No, Alibaba Isn't a Stock Market 'Reverse Merger' Scam

"The China Hustle," a documentary that premiered this month at the Toronto International Film Festival, starkly details how dozens of Chinese companies allegedly sought to defraud investors via reverse mergers. Simply put, privately held firms that buy public ones can use those deals as a shortcut to turn themselves into public companies, entering the market without undergoing the regulatory scrutiny that's normally required.

The filmmakers detailed how numerous Chinese companies intentionally inflated their revenues, lied to financiers about their service scale, and got themselves listed themselves on U.S. stock markets through less-than-honest means.

In addition to this valuable reporting, the film also names current market darling Alibaba (BABA -1.31%) as a suspicious case, painting it with the same brush as those smaller companies that writer/director Jed Rothstein examines more closely. As described by Variety:

At the end of the film, without preamble, "Hustle" turns its sights on Alibaba. In the closing minutes, as a voiceover warns that U.S. investors and regulators must do more to protect themselves from fraud by Chinese companies, Rothstein shows 2014 footage of Alibaba executives ringing the bell on the first day that the company's shares were traded on the New York Stock Exchange. That is followed by 2017 footage of Alibaba founder Jack Ma glad-handing then-President-elect Donald Trump.

Image Source: Getty Images.

I can appreciate Rothstein's concern and agree that we would all benefit from giving companies we own closer financial scrutiny. But the difference between Alibaba and the companies described in his documentary could not be starker.

History of Reverse Merger Scams

The dynamic described in the "The China Hustle" is not a new one. In fact, it's not an exaggeration to say that the documentary itself may be a little late to the party. Practically every financial regulatory authority in the U.S. was alerted to the fraud potential inherent in reverse mergers back in the late 2000s, after a wave of short-seller reports and media exposés of accounting scams. Once the authorities had all the facts, the reaction was swift.  

By late 2011, the Securities and Exchange Commission put forth new rules to toughen the standards for reverse-merger listings. In December 2012, the SEC announced proceedings against Chinese-domiciled affiliates of the Big Four U.S. accounting firms for refusing to produce audit work papers and other documents related to China-based companies under investigation for potential accounting fraud. 

Consider the case of Huakang "David" Zhou and his consulting firm, Warner Technology and Investment Corp. On Dec. 10, 2012, -- just a week after the SEC made its move against the Big Four -- the regulator formally announced that it was charging Zhou with violating securities laws and defrauding investors in a whopping 20 instances of private Chinese companies going public in the U.S. via reverse mergers.

Before all was said and done, some 50 U.S. listed Chinese companies were either delisted or halted from trading in 2011 and 2012 based on claims of fraud and other violations of U.S. securities laws. A number of others were targeted by short sellers, and changed auditors more than once in some cases.

The biggest IPO in history

The first stark difference to note between Alibaba and those 50 or so reverse merger scams is that Alibaba did not utilize the reverse takeover technique to list its shares. Not only that, but it currently boasts a market capitalization of $458 billion, making it one of the largest companies in the world. 

Nor has Alibaba been accused of fraud, though its IPO, management structure, and company finances have been criticized by activist investors. Alibaba is operated by a management committee headed by founder Jack Ma that has operational control, and is not answerable to shareholders. That controversial structure was rejected in Hong Kong, where the company initially sought to list. Regulators there argued that all equity holders should have equal rights. The split voting structure, however, was acceptable to U.S. regulators at the SEC.

Since then, Alibaba has clashed with regulators over how it defines its gross merchandise volume (roughly, the sum of all business transacted on its platforms), on share-based pay for executives, and the application of U.S. Generally Accepted Accounting Principles (GAAP). 

But while it's integration into the U.S. market hasn't been entirely smooth, it's hard to argue that Alibaba is scamming investors, as "The China Hustle" seems to imply. 

Foolish bottom line

While it's difficult at first to tell a fraudulent company from a legitimate one (that's why they're frauds -- the numbers they supply are a lie), there are often clues that investors can look for. To illustrate, let's consider the differences between Alibaba's most recent quarterly results and those of AgFeed Industries Inc. -- a Chinese company that gained access to the US stock market in 2007 via reverse merger -- for the quarter just before AgFeed went belly up in an accounting scandal (paywall) in 2011. There is a massive difference in the scale of these two businesses.

Source: Corporate SEC filings. *AgFeed Industries, Inc. Operating Expenses include $14.3 million of receivable credit and collection losses. Numbers rounded to nearest million. 

Even before regulators made their move on AgFeed, its financial statements were not only unattractive, they were unusually complicated, with writedowns for receivable credit and collection losses eating away at net income. Alibaba, by comparison is a massive, established company with numbers that are fairly easy to reconcile.  

Because of its size and status, Alibaba and its auditors are no doubt cognizant of the reverse-merger scams that rocked Wall Street five years ago. That's probably why, when it announced that it had become the "largest retail economy in the world" in April 2016, it noted that auditor Pricewaterhouse Coopers had corroborated the claim. Its business is complex, and shareholder rights may be essentially non-existent, but its structure bears some similarity to Alphabet; shareholders in both companies are subject to the whims of the founders and their cliques. All this may be cause for reflection -- and the concerns add another great argument to the case for maintaining a reasonably diversified investment portfolio. But it doesn't make Alibaba a scam.