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Foreign investors waking up to risks in China firmsChinese government uneasy over loophole firms use to raise fundsNew York Times25 January 2012Jack Ma, the chairman of the Chinese Internet giant Alibaba, surprised investors last May when he acknowledged that he had transferred the assets of the company’s online payment platform to a private company that he controlled.Executives at Yahoo, which owns around 40 per cent of the privately held Alibaba Group, complained that they had not been properly informed of the move and that the Alibaba board did not approve the transfer.While the dispute was later resolved, it raised questions about the risks of investing in Chinese companies using a little-known regulatory loophole. Legal analysts scrambled to explain that investments in China’s Internet industry, among others, had hidden risks and that government scrutiny of the loophole was increasing.‘There’s still a lot of uncertainty,’ Steven Xiang, the Shanghai-based managing partner at Weil, Gotshal & Manges, a US law firm, said. ‘No regulatory changes have occurred yet. But investors need to consider their risk appetite.’For years, big Internet companies in China, such as Alibaba and Baidu, have raised billions of dollars by effectively skirting Chinese regulations that ban foreign investors from acquiring stakes in companies operating in restricted industries, such as energy, telecommunications and the Internet.Using a complex investment vehicle known as the variable interest entity - or VIE - Chinese companies have been able to accept money from foreign investors through offshore entities they set up.In the case of Alibaba, Mr Ma controls a Chinese company that transfers its economic returns and governance structure to an offshore entity in the Cayman Islands. That vehicle, in turn, is contractually tied to the Alibaba Group and the Hong Kong-listed Alibaba.com, which it operates.Sina.com was one of the first to use this complex arrangement. But virtually every major Chinese Internet company has adopted a similar structure.Private companies often chose this route because they had difficulty raising capital in China, where state-run banks tend to favour government-owned companies.That is perhaps one reason Chinese regulators long ago gave tacit approval to such arrangements. As a result, about 108 of 225 Chinese companies listed on Nasdaq and the New York Stock Exchange use the VIE structure, according to a study done by Fredrik Oqvist, an independent analyst in Beijing.But in recent years, the Chinese government has grown increasingly uneasy with the arrangement. Several regulatory agencies, including the Commerce Ministry and the central bank, have questioned the viability of the complex structure in public statements.Legal experts, though, doubt Chinese regulators will abolish the practice or even force big Chinese companies to unwind their structures any time soon.‘That’d be like taking a knife to about 80 US-listed companies that have used this structure over the past 12 years,’ said Lawrence Sussman, managing partner in the Beijing office of O’Melveny & Myers, a US law firm. ‘This structure is unlikely to go away.’But many legal analysts say the risks are real.‘We’ve developed a structure that’s fraught with risk,’ said Paul Gillis, a visiting professor of accounting at Peking University in Beijing. ‘And until recently, I don’t think investors realised the risks. The Alibaba case is the one that set some of this off.’Alibaba said that it had no choice but to transfer the assets of its online payment platform, Alipay, to a private company controlled by Mr Ma after Beijing regulators tightened controls over online payment systems and threatened to make the operations of Alipay illegal. That could have posed dangers to Alibaba’s fast-growing e-commerce unit, Taobao.An Alibaba Group spokesman, John Spelich, said that the disagreement with Yahoo was resolved and that worries about the VIE structure were exaggerated.
But some critics saw Alibaba’s move as a sign that Mr Ma could move a valuable piece of the Alibaba Group off the books to hide its value from one of its biggest shareholders, Yahoo.At the time of the move, Alibaba and Yahoo had been at odds over Yahoo’s stake in the company.The dispute was resolved in July, when Mr Ma agreed to certain conditions. If Alipay goes public with a stock offering, Alipay will pay the Alibaba Group at least US$2 billion but no more than US$6 billion, plus certain licensing fees.
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