Posted by John SOH Yong Ye, Year 4 undergrad at the School of Economics, Singapore Management University
Alibaba Group Holding Ltd. investors got a taste this week of why investing in Chinese businesses can be fraught no matter how large or blue chip the company is. Although the e-commerce giant, in my view, appears to be on solid legal ground with the disclosures it made to investors ahead of its IPO in September about its challenges with fake goods, the skirmish shows there are limits on how much investors can really know about Alibaba or any public company relying heavily on Chinese operations.
On Wednesday, a Chinese government regulator issued a report criticizing Alibaba for failure to crack down on the sale of fake goods, bribery and other illegal activity on its platform. The regulator said the report was based on discussions last July but that the regulator held off on disclosing details of the talk so as not to affect Alibaba’s IPO. Alibaba called the report flawed and unfair.
From a legal perspective, the timing of events could raises issues about Alibaba’s disclosure in its IPO documents, particularly in light of the Chinese regulator’s implication that its concerns were kept secret to facilitate the IPO. If there were a material misstatement in, or omission from, the 442 page prospectus Alibaba prepared for the IPO and issued last September, the company and even the directors and underwriters could have liability. Liability standards around an offering are much lower than other disclosure missteps.
To avoid liability with an IPO, directors and underwriters must generally show they conducted a reasonable investigation and had reasonable grounds to believe there was not a material error. This is sometimes called the due diligence defense. Outside of public offerings, director liability is extraordinarily rare. Proof of intentional fraud or at least reckless conduct is usually required if there is no offering.
It is because of the low liability threshold in an offering that the WorldCom directors were among the very few directors of public companies who personally had to write checks when WorldCom melted down a few months after a big sale of bonds. After a landmark opinion on due diligence, the underwriters also ended up with liability in WorldCom.
On Thursday’s earnings call, Alibaba Executive Vice Chairman Joe Tsai stated that the company thought the meeting with the regulator last July was routine. And he said that the company did not ask the regulator to delay the report and didn’t see it until it was posted. Under these circumstances, in my view it could be hard to hold anyone liable on the IPO even with the low threshold of liability.
The so-called risk factors Alibaba included in its September prospectus make very clear that Alibaba faced these kinds of risks. One risk factor says “We have received in the past, and we anticipate we will receive in the future, communications alleging that items offered or sold through our online marketplaces… infringe third-party” rights. It even discloses that bad things may come from that: “Any costs incurred as a result of liability or asserted liability relating to the sale of unlawful goods or other infringement could harm our business.”
And the regulatory risks of operating in China are discussed in several places. One disclosure says: “Changes in regulatory enforcement … in [China] could also result in additional compliance obligations and increased costs or place restrictions upon our current or future operations. Any such legislation or regulation could also severely disrupt and constrain our business…”
Although these disclosures are general, unless the company knew of more specific information that was material at the time the company went public, the language is probably sufficient to protect everyone from liability. Such risk factors—frequently criticized as boilerplate—are intended to have that effect. Lawyers sometimes explain them to their clients who balk at such negative disclosure as “insurance policies” to protect everyone if something goes wrong. In this case they look like they have done their job.
The biggest impact the regulator’s white paper may have is to emphasize the lack of reliable information about business in China, even with respect to a large and prestigious company like Alibaba.
Even if Alibaba has been trying all along to do the right thing, investors now know there were some questions – legitimate or not — that someone in the government kept out of public view. Transparency has long been an issue for investors and regulators for other companies listed in the U.S. with significant operations in China. Over the last several years, the Securities and Exchange Commission has fought with Chinese accounting firms and Chinese regulators over the SEC’s ability to review work papers generated in the audit of companies publicly traded in the US. And a little over a year ago, U.S.-based Cooper Tire & Rubber Co.CTB -2.00% saw its sale effectively blocked by a Chinese joint venture partner and a labor union which locked Cooper out of access to its own books and records, even though they had no apparent contractual right to stop the deal.
In the case of Alibaba, the Chinese regulator hasn’t helped the concern over lack of transparency. First, it delayed the issuance of the report, purportedly to facilitate the IPO.
Now, word today emerges that it has taken the report off of its web site as part of what appears to be a potential resolution of the dispute. Late Friday in China, the regulator said it and Alibaba agreed tackle fakes and boost consumer protection online. Alibaba said it felt “vindicated” by the outcome.
The bottom line is that the protective disclosures in massive prospectuses can help a company on the legal front, but investing in companies dependent on Chinese operations has its own risks, even for the largest companies operating there.
Alibaba Group Holding Ltd. investors got a taste this week of why investing in Chinese businesses can be fraught no matter how large or blue chip the company is. Although the e-commerce giant, in my view, appears to be on solid legal ground with the disclosures it made to investors ahead of its IPO in September about its challenges with fake goods, the skirmish shows there are limits on how much investors can really know about Alibaba or any public company relying heavily on Chinese operations.
On Wednesday, a Chinese government regulator issued a report criticizing Alibaba for failure to crack down on the sale of fake goods, bribery and other illegal activity on its platform. The regulator said the report was based on discussions last July but that the regulator held off on disclosing details of the talk so as not to affect Alibaba’s IPO. Alibaba called the report flawed and unfair.
From a legal perspective, the timing of events could raises issues about Alibaba’s disclosure in its IPO documents, particularly in light of the Chinese regulator’s implication that its concerns were kept secret to facilitate the IPO. If there were a material misstatement in, or omission from, the 442 page prospectus Alibaba prepared for the IPO and issued last September, the company and even the directors and underwriters could have liability. Liability standards around an offering are much lower than other disclosure missteps.
To avoid liability with an IPO, directors and underwriters must generally show they conducted a reasonable investigation and had reasonable grounds to believe there was not a material error. This is sometimes called the due diligence defense. Outside of public offerings, director liability is extraordinarily rare. Proof of intentional fraud or at least reckless conduct is usually required if there is no offering.
It is because of the low liability threshold in an offering that the WorldCom directors were among the very few directors of public companies who personally had to write checks when WorldCom melted down a few months after a big sale of bonds. After a landmark opinion on due diligence, the underwriters also ended up with liability in WorldCom.
On Thursday’s earnings call, Alibaba Executive Vice Chairman Joe Tsai stated that the company thought the meeting with the regulator last July was routine. And he said that the company did not ask the regulator to delay the report and didn’t see it until it was posted. Under these circumstances, in my view it could be hard to hold anyone liable on the IPO even with the low threshold of liability.
The so-called risk factors Alibaba included in its September prospectus make very clear that Alibaba faced these kinds of risks. One risk factor says “We have received in the past, and we anticipate we will receive in the future, communications alleging that items offered or sold through our online marketplaces… infringe third-party” rights. It even discloses that bad things may come from that: “Any costs incurred as a result of liability or asserted liability relating to the sale of unlawful goods or other infringement could harm our business.”
And the regulatory risks of operating in China are discussed in several places. One disclosure says: “Changes in regulatory enforcement … in [China] could also result in additional compliance obligations and increased costs or place restrictions upon our current or future operations. Any such legislation or regulation could also severely disrupt and constrain our business…”
Although these disclosures are general, unless the company knew of more specific information that was material at the time the company went public, the language is probably sufficient to protect everyone from liability. Such risk factors—frequently criticized as boilerplate—are intended to have that effect. Lawyers sometimes explain them to their clients who balk at such negative disclosure as “insurance policies” to protect everyone if something goes wrong. In this case they look like they have done their job.
The biggest impact the regulator’s white paper may have is to emphasize the lack of reliable information about business in China, even with respect to a large and prestigious company like Alibaba.
Even if Alibaba has been trying all along to do the right thing, investors now know there were some questions – legitimate or not — that someone in the government kept out of public view. Transparency has long been an issue for investors and regulators for other companies listed in the U.S. with significant operations in China. Over the last several years, the Securities and Exchange Commission has fought with Chinese accounting firms and Chinese regulators over the SEC’s ability to review work papers generated in the audit of companies publicly traded in the US. And a little over a year ago, U.S.-based Cooper Tire & Rubber Co.CTB -2.00% saw its sale effectively blocked by a Chinese joint venture partner and a labor union which locked Cooper out of access to its own books and records, even though they had no apparent contractual right to stop the deal.
In the case of Alibaba, the Chinese regulator hasn’t helped the concern over lack of transparency. First, it delayed the issuance of the report, purportedly to facilitate the IPO.
Now, word today emerges that it has taken the report off of its web site as part of what appears to be a potential resolution of the dispute. Late Friday in China, the regulator said it and Alibaba agreed tackle fakes and boost consumer protection online. Alibaba said it felt “vindicated” by the outcome.
The bottom line is that the protective disclosures in massive prospectuses can help a company on the legal front, but investing in companies dependent on Chinese operations has its own risks, even for the largest companies operating there.
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