UPDATE ON CORPORATE FRAUD IN CHINASeptember 2014

Having emerged as the world’s second largest economy, after the U.S.A., China remains an attractive and growing market which presents great opportunities to multinational companies for development and expansion. However, due to the unique relationship or “guanxi” oriented social culture (i.e. developing connections with people of influence), doing business in Mainland China is not easy and often comes at the cost of fraud and corruption.

In the old days, multinational companies without much personal relationships or connections built up with local government officials typically found it difficult to operate their branches in China, and accordingly state-owned enterprises dominated the market.

Over the past decades, more and more multinational companies shifted their production lines and supply chain to Mainland China. Some of them focused closely on establishing their businesses and achieving high profitability in the new market but failed to put in a strong internal control system to combat frauds. In recent years, a growing

number of enforcement actions have been taken against multinational companies in connection to fraudulent trading activities, irregular business conduct and/or bribery/corruption involving their Chinese counterparts and/or the local government officials.

In December 2009, UTStarcom Inc. (“UTStarcom”), a U.S. listed telecommunications company based in California, was charged by the U.S. Department of Justice and the Securities and Exchange Commission with violation of the Foreign Corrupt Practices Act of the U.S.A. It was discovered that UTStarcom had paid employees of their Chinese customers (including state-owned telecommunications firms) for trips to attend “training sessions” in the U.S.A., which turned out to be no more than sightseeing activities in Hawaii, Las Vegas and other tourist attractions.

Another major corporate fraud scandal reported was in relation to the British drug maker GlaxoSmithKline (“GSK”) in July 2013. GSK China was accused of offering bribes to local medical practitioners, government officials,

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hospitals and others through the accounts of some travel agencies. This was an example of an indirect bribery scheme whereby a third party was engaged to channel funds for bribery. Very often, senior management of multinational companies were under the mis-conception that third party payments of bribery did not extend to the multinational companies. This perception was totally wrong and, most importantly, detrimental to the reputation of business internationally.

Again, in August 2013, the leading French food products manufacturer Danone Dumex was fined RMB 172 million by the Chinese government for price fixing. Investigations discovered that the food company had contracted with distributors to fix the resale prices of their products, thereby violating local legislation including the Anti-Monopoly Law.Anti-corruption has always been the top priority of the Chinese government’s reform policies. Since 2013, the anti-corruption campaign of President Xi Jinping (习近平) has sent a clear message to the public that the new Chinese government is determined to crack down heavily on fraud and corruption. Recently, we have witnessed some high-profile cases in which top Chinese government officials and senior management of state-owned enterprises were placed under scrutiny and disciplinary actions.

One of the new measures in the Chinese government’s anti-corruption campaign is to cut down lavish and extravagant expenditures on dining, transportation, gifts and entertainment, etc. At the corporate level, it has been a common fraud to misuse funds for personal interest or bribery by way of expense reimbursement schemes, such as making fictitious claims or requesting reimbursement of personal expenses as if these were incurred for business purposes.

Mazars has extensive experience in helping clients to investigate such frauds and irregularities in their business operations in China.

We set out below some of our actual cases:

CASE 1We were engaged by the head office of a multinational company to investigate a general manager of its China operations. The general manager was suspected of having abused his power at the company’s expense for his own benefit. In our investigation, we reviewed the accounting records, interviewed company staff and other relevant parties and conducted searches on some suspicious companies and other parties. It was found that the general manager instructed the accountants to adjust the company’s accounting entries to reduce the amount he owed to the company. The general manager was also found to have approved payments to himself, reimbursed club memberships held in his own name and other personal expenses, without prior approval from the senior management at head office.

Fictitious salary records were also found as a cover-up for payments made to the general manager. Furthermore, without any bidding process, service contracts were awarded to companies owned by his spouse and close friends.

Additionally, the general manager had set up a competing company without the knowledge of head office. A non-interest-bearing loan had been granted by the general manager on behalf of the company to the competing company. In total, losses suffered by the company from these various frauds amounted to RMB 4 million. Based on our findings, we made recommendations to the company and provided options for the client, including legal action against the general manager to recover the losses suffered.

CASE 2An anonymous email from a whistle-blower alleged that a sales manager had been claiming personal expenses from the company as business-related expenses. We analysed the expenses reimbursed to the manager against his business trips schedule and found that taxi fares and hotel accommodation expenses were allegedly incurred during days on which the manager was not on business trips. We also discovered that some of the invoices submitted by the manager were fake while others were related to personal groceries and food expenses. The expenses supported by the fake invoices were comingled with the business related expenses such as business lunches or client conferences. We submitted our findings to the company and made recommendations for appropriate disciplinary and legal action against the manager.

In conclusion, a robust internal control system is necessary and reasonably expected by regulators to be implemented to protect a business from financial loss arising from fraud, theft and other dishonest acts, misconducts or omissions. In order to achieve a long term and sustainable business in China and to protect the interests of investors and other stakeholders, it is important for companies to set up and implement effective internal control policies and procedures as well as to enhance corporate governance for prevention and detection of frauds.

We would strongly recommend senior management to practice the rule of thumb “trust but verify!”. Regular health-checks by forensic accountants will also assist senior management to identify fraud risk areas before it is too late. The reputational risks to companies of not doing so can be very costly.

Annie ChanManaging Director, Forensic and Investigation ServicesMazars Hong Kong, China

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The contents of this publication are for reference purposes only. They do not constitute legal advice.

Please contact Ms Annie Chan at annie.chan@mazars.hk for further information on corporate fraud or should you need any assistance.