Alibaba has been a Wall Street darling in the run-up to its initial public offering (IPO) in the United States, but things could be very different in a heartbeat.
The potential game changer? A warning by a Sino-US trade vetting body about “major risks” from buying Alibaba stock or shares of any listed Chinese company that uses the variable interest entity (VIE) mechanism.
US-listed Chinese companies, such as Baidu and JD.com, have such a shareholding structure, but why single out Alibaba and why now?
There are two possible explanations.
One concerns Alibaba’s size. The company could be the largest technology IPO in US history.
Another is that investors may recall how Alibaba founder Jack Ma had stripped off Alipay, the group’s valuable third-party online payment system, and put it under his personal control despite objections from Yahoo, its main shareholder.
But if the VIE is so controversial, why is this highly complex and risky structure even allowed in the first place?
Interestingly, this issue is not addressed by the US-China Economic and Security Review Commission, which issued the warning in a report to the US congress.
The report merely states that “for US investors, a major risk is that the Chinese shareholder of VIE will steal the entity, ignoring the legal arrangements on which the system is based”.
It concludes that US investors face a high risk if they invest in Chinese internet companies that are usually listed through VIE.
This is a problem for investors as VIE is the only way for Chinese internet companies to raise funds from stock markets overseas. In fact, all Chinese tech firms listed in the US are structured similarly.
The Chinese government restricts foreign ownership of sensitive industries and technology firms are just some of them.
To bypass these restrictions, tech firms that want to raise money overseas set up two main entities, one Chinese, the other foreign.
The Chinese business controls licenses and other assets required to do business in China. This entity pays all fees and royalties to the foreign entity under a complex arrangement that ensures the economic benefits of the Chinese operations flow to shareholders in the foreign entity, or the listed entity accessible to investors.
This means that under a VIE structure, foreign shareholders do not own the assets of the company; they simply enjoy the economic benefits produced by the operating company in China.
One big loophole is that the controlling shareholder of the Chinese entity could move the group’s assets around without the need to notify the shareholders of its foreign entity, a nightmare for foreign investors.
VIE is a grey area in Chinese corporate law. The government has yet to explain whether the structure is illegal or not.
The US commission report says many US legal experts believe VIE is illegal under Chinese law and that if something goes wrong, there is no way to bring the dispute to arbitration.
The Chinese government has been urged to issue clear guidelines on VIE and lift related acquisition and fundraising restrictions.
Baidu chief executive Robin Li and Suning Commerce president Zhang Jidong are among those who want the central government to come clean.
Meanwhile, the US commission report is cooling some excitement about Alibaba.
To think it has been doing some dazzling deals to boost its value and stir investor interest.
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