China SOE Bankruptcies, Foreign Buyers, and Product that Never Arrives

Euler Hermes, the German credit insurance company, recently released its bankruptcy filing projections for 2019 here. The Report states that bankruptcies worldwide increased by 10% in 2018 and it projects an additional 6% increase for 2019.

What surprised me is that the increase in bankruptcies worldwide stems almost solely from an increase in formal bankruptcy proceedings in China. The 10% increase worldwide for 2018 was due almost entirely to a 60% increase in China bankruptcies. In 2019, the projection is for a worldwide increase of 6%, with China once again by far the highest in the world with a projected 20% increase.

This compares unfavorably with the relative stability of China’s East Asian neighbors: Japan, Korea, Taiwan and Hong Kong, which are all projected to have a 2% or less growth in bankruptcies in 2019. China also compares unfavorably with the 0% growth in bankruptcies projected for the United States and Germany, China’s two primary European and North American economic competitors.

What is fueling China’s tremendous increase in formal bankruptcies? The Report cites two factors:

“The [ projected 20% increase] will result on one hand from the on-going softening and adjustments of the Chinese economy, notably in regards to credit growth, Belt and Road Initiative and international trade issues, and on the other hand from the increasing inclination to use insolvency procedures, in particular by the authorities, in order to clean the ‘zombie’ state-owned enterprises (exceeding 20,000 cases according to some studies).”

Weakness in China’s economy in generally well known and undisputed. See The Top Ten Issues for China’s Economy and China’s Economic Slowdown and YOUR Business. I am going to focus here on the issue of “zombie” state-owned enterprises. The zombie SOEs are smaller enterprises owned by provincial and lower level Chinese governments that have been money losers for decades. The central government has been pushing to shut down these SOEs for many years, but the local governments have resisted, primarily to prevent job losses and the resulting social unrest.

The Euler Hermes Report suggests the Chinese central government will increase pressure against these zombie SOES in 2019 by taking even more aggressive steps to forestall local government insistence that non-performing SOEs be kept on artificial life support. We should therefore expect a wave of SOE closings in 2019. Some will make use of formal bankruptcy proceedings. If past practice is an indicator, even more will simply disappear. In both 2018 and already in 2019, the international litigators at my law firm have handled a massive increase in matters where a foreign company has paid its Chinese manufacturer for product only to get nothing (or almost nothing) in return and then to learn that the manufacturer no longer exists. See China Business Scam Week, Part 2: Bricks for Products. You must be on your guard for this sort of thing, starting NOW. See China’s Economic Slowdown and YOUR Business.

This slew of China bankruptcies and disappearing companies is an important issue for foreign companies doing business in China or with China. Many foreign business people believe the risk of a sudden closure of a supplier is limited to privately owned Chinese companies. Many foreign companies falsely believe the Chinese government will protect SOEs from any form of economic downturn and, therefore, SOEs are “safer” than their private competitors.

But as the Euler Hermes Report shows, this belief is not based on the facts. Chinese government policy is to protect a group of about 200 “state champion” SOEs. Virtually all other SOEs (without regard to which type of government is the owner) do not benefit from Beijing’s protection and these other SOEs are fair game for closure. China’s central government periodically imposes a program designed to clean up the balance sheet and close non-performing (zombie) SOEs. This type of clean up program is projected for 2019.

What does this mean for foreign buyers? First, it means that long term suppliers of critical products and materials will suddenly disappear without notice, leading to predictable chaos in the supply chain. Second, it means the affected Chinese SOE then has a very strong incentive to make a final fraudulent sale in order to extract a profit from one or more foreign buyers. This profit is then pocketed by the managers who then disappear. This type of scheme has been employed almost as standard procedure in the past and there is no reason not to expect this type of fraud will be used during the 2019 SOE clean up campaign. We wrote about the need to watch out for this sort of scam in China Business Scam Week, Part 2: Bricks for Products:

These things happen with companies that want to make a few final sales before they file for bankruptcy or just shut down and disappear. Just imagine the profits to be made from three $350,000 sales for which no product is ever provided. No just imagine the incentive for the owners of the Chinese manufacturing company to sell and not supply to foreign companies right before (or sometimes even right after) they shut their doors for good.

The China lawyers in my law firm call this the bricks for product scam because the first time we ever saw it was more than a decade ago when a U.S.-Norweigian fish company bought about a million dollars in fish from a Chinese company and every container consisted of a thing layer of fish wrapped around a core of bricks. The company that sent the fish for bricks was no poor and its owner had fled town and was nowhere to be found. In that case (as in most that we see), there were plenty of warning signs, all of which were ignored.

The standard technique is to offer a discount for a larger than usual sale amount and then deliver nothing or almost nothing. Sometimes nothing at all is shipped. In other cases, a fraudulent shipment is made: a container full of bricks, barrels full of water or sand, or a refrigerated container full of rotten fish or fruit. By the time the foreign company discovers the fraud, the Chinese company has already been liquidated and its owners/managers have disappeared. Much of the time, little can be done.

However, if the Chinese company formally declares bankruptcy (which does happen) and if it has some assets left (which also does happen) and if you have a China-centric manufacturing contract (see On SMEs Trusting China Manufacturers. Don’t. Just Don’t.) you at least have a chance at getting some or all of your money back.

Bottom Line: The message of this post is that the danger of paying and getting nothing from your Chinese supplier comes from BOTH private companies and from SOEs. Based on my own experience, I see the SOEs as a greater danger. When you get an offer from a Chinese supplier that seems “too good to be true,” it is. Extreme care is required.

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.