Asia Pac, International - Written by on Monday, October 17, 2011 15:18 - 0 Comments

Don’t get caught: The Chinese ‘Design Institute’ trap

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We’ve heard about the phenomenom of the Chinese state owned Design Institute trap before.

Last week Watts Water was the latest corporate victim following the acquisition of a Chinese business.

The trap

Chinese state owned businesses and projects often retain state-owned Design Institute(s) to assist in product design.  Broadly speaking the product could be anything – even a mouse trap.

Sometimes businesses are tempted to make improper payments to employees of the Design Institute(s).

The purpose of the payment? To influence the Design Institute(s) to recommend certain products and to create technical design specifications which favour a particular company’s products.

This creates numerous potential problems, including under the Bribery Act.

In the Watts Water case (A US case which involved valves) improper payments generated profits for Watts of more than $2.7 million and the payments were found to be disguised as sales commissions in the relevant Chinese business books and records.  In turn this caused Watts’ books and records to be inaccurate under the US Foreign Corrupt Practices Act (FCPA). The US Securities and Exchange Commission (SEC) cease and desist order found Watts failed to devise and maintain a system of internal accounting controls sufficient to prevent and detect the payments.

Buying a problem

The problems stem from an M&A deal.  A business Watts acquired in China had a sales policy which provided that all sales-related expenses, including travel, meals, entertainment, and payment of “consulting fees” to Design Institutes, would be borne by the relevant China business sales employees out of their commissions. It went on to say that sales personnel at the relevant business could utilize their commissions to make payments to Design Institutes of up to 3% of the total contract amount.

The policy was never translated into English or provided to US management.

In fact, the vice president of sales at Watts China, Chang, resisted at least one attempt by several of his colleagues at Watts China to have the policy translated and submitted to Watts’ senior management for approval. In an email discussing this issue, Chang stated that “China sale policy should stay in control within China regional operation” because involving Watts’ management in the U.S. might cause the relevant Chinese business to “lose many flexibility [sic] on working with sale, sale agent and end buyer.”

A textbook approach

In March 2009, Watts’ General Counsel learned of a Commission enforcement action against another company that involved unlawful payments to employees of Chinese Design Institutes. Watts implemented anti-corruption and FCPA training for its Chinese subsidiaries. In July the same year following FCPA training sessions for certain management of Watts China, Watts China’s in-house corporate counsel became aware of potential FCPA violations through conversations with sales personnel who were participating in the training. Shortly thereafter, the in-house lawyer notified Watts’ management in the U.S. of the potential violations.

On July 21, 2009, Watts retained outside counsel to conduct an internal investigation of the relevant China business sales practices. Watts’ outside counsel subsequently retained forensic accountants to assist with the investigation.

Watts self-reported its internal investigation to the SEC. As the internal investigation progressed, Watts shared the results of the investigation with its outside auditors and the staff through periodic reports, and undertook remedial measures.

The costs

Watts was ordered to disgorge $2,755,815 (the profit), pay prejudgment interest of $820,791, and a $200,000 penalty.

Any business which has dealings with a Chinese state owned design institute should read the SEC Order and consider its own training to avoid this known problem.

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