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Archive for May, 2011

After a couple more days, with some added information on this topic we can now start to guess at an outline of what actually happened when Yahoo lost its’ Alipay investment.

There’s been some mud-slinging between the companies involved and the crux seems to be whether or not Alibaba’s board, and thereby Yahoo, was informed of the transfer of Alipay or not. The Chinese side are claiming the duly informed the board, while Yahoo are claiming they got no word about this.

I think they’re both telling the truth, although they’re missing each others points.

Due to restrictions of foreign investment in certain relevant areas of its’ business areas, Alibaba has to conduct parts of its business through VIEs. A VIE is in reality a series of contracts that aim to create ownership of a company without actually holding any equity interest in it. As Chinese laws strictly speaking only ban equity ownership, this type of structure “allows” foreign investment in restricted areas. However, there are quite substantial doubts as to the legitimacy and enforceability of these contracts.

As I mentioned in a previous post the transfer of Alipay was actually made in two stages, the first one transferred 70% of the company, the second one transferred the remaining 30%. Hence we can safely say it was transferred into a VIE, or it would have de-consolidated at the first stage.

Here’s the sequence of events that I think brought about the de-consolidation of Alipay, and the subsequent misunderstanding regarding the information. It should be noted that this is my best guess, I’ve had no way of truly confirming this.

  1. Alibaba wants to transfers 70% of the Alipay into Zhejiang Alibaba E-commerce Company (Zhejiang Alibaba) its’ VIE, in order to facilitate approval from banking authorities.
  2. The board are duly notified that Alipay is being transferred to Zhejiang Alibaba, which looks and acts like just another subsidiary unless you know what you’re looking for.
  3. The regulators still will not approve the company for a banking license, most likely because they still consider it a foreign investment, so Alibaba want to transfer the remaining Alipay equity to Zhejiang Alibaba, which would then be a wholly-domestic company on paper.
  4. The board are notified that the rest of Alipay should be transferred into this subsidiary-looking VIE thing. As it will still be consolidated this does not appear to be a big deal.

This is the bit the Chinese side are talking about, because they informed the board of all of these transfers, Yahoo clearly knew what was going on. Alipay had been transferred to Zhejiang Alibaba, a VIE entity technically separate from the company but consolidated in the financial statements. Thus, Alibaba’s management had fulfilled its duty.

However, from Yahoo’s point of view this was simply an internal transfer to comply with some pesky regulations, they didn’t see the entity as separate until it de-consolidated. The last two steps are what they weren’t informed of, and this was the important bit from their perspective:

  1. The banking authorities take the VIE hardline, saying that this type of legal construction circumvents the law and is therefore not allowed. If Alipay is to get its’ license it needs to desist from this activity.
  2. In order to finally obtain the license and not hurt its’ business too much Alipay cuts the contracts, and disappears from the Alibaba financial statements. The board is not notified.

Thus, Alibaba’s management failed to fulfill its duty.

My guess is that Yahoo’s board representation simply didn’t realise the risks involved in a VIE-structure, or the current legal pressure being asserted on them, and took the decision to allow the transfer of the equity under the view that this was a very solid system of control.

Now Yahoo is pushing to be compensated for what is being called a spin-off, and in reality this might be the only road still open for them. Consolidating Alipay again seems like an impossible task, given what appears to be a hardline approach by the authorities on the matter.

The trend for legal landscape for VIEs is one of increased enforcement of the laws against them, however, this enforcement is not coming from Beijing. Instead we’ve seen regional enforcement, as in the Buddha Steel case, and now also industry specific enforcement with Alipay. Navigating the VIE field is becoming more and more like a maze, and Beijing seem likely to allow local and industry regulators to continue to police the VIE question as they see fit.

Investors should duly take note of this situation and see if their own companies have any system in place to compensate for potentially forced termination of the VIE contracts. Further, is this high-profile case perhaps the final proof needed of just how substantial the uncertainty of enforcing VIE contracts truly is?

Update: Good article which seems to confirm at least some of the guesses I made earlier

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This post will be a quick comment on some new developments in China, an analysis will follow later in the week.

The CSRC has come up with some basic rules for RTOs in China, and reverse listings. The rules are still out for comment by industry professionals and we’re likely to see some minor changes in them still, but the overall road they wish to take is clear: RTOs and reverse listings will be subject to a similar legal framework as regular listings. This means demands on profitability and stable balance sheets.

What this will mean in reality is that listing overseas will become even more attractive to Chinese companies. Although it also provides an opportunity for the SEC to have a long talk with the CSRC about regulations on reverse listings in the US.

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The big news in Chinese-American finance this week has undoubtedly been the Yahoo vs. Alibaba spat.

If you haven’t read about it, you should!

The basics are that Alibaba transferred its profitable Alipay business (Chinese paypal) to a company controlled by Jack Ma, and Simon Xie founders of Alibaba. And now this transfer has resulted in de-consolidation of the company from Yahoos investment in Alibaba. This all came to light this year and Yahoo claim to have had no prior knowledge of this, even though they had board representation in Alibaba.

Now what’s interesting is that it appears as if 70% of the company was transferred in 2009, meaning that there would have had to be a VIE agreement in place for it to stay consolidated even at that point. Which means that the transfer of all the remaining ownership to this new structure should not have had any impact at all, it would merely be 100% VIE.

So the question really is, why did it suddenly de-consolidate?

As we have very little info to go on here it’s very hard to have any type of certainty in the predictions or warnings we get from this example. However, the current debate seems to be talking about the wrong thing.

The fact that the company transferred its ownership to a Chinese entity is not the issue, they avoided a lot of regulation by using a VIE structure, nothing strange about that.

The question investors need to be asking themselves is why, and how, the VIE structure disappeared. This could be the definitive proof of just how risky the VIE structure actually is, but as we have no information of how it was structured it’s hard to say anything for certain.

If we assume that the VIE was set up in the normal fashion then something must have happened with the contractual agreements between Alibaba’s subsidiaries and Alipay. What exactly happened is impossible to say at present, but regardless of what it was it raises some very poignant questions about the issues of VIE contracts. All we know currently is that a VIE has simply walked off the consolidated financial statements without an explanation, this in itself should be enough for anyone investing in VIE companies to start asking some serious questions.

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Let’s get straight to it, this post supposes some prior knowledge of VIE structures, available at other blogs. But suffice to say that it’s a method of controlling, and consolidating companies in China without actually holding any equity ownership in them.

One of the issues with this is that no one knows whether or not these contracts are enforceable, something which is normally disclosed in the risk sections of the annual filings. It’s the one where the company’s lawyers state that the contracts are enforceable, only to use the very next statement to say that there’s so much uncertainty on the issue that they really don’t know.

Now this is all fine and dandy as long as there is disclosure on the issue, and investors know how to evaluate the risks properly. However, some companies seem intent on trying to seem much more solid than their VIE structures make them, and then we get into trouble.Investors might misunderstand the situation, and thereby not take the risks into account. But the biggest question is why a company would be so intent on hiding this structure when it has become more or less industry standard in certain areas.

Imagine if you were to find a company in a heavily regulated industry in China, say a full-blown IT company with online services and the whole shabang, claiming to have complete ownership of their entire operations. What if they even state that their ICP-license is under a wholly-owned entity (In China an ICP license can only be granted to a foreign-domestic JV, with the domestic player holding the majority, and in practice even the JV is nigh impossible as you need to get it passed government authorities)? You’d expect any such company to be called out even before listing on these strange practices.

Well, as it turns out there is a company like this currently being sued on other grounds, but for some reason it appears like they won’t get into this blatant misleading of their investors.

The company is Subaye Inc. and they are in the cloud computer services business. Here’s what their latest 10-K states as their corporate structure:

Subaye's corporate structure according to their latest 10-K

For a company that cannot possibly legally own every part of their business there’s an awful amount of 100% ownership going around!

On to there risk section where the attempts to illuminate the reader as to their actual structure could be described as lackluster at best [emphasis added]:

In order to comply with Chinese laws limiting foreign ownership of Internet and advertising businesses, we conduct our ICP (independent content provider) and online advertising businesses through our subsidiary, Guangzhou Subaye Computer Tech Limited. If the Chinese government determines that these contractual arrangements do not comply with applicable regulations, our ability to operate could be significantly reduced resulting in loss of customers and revenue.

The Chinese government restricts foreign investment in Internet and advertising businesses. Accordingly, we operate our websites and our online advertising business in China through Guangzhou Subaye Computer Tech Limited ”GZ Subaye,” our wholly-owned subsidiary. GZ Subaye holds the licenses and approvals necessary to operate our website and our online advertising business in China. We cannot assure you, however, that we will be able to enforce these contracts. Although we believe we comply with current Chinese regulations, we cannot assure you that the Chinese government would agree that these operating arrangements comply with Chinese licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. If the Chinese government determines that we do not comply with applicable law, it could revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, block our website, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, impose restrictions on our business operations or on our customers, or take other regulatory or enforcement actions against us that could be harmful to our business.

without getting into too much detail, they first state that the industry is restricts foreign investment, and then that in order to comply with these restrictions they operate in it through a wholly-owned subsidiary. I don’t really know quite where to start with this one, so I’ll just let it speak for itself. But the authors duly go on to show an amazing grasp of the English language when they all of a sudden say that they’re not sure if “these contracts” can be enforced, without any contracts mentioned that they could be referring back to.

This looks like a bad cut-and-paste job to me, and I think it should be added onto any lawsuit being brought against the company.

Perhaps the reason it is not brought up is that the PRC council involved actually signed off on the report, stating that the structure presented complied with current PRC legislation. This in itself is worthy of a blog post on how to judge legal opinions in Chinese statements.

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