U.S. Report Casts Doubt on Legal Structure of Alibaba, Other Chinese Firms

U.S. Report Casts Doubt on Legal Structure of Alibaba, Other Chinese Firms

Structure Used by Alibaba, Other Chinese Internet Companies Seeking U.S. Investors

CARLOS TEJADA

Updated June 20, 2014 4:49 p.m. ET

A U.S. government commission warned that investors face “major risks” if they buy shares in Chinese companies like e-commerce firm Alibaba Group Holding Ltd.

A report released this week by a commission that advises Congress on U.S.-China economic issues took aim at the legal structure underpinning Alibaba as well as a host of other Chinese Internet firms, calling it “a complex and highly risky scheme of legal arrangements.” It warned that the structure could lead to losses by shareholders in the U.S.

“U.S. shareholders face major risks from the complexity and purpose” of the structure, said the report, released on Wednesday by the U.S.-China Economic and Security Review Commission. The group, an independent agency directed by Congress, has in the past issued critical reports about China.

While the commission doesn’t directly make policy, its research can inform the work of policy makers and regulators, from members of Congress to agencies focused on securities listings, acquisitions and the U.S. economy.

The report comes amid a surge in Chinese Internet companies tapping the U.S. markets for capital. Alibabahas applied to U.S. securities regulators for approval for what might be the largest initial public offering in history, which could come as soon as this summer. An Alibaba spokeswoman declined to comment.

Other Chinese firms structured similarly include Baidu Inc.,BIDU +0.06% a longtime U.S.-traded search company sometimes called theGoogle GOOGL +0.27% of China, and Alibaba rival JD.com Inc., JD -1.47% whichlisted in the U.S. last month. A Baidu spokesman said it thoroughly disclosed its structure in its filings. He referred to a Moody’s Investors Service report from last month that said the search company could manage the risk related to its structure.

JD.com didn’t respond to requests for comment.

The commission frequently publishes reports about major Chinese industries, often including extensive analysis about specific companies. This week’s report mentioned several Internet companies besides Alibaba, including Baidu.

The report focuses on a structure called a variable-interest entity, or VIE. Chinese companies seeking to sell shares on U.S. markets use the structure to circumvent Chinese government restrictions on foreign ownership of businesses in sensitive industries, including Internet-related businesses.

The VIE structure solves the problem of foreigners investing in prohibited industries by splitting companies into two entities. One, based in China, controls licenses and other assets required to do business in China. Foreign investors can buy shares in the foreign-listed parent of the second entity, which is based offshore.

Under a typical VIE structure, the Chinese entity pays fees and royalties to the foreign entity based on a series of contracts, thus ensuring the economic benefits of the Chinese operations flow to shareholders in the foreign entity.

The structure has drawn criticism from some corporate governance specialists. They argue that it gives foreign investors little control over some assets of the company, which generally remain under the control of the Chinese entity and its owners. In a 2011 dispute that highlighted the problems of such corporate structures, the individuals who controlled Alibaba’s Chinese entity split off the assets of a payments unit and put them under the control of Alibaba founder Jack Ma, over the objections of Yahoo Inc., YHOO -1.82% a large shareholder in the foreign entity.

Investors haven’t seemed too concerned about VIEs. Several companies including Baidu and JD.com have so far have been winners for investors.

“These VIEs are something that we’re used to. They’re part of the cost of investing in China,” said Jane Snorek, senior research analyst at Nuveen Asset Management, which oversees $120 billion.

“It’s to be expected from a Chinese IPO,” she said. “Baidu has the same thing, and their stock was a home run.”

Ms. Snorek said VIEs and governance issues related to Chinese companies sometimes dent the price investors are willing to pay for shares, but these issues take a back seat to the company’s financial prospects. Given Alibaba’s growth, “at the right price, it looks very attractive,” she said.”

Some observers said Alibaba and others have moved to address some concerns by shrinking the share of revenue that comes from the Chinese part of the VIE structure. In the fiscal year ended March 31, Alibaba said 11.8% of its revenue came from its VIEs.

“They’ve gotten the religion,” said Paul Gillis, a visiting professor of accounting at Peking University’s Guanghua School of Management and a critic of the structure, referring to both Alibaba and JD.com. “Experts and regulators have been harping on the dangers of VIEs for the last several years. It’s clear that both Alibaba and JD.com have structured VIEs to minimize that risk.”

Still, in its IPO filing in the U.S., Alibaba warned that contracts between the Chinese and foreign-based entities “may not be as effective as direct ownership in providing us with control over our variable-interest entities.” The Chinese entities that own important licenses and assets are controlled by Mr. Ma and not by Alibaba itself, the filing said.