The next day, the doorbell rings and a team of technicians brings in your new equipment, boxed and wrapped. They unwrap your purchases, set up all the electronics, test them, break up the boxes for recycling and clear out after they have shown you how everything works. By the way, when you ordered the entertainment system, you got a coupon via WeChat for the ergonomic lounge chair, and they delivered that as well. You’ve only lifted a finger and now will be the envy of friends and family.

This is the road China’s consumer market is moving down, and moving quickly. Consider the sales numbers on Alibaba’s platforms Taobao and Tmall on the world’s biggest e-commerce shopping day, Singles Day (November 11), in 2016, US$17.79 billion within 24 hours.¹ Online sales figures for big U.S. shopping days such as Black Friday and Prime Day are in the billions, but still in single digits.

According to PwC’s Total Retail Report 2017, China’s national online retail sales of goods and services for the first quarter of 2017 yielded 1.40 trillion yuan (more than US$200 billion), which was 32.1 percent higher than in 2016.²

These numbers show just how dynamic, and potentially competitive, retailing in China is likely to become. After all, the entertainment system example is not yet a reality, but something both online and offline retailers are working toward that will push them into not just online-to-offline (O2O) technology solutions, but omni-channel solutions involving social media, supply chain optimization and efficient fulfillment options. Alexandra Tirado, CEO of Atlanta-based consulting firm Fortuna Holdings International, which includes China e-retailer JD.com as a client, says that this type of “seamless shopping experience and white glove service” will be the key to success for China’s online and offline retailers. In the online-to-offline conundrum, China’s e-commerce and traditional offline retailers are “looking for ways to connect the online experience to the physical store, and figuring out how to blend technology and the online shopping experience,” says Tirado.

PwC’s Total Retail 2017 report sees the same trends quickly coming to fruition, or “increasing maturity of business in using data analytics and omni-channel technologies to create a seamless customer journey between online and offline channels.”

The omni-channel ecosystem, including efficient use of big data, virtual reality and artificial intelligence, dazzles the imagination and the senses. In reality, there are a few hurdles for retailers to overcome, the main one being the competition between the big e-commerce players including Alibaba’s Tmall and Taobao and JD.com with the brick-and-mortar stores like Gome Electrical, Suning and others.

Thus far, we have looked primarily at retailers selling electronics and white goods, but the current and pending retail eco-systems can apply to retail ranging from groceries to clothes to services. Most brick-and-mortar retailers are still struggling to adapt to the disruption of their markets over the last 10 years by China’s big technology players, commonly called BAT or BAT-J, to refer to Baidu (search engine), Alibaba (retail, fintech, supply chain), Tencent (fintech, social media) and JD.com (retail, fulfillment).

The worldwide focus on the big technology players, with their successes in e-commerce, fintech and social media, tends to cast a lesser light on smaller players, such as micro-retailers and brand-direct e-commerce, as well as traditional brick-and-mortar players. Yet they also play a major role in the world to come. Perhaps recognizing that adapting to the new e-commerce ecosystem was the only way forward – 52 percent of consumers in China prefer to shop online according to PwC, and 80 percent are willing to pay using mobile payments³ – traditional brick-and-mortar retailers have embraced technology primarily through working with the big tech players, and by developing online retail and finance options of their own.

The major brick-and-mortar appliance retailers, Gome Electrical Appliance Holdings Ltd. and Suning Commerce Group for example, have taken different paths. Yet, consider the range of innovations and investments in the retail sector:

• In 2015, Suning accepted investment from Alibaba of US$4.56 billion and itself invested in Alibaba. The tie-up is widely regarded as part of Alibaba’s online-to-offline strategy, and Suning’s plan to develop better technology support.
• Gome, meanwhile, prefers to go it alone. The company is developing its online platform in-house. It acquired com in 2012, and integrated it into gome.com.cn for better sharing of back-end systems, and thus better data analysis capabilities.
• Late in 2016, Tencent and Baidu decided not to join shopping mall developer Dalian Wanda on an e-commerce platform, but that is not stopping Wanda from expanding in the internet technology space. Two months later, the company established Wanda Internet Technology Group and in March 2017, announced the division would develop cloud services with IBM.⁴
• Even foreign retailers are trying to stay in the game, sometimes with mixed results. U.S. retailer Walmart sold its China online retailer Yihaodian to JD.com in late 2016 for a five percent stake in JD.com.

Starting in 2016, legacy brick-and-mortar retailers have taken aggressive steps to push omni-channel strategies with and without technology partners. Gome Electrical Appliances set the company strategy for 2016 as “total retail strategy,” which the company says includes “fully promoting the integration of online and offline businesses” through technology to support the development of a new retail ecosystem. According to the company’s annual report, that strategy allowed Gome Online to increase revenue by 58.8 percent in 2016 and gross merchandise volume (GMV) by 110 percent.⁵

Significant increases in revenue and GMV, such as those posted by Gome, point to the reasons traditional retailers are still in the game despite disruption by the BAT-J companies. China’s e-commerce market is primarily driven by consumer preferences. Advertising and brand guru Tom Doctoroff says, “O2O is one of the most dynamic – and, for consumers, satisfying — areas of commercial innovation. Offline and online blend into holistic, rewarding experiences.”

Retailers wanting to be at the tip of consumer’s fingertips are looking at three aspects of their business:

• Customer engagement
• Experience-led commerce
• Fulfillment

Gome’s President Wang Jun Zhou stated in the company annual report: “In the present and future, success in new retail belongs to those who successfully combine strong supply chains, new retail trends and scenarios, seamless integration between online and offline, and technological proficiency.”

Customer engagement: All about ease of connection

Responsiveness to customers is the key to customer engagement for retailers. Both traditional and e-commerce retailers are using technology to reach new markets, employing big data, and enhancing that reach with physical stores.

“Having well-placed physical stores could become an advantage for existing retailers if they are able to integrate an innovative technology play that engages consumers in an attractive way,” says retail analyst Mavis Hui of DBS Vickers Securities.

When retailers are able to parse data about customers according to location, income and brand recognition, then link that to an in-store experience, they are engaging customers before they even arrive in the physical store.

Traditional companies have an advantage over pure technology players in that they know their markets and consumers already. By striking out on its own, rather than with a big tech partner, Gome’s ambition is to create a retail ecosystem leveraging the company’s market knowledge and technology. Apart from expanding into the after-sales service market with an Internet of Things (IoT) strategy geared toward smart homes, Gome also has decided to delve into financing solutions for the upstream supply chain and providing trade support, strategies designed to enhance product quality, delivery and fulfillment speed.

For most traditional players, in-house technology development has not been the preferred strategy, and Gome’s new business model is too new to declare it a success or failure.

There are, however, smaller players such as clothing brand Ruhan E-commerce that have used their own technology plays to improve their business. Ruhan created the most prevalent retail trend in 2014, the “Internet star” when the company slashed its marketing and advertising budget and contracted with a young model to influence her followers to purchase their clothes through her posts and videos candidly assessing the clothing and accessories she used. Not only did Ruhan increase sales, but its Internet star also started a trend that other retailers have followed.

Experience-led commerce: All about new technology

Aside from the phenomenon of Internet stars, other retailers rely on Key Opinion Leaders (KOLs), such as the experts in the WeChat electronics forum mentioned in the example at the beginning of the article. From these initial experiences already in play, companies are developing consumer experience strategies using Virtual Reality (VR) and Artificial Intelligence (AI) to enhance consumer experiences.

A VR experience scenario might involve a consumer wearing a VR headset at home to browse a store. Brands and retailers would then use AI to track where the customer’s eyes stopped the longest, or what his or her expression revealed during interactions with products.

PwC noted in its Total Retail 2017 report that Macy’s took a step forward in the China retail market on Singles Day 2016, when the U.S. retailer created a virtual tour of the New York flagship store for Chinese consumers.⁶

As always, Alibaba has its eye on the future and what it will mean to consumers. CTO Jeff Zhang says, “Virtual Reality equipment will become the next corner of the consumer market. Once it becomes more realistic, the VR experience will attract more customers to buy online.”

Fulfillment: Technology optimizing the supply chain

Upstream supply chain and last-mile delivery may be the most exciting but least visible impacts technology will have on retail.

DBS Vickers’ Hui says fulfillment issues are an area where technology players and traditional retailers have converging strategies “given China’s huge land mass and relatively primitive logistics support in many PRC cities. Thus, physical stores could continue to act as merchandise collection points for online orders, or as warehouses or hubs to direct and fulfill last-mile delivery needs.”

Smart companies are looking for a quality play, and to most that means developing an ecosystem, which the big tech companies have done through their long list of affiliates. For Tencent that goes from social media to finance to healthcare and retail, and for Alibaba it means going from e-commerce to finance and then delving back into e-commerce and retail via its partnership with Suning, for example.

Gome’s new subsidiary Gome Fintech has a different ecosystem in mind, the supply chain. It aims to bring financing solutions to the upstream supply chain, where suppliers of products have difficulty getting financing from state-owned banks, development loans, factoring and trade support – all areas largely ignored by banks. Gome has the expertise to impact the supply chain in these areas, as well as make a difference in streamlining the supply chain through enhancing quality via stable supplier financing and leveraging the company’s brick-and-mortar stores for last-mile delivery options or click-and-collect scenarios.

PwC notes another fulfillment issue solved by the use of block-chain data.⁷ For many years, luxury goods retailers have struggled with the problem of ensuring products they sell online are authentic. It was one area in which consumers evidenced a lack of trust in purchasing online. However, with block-chain data, products can be tracked from the factory to the consumer’s front door, authenticating not just the product, but also the entire supply chain.

Race to the future

For most retailers, both brick-and-mortar and e-commerce, a key path to the future is through partnering with existing technology companies for the latest in technical advances and for investment. In speeches over the last year, Alibaba’s founder Jack Ma has been calling for both technology and traditional companies to improve their research and implementation plays for big data, cloud computing and artificial intelligence.

Players not traditionally in e-commerce or with a strong technology backgrounds have heavy lifting to do in terms of investment, financial as well as talent costs, in making technology aspirations reality. Partnering with one of the existing tech players, or subcontracting to a technology partner (TP) is an attractive proposition for scaling and financial reasons.

But the retail industry has seen advances with privately owned and more innovative players like Gome and Suning making moves in the past 18 months in O2O sales and supply chain financing options.

In a recent speech, Alibaba’s Ma predicted that “new technology will become our future product, and service innovation is the most important foundation, and to achieve this online and offline business and consumer experience will be the at the core.”

While retail and its supply chain appear to be at a technology inflection point, it is clear that the race to adopt technologies involves identifying the best technology solutions to satisfy customer needs and demands.

The post China Retail’s Newest Inflection Point: From E-commerce to Omni-channel appeared first on China Research Center.

Still, the picture was taken by the supplier and sent to the client, who forwarded it to me along with the email. The photo and email warranted further examination, particularly since the factory had passed a number of social accountability audits required by the retail brands that bought its products. If the allegation turned out to be true, then all orders bound for the U.S. would be cancelled since U.S. Customs regulations prevent products suspected of originating from factories using child or prison labor from entering the U.S.

The concept of social accountability – sometimes called social responsibility, ethical sourcing, and responsible sourcing among other names – became prominent for manufacturers, brands, and retailers in the early 1990s after it came to light that many factories producing clothing and footwear for brands such as Nike had poor working conditions, even in some cases using child or prison labor. From the late 1990s, brands and retailers got serious about implementing labor standards as identified by the International Labour Organization’s Declaration on Fundamental Rights, the United Nation’s Universal Declaration of Human Rights, and local labor laws. In 1997, Social Accountability International, a non-governmental organization that works to improve human rights for workers globally, published the SA8000 Standard, a set of guidelines based on the ILO labor conventions and integrating ISO management system principles. The guidelines promote such concepts as fair pay, limitations on overtime, days off, and preventing child and prison labor.

In the late 1990s and early 2000s, hoping to avoid the situation that the garment industry had faced, many multinational corporations began auditing their suppliers and their supply chains for compliance with local labor laws using the SA8000 standard. But, as my client discovered, particularly in developing countries, rural areas, and in certain categories, the supply chain lacks transparency and labor practices still differ from expectations even after more than 20 years of publicity and advancement in the field.

For me, working in China, allegations of child labor were fortunately rare. More common were issues related to falsified records ranging from faked time sheets to doctored payroll records. In an established area like Dongguan, factories have been audited for labor practices and trained in local labor law for a long time. If the child labor allegation were true, it would be a disappointing set back. I had to ask the question: Is it even possible to have a supply chain that is compliant with responsible sourcing standards?

Hong Kong-based Jon White, Managing Director of Omega Compliance Ltd., a firm that conducts social responsibility audits and consults with brands and retailers in the field, told me that in China, child labor is rare now. In the summer months, however, underage workers – those within a year of the legal working age – can be found in factories after they’ve gotten out of school. They are trying to make some money during the holidays. However, White cautions that “applying a blanket approach to labor law compliance across every category of products is a mistake.” He points out that the garment industry has 15 years of exposure to fair labor compliance and auditing, and that their customers have worked very closely with garment suppliers and have long-term relationships with them that enhance communication on labor issues. By contrast, suppliers in other industries, such as furniture or seasonal categories (like my client) may have only five years of exposure to the concepts, training, and auditing.

Closer to home, The Coca-Cola Company’s Director of Global Workplace Rights, Ed Potter, outlined for me how an industry sector develops toward their goals of implementing a responsible sourcing framework. Potter says that when he joined the company in 2005 to build a framework around the Supplier Guiding Principles defining company expectations around workplace rights, his team started working with China immediately. The standards were new to the fast-moving consumer goods supply chain. Potter’s team discovered that of their 1,600 suppliers and bottlers in China only 29 percent complied strictly with China’s labor laws. But by 2008, working with their supply chain in China, he says Coke raised the compliance rate to 63 percent, and by the end of 2014 it hovered around 90 percent. “The company’s goal is to improve the score each year in every country we work in,” Potter says. But, he counsels that there is still detailed work to do. In his 10 years heading the Workplace Rights team, he feels he has only built a framework, which needs to be filled in now.

Most experts in fair workplace practices agree that monitoring is not the answer; it’s just the first step to get factories to start to understand fair workplace practices. Most brands and retailers have the belief that factory management will follow and manage labor policies themselves. However, many factories still follow the retailer or brand’s lead. An ideal scenario would be for the purchasing team, the factory, and the workers to all take ownership and control of implementing fair workplace practices.

Craig Moss, an Executive Advisor at NGO Social Accountability International, agrees. “A factory owner once mentioned a Chinese idiom ‘he who holds the gold, makes the rules,’ and right now the purchase order is gold, and that’s the way most manufacturers understand and implement labor practices.”

At the factory producing Christmas ornaments, we learned that some workers had brought their children to the factory on a public holiday. The local day care was closed, but the factory was open because of the push to complete purchase orders by the shipping date necessary to meet the all important Christmas shopping season in the U.S. While the few children were looked after by one employee, their parents were able to get overtime pay of three times the normal rate for working on a public holiday. China’s labor law requires this overtime calculation on public holidays so technically, the factory was operating within the law.

Typically, the allegations we look into involve situations in which orders to be shipped prior to Chinese New Year or the National Day holiday would involve factories not paying worker’s overtime and trying to disguise that by creating fake records or turning security cameras off on sensitive days. At certain times of year, Chinese and U.S. holidays align in a way that causes rush orders and necessary overtime for workers.

Sometimes, the client’s purchasing practices are the cause of factories not following local labor laws, and then stepping over the line and falsifying labor records. For some buyers, the bottom line matters more. Factory management would comment they had to require overtime to reach shipping deadlines, in some cases because the buyer changed his mind about the color or the volume at the last minute. Most social accountability experts now agree that educating the supplier and the U.S.-based purchasing teams is key to getting factories to manage compliance to labor laws and standards.

SAI’s Moss points out that over the 15-20 years that social accountability has been practiced, a policing approach comprising audits and customer-designated labor codes has been most common. Factories see social accountability as external compliance. But, he added, leading brands are seeking to change this dynamic now, by supplementing audits with more transparent efforts to collaborate and help suppliers improve their internal processes for managing labor standards and performance.

Suppliers and their factories are often caught between the rock of a purchase order deadline and the hard place of complying with labor standards they agreed to when accepting the purchase order. For my client, the allegation was very serious, in the case of child or prison labor, as U.S. Customs will turn away products. Their company policy was to reject the product if child or prison labor were found. Consequences would be serious for the factory too, which would have lost the purchase order and been forced to absorb the expenses for raw materials and labor. A lot of businesses could not survive that kind of financial blow.

Even though the factory had a reason for children being on the property, an allegation of child labor is difficult to put into an acceptable perspective. The factory management saw the situation as a way to give their workers well-paid overtime, but the allegation could have led them to lose the business or any other future purchase orders. It was difficult to believe that the supplier making the allegation had done so knowing the seriousness of the consequences.

SAI’s Chief Operation Officer, Jane Hwang says that overtime regulations, rather than child labor, are among the biggest challenges for China because of the government’s strict limits conflicting with workers’ economic necessities. Hwang says many of the challenges faced in implementing workplace compliance guidelines are more socio-economic than cultural. “A generation of workers are used to certain conditions and opportunities. That changes. But you can never discount economic necessity and lack of access to opportunities.”

Omega’s White believes that for factories, “the temptation to shortcut is enormous,” precisely because of the facts of purchasing like changes in purchase orders, rushing to meet shipping deadlines, and labor shortages. He says that in some areas, factories are still presenting about 80 percent false or doctored records to auditors. White believes that the key to successful social accountability in a supply chain is “trying to get the brand or retailer to encourage transparency in their manufacturing base.”

For factories, fair labor practices can be complex. SAI’s Moss reports that there are more than 10,000 different labor codes globally. Big brands, industry, local laws, NGO codes, all have different details, language and terminology. A factory such as the one making Christmas ornaments, supplying to five or six different retailers around the world, could have to comply with five or six different labor codes, not to mention local laws.

So how can companies and their business partners in the supply chain avoid unwanted surprises in such a complex environment?

Coke’s Potter cites transparency, ethos, and anticipation as helping the company implement its Workplace Rights Program. After 2005, he says transparency became the key for the company’s work on human rights, which he calls “open source reporting.” This includes publishing all documents and reports on the corporate website, and producing a global workplace rights scorecard accessible to all business units. With huge, complex operations in 207 countries, Coke has “a basic belief that the company cannot be sustainable unless the communities in which it operates are sustainable.” And finally, anticipating the next big thing in the fair workplace practices field helps Coke maintain leadership on the issue, such as endorsing the U.N.’s 2011 Guiding Principles on Human Rights and disclosing country due diligence reports by third parties about Coke’s progress on Human Rights in the supply chain. Potter cites the publication of Coke’s due diligence in Myanmar as one of the benchmarks of transparency in the company’s Workplace Rights Program.

Omega’s White sees brands and retailers working closely with their supply chain partners as the key to success.

SAI’s Moss and Hwang echo the message of partnership. Their teams have seen the most success stories when partnerships in the supply chain encourage open dialogue, transparency, and responsibility. Moss cites one SAI program called Ten Squared, whose approach is to establish worker-management teams in a facility to improve a specific management system issue over 100 days. He says the combination of worker engagement and cross-functional teams helped create “trained, committed people who followed procedures to accomplish goals.”

But guidelines, standards, and sometimes lofty goals can get lost in the hustle to competitiveness. Otherwise, I probably would not have had to look into a case in which a questionable allegation was made in an attempt to hamstring a competitor.

SAI’s Moss thinks that a different type of competitiveness has improved workplace practices in China over the last two years. “The cost of labor pressures, labor shortages, and mobile technology have contributed to factory owners realizing the efficiency of applying labor standards. The most forward-thinking factory owners are working with productivity experts now,” he says. “They want to be competitive in getting and keeping good workers because they realize the cost of turnover and training now.”

At the end of our conversation, Potter tells me, “There are lots of good things happening and it all takes time.” That was true for the Christmas ornament factory as well. The client committed to working with this factory management, and with a number of seasonal production facilities, to understand how purchase orders and timing could be scheduled so that situations like the one in the whistleblowing email would not crop up as a surprise again.

Box on Social Accountability

Terms Used in Relation to Fair Labor Practices:
Social Accountability
Ethical Sourcing
Responsible Sourcing
Social and Environmental Responsibility
Workplace Rights
Labor Compliance
Social Compliance
Labor Relations and Corporate Social Compliance
Corporate Social Responsibility
Ethical Trading
Fair Labor Practices

Organizations and Related Declarations:
International Labour Organization (ILO)
Social Accountability International (SAI)
The U.N. Declaration of Human Rights
Global Social Compliance Program (GSCP)
Ethical Trading Initiative (ETI – UK organization)

The post Responsible Sourcing Standards and Social Accountability: Are They Possible in a Global Supply Chain? appeared first on China Research Center.

Fortunately, occasions when front-page headlines support the analysis in a due diligence report remain rare. On this occasion, the bankruptcy of Pioneer Iron and Steel leading to transfers of company assets from the trading company to other entities owned by the Pioneer Metals Group fulfilled the worst-case risk scenario in a due diligence report I’d given to a client a few years before. The largest risk, depending on what business the client planned to do with Pioneer, was that the corporate structure allowed for undocumented asset transfers. I never expected to see the exact risk we’d documented on the front page of a newspaper.

I noticed the client’s name was not on the list of creditors, so it was likely they had put measures in place to protect their company from the financial losses and potential reputation issues that headlines about deals gone bad can bring.

For most companies, due diligence focuses on protecting a company’s reputation and finances through understanding business partners better. To highlight the importance of due diligence on investment partners or supply chain partners in China, let me provide examples of successes and failures companies have experienced in their China business and show how robust — or superficial — due diligence affected the outcome.

Deals go bad all over the world and in one’s own backyard. Yet, it is often the lure of China, the promise of increasing revenues, the exciting focus on guanxi (networking and relationships), and the mystique of the potential in this huge market that make executives overlook risks they might not ignore in a domestic market or one without as much perceived upside potential. I’ve been involved in numerous situations in which executives with the stars of market potential in their eyes ignored the necessity of deep due diligence on a pre-transaction project. The dealmakers stuck to a fig leaf compliance approach, wanting to cover up the full picture of a risky investment. They would check a compliance box to satisfy a board prior to pushing through a lightly vetted deal. The investment team may have received their bonuses that year, but down the road the fig leaf would fall and companies would often suffer financial and reputation losses. Those types of clients are the best for consultants, public relations firms, and lawyers because we know that these types of deals will probably result in lucrative investigations once the deal goes bad.

A basic principle of any partnership is understanding the identity and experience of a partner. Most people wouldn’t get married without knowing their future spouse’s background, but companies regularly don’t take the time to learn about the companies and executives they do business with, paying them millions of dollars and often losing millions.

The first step of any due diligence is to verify the company’s registration details with China’s Administration for Industry and Commerce (AIC) or Hong Kong’s company registrar. In this case, the AIC records showed the Steel Princess set up a network of companies, ultimately owned by her and her mother, through which she held shares in iron and steel producers in China. The parent company also had holdings and links to Hong Kong companies that in turn had interests in entities in the British Virgin Islands, providing an easy route for transferring money out of China or Hong Kong and causing large risks to investors.

Either the Steel Princess or her mother were the legal representatives of each of the companies in the Pioneer Group. In China, the AIC registration file shows the name of the company’s legal representative, the person responsible for any of the company’s legal obligations such as paying bills or transferring funds. The legal representative is the ultimate controller of the company. The legal representative must sign any contract a company in China enters into. The Steel Princess set up her companies well. She was clearly the boss. By contrast, we often come across scenarios where clients are negotiating with people who are not the company’s legal representatives. Deals are not valid until the legal representative signs off.

The CEO of Pioneer Metals, called by China’s press the Steel Princess because her grandfather was the Minister of Metallurgy in the 1970s, did have connections in the metals industry in the country as a princeling, a child or grandchild of government or party official in China. However, during our research for the client’s due diligence report, we interviewed industry insiders and did not find any history of the Steel Princess having worked in government steel producers or in the Ministry of Metallurgy. The structure of her company and cash infusions appeared to be her main contribution to the industry.

Another risk I pointed out to the client was that the CEO’s grandfather was a policymaker more than 30 years ago. As such, it was unlikely she or her family had any influence with current policymakers. For the client, the risk could be that they were paying a person for a pedigree without any evidence the person had practical skills to get the job done. If the client wanted her to lobby for or against regulations or gain connections in the current government, they might find her connections dated and irrelevant. If they were looking for practical industry knowledge, they might consider someone with different experience.

Restrictions in the metals industry required multinationals to deal with domestic Chinese companies, and Pioneer Metals had a high profile. The CEO was one of the richest women in China, according to various annually published lists. The Forbes or Hurun “rich lists” often attract investors or business partners for those on the lists on the assumption that connections with perceived money and power will help them do business in China. But in our experience, a spot on the rich list is often short-lived. Many former rich list stars have experienced meteor-like falls from grace as a result of high-profile investigations by China’s Economic Crime Bureau. By 2010, China’s richest man in 2006, Huang Guangyu, CEO of Gome Electrical Appliances, was serving a 14-year prison sentence on a fraud and corruption conviction. Another 2006 rich list rising star, Wu Ying of Bense Group, later received a commuted death sentence for the allegedly fraudulent activity that got her onto the rich list.

A quick Internet search will identify high-profile individuals such as the Steel Princess or Huang Guangyu, but a few times, clients provided only the English name of a Chinese person they saw as the key to success of their China business based on a dinner or business meeting. That’s how one due diligence report started on a Shanghai-based gentleman applying for a high net worth account with a multinational bank in New York. The client sent us the individual’s English name and China bank account number. First, like most countries, privacy laws protect bank accounts in China. Second, a Chinese bank account must be registered with the individual’s Chinese name as it appears on his or her Chinese identity card or passport. Obviously, the English name could have been made up. We asked the client for better identifying information, such as a Chinese name and copy of a passport. Fortunately, they sent a business card and passport copy the next day, so we had a proper Chinese name and a company name and address.

The AIC records showed that the gentleman in question was indeed the legal representative of the investment firm he claimed to own, but a visit to the offices in Shanghai’s Pudong district found an office with a locked door. The management of the high-end office building was not familiar with the company or the legal representative, but confirmed the company did rent the office space and pay its bills. Media searches found no record of the investment firm or the firm’s CEO. Industry contacts had never heard of the firm, which according to the client had about US$300 million in assets.

With most companies or individuals in China, it is possible to research and find information on track records within an industry and trace a CEO’s “first bucket of gold,”as many rags to riches stories of Chinese entrepreneurs are documented in profiles of executives for business magazines, known by industry insiders or by current and former employers. But the assets and seed money of our client’s potential client were untraceable. It was as if he had created the money out of thin air.

We had to issue a report stating that we couldn’t find the source of funds or any business profile for the executive and concluded that any transaction with him would be high risk. Fortunately, anti-money laundering regulations require banks to prove the source of their clients’ funds. A few months later, the executive’s name was all over China’s front pages, but not connected to our client. The executive and his investment firm reportedly were the cover for a corrupt government official attempting to siphon off millions of dollars from the Shanghai municipal pension fund and hide the money abroad.

Another scenario where due diligence plays an important role involves compliance with laws in the client’s home country. The U.S. and U.K. both have anti-corruption statutes that apply to multinationals in their home markets as well as international markets. In the U.S., they are the Foreign Corrupt Practices Act and Sarbanes-Oxley acts. In the U.K., it is the Anti-Bribery Act. Companies must have transparent programs in place to show they understand the identities of their suppliers, vendors, and distributors.

Consider cases in which companies applied a fig leaf compliance approach, determining only whether the company is registered with the AIC, for example, rather than verifying any government connections or reputation issues:

• By 2010, Siemens AG paid more than US$ 1 billion in fines to U.S. and German government agencies for overlooking the fact that subsidiaries in foreign countries, including China, used consultants or marketing firms to pay bribes to government officials to obtain contracts. Most of the consulting firms were owned by friends and relatives of government officials. (See https://www.sec.gov/news/press/2008/2008-294.htm for a full article.)
• Also in 2010, telecommunications company Alcatel-Lucent paid US$135 million to the Securities and Exchange Commission for similar payments to government officials made via consultants acting as agents for telecommunications bids. (See www.sec.gov for plenty of examples of similar cases).
• And British pharmaceutical giant GlaxoSmithKline has been involved for the past year in a corruption scandal that began in China where sales and marketing vendors are said to have paid bribes in the forms of airplane tickets, vacations, and cash to doctors to get the company’s drugs in Chinese hospitals, which are state-owned and thus government entities for purposes of the U.K. Anti-Bribery Act and U.S. Foreign Corrupt Practices Act. It should be noted that while fines have not been set, a number of GlaxoSmithKline executives and business partners in China have been imprisoned as the case came about through investigation by China’s Ministry of Public Security. (For a thorough article on this case see: http://www.nytimes.com/2013/07/16/business/global/glaxo-used-travel-firms-in-bribery-china-says.html.)

For industries such as telecommunications, pharmaceuticals, and real estate, government restrictions on participation by foreign companies, project bidding, and a high level of government ownership in domestic China assets creates risk for many forms of corruption in the downstream supply chain.

One telecommunications multinational wanted to get ahead of the game and start a due diligence program for its existing sales and marketing vendors. These vendors were assigned to participate in bids for government projects, and their task was to understand the technical requirements, outline technical specifications for the client, and manage the bid process. They thought that by keeping this kind of arm’s-length approach, they would protect themselves from any situations in which their staff would be in a position to bribe government officials during the bid.

We were assigned to conduct due diligence on hundreds of these agents. The client maintained a few agents in every province in China. The main objective was to determine whether any of the agents were linked to government officials.

We initially identified a few agents either linked to government officials or entities, or linked to the client’s own employees. Unfortunately, the client put its employees in a difficult position requiring sales staff to find the agents, brief them, and sign contracts with them. They had no front-end due diligence process in place to check agents prior to signing contracts. In other words, they had no substantial controls in place. The sales team was, of course, under pressure to win bids and make money. Without any initial controls, the sales team found whomever they thought could win the bid, which included companies with close government connections.

The client also had a substantial base of agents with a track record for working on telecommunications bids and no obvious government connections, so they were not in danger of losing too many of their agents.

The vice president of sales in charge of our project, who reported findings to corporate legal counsel, came to me one day with a report that raised red flags about an agent. The AIC records showed the agent’s company had a connection to an employee and a government official as a minor shareholder. He said, “Are you sure about the findings on this company?”I explained to him that the AIC records were very clear. “But this is my top agent and my top salesperson here. What am I going to do?”

The vice president of sales did not flinch when it came to cutting out a few of the initial agents with unwanted connections, but he balked in this instance. Taking action against this agent could hit sales figures. Shortly thereafter, the system I had set up to compare agent company AIC filings to sales staff names and known government official names was taken back for the sales and marketing team to handle.

It is not uncommon for companies like this one to find themselves a few years down the road caught between over-reliance on guanxi and the vagaries of fig leaf compliance. Executives are often fearful of dropping the fig leaf because of what might be revealed.

From a slightly different perspective, the real estate industry in China has been the source of the most exciting and scandalous due diligence reports and fraud investigations I’ve been involved in. The combination of government ownership of land and skyrocketing land and housing prices over the last 15 years has created interesting bedfellows and motivations.

A U.S. based multinational investment bank requested a due diligence report on a Chinese-owned real estate development company that approached them for funding of a five-star hotel in a prime location of a major Chinese city.

The client felt comfortable with the Chinese real estate company through the CEO, a man born in China who had immigrated to a European country in his 20s after making his first “bucket of gold.” A few years after returning from abroad, the CEO had a thriving real estate development company and planned to list it on the Hong Kong stock exchange. It was not surprising when the investment bankers and the legal counsel requested a conference call to discuss the findings of our report.

With many companies and people involved in the hot real estate market, industry insiders were easy to track down. They led us to other industry insiders and even family members of the CEO. We discovered that the CEO made his first “bucket of gold”through working with the Triads (Chinese mafia) in southern China, and sometimes still used them to threaten business partners. Additionally, the CEO had close connections with the Communist Party secretary of the city involved in granting the land use rights for the hotel, and in the past the developer had received some deals that simply could not have happened without under-the-table government support.

On the phone, the client said, “I just can’t believe these findings. This sounds like a mafia organization, but when we go to their office everyone speaks fluent English. They’re very professional. I mean, the staff are all wearing khakis and Polo shirts.”

To which his colleague (the legal counsel, I presume) replied, “The 9/11 terrorists were also wearing khakis.”

I explained to the investment team that the findings were definitely unusual, and because of that we made sure that we corroborated the most serious allegations with three or more sources that included former and current employees, business partners and even a family member. The client did not go through with the deal, but the developer found other investors. When I’m in China, I go to the bar of the luxury hotel the developer built and wonder whether the story will ever hit the headlines.

For me, China is still one of the most interesting markets for due diligence because of the competition between a market potentially teeming with deals and profits and a very opaque business and legal environment. In that context, many companies have gotten burned financially or their reputations have taken a beating merely due to not taking the time or spending the money to understand their business partners.

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