A Loophole Poses Risks to Investors in Chinese Companies

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Jack Ma, the chairman of the Chinese Internet giant Alibaba, surprised A Loophole Poses Risks to Investors in Chinese Companiesinvestors last May when he acknowledged that he had transferred the assets of the company’s online payment platform to a private company that he controlled.

Executives at Yahoo, which owns around 40 percent of the privately held Alibaba Group, complained that they had not been properly informed of the move, and that the Alibaba board did not approve the transfer.

While the dispute was later resolved, it raised questions about the risks of investing in Chinese companies using a little-known regulatory loophole. Legal analysts scrambled to explain that investments in China’s Internet industry, among others, had hidden risks, and that government scrutiny of the loophole was increasing.

“There’s still a lot of uncertainty,” Steven Xiang, the Shanghai-based managing partner at Weil, Gotshal & Manges, the American law firm, said. “No regulatory changes have occurred yet. But investors need to consider their risk appetite.”

For years, big Internet companies in China, like Alibaba and Baidu, have raised billions of dollars by effectively skirting Chinese regulations that ban foreign investors from acquiring stakes in companies operating in restricted industries, like energy, telecommunications and the Internet.

Using a complex investment vehicle known as the variable interest entity — or V.I.E. — Chinese companies have been able to accept money from foreign investors through offshore entities they set up.

In the case of Alibaba, Mr. Ma controls a Chinese company that transfers its economic returns and governance structure to an offshore entity in the Cayman Islands. That vehicle, in turn, is contractually tied to the Alibaba Group and the Hong Kong-listed Alibaba.com, which it operates.

Sina.com was one of the first to use this complex arrangement. But virtually every major Chinese Internet company has adopted a similar structure.

Worries about United States-listed Chinese companies using this regulatory loophole are often confused with efforts by much smaller Chinese companies to list in the United States through so-called backdoor listings, or by acquiring the shell of an American company and merging Chinese assets into it. Companies using that method came under attack last year because of accounting scandals.

Full article-http://dealbook.nytimes.com/2012/01/23/a-loophole-poses-risks-to-investors-in-chinese-companies/

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