Alibaba tweaks a controversial legal structure
IF YOU want to study how the legal title to assets worth many billions of dollars changes hands in China, then peer carefully at page 116 of Alibaba’s new annual report. The text is dense and you may have to put a cold towel on your head and read it several times. The gist is that the Chinese internet giant is reforming its legal structure, which uses a fragile and ingenious device known as a variable interest entity (VIE). Alibaba’s attempt to make its VIEs safer is to be welcomed and will be watched closely by China’s richest entrepreneurs, many of whom use them, too.
VIEs are ubiquitous, especially among the country’s internet firms, which have a total market capitalisation of over $1trn. The structure dates back to the early 2000s, when Chinese technology companies wanted to tap global capital markets in New York and Hong Kong and to set up international holding companies domiciled outside of mainland China. Yet their sensitive internet assets, such as licences, may not be owned by foreign entities, according to Chinese law.
To get around this, tech firms opted to avoid owning these mainland assets outright, and instead to bundle them into legal entities called VIEs, in turn owned by individuals in China (usually the bosses of the firms and their associates). The VIEs and these individuals sign contracts with the international holding company, handing over to it control of the VIE as well as its profits. This approach remains popular. For example, it is being used by Xiaomi, a tech firm which did a blockbuster initial public offering in Hong Kong this year.
There are three problems with VIEs. First, key-man risk. If the people with nominal title die, divorce or disappear, it is not certain that their heirs and successors can be bound to follow the same contracts. Second, it is not clear if the structure is even legal. China’s courts have set few reliable precedents on VIEs and the official position is one of toleration rather than approval. Third, VIEs allow China’s leading tech firms to be listed abroad, preventing mainlanders from easily owning their shares and participating in their success.
Alibaba’s proposed change is aimed at tackling the first problem, key-man risk. At the moment four of its five VIEs are nominally owned by Jack Ma, the firm’s leader, and Simon Xie, a co-founder and former employee. After the restructuring, the two men will no longer be the dominant counterparties. Instead the VIEs will be owned by two layers of holding companies, which will sign contracts with Alibaba.
These holding companies will ultimately be nominally owned by a broader group of Alibaba’s senior Chinese staff. The idea is that if anyone gets run over by a bus, then the scheme will not be disrupted, because nominal control is spread among a wider group of people. The new approach is far from perfect but it is an improvement. If all goes to plan it will be completed by 2019. Other tech firms may feel pressure to follow.
The other two problems with VIEs remain, however. All firms still carry warnings in their annual reports that the legality of VIEs is uncertain. And mainlanders cannot own shares easily. When Xiaomi floated in Hong Kong in June its plan was that they could buy stock in two ways. They could purchase depositary receipts (which give the rights to the underlying share) that would be listed in Shanghai, or they could buy shares in Hong Kong through “stock connect”, a programme allowing a limited volume of trading between the mainland and Hong Kong.
Unfortunately the listing of depositary receipts fell through, for reasons that remain unclear. Then mainland regulators decided that firms with dual share classes, including Xiaomi, would not be eligible for stock connect (the Chinese authorities and Hong Kong’s exchange are holding negotiations to try to resolve this). China talks a good game about financial reform but its fiddly rules and opaque decision-making are a source of risk and ambiguity—even for its most successful companies.