Alibaba, China’s biggest tech company and a sort of mash-up of amazon.com, EBay, and PayPal rolled into one, just had its IPO on the New York Stock Exchange. The IPO was the third largest in history and Alibaba now has a greater market capitalization than CitiGroup or Facebook.
And, thanks to the byzantine rules that govern foreign investment in China’s stock market, no one who bought stock during the IPO actually owns a single share of Alibaba.
It is illegal under Chinese law for foreigners to own stock in certain categories of companies. Internet companies, for example, are off limits thanks to China’s obsessive desire to stamp out political dissent. Alibaba is very obviously an internet company and as such cannot have foreign stockholders. How, then, can Alibaba have an IPO on an American exchange?
Alibaba has taken advantage of an obscure and complex investment vehicle called the Variable Interest Entity, or VIE. The VIE is how a number of Chinese tech firms have managed to trade on western exchanges in spite of China’s capital controls. There are currently eleven Chinese tech companies besides Alibaba trading on New York exchanges with a combined market capitalization of over $150 billion, all of them using the VIE structure. This includes Baidu (China’s largest search engine) and JD.com (China’s second largest online retailer after Alibaba). The VIE gets around the prohibition on foreign ownership of internet firms by setting up a holding company (usually based in an offshore tax haven) that owns a Chinese subsidiary which then enters into a contract with the original Chinese tech firm entitling the Chinese based subsidiary to part of the profits of the original Chinese firm and obligating the subsidiary to the debts of the original Chinese firm.
In the VIE structure, American stockholders don’t own the Chinese company. They just own a company that has some contracts that are supposed to mimic what it would look like to own the Chinese company. You’re not buying stock in Alibaba when you buy Alibaba on the NYSE. You’re buying a holding company called Alibaba Holdings registered in the Cayman Islands with a claim on some of Alibaba’s profits but no actual ownership stake. You don’t own shares in the real Alibaba and you don’t get a vote in how Alibaba is run, although you do get to share in Alibaba’s profits.
The danger some observers have noted is that those contractual claims on Alibaba’s profits are only enforceable in a Chinese court (because the contract is between the Chinese subsidiary of the Cayman Islands-based holding company and the Chinese incarnation of Alibaba). Will those contracts between the Cayman Islands Alibaba and the Chinese Alibaba be upheld in court? Many experts in Chinese law doubt it. Last year, China’s top court, the Supreme People’s Court, held that an ownership scheme where a Hong Kong company used Chinese subsidiaries to buy a Chinese company that was off-limits to foreign owners was illegal. In that case, a Hong Kong-based firm called Chinachem Financial Services created a subsidiary corporation registered in China that bought shares of a Chinese Bank called Minsheng Bank. Foreign investment in banks is, like investment in web services, highly restricted. When a dispute arose out the arrangement the case went all the way to China’s Supreme Court. The Court held that the arrangement was designed to circumvent ownership restrictions and was invalid under Chinese law.
That scheme, unlike the VIE structure, involved actual ownership and control of the restricted Chinese firm by the mainland Chinese subsidiary. A VIE, by contrast, exercises no voting control over its Chinese partner firm. The foreign holding company and its Chinese subsidiary have a contractual right to profits but they don’t own shares and so exercise no control. Because foreigners don’t control the business the risk of foreign influence in critical industries that Beijing seeks to curb are not present. Further bolstering the case that VIE’s will ultimately be upheld is that the Minsheng Bank case has not been published, which means that it is not technically a binding precedent.
Not everyone is convinced that the distinction between the VIE structure and the typical parent-subsidiary structure the Minsheng Bank case dealt with will be enough for VIE’s to survive legal scrutiny. A year before the Minsheng Bank Case, the China International Economic & Trade Arbitration Commission (CIETAC) ruled on a case of a Singapore firm that used a VIE-type structure to invest in Chinese online gaming firms. CIETAC, the largest international business arbitration body in China, ruled that this arrangement was invalid because it attempted to skirt foreign investment controls. This case has led some observers to argue that the VIE structure would not stand up to scrutiny (though arbitration awards are not binding precedent).
The implications of the CIETAC case are not so clear cut. Online gaming is subject to additional restrictions on foreign investment that bar direct ownership as well as the kind of complex contractual arrangements presented by a VIE. If the direct ownership and the VIE are prohibited by Chinese law when it comes to online gaming but only direct ownership is prohibited in other sectors then we can infer that China intended to bar the VIE in online gaming but not in those other sectors. In the law, qui tacet concenti (silence gives consent).
Whether the VIE could survive a challenge in China’s courts depends in large part on these small distinctions of law (as with the CIETAC case) and fact (as with the Minsheng bank case). These distinctions present hope and danger in roughly equal measure. On the one hand, because under the VIE structure there is no direct foreign ownership and no foreign control it is possible that China’s judiciary will not invalidate the VIE structure the way it invalidated the arrangement in the Minsheng Bank case. The business structure is different enough that the court could find that the factual differences between the two cases necessitate a different result. This is the part that gives investors hope.
The danger lurking on the other side is that the very thing that may make the VIE legal could make it less desirable from a business perspective. The investors in the VIE really don’t exercise control over Alibaba. Investing in a company and getting no say in how the company is run is a significant risk in its own right even if courts uphold the arrangement. The degree to which foreign investors will not control Alibaba is made clear from the strange tale of the AliPay spinoff. In 2011, Yahoo! was one of the largest investors in Alibaba. At this time, Alibaba founder Jack Ma was developing a Chinese doppelganger for the online payment service PayPal. He called his service AliPay. That same year the People’s Bank of China announced that it would soon be imposing new rules on foreign investment in online payment services that would limit AliPay’s ability to operate if it remained part of the Alibaba/Yahoo! partnership. So Ma unilaterally removed AliPay from Alibaba and spun it off as its own company under his sole control. Yahoo! received no compensation* for this. In fact, Yahoo! executives didn’t even know AliPay had been spun off until five weeks after the transaction was complete. They lost an extremely valuable asset for nothing and had little recourse to recover for their multi-billion dollar loss.
It is unlikely that China’s courts will resolve the VIE question any time soon. The Minsheng Bank case took 12 years to resolve. The VIE structure has been used by many Chinese firms and no major disputes have arisen because no Chinese firm using the VIE structure to raise Western capital has been foolish enough to ruin its business reputation by refusing to satisfy the terms of the contracts obligating them to pay profits forward to their Western investors. So the question remains unanswered – which may be just how Beijing would like matters to stay.
Beijing wants to keep foreign control out of critical sectors of the economy but understands firms in those sectors need Western capital to grow. Allowing just the right amount of ambiguity on this question means Beijing can allow Chinese businesses to raise capital overseas while retaining the ability to crack down on the activities of Chinese businesses who do not toe Beijing’s line on sensitive issues like internet censorship. Meanwhile all the risk drifts to Western investors who deserve to know that if the ambiguity is ever resolved it will be resolved in Beijing’s favor without regard to the effect on overseas investors.
*Alibaba and Yahoo! eventually did come to terms on financial compensation to Yahoo! for the cost of losing AliPay, but the terms were considered highly unfavorable to Yahoo! in the view of most financial analysts.