By Howard Wang CA and Kent Kedl

Multinational companies in China are not strangers to internal investigations into employee and third-party malfeasance, using significant compliance, legal, audit and forensic resources in the process. However, rather than helping to solve the problem, traditional investigative approaches are increasingly going wrong, leading to financial and reputational damage.

Poorly executed investigations in China fail to contain potential compliance, regulatory and business continuity problems and can often increase the risk of scrutiny from government investigators, disruption to supply or distribution chains, and disgruntled employees venting on social media. Here are some recent examples.

Business continuity

A China general manager was terminated for embezzlement based on whistleblowing complaints and substantial evidence. The company announced his termination “for gross misconduct” to all employees, sending a strong message about compliance. 

However, insulted by this, the GM retaliated by stealing the company “chops” (company seal or stamp) and business licence, paralysing the company from conducting critical contractual and financial transactions. He continued to represent himself to employees and customers as the GM, and it took the company nearly six months to negotiate a settlement and get the business running again.

Reputation

The US headquarters of a China subsidiary decided to terminate 27 distributors for fraud. In response, the distributors used China’s most popular social media and messaging platform, WeChat, to criticise the company for illegal business practices. Customers quickly cancelled orders and the company was forced to reinstate the distributors (even though the fraud was proven) and negotiate subsequent separation agreements with them. It took nine months for the company to recover.

Financial

A European conglomerate acquired a Chinese company and retained the former owner to continue as GM. However, subsequently the growth rate was not as expected and investigations determined that the GM had been diverting business to a competing company that he had established.

Representatives from headquarters fired the GM, who then locked them out of the operation and moved moulds and equipment to his own factory and started to take clients away. HQ eventually had to negotiate a sale back to the GM at a fraction of the original purchase price.

Regulatory

On the advice of external counsel, a European company terminated a number of potentially corrupt sales agents. Aggrieved, one of the agents, who had strong political connections, passed details of corrupt activities to the local authorities who commenced an investigation into the company. As part of the negotiations with the regulators, the company had to agree a settlement with the agent.

When the solution is the problem

Such situations are, understandably, frustrating for a foreign company’s management. They are being defrauded and initiate an appropriate investigation where they find credible evidence, and then they take action.

So how does the suspect get the upper hand and throw the company into a tailspin? We believe this is because the traditional linear approach to an investigation is causing problems because it does not take into account some unique features of China’s business and legal environment.

Tolerance of conflict of interest

The notion that “everyone is making some money on the side, so I should too” lives on in China. Conflicts of interest, establishing competing side companies and committing financial fraud are common. Often, the perpetrators do not see their actions as unlawful and tend to have an extreme reaction if that income is taken away. Conflicts of interest also become a critical business continuity issue when you find that your supply or distribution chain is dependent on the businesses of the employee you have just fired.

Face

The need to maintain a good reputation among peers, customers and employees — and the severe reactions if that reputation is threatened — is an important but often overlooked motivator. Senior managers who have engaged in fraud and embezzlement will often work hard to clear their name, publicly blaming the company for mistreatment.

Relationships

While guanxi, the system of social networks and influential relationships which facilitates business, is not as important as it once was in order to succeed in business in China, well-connected employees can use the full extent of their political influence to cause problems. These include causing delays in licensing renewals, triggering tax, safety and environmental investigations and stopping shipments through customs.

Labour laws favour the employee

It is extremely difficult to fire employees in China, even for cause. This often makes fraud a “punishment-less crime”.

Conversely, Chinese employees often distrust official arbitration and legal processes so, if they feel cornered, they can lash out against the company or attempt to secure additional compensation through nefarious means, knowing there is very little downside for them.

High threshold required for intervention by the authorities

China’s law enforcement bodies are often under-staffed in Tier-1 Chinese cities and are rarely interested in investigating cases of employee misbehaviour. It is difficult for companies to use the threat of criminal charges as either a carrot or stick to ensure more compliant behaviour.

Heavy reliance on hard-copy company credentials, including the business licence and company chop

Without these representations of corporate authority, it is difficult to conduct business and issue company documents. Employees know this and often take these items in a crisis.

Your objective is to recover

A typical objective of an investigation is to find evidence of wrongdoing and take action. However, your real objective is to ensure business continuity and improve overall business conditions and operations.

Because these situations can quickly devolve into a crisis, Control Risks Group recommends a “recovery-led” approach when planning and conducting an internal investigation.

Unlike the traditional linear technique, the recovery-led approach places primary focus on business continuity, takes into account the unique challenges of operating in China, and inserts a few, very critical steps.

From the beginning, the alternative investigative approach is preventative, rather than reactive. 

It begins by taking the suspicions (step 1) and thinking through all the various undesirable outcomes, and planning an investigation to prevent worst-case scenarios from occurring (step 2).

When planning an investigation in China, foreign companies should also take steps to ensure that Chinese privacy regulations are strictly observed, and political risks and exposures are assessed.

The approach considers the suspected individual and what damage they, or their connections, might do to the organisation — what crisis they could set off. For example, the potential for disruption is quite different if the suspect is a senior commercial leader versus a finance manager.

To ensure a holistic assessment, the investigation includes internal and external sources (step 3).

The most damaging evidence is often found by discreetly talking to people in the market (step 4).

After the evidence is gathered, it is critical to not proceed immediately to take action. Rather, assess the risks, and the pros and cons of various actions (step 5), and put plans in place to mitigate those risks (step 6) before finally taking any action (step 7).

Senior managers who have engaged in fraud and embezzlement will often work hard to clear their name, publicly blaming the company for mistreatment.

Howard Wang CA is a managing director, Fraud & Forensics and Kent Kedl is a senior managing director at Control Risks Group based in Shanghai, China.

This article was first published in the July 2016 issue of Acuity magazine.