One of our recurring themes on this blog is the need for due diligence when working on any business matters in China. Most foreign companies think of due diligence only when planning to make an investment. Most companies are not aware due diligence is required whenever you do any kind of business with a Chinese company. If you do not already know the Chinese company with which you will be conducting business, you must confirm the company really does exist and that you are dealing with the actual company and not an impostor.
I want to share a conversation I had yesterday with some young Chinese lawyers who work for the one of the largest and best law firms in Shandong province. I was discussing with them the question of whether the company seal on a particular document was valid. It seemed like a simple matter. Our resulting conversation was not so simple.
When asked how they go about confirming the validity of a seal, the lawyers told me “you have to go the town where the company is located.” Once there, you then have to determine if the seal is registered. Often the seal is not registered as registration of seals is not mandatory in China. Then you inspect various documents filed with the local authorities to determine if the same seal was used on those documents. If the seal is registered, or if the same seal was used on company documents filed with the local authorities, you pretty much know the seal is valid.
Even this is not enough. Even though the seal is valid, you still have to determine if the seal is being used in an authorized manner. Just on the surface, there are two possible issues. First, an impostor may have created a fake company seal. Second, someone within the company may be using the seal in an unauthorized manner. The only way to resolve these issues is to actually visit the company at its headquarters and to ask: is the person who stamped this document employed at your company? If the answer to this is yes, you then must ask whether the person is authorized to do this particular business.
An affirmative answer to both these questions is the only way you can be assured that the signature and the seal on your document are valid and will effectively bind the company. There is no other way to do it: a visit to the relevant government office and to the company office is required. There is no service available to do the work. You have to hire a Chinese licensed attorney to do it. A Chinese attorney is normally required because local governments rarely open their files to a private person and they certainly will not open their files to a foreigner.
My first response to all of this was to say that this is far too expensive a procedure for many normal commercial transactions. The Chinese lawyers looked at me with a mixture of amusement and contempt. They said they understand my response since it is typical of their North American and European clients. They further stated they are amazed at the naïveté of their foreign clients on the need for basic due diligence in commercial transactions. One lawyer looked at me and said: “What do you think we do all day at this law firm. Most of our young lawyers and legal assistants are primarily engaged in basic due diligence about potential business partners of our Chinese clients. We travel to the local offices and we charge for the expense. Our Chinese clients willingly pay the fee because they know the risk is too great to act in any other way. We constantly see foreign companies enter into contracts without doing any such investigation and it continues to surprise us. You say that our form of due diligence is too expensive. We say that being cheated is far more expensive. Given that the chance of being cheated in China is extremely high, it makes no sense to take the risk. Our Chinese clients would never enter into an important contract without conducting due diligence of the other side and we find it very strange that these foreign clients who know even less about China will willingly take a risk that virtually no Chinese company would take.”
It makes sense to take seriously what these young Chinese lawyers are saying. Let me give you just one example of what can go wrong in China. Say you are dealing with a large and well established Chinese company. There is no question this company exists and makes the product that you wish to purchase. Now ask yourself this: are you really dealing with that big company? Or are you dealing with an impostor? How do you know?
It is easy in China to fake company seals, business cards, bank accounts and even a website. The unsuspecting foreigner makes a deal with the impostor and sends funds to the bank account. Product never arrives. The foreigner contacts the well established Chinese company and that company truthfully responds by saying “we have never heard of you.” It turns out the foreigner had been dealing with a fake, virtual company the entire time. This happens all the the time in China. My law firm’s China lawyers see instances of this at least once a month.
One of the services we constantly provide for our clients is what we call the “first pass review” of a company seal. In this review, one of our China lawyers who is fluent in Chinese and experienced with Chinese contracts will review a seal for our client. This review consists of pretty much nothing more than looking at it to determine whether it may be fake or not. If this review cannot determine that the seal is fake, we then suggest our client conduct a more thorough review to confirm that it is real. This is because our first pass review is good at spotting obvious fakes, but it is not good at making sure a seal is real or that the seal really did come from the company it represents or that it really was authorized by the right company. But as a gratis first pass, it does have its benefits. Shockingly often in fact.
Let me explain.
Pretty much every single month for the last few years, our China lawyers come across an instance where there is something very wrong with the seal/Chinese company with whom our client is thinking of entering into a deal. Just last week, I was cc’ed on some emails between two of our China lawyers doing a first pass review of an alleged company seal. The email exchange was as follows:
First email: Attached please find one of our China Manufacturing Agreements, signed and stamped by the Chinese side. Please note the following that seem out of whack to me:
1. The seal is in blue and not red ink.
2. The seal is rectangular and not circular.
3. The seal is almost illegible — does that matter?
4. The signature is the Chinese manufacturer representative’s English name.
Also, the client tells me that he signed it and scanned it and sent it to them for their signature, but they sent back a copy with their signature but without his, and asked him to sign the copy they had signed. Is that normal?
Second email: None of this is normal or legally binding. The seal should be circular, the ink should be red, and the company name should be entirely in Chinese. The seal should also always be completely legible. And why is the manufacturer signing with his English name? A lot is not right here and you should so instruct the client.
Needless to say, there is additional due diligence that should be done on Chinese companies beyond verifying their company and/or contract seals. Our law firm’s China company investigations typically consist of our reviewing various Chinese government databases to confirm that the Chinese company actually exists and is licensed to sell what it is proposing to sell or to do what it is proposing to do. These investigations also seek to determine whether the Chinese company is well capitalized, is in good standing with the Chinese government regarding fines and taxes, and not involved in lawsuits that would make one doubt its reliability. We also look at the company’s ownership because that sometimes gives us additional good insight about the company. After we search the Chinese government databases, we do an internet search on the company in Chinese and in English to try to get information about its overall reputation.
I am often asked whether these due diligence investigations give comfort and the answer is yes. In just the last few months we have done due diligence searches revealed the following:
- A supplier that had been making since 1974 the widgets our client wanted, with 7 factories throughout China and around $10 million in registered capital. This sort of company is a yes.
- A product supplier that was three months old, has one small factory and about $1 million in registered capital. This sort of company is a probably yes.
- A broker that was formed two months ago and yet claimed to have been making this sort of widget for years. This sort of company is a no.
How do you protect yourself from bad Chinese companies?