China Corporate Social Credit System (Part 3): consequences for businesses (punishments & rewards)

In our previous articles, we discussed the underlying structure and mechanisms of China’s Corporate Social Credit System and concluded that the goal of the Corporate Social Credit System is to enforce existing and new regulations. Furthermore, in our second article we explained how the enforcement of these regulations would be stricter and more systematic, where the Chinese Corporate Social Credit System assesses compliance based on scale ratings and a blacklisting system.

In this final article in our series on China’s Corporate Social Credit System, we elaborate on the consequences for businesses if they have received a negative rating or have become blacklisted and the rewards the receive if they receive a positive rating. Within this article we also provide and summarize the remedies available within the Corporate Social Credit System to rectify bad ratings and blacklisting.

Punishments framework within the Corporate Social Credit System

Within the framework of the Chinese Corporate Social Credit System, companies can experience both punishments and rewards, where we will describe its negative components first. Particularly companies that get blacklisted will be subject to a variety of disciplinary measures by the government, but also bad credit ratings can have negative consequences.

Below you can find a summary of the primary disciplinary measures companies with bad credit will face:

• Restrictions on the issuance of stocks.
• No invitation for bidding and tendering of government projects.
• Restrictions when applying for government funding.
• Restrictions when applying for tax preferences and other administrative disciplinary measures.
• Restricted access to credit.
• Restricted access to flight tickets (for key personnel).
• Restricted access to luxury consumptions such as high-grade seats of trains and high-speed railway tickets (for key personnel).

Companies and their related key personnel whom refuse to follow administrative punishments, repeatedly commit crimes and cause major losses, will receive market and industry ban measures for a certain period of time, until they are ousted from the market forever.

On top of the punishments implemented by governments, low ratings also affect companies in the market. When potential customers or partners perform background checks in the available systems and discover a company is rated “poor”, they may decide not to engage in business with the company in question. This could even be the case for “medium” rated entities. Therefore, the publicness of the system will likely cause a negative spiral by social consequences on top of the government sanctioned disciplinary measures.

Furthermore, the government will implement strict supervision and increase disciplinary efforts related to the safety of people’s lives and property. For example, companies active in industries such as food and medicine, ecological environment, urban safety among others may face increased scrutiny.

In the subsections below, we have further highlighted several direct and indirect consequences which companies may face in the wake of the Corporate Social Credit System which we consider of particular importance.

A. Government inspections

The type of rating which companies will receive will have a direct impact on how often a company will be inspected by relevant government authorities. Companies with good ratings will have a lower frequency of inspection, which reduces the impact inspections have on the normal production and operations of the company. Companies with bad ratings, however, will have higher frequency of inspection and thus may feel a higher burden on their normal operations.

To avoid corruption or strong ties between companies and government officials, the inspector and the inspected company are randomly linked. The inspection information is publicly available; therefore, the principle is coined the “double random, one open”. This idea is part of the government version of the Social Credit System.

B. Connection with personal credit scores of key personnel

It is important to note that the credit records of a company are tied to the credit records of its key personnel, and in particular that of its registered legal representative. This connection works twofold. Firstly, if a company is blacklisted, its senior management will have their personal credit downgraded and may even risk getting blacklisted. The legal representative of a blacklisted company can for example not become legal representative of a new company.

The effect of an individual being blacklisted may have even further reaching consequences. For example, Credit China reported that in certain cases the legal representative of a blacklisted company will be unable to complete immigration procedures. And in addition to being unable to buy flight or train tickets, individuals may experience difficulties purchasing insurance or real estate.

Secondly, the personal credit score of the legal representative also affect the company’s credit score. For example, if a legal representative as an individual is rated as a D-rated tax payer (on a scale of A to D, A being excellent and D being poor), the tax authority will also rate his company a D-rated tax payer.

Since companies can be blacklisted when they cannot be contacted on the registered address or when they fail to file annual reports, it is of utmost importance to be aware of all companies where you as an individual are registered and ensure these companies are compliant. Similarly, it would be important for companies to vet the credit rating of potential senior management personnel.

C. The interconnectedness and large burden that arises because of the Corporate Social Credit System

Under the “unified rewards and punishments” framework, being blacklisted by one state agency means being subject to punishments and restrictions by many, if not all, state agencies. The framework is supported by a range of Memoranda of Understanding (MoUs) signed by multiple government agencies, promising to enforce each other’s blacklists and redlists. As of now, between 20 to 30 government agencies have signed these MoUs. More than 50 of said MoUs have already been signed for the implementation of the system. For example, the tax authority and customs authority have signed an MoU and therefore if a company is blacklisted by the tax authority, it can no longer be treated as an authorized economic operator [AEO] certified enterprise by Customs.

A big risk related to this interdependence is that a small mistake in one area, can ripple through the whole administrative system and affect the company in virtually all aspects of their business. This could cause a vicious downward spiral for companies that make a mistake. Because of the relative sensitivity of the Corporate Social Credit System to violations, it is of utmost importance to be fully compliant and avoid potential problems.

Another important risk that many companies are unaware of, is that the rating of business partners can affect their own rating. Failure to properly monitor business partners’ activities can therefore negatively affect the company. Therefore, a company not only has to keep track of its own ratings, but also of their partners. This obviously adds another burden, because of the time required to check the rating of all business partners. This is a problem particularly for smaller companies, as they do not have the manpower nor funds available to do this.

Admittedly, the Chinese Corporate Social Credit System adds the advantage of easier due diligence when selecting new business partners. A thorough check in the available databases should reveal businesses with ‘irregularities’, so companies can avoid these businesses.

Rewards within the framework of the Corporate Social Credit System

Although China’s Corporate Social Credit System is built on the joint punishments and rewards mechanism, it is argued that in the system the emphasis is on punishments and that rewards are fewer in number and hard to quantify. Admittedly, it is easier to measure and observe when a company is untrustworthy or non-compliant than when a company exceeds expectations.

During a briefing on the implementation of the system in July 2019, Lian Weilang, Deputy Director of the NDRC, acknowledged this issue and emphasized that the government would increase its effort to formulate rewards. According to Lian, the rewards can be summarized as “three better, two lower”; meaning better administrative services, better financing services, and better public services, as well as lower regulatory costs and lower transaction costs.

These measures would make life easier for the excellent companies, however, obtaining an excellent scale rating seems to be very difficult. In the first round of credit evaluation of more than 19,000 firms in the coal sector, only 98 were rated excellent and 1,868 were rated as bad. Although the coal sector isn’t the best example to find “excellent” companies due to the environmental impact of the sector in general, this illustrates that it is exceptional to receive an excellent rating.

We suppose that the bulk of companies in China will be categorized in the two middle scale ratings. There are no specific punishments or rewards for companies in these two categories and therefore, these can be seen as mere indications of whether a company is closer to an excellent or poor rating.

Restoration and remedies

An important focus point for the government within the Corporate Social Credit framework is the potential for credit repair. It is one thing to create a listing of untrustworthy behavior, but the government realizes it is essential to have a system in place for companies to rectify mistakes and remove the impact of negative consequences.

Therefore, a restoration process has been developed. This means that some blacklist entries can be restored, whereas others cannot be restored. Entries relating to public safety violations or serious crimes cannot be restored and such a record will be permanently available in public databases. The entries that can be restored usually will remain in the system for a certain time period. As can be seen in the figure below, the timespan a record will remain in the system depends on the type of entry.

Finally, in order to restore a credit rating, a company cannot simply rectify the original problem and automatically get the credit restored. On the contrary, companies will have to submit an application to have their credit rating repaired. Depending on the type of negative rating and method of application, certain documents have to be supplied. As can be seen from the figure, a serious breach of trust listing requires more materials. In such cases, the key personnel has to follow credit repair training and hand in their participation certificate and a credit report must be supplied as well. Such trainings can only be provided by licensed and certified companies.

Conclusion

As discussed in our previous article, although the Chinese Corporate Social Credit System does not necessarily introduce many new regulations, compliance with existing regulations has become increasingly important.

Even though the requirements which companies must meet are well-defined in existing and new regulation, there currently is no specific database which summarizes all these requirements. Because of the large burden that arises, particularly SMEs, whom have limited manpower and funds to follow up on all requirements, may be adversely affected. Nevertheless, we urge all companies to map out their current social credit status and review company processes because China’s Corporate Social Credit System will be fully implemented as of 2020.

In addition, we believe that with the limited potential to obtain rewards and high risks for punishment, the Corporate Social Credit System will likely foster behavior of avoiding a poor rating and not so much striving for excellence.

If you have any questions about China’s Corporate Social Credit System and how this may affect your company, please do not hesitate to contact us at info@msadvisory.com or check out our dedicated Corporate Social Credit System Services page.

Our China Corporate Social Credit System Series

Part 1 The underlying structure and mechanisms
Part 2 How do the ratings and blacklisting work?
Part 3 Consequences for businesses (punishments & rewards)

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