’s Bank of China due to ‘irregularities’, are illustrative examples.

Localize compliance strategies

The regulatory environment in China is oftentimes quite different from that of the foreign company’s domestic market. It is therefore essential to understand the local specifics and assess compliance liabilities accordingly.

It is also important to bear in mind that PRC laws and regulations may be interpreted and implemented differently at the provincial or even municipal level. As such, companies operating in multiple municipalities are advised to localize their compliance strategies instead of adopting a uniform China strategy.

Meanwhile, staying under the radar of regulators is becoming increasingly difficult, as Chinese regulatory bodies have become more integrated and coordinated.

An offense recorded by the tax bureau, for example, could raise the attention of other authorities such as the PRC Customs, the Administration for Industry and Commerce (AIC), or the State Administration for Market Regulation (SAMR) and other regulatory bodies. Staff in China – and this includes those working for your competitors – are encouraged to be State whistle blowers and are financially incentivized to do so if results prove correct.

Once an incidence of incompliance is recorded, it may have a lasting impact on a company’s China operations, long after the company pays the penalty. The social credit system currently being implemented will only increase transparency and raise compliance risks.

Once the prevalent risks have been identified, stakeholders should work on the design of localized internal mechanisms to promote compliance and limit the incidence of fraud occurring at their China office.

Due diligence in China: HR best practices

Internal fraud though can be minimized by performing a thorough background check on key personnel prior to onboarding them into the organization.

Prospective employers should pay close attention to fictitious credentials, undisclosed criminal records, or more commonly, a poor past performance record with previous employers.

In China, it may be difficult for expat managers or the overseas HR team to spot the red flags and identify a suspicious profile within a pile of CVs received.

To combat this, HR managers in China can verify the candidate’s criminal record, perform a face-to-face interview early-on in the interviewing process (or a video call if the recruiting manager cannot physically travel to China), ask to see the degrees and certificates, as well as request references from past employers – and actually contact these persons.

Once the staff is recruited into the organization, it is essential that their labor contract and the employee handbook make references to the corporate code of ethics and stipulate what forms of fraudulent behavior justifies a termination of employment.

Vetting third-party vendors in China

External fraud, on the other hand, takes place from outside the organization and is perpetrated by third parties. A common example is where suppliers take advantage of lenient customers.

Indeed, it is not uncommon for foreign businesses to be deceived by their Chinese suppliers, such as in the non-delivery of goods upon purchase, the delivery of goods of unsatisfactory quality, or internet fraud from the part of fraudsters disguised as suppliers.

However, there are many ways a company can reduce their risk exposure to external fraud.

For example, they can conduct a discrete investigation of the prospective supplier, including a review of the Administration for Industry and Commerce (AIC) company records, a verification of the business’ financial performance, and ask for references from existing customers.

It is also advisable to go meet the potential supplier face-to-face prior to signing a deal and to visit the supplier’s factory, or otherwise appoint a trusted person or third-party agent to do so on your behalf.

Finally, it is always advisable to start with a minor purchase order to limit financial risk in the event of fraud, as well as to sign a robust supplier contract stipulating the supplier’s obligations and the clients’ rights and reparations in the event of breach of contract. The company’s code of ethics should also be imposed on suppliers through the contractual relationship.

Performing similar due diligence on other third parties, such as prospective distributors or joint venture partners (JV), is also advisable.

Implementing robust China KYC policies

Foreign companies are often held accountable in their home country for their choice of business partner in China. For example, the US Department of Justice is now vigorously enforcing the Foreign Corrupt Practices Act (FCPA) overseas and cracking down on corrupt practices perpetrated by American businesses and their affiliates in China.

Implementing robust Know Your Customer (KYC) policies may be particularly important for firms operating in the financial services space, and more generally for all the actors subject to anti-money laundering regulations both in China and at home.

Moreover, industrial espionage and IP infringement are still prevalent concerns in China, and the threat may very well come from customers – hence the need for a China KYC strategy. Failure to flag operational, financial, and legal problems when deliberating over a prospective JV partner or incoming investor can also prove extremely costly.

It is therefore vital for foreign companies to conduct a critical assessment of their resources and business practices at every stage.

Doing so ensures that the foreign company is in a position of strength to make informed decisions, for instance, at the deal signing stage and limits its exposure to financial and reputational risk that come with doing business with an incompliant partner or fraudulent customer.

Internal control at your China subsidiary

Internal control mechanisms are unlikely to be effective if fraudsters perceive that irregularities go unnoticed or unpunished within the company. Hence, fraud prevention programs must be coupled with monitoring systems and response strategies.

The company’s internal controls should be periodically reviewed to ensure that their effectiveness is maintained over time. One option available to monitor compliance at the local level could be to engage a third-party resource to perform periodic internal audits and fraud risk assessments on the Chinese subsidiary.

In this sense, it is important to work with a firm able to assess the strengths of fraud prevention mechanisms and investigate any irregularities observed, going beyond a high-level review of financial statements.

Many businesses in China still rely on a yearly statutory audit performed by a local CPA to assess the soundness of the accounting work and management practices; in reality, the yearly review work normally provides little guarantees against economic crimes.

Compliance can also be monitored by resources internal to the organization. When fraud is perpetrated within an organization on a recurring basis, the occurrence is likely to be noticed by other staff.

It is thus essential to provide employees with the tools to report any fraudulent behavior they observe, such as having whistleblower programs in place. Such programs must be localized to the China environment if they are to become effective.

For example, by offering a Chinese-language hotline as well as generating language- and culture-specific awareness on the programs within the China work environment.

If the data collected is to be efficiently analyzed, the forms need to accurately reflect the local company structure and contain questions likely to generate informative replies.

Conducting internal investigations in China

It is important to react quickly once fraud is suspected and gather evidence before it is destroyed. Evidence must be properly gathered through an investigation, so that it may be turned over to the police to be used in court later on.

Also, as is more commonly practiced in China, gathering key evidence provides the employer with ample bargaining power during the time that labor termination is negotiated.

Indeed, most foreign companies in China prefer not to resort to police or judicial proceedings, if possible.

These are often viewed as disruptive and costly, and the foreign party can sometimes feel at a disadvantage.

On the other hand, having gathered some evidence is helpful during the negotiation with the employee or at the labor arbitration phase, if any.

Many foreign companies would prefer to reach a mutual agreement with the employee early-on, without the case proceeding to a labor litigation or civil litigation.

Having electronic data protocols is vital to safeguard company data today – and is often the most vulnerable to fraud exposure.

One important step could be to mandate staff to use company proprietary IT software and hardware, instead of their own. Data privacy protection laws in China complicate the evidence-gathering process if that evidence is stored onto a personal laptop or mobile phone.

In China, where most business communication takes place through WeChat and financial transactions through Alipay, employees’ mobile phones are likely to be particularly rich in work-related information.

Foreign companies in China are sometimes reticent to deal with a fraud allegation to begin with, especially when the economic value of the crime is perceived to be low.

Indeed, responding to fraud could become quite disruptive for a business, especially if changes to key management personnel in China becomes necessary. The shareholders may stand to lose the management’s business relationships, informal connections, industry know-how, and much more.

As such, many investors would prefer not to react so as not to risk losing these valuable resources, especially if they see no short-term alternatives. Meanwhile, court proceedings can be lengthy and costly in China, which act as incentive for inaction.

However, this policy of leniency sets precedent for other staff. This should be considered alongside the immediate economic cost of the crime.

Tone from the top: Communicating core company values

A culture of compliance needs to be instigated by the local management, so that the tone from the top as valued by overseas stakeholders gets appropriately communicated to the employees working at the China office.

Compliance and work ethics could be included as KPIs set for local managers alongside those related to the financial performance of the Chinese subsidiary.

Additionally, local managers should be trained on local laws but also on the international compliance regulations that the overseas headquarters is subject to. This way they can understand the implications that economic crimes perpetrated in China has for the overall organization.

If the overseas shareholders can rely on the China management team to monitor and promote compliance to fraud prevention programs, they should be in much stronger position to mitigate their business risks in this jurisdiction.

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