This morning, as I was sitting down to write a blog, I intended to give my thoughts on negotiating with the Chinese – always a fun subject. I didn’t have to look far for source material as all I had to do was examine one of the many scars on my back to recall what worked and what didn’t work at the negotiating table. However, as I started to write that blog a good friend of mine called and asked for my advice on working with the Chinese. He’s a sophisticated investor, has invested globally, and has spent the last eight years traveling to China and investing in Chinese companies. And, like most, his current portfolio reflects the massive decline in the market value of Chinese stocks, at least those that are still public, and the total lack of confidence the market has in anything Chinese.
My friend’s questions to me are ones that I, and my partner Dave Dodge, receive almost daily: How can I trust anyone in China? Why would anyone want to invest in a Chinese company, even if market conditions allowed for funding and there was liquidity?
Let me address these questions and concerns by first going back in time and explaining how Chinese companies went from being the darlings of Wall Street to road kill. Then I’ll discuss what’s true and not true about Chinese companies, and answer my friend’s questions.
In 2003, when Dave and I first started going to China, it was much easier to do business there. Chinese businesses were actively soliciting foreign investors to put money in their companies and the provincial and local governments were very supportive. In fact, they would roll out the red carpet and show you any company within their jurisdiction that they believed met your investment profile. I can remember government officials setting up meeting after meeting for me, with companies within their province, hoping I would bring in foreign capital, increase their tax base, and employ a greater number of their people.
Chinese companies were also anxious to attract foreign capital, as their only other alternative was an asset-based loan at their bank. As with many companies in China, the demand for their goods was there, they just lacked expansion capital in order to increase the size of their company and meet the demand for their product. In addition, the Chinese private capital and equity markets were not as prevalent or robust as they are today and Chinese companies, therefore, clamored for a U.S. public offering, and the follow-on funding that followed, as a way of satisfying their need for growth capital.
While access to foreign capital and the willingness of foreigners to do transactions in China has changed over the years, what hasn’t changed is the mindset of the average Chinese CEO. Although he wants foreign capital, in his eyes we’re still foreigners and, therefore, considered outsiders in contrast to Chinese insiders. The CEO’s perception is that, as outsiders, we’re actually the ones who shouldn’t be trusted as we would cheat and take advantage of insiders. Consequently, a great many Chinese CEOs and their staff feel it’s acceptable to lie to an outsider and deceive him, as foreigners would certainly do the same to him. In addition, most Chinese businessmen feel it’s up to an outsider to do his due diligence and check the facts, and to make sure that he’s not being cheated. If he fails to do this then it’s the outsider’s negligence that’s responsible for any problems or loss that he may experience. The Chinese CEO can be tough in negotiations, and he’ll expect you to be also, but in the end he views each side as responsible for spotting errors and misrepresentations. I point this out because many foreign businessmen come to China and believe that they can be successful in negotiating a business transaction based on the transaction alone and that China is, in the end, no different than any other country when it comes to doing business. Business is business, they reason. They have a contract, so they’re good to go. At the same time many discount the importance of knowing the culture, the history, and the beliefs of the people they’re negotiating and doing business with. They believe that because they’re both in this together, and have a valid contract, that this puts both parties on the same track. They’re wrong. Of course these facts were largely unknown to your average Chinese investor back in 2003. Instead, the investor was excited about doing business in the world’s fastest growing economy and expected everything to go smoothly.
In addressing the mindset of the average Chinese CEO, don’t expect him to outwardly display his feelings towards outsiders. His purpose is to attain his expansion capital, or manufacturing contract, as quickly and as cheaply as possible. Therefore, the foreigner is feted at lavish banquets and shown a great deal of courtesy and deference by his host. All this helps create the illusion that there’s a permanent and long lasting bond between the foreigner and his Chinese counterpart. In fact, many foreigners believe they’ve formed, even after a very short time, a genuine and long lasting friendship with the CEO of the Chinese company. Further, they also believe they have guanxi, or the merging of the business and personal, with the CEO. They believe that they’re now an insider. At this point they’re feeling pretty good about things. They expect their business arrangement to go exceedingly well. They have a valid contract. They have a trusted friend and business associate in the form of the Chinese CEO. And they have a country that wants foreign investment. So, what could go wrong?
Today this line of reasoning sounds naïve as we know so much more about business dealings in China in 2013 than we did in 2003. However, back in 2003, when the Chinese government was doing its best to attract foreign capital, an asset-backed bank loan was the only form of financing available to a majority of Chinese companies. Consequently, the demand for foreign capital quickly grew. What hadn’t changed, however, in the succeeding decade, is the mindset of the average Chinese businessman.
From 2003, through the beginning of 2008, China was on the fast track. Foreign funds were investing large amounts of capital, there were numerous initial public offerings, and many joint ventures and Wholly Foreign-Owned Enterprises (WFOEs) were formed. Foreigners brought boat loads of cash to China and generally extolled China’s huge economic growth. Investors were happy, fund managers were happy, and firms were opening offices in China as quickly as possible. Then it all came to an end.
In 2008 there was a sharp downturn in U.S. economic activity with a resulting financial crisis which caused the failure of many key businesses, along with a decline of trillions of dollars of consumer wealth. That was followed in early 2011 by the discovery of an avalanche of frauds committed by Chinese public companies. The resulting effect was the shattering of investor confidence in Chinese companies. From this point forward, no one trusted a Chinese company’s numbers or claims.
But if investors thought that things were as bad as they could get, they were wrong. It got worse. Many Chinese public companies, realizing that they would not be able to raise money in the near future, at least not without severe dilution, simply went dark. They stopped filing required regulatory documents and went back to running the company as a private Chinese entity, without regard to the now dis-enfranchised public shareholders.
I should insert at this point that not all Chinese companies committed fraud or went dark. There are many Chinese companies that have honest management, accurate accounting, and a desire to honor their commitments. Where they have decided to exit the U.S. public markets they’ve done so by “going private” through a buyout of publicly held shares, and meeting their legal obligations. You don’t hear about these companies. They don’t make the headlines. In addition, my experience is that the younger generation of CEOs is more Western and less outsider / insider inclined. They’ve grown up with the West, unlike their parents whose first exposure was likely when Deng Xiaoping opened
China to the world in 1978.
Since we perform forensic due diligence on companies throughout the world, we’ve seen our share of dishonest companies. Companies where management has refused to pick us up at the airport, take us to their bank, gone to the hospital unexpectedly with the only key to the document storage room, or developed a severe case of amnesia as to where requested documents might be found. On the flip side, we just finished a due diligence report on a listed Chinese company where we were hired by the audit committee to review alleged irregularities. After an extensive review we discovered the company to be compliant. The point I’m making is that most assume that all Chinese companies are non-compliant or hiding things so well that no one discovers their dishonesty. And there’s a great many Chinese companies to which this applies. However, there are also many Chinese companies to which it doesn’t. As a better educated and younger generation enters leadership roles in Chinese business, and they have more international dealings, I expect the business climate in China to improve.
That brings us to our current environment – no one trusts a Chinese company, their management, their numbers, or their intent to deliver shareholder value. Most feel the country is dishonest, the people are dishonest, and no one should ever invest in China. With this background, let’s go over my friend’s questions again and I’ll try and answer them.
How can I trust anyone in China? Why would anyone want to invest in a Chinese company, even if market conditions allowed for funding and there was liquidity? Furthermore, I feel that Chinese companies will just take my money and do what they want with it and I’ll be left with nothing in the end.
How can I trust anyone in China?
I believe you lose trust because both parties aren’t on the same track. They thought they were, but in actuality they were on two different tracks headed to two different destinations, with each side hearing what it wanted to hear. On a business level, the Chinese are easy to understand. They simply want to make money. In my experience, there just isn’t any other motivation. The Chinese businessman will trust you and work with you, even as an outsider, as long as he makes, or believes he’ll make, money. If he doesn’t, or if he believes you’re free-loading off him, that’s when you can have problems. There are several ways to avoid these problems. One method I’ve used is to get everything straight with your Chinese counterpart from the beginning. Tell him what you’ll do, the time frames involved, what you expect from him, what each side’s responsibility is if things don’t go as planned, and what he should expect from you. Have both of you agree on every point, put it in writing, have it translated, and then have both parties sign. This has worked very well for me in the past as it puts everyone on the same page from the start. Setting duties and responsibilities is important as, culturally and historically, the Chinese have, at certain periods, been widely exploited by foreigners. The First and Second Opium Wars in the 19th century are two examples. Their trust levels, therefore, as well as their thought processes, differ from ours. This is especially true since they’ve only had business relationships with foreigners since 1978. Compliance with documentation that both sides have agreed to goes a long way in creating trust.
Next, after you’ve signed an agreement as to your mutual goals and responsibilities, draw up a contract that conforms to Chinese laws and practices. I know this sounds obvious, but this is where a lot of companies fall down. As my good friend Steve Zhu, a partner with the Allbright Law firm in Shanghai, constantly tells me, many U.S. companies conduct business in China as an extension of their U.S. operations. They don’t fully consider what’s required under Chinese law and often rely on translated versions of Chinese law that may or may not be the most current version. Therefore, he emphasizes, if you want to enforce the provisions of your contract with your Chinese partner, and hold them accountable, you have to be compliant with current Chinese law. That also includes compliance with the laws, rules, and other requirements of various Chinese cities in which you may conduct business. Indeed, the requirements in these cities may differ significantly from your current understanding of what the national government, or other local governments, require.
Compliance and trust between parties requires both sides to be on the same page. Getting an up-front written agreement as to each party’s mutual goals and responsibilities will help alleviate misunderstandings that can lead to one party feeling that the other hasn’t lived up to their end of the bargain. In addition, a contract that integrates local and national laws, rules, and regulations will allow both parties to operate as agreed and, if there is a dispute, just as in the US, each party has the right to sue.
If a dispute can’t be settled between parties, then most parties will either litigate or arbitrate, depending on the language of their contract. In resolving a dispute, having your contract compliant with both national and local laws will put you in a strong position as you move forward. China is becoming increasingly litigious, both domestically and with foreigners. If you’re compliant with Chinese law, you have an excellent chance at prevailing. I did when I assisted a fund in taking legal action.
Lastly, I should mention that very few cases settle prior to trial in China as the cost of the litigation process is very low when compared to Western countries and, for a relatively small amount of money, you can go through a trial and take your chances in court.
Why would anyone want to invest in a Chinese company, even if market conditions allowed for funding and there was liquidity?
It’s hard to ignore the world’s #2 economy and, by most experts estimate, the world’s #1 economy within the next two decades. Many multi-national companies are in China, are continuing to locate in China, and are making money. It’s a substantial part of their corporate earnings. Therefore, it’s incumbent on us to determine how we can establish an operation of business in China and work with both the local and provincial governments in protecting our interests. China isn’t going away, and it’s only getting bigger. If we’re going to take advantage of the world’s future #1 economy, we’ve got to figure out how to work with them.
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