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A Loophole Poses Risks to Investors in Chinese Companies

SHANGHAI — Jack Ma, the chairman of the Chinese Internet giant Alibaba, surprised investors last May when he acknowledged that he had transferred the assets of the company’s online payment platform to a private company that he controlled.

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Photo: Getty Images AsiaPac

Executives at Yahoo, which owns around 40 percent of the privately held Alibaba Group, complained that they had not been properly informed of the move, and that the Alibaba board did not approve the transfer.

While the dispute was later resolved, it raised questions about the risks of investing in Chinese companies using a little-known regulatory loophole. Legal analysts scrambled to explain that investments in China’s Internet industry, among others, had hidden risks, and that government scrutiny of the loophole was increasing.

“There’s still a lot of uncertainty,” Steven Xiang, the Shanghai-based managing partner at Weil, Gotshal & Manges, the American law firm, said. “No regulatory changes have occurred yet. But investors need to consider their risk appetite.”

For years, big Internet companies in China, like Alibaba and Baidu, have raised billions of dollars by effectively skirting Chinese regulations that ban foreign investors from acquiring stakes in companies operating in restricted industries, like energy, telecommunications and the Internet.

Using a complex investment vehicle known as the variable interest entity — or V.I.E. — Chinese companies have been able to accept money from foreign investors through offshore entities they set up.

"A back door for foreign investment in restricted industries is scrutinized."

In the case of Alibaba, Mr. Ma controls a Chinese company that transfers its economic returns and governance structure to an offshore entity in the Cayman Islands. That vehicle, in turn, is contractually tied to the Alibaba Group and the Hong Kong-listed Alibaba.com, which it operates.

Sina.com was one of the first to use this complex arrangement. But virtually every major Chinese Internet company has adopted a similar structure.

Worries about United States-listed Chinese companies using this regulatory loophole are often confused with efforts by much smaller Chinese companies to list in the United States through so-called backdoor listings, or by acquiring the shell of an American company and merging Chinese assets into it. Companies using that method came under attack last year because of accounting scandals.

There is no relationship between the two. But last year, investors grew nervous about Chinese stocks, and short-sellers tried to capitalize on the concerns to pummel the share prices of United States-listed Chinese companies.

Chinese companies using the V.I.E. structure are generally much larger and include many of the most profitable young companies in China.

Private companies often chose this route because they had difficulty raising capital in China, where state-run banks tend to favor government-owned companies.

That is perhaps one reason Chinese regulators long ago gave tacit approval to such arrangements. As a result, about 108 of 225 Chinese companies listed on Nasdaq and the New York Stock Exchange use the V.I.E. structure, according to a study done by Fredrik Oqvist, an independent analyst in Beijing.

But in recent years, the Chinese government has grown increasingly uneasy with the arrangement. Several regulatory agencies, including the Ministry of Commerce and the central bank, have questioned the viability of the complex structure in public statements.

Last October, some Western law firms cautioned clients that the China Securities Regulatory Commission had written an internal memo raising doubts about the V.I.E., noting that “foreign parties with unknown motives own significant stakes in major Chinese Internet enterprises.”

Legal experts, though, doubt Chinese regulators will abolish the practice or even force big Chinese companies to unwind their structures any time soon.

“That’d be like taking a knife to about 80 U.S.-listed companies that have used this structure over the past 12 years,” said Lawrence Sussman, managing partner in the Beijing office of O’Melveny & Myers, the United States law firm. “This structure is unlikely to go away.”

But many legal analysts say the risks are real.

“We’ve developed a structure that’s fraught with risk,” said Paul Gillis, a visiting professor of accounting at Peking University in Beijing. “And until recently, I don’t think investors realized the risks. The Alibaba case is the one that set some of this off.”

Alibaba said it had no choice but to transfer the assets of its online payment platform, Alipay, to a private company controlled by Mr. Ma after Beijing regulators tightened controls over online payment systems and threatened to make the operations of Alipay illegal. That could have posed dangers to Alibaba’s fast-growing e-commerce unit, Taobao.

An Alibaba Group spokesman, John Spelich, said that the disagreement with Yahoo was resolved and that worries about the V.I.E. structure were exaggerated.

The V.I.E. structure “is a longstanding, well-recognized and legally compliant model, and there is no indication that it is about to change with regard to responsible companies that play by the rules,” he said in a statement. “As far as I am concerned, last year’s entire V.I.E. controversy was nothing but a tempest in a teapot that benefited the shorts and excited the traditional critics of China and open international trade and investment.”

But some critics saw Alibaba’s move as a sign that Mr. Ma, the company’s chairman, could move a valuable piece of the Alibaba Group off the books to hide its value from one of its biggest shareholders, Yahoo.

At the time of the move, Alibaba and Yahoo had been at odds over Yahoo’s stake in the company. The Alibaba Group remains one of Yahoo’s most valuable assets, and Alibaba has been pressing Yahoo to give up that stake and sell it back to Chinese investors.

The dispute was resolved in July, when Mr. Ma agreed to certain conditions. If Alipay goes public with a stock offering, Alipay will pay the Alibaba Group — which is partly owned by Yahoo and Softbank of Japan — at least $2 billion but no more than $6 billion, plus certain licensing fees.

If Yahoo disposes of its stake ahead of an Alipay stock offering, its stake in Alibaba will most likely be adjusted to reflect Alipay’s value before an offering, analysts say. A sign of confidence in the deal came when last September, when an investment group that included Silver Lake Partners and DST Global agreed to pay about $1.6 billion to acquire a stake in the Alibaba Group, valuing the company at about $32 billion.

Still, the controversy over Alipay leaves open many questions, analysts say. Chief among them is who really controls Alibaba and other Chinese companies that use the V.I.E. structure — the global investors who financed the companies, or the Chinese who control the local operation.

Steven M. Dickinson, a lawyer who has worked in China for years at the United States law firm Harris & Moure, said global investors were ignoring risks. While the Chinese government may not soon move to unravel the deals, it could do so at any time, he says. And if it is to their advantage, the local Chinese owners could also dismantle the structure without approval.

“It’s prohibited for foreigners to own an Internet company of any kind in China — not discouraged, but prohibited,” Mr. Dickinson said. “Every lawyer agrees that if this goes to court in China, those contracts are void; they’re illegal.”