Their US listing should lay to rest any argument that America champions good corporate governance
First published in Business Times, June 4, 2014
Mak Yuen Teen
© MAK YUEN TEEN
WHEN the corporate governance of News Corp came under scrutiny after the phone hacking scandal in 2011, Nell Minow of GovernanceMetrics International (GMI), which rates the corporate governance of companies, was quoted (Financial Times, July 12, 2011) as saying: “We’ve consistently given News Corp an F, only because there is no lower grade.”
A key objection to News Corp’s corporate governance is its dual class share structure, which allows Rupert Murdoch and his family to control 40 per cent of the votes while owning only about 12 per cent of the total outstanding shares. Such a share structure translates into board control by the Murdochs as they pretty much can decide who are appointed to the board, even though they own nowhere near a majority of the shares. This, in turn, is likely to lead to weak board oversight over management, which may, in turn, explain its corporate culture which has been described by one commentator as “corrupt” (http://mediamatters.org). Dual-class shares are not just a matter of shareholder rights – they make companies more susceptible to other problems in corporate governance.
GMI and other governance ratings agencies may soon have to introduce a lower grade than “F” for corporate governance of companies listed in the United States, with two China-based companies, Alibaba and JD.com, trying to outdo each other in terms of poor corporate governance practices.
Alibaba
After trying unsuccessfully to list on the Hong Kong exchange, Alibaba filed its preliminary prospectus with the US Securities and Exchange Commission (SEC) on May 6.
Alibaba certainly comes with a strong business case based on potential growth in online commerce in China. According to its filing, it is the “largest online and mobile commerce company in the world in terms of growth merchandise volume in 2013”. Unlike many technology-based companies at the time of IPO, Alibaba is already profitable, with net income attributable to shareholders of 4.2 billion yuan (S$844 million) for FY2012, 8.4 billion yuan for FY2013, and 17.5 billion yuan for the nine months ended Dec 31, 2013. Its rather colourful charts in the first few pages of the prospectus trot out statistic after statistic about its huge future potential in China and its nice growth story.
Then the colourful charts stop and the rather bland discussion of its risks starts. Every company has business risks, but what sets Alibaba apart from many others are the business and governance risks associated with its corporate governance arrangements and corporate structure. A more balanced presentation of its risks might have included a picture of a fast car hurtling down a road with no brakes – with a cliff up ahead.
Governance risks
Although most of the attention on the corporate governance of Alibaba has focused on its unusual arrangement which allows a partnership made up of 28 founders/managers to nominate a simple majority of the board of directors – in effect allowing management to control the board – this is just the tip of the governance iceberg.
Softbank and Yahoo, which currently own 34.4 per cent and 22.6 per cent respectively of the shares of Alibaba, have entered into agreements to vote their shares in favour of the Alibaba Partnership director nominees. In turn, Yahoo, Jack Ma (Alibaba founder and executive chairman who owns 8.9 per cent) and Joe Tsai (executive vice-chairman who owns 3.6 per cent) have agreed to vote in favour of the single Softbank director nominee. Softbank has also agreed to grant the voting power of its shares exceeding 30 per cent to a voting trust to be voted at the direction of Mr Ma and Mr Tsai.
Softbank and Yahoo have come out publicly voicing strong support for the governance arrangements in Alibaba. Their acquiescence may be because they truly believe that the unorthodox governance arrangements are good for the company and all shareholders, but it should also be pointed out that they stand to benefit from other commercial arrangements with Alibaba – something not available to other shareholders.
Any changes to the articles of association of Alibaba must be approved by 95 per cent of shares voted at a shareholders’ meeting, well beyond the 75 per cent in our Companies Act. This suggests that the existing shareholders, founders and managers are ensuring that they continue to control the company even if they divest substantial amounts of their shares. Further, the articles of association contain a number of antitakeover provisions involving poison pills and board entrenchment that do not require shareholders’ approval. These provisions are designed to frustrate any hostile takeover again, something not permitted under Singapore rules.
The preliminary prospectus also contains six pages describing related party transactions, mainly with Mr Ma, Mr Tsai, Yahoo and Softbank and associates, and numerous warnings about conflicts of interests.
The financial statements in Alibaba’s preliminary prospectus are also audited by auditors who are not inspected fully by the Public Company Accounting Oversight Board (PCAOB) in the US, because PCAOB currently cannot conduct inspections without the approval of the Chinese authorities. The SEC has also initiated proceedings against the China-based affiliate of the independent auditor for failure to produce audit work papers and other documents, which may result in financial statements audited by it being deemed to be noncompliant with US requirements. Given that Alibaba has substantial operations in China and the arguably weaker oversight of the work of the auditors, this may raise questions about the veracity of its financial statements in the preliminary prospectus.
Other corporate structure-related risks
Restrictions on foreign ownership in certain industries imposed by Beijing mean that Chinese companies listed overseas often have in place fairly convoluted corporate structures, essentially to get around these rules. Alibaba is no exception.
Alibaba is incorporated in the Cayman Islands and, therefore, subject to the Companies Law of the Cayman Islands. It conducts its business through wholly owned foreign enterprises, majority-owned entities and variable interest entities (VIEs). The VIEs hold the licences for the Internet service providers and operate the websites for Alibaba’s business. They are generally majority-owned by Mr Ma and minority-ownedby another founder-manager, Simon Xie. Alibaba enters into contractual arrangements with these VIEs to secure the benefits and risks of ownership, and consolidates their results into their financial statements. As the prospectus points out, China laws state that directors and executive officers owe fiduciary duty to the company they direct or manage. This puts Mr Ma in a conflict, as he also owes fiduciary duty to Alibaba as one of its directors.
Although VIEs have been used for many years by foreign companies as a backdoor way to invest in restricted sectors in China with apparent tacit approval from the Chinese authorities, many commentators have pointed out that this may change and these VIEs may have to be unwound. Further, these commentators have also pointed out possible problems with the enforceability of VIE agreements and the ability to exercise effective control over these VIEs.
Of course, all these risks are fully disclosed in Alibaba’s 342-page preliminary prospectus.
JD.com
While Alibaba has received a lot of attention, another Chinese ecommerce firm, JD.com, had earlier filed its registration statement with the SEC on Jan 30 and debuted on Nasdaq on May 22, opening 10 per cent above its IPO price. Again, it has a strong China story.
According to the company, it is the largest online direct sales company in China in terms of transaction volume. However, unlike Alibaba, it has been incurring losses, with net loss attributable to ordinary shareholders of 2.9 billion yuan for FY2011, 3.3 billion for FY2012 and 2.1 billion for the nine months to Sept 30, 2013.
It has a similar corporate structure to Alibaba in terms of incorporation in the Cayman Islands and operating through various entities, including VIEs, and therefore similar risks associated with its corporate structure. Its business risks, many of which relate to operating in China, are also similar to Alibaba.
However, the governance arrangements used by JD.com to entrench control by the founder are different from Alibaba’s. JD.com has a dual-class share structure, with Class A shares having one vote per share and Class B shares having 20 votes. Founder Richard Liu, who is also the chairman and CEO, owns 20 per cent of the shares but has more than 80 per cent of the voting rights.
Further, under the company’s articles, the board of directors will not be able to form a quorum without Mr Liu as long as he remains a director. Therefore, he controls the board. As JD.com acknowledged, the control that he has is a significant deterrent against any potential hostile takeover.
As Reuters (May22) reported, JD.com awarded Mr Liu 93.78 million “immediately vesting restricted share units” as a oneoff bonus “in consideration of his past and future services”, and booked a US$891 million share-based expense. It is unclear what restrictions are applicable to these share units.
Other governance issues in Alibaba such as potential conflict of interests of the founder and other key executives, the inability of the PCAOB to fully inspect the work of the auditor, and SEC action against the China-based affiliate of the auditor also apply to JD.com.
Race to the bottom
The listing of Alibaba and JD.com in the US should lay to rest any argument that America is an example for others to follow when it comes to good corporate governance – even if these companies are foreign companies.
JD.com has had a successful debut on Nasdaq and Alibaba may follow suit. Given their governance arrangements, I believe their China stories will not have a fairy tale ending for minority investors.
The writer is an associate professor of accounting in the NUS Business School¨ where he teaches corporate governance and ethics
