return to ICG Spaces home    ICG Risk Blog    discussions    newsletters    login    

ICG Risk Blog - [ Persistent limitations and deficiencies among the 'guardian class' of business advisors charged with protecting their clients' interests in China ]

Persistent limitations and deficiencies among the 'guardian class' of business advisors charged with protecting their clients' interests in China

  #

Previous: Low cost is not low risk: realities of IP Loss

Low cost is not low risk describes a global IP risk to both domestic and offshore facilities of both established industrial firms and venture capitalist (VC) startups in which:

  • Most firms do not know that they are at risk and, if they do become aware, do not know where to turn for valid assistance
  • Becoming aware of their target status but deprived of competent advice, firms employ non-solutions that lull themselves into a false sense of security
  • Firms silently surrender, fearful of negative consequences to business continuity or souring relationships with a host government (Too often a target firm mistakenly presumes that mitigation of IP loss demands a Rambo-style response.)
  • A firm's management may not confront a threat despite their awareness and even the periodic presence of internal champions for improved protection

We are now seeing firms that have prided themselves on US manufacturing being driven to China by simultaneous margin pressure and the recognition of rising Chinese reverse engineering of their products. Early indications are that these firms, not having sound guidance to the contrary, are operating under the odd assumption that it is better to "do something in China rather than to lose all" to reverse engineering.) Once in Asia, unprotected, more of the firm's assets can be at risk. (Experience has shown that firms driven offshore in such a "flight condition" are generally destabilized, plunged into a "catch-up mode" at any cost and inattentive to IP collection efforts; they usually quickly become an easily harvestable asset.)

How do firms, especially those global firms with broad skill sets, get into such a fix? Who are their advisors? Are they omissive? Answers differ between nascent Venture Capitalist (VC) funded firms and established firms. Venture Capitalist firms are usually small groups of former operators and entrepreneurs whose only external advisors are law firms and investment bankers (for the initial public offering. Established industrial firms are larger, employing tiers of professional managers that contract a broad spectrum of advisory agents, notably management consultancies, IT consultancies, banks, investment houses and law firms. We see three common characteristics among these advisory groups:

  1. Proper (actionable) IP protection guidelines are absent; in their place are ineffectual guidelines that confer a false sense of security among clients
  2. IP is frequently missing among the key characteristics that clients are urged to address when going offshore
  3. Fear of reprisal by a host government refusing them business restrains the level of advice offered to clients

The first two points are understandable as realistic IP protection practices, vulnerability assessments and mitigation practices are poorly understood by client and advisor alike. The third point is more troubling but I would prefer readers to understand it as the inevitable condition of a globally distributed services firm that has regional revenue targets independent of activities or events elsewhere in its network and is frequently beholden to one or more host governments for its ability to operate within their borders rather than a felonious act.

Proper (actionable) IP protection guidelines are absent:

While management consultancies often report what clients are doing as opposed to what the consultancy specifically recommends, their readership takes the implied leap that the related practices are recommended. As it is so infrequently reported, we should first state what does comprise competent threat analysis, what is "at the core of an interdiction process regardless of whether it is counterterrorism (CT) or Intellectual Property (IP) theft." From The danger of confusing terrorist interdiction with the consequences of terrorist action:

Defenders must be able to define a coherent view of their risk tolerance before they can craft a response strategy, a function the defense sector calls a Design Basis Threat (see simple overview.) For a more complex example, see Building Design for Homeland Security and look at the units: Asset Value Assessment, Threat/Hazard Assessment, Vulnerability Assessment, and Risk Assessment/Risk Management.

Unfortunately, the few that get this far attempt to solve the problem using scenario analysis which can never end, often results in analysis paralysis, and usually misses the scenario that delivers the payload or compromises the asset under protection:

Scenario-based responses are dangerously omissive. Witness the events now unfolding in London where the UK has had a thirty year history of dealing with a variety of terrorist attacks and bombings. The "scenario" and "lessons learned" of bombing mass transit (see Atocha’s Impact) in Madrid, Spain, was recent and well know yet it did the English little good in interdicting the London attack.

Moreover, scenario-spinning has no end since it has no scope-like business risk statement to bound it, and so efforts continue without end, usually crippling most well-intended protective efforts (paralysis by analysis)… The net is that the scenarios are very useful for estimating consequences (direct and indirect costs) should a similar event occur but that they are virtually ineffective for interdicting the adversary's preparation, surveillance and actual attack.

As noted in Acting upon knowledge is different from its gathering:

The alternative to scenario planning is to understand the key actors and processes at play, how they might interact (without locking into "the" prediction), especially in a region and culture so different from our own and one in which our own cultural assumptions could lead to under or overrating events, good and bad.

Some recommendations are astonishing. Peter Yu's From Pirates to Partners offers a good history and magnitude of the IP theft problem but then descends into a failed Twelve-Step Action Plan that is nothing short of an apologia for continuation of the current condition; Step 10, Be Patient with China During the Transitional Period, caught our eye. (We can support the first step, Abandon the Coercive Policy, only because US inaction has effectively made realistic enforcement moot. Individual firms must attend to the protection of their IP and that of critical suppliers in their development and manufacturing supply chain.)

McKinsey's Protecting intellectual property in China is slightly better than most in that it discredited reliance upon legal remedies:

Many multinational companies in China are losing the battle to protect their intellectual property, largely because they rely too heavily on legal tactics and fail to factor IP properly into their strategic and operational decisions. When we studied the Chinese operations of ten multinationals competing in IP-sensitive industries... we found that many executives think of protecting IP solely in legal termsand sometimes only after property has been stolen. The most successful companies, however, take strategic and operational action to protect their IP before that happens, thus lowering their litigation costs and improving the odds that their IP will remain safe...

In our experience, some executives are so caught up in the rush to reach the Chinese market that they share technological and business secrets too readily with partners, which subsequently use the information to become competitors.

Complete agreement on these comments but then the advisory dissolves into ineffectual remedies. Consider the implications of In a Scientist's Fall, China Feels Robbed of Glory, Atomised and Chip fraud in China becomes embarrassing setback, then review McKinsey's recommendations for "use of surveillance equipment or firewalls, to prevent large file transfers," "screen all job candidates for high ethical standards," "prefers employees with international work and educational experience, which it hopes will foster a healthy respect for IP," and "requiring non-compete clauses… in employment contracts for all positions." The article concludes with a "Pyramid of IP Protection" from "Must have" to "Nice to have" that is not in the correct order, and although desirable is not achievable with the tools on offer.

IP is missing key characteristic among client offshore guidelines:

No one firm was singled out for the following samples of IP omission; they were close to hand and our experience has shown them to be typical. It becomes easy to understand how otherwise competent suppliers can reach a vulnerable IP posture.

Booz Allen's The China Syndrome (and an earlier China's Gold Rush: Should You Make the Journey East?) cites "Five Factors to Examine": manufacturing cost, transportation efficiency, lead time and scheduling stability, product design and technical capabilities, concluding that:

By analyzing these five critical dimensions for each unique procurement initiative, companies can better understand their geographic sourcing options - which products are candidates to be sourced from low-cost countries and which need to be purchased from more developed markets.

IP is conspicuously absent.

Accenture's The Secrets of Successful Low-Cost-Country Sourcing states that "It’s absolutely essential that LCCS [low-cost-country sourcing] be made a core part of the overall corporate strategy" [but] successful LCCS is not a straightforward proposition [as it] involves a careful balancing of often competing interests within a company and demands great flexibility."

IP is apparently not part of this equation. It is certainly not sufficient to laud a client's "40-strong, largely Chinese procurement team in China. What’s more, the sourcing manager is a strong believer in working with local staff. It’s not just a question of culture and language, he explains: "These are people with a strong local network who are in tune with local market conditions.""

Ariba's Supply Base Localization: A Different Look at Low-cost Country Sourcing states that "Capturing the sourcing savings in a low-cost manufacturing strategy means weighing the risks and understanding total cost" but fails to mention IP. It's section When China Is Not the Answer is devoted solely to total cost piece part analysis: "As sourcing teams [are] getting a better handle on true total cost of ownership, a number of commodities are revealing themselves to be more costly when sourced from Asia versus from supply bases closer to home."

The Supply Chain Resource Consortium's Do Organizations Consider Strategic Cost Management When They Outsource To China? does not cite IP in its value equation nor does it mention IP in its 6-part China Series save for a brief mention of "laws to protect intellectual property."

I was surprised closer to home by an otherwise fine regional accounting and management firm, Plante & Moran, and its partner in the Strategic Planning and Global Services practice, Craig Fitzgerald. Having systematically tracked Fitzgerald's public materials since 2004, especially those having to do with China-related investments, I approached him in March 2006 about the seeming omission of Intellectual Property (IP) protection: "In comparison to your analyses of supplier tiers and recommendations for action, IP gets only a mention. A mantra around our shop for both outsourcing and offshoring is "Low cost is not low risk.""

I was saddened by his voicemail of 23 March, 2006:

I did get your voicemail and email messages, thank you very much. The nature of my consultation doesn't deal with IP protection whatsoever, so I really think us having a conversation would not be productive for you or for my clients as this is an area that I do not get into. I deal specifically with Customer relationship management and Enterprise strategy for auto suppliers. I do not go far afield or get into the tactics… [transcription of retained voicemail]

While Fitzgerald was very polite, all those who listened to his message agreed with my opinion that he closed with a second kind, but firm, attempt to convince me to not call again, all this from a fellow that states that he deals specifically with "Customer relationship management" and "Enterprise strategy for auto suppliers."

Fitzgerald is not alone. In dealings with a US tier one with Chinese operations, their headquarters staff were surprised to hear a key "advisor from Japan" shy away from any discussion of IP protection. I asked if the advisor was Japanese (yes) and if the individual was a long term contractor to this firm and other clients (yes). I noted that Chinese are not fond of Japanese on the best of days (decades ago my Chinese clients wanted, and paid for, tech support out of the US rather than rely on our Japanese distributor) and that the advisor could not raise sensitive issues lest it prejudice his ongoing consulting. Such an individual was not going to offer the US supplier any guidance beyond the mechanics of production and logistics.

Fear of reprisal by a host government:

While I've previously noted that the "established guardian community - major management consultancies, banks, investment houses and law firms - is restrained by fear of reprisal by a host government refusing them business in a designated country," few examples outshine the recent hasty scramble by a Big Four accounting firm, Ernst & Young, to grovelingly withdraw a and refreshingly frank May 3, 2006, assessment of Chinese bank non-performing loan (NPL) exposure. E&Y estimated total Chinese bank NPL at USD $911 billion with the NPL for the four major state-owned banks (the Big Four) spun off from the People's Bank of China (PBOC) in 1983-84 (Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), and Agricultural Bank of China (ABC)) at USD$358 billion - a figure three times greater than China's official estimate of USD$133 billion. More interestingly, E&Y audits ICBC, which is shortly to list).

China Business Services noted that E&Y's retraction "stated that the report "contained errors" requiring retraction of the study in toto. In doing so, E&Y has bowed lower than any western firm one can remember in recent times, offering in addition to the public shame of retraction, its profuse apology as well as sincere regrets.

Definitely read McGregor's China's banks still bedevilled by bad debts in which McGregor shows that E&Y's reporting was similar to that of PwC and McKinsey, and cited the frank comments of a managing director at E&Y, Jack Rodman:

AT first glance, Beijing would appear to have tackled head-on the mountain of bad debt in its state banking system - debt which has built up in the years since China began opening the economy in the late 1970s. In 1999, the Government established bad-debt disposal companies to sell off sour loans, used bank profits to wipe out more, and also pumped in cash from its foreign exchange reserves to recapitalise the institutions.

 In other words, US balance of payment debt paid, and continues to pay, down Chinese bad loans.

In all, China cleared about $US560 billion ($730 billion) of bad debts in a flurry, an amount equal to about half the country's gross domestic product at the time the funds were deployed. So after a period during which China enjoyed boisterous economic growth rates, it is surprising that a series of new reports say non-performing loans (NPLs) remain stubbornly high and may be getting worse.

A report issued on Wednesday by Ernst & Young, the accountancy firm, puts China's total liabilities for NPLs at just over $US900 billion, even higher than its $US875 billion stack of foreign reserves, the largest in the world. E&Y's findings are broadly in line with a report by professional services firm PwC issued last week, and similar in tone to another lengthy report released this week from McKinsey, the consultancy, on China's financial system.

"I think the numbers will be a big surprise because China has been giving the impression (with its banks listing overseas) that the problem is behind us," said Jack Rodman, a managing director with E&Y. "China has not really resolved the issue - they have just moved it from one state enterprise to another."

The three reports say the original stock of bad loans has not been dealt with and that a huge stack of new NPLs has been created. "While there have been improvements in the banking sectors, and the Government has sought to address NPLs, the core causes for the build-up have not been fully dealt with," said the McKinsey report.

"Until these problems are addressed, the problem is likely to persist, and the banking system will remain vulnerable to potential liquidity shocks." The "problems" are familiar - a lack of commercial mindset among banks and skills to assess credit risk, and a sprawling nationwide branch system over which the head office in Beijing has little control.

In other words, the Chinese banking system is insolvent, and investors may never see their money back, much less a profit.

Three of the big four state banks, which have either listed overseas or are preparing to, have an even better record, with their NPL ratio by December last year under 5 per cent, according to PwC. The fall was not due to NPL resolutions, but transfers to the bad debt disposal agencies, and a surge in new lending which made existing bad loans a smaller part of the expanding pie of banking assets.

"So while NPL ratios appear to be decreasing, in number NPLs are probably increasing," says Mike Harris, the PwC report's author. The bad debt disposal agencies, known as asset management companies (AMCs), have taken on $US330 billion in sour loans since 1999, but have only resolved about $US100 billion.

In other words, no substantive change has occurred in Chinese lending and banking practice.

Read Luo Jun's Bank of China's $9.9 Billion IPO Plan Vexed by Bad Loan Legacy for more on the mechanics. I recommend readers to Richard Kuslan's Asia Business Intelligence, Dan Harris' posts at China Law Blog, and byzantine_ruins' The Epic of the Fall:

Readers are referred to the many additional links on Chinese banking revelation are in the bibliography below. In lieu of the E&Y withdrawal, I recommend two reports by the IMF's Richard Podpiera. Read Does Compliance with Basel Core Principles Bring Any Measurable Benefits?, November 2004, for general banking sector performance and Progress in China’s Banking Sector Reform: Has Bank Behavior Changed?, March 2006, for analysis of Chinese lending growth, credit pricing, and regional lending patterns in search of "evidence of changing behavior of the large state-owned commercial banks (SCBs)." All the items by Minxin Pei offer readers a sound view of the structural issues contributing to China's economic and societal pressure.

This reprisal segment closes with the conflicts of interest facing investment bankers Lehman Brothers, Morgan Stanley and Goldman Sachs during the 2005 attempt of China's CNOOC to acquire Unocal:

Lehman Brothers, which has been aggressively wooing Chinese clients, also happens to be the banker for Chevron in the battle for control of Unocal, the American oil company. Chevron's strategy in seeking public support for a deal with Unocal has included denouncing Cnooc's offer not just on its economic merits, but also as a Chinese government-sponsored bid that threatens America's national security. Chevron's lobbying campaign in Washington all but compares China to Russia during the cold war. This has made for some awkward moments for Lehman Brothers in China. "Pitching business there at the moment is not the easiest thing to do," lamented a Lehman banker who just completed a trip to Hong Kong that he called "unsuccessful."...  

Morgan Stanley, which is also trying to create a franchise in China, is representing Unocal. Relying in part on Morgan Stanley's advice, Unocal's board has rejected Cnooc's bid - which is actually higher than Chrevron's offer - as too low, considering the political risks… "Conflict resolution is tremendously complex to start with for most big firms," said Steven Koch, co-chairman of global mergers and acquisitions at Credit Suisse First Boston. "It gets even more complicated when the client is associated with a country's national interests."…

Goldman Sachs… has spent the last several years zealously courting Chinese government officials… Goldman's decision to pursue working for Cnooc was a calculated one. It knew full well that Cnooc had a long shot of winning. As adviser to the losing side in the takeover fight, Goldman would make virtually no money for its months of strategizing...  

But for Goldman, it may have looked like a no-lose situation. If Cnooc won, it would be a watershed deal that would reap millions of dollars in fees for Goldman. But being on the losing side would offer rewards, too. The experience itself has already helped Goldman build deep relationships inside the Chinese government that may give it a leg up in the coming years... [S]ome people close to Cnooc have suggested that Goldman could be blamed if the Chinese company ends up losing the current takeover battle. Critics are already saying that Goldman has miscalculated the level of protectionist sentiment in Washington as well as Chevron's ability to stir up a firestorm of protest against the Chinese company.

The moral that I take from this section in particular and the full note in general is that if you are an investor in China in any fashion and are not performing your own independent, rigorous analysis from multiple sources, but rather relying on the advisory of your accountant, that you are in for a tenure marked by surprise and cost.

Next: Physicians, heal thyselves: The Big Four accountancies are setting up as targets for Intellectual Property (IP) theft

Chinese banks reap rewards of reform
(Asia Pulse/XIC)
Asia Times
Jun 7, 2006

Atomised
Beijing no longer commands instant obedience from China's local authorities
The Economist
Jun 1, 2006

China finance: Investors bet on BOC
ViewsWire
ECONOMIST INTELLIGENCE UNIT
May 26th 2006
Also here

Banking on Reform
Recent reforms have helped China avoid a banking collapse. But how will its banks hold up when the sector fully opens to foreign competition?
by Stephen Thomas and Chen Ji
China Business Review
CBR May-June 2006

Bank of China's $9.9 Billion IPO Plan Vexed by Bad Loan Legacy
Luo Jun
Bloomberg
May 16, 2006

In a Scientist's Fall, China Feels Robbed of Glory
By DAVID BARBOZA
New York Times
May 15, 2006

Chip fraud in China becomes embarrassing setback
Faked development of digital signal processors unravled
By Sumner Lemon, IDG News Service
May 15, 2006

Ernst & Young And China Banks -- Better Wrong Than Right?
Posted by Dan Harris
China Law Blog
May 15, 2006 at 09:35 AM

Non-Performing Accountants (and Loans)
China Business Services
May 15, 2006

Ernst and Young Retracts China Bad Loans Report
Posted by Richard Kuslan
Asia Business Intelligence
May 15, 2006 01:21 PM

China's Banks May Be Troubled, But Nobody Knows The Trouble Ernst & Young Has Seen
Posted by Dan Harris
China Law Blog
May 15, 2006 at 12:41 AM

Ernst & Young Bullied To Withdraw NPL Report By Chinese Authorities
By byzantine_ruins
The Epic of the Fall
May. 15th, 2006 @ 09:35 am

Ernst & Young withdraws NPL Report
E&Y Global headquarters
12 May, 2006

China central bank says report on extent of bank NPLs 'seriously distorted'
AFX/Forbes
05.11.2006, 08:00 AM

China's banks still bedevilled by bad debts
They've just passed the buck, writes Richard McGregor
Richard McGregor
The Australian-FT Business
May 05, 2006

China on Borrowed Time?
David Bosco
Foreign Policy
Wed, 05/03/2006 - 1:22pm.

Troubled Loan Trail Leads To China -- Do Not Try This At Home
Posted by Dan Harris
China Law Blog
May 3, 2006 at 11:16 PM

China bad loans may reach total of $900bn
By Richard McGregor in Beijing
Financial Times
Published: May 3 2006 07:46 | Last updated: May 3 2006 07:46

China Bad Loans May Reach Total of $900bn
China Business 2.0
May 3, 2006
MIRROR of much of the McGregor/FT article

Around Asia's Markets: Bad loans dim ardor for China banks
By Michele Batchelor
Bloomberg News
APRIL 25, 2006

The Chinese Conundrum: External financial strength, Domestic financial weakness
Brad Setser
Director of Research, Roubini Global Economics
Research Associate, Global Economic Governance
Produced for CESifo Conference: "Understanding the Chinese Economy"
Programme, University College, Oxford
This draft April 15, 2006

The Dark Side of China’s Rise
By Minxin Pei
Foreign Policy
March/April 2006
Scrolled to paid archive
Mirror here:
The Dark Side of China's Rise
By 
Minxin Pei Foreign Policy, March/April 2006
Carnegie Endowment for International Peace

Progress in China’s Banking Sector Reform: Has Bank Behavior Changed?
Richard Podpiera
International Monetary Fund Working Paper WP/06/71
Monetary and Financial Systems Department
Authorized for distribution by Abdessatar Ouanes
March 2006

Supply Base Localization: A Different Look at Low-cost Country Sourcing
By David Morgenstern
Supply & Demand Chain Executive
February/March 2006

China Is Stagnating in Its "Trapped Transition"
By Minxin Pei
Financial Times, February 24, 2006
Mirror at CEIP

Competition and trade in the U.S. auto parts sector
by Thomas H. Klier and James M. Rubenstein
Chicago Fed Letter
Research Department of the Federal Reserve Bank of Chicago
NUMBER 222
January 2006

China Is Paying the Price of Rising Social Unrest
By Minxin Pei
Financial Times, November 7, 2005
Mirror at CEIP

A Fresh Approach on China
By Minxin Pei
International Herald Tribune, September 9, 2005
Mirror at CEIP

Protecting intellectual property in China
Litigation is no substitute for strategy.
Meagan C. Dietz, Sarena Shao-Tin Lin, and Lei Yang
The McKinsey Quarterly, 2005 Number 3

There's a New China Syndrome on Wall Street
By ANDREW ROSS SORKIN
New York Times
July 24, 2005

The Secrets of Successful Low-Cost-Country Sourcing
By Kris Timmermans
Accenture
Outlook Journal, June 2005
PDF

The Economic Basis for Social Unrest in China
Albert Keidel
Carnegie Endowment for International Peace
for The Third European-American Dialogue on China
The George Washington University
May 26-27, 2005

OE Auto Parts Supplier Strategy for the Next Ten Years
Marc Santucci
eAutoPortal.com
2 May, 2005

Banking reform to continue despite scandals: official
Xinhua English
March 10, 2005 00:57:36

Sourcing in China not a sure bet
By strategy+business
Special to CNET News.com
February 7, 2005, 10:00 AM PST
[Recycling of content from 
China's Gold Rush: Should You Make the Journey East?]

The China Syndrome
A five-dimension analytical model for deciding when (and when not) to purchase from the East
By Michell Quint & Dermot Shorten

strategy + business
01/18/05

Does Compliance with Basel Core Principles Bring Any Measurable Benefits?
Richard Podpiera
International Monetary Fund Working Paper WP/04/204
Monetary and Financial Systems Department
Authorized for distribution by Abdessatar Ouanes
November 2004

China's Gold Rush: Should You Make the Journey East?
Michell Quint & Dermot Shorten
Booz Allen
November 2004

Rural Financial Sector Reform in China
Thorsten Giehler
Asia Forum on Financial Sector Reforms in China, Frankfurt
26 Oct, 2004

Do Organizations Consider Strategic Cost Management When They Outsource To China?
by Rob Handfield, SCRC
Supply Chain Resource Consortium (SCRC)
4/8/04

China Series by Rob Handfield, SCRC:
Global Sourcing from China: Insights from a Recent Visit - China Series #1
5/3/05
Planning and Controld Systems in China (PLAN) - China Series #2
6/10/05
Identifying and Negotiation with Chinese Suppliers (SOURCE) - China Series #3
6/23/05
Manufacturing in China (MAKE) - China Series # 4
7/6/05
Logistics in China (DELIVER) - China Series # 5
7/20/05
Environmental Risks in China's Supply Chain - China Series # 6
8/22/05

Ch 3-Finance-Sec 2: Commercial banks: The big four state-owned banks
China Hand March 2004 Main Report
Economic Intelligence Unit
March 2004

China -Threat or Opportunity? You Decide
Craig Fitzgerald
Manufacturing Consulting Services, Plante & Moran
March 2003

Strategies for entering the Chinese Market
Craig Fitzgerald
OESA China Business Report
SAE 2003 World Congress
March 3, 2003

From Pirates to Partners: Protecting Intellectual Property in China in the Twenty-First Century
Peter K. Yu
American University Law Review, Vol. 50
Date Posted: December 7, 2000
Last Revised: April 21, 2003
Abstract

Gordon Housworth



InfoT Public  Intellectual Property Theft Public  Risk Containment and Pricing Public  Strategic Risk Public  

discussion

  discuss this article


<<  |  December 2018  |  >>
SunMonTueWedThuFriSat
2526272829301
2345678
9101112131415
16171819202122
23242526272829
303112345
view our rss feed