As tensions grow, so do China-related compliance risks

In the current world of business relationships between the United States and China, The Art of War may well indeed be a prescient guide. U.S. companies that conduct business in any way, shape, or form with the PRC are finding themselves facing fire on an increasingly risk-laden political and economic battlefield.

Cross-border deal making, although actively courted by both nations, demands rigorous risk mitigation and heightened compliance oversight, neither of which can assuredly yield predictable results in the current climate.

The Huawei way?

Recently, a new wrinkle in an ongoing trade war has emerged: detaining company executives. On Dec. 1, Huawei Technologies chief financial officer Sabrina Meng Wanzhou was arrested by Canadian officials. She faces extradition to the U.S. and could be sentenced to up to 30 years in prison if convicted on allegations she, and her company, evaded Iran-targeted sanctions and committed bank fraud.

Huawei, founded by a former Chinese military officer, has long been accused of suspect behavior by the United States and its allies.

Meng’s arrest (although not made public until Dec. 5) was made on the very same day President Trump met with China’s Xi Jinping at a summit in Buenos Aires. The focus of that meeting: how to end a “trade war” between the two economic superpowers. It is a battle that goes beyond tit-for-tat tariffs to encompass allegations of currency manipulation, forced technology transfers, counterfeiting, and intellectual property theft that has long vexed U.S. companies.

Despite assurances from the Trump administration to the contrary, claims that Meng’s arrest and detainment won’t affect ongoing trade negotiations certainly seem overly optimistic, if not far-fetched. Imagine a scenario where Apple’s Tim Cook or Tesla’s Elon Musk was similarly imprisoned. It strains credulity to think the Huawei arrest will not have direct repercussions, as it would in those hypothetical scenarios.

In recent days, tensions have continued to flare. Former Canadian diplomat Michael Kovrig, now an adviser for the International Crisis Group, was recently detained by the Beijing Bureau of Chinese State Security. Also arrested, on still fuzzy allegations, was Canadian Michael Spavor, founder of a “cultural exchange” that facilitates travel to North Korea.

Boots on the ground? 

In a perfect world, U.S. executives would strive to put representatives in China, on either a periodic or ongoing basis, to oversee compliance efforts.

While in-country representation may be a best practice, recent arrests create uncertainty about how Chinese officials might react to even a low-tier regulatory matter or compliance problem. Will the government be content to impose fines, or will matters escalate to the point that even minor allegations warrant an arrest to send an international message?

“The Chinese government means to compete with us in every way possible, playing by the rules at times, bending them at others, and breaking them when necessary to ensure their success.”

E.W. Priestap, Assistant Director, FBI Counterintelligence Division

The State Department, alarmed by the detentions of Canadian citizens, has offered a warning to Americans who plan on traveling to China.

“Our travel advisory for China suggests that anyone exercise caution when traveling to China based in part on the potential for American citizens visiting and residing in China to be arbitrarily interrogated and detained,” Robert J. Palladino, deputy spokesperson for the State Department, said during a press briefing last week.

The view from an IPO

Beyond the all-important imperative to keep employees and executives safe, there is a far larger minefield of compliance challenges, security risks, and legal conundrums that come with operating in China.

Ongoing trade disputes and high-profile arrests did little, however, to deter yet another China-based company from entering the U.S. public marketplace. Tencent Music Entertainment Group, an online music business, went live with an initial public offering late last week.

A review of Tencent’s IPO filings with the SEC, specifically its documentation of risk factors, illustrate pitfalls companies will want to be cognizant of as they pursue Chinese business dealings.

• Uncertainties in the PRC legal system could limit the ability to enforce contractual arrangements. In particular, the PRC legal system is based on written statutes and prior court decisions “which have limited value as precedents,” Tencent wrote.  
• The PRC legal system, the company adds, “is based in part on government policies and internal rules, some of which are not published on a timely basis or at all and may have a retroactive effect; as a result, we may not be aware of our violation of any of these policies and rules until sometime after the violation.”
• PRC regulations establish complex procedures for acquisitions of Chinese companies by foreign investors, which could make it more difficult to pursue growth through mergers and acquisitions.

Audit woes

Tencent noted that an audit report included with its prospectus was prepared by a firm that is not inspected by the Public Company Accounting Oversight Board.

Starting in 2011, Chinese affiliates of the Big Four accounting firms were affected by a conflict between U.S. and Chinese law. The Securities and Exchange Commission and the PCAOB sought to obtain access to Chinese firms’ audit work papers and related documents. Firms were advised, however, that under Chinese law, they could not respond directly to U.S. regulators on those requests without government approval.

“In the event that the SEC restarts the administrative proceedings, depending upon the final outcome, listed companies in the U.S. with major PRC operations may find it difficult or impossible to retain auditors in respect of their operations in the PRC, which could result in financial statements being determined to not be in compliance with the requirements of the Exchange Act, including possible delisting,” Tencent warned.

The accounting risks to public companies entering the China sphere were elucidated upon by SEC and PCAOB officials in a Dec. 7 document.

They “currently face significant challenges in overseeing the financial reporting for U.S.-listed companies whose operations are based in China—a market where U.S. investors’ interest has increased and is significant,” it says. “The PCAOB has worked to increase its access to China’s audit work papers, but progress has been slow and satisfactory resolution remains uncertain.”

The spies who came in from the break room

Among the biggest concerns for U.S. companies is the prospect that their patents, technology, innovations, and intellectual property can be compromised.

This was among the topics explored during a Dec. 12 hearing convened by the Senate Judiciary Committee.

“The Chinese government means to compete with us in every way possible, playing by the rules at times, bending them at others, and breaking them when necessary to ensure their success,” testified E.W. Priestap, assistant director of the FBI’s Counterintelligence Division. “American companies are increasingly having to compete against businesses that are their mirror images, built on stolen ideas, information and innovations, but operating more nimbly and cheaply, not weighed down by the honest expense of developing intellectual property. While U.S. companies may be able to operate and profit in China for a time, it is on borrowed time.”

Espionage concerns often veer into the national security arena.

In June 2018, Chinese telecom giant ZTE Corp. agreed to “severe additional penalties and compliance measures.” It was accused of shipping approximately $32 million of U.S.-origin items to Iran without obtaining the proper export licenses from the U.S. government.

U.S. legislative efforts to combat this sort of violation include the Foreign Investment Risk Review Modernization Act. It granted the Committee on Foreign Investment in the United States (CFIUS) expanded authority to mandate the disclosure of investments by state-owned companies that use opaque corporate structures or financing arrangements to otherwise evade reviews.

The legislation also updated the definition of “critical technologies” to include emerging and dual-use technologies (which have both military and civilian purposes) that are not yet subject to export controls.

These measures are far from perfect, critics say. That presents a threat to companies that find themselves in the midst of a technology dispute because of a Chinese business relationship.

Senator Bob Menendez (D-N.J.), for example, recently asked Treasury Secretary Steven Mnuchin and Commerce Secretary Wilbur Ross “to explain how a Chinese state-owned firm was able to use offshore companies to potentially acquire restricted American technology.”

According to a Dec. 4 article in the Wall Street Journal, that firm, China Orient, used subsidiaries and offshore third parties to evade U.S. export control laws and acquire a majority stake in a U.S. company seeking to purchase a U.S.-made satellite.

“Failure to review this and other similarly-situated transactions, in which Chinese stated-owned entities may gain footholds in sensitive technologies, poses a significant threat to U.S. national security,” Menendez wrote, adding that a Chinese state-owned firm “may ultimately become the beneficial owner of critical U.S. technology, potentially exposing that technology to China’s government or military.”

Companies with overseas operations have been warned that Chinese officials have myriad ways to exploit their proprietary products.

China’s main cyber-security law, for example, mandates security reviews that can force foreign companies to disclose coding, algorithms, and other intellectual property.

A June 2018 report by the White House’s Office of Trade and Manufacturing Policy estimates that the cost of trade secret theft ranges between $180 billion and $540 billion annually.

In November, the Department of Justice announced the creation of a new “China Initiative” to identify priority Chinese trade theft cases. The plan calls for developing an enforcement strategy concerning “non-traditional collectors” (researchers in labs, universities, and the defense industrial base) that are co-opted into illicitly transferring technology and trade secrets.

The agency also wants to better address supply chain threats and more effectively seek out Foreign Corrupt Practices Act violations.

The initiative was announced on the heels of a high-profile indictment brought against a Chinese state-owned company and a Taiwan-based company for an alleged scheme to steal trade secrets from U.S. semi-conductor company Micron.

The Justice Department’s reinvigorated focus on FCPA enforcement related to Chinese business dealings underscores top-of-mind compliance concerns.

These risks are especially heightened in a nation where corruption and bribery are officially discouraged, but with a proverbial, unmistakable wink. An oft-quoted Ming Dynasty adage sums up the attitude: “Soil that is dirty grows the countless things. Water that is clear has no fish.”

“As a rule of thumb, I would suggest to any board with material operations in China that if you have not fired someone in the last 12 months for taking kickbacks or committing expense fraud you really have not been looking,” warned Gordon Orr, a non executive board member at Meituan-Dianping and Lenovo, with a LinkedIn post entitled “Why Boards Should Worry about China.”

Best practices include having a code of conduct and anti-corruption compliance manual, and related training, that is multi-lingual and cognizant of the nuances of the Chinese language, cultural standards, and national law.

Gift giving and entertainment need to be carefully monitored. Monetary thresholds and protocols for advance compliance approvals should be in place and carefully scrutinized and monitored.

The unique political nature of China means that nearly anyone (including company executives and journalists) can fall into the verboten  category of a public official, and even inexpensive gifts or means can fall into the “bribery” bucket.

A cross-functional team, with board-level reporting lines, should be tasked with any and all things related to the risks of operating in China. Supply chain concerns, especially as they relate to U.S. sanctions, import origins, and product restrictions, should be among the priorities.

Even hiring practices need to be carefully scrutinized. That was the costly lesson of JPMorgan Chase’s “Sons and Daughters” program. The company had hired the friends and family of Chinese officials, allegedly in an attempt to curry their favor. In 2016, those practices triggered a $268 million fine for FCPA violations.