Complex patchwork of corruption risks

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While China is by no means unique with regard to experiencing corrupt activities in its commercial dealings, there are several important characteristics that distinguish the Chinese corruption environment from corruption in many other countries. First, China has a relatively immature legal system, with some 30 years of modern history. That legal system has been required to provide the infrastructure for an extraordinary amount of economic growth. Generally, the Chinese legal regime has not developed independently from government or the Chinese Communist Party (CCP). Not surprisingly, a large amount of discretion with regard to administrative and some legal acts is in the hands of Chinese regulators. Second, ownership of a significant portion of the Chinese economy is in the hands of the state. This means that for US and UK law purposes, transactions with employees of state owned enterprises (SOEs) are generally deemed to be conducted with foreign government officials, as defined in the US Foreign Corrupt Practices Act (FCPA). Who constitutes a foreign government official in China is not always clear, but it is certain that majority control by an SOE of a company, whether by means of equity interest or otherwise, could give rise to exposure under the FCPA or the UK Bribery Act. Further, SOEs generally have closer relationships with Chinese regulators than foreign investors.

Two contexts

Commercial corruption risks in China typically arise in two principal contexts: sales and purchase agreements, and investments. China is aggressively pursuing acquisition of foreign and in particular US technology, often using procurement contracts. A typical scenario arises where a US company bids for a Chinese SOE procurement project. Clearly, corruption risks can arise in connection with winning a bid; however, sometimes those risks are not immediately obvious. For example, a request to use a particular Chinese agent for purposes of preparing tender documents could be cover for payment of secret commissions to the buyer in order to secure the bid. Risks also arise in connection with sales to SOEs. Teams of SOE employees often meet with their US or UK counterparts either inside or outside China, where they are entertained and sometimes given gifts, or taken on trips for tourism purposes. In these circumstances, it is important that any entertainment is appropriate for the business context and not lavish.

Susan Munro
Susan Munro

Corruption risks also arise in connection with domestic sales in China. Given China’s size, Chinese subsidiaries of US and UK companies in the manufacturing or services sectors generally work through local distributors and agents in order to make sales. In certain industries, such as pharmaceuticals and medical devices, the majority of customers (including hospitals and clinics) are state owned. In other industries, such as insurance or manufacturing, it is likely that there is a good proportion of SOEs in the customer base. While foreign companies can implement robust compliance programmes to control the activities of their own sales and marketing professionals, it is much more difficult to do the same with regard to third party distributors and agents. Chinese law contains provisions prohibiting unfair competition using bribery in the context of commercial dealings, and in certain circumstances such acts could amount to criminal bribery; however, enforcement of the law is often difficult for evidentiary reasons.

Corruption risks also arise in the context of investments in Chinese businesses. A greenfield investment in a new business will typically require the approval of at least one commercial regulator and if the industry is specifically regulated, approvals may be required from regulators in addition to the Ministry of Commerce (or in the case of financial institutions, only from financial regulators). Some foreign investments, such as investments in direct selling businesses, require multiple levels of approvals from multiple regulators. Historically, obtaining such approvals has presented an explicit corruption risk; however, such risks have diminished as a result of aggressive anti-corruption initiatives undertaken by the Chinese government in recent years.

In recent years, many foreign investors have sought to restructure or exit from their Chinese investments and there has been a significant amount of M&A activity. As a result, more corruption risks have emerged in the form of legacy violations or corrupt business cultures, which US or UK companies or their subsidiaries inherit when they acquire equity (or in some cases assets) in Chinese companies. Those risks are very high when a US or UK listed company makes an acquisition that results in majority ownership and/or control of the target.

In the past two years, many Chinese companies listed on US stock exchanges have faced sanctions and compulsory deregistration as a result of reliance on fraudulent financial statements, or other serious accounting issues. Usually those irregularities constitute books and records violations under the FCPA. In several cases corruption issues have been exposed as well. Foreign investors seeking to exit investments by means of IPOs on US (and potentially UK) stock exchanges have been seriously impacted by the possible existence of fraudulent financial statements and corruption. On the one hand, appetite for listings of Chinese businesses has dropped, and on the other hand if a company attempts a listing it must implement extremely robust compliance measures before it does so.

Until recently, a key method of identifying corruption risks in the context of investments has been to conduct specific FCPA diligence and background checks; however, effective due diligence is becoming increasingly difficult for foreign investors as a result of recent measures taken by Chinese authorities to restrict access to Chinese corporate and other information.

Heightened risks

In this increasingly difficult environment, US and UK nationals face heightened risks in relation to commercial activities in China. In recent years the US Department of Justice has targeted individuals for enforcement action, reasoning that this is likely to send a stronger message than penalties (primarily financial) levied against their employers. It is likely that the Serious Fraud Office in the UK will take a similar approach.

As the international anti-corruption environment evolves and becomes increasingly complicated, foreign companies and nationals doing business in China should act with caution and apply a heightened level of awareness to corruption risks, which can arise in different contexts and adopt different guises.

Susan Munro is a partner at Steptoe & Johnson in Beijing. She can be contacted at +86 10 5834 1199 or by email at smunro@steptoe.com