Juan Carlos Madrigal spoke with the IR Digital team about the importance of identifying and actively managing partner selection risk in China. He also provides several examples of cases where poor partner selection decisions by foreign investors can threaten the profitability or even future viability of an operation in China, and discusses how Pamir helps clients ensure that the actions of their China partners do not become a liability in the short or long term.
Juan Carlos divides his time between Taipei and Shanghai. He provides strategic advice and practical operational support to U.S., European and Latin American clients in market entry and expansion activities, cross-cultural commercial negotiations, strategic partner selection, business dispute mediation, corruption investigations, background checks, and M&A transactions in China and Taiwan.
Can You Tell Us More About Pamir Law Group?
My name is Juan Carlos Madrigal, I’m with Pamir Law Group and we are IR members for China and Taiwan. We are a small boutique cross-border investment shop. We assist foreign investors coming to China and Taiwan for a wide variety of investment projects including mergers and acquisitions, private equity, venture capital, and joint ventures. We assist with transactions and provide operational support to make sure that clients are able to establish an operation successfully and then run it safely and successfully in the long term. Finally, in recent years, we have also started assisting mainly Chinese clients with investment overseas.
What Is the Biggest Challenge Foreign Entrepreneurs Are Currently Facing in China?
In our experience, key partner selection is one of the most important decisions that every foreign investor is going to face in China. And just like in a marriage, it is very important to make sure that you understand the other party to ensure a successful partnership. We have seen many cases of seasoned foreign investors who are willing to go into business and/or a transaction with people they barely know and they don’t spend the time to develop an understanding of the other party. Frankly it is irresponsible to do that without being able to answer a number of basic questions, such as:
Who are these people? Do we really know them? Is their money clean? Is their reputation going to become a liability for us in the short or long term? Can they deliver on their financial and other types of commitments that they have made to us that are necessary for us to succeed?
We have seen many cases where very seasoned business people fail to conduct proper due diligence, sometimes because they are lured by the promises of big profits, and sometimes because there’s a bit of fear of “missing out” on the China market. I don’t think anyone watching this video, whether you’re an executive in an organization or an advisor working with such an organization, should rush into this kind of partnership without taking the necessary steps, and then wind up having to own a potential disaster. No amount of lawyering is going to save you from a bad partner decision in China. Sometimes by the time the client decides to do something it is too late, and even the viability of the company is threatened by the actions of the counterparty, which could have been prevented they had spent this time in advance to perform due diligence.
Can You Provide Any Examples of These Challenges?
Let me give you a couple of examples of cases where a foreign investor rushes into a partnership with a Chinese counterparty, and let me explain how that goes wrong most of the time.
We have seen quite a few North American and European companies that come to us because they had a need to import a product from China. They found a manufacturer and they entered into a relationship where maybe they did one or two successful transactions to build trust. All of a sudden the manufacturer said, “for this transaction we need the entire amount in advance” and the client agrees. Three or four months later, the manufacturer disappears, they cannot get anyone on the phone, and the client realizes that we don’t know whether this company exists or not. Is it properly registered? Does it have assets? They are now in a situation where they are owed money and may not have the ability to sue the manufacturer. Eventually they find out that the company doesn’t exist and they realize that their contact window has only given them an English name. They know they have been dealing with “Johnny Chen”, but who is that? What is his Chinese name? They don’t know. They don’t have the ability to find them or identify them and in the end they have explain to their top management team what happened and why they don’t have a supplier and why they’re not able to get the company’s money back. That’s obviously a bad situation.
Obviously once this happens we certainly can go and try to recover the funds, but that still leaves the company with a problem. They don’t have a supplier and they don’t have the products that they need. So what we recommend most of the time is that before the company goes into this kind of relationship, a thorough understanding is developed of the counterparty in order to prevent this kind of situation, rather than trying to fix them after the fact.
It is also irresponsible to fail to monitor the behavior of these key partners after a transaction takes place or after the key executive comes into the company. We help clients make sure that they always have an understand of what’s going on with their China operation and that they don’t regret it in the long term.
Let me give you an example, we had a client that was a high tech electronics manufacturer and they had a facility in one of the major cities in China. They had decided to build a second manufacturing facility in an inland province in order to reduce their costs.They hired a new manager to head that project, and that person was sent away from the major city into the inland city. Top management basically let that person run the construction project as he saw fit, and they were frankly asleep at the wheel.
After two years of being unsupervised, the company realizes that this key manager had set up a complex scheme of kickbacks whereby he had contractors that were overcharging the company to deliver substandard quality work. The client ended up with a factory that didn’t meet their specifications. It was not functional, and because they had built it with a loan that they obtained from the local government, once they added the cost of servicing the debt, producing in that facility was more expensive than the original facilities, so it was a complete disaster. The CEO was replaced and the company almost went out of business because of this.
Who Should Worry About Partner Selection Risk in China?
My opinion is that everybody should worry about partner selection in China. Anybody that has any kind of exposure to China, whether it is contractual relationships with suppliers or they actually have an operation in China. Partner selection is a key issue that takes planning and management.
Foreign companies that are looking for investors from China need to make sure that the investor’s funds are clean, so that they’re not going to become involved in the next large political scandal in China.
Professional services providers onboarding a new client. Many of the IR members will be in a situation in the future where they will have a new client from mainland China, perhaps to execute a large transaction in their jurisdiction and they either already have or will have an obligation to ensure that the source of the funds is legitimate and that they know their client. It is critical that service providers understand their clients.
Another constituency that should be worried about that is foreign companies that buy products from China, they have the supply chain in China. They need to make sure that they’re able to obtain the products that they need in an ongoing basis because not having access to their supply chain, or any disruption to their supply chain can have catastrophic consequences.
How Can Pamir Law Help Minimise Partner Selection Risk in China?
We help clients minimize partner risk selection in China by helping them answer two basic questions when they’re facing a Chinese counter-party.
Is the person or the company clean? and is their money clean and are they going to be a risk or liability for us? We do this by conducting an extensive background check on the other party, which consists of two sections:
One is a “desktop search” which focuses on obtaining information about the other party from government databases, litigation databases, bankruptcy databases, international sanctions, terrorist finance databases. With this we create a basic understanding of the party.
In the second stage of the background check we deploy a team of on-the-ground investigators to conduct discreet queries about the reputation of the party. During this phase, we usually uncover a wealth of information that is just not available obviously in the public record. We talk to suppliers, members of the local business community, competitors, government officials, and we make sure that we dig out as many skeletons as we can during this phase.
After we conclude the background check and the client has a good understanding of the other party, if required, sometimes we move on to the source of funds report to make sure that the money is actually clean. We partner with a local accounting firm in China that goes through the records of the company to make sure that a) their accounting practices are up to international standards and b) make sure that the origin of the funds that are being moved out of China to be used for the investment project are from legitimate sources. This is critical for M&A cases as well as investor immigration projects where a Chinese investor is coming to the UK or going to the U.S., Malta or Cyprus needs to show that the source of the funds is legitimate.
Finally, once we help the client determine whether the counterparty and their funds are clean today, we help them design and implement programs to ensure that the counterparty remains clean, and they’re clean tomorrow and next year and going forward. This is critical because, in our experience, many of the problems with partner selection actually start manifesting themselves after one or two years, then they do not manifest immediately, so it is very important to keep looking, keep monitoring, and make sure that the partner’s future behavior does not become a liability for you. So periodic background checks and all sorts of standard operating procedure are created to make sure that risk management becomes a part of everything that the company does in China.
Why Work with Pamir Law?
People should work with us because we understand China. Our colleagues collectively have been working in China for over three decades, helping state-owned enterprises from China investing abroad. We also helped many foreign investors come into China, and recently we started helping a new wave of Chinese investment overseas. Myself and my colleagues have seen the movie many times. We know how things go wrong and we know how things go right, and we generally know where the skeletons are hidden, so we are able to ensure that our clients successfully and safely complete their transactions. And also we can also make sure that they are able to run their operations in a safe manner in the long term.