U.S. Companies in China Worry Due Diligence Will End in Spy Dramas

Democratic presidential candidate and former Vice President Joe Biden speaks about his plans to combat racial inequality at a campaign event in Wilmington, Delaware, U.S., July 28, 2020. REUTERS/Jonathan Ernst
Democratic presidential candidate and former Vice President Joe Biden speaks about his plans to combat racial inequality at a campaign event in Wilmington, Delaware, U.S., July 28, 2020. REUTERS/Jonathan Ernst


  • Firms doing critical on-the-ground vetting are on heightened alert as Chinese authorities ramp up police visits

Foreign companies in China are walking a tightrope between their need for business intelligence to comply with proliferating U.S. sanctions and mounting concerns about the risks of carrying out the due diligence required for business on the ground.

Authorities recently questioned staff at consulting firm Bain & Co.’s Shanghai office and detained the Beijing-based workers for U.S. due-diligence company Mintz Group. The news has put companies that conduct due diligence and business intelligence in China on heightened alert, with details about the visits scant and uncertainty swirling around what triggered them.

Consultants and lawyers advising on doing business in China say they are working to address growing concerns about what the moves by Chinese authorities mean, and where the boundaries are when it comes to operations in China. Many have been fielding questions and drafting memos on what China’s expanded anti-espionage law—updated last week to tighten state control over a wider swath of data and digital activities—means for their clients.

Current and former employees working in the field said it isn’t evident that a sector-wide crackdown is under way. One lawyer at an international law firm said he told clients in recent days that it was business as usual for general due-diligence work on corporate deals or basic compliance screenings such as making sure counterparties aren’t sanctioned.

Companies hired to perform checks on financial transactions such as mergers and initial public offerings don’t appear to have come under pressure. Another company whose Shanghai office was recently visited by police, Capvision, specializes in a different type of information-gathering work known as expert-network consulting, in which a client pays for access to experts in an industry.

The work performed by such consulting and due-diligence firms covers a wide range, from checks into investment targets or counterparties to financial and corporate firms, to forensic accounting, to background checks on new hires.

Such firms first took off with the Foreign Corrupt Practices Act, the 1977 U.S. law that led to new compliance requirements by banning U.S. companies from making bribes overseas. Business expanded as compliance needs mounted and overseas deal-making grew.

A company wishing to launch a joint venture with a local partner might hire a due-diligence firm to scour records for lawsuits or past malfeasance. A garment manufacturer working with a new supplier could hire a due-diligence firm to ensure compliance with U.S. laws, while a law firm working on an IPO would hire a firm to make sure the client meets listing requirements.

“These reports are absolutely essential for anyone getting any kind of signoff," said Ian Barclay, managing partner at the investigations and due-diligence firm Wallbrook. “If you’re a board, you can’t do a JV in China or buy a company, if you’re a private-equity firm you can’t go to your investment committee, without this work stream," he said, adding that compliance with local Chinese law is essential for firms doing this work.

Checks might also involve tasks such as mining databases and retrieving legal and corporate records. In China, a mounting concern is that checks might veer into more sensitive areas, such as suppliers linked to China’s Xinjiang region, where allegations of forced labor have prompted sanctions by the U.S. and other countries.

The growing legal burden on U.S. and other foreign companies to verify every link in their supply chains and trace affiliates of their business partners comes as Chinese authorities increase pressure on the firms that gather such information and restrict foreign access to databases. Both trends mean more risks for companies, their investors and employees.

Chinese leaders have signaled the country is open for business following the end of pandemic restrictions. But foreign companies on the ground say they are navigating a tighter web of U.S. sanctions and rising tensions between Washington and Beijing.

China’s regulators asked state-owned enterprises and companies listed in the mainland to ramp up security checks when choosing accounting firms to audit their financials, in a directive Thursday. Those companies should review their auditors’ ability to manage information security and insert separate clauses to prevent leaks by controlling sensitive information effectively, the regulators said.

A U.S. law from late 2021 that blocked many imports from Xinjiang is drawing demands from lawmakers for tougher enforcement. Washington’s restrictions on high-end chip exports to China and the rapidly expanding number of Chinese firms under export controls have added to the workload on compliance.

“At the same time that due diligence is getting harder to do in China, U.S. laws and policies such as the Uyghur labor act are generating more demand for it," said Kurt Tong, managing partner of The Asia Group, a Washington, D.C.-based business advisory firm.

New York-based Kroll, best known for its corporate investigations and risk assessments, has been reviewing local rules in China and the kinds of work it may take on in light of the actions on firms and the amended espionage law, people familiar with the matter said.

Richard Mojica, a trade lawyer with Miller & Chevalier in Washington who has advised companies in the apparel, solar and automotive industries on how to comply with U.S. anti-forced-labor laws, said firms that audit supply chains are increasingly unwilling to take on human-rights-related assignments inside China, especially those connected to Xinjiang.

“What due-diligence firms do in China puts them in conflict with how China thinks about information and what information should be shared with foreigners," said Mr. Tong, a former U.S. consul general in Hong Kong. All countries, including Japan, European nations, the U.S. and China, are grappling with issues around data—a commodity that has national-security implications—and the challenges of who controls the information and its legitimate uses.

“The definition of a state secret has always been loose in China," Mr. Tong said. The country’s expanded anti-espionage law has made it more explicit that information that might be considered private business data in other countries is deemed privileged in the Chinese context—to be used only by Chinese or specific groups in the country cleared to access that information, he said.

China’s State Council Information Office didn’t immediately respond to a fax requesting comment about whether the work performed by consulting and due-diligence firms is under greater scrutiny.

When asked Friday about the police visit to Bain and the possibility that other foreign firms might receive similar visits, a spokeswoman for China’s Foreign Ministry said, “We are committed to fostering a market-oriented, law-based and world-class business environment." She added: “China is a law-based country. All companies in China must operate in accordance with the law."

One reason corporate due-diligence firms serve an important function in China is that there can often be questions about the background of potential business partners, said David Schlesinger, an independent China analyst. That heightens the need for the boards of Western companies to ensure a thorough vetting, he said.

“The boards of Western companies feel they have to have something so they can protect themselves, so they can say, yeah, yeah, we checked," Mr. Schlesinger said. “The issue with China is that it is very easy to think you are operating safely in a gray zone, but in China the gray zones turn quickly into black."

On Monday, U.S. lawmakers urged the Securities and Exchange Commission to require fast-fashion company Shein, which was founded in China and is now based in Singapore, to prove that it doesn’t use forced labor by Uyghurs as a condition for its possible IPO in the U.S. Shein said its suppliers are based in regions such as Brazil, southern China and Turkey and that none are in Xinjiang. “We have zero tolerance for forced labor," the company said.

Last week, U.S. customs authorities banned some imported clothes from Japanese retailer Muji after ruling that the company didn’t provide enough evidence to show that its goods weren’t produced with forced labor. The agency said that while Muji showed that no part of its manufacturing process took place in Xinjiang, internal documents from customs showed one of the companies in Muji’s supply chain is linked to the region. Muji USA didn’t respond to a request for comment on the ban.

“You never know where you stumble on," said Jörg Wuttke, president of the European Union Chamber of Commerce in China. “Is it healthcare data? Is it the data set for how many people died of Covid?…Clarification, more proper straight language, would be extremely helpful for us."

Mr. Wuttke said mixed messages from Beijing have added to the confusion among foreign businesses.

“Everyone wants us to invest more," he said, describing what he called fluffy red carpets laid out by Chinese officials. “It appears a bit like the left hand doesn’t know what the right hand is doing."

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