U.S. Investors in China’s Internet Companies Face Risks

U.S. shareholders face “major risks” from investing in Chinese Internet companies such as Alibaba Group Holding Ltd. that use a variable interest entity, according to a U.S. congressional commission report.

Risks are associated with VIEs because the structures create holding companies to link foreign investors to Chinese firms via a set of complex legal contracts, according to the June 18 report by the U.S.-China Economic and Security Review Commission. There is a “high probability” Chinese courts will not uphold those contracts, the report said.

Alibaba, now preparing for what could be the largest ever initial public offering in the U.S., would follow Chinese Internet companies Baidu Inc. and Weibo Corp. in securing a U.S. listing using the VIE structure. These entities, usually based in tax havens such as the Cayman Islands, help circumvent China’s restrictions on access to foreign capital while putting investors at risk from their legal complexity, the commission said.

“The legal contracts that serve as the basis of the structure are enforceable only in China,” the report said. “As Internet giants Alibaba, Baidu, and Weibo become synonymous with ‘Chinese Amazon,’ ‘Chinese Google,’ and ‘Chinese Twitter,’ risks could mount for unsuspecting U.S. investors who buy into their precarious VIE structures.”

Revenue generated through Alibaba VIEs only accounted for about 12 percent, or 6.17 billion yuan, of sales in the year ended March, according to its SEC filing. Florence Shih, a spokeswoman for Hangzhou-based Alibaba, declined to comment on the report.

Moody’s Review

In a review of Baidu’s VIE structure in May, Moody’s Investors Service found that Baidu can manage the risks of variable interest entity ownership “because the founders and top executives own significant stakes in both the onshore VIEs and the offshore entities.” In addition, the majority of the company’s cash flow resides offshore, Moody’s concluded.

Baidu’s filings have supplied investors with “detailed disclosure as well as a thorough explanation of the company’s structure,” the company said today in an e-mailed statement.

Risks inherent in the VIE structure have been disclosed to investors by the Chinese companies, including Alibaba, as part of their IPO processes, according to the report.

The VIE structure is required because foreign ownership of certain types of Internet businesses, such as online information services, is subject to restrictions under China’s laws, and foreign investors are generally not permitted to own more than 50 percent of the equity interests in a value-added telecommunications service provider.

The commission that published the report was created by the U.S. Congress in October 2000 to monitor the national security implications of the Sino-U.S. trade and economic relationship, and to provide recommendations to Congress for legislative or administrative action.

The report says the U.S. should engage China on remedying the risks with VIEs by eliminating restrictions on China’s Internet; liberalizing China’s financial markets; improving China’s rule of law; and clarifying the legal status of VIEs.