China Due Diligence Just Got a Lot More Difficult

June 4, 2012

A big hat tip to Fredrik at the China Finance Blog for bringing this to my attention:

In a move that is likely to have many investors in China concept stock scratching their heads the Chinese government has further restricted access to SAIC filings, often used as the start of any due diligence on a Chinese investment. The new rules make it virtually impossible to get detailed financials, as filed to the Chinese government, without the expressed consent of the company involved.

One quick note on terminology here. The SAIC is the State Administration of Industry and Commerce. The corporate records at issue here are dealt with on a local basis, and the new rules are apparently not State-level, but have been implemented city by city. Usually when we talk about accessing such documents, the reference is to a local AIC office. Now, whether this whole thing has been pushed from on high (i.e. the SAIC, as opposed to the local AICs) remains a mystery.

Also a small disclaimer: I have yet to look into this directly (just read about this today) and am just going with very preliminary information – I’m actually kind of hoping that this information isn’t accurate. I will follow up with this in detail since it actually affects my legal practice, but for now I’m relying on secondary sources.

Two things. First, why is this important? Well, as you probably know, transparency is a big problem over here. A lot of companies are quite effective at hiding information, evading taxes, minimizing liabilities, etc. We don’t even have a solid credit reporting system here yet.

When foreign investors do deals with Chinese companies, there is a hell of a lot of risk associated with this lack of knowledge. A good China lawyer will always tell you to do some due diligence before jumping into bed with a PRC company, and that legal due diligence always starts with an AIC search. The information you can get is limited, but if there is a huge structural problem or if the company is not in good standing, at least you will know that at the outset.

We used to have huge problems gaining access to AIC files. Rules vary by office, so back in the day, one AIC might allow a licensed Chinese lawyer to copy documents, while another would only allow that lawyer to view the file on site and take notes, and still another AIC might bar access to anyone without the consent of the PRC company.

In recent years, things got better, and the AIC offices nationwide began to harmonize access rules and upload many documents online. The system was working fairly well, in my opinion.

Second, why have some AICs moved to limit access? Fredrik has one theory:

Some are speculating that the reason behind the new restrictions is the use of SAIC filings in short reports written by muddy waters et al. While this may well be true, the effects of the policy will likely be much more widespread as the filings are also used to confirm financial information by investors looking to take long positions in Chinese companies. Perhaps most interestingly, checking SAIC filings was always a relatively cheap way to get some level of confirmation about a company’s financials. The alternatives that we are left with are likely considerably more time consuming and expensive, so these restrictions are potentially putting a higher value on reliable China DD.

In other words, research firms trolling through AIC files looking for information that could be used to discredit Chinese companies, particularly US-listed enterprises, have become a problem. Outfits like Carson Block’s Muddy Waters may be using information gleaned from AIC documents to check the accuracy of SEC filings. Short sellers have had a pretty good run in the past year betting against Chinese companies.

If that’s true, this reaction by the AICs is not such a good idea. A lot of rumors have been thrown around, but at least those based on AIC documents have some basis in reality. With even less transparency, investors will be less, not more, likely to trust disclosures made by Chinese companies.

But even more important, this move could be very bad for other types of deals. In my practice, it’s common to order an AIC report for a joint venture deal, license agreement, or even a supply/manufacturing deal. The number of U.S.-listed Chinese companies is very small compared to the numerous cross-border commercial transactions in China that really call for some preliminary due diligence that an AIC report offers. Making that more difficult is not going to make the FDI community happy, I can tell you that.

If this type of rule change becomes set in stone, adopted by AICs across the country, it will mean that foreign investors will require consent from their local partners (or licensors, etc.) to review their AIC files. This will be another point of negotiation, perhaps an uncomfortable one. And if the PRC company fails to give consent? I’d probably advise pulling the plug on the deal.

I haven’t ordered an AIC report in several months, so I’ll need to look into this to see if the rules here in Beijing (or elsewhere) have indeed changed. Stay tuned.