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chinese red flag zones

Five most common red flag zones in China

Five most common red flag zones in China

China is increasing efforts to align itself with international anti-corruption standards by taking stronger action and enforcements against wrongdoers under its Anti-bribery Laws. Despite, taking a stronger stance towards corruption and bribery, certain compliance risks remain a big challenge in China. To help entities and individuals with business interests in China or are prospecting, we have highlighted some of the major risk areas when conducting business in the world’s second largest economy. While many of these red flags are not exclusively found in China, we seek to present facts that appear to be prevalent in this jurisdiction.

About 20 percent of The Red Flag Group’s due diligence cases from the last twelve months were placed in China. Some of the key red flags which regularly surfaced in those cases provide a solid indication to some of the trends that we are now seeing with compliance issues and challenges faced by companies operating in China or working with a company registered in China.

   1. Corruption and bribery

Despite increasing efforts to curb corruption and bribery in both the public and private sectors, bribery and corrupt practices are still rampant. Giving “red envelopes” (gifts of money) and providing lavish dinners and entertainment is still deeply ingrained in Chinese business culture. China’s annual government spend on banquets and socialising events is one of the highest in the world.

On occasions where companies deal with the government it is not unusual for extravagant gifts to be given to officials. These gifts may range from luxury phones and wristwatches to expensive wines. In some cases, gift vouchers have been given. It is also common for red envelopes to be given in the name of “festival celebrations”. In some industries, third party agents may be used as a vehicle to transfer improper payments. For instance, pharmaceutical companies in China rely on a network of third party agents, subagents and distributors to deal with public hospitals, physicians and other professionals. In a lot of cases, payments are transferred to these third parties as “consulting fees”.

Although certain “grease payments” might be seen as a business norm in China, they can still incur strict liability to companies making or receiving them. For domestic laws, small facilitation payments are a form of commercial bribery and are a violation of Chinese criminal law. As for international regimes, a lot of jurisdictions have been set to target international bribery, such as the Foreign Corrupt Practice Act (FCPA) in the United States and the Bribery Act in the United Kingdom. Thus, extensive background checks and strict monitoring are necessary to minimise chance bribery when dealing with Chinese companies.

   2. State owned enterprises

Understanding the political context is essential for companies who conduct business in China. The People’s Republic of China has maintained its one-party dominance since its establishment in 1949. As written in the Constitution, the Communist Party of China (which today consists of more than 80 million members) is de facto the only legitimate ruling party in China.

Not only does it maintain a tight grip of the political realm, but also the market and some strategic industries. As such, it is not uncommon that key principals in business are members of the Communist Party and hold positions in various government institutions. One example is the National Committee of the Chinese People’s Political Consultative Conference, where business tycoons have a large presence. It is an open secret among the Chinese that political power is an equivalent symbol of business guanxi (connections) and wealth. Broadly speaking, there are three kinds of entities in China: state-owned enterprises (SOEs), private entities and foreign companies.

Although China is largely regarded as a market economy after liberalisation in the eighties, the government has maintained tight controls on certain strategic industries, such as telecommunications and energy, which are dominated by, or consist entirely of, SOEs. According to research, the 500 largest entities in China make up 75 industries, and 39 of these industries are dominated by SOEs. Of the 40 plus Chinese enterprises in the Fortune 500 list, more than a quarter are owned by the government. Although the total proportion has fallen in the last decade or so, SOEs still make up about a 40 percent share of the market today. Whilst it is not a red flag to deal with government entities or entities with a “red background” (having close ties with the Communist Party) per se, it should be noted that certain international anti-bribery legislations, such as the FCPA, impose civil and criminal penalties on bribing foreign officials.

   3. Underdeveloped rule of law

Rule of law is the cornerstone of confidence for businesses and investors. It is an indicator of whether courts are independent when making judgements, and whether they maintain neutrality and protect their interests. The judiciary in China is often criticised for its lack of independence and efficacy. In cases where the government is at stake, courts are likely to skew towards the government as a political tool. Moreover, litigation records are not open for the public to review.

   4. Restrained freedom of speech

Media and publication censorship imposed by the Chinese government is part of the official aim to maintain “social stability” (or as the politicians often put it, “harmony”). Scandals are sometimes actively covered by the state. As a result, permission is required for non-local reporters to work in China, to make sure any scandalous events that would damage the country reputation do not leak out. When engaging a third party in China, online media references are often gathered to understand the company’s background. However, as the media is not fully transparent, media research alone may not be sufficient. Similar to other countries where there is limited freedom of speech, whistleblowing is rare. As a consequence, people are less willing to disclose information due to fear of retaliation. Moreover, journalists are known to accept bribes to write for or against certain companies. Media research alone is therefore not entirely reliable for third party reference. Extra reputation testing and on-ground checks may be necessary.

   5. Human rights abuses

Being the “world’s factory”, China provides labour resources for the production of a high percentage of products sold throughout the world. Despite this, compliance with international human rights regimes and conventions is far below satisfactory, and child labour is still present. It has regularly been reported that Chinese working conditions are poor and the labour rights are not fully protected. Although there is no proper legal or monetary liability for companies who fail to uphold human rights, the company’s reputation, which is a large part of the company’s intangible assets, would be at risk. In an era when integrity is a core business value, it is crucial that human rights compliance risks are identified and controlled. Conducting business in China involves vast opportunities, but these opportunities come with compliance risks.  When engaging business partners in China, not only are thorough due diligence and background checks necessary, it is equally important that existing partners incorporate the integrity emphasised by your company. In cases where risks are identified it is important to prepare for remediation, such as laying out compliance obligations in the contract with your partner, regular compliance training for the third party and internal investigations.