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Path: Sourcing News & Advice
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fraudulent Chinese company

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Three keys to spotting a fraudulent Chinese company

Posted: February 16, 2016

by Steve Dickinson

I
often receive calls from U.S. investors in Chinese companies listed on the U.S.
stock exchanges. The investors are concerned with questions about the value of
their investment and they want me to assist them in analyzing the legal status
of the Chinese entity. My response is that the first step is to determine
whether or not the Chinese entity is an empty shell. If the Chinese entity is an
empty shell, then there is no value in China to protect and further analysis of
the company is a waste of time.

I
have done this research so many times that I have developed a three step test to
determine whether a Chinese company is a fraud. I take a look at the annual or
quarterly report of the Chinese company and if it meets these three tests, it is
virtually certain to be a complete fraud, with no operations, no assets and no
funds in the bank.

The
three indicia of fraud are as follows:

1.
The company has a large amount of cash in the bank. I often see supposed
cash holdings greater than 50% of the company’s annual gross revenues. Interest
rates at Chinese banks is very low and legitimate Chinese companies do not
usually keeps large amounts of their cash in interest bearing bank accounts.

Usually
the supposed large cash account is accompanied by bogus explanations explaining
why the Chinese entity is unable to repatriate the funds to its investors as
dividends. Later investigation usually reveals that these funds were never
actually deposited in the bank. That is, these large deposit accounts are simply
falsified. The odd thing is that auditors will normally verify that the accounts
are real. Once the fraud has been exposed, I have asked auditors what they did
to verify the account. They usually state that they relied on reports from the
management of the company.

In
China, the only way to verify the authenticity of a bank account is to arrive at
the bank unannounced and look at the computer screen while standing BEHIND the
counter as the clerk makes an unplanned query. Virtually no bank in China will
allow this, which means that audit verifications of Chinese bank accounts are
typically of no value.

2.
The company reports profit margins in excess of 30%. I often see fake
companies report profit margins of 50%. China is a very difficult country in
which to do business and I have never seen a legitimate Chinese company with
profit margins even approaching this level, not even state owned monopoly
companies.

It
is certain that Chinese companies located in rural Fujian, Shaansi or
Heilongjiang do not generate margins at this level. These high margins are then
the explanation for why the company has so much free cash; they are so
profitable they are printing money. The claim is that they have some unique
product or some technical monopoly. In my experience, these claims are never
true, as just a few minutes of careful thought would reveal.

3.
The company is formed as a VIE (variable interest entity) when it is
operating in a business sector where foreign investment is not restricted and
the VIE structure is not required. A VIE is required only when a foreign
invested company intends to operate in a restricted sector such as the Internet.
This is why Baidu, and Sina are organized as VIEs.

But
most Chinese business sectors are open to foreign investment. When a company
that operates in manufacturing or retail sales chooses to organize as a VIE,
there is typically only one reason: the organizers are planning to commit fraud
against the foreign investors.

Anyone
can perform this three factor analysis of a U.S listed Chinese company in about
30 minutes and ten minutes is usually enough.

Unfortunately,
our China lawyers are usually contacted by investors long after this analysis
should have been conducted. We are usually called on when the investors begin
realizing that something is wrong and the Chinese company has ceased even to
pretend and is now no longer returning investor calls. Don’t let this happen to
you. If a Chinese company fails to meet the above three factor test, your answer
is clear: don’t invest.

Having
lived in China for years, and having mastered both its language and its legal
system, Steve Dickinson’s unique expertise makes him an invaluable resource for
clients of Harris & Moure law firm. He co-authors the China Law Blog.

Want
to know how to work with factories to produce your unique products? Join
the Smart China Sourcing Summit to learn sourcing best practices, April
17-19, 2016. Co-located with Global Sources 3,000-booth trade show in
Hong Kong. Learn more at http://www.GlobalSources.com/summit

Keep
updated on sourcing best practices and the Summit. Join the Smart China
Sourcing Facebook group at http://www.facebook.com/groups/SmartChinaSourcing

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