Traditional investigative approaches in China can lead a company into a sinkhole

Guest columnists Howard Wang and Kent Kedl posit that traditional investigations don't work well in China because of ingrained features of China's business and legal environment. They suggest changes that will help foreigners in their fraud examinations. — Tim Harvey

Multinational companies in China aren't 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 solve the problem, traditional investigative approaches are increasingly going wrong, which is 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 company in China terminated its general manager (GM) for embezzlement based on whistleblowing complaints and substantial evidence. The company announced his termination "for gross misconduct" to all employees, which sent a strong message about compliance. However, the GM was insulted by this and retaliated by stealing the company "chops" and business license, which paralyzed the company and prevented it from conducting critical contractual and financial transactions. (Chops are registered red stamps or seals that companies use to legally authorize documentation.) He continued to represent himself to employees and customers as the GM. The company spent nearly six months negotiating a settlement and getting the business running again.
• Reputation. The U.S. headquarters of a China subsidiary decided to terminate 27 distributors for fraud. In response, the distributors used WeChat (China's most popular social media and messaging platform) to criticize the company for illegal business practices. Customers quickly stopped their 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, the conglomerate was disappointed with the Chinese company's growth rate. Investigations determined that the GM had been diverting business to a competing company that he'd established. Representatives from headquarters fired the GM, who then locked them out of the operation, moved molds and equipment to his own factory and began 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. One of the aggrieved agents, who had strong political connections, passed details of corrupt activities to the local authorities who began an investigation into the company. As part of the negotiations with the regulators, the company had to agree to a settlement with the agent.

When the solution is the problem

Such situations are, understandably, frustrating for a foreign company's management: It's being defrauded, so it initiates appropriate investigations, finds credible evidence and then takes action.

Figure 1: Traditional "linear investigative approach"

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 (see Figure 1 above) to an investigation is actually causing problems because it doesn't take into account some unique features of China's business and legal environment:

• Tolerance of conflicts 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 still are very common in China. Often, the perpetrators don't 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 your supply or distribution chain is dependent on the businesses of the employee you've just fired.
• Face. The need to maintain a personal reputation and high standing among peers, customers and employees — and the severe reactions if that reputation is threatened — is an important but often overlooked motivator. In particular, senior managers who've engaged in fraud and embezzlement will often work hard to clear their names and publicly blame the company for mistreatment.
• Relationships. Though guanxi (the system of social networks and influential relationships that facilitate business) isn't as important as it once was to succeed in business in China, well-connected employees can use the full extent of their political influence to cause problems, such as causing delays in licensing renewals; triggering tax, safety and environmental investigations; stopping shipments through customs, etc.
• Labor laws favor the employee over the company. Companies find it extremely difficult to fire employees in China even for cause, which 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 because they know there's very little downside for them.
• High threshold required for intervention by the authorities. China's law enforcement bodies are often understaffed in the largest Chinese cities and are rarely interested in investigating cases of employee misbehavior. Companies find it difficult to use the threat of criminal charges as either a carrot or stick to ensure more compliant behavior.
• Heavy reliance on hard-copy company credentials, including business licenses and company chops. Employees will often take these items because they know that firms normally can't conduct business and issue company documents without these representations of corporate authority.

Your objective is to recover

A typical objective of an investigation is to find evidence of wrongdoing and take action. However, your ultimate objective is to ensure business continuity and improve overall business conditions and operations. Because these situations can quickly devolve into crises, we recommend 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 preventive, rather than reactive. (See Figure 2 below.) It begins by taking the suspicions (step 1), thinking through all the various undesirable outcomes and then planning an investigation to prevent worst-case scenarios from occurring (step 2).

Figure 2: Comparison of two approaches

Foreign companies — when planning an investigation in China — should also take steps to strictly observe Chinese privacy regulations and assess political risks and exposures. This approach considers the suspected individual and what damage he or she, or their connections, might do to the organization — what crisis they could set off. For example, the potential for disruption is quite different if the suspect is a senior commercial leader rather than a finance manager.

To ensure a holistic assessment, the investigation includes internal and external sources (step 3). We often find the most damaging evidence by discreetly talking to people in the market. After you gather the evidence, do not immediately take action; rather, assess the risks and the pros and cons of various actions (step 5), and then put plans in place to mitigate those risks (step 6) before finally taking any action (step 7).

You'll notice that, in each of the case studies above, the companies dismissed the suspects without having a plan in place. We find that when companies take a "recovery-led" approach to investigations, the problem — though challenging — is ultimately resolved in the best long-term interests of the company.

Howard Wang, CFE, CA, is a managing director, fraud & forensics at Control Risks Group based in Shanghai, China. His email address is: howard.wang@controlrisks.com. 

Kent Kedl is a senior managing director at Control Risks Group based in Shanghai, China. His email address is: kent.kedl@controlrisks.com.

Tim Harvey, CFE, JP, is director of the ACFE's U.K. Operations and a member of Transparency International and the British Society of Criminology. His email address is: tharvey@ACFE.com.