Congress passed a law this past week in response to the Luckin Coffee scandal titled “Holding Foreign Companies Accountable Act.” If you missed the Luckin Coffee scandal, earlier this year CNN reported that Luckin, a Chinese coffee company listed on NASDAQ, used fake accounting methods to defraud investors of $310 million after going public last year. International businesses are now becoming increasingly worried that their Chinese partners cannot be trusted. While Congress’s new law will protect investors in stock exchanges, many businesses still remain concerned about fraud risks when doing business in mainland China. Fortunately, however, there are a few simple ways to protect yourself when doing business under China’s domestic laws, which we will explain for you in this article.
Is your LLC Counterparty a Shell Company?
Before committing to any significant business transaction, make sure your partner is incorporated and in good standing, as well as whether they are a legitimate business and not a shell company. The first stumbling block for companies doing business in China is the language: most translators are trained to hide the fact that your counterparty is an LLC, which is the type of company in China permitted to operate with no assets. Currently, most linguists will translate both “Corporation” and “LLC” into the same entity type, the nonsense phrase “Company Limited.” (abbreviated as Co., Ltd.) Using the wrong entity terminology creates a high fraud risk in China because, in reality, an LLC in China is quite likely to be a company with no assets or capital and owned by a few close-knit family members, as our translated academic study on shareholder relationships in China LLCs notes:
“Unlike corporations, which have joint stock structures, limited liability companies’ structure depends on the personal relationships between their shareholders as they tend to be formed by groups of friends or relatives who share profit and loss.”
As we’ll discuss shortly, Chinese regulators do not crack down on fraudulent shell companies to the extent that you would expect in the United States or Europe; you are expected to do your own due diligence and understand who you are doing business with.
Misunderstanding the LLC Counterparty: A Fraud Horror Story
Companies from English-speaking countries often wind up grossly misled about the nature of their Chinese business partners due to lack of basic due diligence or Chinese legal translation errors. They are often the target of scams run by Chinese companies not even licensed to operate in that industry, consisting of little more than a virtual office with a local cell phone number. Beijing attorney Liu Meibang published a legal case report we translated from Mandarin about how an Australian company was scammed out of US$120,000 because it misunderstood the nature of its Chinese LLC counterparty:
In this case, anonymized as Australian Company Alpha v. Shenzhen Company Beta, the fictitious Shenzhen company Beta executed a Purchase Contract for electronic components with Alpha, yet Beta was actually incorporated in Hong Kong. Alpha supplied Beta with electronic components worth $180,000 over a one-year period, after which company Beta paid just $60,000 of its accounts payable and refused to pay Alpha the remaining $120,000.
According to Liu’s analysis translated from Chinese below, the Australian company had no grounds for breach of contract since:
“1. Beta could not be sued in Shenzhen because its entity had not been formed through the Shenzhen Administration for Industry and Commerce. Under the Civil Procedure Law, the court having jurisdiction over the defendant’s place of business or the contract’s place of performance may hear the case if the parties have not agreed to a competent court of jurisdiction. In this case, the contract was performed in Hong Kong, whereas the defendant’s location could not be determined. Therefore, the case could not be filed in Shenzhen.
2. There were no formal written contracts between companies Alpha and Beta, and all orders and receipts were sent via email. Therefore, it was difficult to prove the existence of a contractual relationship between the parties without supporting evidence. There were no records of payments between companies Alpha and Beta.”
In the end, their only way to obtain relief was to spend an enormous amount of money to identify and pursue mainland China individuals, and piece together all of the documents and findings into a fraud case. By that point, the counterparty would have ample time to launder the money.
What could have the Australian company Alpha done better to protect itself against fraud from its supplier? My opinion, which is fairly similar to Liu’s and other leading PRC attorneys, is that the company Alpha should have asked for the company Beta’s Business Certificate and verified that company Beta’s incorporation is in good standing. Second, they should have retained a local attorney to draft a contract and found a certified translator to render it into accurate English.
Third, they should have kept and maintained good financial records. Not only by keeping purchase orders but by getting a kind of document called a fapiao, a government-registered VAT Tax receipt usually erroneously translated as “invoice” in reliance on an outdated dictionary entry, for the transactions to prove their existence. Fapiao are generally receipts of transactions with tax paid that have been uploaded to a government lookup system.
Liu concludes his article along these same lines, urging: “Verifying whether the contract is valid and that the counterparty has the legal capacity to make a contract is essential for enforcing a contract; their creditworthiness can tell you whether they can perform the contract.”
Due Diligence on Chinese Companies
The business environment in China is a bit different from other countries; you actually face huge risks on even small things like personal apartment rentals if you don’t do due diligence on your counterparty. Chinese regulators have provided very effective, streamlined tools for finding this information for free and, as we previously saw, expect you to use them for your due diligence. We looked for leading practitioners’ advice on how to resolve this question and found a law practice article titled “Contract Entity Standing Due Diligence: Reviewing a Counterparty’s Entity Standing” (translated from the Chinese here), which gives the following good advice on how to do just that:
“Better understanding your potential partners enables you to take better precautions against potential fulfillment and payment risks when executing contracts. Verifying the entity formation status of the other party to the contract involves finding out whether the entity is in good standing under applicable law, whether it has the legal capacity to enter into a contract, and whether it is able to perform the contract.”
You can find most of this information on China’s Business Credit Lookup System. You may have heard this system referred to as the China “Enterprise Publicity System” and, like many businesses, decided to ignore it because you’re not looking to get publicity in China. “Publicity” is actually their pidgin English word for “lookup,” it just refers to a system where you can look up public information on a variety of companies. A company’s ability to perform a contract can be discerned by looking at annual reports, administrative penalty records, and derogatory items displayed on this and other similar platforms.
Reports generated by the Business Credit Lookup System for a particular business license will include both entity standing and credit information. You should also be aware that, unless you have lookup information reports translated by an ATA Certified linguist, the information you get from them will also be in pidgin English and have a totally different meaning to the original Chinese. The Australian company in the horror story was defrauded of $120,000 largely because it tried to save a little money by having internal employees do complex legal and translation work, despite lacking the requisite professional training.
An important and very positive cultural difference between the business credit lookup system in China is that it’s totally free and highly streamlined. Business registrars in many jurisdictions require paywalls, as do credit reporting agencies, which can make looking up entity data more time consuming than it should be. China has made quite a lot of reported business data available to the public, including you. Any foreign business is free to use the system and benefit from the insights reported there, but make sure you have adequate professional help when navigating the accounting, legal, and linguistic issues when dealing with complex Chinese business matters.
In addition to looking up the business entity credit system, you can take further steps to quickly learn about your contract counterparty. The Dadi law firm advises businesses to verify the counterparty’s entity standing and capacity to contract by “reviewing licenses for organizations operating in restricted industries … for example, pharmaceutical companies must have the appropriate national drug manufacturing and operating license and advertising agencies must have an advertising operating license.” (translated from Chinese) If you receive a document referred to as a “Business License,” don’t be fooled — that’s actually a Business Certificate; the word “license” here is routinely translated incorrectly from the Chinese word zhizhao, meaning “Certificate,” when what you need to see is the license, which is a different word in Mandarin: xukezheng.
Dadi has more advice on preventing fraud: “Use platforms such as China Judgments Online, Credit China, and the China Enforcement Information Disclosure Platform to check whether a company has a history of litigation brought against them or is on the government’s fraudulent entity blacklist to learn more about their credit status.” This is particularly important because when a Chinese sham company goes out and commits fraud, they will not settle on just one victim: they will go out and find dozens or even hundreds of victims. According to the attorney general’s public affairs office, police are generally unable to make arrests until a large number of fraud victims file reports. It’s up to you to do your own homework.
Conclusion: Protect Yourself
Many companies have concerns about doing business in China due to the numerous horror stories about fraud and corruption in the country. However, these challenges can be fully overcome by working with the appropriate professionals. Most English-speaking businesses we work with have American attorneys supervising the transaction and working with local Chinese attorneys to ensure the work is done adequately, but still reviewing incorporation, credit, and transactional documents to keep their client protected. Success with this method largely depends on having an ATA Certified translator with legal training render those documents into correct English, ensuring that the English-speaking professionals are not misled as to what the documents really say.
