Way of the Open Hand
China's economic growth may be robust and durable but business prospects, even for global brands, can prove fragile as porcelain. Keith Williamson, a forensic accountant and head of Alvarez & Marsal (A&M) Global Forensic and Dispute Services in Asia, and James Lei, a forensic accountant and director of the A&M team in Shanghai, examine some of the recent fraud and corruption schemes in China, draw out the common issues and offer insights into how to prevent and detect like misconduct.
Multinational corporations operating in China and Chinese businesses have been making headline news around the world for all the wrong reasons in recent months. At one point, it seemed that a new bribery investigation into pharmaceutical companies was announced by the Chinese authorities every day. Rarely did a week pass without allegations surfacing that another Chinese company international or local listing was based on less-than-accurate financial information.
Some risks of investing and doing business in China have been well publicized in recent years – through, for example, the U.S. Department of Justice (DOJ) or Securities and Exchange Commission (SEC) investigations into allegations of bribes made by U.S. issuers to Chinese government officials; procurement managers taking bribes from suppliers; and companies and investors defrauded by joint-venture partners or local companies that manipulated financial statements, entered into undisclosed related party transactions or conducted "off-book" transactions.
With Chinese authorities now appearing to join the U.S. in taking a more consistently hardline approach to bribery and corruption, and Chinese and international regulators seeking to root out financial fraud in listed companies, multinational corporations face even greater risks of fines, other sanctions and reputational damage. In addition, their China-based executives and management face the very real prospect of spending time in Chinese jails while such issues are investigated, and following their resolution.
Manipulation of Financial Information
Manipulation of financial information and bribery of Chinese government officials have dominated recent allegations about the behavior of multinational and local companies operating in China.
Between 2002 and 2013, the China Securities Regulatory Commission (CSRC) has brought 800 enforcement actions against Chinese public companies for fraudulent financial reporting. In 2013, the CSRC instructed companies that wanted to list on the China Stock Exchange to review their financial information submissions; over 250 then withdrew their listing application. The CSRC selected 30 of the remaining applicants for review and issues of varying severity were identified in every one.
Similar concerns have surfaced in Chinese companies listed abroad, evidenced by the delisting of Chinese issues in recent years from NASDAQ and other major stock exchanges. In many cases, they originally came to market through reverse mergers, in which a closely held firm buys a shell company that is already public on an exchange, thus allowing them to list while avoiding the scrutiny of a public offering. The SEC has deregistered the securities of almost 50 companies and filed fraud cases against more than 40 issuers and executives as part of its investigation of non-U.S.-based firms. Many were Chinese companies that had gained entry to the U.S. capital markets via a reverse takeover. Deliberate overstatement of revenue / profit and misappropriation of company capital have been the major reasons for those issuers delisting, to the detriment of international investors.
Multinational corporations investing in China increasingly face similar issues around financial fraud. In January 2013, Caterpillar (the U.S.-based global machinery manufacturer) announced that it had identified earnings management issues involving a conspiracy by local management at its Chinese subsidiary acquired six months previously. This resulted in a US$580 million goodwill write-off on the investment, or 89% of the original deal value of US$653 million.
Bribery and Corruption
Many household names have faced sanctions of late for non-compliant business conduct in China and they range across the pharmaceutical, IT, telecom and manufacturing sectors. Historically, most allegations have surfaced with and been investigated by U.S. authorities under the Foreign Corrupt Practices Act (FCPA), while the Chinese authorities have generally taken corruption cases against their own government officials for receipt of bribes.
More recently, the Chinese authorities have turned their attention to pharmaceutical companies for alleged bribery of government employees, including doctors, in an attempt to boost product sales locally. They have focused not only on the companies, but also on the management and employees alleged to have overseen or been involved in offering the bribes. At an early stage in the probe into a U.K.-based pharmaceutical company, four local senior managers were arrested along with other staff.
Fabrication of documents and collusion with third parties to disguise false and illegitimate transactions are commonplace in Chinese fraud and corruption cases. Fabricated documents are often used, either to conceal illegal payments (e.g., bribes paid to government officials or misappropriation of assets by management and employees) or when financial results are manipulated.
Documents, including bank statements, invoices, receipts, delivery notes and supplier confirmations, are created or falsified to legitimize an inappropriate transaction or to support a fictitious transaction, balance or activity. Even official receipts ('Fapiao'), required by Chinese tax law and issued by Chinese tax authorities, are fabricated or obtained by deception to further legitimize and support transactions.
Fapiao were designed by the tax authorities to track tax payments and deter evasion; they are mandatory for tax and expense deductions. Blank Fapiao can only be obtained by businesses from the local tax authorities and official Fapiao are provided by businesses to consumers for the amount of services rendered or goods sold. They should, therefore, provide a reliable form of proof of a transaction. A business may endeavor to cover an illegal payment or fictitious transaction by either purchasing fabricated Fapiaos or asking vendors to issue more than are warranted.
Goods, delivery notes and sales agreements are convincingly fabricated to support transactions that inflate revenue and profits. While internally produced documents are easier to falsify, it is not difficult or expensive to obtain replicated company “chops” to stamp purported purchase orders from or sales agreements with customers. If auditors seek to confirm the existence and recoverability of false accounts receivable balances, the business may attempt to intercept communications with the customer and alert them that a balance is incorrect and confirmation is not necessary. They might also fabricate confirmations provided to the auditors.
Inflated revenue and profit may be supported by forged bank statements that appear to confirm sales receipts and show exaggerated cash balances. A number of Chinese overseas listed companies' auditors have resigned over suspicions of forged bank statements or irregularities in the process of balance confirmation.
Collusion with Third Parties
Third parties – customers, suppliers and banks – may collude in fabricating documents and provide confirmation of fictitious transactions, balances or activities, making false and illegitimate transactions even more difficult to direct.
In a recent investigation by Chinese authorities, collusion between travel agents and employees of the local subsidiary of a multinational company received wide publicity. Both the travel agents and employees of the subsidiary were alleged to be receiving kickbacks from hosting regional conference events. It is not uncommon for Chinese companies to outsource the planning and organization of conferences or corporate events to local travel agents. Strong financial controls over the settlement of conference costs requires original invoices, event agendas, signed attendance logs and even photos of the event, but these documents are often fabricated in the pursuit of personal gain and to facilitate the payment of bribes to vendors and government officials.
Attendance logs are fabricated by having one individual sign ostensibly on behalf of others. Photos submitted as proof that the event happened are often either taken from other corporate events or have been created on computer. Verification of documents is especially challenging if the colluding parties deal in cash rather than bank transfers or checks.
Detection and Deterrence
Tightened financial controls and closer review of transactions and supporting documents are needed to detect, spot and deter. Counter-measures must include:
- Review signatures, company “chops” and the quality of documents' format and information
- Verify the authenticity of Fapiao on the tax bureau website or via the tax bureau telephone hotline
- Perform enhanced due diligence on third parties' corporate information
- Carry out site visits of third parties' principal places of business to identify false customers and suppliers
- Review financial information filed with the authorities, including annual reports and any other publicly available financial information
- Where available, review relevant accounting records of third parties to confirm transactions or balances
Foreign stakeholders looking at Chinese businesses are strongly advised to conduct thorough forensic and financial due diligence prior to investment. From day one, post-acquisition or investment, effective compliance, fraud monitoring and internal financial controls are essential to prevent illicit payments. If the worst happens, legal counsel and forensic accountants with local knowledge must react quickly to contain the damage and advise on prevention.
 ZHANG Zhongan, CSRCT Rectification Orders on 55 Companies implicated in Fraudulent Activities, Guangzhou Daily, 16 March 2013.
 CSRC Update on IPO Inspection Progress, CSRC,11 October 2013.
 Light Punishment is Condoning Fraud in Stock Market, People's Daily, People, 8 July 2013.
 Bloomberg News, 24 January 2013
 DING Feng, RMB 360 Million Loss and Termination of Local Management Following Caterpillar's Acquisition of Chinese Target Company Xinhuanet, 21 January 2013.
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This article first appeared in Fraud Intelligence.