Alibaba’s IPO is the most anticipated of the year, but the US-China Economic and Security Review Commission (USCC) has issued a report warning investors that the variable interest entity (VIE) structure commonly used by Chinese internet stocks to list in the West involves more legal risk than they may realize.

Alibaba

VIE structure is meant to bypass Chinese regulations

Technically, Chinese internet stocks aren’t allowed to have foreign investors. China restricts strategic and emerging industries (SEIs) and other politically sensitive industries from foreign ownership, and it’s almost impossible for a major internet company to get permission to list outside China. VIEs are a workaround that creates a chain of contracts that connect investors to the company without actually selling shares that would explicitly violate Chinese law. USCC policy analyst Kevin Rosier presents Weibo Corp (ADR) (NASDAQ:WB) as an example, but he says that Baidu Inc (ADR) (NASDAQ:BIDU), Renren Inc (NYSE:RENN), and basically every other major Chinese internet company uses the same structure.

The company that’s actually trading on the NASDAQ is Weibo Corp (ADR) (NASDAQ:WB) based in the Cayman Islands, which is the sole owner of Weibo Hong Kong Limited, which owns the Chinese subsidiary Weibo Internet Technology (China) Co. Ltd. Beijing Weibo Interactive Internet Echnology Co Ltd, the company that actually runs the Weibo service, is owned by Beijing Weiming Technology Co Ltd, which has contractual arrangements with Weibo Internet Technology.

weibo structure 0714

“In sum, this intricate ruse is a way of making the business appear to be Chinese-owned to Chinese regulators while claiming to be a foreign-owned business to foreign investors.Neither claim is technically true, and the arrangement is highly risky and potentially illegal in China,” writes Rosier. “Since the entire VIE structure is built on the premise of circumventing Chinese government regulations, relying on Chinese courts to uphold the VIE contracts in court is highly risky.”

Shareholders may not have legal recourse against Alibaba

Rosier points out that the VIE structure hasn’t been challenged in court, so there’s no existing precedent to guide investors on how such a suit might play out, but he thinks investors should be more concerned about the lack of judicial support.

He highlights an episode in 2010 when Alibaba chairman Jack Ma spun off the online payment service Alipay into a separate company with himself as the sole owner, leaving Yahoo! Inc. (NASDAQ:YHOO) in the cold. Under the preferential stock issue that Alibaba is proposing, investors will have no right to vote on company decisions. Couple that with the VIE structure makes a legal battle risky, and Rosier thinks the market is underestimating the level of risk in the coming Alibaba IPO.