Our China lawyers have over the last few months have been getting more than the usual number of emails and phone calls from foreign companies (U.S. and European) telling us they’ve been scammed or seeking our assistance in determining whether they are about to get scammed. The following are the four most common China scams we are seeing.
Bricks for Product
A savvy chemical industry client once told me that “more than 95% of China companies selling chemicals online are fraudsters and many of these companies are not even in China.” I have no doubt this person was exaggerating for effect, but another such person I know insists the percentage does exceed 50 percent. This is old news.
But here’s the “new news”. The sending of “junk” instead of real product has spread to pretty much every industry in China and ordering your products from reputable online sites provides little protection. Our China attorneys have consistently found that ordering products from a Chinese manufacturer listed on a site that claims to screen its vendors or provide you with recourse provides little to no added protection.
The below email is 100% par for this new course:
Not sure what to do here with my situation. I worked with a reputable company in China to manufacture window awnings. I received samples from them and all was good. I placed an order for 5,000 pieces and they are of the wrong material and warped. The sections that are supposed to open do not operate correctly because of the wrong material. I spent hundreds of thousands on this order and now they will not get back to me. They told me they were going to rework the products because they knew there was an issue. Now I have all this useless product I cannot sell and I am paying storage on it because I am hoping still to be able to return it. I used ______________ to find them and but it seems they cannot or will not do much to help me. I’m trying to get a new product to market but that is proving really difficult because I have been hurt so badly financially. Can you help?
My response to these sort of emails is usually consists of explaining how we determine the odds of our being able to get them some or all of their money back.
But here I can say more about why this sort of thing happens and what you can do to prevent it from happening to you.
1. These things happen because the buyer does not conduct due diligence on the seller. Half the time when I get an email like the above and I spend two minutes searching out the Chinese company on the internet I find multiple instances of fraud committed by the same Chinese company.
2. These things happen with companies that want to make a few final sales before they file for bankruptcy or just shut down and disappear. Imagine the profits to be made from three $350,000 sales for which no product is ever provided. Now imagine the incentive for the owners of a Chinese manufacturing company to sell products to a foreign company and then never supply those products and do this right before (or sometimes even right after) they shut their doors for good.
3. Much of the time, the Chinese company that commits the fraud never really existed; it was never registered anywhere in China or if it is registered as a real company in China, it is registered for something like plumbing repairs, not for manufacturing.
4. These fraudsters are smart and there are good reasons why they spend the money to send you something instead of nothing at all and why they claim they will remedy the problems. The reasons are usually two-fold. One, sending incredibly bad product is less likely to lead to criminal charges than sending no product at all. This allows the fraudster to assert that it sent you the you ordered and “it’s not my fault those Americans/Europeans/Australians are so picky.” Two, by stalling they keep their scam alive for much longer. They’ve paid for advertising and for a website and they’ve even bought the really bad product and they want to maximize these expenditures
5. Be careful when establishing business relationships with a new company. Do as much due diligence as you can. Send people you trust to do an on-site investigation of the manufacturing site. Do a site inspection on goods before payment. Make sure the company exists and is legally able to conduct the business for which you will be paying it.
6. Use a contract that actually works for China and that sets forth clearly what you are buying and what happens if your China supplier fails to comply. See China Contracts: Make Them Enforceable Or Don’t Bother.
7. Know the market price of whatever it is you are seeking to purchase before you purchase it. Do not trust a company that gives you an unreasonably low price quote.
8. Consider a small trial order to reduce your risk. The problem with this though is that many scammers will provide you with a good trial and then scam you when you order the full amount. But if you combine this with a contract that works for China and proof that the company actually exists and is operating legally, you will be lowering your risks.
One more thing that warrants its own special mention. Do not buy product from China without first registering your trademark in China because many of the fraudsters sending out bad product are also registering YOUR brand names and/or product names and/or logos in China as THEIR trademarks in China and then coming back later seeking to sell you these trademarks (for a lot of money) under threat of blocking your products from leaving China for violating THEIR trademarks. See 8 Reasons to Register Your Trademarks in China.
The Switched Bank Account Scam
We often write about this particular scam because our international lawyers constantly get contacted by smart companies that have fallen victim to it.
Last year the Wall Street Journal wrote on how there has been an increase in criminals breaking into email accounts and changing bank-account information to capture payments intended for suppliers:
The increasing prevalence of the schemes has drawn the attention of law enforcement. Attackers who once pretended to be executives directing subordinates to transfer money are using new techniques, including malicious software to break into email systems and redirect the payments.
And as the Wall Street Journal noted, these bank account scams are increasing and most involve China:
In an analysis of 44 recent fraudulent transfers, 84% of the transfers went to accounts in China and Hong Kong where it is more difficult for victims to recover their money, the FBI alert said, and complaints about these scams more than tripled last year.
The Wall Street Journal describes these scams as follows:
When the buyer sends an order, the scammers step in, ultimately intercepting the seller’s invoice and changing payment instructions before sending it back to the buyer. With the modified invoice, funds are sent to the criminals instead of to the seller.
The bank switch scam usually involves your regular Chinese supplier asking you to make a payment to a new bank account, though it sometimes can involve your first payment to a new Chinese supplier. After you make the payment, your China supplier insists you still owe it the full amount because it never received your payment. When you explain to your China supplier that you already paid it, your supplier points out that the bank account to which you sent the funds is not theirs and so you still owe them the money.
The Wall Street Journal article then discusses how easy these bank switch scams can be to pull off and how difficult they are to stop:
True business email compromise is almost invisible to both victim companies involved in the transaction,” he said. “It’s going to take a lot more effort to stop it than a simple reminder to phone the CEO before wiring money on his behalf.
There are some things you can do beyond just reminding your people “to phone the CEO before wiring money on his behalf.” You should do the following to minimize your chances of falling victim to this common scam:
1. Get to know the people at your suppliers who speak English (if you don’t speak Chinese) and get your supplier’s landline phone numbers as that cannot be hacked. Call if you have any concerns.
2. Get your supplier’s bank account information in advance and ask them to refer to “bank account information document” on their invoices, rather than listing out full bank details every time.
3. Check your bank account every day, maybe even twice a day. If you catch a wire early enough you can sometimes stop it.
4. Do a first small wire to confirm the account.
5. If possible, pay your Chinese suppliers to their bank accounts in mainland China as that is generally safer than paying them overseas, be it Hong Kong, Taiwan or anywhere else.
6. Have a special procedure set up with your suppliers for confirming bank account changes.
7. Have an internal procedure for confirming all payments over a certain amount.
8. Get an insurance policy that covers computer hacking or fraud and make sure it covers this sort of scam. We have been able to quite easily get insurance companies to pay off on such policies.
What can you do if you have already been victimized? We do the following when retained by a company victimized by this fraud:
1. We determine whether insurance claims can be made. This is usually your best chance of recovering your losses. We help by explaining to the insurance company how the scam happened and why our client is entitled to coverage under its policy and we get the Chinese supplier to help as well.
2. We seek (and usually get) some monetary contribution from the Chinese supplier by letting it know that it was (or might have been) their computer system the scammer hacked and therefore it should pay some of our client’s loss.
3. We work with our client to minimize problems with its Chinese supplier. If that relationship needs to be severed, we counsel them on how to do that without creating new problems. See Why Changing China Suppliers Can Be So Risky.
4. We determine whether there is a chance to recover anything from the perpetrator. Just running this option to ground helps immensely in dealing with both the Chinese supplier and with our client’s insurance company, neither of whom want to pay anything until they are convinced that our client has done everything it could to try to recover from the crooks themselves
The China Stock Option Scam
This scam starts with a Chinese company offering stock ownership as an alternative form of payment. The typical scam usually goes like this. The Chinese company — usually in the tech sector — is in desperate need of the expensive skills or knowledge of a foreign person or entity. The Chinese company tells the foreign tech people or entity that it “needs your services but because we are just a start up we will need to pay you in stock instead of cash.” So, instead of paying cash, the Chinese company offers founders’ stock or employee stock options in their Chinese entity. Just as is the case with Silicon Valley founders stock/stock options, the idea here is that the Chinese entity will go public (“do an IPO”) and the stock it has given out will then provide its recipients with big returns.
Unfortunately, this is nearly impossible because foreigners cannot own stock in Chinese domestic companies not already listed on a stock market. So any such option or stock transfer is void from the start. Foreigners are not permitted to be shareholders of Chinese domestic companies, nor does China recognize the concept of nominee shareholders. Chinese companies will also use this Silicon Valley approach of offering a stock option package as a key benefit in the employment package. By offering stock options, the Chinese company can pay less and secure greater loyalty, while still exploiting the skills and extracting the knowledge of foreign individuals in developing an innovative software or other high tech product.
This exploitation/extraction period typically lasts one to three years, at which point the Chinese company tells the foreign individual, “sorry, the Chinese government has now informed us that we cannot issue stock options to you.” Sometimes, to better hide the scheme, the Chinese company will propose a series of fantasy work arounds, such as elaborate nominee schemes illegal under Chinese law. These proposals often convince the foreign person to waste another year or two with the Chinese company. But, in the end, the result is always the same. The Chinese company defaults on its promise to provide the foreign individual with stock in the company and the foreign individual is left high and dry. Since the founders stock/stock option scheme was void from the start, there is nothing the foreigners can do to enforce their rights in China, since they never had any such rights.
A similar scam is often perpetrated on foreign entities. The foreign entity has a technical service of great value to the Chinese tech company. The Chinese company then says: “We need your services, but we are growing so fast we simply don’t have the ability to pay you in cash for that. However, since we are growing so fast, it is certain we will soon do an IPO on the Shanghai stock exchange. So, instead of paying you in cash, we will agree to pay in you in stock options. Our stock will in the end give you way more money and by working with us, you will gain entry into the lucrative Chinese market and highly profitable work with other Chinese companies will follow.”
This scam results in the same sad result as the employee stock option scam. First, as with employee stock options, a foreigner cannot own stock in the Chinese entity, so the option is void from the start. Second, the private Chinese entity never does an IPO on the Shanghai market, so the whole concept was an illusion. Third, the only thing the foreign entity achieved was to identify itself as an easy mark and there will be no future profitable work available to it in China. Finally, the foreign company does not figure out the scam until after it has already transferred its service or valuable information to the Chinese entity.
There are a couple of elegant variations Chinese entities use to implement the Chinese stock scam. In the rare case where a private Chinese company actually completes an IPO, the listing is on a foreign exchange: usually either Hong Kong or the United States or London, where due to Chinese law requirements the actual listing entity is not the Chinese company for which stock options or stock were purportedly given. Instead, the listing entity is some form of subsidiary or other affiliate of the Chinese company, so that when the IPO does actually take place, the holder of the scam option or stock in the Chinese company can legitimately be told: “your stock option (or stock) is with the Chinese parent company; you do not have an option with the affiliate actually listed. Sorry.”
For all intents and purposes, private companies in China are locked out of China’s domestic IPO market. See this Wall Street Journal article. On the other hand, such companies have become attractive targets for private equity financing. But the story here is the same. The private equity financing occurs in China, resulting in a big payout to existing shareholders of the Chinese entity. The foreign stock option holder looks for an equivalent benefit. The Chinese entity then responds: this was a private equity deal, not an IPO. You did not own any stock at the time of the private financing, so you are not entitled to any benefit.
The way to avoid this scam is easy. Do not accept promises of stock options or stock in a Chinese company in place of employment compensation or payment for services. Any Chinese company that makes the offer of payment in stock is either ignorant of the requirements of Chinese law or intentionally committing fraud. Either way, foreign individuals and companies should refuse to work with a Chinese company in return for stock or stock options.
The Fake Joint Venture
This scam is an oldy but a goody and — dare I say it — one of my favorites. The reason I say it is one of my favorites is because anyone who falls prey to it brings it on themselves, at least in part. Our China lawyers see this one quite often and as far as I know, it has always involved an American company, which I fear says something about American naïveté.
This scam is very simple and it nearly always goes down the same way. It starts with a Chinese company convincing a foreign company to do a joint venture. The foreign company then contributes something to the joint venture to secure its ownership stake in it. This contribution usually consists of money, but it sometimes involves other assets as well, such as intellectual property, equipment, personnel (usually unpaid) or know-how. The Chinese company says it will handle the setting up of the joint venture and the foreign company readily agrees to this.
But instead of actually setting up a joint venture in which the foreign company has an ownership stake, the Chinese side takes the assets from the foreign company and does nothing official towards forming a joint venture. Typically, the Chinese company never sends the foreign company any remotely official documents regarding the alleged joint venture, but sometimes it sends fakes. Either way, the end result is that the foreign company believes it to be a part-owner of a China joint venture and it starts acting accordingly.
Usually for years everything is fine, but then the foreign company begins wondering why it has never received money from the joint venture when it now seems to be doing well. So they contact their supposed joint venture partner (the Chinese company) and when they fail to get any answers, they contact our law firm to look into bringing a lawsuit. We do some quick research and learn that there is no joint venture.
In some circumstances it may be possible to sue individuals and companies for fraud, but usually there is no recourse.
How do you avoid this scam happening to you? You retain a qualified lawyer to make sure a real joint venture gets formed with your company as one of its owners.