Risk is back

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Multinationals in China woke with a start in 2013 after shutting their eyes to an increasingly complex threat from fraud and corruption the year before.

A survey on fraud in China， part of an annual global report released by corporate investigator Kroll， showed firms reeling from a spate of high-profile corruption scandals in China.

The apprehension is palpable. Companies that described themselves as highly vulnerable to procurement fraud or other forms of malfeasance connected with their suppliers jumped to 23% of those surveyed， compared with just 2% the year before. The perception of high vulnerability to conflicts of interest with management surged to 21%， from 2% in 2012.

Rising trepidation is being felt across the board， from intellectual property theft to regulatory risks. Companies are suddenly scared again after what analysts called a “false sense of security” prevailed the year before.

“It’s almost like people were dreaming or sleeping last year but coming back to reality this year，” said Violet Ho， Kroll senior managing director and head of greater China.

Though the latest statistics contrast sharply with those from last year， the feeling of vulnerability in China’s market is not a departure from 2011. In fact， Ho said this year’s data are a continuation of trends seen two years ago， before companies seemed to doze off.

A year to remember

As to why companies forgot about fraud in 2012 and what dumped the cold water on sleepy eyed executives this year – that’s hardly a mystery.

A slew of fraud cases involving Chinese companies listed in the US and Canada jolted the international investment community starting in May 2011. The cases induced a wave of skepticism among global companies looking for China partners.

Although the fraud cases continued into 2012， the headlines on Chinese firms that had filed false reports to the SEC subsided， giving the global community a sense of temporary relief.

This year has witnessed several major corruption and fraud cases at the heart of international business in China. Those came alongside the trial of Bo Xilai， a fallen top official， as well as a purge through the oil industry.

A Chinese investigation into UK drugmaker GlaxoSmithKline （GSK） publicly announced in June sent global pharmaceutical firms into a panic. The probe， which focused on kickbacks given to doctors for proscribing GSK drugs， has spread since then to other drugmakers such as Bayer.

Baby-formula makers have similarly been hit， but for price fixing. Earlier this year， China’s central economic planning agency accused France’s Danone and Switzerland’s Nestle， among other firms， of fixing prices of baby formula. The companies have since caved， promising to lower prices. They also paid US$100 million in fines.

High volume， high risk

GSK’s case drew extra media attention to the drug industry in China after several GSK executives and the head of a consulting firm were detained by police. Pharmaceutical companies， along with automakers and chemical firms， in China take part in a highly lucrative market but one that also faces substantial fraud and regulatory risks， a Shanghai-based lawyer told China Economic Review.

“These are sensitive industries that are fast-growing and the volume [of money] is very high，” said the lawyer， who advises European companies on Chinese corruption policy. “They’re the key industries affected by business risks that you don’t have in the West.”

In GSK’s case， that risk was reportedly a culture of bribery used to beat out competitors in drug sales. Accord- ing to some reports， Chinese doctors were even sent on exotic getaways with prostitutes as a reward for high sales.

Kickbacks and corruption are nothing new in China. However， foreign companies may not be aware of the risk they are exposed to when entering the market， according to the lawyer. When a multinational firm markets products or outsources to China， any corrupt practices perpetrated by local staff could make the company liable under Chinese regulation， putting at risk investments and even foreign staff based in the country. GSK headquarters claimed it was unaware of any corrupt dealings in its China business.

No more red envelopes

What’s new in 2013， Ho at Kroll said， is the sophistication of corruption and the involvement of senior management in fraud. It’s no longer just slipping a few bank notes into a partner’s pocket and shaking hands.

“It used to be， if you go a few years back， the common fraud type in China was physical theft and also petty fraud， commercial fraud， kickbacks and whatnot. Now we are seeing a lot more fraud perpetrated by your CEOs， CFOs or at least middle level managers in key functions.”

More complex networks of fraud are particularly taking root in companies that outsource manufacturing. A company that sources products from China will often partner with a Chinese company that procures from several manufacturers. The local manufacturers often pay bribes to the Chinese company in order to secure contracts. Yet， at the same time， the manufacturer will inflate the price of the product. Both sides can profit wildly at the expense of the foreign firm.

In several cases investigated by Kroll this year， entire departments in some companies were involved in such deals. The bribes were often skimmed off as a percentage of the total.

“This time it’s no longer a redpackage type of arrangement because the amount involved is staggering，” Ho said， referring to the cash-stuffed red envelopes exchanged during Chinese New Year but also used to pass bribes.

Wake-up call

As collusion between vendors and suppliers grows increasingly complex， detecting fraud becomes more challenging. Sophisticated corruption in China has existed for years， said John Besant-Jones， founder of due diligence firm Red Flag Accounting. What’s changing is the attention foreign companies are giving to it today.

“It is probably just as fair to say that there is an increasing awareness of more sophisticated frauds rather than only say that there is an increasing number，” noted Besant-Jones.

Data from Kroll supports that idea. The number of respondents actually affected by fraud inched up only by two percentage points this year to 67%， a figure that demonstrates current fears in the market are not all translating into actual cases.

In that respect， the heightened apprehension this year isn’t necessarily a bad sign， according to Ho. It shows that multinational firms have lost some of the complacency Kroll observed the year before.

If the headlines stay filled with horror stories of scandals at major multinationals， foreign firms will likely try harder to stay alert in 2014.