Managing Risks in China - Bribery, Corruption, and Little Red Packets

BRIBERY RISKS - NATURE VERSUS NURTURE

In a country where all assets were theoretically public just a few decades ago, it is hard to find a long-standing business with an entirely clean record. Law firms in China say that the idea of "original sin" is the best way of explaining unknown origins of capital for PRC companies - that is, most of them were started with funds originally meant to belong to the state. While most have come clean and now rely on legitimate sources of capital for ongoing operation and expansion, the more prevalent concern for foreign companies doing business in China is the continued practice of requesting and accepting personal payments to facilitate business transactions.

"I think the risks in China come down to operational risk," says Peter Yuen, a partner at Freshfields Bruckhaus Deringer. As things can be difficult to monitor, due to language and cultural issues, it might appear to some that certain transgressions are inevitable. "In my view, this is not strictly correct - there are things people can do," he says, "to try and regulate matters properly so that, at the very least, they can demonstrate to their regulators at home that proper policy was put in place to deal with these issues."

Although Yuen thinks it would be unfair to say that bribery is a way of life in China, people here tend not to be as confrontational in business dealings, and 'smoothing the way' can lead towards grey areas. At times, personal monetary compensation may be resorted to in place of referring the issue to the relevant department for compliance negotiations. From a Chinese perspective, such cases may be seen as a natural progression, and Yuen notes that education is important to add fairness and openness to the process so that people are not afraid to speak up about questionable practices.

While senior management may have the right idea, implementation by locally-recruited middle management is often the problem. Those that don't see it through properly are usually not commercially and culturally attuned to the situation. "The middle-management need to set the example, in terms of promoting the culture of transparency and being vigilant when it comes to dealing with their customers and suppliers, and others," says Yuen.

LEGAL MEASURES - THE POLICY FROM ABOVE

Chinese prosecutors probed 9,582 commercial bribery cases worth Rmb1.5 billion (US$193.8 million) in 2006, and have set even higher goals for future actions. So far, prosecutors say, commercial bribery has been markedly deterred by the sentencing of several high-ranking officials, including the former president of China Construction Bank, who was sentenced to 15 years in prison for taking bribes worth Rmb4.2 million, and a former official in China's Ministry of Finance, who received 13 years for taking bribes worth Rmb2.15 million¹.

China's top-down approach to tackling corruption has made headlines internationally, and has gained respect both at home and abroad. In the newly released 2007 Corruption Perceptions Index, Transparency International rated China 72nd out of 180 countries and regions, which is the same ranking as India, up two spots from last year's ranking of 70 out of the last year's 163 countries and regions.

The organization attributed the increase to a series of reforms in personnel systems, the judiciary, administrative approval systems and financial systems. It also highlighted the establishment of the National Bureau of Corruption Prevention, which it said showed an important step in accelerating the build-up of a clean governance system.

Transparency International's Ran Liao, Senior Programme Coordinator for East and South Asia, says that China has seen remarkable improvement in the fight against corruption over the past ten years, particularly in the area of institution-building. And while it can't be said that there's no bribery at all in China, he says, "the deterrent is there - which means that the government has tried to do something to stop it."

Liao credits the system-building approach China has taken, but says that it is far from enough. As the majority of large companies in China are former or current state-owned enterprises [SOEs], conflicts of interest arise when management is appointed by and accountable to the Communist Party rather than by the shareholders. "In this case, it's really hard to talk about fighting corruption," he says. Liao notes that there are no existing rules to regulate conflicts of interest, which is one of the biggest problems China faces today.

The other major challenge, says Liao, is governance - putting laws passed by the central government into action at a local level has always been difficult. As the traditional Chinese saying goes, "You have a policy from above; we have a counter-policy from below" [上有政策下有对策]. Nevertheless, highly-publicized sanctions against errant officials appear to have had a considerable effect. When one Shanghai official was dismissed for wasting Rmb3 billion worth of pensions on kickbacks in real estate dealings, people of the city celebrated his departure with fireworks.

Current legislation includes the PRC Criminal Law, for which the sixth and most recent revision was promulgated on June 29 2006. This law defines bribery as giving money or property of 'substantial value' to an employee of a company, a government official, or an organization [including a government agency, state-owned company, enterprise or civil organization] for the purpose of seeking an improper benefit.

Business transactions are also governed by the PRC Anti-unfair Competition Law(中华人民共和国反不正当竞争法), which prohibits business operators from offering money or property to their counterparts, including various means of commercial bribery such as kickbacks disguised as commission, or other means such as sponsored travel and entertainment. Violators face fines from local administrators ranging from Rmb100,000 to Rmb200,000.

Also of relevance is the definition given by the Supreme People's Court and Supreme People's Procuratorate of ten further types of bribe-taking by officials, in the Opinion on Several Issues Concerning the Application of the Law in Handling Criminal Cases of Receiving Bribes².

ENFORCEMENT PROBLEMS

However, while the new laws may be well planned, common practice speaks volumes about the challenges faced by lawmakers and prosecutors in tackling commercial bribery. Alias Mr Chan, an integrity officer at a major American retailer operating in the PRC and formerly of Hong Kong's Independent Commission Against Corruption [ICAC], feels that the atmosphere for doing business in China encourages corruption, because taking risks that may not be legal do in fact pay off.

"Because corruption is quite prevalent here, the business environment is not fair here. If you dare to pay out more, you are likely to get more business; this is not fair to those who would like to comply with the law." Common practice may include the giving of bribes or red packets to quality assurance colleagues, in order to get products to pass, which can generate problems for a company later on in terms of health hazards, related liabilities, and the reputation of the company. "It actually affects all parts of the business and many aspects of society," he says.

Yet inappropriate offers made to his company's employees, based on experience, might not be handled by the local police, who have set a minimum standard for accepting cases. In Shenzhen for example, if no more than Rmb20,000 is involved, they may not begin an investigation, and may not accept the case. "In different cities, the threshold is different," he says, also noting that the determination to pursue such cases also varies from city to city. Shanghai police, for example, appear to be more determined in handling economic crime than Shenzhen police, says Chan. The standard in China is of course much different from that in Hong Kong, where cases of only a few hundred dollars can end up in court.

For companies dealing with manufacturers, key areas to watch include (but are not limited to) quality assurance, factory audits, and in fulfilling certain social compliance standards, such as the SA8000 social accountability standard, and ISO certifications. Areas where a high volume of money is handled, such as sales, business sourcing and handling purchase orders, may be particularly prone to bribery risks, as even small percentages can be significant. "Basically, I think corruption could happen in every part, and I don't think it's limited to certain departments,¡¨ says Chan. ¡§I'd say it's the normal way of doing business here."

One example of the prevalence of corruption can be found in the pharmaceutical industry, where regular business practice has at times included kickbacks to hospitals and healthcare providers. In an investigative series by the South China Morning Post in September, one orthopaedic surgeon who had quit the business reported that the majority of the earnings of his fellow surgeons came from "hong bao," or "red packets," from manufacturers of drugs and prosthetic devices that were often given to patients that did not need them³. China's Ministry of Health has since announced an inspection tour of major hospitals to curb corruption and improve efficiency, and arrests have been made.

In such cases, it is clear that a line has been crossed when legitimate marketing and the occasional paid dinner escalates into major expenses for the purpose of procuring orders. Many times, though, things are not so clear. According to Dane Chamorro of the consultancy Control Risks, this can largely be attributed to the cultural gap between China and places like North America, which operate on different principles. "Foreigners don't realize the degree to which it's accepted in developing countries," he says. In China, industries have a standard "fee" for a middleman, and finding out exactly what that standard should be takes a good deal of research. When such fees are not in line with industry practice, the money is likely to be funnelled off inappropriately. At the same time, approval processes involving mid-level officials are known to have a certain amount of "leakage."

"China is a high commercial risk," says Chamorro, who thinks that the PRC ranks alongside places like Indonesia in this respect. "The legal system doesn't exist to protect private parties; it exists to protect the interests of the state." The law is not a reliable recourse for foreign investors, he says, and disputes may end up with foreigners getting the short end of the stick. "The system will not protect you, so you need to protect yourself," he says.

Knowing where to draw the line takes a certain amount of cultural sensitivity, and also depends on which business centre is involved, the particular industry, market expectations, and expected norms - and unfortunately, practitioners say that there's no ready-made anti-corruption handbook for China or any other place. "It's up to management to draw the line, so people on the ground don't operate in a vacuum or grey area; that's clearly undesirable," says Yuen of Freshfields.

So where should the line be drawn between entertainment and unfair competition? "I think it mostly depends on two principles," says Joanne Yip. "One is using your common sense; whether it will give people an impression whether a favor is going to be given that may affect his business decision, and the other is whether the entertainment is of value."

Also, whether a gift is considered to be of a "significant amount" must inherently depend on the living standards in different places around China - in a very small village, for example, this could be merely a few hundred Yuan.

TRUTH AND CONSEQUENCES

Criminal liability under PRC law is an issue over certain amounts, but even a small payment may qualify for punishment if it is made to government officials or party leaders. Foreign-invested enterprises face particular scrutiny in all areas of legal compliance as well. Despite persistent problems with corruption, it is not at all tolerated by higher-ranking officials and enforcement authorities - such people have been thoroughly screened over the years to get to where they are. "China is not a kleptocracy," says Chamorro. "For the most part, they are clean and competent people."

Civil liability may technically be possible as well, but it is rarely pursued in practice, due to the difficulty of proof in China's courts. The lack of discovery methods, which is an important weapon in civil litigation, makes it less likely for private parties to pursue legal action in general. Practitioners note that such actions would practically require a 'smoking gun' document in hand.

Foreign liability, on the other hand, can be much more stringent. The Foreign Corrupt Practices Act [FCPA], which is enforced by the US Department of Justice [DOJ], prohibits bribery of foreign government officials to obtain or retain business.⁴ Prosecutions over the past year have increased in frequency and in severity of the penalties involved, causing many multinational companies to take extra precautions. According to the DOJ, "The antibribery provisions of the FCPA make it unlawful for a US person, and certain foreign issuers of securities, to make a corrupt payment to a foreign official for the purpose of obtaining or retaining business for or with, or directing business to, any person."

The FCPA also prohibits corrupt payments through intermediaries, or third parties, while knowing [including conscious disregard and deliberate ignorance] that some or all of the payment will be received in the end by a foreign official.

The DOJ recommends conducting due diligence to ensure that business relationships are made only with reputable, qualified partners and representatives, and says that US firms should look out for "red flags" such as "unusual payment patterns or financial arrangements, a history of corruption in the country, a refusal by the foreign joint venture partner or representative to provide a certification ... unusually high commissions, lack of transparency in expenses and accounting records, apparent lack of qualifications or resources ... and whether the joint venture partner or representative has been recommended by an official of the potential governmental customer."

Criminal sanctions for FCPA violations include fines of up to US$2 million for companies, and fines of up to $100,000 and up to five years imprisonment for individuals. Under the Alternative Fines Act, actual fines may be up to twice the benefit that the defendant sought to obtain by making the corrupt payment. In addition, civil actions may be brought by the Attorney General or the Securities and Exchange Commission [SEC] as appropriate, resulting in fines of up to $500,000 for companies or individuals - both of these authorities may also bring a civil action to enjoin any act or practice of a firm when it appears that it will be in violation of the antibribery provisions.

Other actions against firms found in violation of the FCPA include being barred from doing business with the US government, being ruled ineligible to receive export licenses, being suspended or barred from the securities business by the SEC, and suspension or debarment from agency programs of the Commodity Futures Trading Commission and the Overseas Private Investment Corporation. The DOJ also notes that a payment made to a foreign government official that is unlawful under the FCPA cannot be deducted under tax laws as a business expense.

According to the FCPA 'get-out clause', small 'facilitation payments' such as red packets will not be considered criminal, unless in substantial amounts, although such practices may be considered unlawful in the UK, particularly if local laws are broken.

American executives in particular need to be aware of FCPA implications. UK lawyer and leading fraud and regulatory investigation expert Jeremy Summers notes that any company with American shareholders - or even a company sending e-mails through an American system - may be considered to be within the jurisdiction of US criminal prosecutors. "The world of the director has become a much more dangerous place," he says, noting that the US has taken the lead in legislating against corporate misconduct, with such measures as Sarbanes-Oxley and the FCPA. Whereas in the past business leaders may have taken for granted so-called 'grey areas' in doing business overseas and offshore, Summers says that the landscape has changed drastically in the last ten years. "Those days are gone, and executives really have to be aware," he says. The rule of thumb, he advises, is "stop, look, think."

UK companies should pay particular attention to developments in anti-corruption law, as the Transparency International Anti-corruption Bill [TI Bill] is currently being pushed forward as a private member's bill in the House of Lords by Lord Chidgey. The TI Bill carries a maximum seven-year sentence, and covers corruption involving agents, bribery of foreign officials, and foreign bid rigging, in addition to measures against corruption at home, and imposes a duty on UK companies to ensure that foreign subsidiaries and contracting parties overseas comply with the Act, once passed.⁵

Executives should also be aware that their director and officer [D&O] liability insurance policies are likely to have an 'opt-out clause' that lets insurers escape liability when an individual is prosecuted for breaking anti-bribery and anti-corruption laws. D&O policies will tend not cover them in such cases, especially if they are convicted.

HANDLING CASES OF REPORTED BRIBERY

Companies operating in China should ensure that a system is in place and procedures are established for dealing with reports of bribery or requests for bribes. Peter Yuen of Freshfields says that he's seen companies brush off tip-offs from whistleblowers reporting bribery, only to have it come back to haunt them. "I would suggest that when the management sees a tip-off of this nature, they should take it seriously," he says. Of course, not every e-mail requires a full investigation, but at minimum, every responsible employer should take such information seriously and appoint someone from an unrelated department in the senior management to independently look into it and see if it warrants any further attention.

If and when disciplinary action is applied, Yuen says, the same standards must apply to all. "As an employer, you must be seen to be acting fairly as a manager, or else you'll run the risk of creating additional HR issues, which may well lead to HR related liability," he says.

Such actions should be given to the board of directors for deliberation, and perhaps to appoint independent counsel or set up a permanent independent committee, in order to avoid a witch-hunt. If the board thinks an investigation is warranted, they should get legal counsel involved as soon as possible in order to gain the protection of legal professional privilege.

MANAGING RISKS - PREVENTION FIRST

In our example in the introduction, basic precaution and avoiding suspicious people and situations should be a first line of defense. If it sounds too good to be true, so to speak, ask more questions and pay careful attention to the answers, or lack thereof. When it comes to protecting employees and colleagues from bribery-related risks, Chamorro of Control Risks recommends instituting a policy like the one below and explaining to people why you are taking such measures. This may be a new concept to many people, particularly when dealing with a different culture.

Chamorro notes that the lack of verifiable information is a worrying trend in China, and says that companies should go through more processes than they normally would in places like Europe or North America. "The amount of information people collect and maintain is very, very limited; mainly, this is just because of poor practice," he says. In addition, Chamorro also recommends the following measures:

• Document everything, and incorporate due diligence into ongoing business operations, rather than just for first-time transactions or initial agreements. Long-standing business relationships can violate trust when complacence has set in.

• Avoid people who promise time or influence with an official in exchange for a facilitation fee, except where the person is acting as an agent and there is a standardized process in place for the person's role.

• Record gifts of money and food, such as red packets and mooncake, and distribute them among the company employees, rather than accepting them as an individual.

• ell employees what the standards and practices are, make sure that everyone understands them, and clearly lay out disciplinary actions to be followed.

• Rather than lavishing attention on an influential person, it may be more appropriate [and a better long-term strategy, considering turnover nowadays] to treat their whole department to modest dinners and entertainment.

• Building relationships with people who make the appointments is more important, he says, as is getting to know the local police and fire department, who will be much more likely to promptly handle any trouble if they know you first. "You have to have these relationships before you need them," he says.

According to Liao of Transparency International, having a code of conduct to follow is the most important measure that international companies can take against bribery. "If you cut the supply side, the Chinese officials cannot demand it," he says, noting that not paying bribes can become standard practice "only if all people do so, and it becomes a collective action."

In the end, common sense must prevail - when dealing with another culture, it is important that both sides understand each others' norms and expectations, as well as their responsibilities under their own respective laws. Taking the time to understand these laws, which are distinct products of the culture they belong to, as well as how they are implemented in actual practice, would clearly be in the interests of all parties involved.

Endnotes

1 See Prosecutors to target bribery in 2007 on pages 4-5 of the March 2007 issue of CLP

2 See page 9 of the September 2007 issue of CLP

3 See "Operation where everyone gets a cut", South China Morning Post, page A6, September 11 2007

4 See http://www.usdoj.gov/criminal/fraud/docs/dojdocb.html

5 See http://www.transparency.org.uk/programmes/DCRCL/TI-UK_BackgroundNote_CorruptionBill-15March07.pdf