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Due Diligence for Foreign Joint Ventures in China
By David Carnes

Due diligence is an absolute must if you plan to team up with a
Chinese partner. It’s a jungle out there, so be wary. This is no
place to cut expenses or rush through things because a half-done
job may cost you twice as much time and money later. Due
diligence is not a particularly prevalent practice among the
Chinese and they may have trouble understanding why you are
“making things difficult”. If your prospective partner refuses
to cooperate, don’t be afraid to walk away.

There are three main types of due diligence that you need to
concern yourself with - financial, legal, and environmental.
Keep in mind that these three inquiries often overlap.

Financial Due Diligence

Many Chinese enterprises (it is said) have three sets of
financial records: one for the
owners, one for the tax authorities, and one for foreign
investors. Accordingly, determining the value of an enterprise
based on its financial records can be difficult. It might be
necessary to carry out an independent assessment of the
enterprise’s reputation, connections, and key employees.

Key pitfalls to watch out for are:

Double-dealing employees - it is not at all uncommon in China
for senior management to have their own businesses that
directly compete with their employer, and for these executives
to use their employer’s confidential information to further
their own private interests.

Corrupt relationships with Chinese government officials - this
presents the risk of civil liability or prosecution, not only
by the Chinese authorities should things take a turn for the
worse, but also by the US authorities if you happen to be
American or otherwise subject to the US Foreign Corrupt
Practices Act (some other nations have equivalent legislation
check your home jurisdiction if you are unsure).

Intellectual property piracy - rampant in China.

Legal due diligence

Legal due diligence focuses on a variety of issues including
contract rights, corporate authority, regulatory compliance,
ownership of assets, and liabilities and claims against the
target company. Issues that often arise include:

Scope of business issues - At the minimum, you should
authenticate and inspect an original of the enterprise’s
business license (the scope of business is listed thereon).

Contracts - whether contractual arrangements are adequately
documented (or documented at all).

Ownership of buildings and Land Use Rights - Check to make sure
all buildings are owned outright and all land is “granted”
rather than merely “allocated”.

Intellectual property - make sure that trademarks, etc. used by
the target company are either owned by it or licensed to it.

Constitutional documents such as Articles of Association - make
sure that they are up to date (properly amended to reflect the
company’s current situation).

Construction permits and approvals - these should be examined
not only for construction in progress, but also for existing
structures

Labor disputes - determine whether there are any outstanding
disputes, and the level of employee morale.

Debts and encumbrances - make sure that these are adequately
documented and not excessive.

Environmental Due Diligence

In a nutshell, you need to know whether your partner’s site
environment or your FIE’s proposed site environment has been
contaminated (contamination of your Chinese partner’s site
could affect its financial stability even if it is not used for
the FIE).

David Carnes is licensed to practice law in California. He speaks and reads Mandarin Chinese and has several years experience working with Chinese law firms and Sino-American joint ventures. Check out his website, China Legal Archives.

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