China Internal Company Frauds – Harris Bricken Sliwoski LLP

Most of what we write about frauds involving China are about frauds perpetrated by Chinese companies against foreign companies. But as a reader recently emailed me, frauds perpetrated within foreign companies in China “are at least as common and every bit as damaging.”

I agree, and today’s post highlights six of the most common internal company frauds our China lawyers see.

Before I talk about internal company fraud, I want to quote a long-time client and friend on how to deal with these. This person is from Europe but his “business empire” extends pretty much around the world and it includes some extremely difficult places in which to do business — places that make China look like a piece of cake. Once when I told him I was convinced people in one of his businesses (in a country usually prefaced with the words “war-torn”) were skimming fairly large amounts from his company, his response was something like the following:

My goal is not to stop all internal theft as that would be impossible. My goal is to keep my eye on the prize and the prize is to maximize profits and to succeed wildly. And so as much as I hate company theft, my cracking down on it must be at the right time and in the right way. I am not going to decimate a booming business by firing those who helped me build it even if they are stealing from me. In the meantime though, if you think you know who is stealing from me, let me know so that I can act when the timing is right.

I have used the “keep your eye on the prize” line hundreds of times and I especially like using that line when talking about stopping counterfeits.

When it comes to internal company fraud, this means it is critically important you do whatever you can to prevent and/or root out the sort of fraud that will destroy your company, but far less important that you stop employees from taking pens or sodas home. What you should do with the far more common in between sorts of frauds is going to depend on the specific nature of your situation.

In any event, here are the top six China internal company frauds:

1. No real company. No real employees. This one was incredibly common ten years ago, but far less dangerous then. It is far less common today but far more dangerous. See Doing Business in China Without a WFOE: Will the Defendant Please Rise. With this fraud, your “general manager” or someone else with a lot of power will charge your company to set up a China WFOE and then for years acts as though you in fact have a China WFOE or China Joint Venture when you don’t. The spoils from this fraud can be huge and ongoing. Suppose your WFOE generates $4 million in income a year and pays $1 million to its “employees” in salary. If there were a real WFOE, China income taxes would be around $800,000 a year and employee taxes and benefits would be another $400,000 or so. Now imagine this “WFOE” does not exist and so it also has no real employees. Someone other than your company is now clearing about $1.2 million a year by not paying taxes. Even worse, at some point your fake WFOE will get shut down by the authorities and you will then get hit with a massive tax bill that includes back taxes, plus interest, plus penalties, plus worse. See China’s Tax Authorities Want You.

How do you spot this one? We have had a couple companies come to us after learning their general manager was living in a multi-million dollar condo and driving a $100,000+ car on a salary that could in no way sustain such a lifestyle. This is one way to spot this fraud, but the better way is to do the research to confirm that your China WFOE is in fact a China WFOE and that all of your WFOE “employees” are in fact WFOE employees.

2. Overstated or Understated Income. Not sure which of these two is more common but they both happen quite often. Overstating income is usually done to meet performance goals or to prevent a company from being shut down. Understating income is usually done to hide that someone is improperly taking money from the company. Overstated income can mean your company sinks money into an enterprise it probably should abandon. Understated income means you owe taxes and interest and penalties of which you were not aware. How do you stop these? Financial audits. It also helps to have someone in your company who cares about and understands what is happening in China.

3. Friends and Relatives and Side Companies. Using friends and relatives as your China WFOE’s suppliers and paying more for the “privilege” is incredibly common. If the friends and relatives are charging 1 to 5% more you may never catch it and it may not be all that big of a deal if you don’t. But when our China lawyers are brought in on these situations, we typically see more like 30 to 50% in up-charging. I cannot tell you how many times we have worked with an American or a European company that terminates its China sourcing agency only to learn (usually from the factories that were actually making their product) that in addition to the 5% fee it knew it was paying its sourcing agent, it also was paying a 40% skimming premium. See Hidden commissions between China factories and sourcing agents. Even more common (at least in terms of what our China lawyers see) are outside companies set up by your own general manager. How do you stop these fraudulent supplier deals? You monitor pricing and you monitor who owns your suppliers. You also need to be very clear in your Employer Rules and Regulations (and pretty much every other place possible) that you will not tolerate supplier fraud.

4. Bribes. This one is too multi-faceted and complicated and important for me to cover in the depth it deserves so I will opt to be incredibly brief. Bribery is bad for your business and you need to do what you can to prevent it. China Bribery: Not Smart and not Necessary.

5. Side Door Sales. This fraud is very profitable and very common. Imagine you can charge $800 for a widget which cost you literally nothing to develop or make or market. Imagine also that you have people calling you every day to buy this product. Now imagine that one of your employees is doing this with your product. We see this sort of thing most often in the following two situations:

a. The China WFOE makes and sells a product all within China, or it makes the product in China and sells it to SE Asia or to some other emerging market country not so much on the foreign company’s radar.

b. The China WFOE is in a business where it both buys and sells a product. As an example, a fish brokerage company that buys fish in China and then sells that fish worldwide might have an employee who uses company assets to buy $500,000 worth of fish and then sells that fish for $525,000 and then pays everyone back without anyone ever being the wiser. Or what if your employee is in cahoots with an employee at the fish company and they do the deal without any money even changing hands until your employee gets paid? What if your employee is siphoning off 50% of your business with this scheme? What if your employee becomes so successful at this that he or she no longer needs your money to do these transactions because he or she has built up its own funding, but he or she keeps using your good reputation and your marketing dollars to further his or her own business? What is amazing about this fraud is that nearly every time this sort of employee is terminated he or she already has a company set up and ready to compete against the foreign company a day or so after the termination. This fish company example is straight from real life but it involved Vietnam, not China and the fraudster was the American head of our client’s Vietnam operations.

How do you stop this sort of fraud? With Employer Rules and Regulations that make clear this will not be tolerated. With non-compete and non-solicitation agreements/provisions that prohibit this. And then you sue.

6. Fake Employees. Would you know if your China WFOE had 200 employees, not the 250 employees to whom it is allegedly paying salaries and benefits? If you answered in the negative to this, you should act now so that you can answer this positively the next time because putting non-working friends and relatives on payroll is a classic China fraud. This one is particularly commonly used in China Joint Ventures to zero out profits so there never are any profits that need to be shared with the foreign JV partner.

What are you seeing out there?

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