Risk and corporate governance in China

The Chinese market presents tremendous investment and business development opportunities for foreign companies, but its unique regulatory, accounting, governance and cultural risks need to be understood.

Mistakes are costly. In 2013, after accounting “misconduct” at a Chinese division, Caterpillar took a $580m writedown. The next year, GlaxoSmithKline paid a record $490m fine following a bribery scandal. Yet investment continues. Through August 2016, foreign direct investment increased 4.5% year on year.

Many foreign firms come to China without fully understanding the landscape, says OC&C Strategy Consultants partner Jack Chuang. “[Then] they have to exit or resell the business,” he says. As competition increases, this has to change, he adds. “They need to come into China with long-term thinking.”

Matthieu David-Experton, founder and president of Daxue Consulting, says foreign companies need to appreciate “what you can own and what you can not own in China”. Regulations vary across industries, which he groups into categories: “encouraged” are open for investment, allowing greater legal flexibility in the form of wholly foreign-owned enterprises; “regulated” require joint ventures; and “protected” sectors necessitate derivative contracts, giving foreigners a share in an agreement, not direct ownership.

According to The Wall Street Journal, China’s State Council recently promised to ease restrictions on foreign capital providers. Specifically, it aims to support the culture, education, medical care and sports sectors. Simultaneously, though, it is strengthening its grip on oversupplied domains such as aluminum, coal and steel.

David-Experton cites recent regulatory clampdowns on foreign advertisements and websites. Ambiguous regulations, he says, are “putting concerns in investors’ minds… They hear some mixed messages from the government.”

Benjamin Cavender, senior analyst at China Market Research Group, says this benefits local players: “If you’re a foreign firm, you’re never going to have the [government] relationship pull you need.”

Chuang says business practices and regulations differ regionally. “It’s almost as if you’re going into the EU, except you have one central government, but you have different local conferences,” he says.

Intellectual property (IP) violations and copycats are also concerning. “If your brand is well known enough in China, you will have knock-offs,” Chuang says. Foreign companies should register brands under their own legal entities and not allow local partners to do so. “Whichever entity registers the brand, that brand belongs to that entity,” he explains.

Cavender says Chinese firms suing each other over IP protection is a positive sign. “The more that that happens, the stronger the legal framework in China becomes. And that’s good for foreign companies.”

He acknowledges, however, that foreign companies in joint ventures agree to technological transfers, but that “oftentimes, a lot more gets transferred than they would like to see and that ends up hurting them in the long term. The IP situation is getting better, but there are a lot of risks.”

SHYING AWAY FROM TROUBLE

Corruption exists, but is being fought by president Xi Jinping. According to reports, in 2015 alone, China punished 300,000 officials to varying degrees. Consequently, sectors including luxury goods, catering, alcoholic beverages, and travel have been hit. “People are more sceptical to invest if the market is shrinking,” David-Experton says.

“At the national level, officials are really shying away from anything that would get them in trouble,” Cavender adds. He says larger corporations are also improving their practices, but that in “grittier sectors” such as construction and heavy manufacturing, “there is still a fair amount of corruption”.

With creative accountants, he says, “the companies are very good at hiding how they are structured, where the money really is, what their liabilities really are”. Overall, though, “Chinese firms are getting much better about how they handle their accounting and how they comply with GAAP principles.”

Additionally, new industries are inherently more transparent. Online and app companies are built around technologies that enable third parties to track transactions and customer data, reducing fraud.

“It’s much easier for an investor to see the real data and to corroborate,” David-Experton says.

Many local companies see value in raising their standards. “Overall, Chinese companies are becoming much more in line to what Western companies are used to,” says Chuang.

According to David-Experton, another issue is that local accounting practices differ from International Financial Reporting Standards (IFRS). For example, brands are valued less in China and turnover is not always declared. “You need to value it, but to justify [unaudited figures] to your board is really difficult,” he says. Consequently, companies should “be much more entrepreneurial in the way they do the acquisition, and not purely financial”.

Cavender notes that succession planning is also bolstering corporate governance. “[Private companies] want best practice standards in place because they want to be able to maintain momentum past the founder retiring.”

Chuang adds: “There’s quite a few first-generation company owners that are trying to modernise. They have a better governance structure for the second generation so that a more professional management team can take over and run the company.”

Confidence grows as China’s financial markets globalise and its institutional investor base deepens. “Venture capitalists are helping [enterprises] get better governance from the beginning,” says David-Experton. “I think this is where the change is going to happen.”

Environmental risks are also being addressed, albeit incrementally. “The government has done a lot because it knows it is going to be a very big issue in society,” David-Experton says. “It will still be an issue, but it will improve over the next five, 10 years.”

Cultural differences can impede deal success, creating a need to explicitly articulate roles. Speaking about joint ventures, David-Experton says: “There is a lot of power that is not written into the contract; the power of influence, the power of knowledge.”

Cavender adds: “Companies here feel like they’re being approached by people who have a sackful of money, but are just interested in doing a deal and not much more. The human element actually plays a bigger role here.”

Though unique risks remain, continued economic expansion ensures cross-border deals and investment will continue. David-Experton says companies should methodically enter China and acquire minority stakes initially. “[Go] step-by-step, with KPIs, with the ex-owner of the company… After a couple years, buy the company after they know the company from the inside.”