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.

Management due diligence

There are two aspects to this that affect joint ventures (JVs) or mergers with Chinese companies.

● Existing managerial habits

Some Chinese companies, especially state-owned enterprises (SOEs), tend to have an outdated approach toward management that extends way back to China's iron rice bowl. This, coupled with the fact that as SOEs are representatives of the government itself and often above scrutiny, can often lead to polar opposites when it comes to business management and good corporate practice. You need to be open to the conducting of a human resource (HR) assessment of the capabilities of the managerial staff to work in the corporate environment you require.

● Inheriting staff from Chinese companies

If staff are transferred from an SOE to a new JV, or are inherited via a merger, you need to conduct checks on whom you will inherit and their pension/welfare obligations. Many new investors have found themselves unwittingly crushed by the sheer weight of taking on not just staff, but also long-term social costs as well. Make sure you do your due diligence on the financial aspect of HR and do not just willy-nilly accept whatever staff you are given. If layoffs need to be conducted, make sure the Chinese side does this as part of their responsibility instead of just passing it off to a new foreign partner. This is particularly true when an acquisition is made for just part of a Chinese SOE.

Listings overseas

To comply with regulatory regimes elsewhere, auditors will need to ascertain that the company is clean and that all assets and liabilities have been correctly stated. Yet it is also common for Chinese companies to have potential debts running into millions of dollars. Due diligence, as well as a statement, needs to be made to the auditors to convey the true position of the company.

As Chinese companies are not monitored as diligently as foreign-invested enterprises in China, this can lead to issues with the internal accounts, as well as a skimping on other major sources of mandatory expenditure. These mandatory payments-the social payments businesses in China are obliged to make to various funds on the employees' behalf, pension, medical insurance and so on-differ regionally in China and are also updated every year, making them awkward to keep track of. Nonetheless, the company had been underpaying these, and the potential liability ran into millions of dollars. How to uncover how much of this could be considered a liability and if there was any room for local negotiation to improve upon what is termed as a "mandatory" payment was an interesting question of Chinese Central Government versus provincial authorities.

Due diligence then can also reach the very heart of Chinese law and the responsible authority-in this case a legal opinion on whether the collection and management of mandatory welfare for staff is a state or provincial responsibility. If provincial, then the governments were prepared to negotiate; if state, they would not negotiate.

Due diligence on matters affecting national businesses therefore will require trips to Beijing to examine such questions with the Central Government officials, as well as a presence in the city concerned.

Anti-monopoly law and considerations

It is also important to note that with the passing of China's anti-monopoly law on August 30, 2007, mergers and acquisitions where foreign investment is involved, including equity JVs and cooperative JVs, now fall under a new regulatory system. The anti-monopoly law prohibits three kinds of monopoly acts: reaching monopolizing agreements; abusing a dominant market position; and the concentration of business operations which may exclude or restrict competition. Conduct subject to an anti-monopoly inspection includes mergers and acquisitions, JVs, as well as licensing and technology transfer. While most of the provisions of the anti-monopoly law apply to both domestic and foreign-funded companies, there is a mandatory security inspection provision on mergers and acquisitions by foreign investors on any merger or acquisition that may have an impact on state security. The foreign investor must go through a state security inspection before he is allowed to proceed with the merger or acquisition.

(In Issue No.5 we will continue discussing due diligence procedures in China)

The author is with Dezan Shira & Associates--www.dezshira.com