Compliance Alert: Finding and dealing with ‘Red Hats’ in China

The old Chinese saying “money and power always come together” acknowledges the prevalence of using political power to gain business advantage in China. In ancient China, governmental officials opened their own businesses, which earned them the title “Red Hat Businessmen” alluding to the official hat under the Qing Dynasty of China.   

Today, “Red Hat” generally refers to those Chinese businesses that are connected in some way with the government. 

Red Hats may be state-owned enterprises (SOE Red Hat) or purely private businesses (private Red Hat) so closely connected to the government to affect governmental decision-making, such as senior officials’ family members who act as middlemen or co-investors in projects that need government approval or backing. As a consequence of their close governmental connections, employees of Red Hats may be “foreign officials” under the FCPA.

Red Hats are playing a vital role in Chinese economy, and U.S. companies doing business in China are likely to encounter them on a regular basis, which could increase their risks under the FCPA. For example, large SOEs are a primary pillar of the Chinese economy, managing transactions in most important industries like oil and gas, steel, telecom, banking and transportation. In addition, there are another 80,000 small SOEs scattered around the country. 

As for private Red Hats, family members of politicians are themselves successful entrepreneurs, who are known to do particularly well in business due to their political connections. Even if they are not, companies still consider their political connections very valuable.

When encountering Red Hats, companies should conduct due diligence to determine whether a Red Hat qualifies as a “foreign official” and assess their risks under the FCPA:

1. Industry. FCPA risk is highest when SOE Red Hats are involved in industries where SOEs enjoy state-sanctioned monopolies, such as oil and gas, steel, telecom, banking and transportation. In these industries, most SOE Red Hats are wholly owned by the state, and the state has the power to appoint the directors and principals, as well as to approve material decisions such as mergers, divisions and dissolutions, recapitalization, and the issuance of corporate bonds. 

In practice, most of the SOE Red Hats involved in FCPA actions are in these exclusive industries, such as the industries of oil and electricity in United States v. Carson, the telecommunications industry in the SEC’s enforcement action against Lucent Technologies, Inc., and the banking industry in the investigation against JP Morgan.

In industries where SOE Red Hats must compete with private companies, FCPA risk is minimized because most of these SOE Red Hats are partially state-owned and the state nominates candidates for leadership positions rather than directly appointing them. Companies must conduct thorough due diligence to determine whether the state exerts its decision-making power through its representatives.

2. Local Policies. Local policies may shed light on the legality of payments to certain Red Hats. One example is a special Red Hat known as the “Red Hat Intermediary,” which is mostly run by private persons who are connected to the government officials, and to which the government outsources its administrative examination and approval authority. As a result, companies frequently pay Red Hat Intermediaries in exchange for licenses, permits or certifications. 

However, the State Council of the Republic of China (more well-known as the Central People’s Government) issued a Notice in 2015 denouncing Red Hat Intermediaries as a breeding ground of corruption, and announced specific measures designed to combat corruption, including narrowing the administrative examination and approval that could be outsourced, prohibiting government-related persons providing relevant services, and regulating fees and charges. This puts companies on notice of the corruption risks associated with Red Hat Intermediaries.

Special attention should also be paid to recent China capital market reforms, which introduced private and foreign investment to the SOE Red Hats, even in industries with state monopolies. These reforms reduce the likelihood that employees of SOE Red Hats may be deemed “foreign officials” under the FCPA because they decrease the political and policy-driven oversight of the government. 

The State Council still stresses that these reforms do not qualify as “privatization” and not all of the governmental management will be delegated. Therefore, in order to accurately assess the risks under the FCPA in this situation, companies need to wait for China to issue more specific guidelines.

3. Party Member. FCPA risks are heightened if the employee of Red Hat is a member of the Communist Party of China (CPC). The CPC is the only ruling political party in China, and almost all important government posts in China are CPC members.  

Whether working in government or private sector, all CPC members are required to comply with CPC’s party discipline, implement the party policy and work on the party’s goals. Therefore, CPC and the government, to some extent, are fused together. 

CPC members in the private sector are still closely associated with the governmental authority and have access to privileges rarely available to non-members, such as customs and tax preferences. 

Taken together, a CPC member is nearly indistinguishable from the government official.

4. Local Business Culture. Local business culture can also influence how to interpret the dealings between the companies and Red Hats. Chinese culture places an emphasis on the importance of strong personal relationships — even in professional settings. Therefore, in China, it is common for people who want to proceed with a business transaction to provide small favors or gifts to each other. These small favors, such as providing an internship or referring business to an official’s family members, can create great risks under the FCPA because they are likely to be interpreted as intending to corruptly influence the officials to obtain or retain business. 

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While China will continue to attract significant foreign investment, companies must be aware that they are likely to encounter Red Hats who bring risks under FCPA.  

To reduce such risks, companies should determine through due diligence whether employees of particular Red Hats qualify as “foreign officials” for FCPA purposes. They can then begin to safeguard themselves and their employees from enforcement risks.

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Yihong Zhang received her Juris Doctor from The George Washington University Law School in 2016 and an LL.B. from the Renmin University of China in 2013. During law school, she interned with the Financial Integrity Unit of the World Bank, focusing on international compliance practices in anti-corruption and anti-money laundering. She can be contacted here.