Investing in a Technology-Driven Society

By Andrea Nickerson

On September 29, 2014, the Securities and Exchange Commission (“SEC”) announced the discovery of a probable fraudulent investment scheme in South Florida. Two Miami Beach men allegedly raised more than $5.7 million in capital from a mere 100 investors for a purported startup television network and production company called Vision Broadcast Network.

Like many similar schemes, the men provided investors with false financial statements, and even claimed that Michael Jordan was planning to invest in the company. Between 2007 and 2010, the company’s creators took more than $450,000 for undisclosed commissions, $1.3 million for nonexistent consulting services, and several hundred thousand dollars for personal expenses like luxury car leases and golf equipment.

The Vision Broadcast fraud demonstrates several themes in modern investments frauds. As the title of this blog alludes to, investing “in” today’s technology-driven society connotes more than a single common meaning. First, the phrase highlights the environment in which today’s investors receive most of their information and make their investment decisions. Technology provides investors with numerous resources for researching companies, investment strategies, securities products, and investment professionals. Investors can also easily supervise their investments and market performance in real time via computer, tablet, or mobile phone.

However, technology also provides cost effective and efficient mediums through which fraudulent parties can contact large pools of potential investors. Social media and websites can quickly and inexpensively be used to create a seemingly legitimate company in the matter of a few hours. Messages posted to investor online bulletin boards may also be used to conduct a scam. Investors may uncover these internet-based sources and reasonably think that a company like Vision Broadcast actually exists. Thus, investing “in” a technology-driven society in this sense presents some measure of both security and danger to investors.

Second, the phrase makes reference to the growing public interest in investing in the technology industry itself. The success of technology-based companies like Facebook, Twitter, Google, Apple, and Netflix has led many investors to speculate in hopes of profiting from the next billion dollar idea.

According to Heather Somerville’s article, “Silicon Valley tech companies reap record-level investments”, technology companies in California received more than $4.7 billion in venture capital in the first quarter of 2014 alone. This amount was nearly half the total invested in all industries by venture firms nationwide.

Although some start-up technologies companies are profitable, initial investment is very risky. Aside from the potential for fraud, these firms require high start-up costs and face extreme competition. The SEC warns, “Don’t invest in small, thinly-traded companies unless you’re prepared to lose every penny.”

Recently, the Investor Rights clinic assisted a client who was solicited to invest in a start-up biodiesel energy and aqua-farming company located in California. The company did not provide any financial information, prospectus, or account statements, but promised substantial returns due to the high demand of the industry. Unfortunately, the shares issued by the company were not marketable, and the broker and brokerage firm that solicited the sale could no longer be located.

Because of the increasing occurrence of technology-related scams, investors need to be diligent in researching securities and the people or companies recommending them. In the SEC’s Avoiding Internet Investment Scams: Tips for Investors, the Commission first recommends independently investigating the security and the person selling it to see if they are registered with the SEC, the Financial Industry Regulatory Authority (FINRA), or state authorities. Independent resources can also provide substantial information related to the performance and validity of the investment and related parties.

Second, the Commission warns against investments that sound too good to be true, and promise “guaranteed” or “risk-free” returns. Even the safest investments carry some risk. The Commission also advises investors to be on the lookout for common internet scams, including spam and “pump and dump” schemes.

As is evident, technology can provide both safeguards and pitfalls to investors. Further, the technology industry itself presents unique investment and potentially profitable opportunities. However, investing “in” a technology-driven society requires that, more than ever, investors are skeptical in their analysis of technology-based information and investments.

VIE Structure Makes Alibaba Less Attractive to Foreign Investors

By Zhen Pan

When asked what Alibaba is, most people think of “Alibaba and the 40 Thieves” but on September 18, 2014, Alibaba Group Holding Ltd. (“Alibaba”), a Chinese e-commerce company, announced its initial public offering (IPO) at the New York Stock Exchange. The price of the stock (ticker: BABA), was set at $68 per share, raising $21.8 billion for the company. Strong investor interest made this IPO the most-anticipated public stock debut of the year and the largest in U.S. history.

People may think of Alibaba as a combination of Amazon, eBay, and PayPal. Alibaba is now the largest e-commerce company in the world with sales accounting for 84% of China’s online shopping. In 2013, Ailbaba processed over 11 billion orders worth $248 billion. Given the company’s size and scope, Alibaba is naturally attractive to investors. Recently however, several Forbes articles raise concerns about the prospects of Alibaba and have listed reasons suggesting that investors avoid investing in this Chinese e-commerce giant.

Because Alibaba is a complicated variable interest entity (“VIE”), some are worried about the legality of the company’s structure. In order to have a better understanding of these concerns, knowing the VIE structure is essential. VIE is a strategic structure created to circumvent China’s restrictions on foreign ownership of companies in sensitive industries such as: finance, technology, education and media. The restrictions prevent fast-growing Chinese companies such as Sina (a media company), Baidu (Chinese Google), and Renren (Chinese Facebook) from accessing foreign capital. To establish a company under a VIE structure, an offshore holding company is established which will either list on foreign stock markets or be controlled by a private investor. This holding company then establishes a wholly foreign-owned enterprise (“WFOE”) in China. The WFOE establishes a Chinese company in mainland China, owned by local Chinese managers to hold licenses and permits. The WFOE controls the mainland company through legal contracts. This is the so-called “contractual ownership” — not ownership through assets, but ownership through management contracts.

Many skeptics claim that investments will have no protection in Chinese courts because of the way the stock circumvents Chinese government restrictions forbidding foreigners from investing directly in internet services in China. Additionally, advisors are concerned about the “contractual rights” to the profits of Alibaba. Due to the VIE, non-Chinese investors can only invest in the security being offered in the IPO but not in Alibaba the company. As a recent Forbes article suggests, a VIE is “unlike a normal equity investment; you are not investing in the company but you are investing in a contract.” An offshore holding company based in the Cayman Islands has contractual rights to the profits of Alibaba but most of the company’s assets are owned by the founders. Another article also mentions that the Chairman, Jack Ma, took ownership of Alipay, the online payment service, away from investors Softbank and Yahoo, suggesting a potential power abuse.

In reality, the Chinese government has never explicitly said that VIE structures are illegal. The Supreme People’s Court of China invalidated a VIE structure used by a bank, because the bank had not utilized the normal VIE structure, which gave the actual owners too much control over voting. This is the only case invalidating the VIE structure. One of the unique feature of Chinaʼs civil law system is that court decisions have no binding legal precedent, giving the ruling little other than symbolic significance. Therefore, the validity of a VIE structure is determined on a case-by-case basis, making the VIE a grey area. However, the Chinese government is reluctant to tamper with one of the few channels that allow Chinese companies to tap into foreign capital.

Given that Alibaba’s revenue is bigger than that of eBay and Amazon combined and that China’s GDP is smaller than the US, this shows that Alibaba is doing pretty well relative to its US counterparts. Alibaba connects buyers and sellers of industrial and commercial goods and services in China and boosts stock prices. Thus, at this stage, it is too early to advise people to avoid investing in BABA. Every day we are able to further observe and record the credibility of Alibaba.