Bodyguard Optional: Risk and Governance in China

Our first interview covers some of the most important aspects of business operations in China – risk and governance. We talk with Mimi Yang, Partner at Ropes and Gray, Shanghai. Mimi has extensive experience in litigation, enforcement, and investigations in the United States and China. As such, she has an occasional need for bodyguards at work.

What do you see as some of the key risks for investors, shareholders and board directors in Chinese corporations?
I think the biggest risks are the lack of transparency and corporate governance structures in Chinese corporations.

With respect to transparency, many mid-sized or smaller Chinese companies are family-based or have a close-knit management team. Investors and independent board director may find it hard or challenging to monitor the management’s decision-making process and enforce corporate decisions that are in the best interest of the shareholders. Also, Chinese society relies strongly on guanxi, so it is imperative to understand whether the company’s relationships with the government is based on operational strength or based on bribery. Lastly, some Chinese companies are State-Owned Entities (SOEs), meaning that not only do they aim to maximize investor/shareholder value, but they also need to advance the government’s policy targets. Sometimes, these two goals may conflict with each other, and thus it is not always apparent to the investor or shareholder whether a certain course of action taken by the company is in the best interest of the shareholders.

With respect to corporate governance, while Chinese corporations have improved drastically in this aspect, they still lag somewhat behind their foreign counterparts, especially companies operating in jurisdictions with strong regulatory authorities (such as the U.S.). For instance, Chinese companies often keep two sets of books, and this can be confusing for investors who are trying to find out the real state of the company’s financial status. It is also important for investors to know whether the corporate governance structure is actually effective, such as the use of truly independent auditors and the existence of truly independent directors.

What about risks for international companies operating in China?
Because most of my work is in the anti-corruption and securities fraud space, these types of risks are the most common ones I see. For U.S. or U.S.-listed companies, I think that they have to be aware of corruption or bribery related risks. This is because the U.S. authorities have prioritized enforcement of the Foreign Corrupt Practices Act, which has resulted in millions of dollars of fines imposed on companies for corruption-related misconduct in China. Due to the culture of gift-giving and guanxi in China, this increases the risk that an act which may seem quite harmless in the Chinese cultural context may actually violate the U.S. laws. In fact, during many of my investigations on behalf of my clients, a lot of the employees who engage in misconduct justify their behavior by saying it is impossible to do business in China without providing some sort of benefit to their customers.

What are the most common types of commercial fraud and corruption you encounter in China? And the most unique and unusual?
The most common scheme that I have encountered in China is the usage of third parties in fraud or corruption activities. Many, if not most, companies already have policies prohibiting bribes or corruption-related activities. However, employees will come up with ways to circumvent the policies, and collusion with third parties is very prevalent in these schemes. For instance, employees will engage agent or vendors to create slush funds to funnel money to end customers, often by overpaying the third parties or asking the third parties to overcharge the company. In some instances, the employees will embezzle the money themselves for personal enrichment.

I’m not sure if the cases I’ve seen are particularly unique or unusual, because chances are that if it’s happened once, it’s probably happened many times in the past (but this is the first time the misconduct has been caught). I will say that one of the more interesting investigations I have done involved an employee who was allegedly in the mafia. During the investigation, two bodyguards were hired to protect me and another attorney – they were the biggest Chinese men I had seen! They always carried a suitcase and followed us around everywhere. It was the first and only time I actually felt like a celebrity – a very boring celebrity who only trekked between the hotel and various conference rooms. I imagine it must have been even more boring for the bodyguards.

As more Chinese companies consider listing on US stock markets, where do you see gaps in their internal operations that need to be addressed in order to conform with international standards?   I think the major considerations that Chinese companies need to think about before listing in the U.S. are the challenges with understanding the complex US regulatory landscape, as well as reporting and disclosure requirements.  The U.S., compared to other countries, has a relatively strong regulator in the Securities and Exchange Commission (SEC).  Some famous short sellers are also notorious for targeting Chinese companies for accounting irregularities.  Finally, individual shareholders can bring actions against the company itself for disclosure issues, accounting fraud, and other violations of securities laws.  While nothing can absolutely prevent the SEC, short sellers, or shareholders from going after the company, Chinese companies should consider taking steps to prevent impropriety, including:

  • Establishing a robust system of corporate governance and making sure the company’s internal controls are effective;
  • Educating the board of directors on their fiduciary duties and the U.S. legal regime, or appointing independent directors and board subcommittees if they do not yet exist within the organization;
  • Promoting transparency within the organization and establishing a strong, experienced investor relations team for communications with investors;
  • Thoroughly understanding financial reporting requirements, accounting standards (such as U.S. GAAP) and disclosure requirements, which often involves putting together a finance team that is well-versed in those issues; and
  • Establishing reporting systems and a risk management framework.

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