Two weeks ago Alibaba (‘BABA’), China’s biggest e-commerce company, marked the biggest IPO (initial public offering of shares to the public) in history. The company raised some $25 billion (Visa was second at $19.7 billion in March 2008). This huge IPO also offers a couple large corporate governance lessons.

Economic Risk Doesn’t Equal Voting Control

One of the major reasons why Alibaba went public in New York and not in Hong Kong was the fact that Hong Kong wouldn’t allow the company’s founders to have their cake and eat it too. The NYSE doesn’t seem to have a problem with that. It all revolves around what, unfortunately, is becoming more common these days: the dual-class share structure. Basically, the dual-class share structure allows some shareholders more voting rights than others. In Alibaba’s case, the founders can control the company’s voting majority without having to risk their own equal capital.

Let’s run through a quick example to illustrate the separation of control from economic ownership found in these “anomalies” of corporate governance. Let’s take a company that offers a dual-class structure where the founder gets four votes for every one of the other shareholders. Suppose that there are four million shares outstanding where the founder owns one million shares and the other shareholders control three million shares. Even in this case where the founder has only 25 percent of the shares outstanding he can still control all decisions in the company (he has 57 percent of the vote as he gets four million votes out of a total of seven million votes). If the founder wished to take 57 percent of the control why should he not take 57 percent of the economic risk?

This really isn’t anything new in tech land recently as Google, Groupon and Facebook all are using this structure. In the past, media companies used this to “protect their journalistic integrity”. Unfortunately I find a lot not to like with such a structure. Proponents will suggest it allows the founders to focus on the long-term strategy and not be forced to fixate on short-term performance.

This is a weak and specious suggestion in my opinion. If the board can’t think long-term then get a new board? Why not just remain private, sell fewer shares, or use debt financing?

A study by The Investor Responsibility Research Center Institute finds that “controlled companies — particularly those with multiple classes of shares — generally underperform over the long term. As compared to companies with dispersed ownership, controlled companies experience more stock price volatility, increased material weakness in accounting controls, more related party transactions, and offer fewer rights to unaffiliated shareholders. The study results challenge the notion that multiclass voting structures benefit a company and its shareowners over the long term.” Aligning risk with control seems to work best for all involved. In fact an investment strategy which focuses on companies with talented management with “skin in the game” can generate very attractive returns (more on this in another column).

Do You Really Own It?

If you dig through Alibaba’s filings you will come across three words that may be common to Chinese investors: Variable Interest Entity (VIE).

In fillings with the US Securities and Exchange Commission, Alibaba says the licences to operate various websites in China are held by VIEs, that are 100 percent owned by Chinese citizens. Specifically Jack Ma, Alibaba’s founder and chairman owns this, and not owned by the main Alibaba Company that’s filing for the IPO. The arrangement, it says, is required under Chinese law.

Chinese companies have to adopt the VIE structure if they want to list overseas and comply with the Chinese regulations. The structure involves setting up two entities, one based in China and one abroad, often in Cayman or some offshore domicile. The Chinese entity — the VIE that gives the structure its name — holds the sensitive permits and licences required to do business in China.

The second entity is typically an offshore holding company in which foreigners can buy shares. The Chinese entity — which is often controlled by the holding company’s top executives — pays fees and royalties to the offshore company based on a set of contracts between the two.

VIEs are used broadly by the bevy of internet companies that for years have listed in New York. Buried deep in regulatory filings like 20Fs, the structure long received little notice. Over the last couple of years we have seen the SEC push Chinese companies using the structure to provide more extensive explanations of the relationship between the VIE and listed firm in their annual earnings reports.

A source of major unease is that if too many of a company’s assets are in the VIE then the local management could be tempted to split with the listed firm, leaving US investors with no direct claim over their investment. Additionally, there is an environment of uncertainty involved here. Beijing has neither endorsed the use of VIEs to circumvent ownership rules or come out against them. China’s courts haven’t explicitly ruled against them either.

The Alibaba-Yahoo spat isn’t the only time the VIE structure has led to disputes but it is a more recent example. From what I have seen, GigaMedia is another online computer games company that successfully dissolved the relationship between the VIE and the US-listed company after a Shanghai arbitration panel found in its favour.

There appear to be two ways that a VIE structure might collapse and cause investors damage. The first, of course, would be an outright attack by the Chinese government. Many of the VIEs are constructed to ultimately circumvent government restriction on foreign investment in certain sectors. From Alibaba’s 20F:

If we are determined not to be in compliance, the PRC government could levy fines, revoke our business and operating licences, require us to discontinue or restrict our operations, restrict our ability to collect payments, block our website, require us to restructure our business, corporate structure or operations, impose restrictions on our business operations or on our customers, impose additional conditions or requirements with which we may not be able to comply, or take other regulatory or enforcement actions against us that could be harmful to our business.

The government could simply wake up one morning and prohibit any agreement that transfers control, directly or indirectly, of any company in prohibited industries to foreigners. Such an attack would follow the Western concept of voiding contracts that are contrary to public policy and would have serious ramifications. It could leave shareholders holding worthless paper.

The other way a VIE structure might collapse is if the legal owner or founders of the VIE decides to take his company back and breach all the VIE agreements. This was the case with GigaMedia’s majority owned subsidiary T2CN. In most cases it is unlikely to happen, since the legal owner of the VIE is also the majority shareholder, and typically the CEO, of the listed company. But if the VIE owner were forced out of the public company, it is possible that he or she may choose to take “his/her ball” and go home, refusing to play. The public company would then have to sue in Chinese courts to enforce the agreement.

In either adverse case shareholders may suddenly own something worth substantially less or even nothing at all. There are other governance risks with this structure and they can be found in Alibaba’s 20F filing for those who wish to dig further.

I have bought Chinese stocks that operate VIE’s in the past. I have bought them nervously. This is an aspect I believe all investors will need to consider and weigh whether these risks outweigh what you believe to be the reward. At the very least, I would suggest Chinese companies with these structures should trade at a discount to market multiples. These properties alone may not be sufficient for some to exclude Alibaba from an investment portfolio but they are aspects that should be at least considered seriously. Corporate governance matters. In fact it often matters most when you need it to matter most.

Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd. The views expressed are his own. Anchor Investment Management Ltd is licensed to conduct investment business by the Bermuda Monetary Authority. He can be reached via e-mail at nkowalski@anchor.bm

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