In China, the dangers of due diligence

Shanghai: When Peter Humphrey and his wife, Yu Yingzheng, appeared on Chinese national television recently, handcuffed and wearing orange prison vests, it was the first time in more than a month that family and friends had seen the British-American couple, well-known figures in the foreign business world in Shanghai.

But any sense of relief was tempered by what they saw next: Humphrey, his face electronically blurred, his head bowed, confessed to a crime and apologized to the Chinese government.

The broadcast not only stirred immediate alarm among foreigners in China, but also cast a light on a murky corner of business life in the world's most dynamic economy. Until they disappeared in July, Humphrey and Yu ran ChinaWhys, one of many firms in the hush-hush industry of consultants and investigators in Beijing, Shanghai and Hong Kong that promise to guide foreign corporations through China's opaque and often treacherous business environment.

The companies sell services that are considered essential to doing business in China, including background checks, financial audits, fraud investigations and trademark protection. In most of the world, such work is fairly mundane. But in China, where public records are limited and corruption is rampant, it can be tricky and dangerous.

The arrests of Humphrey and Yu on charges of illegally acquiring private personal information, and the recent jailing of several other business researchers on similar charges, suggest the risks are rising. Taken together with the bribery investigation against GlaxoSmithKline, the increasing pressure on US car companies to lower their prices here, and the not-so-veiled threats against US technology companies to subcontract to Chinese companies, China appears to be throwing new obstacles in the way of foreign companies doing business in China.

A spokesman for Bayer HealthCare, a pharmaceutical company based in Germany, said Friday that Chinese officials had begun investigating the company's China operations for "a potential case of unfair competition."

Representatives from a local office of China's State Administration for Industry and Commerce visited one of Bayer's offices at the end of August, said the spokesman, Oliver Renner. He added that Bayer would investigate any accusations of violation of corporate policies and "take full responsibility for appropriate measures."

It is unclear whether the investigation into Bayer is related to the ones that Chinese officials have opened into GlaxoSmithKline and other foreign pharmaceutical companies. Earlier this year, Chinese officials also investigated makers of infant milk powder for price fixing; most of the companies under scrutiny were foreign ones. Officials fined several of the companies the equivalent of millions of dollars, and the companies said they would pay the fines.

Foreign investors - hedge funds, private equity firms and multinational companies - typically hire consulting firms like ChinaWhys to investigate potential partners and employees or keep tabs on current ones.

The goal is to uncover wrongdoing that could hurt investments, things like a hidden relationship with a supplier or a fraud that could sink a publicly listed company.

"Unfortunately, even as due diligence into the integrity of domestic enterprises in China has become more important in the light of perceived widespread fraud and misrepresentation, access to records has become even more difficult," said John Kuzmik, a consultant and former partner-in-charge of the law firm Baker Botts in Hong Kong. "Investigators are working in a very gray and somewhat dangerous environment."

China has yet to develop a comprehensive system for collecting and assessing individual credit histories, or even accessing criminal or land records, Kuzmik said. And in 2012, the government began clamping down on access to corporate and household registration documents.

Indeed, much of the business going to these firms comes from Western lawyers, who must perform due diligence on Chinese deals for their clients but are wary about getting their hands dirty in the process.

"We work with private investigators but we don't want to know where they get the information," said a lawyer in a major U.S. law firm in China.

Because the rules about access to corporate and other records are uncertain - the police and the courts themselves are susceptible to outside influence - the greatest risk may be an investigation of an individual with the means to retaliate.

An arrest like Humphrey's is "never about the legal issues. It's always about who has an interest in suppressing information," a Western consultant in Beijing said.

Humphrey, 57, who is British, and Yu, 60, who is a Chinese-born, naturalized American, fit easily into the orbit of private investigators who must be part gumshoe, part financial analyst. Humphrey, who first came to China in 1979, had a long career as a foreign correspondent with Reuters, including in Central Europe. Yu is an accountant.

Humphrey was the founder of the Shanghai chapter of a Texas-based group, the Association of Certified Fraud Examiners, and gave a lengthy presentation in 2012 at a conference in Hong Kong about how his company operated. Among his pieces of advice: "Think like the fraudsters."

ChinaWhys, which kept modest offices in Shanghai, had about 10 employees, according to Xinhua, China's state-run news agency.

Its clients included manufacturing, hotel and real estate companies and, most notably, GlaxoSmithKline, the pharmaceutical giant, which the Chinese government has accused of widespread bribery of Chinese doctors.

A Glaxo spokesman said Humphrey was never an employee of the company, but declined to say for how long or under what circumstances ChinaWhys did work for the company.

Acquaintances of Humphrey said they believed that Glaxo had asked Humphrey to find out if the company was in compliance with the Foreign Corrupt Practices Act.

In the CCTV report last month, a uniformed Shanghai police officer, Lu Wei, said the couple had collected the personal household registrations of Chinese citizens, known as hukous, automobile and homeownership records and details of cross-border travel.

The couple paid $130 to $163 per item of illegally obtained information, which they packaged into reports they sold for more than $16,000 each, making about $980,400 annual profit, the report said.

It seemed likely that Humphrey and Yu were caught because they failed to adapt after the rules of the road changed last year.

That was when the Chinese government tightened access to corporate records at state industry and commerce bureaus, which give information about company structure, and made hukous virtually off-limits, several Western consultants said. The powerful Ministry of Public Security controls hukous, which are important to investors because they are often the only way to verify that someone is who he or she claims to be.

Many investigators stopped seeking hukous after a subsidiary of Dun & Bradstreet was charged in September 2012 by the Shanghai public prosecutor with "illegally obtaining private information from Chinese citizens." Four employees were sentenced to up to two years in jail.

Humphrey appeared to be aware of the new limitations and wrote about them earlier this year on the website of the fraud examiners group.

There was no word from the Chinese authorities about when or whether Humphrey and Yu would be put on trial. The British Embassy in Beijing said it was concerned that Humphrey was "publicly interviewed about the details of his case, which is currently under investigation and has yet to come to trial."

People with knowledge of the case said Humphrey was being held in the Shanghai Detention Center in Pudong.

The U.S. Embassy in Beijing said consular officers had visited Yu on a regular basis since her arrest and would continue to do so.