Why should foreign companies in China be ready to expect the unexpected?

Why should foreign companies in China be ready to expect the unexpected?
Two exceptional cases to explain you why and what you can do about it

Police in China seize 20,000 tonnes of low-grade ‘fake’ salt 

The above is an actual headline taken from the Thursday, July 2, 2015 issue of the South China Morning Post.  China is a market which provides many opportunities to foreign companies, with its GDP currently growing at approximately 6.5% – 7% per annum and this economy expected to overtake the United States as the largest economy during the next decade. Moore Stephens knows this—that is why we are here.  It is our hope that we may be of assistance to multi-national corporations looking to take advantage of this growth. 

Whereas there have been numerous success stories driven by this growth, it is still common for many foreign companies to enter this market unprepared, or worse, uninformed of the potential pitfalls. Even the most sophisticated companies cannot envision all the potential problems they may encounter. If you were going to open a chain of eating establishments in China (a lucrative endeavor by the way) would it ever occur to you that someone may be selling you counterfeit salt? We cannot anticipate every problem, however, experienced professionals like Moore Stephens do have some local knowledge and can share that with multinationals willing to spend the time and effort into learning the do’s and don’ts of this market. 

This article will describe that even though it is impossible to anticipate every situation which may liquidate your investment, expose your trade secrets, and/or damage your valuable reputation, it makes sense to be as well prepared as possible when doing business in China. What follows are 2 exceptional business cases—all true.  We will provide our advice on the necessary actions and precautionary measures that should have been taken by these foreign enterprises to mitigate the China specific risk. 

Qantas products were produced by a prison in China 
Australian Airline Qantas, had to launch an investigation after hearing a newspaper allegation that its in-flight disposable headphones were being manufactured by inmates of a Chinese prison who suffered through cruel working conditions and received a compensation of only $1.30/month. This company had a contract with a Vietnamese company, who then sub-contracted to a Chinese manufacturer, who then sub-contracted to a prison! This case came to light when a New-Zealand inmate was released from this prison and shared this information in the public.  

Read more about it here.

Rip Curl in China were producing products unknowingly in North Korea 
The iconic Australian surf-wear giant, Rip Curl, entangled itself in a similar situation. Rip Curl had a contract with a Chinese manufacturing supplier who had subcontracted the production to an unauthorized subcontractor in North Korea! The company unknowingly ended up selling millions of dollars’ worth of clothing manufactured in North Korea, where the workers endured slave-like treatment.

Read more about it here

Our thoughts 
These are some of the worst of the abuses we have seen in China. They don’t happen every day, but they do happen. What can we draw from these examples? 

  • Due Diligence: Investigate your potential partners before entering into an agreement with them.  Ask us to call their suppliers, their peer group, journalists. Have they ever engaged in unsavory behavior in the past?
  • Know your Suppliers: Visit the company before, during, and after the negotiation process. Make sure they have the capacity to produce your orders. If they are working 18 hours every day producing existing orders, how are they going to fill your large contract? Will they do it themselves on their state of the art equipment, or will they sub-contract it to their friends? Or to a prison? Or to the North Koreans?
  • The Downside: We hope you are ethical enough to not use prisoners to make your products…or children…or slaves.  But even if you are crass enough to turn a blind eye to such horrific practices, at least consider the public relations nightmares that result.
  • You Take 100% of the Risk, Get 0% of the Benefit: When your manufacturers are using industrial salt to make cookies, they save money.  When your partners hire children instead of adults, they save money.  When your partners contract North Korean slaves to manufacture your clothing, it is a bonus for them—much cheaper to get it done in North Korea than in China. None of that benefit comes back to you. When the factory saves money by hiring prisoners, the factory boss does not give you a rebate.  The money saved goes right into his pocket—not yours, and you take all the p.r. risk.
  • Monitor: Note one important fact about all these cases: Every horror story we can think of takes place after the contract is signed. After the initial due diligence is completed. The unauthorized sub-contracting, the overproduction, the use of cheaper raw materials—all this happens after you have given the factory authorization to use your valuable trademarks and after you have put your reputation on the line. Rip Curl would never agree to buy clothing made by North Korean slaves—but that is exactly what happened because Rip Curl did not monitor.

When you have the opportunity to financially review your suppliers, you should very carefully, with the support of qualified professionals, conduct a deep financial investigation to discover any red flags and/or other discrepancies. Are the companies paying the right amount of social security for their employees in China? Does the factory, knowing its size, order size and production capacity, generates profits in line with these facts, i.e. plausibility of financial results? Is the company following Chinese Accounting Standards, or chooses to keep one of the books for the government – with low or no profit - and the other books for only internal management reporting consisting of actual numbers? Are payments made to one bank account which is registered in the name of the company, the company engages in many cash transactions or do the key management officials use their personal bank accounts for transactions? In other words, are there proper internal control measures in place to track and record accordingly the financial flows within the company? 

If the answers to these questions are unsatisfactory, this does not immediately mean that the supplier is unreliable and does not provide good products, however it does show the company has these types of problems within the company – either knowingly or unknowingly – which could potentially have an impact on your company as the client. ‘Where there is smoke, there is fire’ is something we have experienced many times and particularly in China something to take very carefully in mind. Companies must know who they are working with and the above shows that not even foreign multinationals in China always take the right steps. And, unfortunately, be ready for anything, and keep your eyes open.  

This article has been prepared in collaboration with CBI Consulting. CBI was founded in 1999 in Taipei, Taiwan, by our current General Manager, Kevyn Kennedy. After growing demand from clients, we opened our head office in Shanghai to manage increasing Mainland China projects. In order to provide further services and client interface, we established further offices in Guangzhou and Hong Kong.

Moore Stephens Consulting provides full financial services to foreign companies active in China and Hong Kong. For more information regarding this article, please do not hesitate to contact us at info@msadvisory.com or visit their website to be updated on news about China. 

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