Alibaba’s Behemoth IPO Making Few Ripples in WashingtonDavid J. Lynch and Robert Schmidt
Alibaba Group Holding Ltd.’s proposal for what could be the largest initial stock offering in U.S. history is sailing through Washington with few bumps.
While a federal commission has warned that the offering by the world’s biggest Internet retailer poses “major risks” for investors, the reaction from securities regulators, Congress, cabinet secretaries and competitors has been a collective shrug.
Alibaba owes its success navigating Washington’s political shoals in part to a handful of key hires over the past three years. The Hangzhou, China-based company retained a lobbying firm headed by Ronald Reagan’s last chief of staff; a former general counsel from the U.S. Trade Representative Office; and an ex-chief of staff at the Treasury Department to oversee international communications and government relations.
The Securities and Exchange Commission -- the principal regulatory hurdle Alibaba must clear before raising perhaps $20 billion -- has shown no sign it will decline to approve the stock sale that could come as early as next month. Questions about the firm’s corporate structure, accounting and sale of counterfeit goods have gone unexplored by the administration of President Barack Obama or by companies Alibaba dwarfs in sales, including Amazon.com Inc. and EBay Inc.
“This is going to be a watershed IPO,” said Anant Sundaram, a corporate governance expert at Dartmouth’s Tuck School of Business. “How come nobody at the U.S. Trade Representative, nobody at the Department of Commerce, nobody at some congressional oversight body is saying, ‘Guys, what is going on here?’ It just puzzles me that nobody is concerned.”
Senator Robert Casey, a Pennsylvania Democrat on the Senate Finance Committee, sounded a rare discordant note this week, asking the SEC to show how it’s addressing risks for buyers of stock in Chinese offerings structured like Alibaba’s.
“American investors in Chinese companies often do not enjoy the same protections and legal guarantees that they are afforded when they invest in American firms,” Casey wrote in a July 8 letter to the agency.
Alibaba has flown under Washington’s radar for several reasons. The company, with embryonic U.S. retail operations, has avoided attracting competitors’ fire by stressing its focus on the underdeveloped Chinese e-commerce market. It’s also defused U.S. government criticism by intensifying efforts to prevent pirated goods from being sold on its websites.
The company’s version of a much-debated corporate structure has been designed to minimize potential risks to investors. In any case, Alibaba has little reason to expect regulatory trouble: The SEC has assented to the same device in dozens of public offerings since 2000.
The SEC’s anticipated approval of the offering documents will follow a staff review and won’t be voted on by the full five-member commission. The process isn’t designed to judge the offering, only to ensure investors are alerted to all risks.
“The federal system is very much a non-merit based regulatory system,” said David Martin, a former head of the SEC’s division of corporation finance who is now a partner at the Covington & Burling law firm in Washington. “It effectively takes the position that you can sell anything you want, as long as you disclose it accurately.”
Ashley Zandy, an Alibaba spokeswoman, said she couldn’t comment because the company is in a pre-IPO quiet period. As required, the company has listed risks to investors in its SEC filings, including warnings about the transparency of its audits and the chance that Chinese regulators could challenge the legality of its structure.
Alibaba’s Washington reception contrasts with the spotlight trained on other China-related issues in a town where a mere whiff of controversy can spawn congressional hearings, talk-show debates and dueling advocacy reports. The House Appropriations Committee last month approved legislation renaming the street in front of the Chinese Embassy in Washington for imprisoned dissident Liu Xiaobo. In 2013, a Chinese company’s acquisition of Smithfield Foods Inc., a pork producer, stirred congressional complaints about alleged threats to U.S. food security.
Contributing to Alibaba’s momentum is a frothy market -- the Standard & Poor’s 500 index has doubled over the past five years -- coupled with great investor interest in Chinese Internet firms.
Michael Wessel, a member of the U.S.-China Security Review Commission that last month released the report critical of Alibaba’s proposal, said the market’s enthusiasm reminds him of the 1990s Internet boom, before many technology stocks plunged in value. “A lot of people are looking with glassy-eyed enthusiasm at some of these companies,” Wessel said.
The U.S.-China commission’s staff review took particular issue with the corporate structure that Chinese tech companies often use to go public, equating it to an “intricate ruse” that leaves a small cadre of executives in control while giving American shareholders few rights.
Known as a variable interest entity, or VIE, the setup allows Chinese companies to dodge a home-country prohibition against foreign investment in key industries, including the Internet and telecommunications. All of the major Chinese Internet companies that list on U.S. exchanges use the structure, including search firm Baidu Inc., online retailer JD.com Inc. and Weibo Corp., a micro-blogging service.
Some multinationals, including Amazon, also use the structure in China, leaving them poorly placed to raise questions about Alibaba.
Under a VIE, a Chinese company incorporates offshore, usually in the Cayman Islands, and uses that vehicle to go public. It then operates in China through a wholly foreign-owned subsidiary and a VIE with the latter containing the parts of the business, such as the license to operate an Internet company, that are off limits to foreign ownership.
The VIE is linked to the publicly-held parent via contracts rather than ownership. The arrangement, although tolerated by the Chinese government, “can be considered illegal in China,” the security review commission’s report said. Any dispute would force shareholders to sue in Chinese courts.
“This puts Enron to shame,” Wessel said. “These could be some of the riskiest investments anyone could engage in.”
Alibaba’s proposed structure, including having a board majority appointed by its partners, kept Hong Kong regulators from endorsing its listing, prompting the firm to go to the New York Stock Exchange instead.
Alibaba’s use of VIEs has already come under scrutiny. In late 2010, its chairman and co-founder Jack Ma took personal ownership of Alipay, the company’s electronic payment unit, when Chinese regulators refused to award it a banking license as a VIE. The move surprised and irritated Alibaba’s major shareholders, Yahoo! Inc. and Softbank Corp.
“The VIE arrangement should be receiving scrutiny because Alibaba itself has done things that raised questions about VIEs,” said Yasheng Huang, professor of global economics and management at the Massachusetts Institute of Technology and the author of five books on the Chinese economy.
In the U.S., the SEC has approved dozens of initial offerings of Chinese companies using VIEs since 2000 when it was first employed by Internet company Sina Corp. to go public.
Alibaba has been building a Washington presence since at least 2011, when it retained the Duberstein Group, run by Reagan’s former chief of staff Kenneth Duberstein. It pays the firm $100,000 a quarter, according to Senate filings.
In May the company announced that it had hired Jim Wilkinson as its head of international corporate affairs. A former executive vice president at PepsiCo Inc., Wilkinson also was chief of staff for Treasury Secretary Henry Paulson during the financial crisis and a senior adviser to Secretary of State Condoleezza Rice.
The SEC has no special procedures for high-value offerings, current and former SEC employees say. Alibaba’s filings are being vetted by a securities lawyer and an accountant in the agency’s corporation finance division, said a current employee who spoke on condition of anonymity.
While the agency’s discussions with Alibaba won’t be made public until after the IPO, some of its questions can be discerned as the company submits revised filings in response to questions from the SEC staff.
In June, for example, Alibaba laid out additional details on the 27 people who control the majority of board nominations - - a key corporate governance issue. It also provided new financial details for the company’s main shopping sites, Tmall and Taobao Marketplace.
Alibaba designed its corporate structure to mitigate potential objections to VIEs, according to Paul Gillis, a professor at Peking University’s Guanghua School of Management.
Unlike earlier Chinese companies, which went public with as much as 99 percent of their revenue assigned to the VIE, less than 12 percent of Alibaba’s revenue and 8 percent of its assets are sequestered inside the structure.
“Alibaba Group is one of the best in terms of minimizing the amount of business conducted in the VIE,” said Gillis, who spent 28 years with the accounting firm PwC. “Alipay was one of the worst. They’ve gotten religion here.”
Alibaba also defanged potential Washington opposition by addressing longstanding complaints from U.S. apparel makers, movie studios and software firms about its role in facilitating the sale of pirated goods.
The company was included for three years in the U.S. Trade Representative’s annual listing of “notorious markets,” where phony or pirated goods were routinely available. Taobao was named for four years, through 2011.
In April 2012, the Chinese company hired James Mendenhall, former general counsel in the U.S. trade representative’s office, to spearhead its drive to escape Washington’s black list. An attorney with Sidley Austin LLP in Washington, Mendenhall worked for the trade office from 2001 until January 2007, including representing the agency on the Treasury panel that scrutinizes for national security implications the takeovers of U.S. businesses by foreign investors.
Alibaba in September 2012 announced a partnership with the International AntiCounterfeiting Coalition, an industry group, to tighten its policies on removing purveyors of pirated goods.
Previously, trying to get Taobao to remove an offending item required companies to navigate a lengthy and frustrating process. The first step -- registering a trademark with Taobao - - could take six months, according to Robert Barchiesi, the coalition’s president. Then, companies had to submit evidence of the phony sales, which could lead to repeated exchanges with Taobao and the accused vendor.
“It wasn’t very user friendly,” said Barchiesi.
Now, under a streamlined system, the coalition’s 250 member companies, including Levi Strauss & Co., Microsoft Corp. and Pfizer Inc., can register in one or two days, Barchiesi said. The subsequent complaint and investigation process is “very quick,” he said.
Ensuring that none of the 760 million items the site offers are phony or stolen has been a problem. In the first 10 months of 2013, Taobao removed 114 million allegedly counterfeit listings, more than eight times the number during all of 2010, according to the company’s filings.
In 2012, the U.S. Trade Representative dropped the company from its notorious markets list, saying it had made “notable efforts” to eliminate counterfeit products.
“We have been encouraged by Taobao’s real efforts to address our concerns,” said Adam Coates, managing director for compliance and enforcement for the Software Alliance, which includes companies such as IBM and Oracle.
Not everyone is satisfied with Taobao’s efforts. Earlier this year, Nintendo Co. Ltd. complained to the Trade Representative that Taobao was still selling pirated computer games despite three years of requests to stop.
“Taobao’s compliance with Nintendo’s take down requests is sometimes outstanding, but also can be inconsistent and nearly non-existent at times,” wrote Devon Pritchard, the company’s senior vice president and general counsel.
Likewise, the American Apparel & Footwear Association says its members -- which include brands such as New Balance, Perry Ellis and Under Armour -- still find too many counterfeit versions of their products on Taobao. The association objected to the government’s decision to remove the Chinese company from the 2012 notorious markets list, said Steve Lamar, the association’s executive vice president.
Alibaba, like other Chinese companies, also faces questions about its accounting due to a dispute over international audit inspections. The Chinese government has prevented the U.S. accounting oversight board from reviewing the work of auditors in China, a stand-off that Alibaba notes in its prospectus may cause shareholders to “lose confidence in our reported financial information and procedures.”
Daniel Goelzer, a former acting chairman of the U.S. Public Company Accounting Oversight Board, said the lack of regulatory reviews is worrisome. “It is a gap in investor protection,” he said. “Having an inspection contributes to the reliability of the audit.”
Still, such concerns may be less weighty to investors than the performance of other Chinese companies using corporate structures akin to that of Alibaba.
Baidu, another Chinese Internet company, went public in August 2005 at a split-adjusted price of $2.70 per share. It closed yesterday at $183.32 in New York.
“Chinese companies’ governance is wildly out of line with U.S. standards,” said Damon Silvers, director of policy at the AFL-CIO labor union who advises regulators on issues of importance to institutional investors. “On the other hand, China is rapidly becoming the world’s largest economy and a lot of people want to play.”