Tea Leaf Nation
A Glitch in the Cash Machine
There's a wrinkle to those hot Chinese tech IPOs.
Investors, ready your wallets. In the past week, Sina Weibo, China’s massive microblogging platform with 280 million users, and Alibaba, the operator of China’s largest online marketplace which generated $1.84 billion in revenue in the fourth quarter of 2013 alone, have respectively filed for, and announced plans to file for, initial public offerings (IPOs) in the United States. The Weibo IPO is expected to raise as much as $500 million, while Alibaba’s might top $15 billion, making it one of the biggest stock offerings in history. But as investment bankers busy themselves with counting zeros and investors lick their chops, few will pay much mind to a fundamental oddity in the companies’ corporate structures with the potential to haunt their stock prices for years to come.
At first glance, Chinese tech IPOs look like win-win propositions: Global investors get to profit from China’s incredible growth story — particularly in the Internet sector, where total user have reached a stratospheric 618 million as of January 2014 — while the firms get the money they need to fuel further growth. Indeed, Chinese companies listed in the United States have collectively outperformed the U.S. market lately. According to one index that tracks such companies, their share prices have gone up almost 70 percent in the past year, compared to 12 percent of the benchmark Dow Jones industrial average. But a problem is being swept under the rug: Their corporate structures are likely illegal under Chinese law, though the day of reckoning has yet to come.
It all starts with the fact that Chinese laws and regulations by and large prohibit foreign ownership in the Internet sector, one of many industries deemed sensitive or strategic to China’s national interest, along with others like education, fisheries, gambling, and air traffic control. In order to have their cake and eat it too, the companies have to perform a legal abracadabra of sorts. Weibo’s filing with the U.S. Securities and Exchange Commission (SEC) discloses a variable interest entity structure, or VIE, typical among Chinese companies listed in the United States. Chinese citizens form a VIE, but the VIE then signs multiple contracts with another company wholly owned by a foreign holding company, giving the latter full de facto control. Ideally, under this arrangement, the Chinese regulators treat the VIE as Chinese, while international investors feel comfortable that the VIE company will turn over most of its profits to the holding company. Presto.
This wasn’t the purpose for which VIEs were intended. Paul Gillis, a professor at the Guanghua School of Management at the prestigious Peking University in Beijing, explained to Foreign Policy that a VIE is an accounting concept introduced after the October 2001 exposure of accounting tricks obfuscating U.S. energy company Enron’s financial decay. VIEs were intended to ensure a company’s financial statements accurately reflect debts incurred by entities that it controls. But Chinese companies have "flipped the rule on its ear," according to Gillis, by using the VIE structure to place assets of Chinese domestic entities onto the balance sheets of their overseas holding companies.
Fredrik Oqvist, the founder and CEO of consulting company ChinaRAI, which has built a database of Chinese VIE companies listed in the U.S., estimates that approximately half of the Chinese companies listed on the New York Stock Exchange and Nasdaq use this structure. But the switcheroo has fooled no one. Although Chinese regulators have mostly tolerated the transgressions, high profile snafus involving VIE companies have sometimes popped up to shake the markets. In May 2011, it was confirmed that Alibaba founder and Chairman Jack Ma, the owner of such a VIE entity, transferred assets out without informing Yahoo or Softbank, two major shareholders in Alibaba that also sit on its board. (Shortly after this revelation, Yahoo’s share price took a huge hit, losing $2 billion in market value.) In August 2011, filings revealed that founder-owned shares of the VIE for Tudou, one of China’s top online video sites, had became entangled in an ugly divorce, causing significant delays to the IPO and making plain that the Chinese courts had the final say on who owns the VIE, not foreigners.
If those signs are not clear enough, in June 2013, the Chinese Supreme Court ruled on a 10-year-old case, in the process invalidating a set of VIE contracts because they "circumvented Chinese laws and regulations." The Chinese Supreme Court’s decision did not void or prohibit all VIE contracts, but the decision has prompted the SEC to require some companies with VIE structures, like Chinese search giant Baidu, to make more detailed disclosures in its filings.
If the enforceability of the VIE contracts is highly questionable, should the holding companies be allowed to claim that they exercise effective control over these operating entities? Sina Corp., which operates Weibo, did not respond to an emailed request for comment, while a spokesperson for Alibaba declined to comment. But Gillis believes that the SEC is "in a tough position," because it has to rely on Chinese lawyers for listed companies, who deem the contracts enforceable. Gillis describes the Chinese legal community as split on the issue, but adds that "the ones questioning enforceability are not the ones signing the opinions" that declare them enforceable. Oqvist agrees that a regulator like the SEC should perhaps request further disclosure by the companies’ Chinese lawyers to give a better explanation of why they think the contracts are enforceable, "given the circumstantial evidence that they are not." Even Weibo’s own IPO offering document notes, "There are very few precedents and little official guidance as to how contractual arrangements in the context of a variable interest entity should be interpreted or enforced."
Although the VIE structure is highly problematic, that doesn’t necessarily impugn the Chinese companies that use it. Some of the most respected companies in China, serviced by major U.S. accounting firms, use the VIE structure. They do so to wrangle with China’s sometimes-draconian foreign ownership restrictions in their sectors, not to dodge the financial or corporate governance requirements set out by the U.S. exchanges on which they list. And the VIE arrangements are clearly disclosed in the companies’ public documents. In fact, Oqvist believes that if an investor avoided all Chinese companies with VIE structures, that person would not be left with "very many growth companies" to choose from.
Collectively, the companies that employ the structure may have become "too big to fail" anyway. But individually, each is vulnerable to the whims of the Chinese courts, regulators, or shareholders. Gillis believes Chinese authorities should "regularize" a system by which a Chinese company would receive foreign investment. "It is not in China’s interest to have so much of its economy built on a potentially illegal structure," he said.