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Markkula Center for Applied Ethics

When Things Go Wrong in China

Margaret Steen

Tapping the Chinese market is an essential part of many businesses' growth plans. But the significant language barrier, the physical distance from headquarters, and complex Chinese corporate structures can present challenges when local customs - paying kickbacks, for example – run up against American law.

At a recent meeting of the Business and Organizational Ethics Partnership at Santa Clara University's Markkula Center for Applied Ethics, participants discussed fraud, investigations, and the rule of law with Chris Forrester, a partner at Morrison & Foerster, and Randy Gausman, former CFO of Rae Systems.

The discussion was called, "When Things Go Wrong in China," and participants discussed scenarios from discovering that the bank or factory a business lists as an asset is virtual in nature, and doesn't actually exist, to finding that the company has its cash deposited in the chairman's personal bank account. U.S. regulators and courts have no jurisdiction in China, and business practices vary widely

Gausman detailed a harrowing process after Rae Systems discovered possible violations of the Foreign Corrupt Practices Act in a joint venture it had recently acquired in China. Through his and others' herculean efforts over two and a half years, the company ultimately secured a non-prosecution agreement with the U.S. Department of Justice. But the outcome came at a significant cost to the company and many of the individuals involved.

In late 2006, about the time Gausman became CFO of Rae Systems, a maker of radiation detection equipment, the company formed joint ventures with two formerly state-owned enterprises in China. The company had done some cursory training and due diligence at one of them. But the other was far from Beijing and had only a few employees who spoke English. All accounting records were kept by hand; there were no computers, written procedures, or standards.

As they closed the books on the ventures' first year, Gausman learned from the company's internal audit team of unusual income statement entries, cash advances, and travel expense reports. He immediately alerted the board of directors' audit chair, and the company launched an investigation using outside counsel and investigators.

Over time, the investigation revealed that the joint ventures were making sales by giving extravagant gifts including jewelry and fur coats to customers, all of whom were government employees. Because this was a widespread, common practice, the sales staff in China basically stopped selling when the practice was halted.

The company reported its investigation to the U.S. Department of Justice and the Securities and Exchange Commission, a fact that contributed to the DOJ's eventual decision not to prosecute. Gausman and the audit chair traveled to Washington twice to meet with officials there about the investigation and how the company was identifying, addressing, and then fixing the problems.

In 2010, the government agreed not to prosecute the company partly because of its cooperation and progress in implementing new controls. The company did pay fines of $1.7 million to the DOJ, disgorged $1.1 million of profits, and paid over $4 million in legal and accounting fees, as well as agreeing to ongoing monitoring. These were staggering blows to a company with only $85 million in annual revenue. Two months later, the company essentially gave away the most problematic joint venture so that it could sell the rest of the company to private buyers, who saw the joint venture as too risky.

In addition to shareholder losses, Gausman noted personal and professional fallout from the ordeal. He had joined the company with hopes of helping it grow and prosper. Instead, he found himself working to avoid the indictment of the company and possibly some of its officers. Although he built great relationships with the board and the audit committee, he lost the trust of the CEO, who replaced the audit committee chair in the middle of the investigation.

As he persevered with resolving the company's problems, Gausman knew that he would not be able to stay with the company when it was over. "You have to have a strong moral compass to see this through," Gausman said the audit chair told him.

What can companies do to avoid problems like this? Participants came up with a list of action items, including:

  • Listen carefully to those on the ground in the China operation
  • Make sure you have internal controls that are audited by trusted personnel
  • Do not ignore warning signs
  • Have a healthy but respectful skepticism; "trust but verify" might be a good starting point.
  • Integrate U.S. managers into Chinese operations and vice versa
  • Make sure you have bilingual staff members in key positions in the China operation
  • Make sure employees understand they won't be fired for reporting problems

Margaret Steen is a freelance writer, editor, and writing instructor.

Aug 1, 2012