Economic stress on SME manufacturers in China continues to increase. This is a long term trend. As a result, China based non-government economists are predicting a wave of plant closures and bankruptcies that will ripple through the entire PRC SME manufacturing sector over the next few years. The large state owned enterprises will not be significantly impacted; the impact will primarily center on small and medium enterprises. This means bankruptcy and closures both in the private sector and in the provincial and local state owned manufacturing sector.
The companies that will be swept away will mostly be weak and technologically backward entities that would have been eliminated many years ago in a market economy. The Chinese system tends to keep these weak players alive far longer than economically rational. Then the life support is suddenly removed and they all die at once. This sudden rise in business deaths is what is being predicted for the next decade.
The concern for foreign buyers of Chinese product is that an increase in closures and bankruptcies will also mean an increase in scams and frauds. When a factory in China knows it will be shutting down, its owners often set up a deal that allows them to bring in as much cash as possible in the short term. The owners then take the cash, shut down the company and move on. No bankruptcy is involved. They just shut the doors, keeping the money sent to them by their foreign product buyers.
My law firm’s international manufacturing lawyers have both seen and written about this scam countless times. See e.g. China Smells Like 2008: The Gloom and Doom Edition.
In implementing their scam, the factory owners are faced with a problem. If they commit fraud against another Chinese person or entity, they likely will be pursued for retribution. That retribution may be criminal investigation and prosecution through China’s criminal justice system. Or the retribution may be informal action carried out by an effective criminal gang system active in China.
Perpetrating a scam on a Chinese entity involves considerable risk. On the other hand, scams against foreign buyers have hardly any risk at all. When a foreign buyer is cheated, the Chinese police typically do nothing at all, either because they are paid by the scammers to do nothing or because they simply don’t care about foreign companies being cheated. On top of this, there is virtually nothing your Embassy or Consulate can do beyond put the names of the offenders on a list. The Chinese courts can do little to nothing as well and the informal methods of retribution are rarely available to foreign entities. For these reasons, when it comes time to do that last big scam or series of scams before shutting down a factory, foreign buyers will always be the preferred target.
The scams at this stage follow a regular pattern. The three primary patterns are as follows:
Chinese Factory Scam Model One
It is typical for Chinese factories to require buyers make an initial deposit on the date they accept their buyers’ purchase orders. A common structure for China suppliers is 30% down and 70% paid prior to shipment. Using this structure, a factory that knows it will shut down will take the deposit, do no work at all and simply fail to deliver. If the factory does this with enough foreign customers, it can collect a substantial sum to funding its owner’s retirement.
This kind of scam is hard to detect and for that reason is very effective. The problem for the scammer is that in a declining market, the total return for the scammer may be disappointingly small. So to milk more from unsuspecting buyers, failing Chinese factories will go for an even bigger score. They go to their buyers and offer to sell their product at a substantial discount. But the price for this discount is a substantial increase in the order amount and an increase in the deposit from 30% to 50%. The Chinese side says: “It is a great deal for you. Make a full year of orders all at once and you will save big money.” Using this scam, the Chinese factory collects a much larger deposit amount and the owners shut down the factory and disappear.
In China Tariffs and What to do Now we focused on how Chinese factories were offering to illegally transship their products to Malaysia or Thailand or Vietnam or Bangladesh or the Philippines (mostly) to avoid U.S. tariffs:
But before I discuss what companies do about their tariff problems, it is far more important I start out discussing what they should NOT do. They should not have their China products shipped to Taiwan or to Malaysia or to Thailand or Vietnam or anywhere else and then have those products shipped to the United States as though they are not from China. Doing this sort of transshipping can and does lead to massive fines and to JAIL TIME. I am not kidding. I am starting out with a post on what not to do because the risks from this one thing far exceed the benefits of the things we will be discussing in our subsequent posts.
And yet, many are telling us that their Chinese factories are suggesting these exact sort of transshipments and giving assurances that they are legal or that nobody ever gets caught, neither of which are remotely true. Step back for just a second and ask yourself why you are even considering taking legal advice about United States customs law from a Chinese factory owner or salesperson who has all the incentive in the world to sell you Chinese products and very little incentive to keep you out of jail. Please, please, please don’t fall for that. Please.
Chinese companies and the U.S. importers of their products often believe they can get around United States tariffs by transshipping the products to Malaysia, Vietnam, Philippines, Sri Lanka, Thailand, Bangladesh, India, [or some other country] before sending them on to the United States. Their plan is to relabel the products with a new country of origin and then export the products to the US free of China , without US Customs and Border Protection (“CBP”) ever being the wiser.
I bring this up because many of the same factories making these illegal transshipping offers are at the same time offering to discount their prices in return for a large increase in the deposit. This sort of “double” offer to illegally avoid tariffs and raise the down payment amount is a terrific indicator of a brewing scam.
Chinese Factory Scam Model Two
Chinese factory sells a standard product, usually something like a chemical or a basic raw material or a food product. As with scam number one, it pumps up its orders by offering a substantial discount — sometimes even too good to be true. In exchange for the discount, the factory requires full payment before shipment. Then the factory ships a non-conforming product, collects the payment and disappears.
The below are some examples brought to the attention of our China lawyers by foreign companies scammed by Chinese factories:
1. Container of custom cut food product: 25 containers, neatly packed. The first layer of these cartons contain conforming product. The rest of the container is filled with bricks.
2. Barrels of a granulated chemical (say citric acid). The top two inches in each barrel is conforming product and the rest is filled with sand. Or barrels are for a liquid chemical (say sulphuric acid). The barrels are filled with salt water.
3. Containers filled with frozen food product, which when thawed, reveal that the food is rotten. In my own experience, this happened with 8 containers of frozen salmon. The decay was so bad that the containers were declared a hazardous waste site and the buyer was required to pay the substantial cost of a hazardous waste clean up.
Chinese Factory Scam Model Three
The owner of the Chinese factory contacts a foreign customer (oftentimes a regular buyer who gets all or most of its product(s) from the dying Chinese factory) and offers to sell their factory and their business to the foreign customer at an unrealistically low price. In exchange for this low price, the deal must close fast. This fast close means no time for due diligence and no involvement of experienced and trustworthy China lawyers or consultants.
The foreign buyer pays the purchase price by wire transfer to the Chinese factory and then travels to China to inspect its factory and find the following:
1. The factory building was rented, not owned. The building is stripped. Not only has all the machinery been removed, but even the window glass and plumbing fixtures are gone.
2. The bank account has been emptied by the former owners and they have disappeared.
3. The landlord shows up and demands a full year’s rent on the factory that has not been paid. Three hundred workers show up and demand six months in unpaid salaries. The local government shows up and demands two years in back taxes. To make it even “better” the local government colludes with the workers to take the passports of the foreign owners, lock them up in a local hotel, and then announce that they will not be able to leave town until all back payments are made.
The above sort of scams are committed in China ALL THE TIME. However, their frequency and severity increase when there are waves of factory closures and bankruptcies and our international dispute resolution lawyers are saying that they’ve seen more of these in the last six months than in the three years before that. For some of the things you need to be doing now to reduce your chances of problems stemming from this wave, stay tuned for tomorrow’s post.
But in the meantime, be careful out there.