RIL, a private Canadian investment firm, entered into a Joint Venture (JV) with a Village and Township Enterprise (VTE) in Shanghai China in 1993. The Chinese manager then secretly obtained a document called a Power of Attorney from the local county government which gave him full rights to borrow money and mortgage the capital deposits of the company without the approval of the Board of Directors. He then arranged loans in the name of the JV to repay personal debts which were owed to 3 local entities, including the same county government. Shanghai’s courts held these loans to be legal and forced the JV to repay these debts – which were equal to the company’s remaining capital.

RIL, with partners, began acquiring and managing commercial real estate in Canada and the U.S. in 1967, and began doing the same on behalf of Japanese investors in 1984. At the suggestion of one of our Japanese investors, our firm entered the Chinese market in 1993 with the intent of making an initial, small equity investment. We were looking for an existing firm with a track record of sales, a competent management, which was located within Shanghai, and in which controlling interest could be acquired for less than C$500,000. Our intent was to develop expertise in the area of investment in, and management of, financially troubled Chinese companies. Through the good offices of a Shanghai Municipal government official who was introduced to us by this client, we investigated numerous investment opportunities. We decided to enter into a contract to acquire controlling interest in a cash-starved but promising VTE called the Shanghai Huanfeng Instrument Co., Ltd. in Shanghai’s Chongming County – the large island on the north side of the Yangtse estuary, directly opposite central Shanghai. This firm was a manufacturer of electronic safes and security products which were enjoying modest but growing sales in Shanghai and the surrounding provinces. Plans for expansion and the need for investment capital centered on the introduction of a new, electronic safe that used a patented locking system developed by the firm. Being a publicly-owned entity, contract negotiations took place between RIL and the Chongming County Government’s Foreign Economic and Trade Office. After the terms of the contract were approved by the county government, a contract creating a new jointly-owned entity called the Shanghai Rundle-Huanfeng Instrument Co., Ltd., (the JV) was signed on March 23rd, 1993 and was registered with the Chongming County Government, which was the governing authority over the JV. RIL would hold a 60%, controlling interest in the new firm, would control 4 of the 7 seats on the board of directors, and would name the Chairman of the company. All capital expenditures would require the approval of a majority of the board, and all capital funds were to be held in a joint-signature account of a national bank in Chongming.

The first year of operations went well, with sales of existing products increasing and plans for the larger, improved electronic safe progressing well. However, with neither the knowledge nor approval of the Board of Directors, the accounts of 2 unrelated companies, both owned by relatives of the local manager, and both highly indebted, were secretly ‘combined’ with those of the JV. In addition to this, a Power of Attorney was then issued to the local manager by the Chongming County Government – again without the knowledge, much less the approval of the Board of Directors. Loans equal to all the remaining capital in the JV (US$106,800.) were then secretly, but ‘legally’ drawn in the JV’s name by the local manager from 2 local government entities and from the local branch of the Agricultural Bank of China. RIL first discovered there were problems when the Agricultural Bank’s Chongming branch informed us that the chairman’s signature was required on a loan authorization form – for a loan that had already been made. Following our firm’s adamant refusal to permit the repayment of these loans, the JV was sued by these 3 lending entities, first in the local Chongming court, and then on appeal, in the Second Middle Court in Shanghai. In each of these 6 cases, the courts ruled that the Power of Attorney was valid and that the loans were also valid and therefor had be repaid by the JV. While the courts clearly acknowledged that the lenders were in violation of a national law prohibiting lending by unlicenced financial institutions, and agreed that there were ‘serious problems’ with the borrowers’ actions, these were deemed to be internal problems of the JV and did not affect the legality of the JV’s obligations to the 3 lenders. The funds were then withdrawn under court order from the JV’s joint-signature account without the Chairman’s signature and disbursed to the 3 lenders.

Our firm then brought this case before the respected China International Economic and Trade Arbitration Commission (CIETAC), which rejected the local manager’s contention that his actions were legal and ordered that all the funds from all 3 loans be returned to the JV. While respected by the international community, the arbitration commission’s verdicts are not enforceable by law. We then submitted a request to the Shanghai Supreme Court for judicial review of the lower courts’ decisions, but this request was ignored.

The first issue, therefore, was not whether our firm was defrauded – this point was clearly established – but instead, by whom. Both the governments’ and the courts’ position was; that the legal conflicts between the JV contract and the unauthorised issuance of the Power of Attorney were “unfortunate”, but that this was “accepted local practice at the time” in Chongming county, and must, therefore, be considered to be legal. Being legal, the reasoning followed, all debts incurred in the JV’s name using the Power of Attorney were then also legal and binding. This was in spite of the fact that;

1 The issuance of the Power of Attorney was a clear violation of the most fundamental term in any corporate contract; the right of the owners to control their investment. Moreover, our contract was violated by, and for the benefit of, the very government that issued, approved, registered and had governing authority over the contract.

2 The loans made to the JV were not made by innocent 3rd party lenders. Instead, these loans were made by the Chongming County Government’s own Public Health Bureau, the local (Chengqiao) Township Government – former owner of the VTE, and the Chongming branch of the Agricultural Bank of China – all local Government or state-owned entities that were fully aware that our firm was a international JV which was established on the basis of a contract. They were also all aware that RIL was the majority shareholder of this JV and that the Board of Directors had not approved these loans. Moreover, lending by non-licenced entities was banned by Beijing in 1992 as a result of precisely this sort of fraud. The Chongming County Government explained that they were not legally obliged to obey this law, because it was, again, not ‘accepted local practice’.

3 All 3 of these lending entities had previously extended loans of exactly the same amounts to the 2 unrelated companies whose accounts were allegedly combined with those of the JV – which was ruled to be illegal by the Arbitration Commission. The debts of these 2 firms (owed to these 3 lending entities) had no hope of being repaid, and were only (and immediately) repaid with the proceeds of the newer loans that were made to the JV – by the same 3 entities. These 3 loans to the JV, therefore, were simply mechanisms for the 3 lenders to obtain repayment from the JV of their earlier loans to the 2 unrelated, bankrupt firms – which they knew to be owned by the local manager’s relatives. This immediate repayment of the 2 unrelated companies’ debts was clearly explained by both the local manager and the 3 lenders themselves in court. Yet when we sought to obtain copies the JV’s bank records to document these points, the JV’s banks (the Agricultural Bank of China and the Chengqiao Credit Union) both refused to allow us access to them or to provide us with copies. We then requested the Shanghai Second Middle Court to order our banks to surrender these documents to us. Incredibly, this too was denied by the court.

The second, larger issue, and the one that motivated our firm to pursue this case in spite of the relatively modest sum of money involved, was the issue of systemic corruption in China. When foreign investors are legally bound by their contractual obligations, but our Chinese partners and local government and bank officials are free to violate them for their own benefit, all with the tacit support of the Chinese legal system, it is our view that something is fundamentally wrong. Moreover, it is not just the initial misdeeds by unsophisticated local officials that concerned us. Instead, it was the chronic inability of (even) Metropolitan Shanghai’s government and legal system to function in a professional or ethical manner that so distressed us.

I A ‘Chinese contract’ can be a contradiction in terms. Personal relationships routinely subvert the rule of law there.

II Due diligence, while still important, assumes the existence of a functioning legal system. If your future business partners and the bank and government officials of the area in which you are going to invest have both the intent and the means to misappropriate your invested capital, then the ‘good condition’ of the target company that your due diligence analysis uncovers may merely be bait for a fraud.

III Limited control by China’s central government over its vast countryside has been a recurring problem for centuries. While 4 national banks do exist, local bank managers run their branches with very little control from outside. Once investment capital has been transferred from the main branches in the largest cities, it is effectively beyond the rule of law. Moreover, in the event of irregularities or disputes, it is common for local banks to refuse clients access to, or copies of, their own bank accounts’ records.

IV We encountered many honest officials who were genuinely shocked by our problem. However, only a handful of them were willing to intervene on our behalf, including those with the clear legal responsibility to do so. Even then, it took months, or in one case, years of persuasion to get them to put pen to paper. The main problem was, in our view, a combination of the tremendous difference in wealth between Chinese and foreigners – with its attendant feelings of resentment and entitlement, as well as the subtle, but still important role of the Chinese Communist Party. Angering the government can still have serious ramifications, especially for senior public officials and licenced professionals – the very groups whose assistance is so crucial. Access to quality housing, promotions, professional licences, passports and exit visas are all still granted exclusively, and arbitrarily, by the government. Keeping one’s head down and one’s record clean, therefore, remains a national preoccupation for most Chinese.

V China has great potential for careful and persistent businesses. Opportunities for the sale of foreign goods and services and the purchase of Chinese manufactured products are vast. Even in the area of direct foreign investment, large projects that are carefully structured and directly managed can and do yield good results. However, for smaller investors who must rely to a greater extent on the Chinese legal, financial and political systems as they are, extreme caution is strongly advised.