Many cases of fraud in China involve unauthorised production of goods or replication of businesses

Peter Humphrey, founder and managing director of the Shanghai-based advisory firm ChinaWhys, knows a thing or two about fraud in China. Over the past 10 years, the ex-Reuters man and fluent Chinese speaker has advised in about 1,200 investigations into fraud and related cases. More than half of these investigations dealt with white-collar crime committed by employees and partners of Western multinational companies.

Several of these cases are dissected in eye-opening detail in a report compiled by Humphrey and issued by the excellent China Policy Institute (headed by another ex-Reuters man, Richard Pascoe) of Nottingham University in the UK.

You name it, it happens
Most of the victims in the cases tackled by Humphrey were American or European companies with operations in China, and the amounts of money involved ranged from tens of thousands to tens of millions of US dollars. The extent and variety of violations is staggering.

“Most of the frauds were supply chain frauds involving distribution or procurement rackets, unauthorised production of goods or replication of businesses. We have also conducted investigations into financial fraud, construction fraud, securities fraud, inventory fraud, real estate fraud, and cash theft.”

How big is the problem? Scholars at Beijing’s Tsinghua University estimate that the equivalent of 16 percent of China’s GDP is lost to fraud and corruption each year. That’s four times the estimated fraud rate in the United States.

In a separate interview by email, Humphrey said ChinaWhys had two kinds of clients. “One who sees problems coming and the other who doesn't and is, in effect, bolting the stable door after the horse has gone. The first kind are those who have the vision to avoid problems by spending some money on thorough due diligence before doing a deal. And there are those who leave half their brain on China's doorstep on the way in, abandon all their best practices, and end up with a disastrous fraud on their hands and have to try and put the toothpaste back into the tube. A very costly exercise."

Prosecutions rare
In his report, Humphrey says it is rare for multinationals to litigate or prosecute a case of white-collar crime in the courts. He says you face a rather un-level playing field in Chinese courts, and victims tend to want to avoid offending Chinese authorities.

“Although I have seen some cases litigated or prosecuted with the support of our evidence, more commonly multinationals here opt to limit their countermeasures to the termination of staff, suppliers, distributors or business partners, i.e. they conduct a housecleaning and then rebuild their internal controls and defences against fraud.”

In one case he cites, the unnamed victim was a leading multinational manufacturer of personal and household hygiene products. After a seizure of fake products, rumours arose that insiders were involved. Inquiries confirmed the activities and interactions of several preliminary suspects inside and outside the company.

“We involved Chinese police, who detained several suspects and questioned them. Police seized a laptop from one of the suspects and we helped to unlock two important documents that were found on it, the counterfeit syndicate’s business plan year and their secret shareholding agreement, which differed markedly from the registered shareholding structure of their company that we had already examined.”

In the secret agreement, a number of the multinational’s employees were listed together with their share percentage. Consequently, police made further arrests of these employees as members of the counterfeit syndicate.

The thwarted business plan was valued at US$10 million over the next year and foresaw substantial further growth thereafter. But the business was nipped in the bud. A dozen people went to jail and more than 150 staff were removed over the next 12 months.

A second case involved a European multinational hypermarket chain. A newly appointed general manager received anonymous letters alleging that various buyers were operating fraudulent or corrupt schemes. The allegations named quite a few people in various sub-departments of the buying operation as well as some suppliers with which they allegedly had unethical relations.

“We checked these companies’ ownership and physical operations, we checked for conflicts of interest, and we looked into the lifestyles and affiliations of the suspects. A number of shareholdings owned by employees were uncovered, and many of the suppliers were found to have no physical existence at all, i.e. they were phantom vendors,” the report says.

Other scams included kickbacks, goods rebate schemes and manipulation of the hypermarket chain’s electronic transaction system.

Conclusive evidence was obtained that four senior buyers had led fraudulent schemes and an expatriate who oversaw the buying operation had ignored their sins in exchange for sexual favours. All these staff were dismissed, and their suppliers terminated.

“Analysis to quantify the losses suggested that the multinational had been paying up to 30 percent more than it should in some instances for the goods procured by the corrupt buyers, thus eroding the true potential profit margins and causing several millions of dollars in losses annually. But the multinational did not prosecute any of the culprits out of fear of embarrassing the joint venture partner, a Chinese state-owned enterprise.” The expatriate sued for wrongful dismissal but lost the case.

Culture gap
The list of scams goes on – and on. Humphrey says the high incidence of fraud in China occurs against a background of a get-rich-quick social revolution and economic development that has spawned a high level of graft in both public and private sectors. “Not only that, due to the culture gap between many multinationals and their China operations, it is often hard to detect and respond to the challenges of white-collar crime. That gap is one of the single most important factors.”

The report said multinational head offices and their representatives were often blind to what was happening inside their own China operations. “This blindness creates opportunity and temptation for unscrupulous individuals to commit fraud, thinking, often correctly, that they will go undetected. Very few multinationals bridge this gap well.”

You have been warned
Companies who find themselves ensnared in fraud can hardly complain that they have not been forewarned of the clear and present dangers of doing business in China. Foreign governments and chambers of commerce routinely issue warnings about the pitfalls.

The Canadian Trade Commissioner Service in China, for example, has alerted companies to be wary of unsolicited emails from a “representative” of a purported China-based state-owned enterprise or an import/export intermediary seeking to have a Canadian company enter into a lucrative supply contract.

Over the course of follow-up exchanges, the recipient Canadian company is asked to quote on an unusually large order, and provide specifications, delivery times, banking information, and so on. Often a “draft” English-language contract is sent and negotiations begin in earnest. Eventually, the Canadian company is invited to come to China to sign the purchasing agreement or contract.

In several instances, this has resulted in a Canadian company travelling to China only to be asked to cover expenses for staff fees, commissions, gifts, hosting of “official banquets” or similar “closing” inducements. After the contract is signed, many of these apparent deals eventually fall through and the Canadian company loses out on time and money spent pursuing the deal.

Here are just some of the warnings issued to UK companies about sharp practices in China: some Chinese websites offer attractive products at purchasing prices that are unusually low. Once ordered and paid for, the goods are not delivered or the quality does not fulfil the offer. Any subsequent complaint is in vain and the Chinese company often disappears.

In addition, some suspect companies send out multiple offers for large contracts to British and other foreign companies. The contracts are usually for the supply of manufactured products from the UK, in large quantities, on very beneficial financial terms that understandably are very attractive to UK suppliers.

Following short negotiations, these scams are generally used to entice UK companies to visit the market and give advance payments, gifts and lavish meals to secure the deal. Very often the company ends up with a worthless contract and the Chinese individuals disappear.

And the UK advises: don’t get on the plane or incur any major expenses without carrying out due diligence checks. If you get an offer that looks too good to be true, it probably is.

Use a lawyer you trust to check all legal documents are accurately translated in dual languages before agreeing to sign anything. If you are pressured to sign without this comfort, walk away from the deal.