On Friday, September 19, people from Beijing to New York could be seen celebrating the success of the Alibaba IPO. For months leading up to the offering, analysts and commentators had cautioned U.S. investors to be wary of the Chinese e-commerce giant. The skepticism was largely due to questions concerning the company’s corporate governance structure, known as a variable interest entity or “VIE”. The initial numbers and the subsequent celebrations, however, suggest that investors are not concerned. The stock (ticker symbol “BABA”) finished the trading day at $93.89, 38% above the initial set price of $68 and well above the average 26% IPO jump for U.S. listed technology and internet deals this year. This puts the company’s market value at $231 billion and, depending on whether underwriters exercise their stock options over the next couple of weeks, could make Alibaba the largest ever IPO in U.S. history. Despite the seemingly successful offering, however, the jury is still out on the soundness of individuals investing in VIEs, as it is yet to be seen whether the resurfaced questions surrounding the structure will spark any action by regulators.
Originally developed as a workaround to Chinese regulations, VIEs allow Chinese companies to raise capital in industries in which direct foreign investment is restricted or limited, such as technology, while at the same time continuing to operate in China. Under a VIE structure, foreign investors purchase shares in an offshore entity, typically a shell company in the Cayman Islands, which has neither equity in the Chinese operating company nor any revenue generating business of its own. Rather, the shell company derives economic benefits solely through a contractual agreement with the operating company. Simply put, investors of Alibaba are not really buying shares of Alibaba, but are instead buying shares of a holding company that has the contractual rights to Alibaba’s profits. Since neither the shell company nor the operating company is based in the U.S., however, the necessary assumption is that the contracts will be legally enforceable in Chinese courts – an issue that has yet to be decided.
Though Alibaba is hardly the first company to use the VIE structure (over 90 Chinese companies listed on the New York Stock Exchange and NASDAQ are VIEs), the sheer size of the IPO has brought attention to the structure’s questionable legality. This includes a letter from Senator Bob Casey urging the SEC to take a closer look at VIEs due to their inherent opaque design, as well as a cautionary report by the U.S.-China Economic and Security Review Commission warning that “relying on Chinese courts to uphold the VIE contracts is highly risky.” Alibaba itself has been very open about the risks associated with the structure, making very clear in its SEC Form F-1 filing that “if the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment . . . we could be subject to penalties or be forced to relinquish our interests in those operations.” In other words, if Chinese courts deem variable interest entities illegal, U.S. shareholders will have no legal recourse to recover losses.
Although legal precedence is lacking, there have been some indicative decisions from the Chinese government recently. In 2013, for example, China’s top judicial body ruled that a comparable agreement between Hong Kong and a Mainland companies was tantamount to “concealing illegal intentions with a lawful form.” Additionally, the General Administration of Press and Publication in 2009 published a notice explicitly prohibiting VIEs in the online gaming sector. Coincidentally, what was perhaps most telling of the Chinese government’s stance on VIEs was its silence during Alibaba’s 2011 dispute with Yahoo, which at the time owned a 43% share in Alibaba. Jack Ma, Alibaba’s founder and CEO, unilaterally and secretly spun off Alipay, a then-profitable part of Alibaba, to a separate the company that Ma himself owned. After heated public argument, the two companies eventually reached a deal which allowed Yahoo to indirectly participate in Alipay’s profit. Despite the publicity of the dispute, the Chinese government remained relatively silent on VIEs in 2011, and continues to do so now.
Considering that neither Yahoo, motivated by a 43% ownership position, nor the potentially largest IPO in U.S. history could compel action by regulators, investors should still be wary of VIEs. From China’s standpoint, the ambiguity surrounding VIEs has obvious benefits: the technology industry benefits from foreign capital while the government may at any time declare VIEs illegal. Until Chinese regulators have incentives to take a firm stance, U.S. investors will remain vulnerable. The success of Alibaba’s IPO does little to change that and the related celebration is at best premature.