June 2008

Anti-corruption, ethics andcompliance in China

Ethical Corporation

2009

Learn how to have a successful anti-corruption strategy

Executive SummaryThe full report is available at www.ethicalcorp.com/china

ANTI-CORRUPTION, ETHICS AND COMPLIANCE IN CHINA`

Foreword ............................................................................................................................................................3

Executive summary ............................................................................................................................................4

Introduction ........................................................................................................................................................5

Section 1: Doing business ethically in China ......................................................................................................71.1 Chinese laws and regulations ........................................................................................................................7

1.1.1 Criminal Law ..........................................................................................................................................71.1.2 Company Law........................................................................................................................................71.1.3 The Unfair Competition Law..................................................................................................................81.1.4 3 sets of local anti-corruption regulations ..........................................................................................81.1.5 United Nations Convention against Corruption ....................................................................................91.1.6 Internal Party Disciplinary Committee ................................................................................................10

1.2 Chinese business norms ..............................................................................................................................101.3 Evolution of China’s anti-corruption business culture and regulations........................................................12

Section 2: China’s engagement with international anti-corruption conventionsand initiatives ..................................................................................................................................................152.1 General resistance and support for international conventions....................................................................15

2.1.1 Foreign Corrupt Practices Act ..............................................................................................................152.1.2 Sarbanes-Oxley Act ............................................................................................................................152.1.3 Organisation for Economic Co-operation and Development provisions ............................................16

2.2 Comparison of national regulations to global conventions ........................................................................17

Section 3: Case studies ....................................................................................................................................193.1 Introduction to case studies ........................................................................................................................193.2 Case study: Groupe Danone ......................................................................................................................193.3 Case study: Wumart Stores Incorporated ....................................................................................................213.4 Case study: European manufacturer ..........................................................................................................22

Section 4: Final analysis ..................................................................................................................................24

Appendices ........................................................................................................................................................25Appendix A: Methodology ................................................................................................................................25Appendix B: Questionnaire................................................................................................................................25Appendix C: Summary of interview responses..................................................................................................25

References ........................................................................................................................................................30

Contents

ANTI-CORRUPTION, ETHICS AND COMPLIANCE IN CHINA`

Nearly every industry is taking advantage of lowoperating costs in China. However, few compa-

nies have effectively evaded all corruption risks.Our research at Ethical Corporation supports a

number of external studies on corruption in theregion. 2008 figures published by Transparency Inter-national rank China as having one of the mostcorrupt operating environments. It scored 3.6 out ofa possible 10 points in the Corruption PerceptionsIndex – below 5 indicates a serious corruptionproblem exists within the public sector. In addition,China earned a score of 6.5 (out of an optimal 10) onthe Bribe Payers Index, placing them 21 out of 22leading international and regional exportingcountries.

Our research found that most senior foreign execu-tives working in country for any substantial period oftime had encountered corruption or malfeasance insome form. This briefing aims to equip executives withthe information and tools to reduce such risks.

Although corruption remains a significant obstacleto company operations, anti-corruption efforts aremaking some headway. The majority of executivesinterviewed for this report expressed confidence thatcorruption can and is being reduced in China.

The national government, lead by the ChineseCommunist Party, has demonstrated a commitmentto reducing high levels of corruption through action.Ocial laws are far om specific, but do addresscorruption more directly than laws in somecountries. Corruption is specifically addressed innational laws such as the Chinese Criminal Law, theCorporate Law, and in commitments to a number ofinternational conventions such as the United NationsConvention against Corruption.

Ethical Corporation is grateful to in-countryresearchers and all corporate representatives forproviding significant insight and co-operation duringinterviews.

Foreword

Ethical Corporation

ANTI-CORRUPTION, ETHICS AND COMPLIANCE IN CHINA`

Despite considerable progress in the fight againstcorruption, China remains highly vulnerable to

ethical and compliance violations. Multinationalcompanies routinely face corruption-related challengesin their mainland China business operations, eitherthrough local staff, joint-venture ( JV) partners or otheraliates such as vendors, agents, suppliers and/ordistributors. It is also clear that the problem does not goaway when foreign companies incorporate in China asWholly Foreign Owned Enterprises (WFOEs).

Transparency and anti-corruption initiatives arenotably more prevalent - and increasingly effective - inChina’s coastal provinces, particularly the Yangtze RiverDelta (YRD) in eastern China, the Beijing-TianjinCorridor (BTC) in northern China and the Pearl RiverDelta (PRD) in southern China and bordering the HongKong Special Administrative Region (SAR) where foreigninvestment has been most sustained and concentratedover the past 30 years since the inauguration of PremierDeng Xiaoping’s ‘Reform and Opening Up’ programmein 1979. Multinational companies operating in the lessdeveloped inland provinces of China equently comeacross corruption issues not only with local companiesbut also the provincial or city authorities and ocialswhere they are operating. In some cases the relation-ship between the authorities, ocials and localcompanies is blurred to the point where protectionismbecomes inevitable. In such environments, intellectualproperty (IP) protection is a particular concern for multi-national companies.

It is fair to say that most senior foreign executivesworking in-country for any substantial period of timehave encountered corruption or malfeasance in someshape or form in China at least once. Some of thesenior executives interviewed for this briefing hadonly heard of the problems it can cause; others had

experienced them personally at first hand. Corruptionissues range om small cases of bribery to circumventbureaucratic hassles to major bribes and gi giving inorder to secure major business contracts.

Most of the executives interviewed believe thatChina has come a long way in creating a more effectiveenvironment of legal-regulatory compliance and havegone some way to raising local ethical and compliancestandards to those approaching international levels.However, China’s traditional business culture ofworking closely with family or iends illustrates thefundamental importance of personal relationships andtrust, with somebody’s word oen replacing writtencontracts – an unimaginable scenario in the U.S.A. orthe European Union (EU). The cultivation and mainte-nance of good relationships, or “guanxi” as it is knownin Chinese, is central to Chinese business and becomesthat much easier if conducted amongst iends andfamily rather than with strangers. Hence Chinesebusiness culture has further to go in reaching compli-ance with rigorous international complianceregulations such as the Foreign Corrupt Practices Act(FCPA) of 1977 and the more recent Sarbanes-Oxley Act(SOX) of 2002, both now applicable in the U.S.A.

Importantly, most of the executives interviewedfor this briefing are positive about China’s ability tocontinue and complete this process of tightening uplegal-regulatory procedures, though, crucially, someinterviewees expressed doubts about enforcementand the underlying nature of Chinese business – thatit fundamentally relies on mutually beneficialrelationships (and by implication, some form ofcorruption to oil the wheels) in order to succeed. Asis oen the case in China, while the laws exist on thestatute books, effective enforcement through the legalsystem is oen lacking.

Executive summary

ANTI-CORRUPTION, ETHICS AND COMPLIANCE IN CHINA`

Like any emerging market, China suffers omcorruption and an oen unethical business

environment. What makes China different om manyother national economies is the scale of the bureau-cracy and the pace of economic development om alow base, both of which have created conditionsideally suited to the growth of corruption and oppor-tunities for massive financial gain by underpaid localgovernment ocials and by entrepreneurs eager toamass personal fortunes as quickly as possible.

Multinational companies looking to adhere toregulatory standards in their mainland China opera-tions oen discover that the compliance environmentis not particularly robust and that concepts such ascorporate governance, fiduciary duty and overallbusiness ethics have yet to evolve. According to onemultinational manager based in Shanghai, theChinese have being doing business with family andiends for hundreds of years, so they have further togo in complying with international complianceregulations. There is clearly an embedded culture thatneeds to be changed. It should come as no surprise,then, that related-party transactions are common-place and bribery in commercial dealings routine.

Making things worse are the actions of multina-tional management, who at a senior level are stilllargely ex-patriots, who, having a limited under-standing of local conditions and the language, opt toleave investment and operational decisions to theirlocal Chinese managers. The head of a Japanesemanufacturing operation setting up in China thatfaced allegations of aud within its organisation ineastern China discovered that its most senior localmanager - a long-serving Japanese-speaking employeewho had previously lived in Japan - was deaudingthe company on a massive scale by selling surplus,reject and returned product back into the market.Japanese senior management’s ignorance of Chineseand English language requirements had forced themto rely too heavily on one individual within thecompany with disastrous consequences.

Multinational companies which have been inChina for decades are also targets. In a typical case in2007, a well-known European consumer goodsmanufacturer received poison-pen letters allegingaud by senior sales managers within the company.It subsequently emerged that a network of localmanagers, who had known each other since theiruniversity days, were deauding the companythrough various methods including setting up shelldistribution companies through which theychannelled product en route to the retailer. The

company was only one in a long line of former multi-national employers that had been deauded usingexactly the same methods. Aaid to disrupt itsbusiness even more than it already had and risk anti-foreign feeling exploding in the oce, the companyallowed the managers to resign without attemptingto press charges.

In recent years, and notably since accession to theWorld Trade Organisation (WTO) in 2001, the Chinesegovernment in Beijing has sought to enforce its ownincreasingly tough legislation governing corruption and‘economic crimes’ (which are subject to the deathpenalty in China). In 2006 the head of the State Foodand Drug Administration (SFDA - the governmentwatchdog body responsible for monitoring food anddrug safety) was executed for approving untestedmedicine - including an antibiotic that killed at leastten people - in exchange for cash payments.

The authorities have cracked down on localbusiness people too, not least because of concernsabout social unrest sparked by fake investments andpyramid schemes. In 2007 a local entrepreneurreceived a death sentence in north eastern China fordeauding investors in a would-be ant-breedingscheme. The man had promised returns of up to 60%for investors who purchased ant-breeding kits omtwo companies he ran. The insects were to be used intraditional medicinal wines, herbal remedies andaphrodisiacs. The business attracted more than 10,000investors between 2002 and 2005, when investigatorsfinally shut it down. The closure set off a panic amongsmall-time players who saw their life savings disap-pear overnight (many were laid-off industrial workersusing their meagre redundancy payments), promptingthe authorities to take swi action to restore ‘socialharmony’ – Beijing’s number one political priority.

Meanwhile, household names have also fallen foulof increasingly strict anti-corruption and complianceregulations. The former chairman of GuangdongKelon Electrical Holdings, once China’s biggest reig-erator maker, received a 12-year jail term forfalsiing and withholding information and forembezzlement of up US$49m. Guangdong Kelon wassubsequently acquired by Qingdao Hisense Air-Conditioning Company1. More recently, the founderof Beijing-based Wumart Stores Inc, a major super-market chain based in the capital, has been foundguilty of corruption and jailed (see Section 3: Casestudies), while, Huang Guangyu, the founder ofconsumer electronics giant Gome (one of thecountry’s largest retailers), and reportedly China’srichest man, has disappeared amidst rumours of

Introduction

ANTI-CORRUPTION, ETHICS AND COMPLIANCE IN CHINA`

corruption and stock market manipulation related toGome’s share price.

Those familiar with China’s internal politics werenot surprised by Huang Guangyu’s detention. In factit has happened before that high profile Chinesebusiness people who had become household nameshave been found guilty of corruption and ethicallapses. Before Huang, the most famous case in Chinahad been that of Yang Bin, the Chairman of Euro-AsiaAgriculture, a large agri-business company specialisingin growing orchids and based in the north-eastern cityof Shenyang. Yang had become the richest man inChina, a “poster boy” in the Chinese press for Chineseentrepreneurism and Euro-Asia had spectacularlylisted on the Hong Kong Stock Exchange (HKSE).Euro-Asia continued to grow to include substantialgreenhouse operations across north-eastern China, atheme park in Shenyang and, most controversially,close business links with neighbouring North Korea.However, Yang was found guilty of various corruption

related offences and failure to pay tax and was verypublicly jailed for 18 years in 2002.

As its global profile grows, China is aware of itsinternational regulatory obligations. A series of high-profile corporate scandals amongst U.S. - andEuropean-based multinational companies over thepast decade and subsequent legislation to regulatebusiness have heightened international scrutiny ofmultinational companies worldwide. The U.S. FCPA,which outlaws bribery of government ocials world-wide and which actually came into force in the U.S.back in 1977, is enjoying a new lease of life as theSecurities and Exchange Commission (SEC) uses it tofine U.S.-registered, U.S.-invested or U.S.-listedcompanies for non-compliance in countries aroundthe world. And according to the China-basedmanager of one multinational fined for FCPA viola-tions, the SEC and U.S. Department of Justice (DOJ)closely scrutinise violators for signs of improvementand full compliance.

Ethical Corporation report centreRecent publications cover topics such as anti-corruption, voluntary initiatives in CSR, emerging marketissues, and managing carbon emissions. You can also visit Ethical Corporation’s website and downloadsome free research papers: www.ethicalcorp.com/reports

Anti-corruption, ethics and compliance in RussiaPractical information to develop local compliance strategies and overcome corruption challenges. For more information,current prices or online ordering, visit: www.ethicalcorp.com/russia

Anti-corruption, ethics and compliance in China and Counter corruption in your supply chain in ChinaLearn more about the issues critical to your operational security, ethical management and success in China. For more information,current prices or online ordering, visit: www.ethicalcorp.com/china

Best practices for designing effective ethics programmesFind out which ethics and compliance training is most effective and productive. For more information, current prices or onlineordering, visit: www.ethicalcorp.com/ectraining

How to manage carbon reduction, and make it payA hands-on management briefing on real-life ways big UK companies cut carbon, and their costs. Order online or obtain moreinformation at: www.ethicalcorp.com/crc

Corporate greenhouse gas emissions reportingLearn how your competitors are calculating and verifying their GHG emissions – and discover which metrics and verification standardswill work for you. For more information, current prices or online ordering, visit: www.ethicalcorp.com/greenhousegas

Guide to industry initiatives in CSRGet the inside track from some of the world’s key industry-based initiatives. For more information, current prices or online ordering,visit: www.ethicalcorp.com/initiatives

Job-specific guides for embedding CSR throughout your companyWinning methods for integrating sustainability into operational departments including communications, finance and facilities.For more information, current prices or online ordering, visit: www.ethicalcorp.com/csr

Essential strategies for effective emissions trading and offsettingWith practical information from the leading companies, this report is everything you need to develop your company’s emissionstrading and offsetting strategy. Including case studies from 15 companies across industry. For more information, current prices oronline ordering, visit: www.ethicalcorp.com/emissionstrading

The must-have guide to water ethics, footprinting, programmes and supply securityLearn how water risks factor into your operations, and what you should do to ethically manage water use.For more information, current prices or online ordering, visit: www.ethicalcorp.com/water

Ethical Corporation report order form

Your information

First name: .............................................................................. Last name:..........................................................................

Company:..............................................................................................................................................................................

Telephone: ............................................................................................................................................................................

Email:....................................................................................................................................................................................

Address:................................................................................................................................................................................

City:..........................................................................................State/Province: ....................................................................

Zip/Postcode: ..........................................................................Country: ..............................................................................

Report name:........................................................................................................................................................................

Quantity: .................................................................................. Final price+VAT: ..................................................................

Payment Details

Name (as it appears on card): ............................................................................................................................................

Card number:�������� �������� �������� ��������Type of card: ......................................................................................................................................................................

Expiry date: ............................................................................Security Code: ....................................................................

Order options:Secure online form: www.ethicalcorp.com/reports

Telephone: Client Services at +44 20 7375 7500

Email: research@ethicalcorp.com

Mail this form to: 7–9 Fashion Street,

London, UK E1 6PX

Ethical CorporationIn-depth responsible business research, training and advisory

Ethical Corporation produces robust and accessible business intelligencereports for business executives. Reports focus on cutting edge ethical businessmanagement issues are based on in-depth research with leading multinationalcompanies.

© Ethical Corporation 2009

All rights reserved