An 'outside-in' approach to investigating conflicts of interest in China

An 'outside-in' approach to investigating conflicts of interest in China


A conflict of interest (COI) results when an employee derives personal benefit from actions or decisions made in their official capacity within the company. Some recent, real-life examples include:
 

A foreign company buys a Chinese company and retains the former owners to work with the new company; however, the business experiences no growth for two years. It was later discovered that, on the day of purchase, the former owners set up companies on the side and immediately started to siphon business off to their own companies.

 

A sales manager sets up multiple distribution companies through friends and families. She gives special pricing and rebates to these companies so they win more business than other distributors. She receives a portion of their business into her personal bank account.

 

A procurement manager sets up a deal with suppliers whereby he receives a 10% kickback for awarding them business.

 
You are probably thinking, that is all well and good, but this is not a problem for our company in China. You may be right … but you are probably wrong. If your company has been in China for over ten years, our research shows that you have over a 75% chance of having some undiscovered COI issues. The seriousness and impact of COIs to the company can be debated, but their prevalence cannot – COI is an issue doing business in China.

Too serious to ignore but very difficult to investigate

In the past, many companies ignored COI issues because they assumed that it was just the cost of doing business in China … until they started counting the cost: lost revenue from employees siphoning off business to competing companies that they own, losing margin through excessive discounts to COI companies, loss of legitimate distributors and suppliers unable to compete with the insider-trading, and in the most serious of cases, damage to reputations and erosion of shareholder value. Serial COI problems result in losses to a company – the proverbial death by a thousand cuts – and are a serious distraction to managers who would rather focus on growing the business.

But as companies are coming to realise the seriousness of COI issues, they are getting frustrated by their lack of success investigating and prosecuting COI cases. Traditional financial audits usually do not work – if they did, the company would have discovered the problems long before a whistle-blower came forward. But even when a company finds evidence, what should it do with it? Local law enforcement agencies in China are rarely interested in taking on such cases – usually they tell companies that these are an “internal matter” that they should deal themselves – and strict Chinese labour laws often present difficulties in firing employees, even with cause.

Outside-in: a different – and more successful – approach to COI

COI issues are usually discovered when a whistle-blower makes allegations that someone in the company is self-dealing through conflicted interests. The whistle-blower typically gives some company names and a description of how an employee is using them for their own benefit. Companies then conduct a financial audit, but in most cases cannot find a connection. It is unsurprising that audits rarely uncover COI issues, primarily because auditors do not usually go around looking for problems: an auditor is not an investigator. Auditors follow a prescribed set of tasks to ensure that proper governance has been carried out in book- and recordkeeping. If they find an issue, they raise their hand, but because COI issues are, by definition, perpetrated by company insiders, they are quite easy to hide and can only be identified through a rigorous investigative process.

COI is fundamentally a problem that happens outside the company with third parties with links back to inside employees, so it is recommended that investigations start outside of the company and the move inside:

Outside Inside

1. Business intelligence – Using public record research and discreet market enquiries, whistle-blower allegations should be investigated to establish the validity of the alleged behaviour in the market. Is the employee really connected to the named company, either through direct/family ownership or through a business agreement? Is the alleged COI company known to be doing business with the client company and, if so, how? How, specifically, might the employee be benefiting (through kickbacks? equity ownership? as a competitor)? What can we find out about how this connection works back to the client company (for example, what types of transactions are carried out? under what names? etc.)? We often find hard evidence in this process, such as the employee registered as a director of a conflicted company. At the very least, enough evidence can be found to either close the case or then take “inside” the company to explore further.

2. Data analytics – Using a large company dataset consisting of HR files, vendor and distributor masters and financial transactions, findings from the business intelligence work are taken and applied to look for evidence of connections inside the company. We look for suspicious connections and transactions, for example, an employee’s personal telephone given as the contact number for a third party, a series of third-party transactions for round numbers, invoices paid to a vendor outside the normal accounts payable cycle, etc.

3. Transaction testing – Testing is required to find the specific transactions recorded in the company’s system associated with the outlier connections. Out of the context of a COI investigation, these transactions usually appear normal in a traditional audit, but when combined with the evidence gathered through business intelligence and data analytics, they become the “gotcha” evidence a company needs to act against an employee.

Don’t just plug the leaks … fortify the dam

Too often we see clients focusing too much on chasing perpetrators and ignoring the fundamental vulnerabilities in their systems and processes that got them into trouble in the first place. In addition to the high success rate of the “outside-in” approach, the ultimate value is that it clearly identifies systemic problems in selecting, qualifying and managing third parties. Investigations often enable a company to shut down an instance of self-dealing and to then strengthen its processes and governance to mitigate against COI risk. Once a company starts to gain a reputation for taking COI seriously, it no longer has to hear, “this is just the way business is done in China”. Rather, its financial performance improves, and its management has more time to focus on more important things.

 

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