Transcript: Due Diligence on Chinese Suppliers

· Transcripts - CBLP

Art:

Welcome to the China business law podcast a show about the practice of law in China from real in-house and law firm professionals on the ground.  Today, we have the pleasure of being joined again by Jason Chang, Of Counsel at DLA Piper.  And Jason's really it's a pleasure to have you on again. Last time we were talking about force majeure. 

You have since written another client alert about essentially doing due diligence on suppliers in general. But as it relates now to personal protective equipment medical supplies is a lot of people are buying these supplies from vendors in China. So we thought we'd kind of get into a general discussion of what kind of due diligence issues come up when you're doing diligence on on suppliers from China. 

Jason, remind people a bit of your practice area, your background, in case they hadn't listened to the earlier podcast we did.

Jason:

Great. Thanks so much for having me again on your podcast. It's always a pleasure. My name is Jason Chang. I'm Of Counsel at DLA Piper.  My practice primarily focuses on compliance and investigations. Most of my work is US-China-related. I was previously based in China from 2011 to 2017 and moved back a couple years ago, and I still maintain and primarily work on US-China issues not so much as an M&A attorney or a transactions attorney but more on the risk mitigation/compliance/operational risk and FCPA, anti-bribery, anti-corruption, US Securities law, things of that nature. So it's more regulatory and investigations, litigation rather than transactional. 

But yeah, like you said are now that we are several months into the coronavirus outbreak and now it's something that's hitting the United States very hard. We're looking at a lot of personal protective equipment and medical supplies flowing into the United States from all over the world. But primarily from China. A lot of it is coming from China. And so I think a very relevant sort of issue that US companies, individuals, universities, corporations and donors are looking at is how to vet Chinese medical suppliers and ensure that the supplies that they're receiving are up to the right quality, are safe. The price that they're paying is fair and that they aren't running into any sort of what we call red flags in terms of sort of the compliance issues that we typically look at in in due diligence. So that's kind of what the hot topic is in my world of US-China practice and happy to share some of our experiences and some of the key issues that we that we are looking at.

Art:

So let's maybe before we get into some of the specific issues. First we want to say that this discussion is not to be construed as giving legal advice in any way shape or form and we recommend our listeners if they has specific issues to seek legal counsel because every person, every company's issues, are usually quite specific and so we'd like to say that up front. 

If folks are looking to make these purchases particularly in bulk amounts, and maybe they don't have any relationships with suppliers in China previously. How do they you know, what's the what's the first step? Let's start with quality and safety. What are some of the things that they want to look for in general and this would be you looking at quality of vendors selling any kind of product. But in this case we can get into a bit about medical supplies and PPE. 

Jason:

Yeah, that's definitely first and foremost the most central and important question is regards to quality and safety. I'd like to caveat. I know that if you do already have a supply chain that flows from China or you are a life sciences company with a subsidiary in China, and have working relationships with a lot of the suppliers that are based in China. I think your experience and your trusted related business relationships that you do have can definitely help you navigate this much more easily than say if you're new to the China space. 

You're basically trying to source products in China for the first time or maybe you're not a life sciences company, but for whatever reason now you want to source products in China, you're going to want to really look closer into some of the quality and safety issues that are that are that do happen from time to time and it's very important to take notice and be very careful and that's the standard type of things. 

You would think about defective products the level of the quality for medical supplies, particularly PPE you want to look at what the product is contaminated whether it's potentially used or second hand products and then also most importantly whether the products adhere to applicable regulations and standards by the US Food and Drug Administration. 

One important thing to note about the US FDA regulations. Is that during this coronavirus outbreak, there are currently temporary enforcement policies specifically for the purchase of and the use of protective personal equipment in the medical and healthcare facility context, so these are going to be different and a bit more easier to meet in terms of these standards. So it's important to look at this with the new set of new set of eyes for or FDA regulations and standards.

Other types of issues you want to take into consideration are unauthorized factory productions, potential knockoff products. So those are your typical trademark issues in China and also brand protection issues products that are not appropriately audited or inspected for quality safety and compliance. We've also seen a lot of these issues come up. 

So especially since there are these travel bans. Yeah. It's difficult for you to get Fly. You’re prohibited for you to fly your people out to China to do say a quality or safety inspection. So there's a lot more hiring of third parties that are already on the ground in China to help you look in and audit and for quality and safety and labeling compliance and things like that. So that's kind of the high level for quality and safety particularly as it pertains to PPE coming in from China to the US and we should say again. 

Art:

We're going to sound like a broken record on this podcast, but we should say that the quality and safety issues that would you want to do your diligence on for manufacturers in China the same the same process you want to do from manufacturers from Vietnam or other parts of Southeast Asia, around the world. These are these are best practices and there's defective products wherever products are made.  Again, we're trying to give you some general guidelines General tips here. 

Jason:

So, in addition to complying with the US FDA regulations and standards for temporary enforcement policies for PPE. The Chinese government has also looked at this very closely the issue of quality and safety specifically the quality and safety of PPE products that have been exported to other countries both in the United States and in Europe.

Up and just recently. I know that the Chinese government has been looking at this and has crackdown on companies that didn't meet the quality and safety standards that were required of them. And so, I do know that the quality and safety issue is being looked at both on the China side as well as the US side. It's a dual enforcement.

Art:

One of the things about quality and safety, which is challenging - you don't have your own people to come in and do kind of inspections and so forth. You're relying on third parties, but you're also in general having a very accelerated timeline to order these products. And so, I'm just thinking that, you probably have seen this in some of the clients that you're working with and folks that you're working with in general, this trying to monitor safety and quality issues but at the same time realizing that speed is important as well. 

Jason:

So obviously working with authorized distributors and people who are who have been in the business for ten, twenty, thirty years making PPE and ensuring that the product that you are purchasing are from them. We have seen more sort of hiring of these third parties vendors in China who are on the ground in China who can inspect the product before they get on a plane or  boat to the United States because in terms of the time if you're not checking the product until it comes the United States and then you find out a certain percentage or certain sampling of the products have been identified as defective. Then you are really losing a lot of time. 

So I think there are different ways to do it and I think really getting in front of it and doing the inspections out in China is clearly going to be a better alternative than in the US but I do want to say you can also do the a bit of the sampling inspection in the in China and then when that arrives in the United States, you also do another inspection and that can also evaluate whether for example if products were in any way contaminated in route to the US or whatnot or even if the products are audited for being the identical products that had left China. 

Art:

Well now you mentioned third parties and we have third parties who are getting involved in some of the inspections. We also have third parties getting involved in the procurement of these supplies and that presents another risk, right? It could be middlemen in the US, middlemen in China anywhere along the chain.  But what kind of risks pop up when you have other extra parties in the mix. 

Jason:

Yeah, that's a fantastic question. And one of the key issues is really one of one of the practice areas that I focus a lot on is anti-corruption and then bribery and general third-party due diligence in terms of working with agents consultants and various of the third parties. It really is a place where companies, multinational companies are increasingly being very careful about in terms of understanding and knowing their clients and it's a process in which you understand who the so-called middleman or agents or consultants who are putting the deal together, right? 

So maybe the buyer doesn't know the manufacturer directly but through various agents and consultants are connected to these to the buyer and the seller are connected. Well, how did those agents and consultants connect the buyer and the seller how what type of incentives are in place for the agents and consultants. Are they receiving a commission? How much is the commission that they're receiving, is it is a reasonable? Is it legal? 

You also want to look at specifically for the US Foreign Corrupt Practices Act issues. You want to look at whether the agent or any of the agents are middlemen are considered government officials and according to the definition under US Foreign Corrupt Practices Act. Is that would you want to be basically looking at potential bribery issues, commercial bribery issues or bribery to government officials which is which is always a hotspot both under Chinese law as well as US law. So that's another thing you want to make sure that whatever deal that is being created is a deal that complies with applicable laws and regulations.

That's on the corruption and bribery side. There's also the price gouging aspect of it, which is a hot topic these days especially with the US State Attorney General's office in the United States. A lot of State AG's and are looking at the issue of price gouging of medical supplies during this emergency crisis. So this is kind of another one of the issues that are becoming front and center basically.  State Attorney General's throughout the country are enforcing state unfair trade practices, which are standards are generally different and they vary by state by state, but the concept is generally that companies and selling this PPE should not be taking advantage of consumers during the coronavirus outbreak sellers particularly selling goods over state lines or over country lines must comply with these with these state price gouging statutes generally speaking increases of 10% or more over pre-emergency prices you're going to be looking at potential price gouging.  So it's definitely something that's been a focus area in the United States and it would it would also apply to two companies in China that are going across the state line and selling across to the US as well. 

Art:

You know price gouging is a problem anytime you have a mismatch in supply and demand on products whether it's PPE or anything and China we also want to point out has very aggressive laws against price gouging and is actually enforcing those laws quite aggressively in vigorously right now to make sure that there's no price gouging on products for export that we're talking about. So this is definitely an issue that people are aware of and we have rules on the books that are being enforced as best as they can. 

So, we talked about quality and safety. We've talked about working with third parties. Any other risks you think in general that people need to be aware of when they're sourcing again sourcing products from a place like China or things that you can think of specifically for this for this situation?

Jason:

Yeah, the other group I would bucket this is under general compliance considerations when vetting Chinese medical suppliers or any suppliers. So this definitely it doesn't apply just to China or just to medical supplies. It just generally applies for global sourcing of goods and services. 

So I usually bucket this under a general fraud prevention tax evasion and money laundering sort of due diligence.  And these are really about crossing the T's and dotting the I’s to make sure your company and your transaction is not potentially involved in you know, questionable payments to offshore third parties, right? You're not involved in any unconventional invoicing techniques to evade taxes or somebody like one of the middlemen or the agents or trying to avoid taxes.

Another aspect of this includes having appropriate supporting documentation that is both accurate and complete in terms of what are the goods or services rendered you want to also have proper documentation that is filed. For example, in this case filed with the US Customs and other agencies for the importation of PPE from China. So this is one of those situations where it's a combination of asking the questions up front and also gathering the appropriate documentation so that you can kind of you know mitigate the risk. Now, you won't 100% in any transaction 100% make the risk go down to zero, but at least when you go through some of these standard due diligence exercises you can certainly mitigate against some of the larger or easy or so to speak easier risks to identify.

Art:

Yeah, generally, you know if someone is if you're dealing with a party and suddenly at the end of the negotiations, somebody wants you to pay someone you've never heard of before or in a country that's has no connection to where your products are coming from. It's usually a red flag. 

You know experienced business people doing cross-border business should have a decent sense for them. But anything that doesn't sit right or feel right, looks out of the ordinary. A lot of this is common sense, but you need to be aware of it and you know thinking about. 

You know, we've talked about some of the main risks. How does one actually go about kind of try to mitigate some of these risks, you know, we talked about some of the inspections you can do some of the document how you can try and document the transactions. What are some other ways you can do diligence on the people involved in the transactions and other other red flags you might be able to try and spot. 

Jason:

Yeah, so I would bucket the process of for mitigating these risks into a four step process. The first step is really collecting supplier information and documentation. The second step is about what I consider third party intake question. So these are basically asking questions up front regarding your supplier. Who they are. You know, what is their background their other qualifications.  Step 3 would be a conducting your own research. So looking at what the supplier is? Not just what they tell you but also what you can Google and research and things like that and then step four is identifying an escalating red flags. So if you're finding anything questionable or they're telling you something that doesn't seem to make sense. Are you resolving the issue are you identifying that risk and finding the appropriate way to either resolve it ask questions with from a professional if needed.  Or what other steps you need to take to address that issue and now there are certain things you can let's say that which are China specific. 

Art

So, you know a lot of now some of the information is publicly available or relatively easy to get in some of its not but some of the basic business documents you should you know on the company for example are you know you can request there.  There are also ways that you could potentially find these things online and so forth various databases, but generally you should be able to get so example the business license of the company in China, you can see if it has the proper business scope. You know, that's one of the distinctions about companies in China's that there they actually have very specific business Scopes right with that are authorized to do things where it's in the US, often, you know companies are set up the relative, you know, as long as you're not doing anything illegal, that's their business scope.

And which is a which is something that's you know, outside of outside of the u.s. Is places like China and other places. It's actually more defined than that. You could also look at the business license and get a sense of their registered Capital right and see how capitalized they are because that's relevant. So it's that's are you dealing with a big company? That's the best way to see it right now that sometimes the companies registered Capital actual registered Capital maybe almost a historical Legacy thing in the cleat actually is a much bigger company and there's nothing, you know wrong with that. But generally it's good to see a company’s registered capital. And so there are documents that you can get.

Are there standard kind of now someone who's never dealt with a Chinese vendor before this really is probably not something they should just send a standard diligence document request this right? That it needs to be given a little more thought for the situation, right? 

Jason

No, absolutely if this is your first time engaging a Chinese supplier and you know we don't give legal advice on this but I would say that would be a type of very very strong case for getting professional help in terms of understanding and working with the supplier.Whether it's drafting the agreement whether it's looking at the terms and also asking the right questions in terms of what type of diligence you can and can't do in China and what sort of information you can get.  One thing. I think that's very important is and it's something that we continually do is make sure you have the right Chinese and English name for the entity and for the individuals such as the legal authorized legal representative and shareholders because when you actually do the search in China it's not necessarily going to be their Roman alphabet pinyin name. You're going to have to search the Chinese name and that's when you're actually going to get the type of quality due diligence reports based off the Chinese name of the individuals or the entities. That's just one example.

Art:

And how about if we get into some of the contracts themselves? No talking about specific terms per se but when you're dealing with a third party or say a vendor for the first time and you know, particularly if there's a time crunch involved, how do you go about kind of negotiating those terms or should I say making sure that the contract has everything in writing everything is clear and transparent. I could see a situation for example where you know there would be so much pressure to close the transaction that the contract is kind of neglected or you know, the crossing the T's and dotting the I’s is a bit more of an afterthought. How important is it to still get that contract right and to take the time to sit with the vendor and go through it and make sure that both sides are clear on the contract terms.

Jason:

So I would say this is directly related to the appetite for risk of the potential buyer and also the potential seller and a big part of that is how much money is transacted and what type of volumes of product are you expecting. So, for example, I had a friend receive a donation of  units of personal protective equipment. I don't think there was a single invoice or receipt or whatnot for that for that donation. He just from a from a charitable perspective this Chinese businessmen just decided to provide it and they accepted it when it got to the United States then it was okay. Well, let's test it for basic quality and they ran some quick test sampling not even one percent just took out a couple of these surgical masks and they were waterproof and things like that. And so they decided to use it. 

Now keep in mind if you do use your masks for a healthcare facility, so if you do donate to a hospital or nursing facility, you will use these masks whatever or whatever PPE that you do receive would have to comply with those FDA regulations that we talked about earlier. But if you do just want to donate these and provide them to say your grocery store your local community and other employees in the community that are not healthcare-related. Then the FDA piece of it would not apply. 

And so obviously there's always going to be some amount of risk when you do donate products to a third party and it's best to at that stage, maybe make it very clear that whatever products that you're providing whether it's a donation or whether it's a purchase is provided as is and my and make sure of course you probably make sure they work and I'm sure they do and but I would say you need to really memorialize and clearly outline in articulate the product and the payment how to pay when to pay and when liability shifts.  If it's a large amount of products, a prudent person should probably get the lawyer to really draft that I think about these issues that were discussing in much more detail. 

Art: 

We talked about the diligence as well and these things are important because from your own perspective if you're if you are acting as a buyer if you're acting as a donor as or if you're acting as a seller, you know, you need to be aware of these things as well. Of course, so can't be an easy time for any one given the time pressures in this in the health concerns and we're an extraordinary times. But yeah, you do need a lawyer if you are if you are doing volumes.  It's no time to skimp on getting legal advice and anything else. 

Jason:

Yeah, I would also add to that and having the legal advice and a trusted legal advisor to help you make the decision to walk away as well from a deal from a proposed deal that that either is a high level of risk. Maybe it's too good to be true. And that's probably true. It's too good to be true. There are also a lot of fraudsters and scams and unsolicited sort of, you know emails from from individuals who may not even have any PPE to sell but is really looking to exploit using sort of like a social engineering scam or some other of those your typical email, you know, email scams and phishing scams that you do see they are trying to prey on people who are really desperate to get a deal until you make the purchase and then rushing through the process and not vetting it with another set of eyes to kind of, you know, see the deal and analyze it and maybe potentially also just walk away and maybe that was the best decision to make was no deal. 

Art:

Can we generally say that if someone is actively soliciting orders I mean is that is that a non-starter? You know, if you're trying to source this product and someone emails you should you almost by default just dismiss it out of hand, right? Because this the supply and demand right now is so mismatched that no one should be having to you know, solicit for orders, right?

Jason:

I mean, that's almost yeah, okay, from an email that you've never heard of a person that you've never heard of and it has typos and they're saying are you looking for n95 masks? And apparently they have a pretty simple, you know legit fair deal and then like a little link that you can click on it says click here and then we can start the process. I would absolutely dismiss it depending on who is who is contacting you.

Art:

Yeah, if it's if it's something you had someone you've never heard of before or someone. You don't know, no matter how fantastic their website looks or even if there's no typos in the email. I think I would hesitate I would hesitate because there are enough ways to source it that you don't have to do that right now. I mean, I know it's again there.  There are groups that are trying to organize this a bit like the American Chamber of Commerce and so forth at least has you know, some kind of I believe they do have some kind of process set up right where you shouldn't have to just be, you know responding to emails from people you never heard of before but I know I know these are also desperate times. 

Jason:

So maybe another little bit on the background and reputational search. Okay, I would just emphasize that it's not it can be better than a lot of times people think about the background and reputational search and they think of Google and then they just go on the Google search line and then they just start typing in the company name now certainly desktop research on suppliers.

It would also include a Google search but it is there are definitely many more tools in the toolbox for conducting these sort of searches. So particularly if you're talking about a Chinese supplier, you want to look at the Chinese native language and the Chinese company search tools. There's actually a lot of them and they're quite convenient. They have subscription rates there that are very affordable. And then you just literally type in the name of the company and then they'll pull up a lot of the high-level information obviously without going and pulling specific docs at whatever locale that the companies registered in but they can pull up like you said a lot of the basic corporate information and things of publicly available.

Yeah, exactly and including the names of the authorized legal representative and shareholders and but I would also recommend another consideration which is doing another level of due diligence, which is not just the entity you're doing business with but think about the names of all the agents, consultants, middlemen, shareholders, significant controlling shareholders, the authorized legal representative and then running a recursive search on those entities and individuals as well. So it's not just one search of one target entity but maybe kind of like one level down in or enough levels where you can capture kind of who is owning and controlling the company and who are the key players who are orchestrating the deal, I would broaden the scope of the reputational search to that group of people.

Rather than just say run it on the company and obviously the background and the search is you know speed is of ultimate importance here. So whatever you can do in terms of on the desktop and on your internet would be preferable rather than going out and pulling all this which would take days if not like a week.

Art:

Yeah, no. No, it's a I think that's the whole that's the that's the whole theme of this episode is you have to do your diligence do it as quickly as possible, but still be still be thorough because on the one hand there's speed is of the essence. But also the risks are little are elevated in this in this situation and everyone's trying as you know, it's the same goal. Its to get this equipment and so forth to people and keep people safe and let's all just hope that the situation gets better and better as soon as possible. 

Well I know that this has been going to be helpful for our listeners. I appreciate Jason coming on and giving your expertise again on this important and timely issue. So really appreciate it. Thanks a lot Jason.

Jason:

My pleasure. Thank you. 

Art:

Yeah, absolutely and and I would just want to give a shout out again and let people know to reach out to you for anything LinkedIn you are you are on your also on the firm's website DLA Piper any anything else any those are the preferred ways for people to contact you right?

Jason:

Yeah, just you can find my information on the DLA Piper website. You can give me an email JasonChang@DLAPiper.com. 

Art:

Cool. All right, well that's about it for today and thanks again Jason, and I think people will benefit a lot from listening tothis episode and we'll get it up posted as soon as possible. Thanks Jason. 

Jason:

Thank you.