The Alibaba F-1, filed on Tuesday, states that its Chinese counsel, Fangda Partners, believes the company’s contractual relationships are in accordance with the laws of the People’s Republic of China. The document also notes that Fangda believes “there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, rules and regulations.”
In reality, the legality of Alibaba’s contractual arrangements is very much in doubt. As a result, Beijing has the right to effectively confiscate the business of the issuer. Investors are making a bet that Chinese officials will not do so, but the risk of such an adverse event is not small—and there are indications that the risk will increase over time.
Alibaba’s e-commerce business is off-limits to foreign ownership, which is why investors, in one of the most anticipated IPOs in history, are not buying stock of a Chinese company. Instead, they will get shares of Alibaba Group Holding Limited, which is incorporated in the Cayman Islands. Group Holding Limited sits atop a complicated “Variable Interest Entity” structure that, through a series of contracts, gives the company the economic benefits of ownership of the Alibaba business.
Chinese internet businesses with foreign “owners”—including Weibo Corp., whose high-profile offering occurred in the middle of last month—invariably have VIE structures. The argument is that the Chinese government has effectively blessed the arrangements by permitting offerings in offshore markets to go forward. Moreover, people believe that if Beijing were to declare a VIE arrangement illegal, it would be like setting off a nuclear weapon, shutting off new Chinese companies from foreign equity markets. The arguments sound compelling, and in fact they are good enough for foreign investors in a string of recent offerings.
What’s wrong with the narrative? For starters, the Supreme People’s Court, the highest tribunal in the People’s Republic, declared the contractual arrangements under consideration in the Chinachem case, similar in effect to VIE structures, to be illegal. The 2012 decision has no technical value as precedent—China, after all, is a civil law jurisdiction—but the court’s reasoning is sound and consistent with rulings in other countries. All the Chinachem judges did was point out the obvious: complicated schemes will not be respected if they were structured to evade the clear intent of Chinese law. Arbitration rulings in Shanghai on VIE structures, not surprisingly, have come to the same result.
Alibaba investors need to remember how these disputes come about. Chinachem, a Hong Kong business, made an investment, indirectly, into China Minsheng Banking Corp. After the value of the Minsheng shares soared, the Chinese parties decided to cut out Chinachem, starting a long chain of events that led to the confiscation of its share interest.
Think this isn’t relevant to Alibaba? Jack Ma, the driving force behind the e-commerce giant, put together a VIE structure in order to entice Yahoo! into taking up a large minority stake in Alibaba in 2005. In a two-stage transaction in 2009 and 2010, he transferred Alipay, Alibaba’s increasingly valuable online payment arm, to an entity in which he had a substantial interest, all without informing the Sunnyvale, California company. When Yahoo! learned of the surreptitious transfers, Ma defended the moves by stating that the People’s Bank of China, China’s central bank, had demanded them in order to obtain a necessary license. In essence, Ma argued Alipay could not operate its business because of the VIE arrangement he himself had put together.
If Alibaba is such a good investment—I think it isn’t but that’s another story—what is to prevent Ma from trying the same maneuver some years down the road when the stock has increased in value?
Or what is to prevent him from disadvantaging shareholders soon after the offering? In fact, there is already pressure for him to eject foreign shareholders. As soon as the F-1 was filed last week, China’s noisy netizens were calling Ma a “traitor”—a word that for historical reasons has more emotional resonance in China than almost anywhere else— for permitting Yahoo! and SoftBank, a Japanese company, to take large stakes in Alibaba.
The Communist Party has noticed the anti-outsider anger simmering in society. Since last year it has been launching what look to be discriminatory investigations of multinationals. It is, therefore, not too much of a stretch to think that officials will take a fresh look at Alibaba’s VIE structure, especially because many of them want to keep profits generated in the China market at home.
Chinese officials have repeatedly tried to declare VIEs illegal. As the O’Melveny law firm notes, five years ago one department, the General Administration of Press and Publications, even banned them in an industry where they had already been employed in foreign offerings. Chinese internet companies have since used VIEs in numerous offshore listings, but that victory is by no means final.
Just ask the institutional investors in China Unicom. Beijing in the middle of the 1990s permitted foreign companies to buy stock in that telecom company through the China-China-Foreign structure, which like VIEs blatantly skirted clear Chinese prohibitions on foreign investment. Eventually, the central government forced those structures to be unwound, with disadvantageous consequences for Unicom’s ejected foreign investors.
There is also an over-the-horizon political risk factor for Alibaba. It appears that Alvin Jiang, the grandson of former leader Jiang Zemin, holds a large block of Alibaba shares through Boyu Capital. Some observers believe Xi Jinping, the current ruler, is gunning for his grandfather or will do so soon. At the moment, the Jiang family looks safe, but that could change fast as Xi’s ambitions soar and as his investigations, detentions, and purges of Jiang’s protégés intensify. If Xi goes after the family itself, Alvin’s high-profile Alibaba stake will probably come under scrutiny, and any investigation could broaden out to a general questioning of effective offshore ownership of the company, something possible in a China where anti-foreigner sentiment is on the upswing.
Foreign investors in Alibaba Group Holding Limited look like they will be at the mercy of hostile forces in a volatile situation. Most foreign owners of Alibaba shares will have little understanding of internal Chinese politics, and none of them will have any control over them.
Follow me on Twitter @GordonGChang and on Forbes
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