In recent years, the escalating trade and political tensions between the U.S. and China have led to speculation that there will be an eventual economic decoupling of the two nations and perhaps a wider decoupling of swaths of the Western economy from China.

In reality, China is and will continue to be a major global economy, with strong multilateral trade relations with Western economies that are reliant on China’s raw materials, goods and services and view China as a huge and ever-growing market for their own goods and services. While China may seem more ideologically and politically distant and even isolated from the West than it has been for many years, it is in fact more economically influential globally. Western businesses continue, in great numbers, to invest, operate and enter into partnerships in China.

Those multinational businesses need to comply with local and international laws and regulations, investigate any wrongdoings by their employees and management, and resolve legal disputes with business partners and third parties. Chinese regulations present unique challenges, heightened in the current climate of mutual distrust between Western countries and China.

This article outlines the key current challenges in cross-border operations and investigations and advises on how to navigate regulations in China.

COVID-related lockdowns and travel restrictions

Travel into China remains extremely restricted for foreign nationals. Periodic lockdowns in major cities continue to cause disruption to travel between cities and limit access to businesses and offices.

Visits to businesses in China for compliance or investigation purposes or to collect evidence for legal disputes therefore need to be carefully planned with contingencies anticipating possible postponement and delays. For best results in investigations and reviews, it is advisable to use local talent, who can travel freely or with limited quarantine requirements to and from the target premises, and to make maximum use of technology to perform work remotely, within the parameters of data privacy and state secrets laws.

Data privacy and state secret laws

In recent years, the transmission of data or documentation outside China, often instructed by a foreign law enforcement agency or regulator in investigation situations, typically required a legal review by a Chinese law firm to ensure that the information transmitted complied with the State Secrets Law and did not include any information that could be classified as Chinese “state secret.” This inevitably added to the time and expense of investigations and reviews and commanded an initial review of data and documentation in China, with security in place to ensure that the information could not be accessed outside of China, by hosting data on a Chinese server inaccessible outside China.

With the enactment of the Data Security Law and Personal Information Protection Law in November 2021, the time and expense required to provide data from China to a foreign judicial or law enforcement agency has increased further. Any data stored in China, regardless of its origin, requires preapproval by relevant Chinese authorities prior to any transmission outside China to any foreign judicial or law enforcement agency. The financial and business consequences of a breach of the Data Security Law are severe and prohibitive, including fines, the possible forced shutdown of businesses and potential criminal liabilities.

To ensure that businesses and their partners do not even inadvertently breach the data privacy and state secret laws, it is important to seek Chinese legal advice at the earliest possible stage and to put in place appropriate safeguards. Such advice and safeguards will also assist in securing the cooperation of businesses located in China, some of which may be reluctant to share data with third parties following the enactment of the Data Security Law. In some cases, it may be necessary to conduct reviews and analyses of a business’s data in its offices to provide comfort that its data will not be transmitted externally without the business’s knowledge and permission.

Integrity of financial records

Many high profile short-sellers have uncovered financial reporting scandals emanating from businesses with substantial operations in China over recent years. These scandals, coupled with China’s historical reluctance to provide access for foreign regulators to audit working papers of Chinese companies listed overseas (which has been the subject of a long-running but possibly soon-resolved dispute between U.S. and Chinese regulators), have created a certain level of distrust and suspicion of the integrity of financial results reported by Chinese entities.

The scrutiny of investors, short-sellers, and local and foreign regulators has undoubtedly resulted in the production of more reliable financial information in China. However, it is important to be aware of some of the most common issues that may persist, and to exercise appropriate levels of professional scepticism and caution when reviewing financial records. Issues about the integrity of financial records include the maintenance of multiple sets of books and records (e.g., for tax and nontax purposes), the use of fake or manipulated bank statements, expenses supported by fake or substitute tax invoices (“fapiao”), collusion with third parties to obtain false documentation, round-tripping of cash to settle aged accounts receivable balances, and sales to fictitious third parties or undisclosed related parties.

Given these issues, it is essential to involve local experienced talent who are aware of such schemes’ execution and concealment and to seek reliable independent corroboration of transactions, assets, liabilities and explanations wherever possible.

Cultural factors

As with every country in the world, there are cultural elements to doing business in China that are important to be aware of when conducting investigations and compliance reviews or navigating legal disputes.

A common challenge to navigate is the business’s hierarchical management structure. This can create delays, complications and roadblocks in terms of obtaining access to data, people and information, as pleasing one's boss sometimes trumps compliance obligations in China. When this is accompanied by a culturally low adoption of whistleblowing, the tone from the top becomes even more important in trying to ensure people do the right thing.

The finance function, which is often an important gatekeeper for Western businesses, can sometimes be staffed with employees who are given relatively low status in the organization and/or have poor qualifications compared to their Western counterparts. Again, this can cause challenges from a compliance perspective and in obtaining the level of support, input and autonomy that is needed from finance and accounting teams to aid investigations and compliance reviews.

Finally, as in any market, there are local ways of building business relationships in China that are important to understand and embrace to secure the trust and assistance that is needed for the smooth running of an investigation or compliance review. Whether it is adhering to structured lines of communication or handling matters in a way that minimizes any loss of face, all recognition and adoption of local cultural and behavioral traits will help smooth and secure the cooperation needed.

Conclusion

The challenges of handling investigations, compliance reviews and disputes in China may be greater than ever as a result of the legal and practical impediments arising from U.S.-China tensions and China’s current response to COVID-19 but, like more longstanding challenges, these can be overcome with patience, flexibility and the engagement of local Chinese expertise early and throughout proceedings.