China’s Corporate Credit Risk Classification System – What We Know

A classification system under the China corporate credit system will be rolled out nationwide over the next two years. Under the system, companies operating in China will receive a grade based on their risk level for engaging in bad behavior. Higher-risk companies will be subject to more scrutiny and a higher frequency of random inspections, whereas low-risk companies will benefit from less interference from regulatory authorities. The new system aims to improve the business environment by reducing bureaucratic procedures for compliant companies and help authorities better allocate resources for supervision.

On January 13, the State Administration of Market Regulation (SAMR), published details of a new plan to create a corporate credit risk classification system (“classification system”). This classification system would classify companies operating in China into four different categories depending on their previous behavior, which will then decide how much regulatory supervision they will receive from local market supervision departments. 

The SAMR is China’s main market regulator and has oversight over a wide range of market issues, such as business registration, pricing supervision, quality control, drug approval, food safety, intellectual property protection, and anti-monopoly matters. 

The establishment of the classification system is part of a wider effort by the government to minimize bureaucracy for companies that have a history of compliance and good behavior, cultivate a better business environment, and foster innovation. At the same time, it aims to help market regulatory departments better allocate resources and accurately target and reprimand companies that engage in illegal, anti-competitive, and ‘untrustworthy’ behavior. 

A pilot program of the automated classification system has been carried out in Shandong province since 2019, and the new implementation of the system will be based in part on the results of this test run. 

In this article, we provide an overview of how companies are evaluated and classified under the classification system and discuss the impact it will have upon companies in China. 

Background: China’s corporate social credit system 

China first announced the social credit system and corporate social credit system in 2014. Since then, the corporate social credit system has grown into a comprehensive mechanism for collecting, aggregating, and analyzing data from businesses to create a score that determines rewards and punishments. 

Businesses are mostly assessed on standard regulatory and compliance criteria that they are already legally required to fulfill. This includes paying taxes on time, holding requisite licenses, meeting product quality standards, and fulfilling environmental protection requirements. Additionally, companies are subject to an array of industry-specific requirements depending on the nature of their business.

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Among other measures of the China corporate credit system are a number of entity lists that keep track of companies that have engaged in ‘untrustworthy’ or illegal behavior. This includes the Seriously Illegal and Dishonest Entities List, which subjects companies to certain restrictions, such as disqualification from government reward schemes, increased frequency of inspections, and other regulatory measures. This list is a measure taken in addition to other legal punishment or fines meted out as a result of the infringement. 

The new classification system is an additional tool for the SAMR to assess the behavior and risk of illegal activity by companies, and help it better allocate resources and more accurately target non-complying companies. 

How are companies classified under the system? 

Companies will receive a grade from A to D based on their prior behavior. The grade that companies receive will determine how frequently it is subject to random inspections by the regulatory authorities. The results of any random inspections will also be made available to the public, but the grade itself will only be used internally by the relevant regulatory departments. 

It is important to note that this classification system is mainly for general-purpose use and will not replace other means of determining market regulation of companies in different professional fields. Industries that can impact the safety of life and property, public safety, and other key areas that can cause social harm – food, medicine, special equipment – will also be subject to additional market supervision requirements. 

According to a report published by SAMR detailing the results of the Shandong pilot program, issues were found during random inspections of grade B, C, and D companies in 8.77 percent, 12.26 percent, and 38.96 percent of instances, respectively. The Shandong pilot program also included an ‘E’ category (which revealed issues in 53.7 percent of random inspections), but it appears to have been scrapped for the nationwide scheme. 

How does the system assess companies’ credit risk? 

Local market regulation departments will be required to gather a range of information on companies, which will be compiled into a ‘national corporate credit information publicity system’. A company’s credit risk status – and associated grade – will be determined automatically based on this information. This information will be updated constantly based on the findings from inspections and interviews. 

The information includes: 

• Company registration, filings, and equity pledge registration 
• Intellectual property pledge registration
• Administrative licensing
• History of administrative punishment 
• Inclusion in the list of abnormal business operations and serious untrustworthy entities 
• Information from random inspections 

Local market regulation departments will also be tasked with differentiating the classification system for companies engaged in different fields and industries, which will therefore require specific information. These indicators will also be weighted differently depending on how important the information is for the credit risk of a company operating in its given field or industry. 

Corporate credit risk information related to specific fields may include: 

• Information on safety supervision of drugs, special equipment, and quality of industrial products 
• Infringement and counterfeiting
• Price enforcement, anti-monopoly, and anti-unfair competition enforcement 
• Consumer rights protection requirements 
• Requirements such as measurements, standards, inspection and testing, certification, accreditation, etc. 

According to the guidelines, the system’s mechanism will automatically assess a company’s corporate risk level by using “modern scientific and technological means such as big data, machine learning, and artificial intelligence”. 

When will the classification system come into effect? 

A specific date for the implementation of the system has not been announced yet, but the guidelines issued by SAMR set out two concrete goals for provincial-level market regulation departments to meet: 

• By end of 2022: Establish a general-use corporate credit risk classification mechanism and scientifically classify all corporations under the jurisdiction (of the local market regulation department); begin requisite work, such as random inspections and publication of results, based on the companies’ classification. 
• By end of 2023: Combine corporate credit risk classification management system with the regulation of various professional fields and establish a complete corporate credit risk classification mechanism targeting different professional fields. 

In addition, the guidelines state that departments must strive to have fully implemented the entire system within three years. This includes not only the classification system and the management of the system itself, but also an early warning and detection system, processes for warning and reprimanding companies, and handling credit risks. 

Early warning and risk prevention 

In addition to assessing companies’ current credit risk levels, the guidelines require an early detection and warning system for potential risks to be built into the classification system. This will allow local regulatory departments to determine potential risks by first identifying behavior and activity that is closely correlated with high corporate credit risk. This behavior would also be adjusted for different professional fields.  

Such behavior and activity could include abnormal registration, abnormal amendments to registration, or an unusual increase in complaints and reports. This activity is monitored and updated in real time, which will allow the regulatory department to promptly identify and get an early warning of potential hidden risks. The regulatory department can then issue reminders and warnings and conduct interviews or inspections of the company.

Impact on domestic and foreign companies 

The new system applies to all companies that operate within China. There is also currently no indication that foreign companies will be treated differently under the system, and they will have to comply with any requests from the regulatory authorities and accept the results of evaluations and random inspections. According to the report on the pilot program in Shandong, in 2021, the ratio of random inspections of companies classified as grade B and C was reduced to 1 percent and 0.8 percent, respectively, whereas Grade A companies were not subject to any inspections.

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In the long run, the new classification system can help to reduce bureaucracy for companies operating in China. It may act as a kind of reward system for companies that are well-behaved, reducing costs and labor associated with accommodating random inspections and other supervisory requirements. 

However, there remain several unanswered questions with regards to the implementation of the system. One issue that may be of concern to companies is the accuracy of the automated classification system, especially in the early stages of implementation when technical issues may not yet have been ironed out. Currently, the SAMR has not indicated a mechanism for companies to appeal if they disagree with the outcome of the automated evaluation. 

In addition, it is currently unclear exactly what steps companies must take, and how long the process will be, to be reclassified as low risk or general risk if it has previously been categorized as high risk. However, information in the report on the Shandong pilot program states that company classification was updated monthly, indicating that the company can change its course fairly quickly. 

At the same time, the guidelines also urge local market regulation departments to “strengthen communication with enterprises, remind enterprises of risks in a timely manner, and guide enterprises to strengthen self-management, self-discipline, and operate with integrity in accordance with the law”. This indicates that local regulators are required to aid companies to help them comply with the requirements. 

Foreign companies operating in China are advised to maintain close communication with the regulatory department in their jurisdiction to ensure compliance with all local laws and administrative requirements. For help with legal, financial, HR, and operational due diligence in China, speak to one of our local professionals by contacting China@dezshira.com. 

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