Could Alibaba Be The Next Enron?
Most U.S. investors have never heard of China Minsheng Bank Corp. Ltd or GigaMedia Ltd. (Nasdaq: GIGM ). But both companies ended up in deep trouble for using a risky corporate structure. It was a structure used by Enron back in the 1990's, and ultimately led to the loss of billions in investors' funds.
And the hottest initial public offering of 2014, Alibaba Group Holding Ltd (Nasdaq: BABA ) is using the same trick. A closer look at the issue explains why you should think twice about buying shares of Alibaba. If you already own shares, then you need to know about this key risk.
To help shield the true nature of its balance sheet, Enron's financial masterminds used an unusual contract known as a variable interest structure, or VIE. Using a VIE, a company can disconnect the ownership of its assets from the claims of shareholders. In effect, key assets are placed into separate corporations, which are wholly-owned by the company's management. Ancillary contracts are then typically established that pledge equity, assign profits and establish consulting agreements.
In the United States, embarrassed financial regulators abolished the use of a VIE after the dot-com implosion. Rules now clearly state that all assets and liabilities in a corporation are controlled solely and directly by shareholders. Gone are the days of "off-balance sheet" side deals that are typically a mere accounting trick to defraud investors.
Trouble is, the VIE structure remains quite popular in China, as dozens of firms use them. The stated logic for them appears quite logical. The Chinese government has a very hefty set of restrictions about what kinds of businesses and assets and can be owned by foreigners. For example, Chinese banks are off-limits, so banks sought ways to get around that. That's where Minsheng Bank came in.
Minsheng's founder, Nina Wang, a billionaire from Hong Kong took control of a Chinese mainland holding company to acquire shares of Minsheng. The arrangement lasted for several years until Chinese courts decided that Ms. Wang's contracts (through a VIE) were not valid. Almost all of her equity in Minsheng bank vanished overnight. The Chinese courts ruled that the VIE was aimed at "concealing illegal intentions with a lawful form." Paul Boltz, a lawyer with Hong Kong's Ropes & Gray law firm told The New York Times that "this case shows that contracts used to get around China's foreign investment restrictions can be struck down by the courts." Minsheng Bank is now flourishing again, though Nina Wang's heirs own just a tiny fraction of the bank.
After that court decision, you would think that many other Chinese companies using a VIE would have moved quickly to dissolve these structures, lest they run the risk of seeing their contracts invalidated. But they haven't and instead continue to embrace them.
The case involving GigaMedia is a bit more complex. The Taiwan-based video game company used a VIE in 2011 to gain control over a Chinese rival. When disputes arose, GigaMedia found that it had no legal claims to stand on in court. Shares of GigaMedia, which traded for $25 back in 2007, now trade for $1. That crash isn't solely the result of the VIE debacle, but it didn't help assure U.S. investors about management's integrity and intelligence.
Jack Ma's thoughts
It's hard not to be impressed by Alibaba's Jack Ma. A recent profile on 60 Minutes gave the impression of a humble -- and brilliant -- visionary. He is a kind of Steve Jobs or Mark Zuckerberg, minus the hubris. But he has also shown an especially deft hand in manipulating contracts to ensure that his firm -- and his interests -- are protected. For example, unbeknownst to Yahoo!, Inc. (Nasdaq: YHOO ), the company's largest outside shareholder, he placed a payment division known as Alipay into a VIE. Yahoo was rudely surprised when it found out that it technically had no ownership interest in that asset. (The two sides ended up settling the issue out of court, mostly in Alibaba's favor.)
Yet Ma holds many other Alibaba assets in a VIE. Ostensibly, the goal has been to circumvent Chinese foreign ownership rules, but as we've seen, they can also leave outside shareholders holding the bag. Make no mistake, if a Chinese court decided to challenge Alibaba's use of a VIE, then Jack Ma would likely be insulated from the fallout, as he and his close associates are the direct owner of the key assets, not outside shareholders.
The Securities & Exchange Commission is well aware of the issue, and now compels companies using a VIE to note that their contracts may not be enforceable in Chinese courts. To his credit, Alibaba's Ma has been forthcoming about the issue. He said that if China loosened foreign ownership laws, he would unwind the VIE structure. Yet there's no way of knowing if the government will shift gears. And until we see any changes, investors run the risk of owning the next Minsheng Bank or GigaMedia through their stake in Alibaba.
Risks To Consider: As an upside risk, Chinese stocks may garner a higher multiple if the Chinese laws are changed and the VIEs are unwound.
Action To Take --> The VIE structure is used by many Chinese companies, and you should read the financial filings of any Chinese stock you may own. As Enron showed us, balance sheet games can often come back to bite -- hard.
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