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Introduction to Due Diligence in China
 

Key words: due diligence, Chinese companies, China, investigation, investment, trade, verification

As most people know, conducting a comprehensive due diligence is an essential (often time-consuming) step to ensure not only success in the China market, but also preventing outright failure. In comparison to the legal environment in more economically developed countries such as the United States or member countries of the EU, in which the accounting books and financial records of a company are somewhat reliable, Chinese companies often suffer from a lack of transparency and rigid organizational structure.

As such, one’s method of conducting due diligence must bear in mind such factors, and may require verification from two to three different sources (depending on the importance of the information).


At the outset of any investigation, a company must assess how risky/important this deal is to their company in terms of investment (of time, money, reputation, and other resources) as well as other factors such as the risk of IP misappropriation, etc. Once this is determined, a rough budget must be set. As a rough guide and although there are some who will state otherwise, a comprehensive legal due diligence for the purposes of a merger or acquisition will cost around US$10,000 and up, while a comprehensive accounting/financial due diligence will be slightly more (based on high-end Chinese firm rates and international firms). However, for trade transactions which require substantially less investigations, costs could range from US$1,000 and up.

A. DUE DILIGENCE PROCESS:

Conducting due diligence in China must often be done by Chinese professionals, not simply because of language, but also cultural and other sensitivities to slight abnormalities which may reveal larger problems. As such, it is our recommendation that companies do engage local advisors, whether they be from international firms with offices in China or local firms.

Typically, the process will proceed as follows (we outline a comprehensive due diligence procedure, other less intensive transactions will warrant lesser investigations/steps where appropriate):

a. A Memorandum of Understanding or Letter of Intent outlining the main heads of agreement that will be signed between Chinese party and foreign party, often accompanied by a formal appendix with specific agreements pertaining to the due diligence activity such as an exclusivity agreement and confidentiality agreement.
b. Party will serve the counter-party with a due diligence document request list, setting out various documents/certificates which are required from company.
c. Review of the returned documents, and analysis of issues. Request of further documentation based on the findings.
d. Independent verification through the following sources:
i) Conduct interviews with management;
ii) Review registrations with local Administration of Industry and Commerce, as well as other relevant government filings;
iii) Site survey;
iv) Environmental audit. This would be particularly relevant for the sale which you are conducting, with the factory’s potential environmental impacts;
v) Verification with banks; and
vi) Employment of investigative/valuation agencies, where necessary.

B. INFORMATION REVIEWED:
Like other jurisdictions, there are certain areas of the company which must be reviewed. We set out the areas of particular importance below:
1) Corporate organization:
a. Corporate structure; and
b. Corporate approvals by relevant government organizations.

Note: Corporate structures are very dissimilar to that of other countries, therefore, it is important to understand the basics of Chinese corporate law in order to understand the implications of findings.

2) Land:
a. Land use rights;
b. Building ownership rights; and
c. Environmental compliance.

Note: Chinese land ‘ownership’ is very unique in that it allows for a system of long-term leases of the land itself, and full ownership rights to the land. Documents must be investigated carefully, particularly, if the land and/or property is of substantial value in relation to the transaction.

3) Debts: Loans, guarantees and mortgage contracts.

Note: China does not yet have a strong central credit reporting system for companies. As such, any reports offered must be verified against independent sources in order to confirm the same, as the initial report may simply lack information regarding the company, resulting in a positive report when, in fact, there are a number of outstanding liabilities.

4) IP rights: Ensure that IP registrations are properly conducted, company is free from violation of others' IP rights, licensing agreements are properly concluded, etc.

5) Material contracts: Particularly, if you are merging or acquiring the company as a going concern, the company must be very careful to ensure that they fully understand obligations and investigate any outstanding commitments and/or liabilities thereunder.

Note: Chinese contracts are often very brief due to the nature of business relations in China. While this is acceptable to some point, it can be seen as very risky in the event that relations turn 'sour'. There are a number of options available to mitigate such risks.

6) Tax filings and payment: Ensure that taxes have been appropriately filed and necessary payments have been made. (This will have to be conducted in coordination with an accounting firm.)

7) Regulatory/legal compliance:

8) Special permits and other approvals: This category is often based on the business scope of the target or counter-party to the transaction.

9) Employee matters: A strong workforce is particularly important in China, given the concentration of foreign investment in labor-intensive sectors and vast population for the service business.

10) Pending litigation/claims: This investigation, as litigation is often difficult to predict, is accompanied by strong warranty clauses assuring the counter-party that there are no outstanding or expected litigations or claims; and

11) Insurance coverage.

 

 

 

Source: http://en.unsbiz.com/articles/Due-Diligence-in-China/03200709261193384589325.html



 

 

 

 

 

 

 

 

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Introduction to Due Diligence in China

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Employee Background Check
Intellectual property--The Best Protection is Prevention
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The Importance of Comprehensive Business Information Services
The What and How of Background Checking

Growing of China Credit Database  

Credit Report

 

 

 

 

 

 

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