Alibaba: The Next Enron?
By David Sterman at Top Stock Analysts
Most U.S. investors have never heard of China Minsheng Bank Corp. Ltd or GigaMedia Ltd. (Nasdaq: GIGM). But both companies ended up in deep trouble for using a risky corporate structure. It was a structure used by Enron back in the 1990's, and ultimately led to the loss of billions in investors' funds.
And the hottest initial public offering of 2014, Alibaba Group Holding Ltd (Nasdaq: BABA) is using the same trick. A closer look at the issue explains why you should think twice about buying shares of Alibaba. If you already own shares, then you need to know about this key risk.
Accounting Obfuscation
To help shield the true nature of its balance sheet, Enron's financial masterminds used an unusual contract known as a variable interest structure, or VIE. Using a VIE, a company can disconnect the ownership of its assets from the claims of shareholders. In effect, key assets are placed into separate corporations, which are wholly-owned by the company's management. Ancillary contracts are then typically established that pledge equity, assign profits and establish consulting agreements.
In the United States, embarrassed financial regulators abolished the use of a VIE after the dot-com implosion. Rules now clearly state that all assets and liabilities in a corporation are controlled solely and directly by shareholders. Gone are the days of "off-balance sheet" side deals that are typically a mere accounting trick to defraud investors.
Trouble is, the VIE structure remains quite popular in China, as dozens of firms use them. The stated logic for them appears quite logical. The Chinese government has a very hefty set of restrictions about what kinds of businesses and assets and can be owned by foreigners. For example, Chinese banks are off-limits, so banks sought ways to get around that. That's where Minsheng Bank came in.
Keep reading: Alibaba: The Next Enron? | Top Stock Analysts.
