June 22 (Bloomberg) -- Yahoo! Inc. and Japan’s Softbank Corp., eager for a slice of profits in China’s Internet industry, found that even a seemingly safe way around restrictions can turn risky and threaten the value of their stake in the country’s biggest e-commerce provider.
Yahoo and Softbank, major shareholders of online-commerce company Alibaba Group Holding Ltd., have been bypassing the restrictions by contracting with Chinese partners to provide technical services in exchange for a share of revenue.
The tactic worked until Alibaba Group’s online payment service, Alipay, applied for an operating license under China’s new rules for payment service providers. Regulators balked and asked Alipay to prove it had no contractual ties to foreign investors, according to domestic media including the People’s Daily and the Nanfang Daily.
That Chinese officials hadn’t challenged the investments earlier is characteristic of a regulatory environment fraught with inconsistent enforcement, broadly worded rules and a lack of transparency, said lawyers including Tom Shoesmith, head of law firm Pillsbury Winthrop Shaw Pittman LLP’s China practice.
“Western businesses come into China and they want to know what the rules are,” Shoesmith said. “There’s the technically correct answer, there’s the practical answer, and then the third one is, ‘Who cares anyway?’ Sometimes the answer is ‘Who cares anyway?’ until you get busted.”
As Alibaba founder Jack Ma haggles with the shareholders, including Sunnyvale, California-based Yahoo, over compensation for the soured investment, the share price of Alibaba.com Ltd., Alibaba’s publicly traded unit, remains close to a two-year low.
In a joint statement today, Yahoo, Softbank and Alibaba said “substantive” progress has been made toward an agreement on Alipay.
“Our objective is to reach an agreement in a timely manner,” the companies said. No further comments would be made “until it is appropriate to do so,” they said.
Alibaba.com rose 5.6 percent to HK$11.98 at 4 p.m. in Hong Kong trading, and Softbank advanced 4.4 percent to 2,985 yen in Tokyo. Yahoo gained 2.4 percent to $15.35 Nasdaq Stock Market trading yesterday.
Unclear regulations are one of the top five obstacles for American investors in China, which also include intellectual property infringement, according to the 2011 White Paper by the American Chamber of Commerce in the People’s Republic of China.
Ted Dean, the chamber’s chairman, said there is often a lack of regulatory clarity in government approvals for products and licenses.
“There are cases where in actuality the government is operating on internal guidance that foreign companies don’t have access to or discover after the fact,” Dean said. “Or the guidance is communicated to them in the approval process orally and you ask, ‘Where’s that in the law?’”
The result was usually lost business or increased costs for the companies to discover unpublished rules, Dean said.
Authorities in the southern city of Shenzhen slapped a 13.7 million yuan ($2.1 million) tax bill on a Hong Kong individual for selling a local shipping and storage asset to a Singaporean company.
Brendan Kelly, a Shanghai-based tax partner at Baker & McKenzie LLP, said the legal basis for the Shenzhen tax bureau’s assessment is questionable under China’s 3 1/2-year-old tax code because the relevant tax avoidance laws so far apply to corporations and not to individuals.
Reluctant to Sue
Foreign investors are reluctant to sue, even if the law is on their side, because it’s often viewed as counterproductive and harmful to their relationship with regulators, Kelly said.
“You figure you’ll pay for it some other way down the line,” he said. “There are so many gray areas in the law.”
China’s national security review for foreign mergers and acquisitions, which came into effect in March, is already stalling deals because even authorities aren’t sure how it applies, said Lester Ross, a Beijing-based partner at Wilmer Cutler Pickering Hale & Dorr LLP.
The regulations define sectors such as agricultural products and infrastructure facilities as broadly relating to national security. Transactions less than $300 million that otherwise could have been dealt with at the local level are now being referred to the commerce ministry for review, Ross said.
“In part because the national security regulation is at minimum vague and at worst broader than the published version indicates, local governments are paralyzed,” Ross said.
Services-for-revenue contracts like the one used by Yahoo and Softbank to tap domestic profits put off-limits by China’s rules have burned investors before. Foreign companies circumventing restrictions on investing in China’s telecommunications networks had their structures declared illegal in the late 1990s.
China Unicom (Hong Kong) Ltd. spent at least 1.19 billion yuan ($184 million) compensating foreign partners including Sprint Corp. and Deutsche Telekom AG, according to its 2001 interim results.
U.S.-listed Chinese companies like Baidu Inc. and Sina Corp. today use the same structure as Yahoo and Softbank, by arranging software licensing and other service contracts in exchange for a share of revenue with foreign investors.
As of April, 42 percent of U.S.-listed Chinese companies used the so-called variable-interest entities structure, or VIE, according to Paul Gillis, a visiting accounting professor at Peking University who cited a paper written by Fredrik Oqvist, a former student at the university. The companies are concentrated in the Internet sector because of its restricted nature.
They also include educational companies such as New Oriental Education & Technology Group Inc. which used a VIE in part because foreign ownership of primary and middle schools in China is prohibited, according to the company’s 2006 U.S. listing prospectus.
“Investors are at risk of losing their investments if Chinese officials decide to strictly enforce laws that prohibit foreign investment in certain sectors,” Gillis wrote in an e-mail about Alibaba’s experience.
Delaware-incorporated Buddha Steel Inc. was forced to withdraw its application for a $38 million U.S. listing in March after officials in northeastern China’s Hebei province said its VIE contravened foreign investment rules. Buddha Steel canceled its contractual relationships with a Hebei-based cold-rolled steel manufacturer after the government’s objection.
Alibaba’s Hong Kong-listed unit Alibaba.com didn’t try to hide the questionable legal status of the VIEs in its 2007 Hong Kong listing prospectus.
“We cannot assure you that the PRC government would agree that these arrangements comply with PRC licensing, registration, or other regulatory requirements,” the company said in describing its risk factors.
In response to questions about the loss of Alipay, Yahoo founder and Alibaba Group board member Jerry Yang told analysts on May 25 that “based on our own inquiries and various interactions” with the People’s Bank of China, the company had come to believe the regulator was planning a “different” regulatory structure surrounding online payment companies.
Alibaba spokesman John Spelich declined to confirm Alipay Chief Financial Officer Jing Xiandong’s comments, reported by the Nanfang Daily on June 16, that the central bank had asked Alipay for documentation showing that it wasn’t operating under a VIE structure. The PBOC didn’t respond to a faxed request to confirm it had objected to Alipay’s VIE.
In a letter to clients, Shoesmith wrote that Buddha Steel’s experience was probably a one-off occurrence for the very reason that the nation’s Internet “crown jewels” would be affected by any crackdown.
“This is rule of law with Chinese characteristics,” said Shoesmith. “It leaves lots of discretion to the government to decide on a case-by-case basis.”
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