BUSINESS

HOW TO LOSE YOUR SHIRT IN CHINA

The economy beckons, but its business climate makes China a killing field for Canadian firms

ANDREA MANDEL CAMPBELL January 29 2007
BUSINESS

HOW TO LOSE YOUR SHIRT IN CHINA

The economy beckons, but its business climate makes China a killing field for Canadian firms

ANDREA MANDEL CAMPBELL January 29 2007

HOW TO LOSE YOUR SHIRT IN CHINA

The economy beckons, but its business climate makes China a killing field for Canadian firms

BUSINESS

BY ANDREA MANDEL CAMPBELL • RagUpathy Madiyalakan can’t help chuckling as he recounts his company’s disastrous foray into China. If he didn’t laugh, he’d probably cry. His Edmonton-based Quest PharmaTech is teetering on the brink, and the newly named executive chairman frankly doesn’t know if the small, publicly listed firm will survive the fallout from a seven-year odyssey plagued by bureaucratic dissembling, broken promises and corruption. “We are on the verge of collapse because of the failure we had in China,” says Madiyalakan. “It’s been a disaster from day one.”

Quest has spent the past two years trying to extricate itself from the quagmire, even changing its name and dumping its former management. But it may not be enough. The pharmaceutical firm has lost millions,

and its market capitalization, which once hovered in the $60-million to $70-million range, has been slashed to $2.9 million by furious investors. Like so many Canadian comrades-in-arms who wade into China only to be picked off like cannon fodder, Quest was felled by a fatal combination of wideeyed naïveté and a business environment that has made China into a killing field for Canadian firms.

Just about everybody’s been burned in China, from General Motors to South Korea’s LG Electronics, but market veterans say Canadians seem to have a particularly hard time grappling with the country’s no-holds-barred, get-rich-quick mentality. The list of firms scorched by the ferociously competitive market is long—from the Royal Bank of Canada and fruit manufacturer Sun-Rype Products, to a string of junior miners—and might explain why, despite countless Team Canada trade missions, Canadian foreign direct investment into China is limping along at a paltry $ 1 billion to date, while the rest of the world has poured some US$356 billion into China

since 2001.

Canadians aren’t exactly seasoned global traders to begin with, preferring to do the bulk of their business with the U.S., if they leave Canada at all. Their cautious, trusting nature is in sharp contrast to Chinese culture, where the word for honest, loashi, is a derogatory term meaning to be gullible or to follow blindly. “You’re better off going to Vegas for the weekend,” says Jim Sherry, a former federal trade commissioner turned consultant. “You’ll lose money just as fast and have more fun.” The carnage is so predictable that government bureaucrats and business consultants openly wonder whether Canadian companies are cut out for China. As one trade commissioner, formerly based in China, admitted: “Every joint venture [between a Canadian and Chinese company] that I knew of, they all failed, all except one, and even that ended.” Gervais Lavoie, a long-time China hand and a director for the Beijing chapter of the Canada China Business Council, tells Canadian companies flat out not to come. “I tell them China is going to eat you raw, because you are so green they won’t have time to cook you,” he says with a grin. “Canadians come to get screwed and the Chinese go, ‘okay, we’ll give you a run for your money.’ ”

Quest PharmaTech could have used Lavoie’s advice, but at the time it seemed like a nobrainer. The company, then known as Altachem Pharma, had just gone public in 1999. It was quickly taken up by the idea of combining its technology with China’s cheap labour to manufacture its pellet cores—translucent glucose spheres used to make drug capsules— which it could then sell into the massive and fast-growing market. Chinese government officials made it easy, luring the firm with tax breaks and a sprawling 40,000-sq.-foot facility, complete with landscaping and security guards, in one of Shanghai’s spanking new industrial parks. But the company’s ambitious plans soon began to unravel.

The joint venture was plagued by technological foul-ups almost from the start. Within a year, Altachem’s government partners pulled out of the money-losing venture, leaving the Canadians on the hook for the factory’s 50-year lease. They decided to go it alone, even though it took three months of paperwork just to transfer money to pay their Chinese workers, and they caught their Chinese general manager running a side business out of the Shanghai facility. They had to hire a Canadian supervisor to keep an eye on the operation, adding to the less quantifiable costs of pervasive bureaucratic corruption. “I don’t want to get too much into it,” says Madi-

yalakan darkly, “but the corruption is there.”

When it became apparent the venture would never be profitable, Altachem decided to expand into another line of business, only to be blocked by new environmental laws. Cashstrapped, it had no alternative except to sell the facility. But when it came time to find a buyer, the company discovered it didn’t have actual title to the land. While Altachem’s original partners, a ward within the city of Shanghai, had a contractual obligation to hand over the deed, the move was blocked by higherups who claimed it was outside the ward’s jurisdiction. Caught between competing factions within the Shanghai government, the company had no choice but to return the property to the city for a paltry $145,000, a fraction of the $2.2 million it paid for the plant. To get the money out of China, it needed 14 approvals from six different government agencies.

And that’s not even the whole story. Altachem embarked on a second venture after a Chinese middleman, living in the U.S., convinced the company he could find a Chinese distributor for another of its technologies. The go-between was paid a hefty sum to hook them up with a Chinese cashmere manufacturer that was looking to get into the drug business.

The Edmonton firm invested US$3 million to develop a high quality bacterial disinfectant, but after just six months, the impatient Chinese partner walked out of the deal. “They didn’t understand biotechnology, they didn’t realize it takes time,” says Madiyalakan.

Unable to find anyone to market or distribute the product, which is more expensive than the cut-rate Chinese market would pay,

Altachem shut down the venture in 2005.

All told, Madiyalakan estimates the company lost $6 million, including $3 million in operating expenses and $1 million in foreign exchange and withholding taxes just to move its own money out of the country. “Maybe big companies can do alright in China,” he declares, “but it’s not a place for small companies.”

In the past three decades, China has undergone a dramatic transformation as its creaking Communist economy embraces capitalism. The Middle Kingdom, many agree, has made great strides to embrace Western-style accounting practices and bulk up its judicial system. With the country’s accession to the World Trade Organization in 2001, and much of its business elite Western-educated, “it is possible to do good business and with high ethical standards,” says Howard Balloch, Canada’s former ambassador to China and president of Beijing-based investment boutique, the Balloch Group.

Yet for many foreigners, the changes are only skin deep. While the country may have donned the exterior trappings of the West, a survival ethos prevails where the ends justify the means, and “lying and cheating are fine as long as you don’t get caught,” says Sam Goodman, a Canadian living in Beijing. “If I had to define China now, it’s appearance over substance. Things appear different but the substance isn’t there. Anyone who says the people have changed—that’s bullshit. This is still the wild, wild West.”

Goodman speaks from experience. The Toronto-born former tree planter and wrestler came to Beijing in the mid ’90s to study Mandarin. Learning the language wasn’t a problem, but he quickly hit the proverbial Great Wall of China when it came to eating rice and noodles every day. Figuring the only way he could get Western food was if he made it himself, Goodman decided to open a restaurant. He knew it wouldn’t be easy, but he relished the challenge. Goodman decided to call his new venture “Beijing Sammies: Where East Eats West.” He had no idea just how true that tag line would turn out to be.

A friend had warned Goodman that his Chinese partner in the deli would screw him over within eight months. It only took four. At 4:30 one morning, he awoke to find the partner—the cousin of a friend—had taken the business licence and changed the locks. The partner was supposed to handle all the Chinese government red tape while Goodman managed the business. Instead, “he decided to deal with things by getting rid of me,” says Goodman, who, together with friends, broke into the café and took everything that wasn’t nailed down. The partner relented and a newly independent Goodman reopened for business 10 days later.

But that was just the beginning of his troubles. First, the landlord’s go-between took off with his six-month rent deposit. Then, after paying a second time and renovating the place, he was belatedly informed that the street was slated for demolition. He got $28 in compensation. Still, Sammies’ sandwiches, salads and fruit smoothies were an instant hit, and in 1999, two years after launching the business, Goodman opened a central kitchen, delivering food throughout downtown Beijing. To finance the $350,000 expansion, Goodman took on a Chinese investor. “That was my second mistake,” he says.

The partner kept demanding to be made majority shareholder, but never seemed to

cough up any money. It was a “miserable” experience,

Goodman, not a unique one. “Every single joint venture I’ve heard of has been screwed over. Every single one,” he says. “They do it because they can, there’s no legal recourse, because you’re in their sandbox. They don’t value what you bring to the table. It’s just a completely different way of doing business,” Goodman concludes, adding, “The Chinese are the most pragmatic people I’ve ever met. Don’t get me wrong—there are good and bad people everywhere—but doing business, oh my goodness, I wouldn’t have a full Chinese partner ever again.”

Goodman replaced his Chinese investor with a group of expats, and by 2003 Beijing Sammies was humming, with five cafés and a booming corporate catering business. Then SARS hit, stopping the city dead in its tracks. Goodman worked tirelessly through the crisis, but on his return from a much-needed vacation, he discovered several of his employees had quit to start a rival delivery service. That same day, while checking on his café in the city’s Silk Alley, he learned the locale lay in the path of the city’s notorious wrecking ball; he had a month to vacate. The coup de grâce was a phone call informing him he was being kicked out of another location to make way for a Starbucks. “I was stabbed in the back, kicked in the face and punched in the stomach, all in one day,” says Goodman.

The entrepreneur had finally had enough and sold the business, one more victim of the shifting sands and tenuous loyalties that characterize the Chinese market. But like many point out, it’s not only the Chinese who take advantage of the amorphous rules

and shades of grey. There are plenty of Canadians out to make a quick buck. “The temptation is there and the opportunity is there for anyone,” says Robert Kwauk, who heads up the China practice for law firm Blake, Cassels & Graydon in Beijing. “The rogues are not just Chinese.”

Barry London, and Ont., Stuart and Hansen by all accounts were born were in impressively smooth operators. “They were the two best salesmen I have ever come across in my life,” says Pierre Pomerleau, head of the Quebec construction firm Pomerleau Inc. “If they would have been straight and honest, they would have been billionaires.” Instead, they used their prodigious talents to pull off one of the most infamous scams in recent Chinese history, bilking international investment banks of millions and fleecing a phalanx of construction companies from Canada to France and Germany that left the Canadian government on the hook for millions.

The brothers were feted during the inaugural Team Canada trade mission in 1994 for their ambitious plans to develop what was eventually touted as a US$500-million exclusive housing development on Shanghai’s upand-coming east side. The Shanghai Links Executive Community was to include a Jack Nicklaus-designed golf course, yacht club and 800 American-style homes for the employees of multinational corporations living in China. To finance the project, the Hansens, through their Sealand Housing Corp., secured US$50 million from Bankers Trust,

Deutsche Bank and HSBC Private Equity Management, among others, in return for a 40 per cent equity stake. They promised to duplicate the model in scores of Third World countries and list the SLEC venture on the New York Stock Exchange.

Things started to smell “fishy” about six months into construction, says Pomerleau, when Barry Hansen tried to cancel the construction contract that Pomerleau shared with France’s Bouygues. Suspicious, the firms began investigating and discovered that the expat housing leases the Hansens had purportedly signed with companies such as General Motors and Exxon—which had been used to get their bank funding—had all been forged. The construction firms alerted the financial institutions, and the project’s account was temporarily frozen, touching off a legal battle spanning nearly a decade and involving half-a-dozen countries.

It would later come to light during court proceedings in Britain that the Hansens had also forged documents to show they’d paid the Shanghai government for rights to develop the 200-hectare plot. In 2001, a British judge found Sealand and the Hansens guilty of fraud, perjury and forgery, dubbing the brothers “unscrupulous traders.” But endless appeals by the Hansens delayed proceedings until 2005, when the banks were finally awarded US$60 million in damages. They have yet to see a cent, though they were able to divest themselves in 2006 of the Shanghai Links, which has since been completed by another company.

Pomerleau is clearly chastened by the experience, but at least his losses were backstopped by Export Development Canada, the government export credit agency, which shelled out $5 million in insurance claims to Pomerleau and his subcontractors. As for the Hansens, they are likely no worse for wear, says the Quebec builder. “They’re probably on an island somewhere drinking pina coladas out of a coconut,” he says.

Gervais tacular, Lavoie’s but it helps story explain isn’t quite why as Canaspecdians, despite promising starts, have very little to show for themselves in China. In 1993, Lavoie came up with the idea of selling fruit juice to a growing market of newly wealthy Chinese. He approached Lassonde Industries, the manufacturer of Allen’s and Rougement juice brands, to buy a secondhand juice machine, and ended up cobbling together a joint venture in which the Quebec company chipped in the equipment and

a Chinese partner supplied an idle cement factory and US$500,000 in seed money. The brand was called Rumeng, which roughly translates as “dreams of women” in Chinese, and its slick, black-labelled bottles of apricot, peach and strawberry nectars sold for US$10 a bottle in high-end restaurants.

Within five years of its 1995 start-up, the hugely popular drink line was ringing in annual sales of more than US$15 million and was the third-largest juice brand in China. As Lavoie tells the story, Lassonde had paid little attention to the faraway operation, happy to let Lavoie and the Chinese run the show—until it realized that Rumeng, representing just 10 per cent of Lassonde’s revenues, was responsible for a whopping 40 per cent of profits. The Quebecers decided to take charge, buying out the Chinese partner in 2000 and replacing local management with a Canadian chief financial officer and a marketing manager from France. Lavoie, with a 15 per cent stake, had no more say in daily operations.

It took just a year for profits to flatline, and by 2003 Rumeng was losing money. Lavoie and the Chinese offered to buy control of the company, but Lassonde refused, says the entrepreneur, who resigned soon after. The Que-

becers turned down at least three other buyout offers, including one from China’s largest juice company, he adds. Lassonde eventually declared a $l3-million loss on the venture and left China. The Chinese partner claims it still owes him $2.3 million. Lassonde declined to comment. “The Chinese thought, ‘this is impossible, especially from Canadian people,’ ” says Lavoie, adding, “A Chinese would never do what Lassonde did to us.”

For most Canadians, however, their greatest sin is one of omission. The Chinese market is a jungle of conflicting regulations and nebulous political machinations, and for

many a newcomer, much is lost in translation. Yet Canadian companies repeatedly fail to take the most elementary precautions or are so afraid of getting burned they miss out on huge opportunities. And it’s not just the small companies—some of Canada’s largest firms are guilty of the same transgressions.

Quebec-based Bombardier does a booming business building trains for China’s expanding infrastructure, but its airplanes have largely failed to take off with the country’s fastgrowing aviation industry.

The reason? The manufacturer, fearful its technology might be stolen, deliberated for a year over whether to strike a joint venture with Harbin Aircraft Manufacturing Corp. to build planes in northern China, according to an individual familiar with the negotiations. Bombardier’s archrival, Embraer, came knocking, and within a month inked a deal with Harbin; a year later, the Brazilian-Chinese planes were in the air, snapped up by a phalanx of Chinese airlines.

The Royal Bank of Canada opened its first branch in Beijing last year, marking a cautious return to China almost a decade after the bank was bilked out of tens of millions of dollars. According to veteran China hands, the Royal Bank cut and ran in the late 1990s after agreeing to lend money to what it believed was a subsidiary of the China

Nonferrous Metal Mining (Group) Co. Ltd., a state-run metal trader. The Canadian bank asked CNMC to guarantee the credit facility, mistakenly believing that, since it was government-owned, the guarantee was equivalent to sovereign risk and therefore backed by the government. The Chinese company obliged, providing a “letter of comfort,” which was of little consolation when the loan was drawn down and never repaid. Canada’s largest bank should have known better, say those familiar with the case, but more importantly, it should have had enough gumption to stay the course. “So somebody stole money—

last year

you learn your lesson and move on,” said one Chinese-Canadian businessman. “It’s nothing personal, it’s business.”

Doing business in China is a bit like the country’s chaotic traffic; cars regularly ignore

lights and lanes and heedlessly plow through throngs of pedestrians. Yet if you get run over, it’s your fault because even if you think you have the right of way you would be stupid not to realize that a car can kill you. In the same way, many Canadian companies have only themselves to blame when they get mowed down because they blindly adhere to traffic signals that bare little resemblance to the reality on the ground. “The way Canadians, particularly, suspend good judgment when dealing with China is absolutely outstanding,” says Balloch, the former ambassador. John Gruetzner, a Beijing-based Canadian consultant, agrees. “You can talk about Canadians being screwed in China, but you can also see Canadians screwing themselves for not understanding the market,” he says.

Altachem is a case in point. The company imported a $l-million processing machine from Italy that could not be used because it operated using refined sugar from beets when, in China, sugar cane is the standard.

It didn’t send anybody from Edmonton to oversee the operation, instead relying on a single Chinese manager who was hired because one of the company’s Chinese-Canadian employees said he knew someone back in China who spoke English. Altachem trusted government bureaucrats who promised they would give the company title to the factory land without finding out whether it was in their power to do so. Nor did it hedge against the currency exchange or take precautions to make sure it could get its money out of the country. Most fundamentally, it failed to determine whether there was really a market for its product in China. “We were promised all sorts of things and we got carried away and went,” says Madiyalakan. “We didn’t plan for failure.”