Chinese e-commerce giant Alibaba’s upcoming IPO on the New York Stock exchange is widely expected to be the largest ever in US history. But just how much risk are investors willing to take on to get a piece of the action?
Just last week a US Congressional Commission report warned that shareholders face “major risks” from investing in Chinese internet companies like Alibaba that use a variable interest entity structure to get around China’s foreign ownership laws.
Foreign ownership is prohibited in key areas of the Chinese economy including in finance, media, education and the internet. In essence foreign companies are not legally eligible to run an internet business in China such as Alibaba. So they have to enter into a set of contractual agreements -- the VIE -- with Chinese nationals who hold the licences to reap economic benefits from its investment and exercise indirect control.
Here, for example is the VIE structure of Weibo, China’s leading micro-blogging website.
When foreign investors buy shares of Weibo on the NASDAQ, they are buying into Weibo Corporation in the Cayman Islands. That company is then linked to a string of other companies through a byzantine series of contracts that attempt to mimic the conventional control normally obtained through ownership.
The result is an extremely precarious situation in which Chinese regulators are told the business is Chinese-owned and foreign investors are told they own it. As the US-China Economic and Security Review Commission report states: “Neither claim is technically true, and the arrangement is highly risky and potentially illegal in China.”
Because of the shaky ground the structure is built upon, "the contracts are only binding and enforceable if Chinese courts are willing to uphold them", the report says. The major risk for US investors is “that the Chinese shareholder... will steal the entity, ignoring the legal arrangements on which the system is based" it said.
The report highlighted that Alibaba’s filings with the Securities and Exchange Commision ahead of its IPO indicate that it will use VIEs as well as a dual share preferential stock structure that consolidates control of the company with its founders in China.
"Alibaba's controversial history, with its first major foreign investor Yahoo, sheds light on the risks US investors face in buying into Chinese internet companies under the VIE structure," it said.
In 2011, Alibaba CEO Jack Ma secretively spun off Alipay from Alibaba Group, placing it under his own control in what has been the most high-profile case of the VIE structure being used against the interests of its foreign investors.
Legal developments in China in the past couple of years have prompted regulatory bodies in the US and Hong Kong to demand more assurances from Chinese companies that they have a solid legal grounding for the use of the structure.
The first major warning came in October 2012, when China’s Supreme People’s Court invalidated similar contracts between Chinachem Financial Services, a Hong Kong company, and China Small and Medium Enterprise Investment, a mainland Chinese firm. The Supreme Court ruled that the agreements between the two companies were invalid and aimed to circumvent Chinese laws and regulations. The arrangement, the ruling stated constituted “concealing illegal intentions with a lawful form.”
Despite there being a number of other decisions that seem to indicate VIEs have completely fallen out of favour in China, the recent spate of Chinese companies listing on overseas bourses suggests Chinese regulators have tacitly approved it, says Paul Gillis, a visiting professor of accounting at Peking University’s Guanghua School of Management.
“I’m expecting to see reform some time in the next year or two which will regularise these structures and basically make them unnecessary,” says Gillis.
Closing the regulatory loophole would not only benefit foreign investors but Chinese investors too, he says.
“If China allowed direct investment into the internet sector, those same Chinese companies could get listings on China’s stock exchanges and sell their shares to Chinese people.”
It’s unlikely that investors’ appetite for the upcoming Alibaba deal will be dampened by concerns over the company’s structure. Gillis, who is no fan of the structure, says it has done as much as they can to minimise the amount of business that they conduct within the VIE.
“What we have seen in the past is that the highest risk VIE structures are those where the entire business is operated in the VIE because in those situations, it’s much easier for the owner of the VIE to simply take the business and disregard the contract.”
In a letter to employees at the time of the Alibaba IPO filing, Ma said that “a public listing has never been our goal” but was merely “a gas station along the road to the future” and that after going public, the company would continue to adhere to the principle of “customer first, employee second, shareholder third.”
Until real reforms are made, investors will need to decide just how much they trust Jack Ma to look out for their interests.