Doing your China due diligence

Conducting thorough due diligence is essential in China, but there are decisions to make
about the proper priorities as well as the best processes to choose

Issue: March 2010

I know I need to conduct some due diligence in China before entering into any definitive
agreements, but I’m worried this will take a long time, and I’m not sure how much information
I’ll be able to get. Should I carry out independent investigations as well as doing the normal
financial and legal due diligence? Is there anything else I should bear in mind that is specific to
China?

What should I watch out for when doing my

China due diligence?

The international perspective

While each matter is different, some key elements of due diligence in China include: ensuring the
Chinese party is well advised, independently verifying what you are told, proceeding with
standard information requests and speaking with management.

If the Chinese company is small or inexperienced at dealing with foreign counterparties, they may
fail to provide sufficient information because they do not know what is needed or why it is
needed. An important step is to ensure that the Chinese party is advised by competent counsel at
the outset who can guide them and assist with the document collection process. This may avoid
mistrust or extended questioning when insufficient or inappropriate documentation is provided.
It may also hasten the overall process and give a clearer picture of what is missing.

Regardless of what documents are provided, independent verification will always be a valuable
step in any due diligence process. Basic corporate documents are fundamental in any due
diligence process; however the information contained in them can be checked against public
records by conducting company searches and speaking to third parties such as customers and
suppliers.

Understanding the business and the legal framework of the target company is especially
important in China. Standard questions should still, therefore, be asked in relation to longer term
contracts, supplier and customer arrangements, intellectual property, real estate, litigation and
employment. Without asking for such information it will be almost impossible to assess the risks
associated with dealing with the Chinese counterparty.

Unlike many foreign companies which have well-documented business arrangements,

information obtained from management discussions can often give a clearer insight into how a
Chinese company is run. It is valuable to arrange sufficient time to meet with key management
personnel. From those discussions, it will be possible to put the documents provided in context.

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Management sometimes refers to aspects of the business which are not covered by the
documents provided, which can also enable a more targeted due diligence exercise.

Jack Wang
Partner
Freshfields Bruckhaus Deringer

The domestic perspective

For a sizeable China transaction, usually people know about hiring one of the big four accounting
firms plus a large law firm, because they are said to be required. On the other hand, many of the
so-called business issues – such as the local partner’s claim of influence with the provincial
government, or the target’s claim of being the largest supplier of a material in northern China –
do not get the same degree of professional attention. Regardless, to me it’s generally not the
coverage of the due diligence that people do in China, but the extent to which people trust the
local parties’ claims or information in the covered due diligence, that has caused many issues
during and after transactions.

My view is that when you conduct due diligence on a company in China, for the issues that really
matter to you: avoid blindly trusting the words or information given by the target’s managers, or
even many third-party local agencies. Target management has an implicit conflict of interest with
you. Many local agencies can be influenced to be less neutral than desired. Responses to due
diligence checklists are seldom complete the first time. Problematic documents are often hidden
unless specifically requested by experienced professionals. Too many inexperienced investigators
just robotically go through their checklists – “Has your company exceeded the legal maximum
working hours? No? [Check.] Taken or given bribes? No? [Check.] … OK, thanks for your
time.” Truth is never found so easily at face value.

To find the real facts: send your own trusted employees (or go yourself) for a personal visit, and
pay attention to things people try to hide from your visit path. Have anonymous interviews with
employees or local people around the factory. Try all the online or offline information sources
you can find. Send everything you get to experienced professionals for them to analyse. Your
team must be creative in collecting every piece of information, be diligent in looking between the
lines for inconsistencies, and be resolute in grilling people and checking everything against
opinions from your own professionals, until you get to the bottom of the issues you really care
about.

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Richard C Lee
Senior counsel
AllBright Law Offices

The specialist perspective

Ideally, independent investigative due diligence, financial and legal due diligence should be carried
out in parallel because they all address different aspects of the transaction. The results from these
due diligence efforts, when reviewed in combination, will arm the investors with the necessary
intelligence with which to make sound business decisions and mitigate risks.

However, when time and budget is of real concern, investigative due diligence is probably the
most efficient way to get fundamentally important information. Investigative due diligence is
unique because: (i) Unlike financial and legal due diligence which greatly relies on information
provided by the subjects, investigative due diligence is carried out independently with information
obtained through public records, media sources, and well-placed human sources. As such, the
results are not influenced by information inaccuracy or fabrication on the part of the subject; (ii)
Investigative due diligence focuses on the people behind the scenes, and their backgrounds and
reputations. Such emphasis means that you will be geared to uncover things that may be
categorised as deal killers.

While there are some common issues of which investors should have sufficient understanding
regardless of where the investment takes place, the following are some issues that are of
particular importance when performing due diligence in China:

 It is not uncommon for investors to have tunnel vision and to limit their due diligence
strictly to the entity in which they are considering investing. It is always helpful to
understand the overall structure of the group and the interrelationships among various
member companies of the group in order to determine if there are any cross-liability
issues and the real reason behind the financing efforts. It is also important to identify
undisclosed commercial interests, whether directly owned or through family members or
other nominees, particularly those that may pose potential conflicts of interest.
 It is important to understand the nature of the relationship between the subject and the
key government regulators. Keep in mind that that today’s political assets may very well
be tomorrow’s political liabilities, if the relationships are based on bribery and corruption
instead of institutional support and good will.

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  Reputation of the key principals: How did they make their first bucket of gold? Do they
renege on promises? Are they associated with individuals of ill repute? Do they have a
controversial lifestyle or business acumen? Most of these questions can only be addressed
through discreet human source inquiry which is unique to investigative due diligence.

Violet Ho
Managing director
Kroll

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