Sunday, July 21, 2013
Eaten Alive by Parasites in China
Congratulations! You've finally set-up a company (office, or presence) inside China. It took a lot of planning, hard work, and money to finally get this launch. Now you are a bonafied multi-national company.
With your brand spanking new China company, you've offloaded the mundane, if not painful, tasks of communicating with your overseas factories from your internal operations here in the U.S. The prospect of saving even more costs is also worth celebrating.
But not so quick. You might want to pay extra attention to your Chinese operations before you ride off into the sunset...
I've been doing business in China for over a decade. Like you, I also have a company set-up in China that does all sourcing-related work. However, it took me years of trial and error to get all the issues worked out. These issues have costed me a log of money and grief. I am going to share some of these with you here today.
First and foremost, I am a Chinese-American, a naturalized U.S. citizen. So I speak fluent Chinese. I even have relatives in the greater China region. So when we started doing business inside China, it felt like a natural extension. With the ability to become one of the natives, it was going to be pieces of puzzle coming together. Naturally, if you do not have any Chinese heritage, or your contacts to China is really a friend of a friend, you'll probably want to raise your internal alarm level a few notches higher...
From when we started to outsource to China in 2001 till just as recent as a few months ago, there is one scam that seemed to have repeated itself many times. It is a favorite amongst Chinese people dealing with foreign buyers. And yes, even having a presence, office, or company inside China does not make you immune to this.
Today, we have a company partner permanently stationed in China overseeing the management, and a very, very strict certification process for all of our supply chain that had been continuously evolved and improved over the decade, but even under these circumstances, we still experience this common "scam" being applied to us. Of course, nowadays, we have the benefit of an early detection system that steers us clear from this potential threat. However, I am seeing many new comers to this game falling prey to this unethical and ruthless scam.
Like cancer, in the early stages, you will never feel anything is going wrong. As a matter of fact, you may live with this your entire life and not skip a beat. However, should something of a higher magnitude that goes awry, such as a product quality issue, the interconnections that built the scam may easily break and you'll end up to be the last one holding the bag. Of course, the scammers have all the incentives to keep the scheme going as long as possible as they profit from it. Although some unforeseen event may cause a domino effect to unveil the gruesome truth, the biggest and most common revelation of the scam is not due to unexpected surprises such as quality issues or delays in shipment. The biggest motivation for the scammers to end the scheme often times is when a big order that's coming in.
How "big" is big enough? There is no set rules. It depends on the experience and appetite of the scammer in question. Some inexperienced scammers will settle for petty amount as they are still building up their skills. But if you are among the less fortunate ones, the more experienced scammers will truly wreck havoc and have dire financial consequences.
OK. What is this common scam that should be feared like a plaque? It is simply a form of embezzlement. Due to the unfamiliar and very complicated Chinese legal structure, and most of all, the overall environment where most people only care about making money and not ethics, this scam is allowed to flourish unchecked. These scammers usually get away with respects from their peers because of their ability to lie and deceive, and most of all, to suck money from their foreign hosts. Their actions are often not prosecuted and never being looked down because foreigners are deemed as overtly rich and have to obligation to feed the Chinese population when you set up shop here. In short, there is a lot of cultural and popular support for this type of scam, and that is exactly why it won't go out of style any time soon.
There are two types of players running the same scam, each has a different role in your corporate hierarchy. One is an external threat, the other is internal. Unfortunately, it is entirely possible that they can co-exist at the same time. Although they are two distinct forces, the end-game is the same -- embezzle your hard-earned money.
Here's the definition of "embezzle" according to dictionary.com:
to appropriate fraudulently to one's own use, as money or property entrusted to one's care.
1). The External Parasites. You are buying directly from a Chinese factory (from U.S. or within your China operations), and due to some export or other B.S. so-called new Chinese laws, you are directed to pay a third-party export company as the factory may have its own export license temporarily suspended or revoked. While this is not technical wrong, as many factories may not have the necessary export license and go through trading companies that does nothing but export, the key to watch out for is the sudden change of payee. You might receive tons of assurances from your factory rep about the need to start going through a trading company due to whatever reason, but in the end, it's just part of the scheme.
Premise: As with any corporate entity, a factory is not a person. Most buyers end up dealing with a factory rep; this rep can either be a sales person or customer service. The person in question of parasitic actions is the very same factory rep.
Symptom: Sudden change of payee. If you have been paying directly to the factory and were suddenly redirected to pay a third-party company, no matter how legitimate the reason may seem to be, you must be on guard for possible fraudulent activity.
Structure: The factory rep may have set-up a company on his own on the side. This company is usually the new payee. Instead of you paying directly to the factory, now you are literally paying a broker to handle your orders.
Problem: While going through a broker is not really a huge issue, being deceive and defrauded is. The factory rep who redirects your payment for personal gains set you up for two possible problems:
#1: He may just take the money and run. When the order is big enough, with the huge deposit that you've wired, it may just be enough for him to quit his job and disappear. When this happens, your money is just wiped out. Since the factory did not receive your deposit, and the rep is nowhere to be found, there is no way the factory is going to be responsible for this.
#2: Assuming the payment went through, the factory rep and his own company turns around and pay the factory to get the order going (while keeping his own cut), there is still another potential danger brewing. As with everything made in China, quality consistency is always an issue. If something should go wrong, and you demand the factory rep to remake the product, it just may not work out. You are technically NOT the buyer. Factory is receiving funds from his own rep's company, so that company is technically the buyer. Factory is not obligated to you to fulfill your demands. On the other hand, the company set-up by your factory rep is too small to make any demands. You will be left powerless to do anything. You either accept things as they are, or see your factory rep disappear as there is no way he can shoulder the cost of a redo.
Sustainability: The above scam isn't going away anytime soon. While the foreign buyer always ends up losers, many factories actually welcome, if not encourage, this type of transactions. For the factories, since all these reps are just employees, and all employees come and go all the time, there is no permanent attachment to them and their well-being. Factory is motivated by the fact that these scams run by its own employees actually set-up a shield between you, the buyer, and the factory. The factory now does not have to deal with you, and if anything should go wrong, it'll be the responsibility of the factory rep and his fake company. Factory can just focus on manufacturing and collect money.
Furthermore, this type of scam is so common in China, these so-called factory reps move from one factory to the next on a regular basis, no factory will actively discourage, or prohibit, this type of action in fear of damaging its own reputation. If there should be a case where things really blow up, factory can just as easily put all the blames and responsibilities on the factory rep and his scam.
2). The Internal Parasites. The second scenario is less obvious and much more probable. Your China operations has taken over the sourcing tasks that were previously performed by your U.S. staff. Everything seems honky-dory and everybody is happy. Small and odd issues will start to creep up. Initially, you'll just write it off as part of doing business in China. But then things will take a dive for the worse. You'll start seeing a pattern developing behind different issues that were thought not to be connected. When finally, the shell cracks open, and then you finally realized that you've been duped by your very own China employees.
Premise: You have your own China operations with native Chinese employees. They are eager to prove themselves to you. You may have already set-up some sourcing and/or procurement channels to avoid having unproven employees going astray.
Symptom: Your employees will start presenting cases where they need to source products through established channel for various reasons. Or worse, if the China operation is set-up specifically to do sourcing, your employees might not need to identify who they source to.
Structure: Your employee will benefit from one of two ways, depending on his past experience and expertise:
#1: Kick-Backs. This is the most common form of internal embezzlement in China, from government officials down to the common peasants. This has a very long and deep-rooted history that is now embedded in the Chinese DNA. Your own employees is in essence getting a commission from your vendors. This is not just limited to new vendors that your employees may have set-up, if experienced enough, your employees might still be able to manage to get a cut from your established vendors.
#2: Your Employee is your Vendor. Your employee might very well set-up a company and become your vendor. Or he might get his relatives or friends to do the same. In any event, you'll pay this vendor, and he'll keep his cut and then buy from the real vendor.
Problem: With kick-backs, you will experience less of a problem when a quality issue arises. You are still working directly with the factory. If there is any discrepancy in quality, or even payments, the employee in question will simply not be able to receive the kick-backs from the factory. However, when your employee becomes your vendor, you will run into exactly the same problem as mentioned previously: 1). He may just take the money and run on big orders, or 2). When a quality issue becomes big enough, your employee may keep the money and run since he has no real negotiating power with the real factory.
Sustainability: As far as kick-back goes, it is difficult to prevent it. The overall culture views this as a legitimate part of a person's income; everybody is doing it. Although we have been able to minimize this to about as unlikely as possible through many different management check points and education, we are still not 100% certain that we have totally eliminated this in our own company. By the same token, while it may be technically more feasible to detect when your employee decides to become your vendor, this form of embezzlement is still very common in China. It is viewed with less of an ethical violation than kick-backs since all transactions are supposedly legal buying and selling between businesses, except, of course, the apparent conflict of interest.
Domestic Chinese businesses who are also prone to have their blood sucked out by these parasites have more leisure perspective: "if you can't beat them, join them." This type of reaction usually stem from the exact same motive for profit as the scammers themselves. Many factories in China, once they find out their own sales people have been diverting customers' order and payment to a third party company, will usually turn around and work with the sales staff as a team. Instead of losing the business, the factory will unofficial recognize the sales staff as a third-party company concurrently. By doing this, the factory will be able to keep the order at the same volume and profit, and best of all, builds a firewall between the customer and itself in case a quality issue arises. As a matter of fact, factory will receive the greatest benefit among the three parties involved. Instead of prohibiting this type of activities, the factory becomes a more-than-willing collaborator in the scheme. And this is exactly why that this type of behavior will not cease to exist. As long as the factories directly or indirectly encourage their sales force to scam the foreign buyers, we will never see an end to this.
Don't look to the Chinese law to protect you from all different types of embezzlement - unless the amount is so high it's newsworthy, you are just at the mercy of such parasitic actions. Recently, with the new political leadership, the government seems to be cracking down on state-level corruptions. While this has tamed government officials, it has relatively little impact on businesses. To your average factory rep and employees, this has even less influence on what they may decide to do to you.
There is no complete solution to guard against these parasitic actions. They are not exclusive to China either; any developing country will exhibit similar behaviors. It is not that China does not have the laws to regulate against such criminal activity, it's just that they are never enforced. This has more to do with the overall culture rather than lack of legislation. When personal morals and professional ethics are usually trumpeted by profit motive alone, there is not much that the buyers can do. The result of all these fraudulent activities is that your costs will continue to rise, and accountability continues to diminish. You'll eventually hit a point where sourcing in China, or operating in China, becomes too expensive or problematic. When you arrive at this point, you've pretty much taken yourself out of the competitive global market. And don't even think about moving to India or Vietnam. If you can't work within the China system, you won't have a chance with even less developed countries.
For our part, we have developed a system where all of the above activities can be greatly minimized. If you do not own a China operation, we are also able to help you to ensure that things are on the up-and-up here in China.