Investing In Alibaba Group: Sure Payoff Or Legal Nightmare?

Screen Shot 2014-10-24 at 7.33.18 PMBy Yayi Ding

Last month, Chinese e-commerce giant Alibaba Group announced one of the biggest initial public offerings (IPOs) in US history, raising more than $21 billion USD. However, one could argue that the entire scheme might have been borderline illegal; of all the investors who “purchased” Alibaba’s stocks at IPO, none of them ended up actually owning a single share in Alibaba.

How could this be? Well, for starters, Chinese government regulations do not allow foreigners to own stock in Chinese Internet companies, Alibaba included. To circumvent these regulations and pursue an IPO on an American stock exchange, Alibaba had to adopt a complicated ownership structure known as a “Variable Interest Entity” (VIE). Through this structure, foreign shareholders do not buy into Alibaba, but rather buy into Alibaba Holdings, an offshore “holding company” that is registered in the Cayman Islands. Shareholders get a stake in the holding company and in Alibaba’s profits, but ultimately do not own shares in Alibaba and have no say in how the company is run.

What are the legal implications of such an arrangement? Most significantly, foreign shareholders have little legal recourse if problems emerge within the company. Any potential contractual claims regarding Alibaba’s profits would have to be raised before a Chinese court, since the contract would have been formed between the Cayman Islands Alibaba and the Chinese Alibaba. Yet, just last year, the Supreme People’s Court (China’s highest court) disallowed a similar ownership arrangement because it circumvented the central government’s foreign ownership restrictions. For this reason, experts in Chinese law doubt that Chinese courts would uphold contractual agreements in this case. (On a side note, Alibaba’s VIE ownership structure may also be concerning from a business perspective; shareholders have no influence over management, which presents significant risk even if Chinese courts opt to uphold contractual agreements.)

Various observers and analysts have provided input on the situation. Senator Bob Casey of Pennsylvania and the US-China Economic and Security Review Commission have both warned potential investors to take caution. Similarly, Mark Mobius of Franklin Templeton Investments has observed that even though Alibaba’s VIE ownership structure presents significant risk for investors, stock exchange regulators have deferred to the capital-maximizing wishes of stockbrokers, investment bankers, and others, by allowing Alibaba to enter the New York Stock Exchange. Nonetheless, these warnings seem to have come with little effect; Alibaba’s shares soared to $87.91 – 29 percent higher than its IPO price – at closing on Friday, October 17.

How has Alibaba itself responded to the possibility that shareholders’ claims might be unenforceable at court? And how has Alibaba endeavored to reassure potential investors that buying into the company is a wise bet? In a word: “Trust.” Alibaba’s founder Jack Ma has made his point clear: “Trust us . . . when you trust, everything is simple. If you don’t trust, everything gets complicated.”

Ready to take a leap of faith?

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