Alibaba’s record IPO overcame concerns about Chinese stocks. Investors had been badly burned by Chinese stocks in the past few years, but they were en-thusiastic about Alibaba. There was considerable discussion of the risks of Chin-ese stocks, and in particular the variable interest entity (VIE) structure used by Alibaba and many other overseas listed Chinese stocks. These risks remain, al-though Alibaba’s offering might have changed the picture.
Variable Interest Entities
At the top of the list of concerns about Alibaba was the variable interest entity structure. I just searched Google news for variable interest entity and found 881 results. When I first wrote about VIEs in March 2011 nobody was talking about VIEs. It seems difficult to find anyone who is not aware of the structure today. The Alibaba IPO called considerable attention to the structure, including a report from a congressional commission and a letter from Senator Casey to the SEC. Certainly Chinese officials heard an earful about VIEs.
I think all this attention may help to bring a resolution to the VIE situation. I believe that the chance of Chinese regulators banning the VIE structure has fal-len below remote. Instead, I expect they will eventually move to modify for-eign investment rules to make the VIE structure obsolete. Changing the foreign in-vestment rules to allow direct foreign investment in Chinese companies in e-commerce could allow companies like Alibaba to get rid of both their VIE and their Cayman Island structures, to the great benefit of shareholders.
I expect that China may want to ensure that internet companies remain under the control of Chinese citizens, and Alibaba control structure that keeps Jack Ma in charge may be exactly what the doctor ordered. Allowing companies like Alibaba to directly list abroad without Cayman Island companies and VIEs might also allow Alibaba to seek a secondary stock listing on the Chinese stock ex-changes. Because of China’s strict exchange controls, most Chinese investors could not participate in the IPO of Alibaba.
The difficulties faced by the SEC and PCAOB in enforcing American securities laws on Chinese companies listed in the United States have not been resolved. These issues received far less attention than the VIE structure. The SEC’s case against the Big Four accounting firms has not been settled. While an administra-tive trial judge banned the firms from practice before the SEC, the judgment has been stayed pending appeal before the SEC. If the judgment is ultimately up-held, it could lead to the delisting of all Chinese companies, including Alibaba, from U.S. markets. Similarly, a failure of the PCAOB to obtain the right to in-spect auditors could lead to the same result. Such an extreme measure seems far more unlikely after the Alibaba IPO, which has raised the stakes for both US and Chinese regulators to find a compromise.
Today was a very bad day for the Hong Kong Stock Exchange (HKSE). It had the Alibaba listing in its hands, only to let it slip away because it would not allow the control structure that kept Jack Ma in control. An investor group said that invest-ors would significantly discount stocks with these control structures – they look quite foolish today. The Hong Kong Stock Exchange is determining whether to modify their rules. If the HKSE cannot win the listings of entrepreneurial companies coming out of China, the future for that exchange is bleak.