In September, Alibaba Group launched the largest IPO in history, raising $25 billion from investors keen to own a slice of China’s most successful e-commerce company. For the moment, the potential for vast wealth overrode concerns about Alibaba’s unusual corporate structure and governance practices. Maybe it shouldn’t have. Alibaba uses what is called a variable interest entity (VIE) structure, which has its roots in the collapse of the energy giant Enron in 2001 and could likewise be the downfall of investors in Alibaba and other Chinese stocks.
The VIE structure involves control of a company through contracts instead of ownership. In other words, significant parts of Alibaba are not owned by the public company but are, rather, held in corporations, which are owned by the Alibaba founder Jack Ma and his close associates. These corporations have signed contracts with the Alibaba Group that give the public company control of VIE operations and access to its profits. Contractual control is inferior to actual ownership, putting investors at considerable risk.
About half of the more than 200 Chinese companies that are traded on U.S. exchanges use the VIE structure. The purpose is to circumvent Chinese restrictions on foreign investment in sensitive sectors of the Chinese economy, most notably including the e-commerce and education sectors, which are particularly attractive to foreign investors. Because the VIE is owned by Chinese individuals, the company can present itself to Chinese regulators as locally owned, thereby enabling it to obtain permits that are not available to companies that receive foreign investment. Meanwhile, on the foreign investor side, the company can present the VIE as if it were a wholly owned subsidiary.
The differences in accounting on the Chinese and U.S. sides are possible because of U.S. accounting rules that were adopted in response to the Enron scandal. Enron had made clever use of special purpose entities (SPEs) owned by its treasurer, Andrew Fastow, to borrow significant sums. At the time, such entities were