Due Diligence for Chinese Joint Ventures

Published on this site: November 30th, 2006 - See more articles from this month

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.

1. 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.

2. 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.

3. 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. His website, China Legal Bulletin, is at http://www.lunaticwisdom.com/blog1.