Buying stock in online giant Alibaba (阿里巴巴) or other Chinese Internet companies that bypass Beijing’s restrictions on foreign ownership could be a big risk for investors, a US government panel has said.
An agency that advises the US Congress on national security implications of the US-China trade and economic relationship raised the red flag last week, as Alibaba, the world’s largest online retailer, prepares for its US stock listing.
Alibaba, social networking giant Weibo (微博) and several other Chinese Internet firms use a complex legal mechanism in which “ownership is deliberately obscured by a series of shell companies,” the US-China Economic and Security Review Commission (USCC) said in a report on Wednesday.
In the case of Weibo, for example, the report said that a Cayman Islands corporation owns 100 percent of a Hong Kong company that in turn controls the group through three layers of Chinese entities.
“This intricate ruse is a way of making the business appear to be Chinese-owned to Chinese regulators while claiming to be a foreign-owned business to foreign investors. Neither claim is technically true, and the arrangement is highly risky and potentially illegal in China,” the report said.
It added that “the contracts are only binding and enforceable if Chinese courts are willing to uphold them.”
As a result, “for US investors, a major risk is that the Chinese shareholder... will steal the entity, ignoring the legal arrangements on which the system is based,” it said.
The companies must rely on foreign investors, because they cannot access sufficient capital in China’s banking system or its bond market, and they need permission to list overseas, the USCC said.
To circumvent these restrictions, the leading Chinese Internet companies use a Variable Interest Entity (VIE), essentially a holding company that links foreign investors and Chinese firms through a set of complex legal contracts. VIEs are usually based in tax havens such as the Cayman Islands.
“US shareholders face major risks from the complexity” of the VIE structure, the report said.
Wall Street has seen a flood of initial public offerings (IPOs) recently by Chinese Internet companies, including Baidu (百度), Renren (人人網), Weibo and JD.com (京東), the No. 2 online retailer.
Alibaba last month filed for a US-based IPO that some analysts estimate will raise US$15 billion.
The USCC report highlights that Alibaba’s filings with the US Securities and Exchange Commission show it is to use a VIE and a preferential stock structure to consolidate decisionmaking power with the firm’s 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.
Yahoo lost any direct benefit from Alibaba’s spinoff of an online payment tool called Alipay, in a secret move by Alibaba founder and chairman Jack Ma (馬雲).
“Under the VIE structure, there is no obligation of the parent company to notify foreign investors of these kinds of decisions, which can prove very costly for them,” the report said.
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