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Business> Legal-Ease
UPDATED: January 29, 2008 NO.5 JAN.31, 2008
Conducting Due Diligence in China
 
By CHRIS DEVONSHIRE-ELLIS
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Ninety percent of problems when setting up a business in China can be avoided by the deployment of due diligence at the front-end of the investment planning. Here we point out some of the areas that can hinder a sensible approach to due diligence, the hidden risks and basic checks.

China governmental due diligence

China can be in conflict between various levels of governments. First, there is conflict between different ministries and their responsibilities, and second, there can be differences in where the actual China legal responsibility lies. It can be vital on occasion to know which level of government has the authority. Inter-governmental conflicts and the implications are discussed here as follows:

Conflicts between ministries and their local agencies

A common conflict that arises is between the department of commerce and the tax bureau. Applied on a local basis, it can manifest itself in the department of commerce and other related government officials, which can extend to the mayor, being out of compliance in their statements to foreign investors, especially when it comes to some areas of tax and Customs administration. Keen to secure foreign investment, they can be prone to "oversell" the attractiveness of the investment and omit to recognize the authority of the tax bureau post incorporation. This is dangerous as by then the investment has been realized and the funds transferred.

Governmental legal responsibilities

Earlier we discussed the case of the national retail outlet with large unpaid statutory welfare amounts as liabilities. In order to satisfy the auditor responsible for assessing the risk of debt, a case had to be discussed as to whether it was the remit of the local government to possess authority to negotiate this amount, and whether the state would be able to challenge this. It's a classic China conundrum-state vs. local government. In this type of instance, legal counsel needs to be sought to provide a valid opinion on the issue. Millions of dollars were at stake, as was the potential performance of the prospectus for listing the business in Hong Kong. On this occasion, it was successfully argued that the local government did have the right to negotiate the amount of unpaid "mandatory" welfare payments owed to Chinese nationals within its local region. Consequently, a lower figure of liabilities, based on previously discussed guidelines with the various governments concerned, saw an overall reduction in the total welfare liability of some 40 percent. This was not a small sum, and affected the prospectus. The auditors accepted the argument, and accordingly reduced the amount of liabilities the company showed in its balance sheet. On this occasion then, due diligence was backed by a valid legal opinion and accepted as such by the auditor.

M&A environmental issues

As the Chinese Government becomes more and more concerned about the environmental issues in China, it is taking decisive steps to regulate and to ensure the compliance with the environmental standards. As a result, mergers and acquisitions (M&As) require very conscientious due diligence on the environmental liabilities. For example, a factory that has been polluting the local rivers for some 20 years may one day get prosecuted for massive damages.

To avoid the risk of getting involved in M&A activities that might end up in a disaster, in the due diligence context, attention should be paid to the following information:

● What is the current environmental situation of the company?

● Has it had any environmental problems in the past or might it get any environmental problems in the future after the take-over?

● If yes, then what kinds of countermeasures have been taken and what are the results?

● Has the company stored or used any hazardous substances, raw materials, objects, etc. or has it been involved in any hazardous procedures?

● Has the company paid any pollutant discharge fees over the last years?

● What is the company's policy regarding the environmental issues?

●Can the company provide any documentary evidence regarding this information, such as environmental impact assessments, licenses, approvals, permits, permissions, certificates, applications, registrations and notifications?

● Can the company provide any reports on its environmental situation produced by (private and governmental) third parties over the last five years?

Such matters need to be attended to, and if necessary, professional advice taken.

Summary

As can be seen, due diligence is a process that should be carried out by every foreign investor when looking at investment in China. It is negligent if you do not. However, for simple investments, there is much due diligence that can be conducted at minimal cost. Naturally, the higher the investment is, the more the need to protect it and the deeper the due diligence needs to be performed. Most due diligence in China requires not just a basic legal check of documentation, but also a fine-tuned look at financials and the tax position. To do so requires experience and knowledge.



 
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