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.