Alibaba investors are aware that BABA trades on different exchanges, but many more investors don’t know what that means for their shares. So, this post is not meant to provide scare tactics or present a bullish/bearish case for $BABA or any Chinese stocks listed on US stock exchanges. It is a post to help with some clarification around what is happening in the background. To allow investors to make informed decisions. This applies to every Chinese company on the US stock exchanges – and I mean every company! So, as always, do your research.
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The first thing we need to understand is what are the Variable Interest Entity (VIE) and American Depositary Share (ADS) definitions.
Variable Interest Entity – Quick points
- A variable interest entity (VIE) refers to a legal business structure in which an investor has a controlling interest despite not having a majority of voting rights.
- Investors in VIEs do not participate in residual gains or losses.
- VIEs are set up with a unique structure where investors do not have a direct ownership stake in the entity but rather have special contracts, which specifies rules and a percentage of profits.
- Therefore, in a VIE, the investor does not participate in residual profits or losses that usually come with ownership.
- The contracts do not provide for voting rights either.
- American Depositary Shares (ADS) refer to shares in foreign companies that are held by U.S. depositary banks and can be traded in the U.S., including on major exchanges.
- The terms American Depositary Shares and American Depositary Receipts are often used interchangeably.
- ADSs allow foreign companies access to a wider investor base and the world’s most sophisticated financial marketplace.
- An ADR is a negotiable certificate issued by a U.S. bank, under agreement with the foreign company, and is evidence of ownership of ADSs, much the same way a stock certificate denotes ownership of equity shares.
Why is this important to know?
Every Chinese company that is listed on US stock exchanges is impacted by these rules. It is not common knowledge that China forbids foreigners from owning stock in a Chinese company. So, every single Chinese stock has the same VIE risk. This goes for NIO, Tencent, NetEase, JD.com etc. Under Chinese law, there is no way for a foreigner to do business in China other than through a VIE.
In short no – this is because they are both fully fungible. Meaning that you can convert from one to the other (US’ ADSs convert to about 8 HK shares). There is a lot of misconception that ADSs only give you economic ownership of a VIE. Where an HK listing provides direct ownership of the company… Ummm nope. They both provide ownership in a company, but that company is Alibaba Group Holding Limited. This company is incorporated in the Cayman Islands.
All Chinese companies on US exchanges are. Don’t believe me – go look at the SEC filings and search for the words “Cayman Islands”. Here is Alibaba’s one https://www.sec.gov/Archives/edgar/data/1577552/000104746919006309/a2240097z424b5.htm. Alibaba Group Holding Limited is a holding company that has economic interests in China. This is done via contracts with certain VIEs. As we now know, VIEs must be owned by a Chinese citizen. See where I am going with this?
Some investors fear the risk that the CCP could confiscate VIEs, which would impact the income of the holding company. So even if they do it to the $9988, it is going to impact the BABA shares in the US. Alibaba is massive and forms part of several significant mutual funds across the globe. Particularly in Asia so if the CCP were to do this, there would be a massive uproar. Not saying they would not do it, but the risk is very very low.
This is an excerpt from the SEC filing of Alibaba about fungibility and conversion between the two
Corporate Information
“Alibaba Group Holding Limited is a Cayman Islands holding company established under the Companies Law of the Cayman Islands (as amended) on June 28, 1999, and we conduct our business in China through our subsidiaries and variable interest entities. Our ADSs are listed on the NYSE under the symbol “BABA.”
https://www.sec.gov/Archives/edgar/data/1577552/000104746919006309/a2240097z424b5.htm
So, $BABA represents ownership of a holding company in the Cayman Islands, not Alibaba itself. They do not even have ownership of Alibaba’s equity. It is kind of poetic that Alibaba was able to raise billions from foreign investors. Even without giving up a single bit of ownership. This goes for all Chinese listed companies on US exchanges.
This is where some Alibaba investors see the risk.
The SEC just last month in a report published in November 2020 expressed serious concerns:
“These China-based Issuer VIE structures pose risks to U.S. investors that are not present in other organizational structures. For example, exerting control through contractual arrangements may be less effective than direct equity ownership, and a company may incur substantial costs to enforce the terms of the arrangements, including those relating to the distribution of funds among the entities. Further, the Chinese government could determine that the agreements establishing the VIE structure do not comply with Chinese law and regulations. Including those related to restrictions on foreign ownership, which could subject a China-based Issuer to penalties, revocation of business and operating licenses, or forfeiture of ownership interests. ” Source: https://www.sec.gov/corpfin/disclosure-considerations-china-based-issuers
If you are interested, mainland Chinese companies listed on the HK Exchange are also VIE’s and considered “offshore”. Here is what the org structure looks like https://cdn.i-scmp.com/sites/default/files/d8/images/methode/2020/12/21/7b58a856-4294-11eb-be63-b2d34bb06b66_972x_163317.jpg
ADS information https://www.investopedia.com/terms/a/ads.asp
VIE information https://www.investopedia.com/terms/v/variable-interest-entity.asp
