Do you think it is advisable for HKEx to re-look at revising its rules on dual-class share structures?

Case overview

In 2013, Alibaba Group Holdings Limited (Alibaba) wanted to go for an Initial Public Offering(IPO)andwascontemplatingtheviabilityofthreestockexchanges-Hong Kong Exchanges and Clearing Limited (HKEx), New York Stock Exchange (NYSE), and NASDAQ. Their first choice was to list on HKEx. However, their application was turned down because Alibaba's unique 28-man partnership structure did not meet HKEx's listing requirements, and was similar to a dual-class structure. Alibaba's failed listing on the HKEx then kick-started regulatory and public debate about potential changes to existing listing rules, for fear of losing more future listings. The purpose of this case is to allow a discussion of issues such as dual-class share structure; mismatch between shareownershipandcontrol;andthetensionbetweenregulatoryandcommercial motivations of stock exchanges.

Background

"Nobody wanted to believe Jack Ma."-Jack Ma Not even HKEx when Jack Ma, Chairman of Alibaba, brought an attractive proposal to the table in 2013 -listing his wildly successful e-commerce brainchild Alibaba. After weeks of intense negotiation, the listing was rejected on the premise that its unique 28-man partnership structure did not meet HKEx's listing requirements.Ma was now faced with a tough decision. Change the partnership structure that has worked so well for the US$168 billion e-commerce giant? Or abandon his dreams of a Hong Kong (H.K.) listing and head for greener pastures on the NYSE or NASDAQ?

The birth of an E-commerce hero

Jack Ma began his career as an English tour guide in Hangzhou, China, and had no experience with computers or any technology-related equipment. This changed when hediscoveredthatinternetsearchesbroughtupnoinformationaboutChina.Ma realisedthatthiswashisopportunitytofillagapingholeontheinternet,and proceeded to set up China's first commercial website, China Pages. Ma's business competed with China Telecom and when the state-ownedcompany offeredtoembarkonajointventure,Mafoundtheoffertoogoodtorefuse6. Although Ma was a director, he had no control over the five-man board and his ideas were turned down and outvoted time and again. With his hands tied and no way to move his ideas forward, Ma decided that his best option at that point was to resign. Inearly1999,Madecidedtogivehisentrepreneurshipdreamanotherchance.He envisaged a global e-commerce company and shared this dream with the 18 others hehadgatheredinhisapartment.Thatnightturnedouttobetheturningpointin Ma's e-commerce journey. With just US$60,000 to its name, Ma and his 18 partners started the company, Alibaba, a name chosen for its simple spelling and its association with the well-known "Open Sesame" command. Ma believed in his approach to create a successful business for the Chinese context -globalvision,localwin.UnlikemanyotherChineseentrepreneurswhoadapted successfulU.S.internetbusinessmodelsthatmanagedBusiness-to-Consumer(B2C) andConsumer-to-Consumer(C2C)transactions,Alibabacreateditsown business model. It focused on the Business-to-Business (B2B) sector and connected small and medium-sized companies with one another.

The Alibaba Group

Today,Alibaba isthelargestproviderofonlineandmobilemarketplacesinChina, making up 80% of China's B2C and C2C markets. Alibaba also accounts for more than 70% of the parcels delivered in China and its dominance in parcel delivery continues to grow. On a globalbasis, Alibaba has outperformed both eBay and Amazon in terms ofgrossmerchandisevalue,whichgeneratedUS$67.8billionandUS$87.8billion respectively in 2012. Alibabahasseveral keylinesofbusiness -Alibaba.com,Taobao,TmallandAlipay. Alibabaalso offers cloud computing and other peripheral services.

Alibaba.com Alibaba.com was the Group's first foray into the e-commerce sector in 1999. It is a B2B onlineportalconnectingChinesemanufacturerswithbuyersallaroundtheworld. Alibaba.com's business model is based on two observations of the Chinese market. First, the Chinese are cost-conscious. This led Alibaba.com to provide basic services to bothitsbuyersandsellersatnocost.Tocatertosellerswhoareslightlylessprice sensitive,Alibaba.comoffersextraservicesandonlineadvertisingoptions.Second, Chineseconsumersareconcernedaboutthereliabilityofsellers.Toaddressthis matter,sellerslistedonAlibaba.comcanopttohavetheirclaimsreviewedby independent third parties through its Independent Verification Service (IVS). To date, Alibaba.com has more than 4.4 million registered users from over 200 countries and territories. Taobao and

Tmall

In 2003, the Group launched Taobao, the Chinese equivalent of eBay, becoming the market leader in China's C2C market within two years of its commencement. In 2010, Alibaba launched Tmall.com, a spin-off from Taobao. It has since become China's most popular B2C online shopping platform. In 2012, Taobao and Tmall.com generated a combined gross merchandise volume of RMB1.1 trillion (US$171.2 billion).

Alipay is China's leading online payment service, dominating 80% of China's online transaction market share, and close to US$150 billion in FY2013 reported revenue. The Alipay system supports all of Alibaba's online transactions. This system allows sellers tocollect moneyforgoodsupfrontandplacestheamountsinanescrowaccount, ensuring buyers do not default on payment.

28 men at the helm

Alibaba hasa28-manpartnershipstructure,consistingsolelyoffoundersofthe companyandkeyseniorexecutives.These28partnersdonotsitontheboardof directors but they have the power to nominate a simple majority of the directors. Although nominations are primarily made by the 28 partners, all shareholders have the right to vote for or against the nomination according to their shareholdings. The 28 partners hold a combined 13% of Alibaba's total shares, while Yahoo! Inc. (Yahoo!) and SoftBank Corporation (SoftBank) holds 24% and 37% respectively. The remaining shares are held by dispersed minority shareholders. However, if the nominated candidates are rejected,thepartnersareableto nominateothersuitablecandidates.Thisprocess repeats itself until the board of directors is formed. Thepurposeofthispartnershipstructure,accordingtoMa,istoensurethatthe company is operated by "a group of people who are passionate about the company andaremission-driven." This view is supported by Joe Tsai, GroupExecutiveVice-Chairman, who believes the partnership structure helps to preserve the company's innovative culture even if the initial founders leave the company, assuring the company of a long-term strategic focus rather than myopic or short-term gains.

Alibaba's genie lamp -A Stock Exchange listing

Alibabahasbeensuccessfulinthee-commerceindustryoverthelastdecade,as evidenced by the twelve different valuation estimates compiled by Bloomberg in 2014 that put its value at about US$168 billion. Listing was the next logical step for Alibaba. The Group wanted to be listed on a stock exchangeinordertoraisecapitalforfurtherexpansioninthepromisingmobile shopping and social media sectors. A Tale of Two Cities -Pearl of the Orient or The Big Apple In July 2013, Alibaba was ready for an IPO but was still deliberating between the three stockexchangesithadshortlisted -NYSE,NASDAQandHKEx35.Attheheartofit, Alibaba's decision boiled down to a simple dichotomy between two countries -H.K. or the United States (U.S.). A U.S. listing has several advantages over aH.K. one. First, the U.S. stock exchanges allow for Alibaba's existing partnership structure36. On the other hand, HKEx adopts a "one share, one vote" principle and does not allow Dual Class Share (DCS) structures except under exceptional circumstances.Second, the world's largest technology firms, such as Facebook and Amazon, are listed on the U.S. stock exchanges, with most of them listed on NASDAQ. In contrast, H.K. does not have many "high-tech" or "internet" companies listed.

Third,westerninvestorshaveabettergraspofthetechnologysector,boostingthe accuracy of their valuations of tech companies. Furthermore, NYSE and NASDAQ are the world's largest stock exchanges in terms of market capitalization. Fourth, NASDAQ does not require companies to have earned a profit for three years before going public, unlike H.K. which has the requirement. On the other hand, a U.S. listing also has its disadvantages over a H.K. listing. The U.S. has a litigious culture which may be a problem for Alibaba if it does not provide timely disclosures,astheywouldfacepotentiallawsuits.ThisisaconcernforAlibabaas Taobaohasfacedproblemswithcounterfeitgoods inthepast46andhadtriedto resolve the problem but to no avail. Conversely, H.K. does not have a class-action legal system. In addition, the U.S. also scrutinizes its financial markets more closely than any other country in the world. U.S.-listed companies face higher compliance costs due to the additional regulations required by the Sarbanes-Oxley Act. Next,ChinesecompanieslistedintheU.S.areundervalued.Therehavebeenmany accounting irregularities, frauds, and scandals in the U.S. by Chinese companies over the past decade, leading to lower investor confidence towards this class of companies. Lastbutnotleast,itwouldbeeasierforAlibaba tomaintainthe status-quoevenafter listingbecauseH.K.hasasimilarculture,usesthesamelanguage,andenjoys geographical proximity to China. This is particularly relevant as Alibaba's revenues are mainly generated in China. In September 2013, Alibaba decided on a H.K. listing and submitted its application to HKEx. In order to list, Alibaba would have to gain the approval of both the Hong Kong SecuritiesandFuturesCommission(HKSFC)andtheStockExchangeofHongKong (SEHK).

The genie's lamp shatters

In late September 2013, just weeks after submitting its application, negotiations with HKEx fell through. The reason for their rejection stems from Alibaba's listing proposal which grants additionalpowerstothe28partnersatthehelm.HKEx claimsthatsuchpowers undermine the "one share, one vote" principle as it closely resembles a DCS structure that grants more power to a small group of people who hold fewer shares.Charles Li, CEO of HKEx, reinforced this stand by explaining that HKEx adopts a "one share, one vote" principle and does not allow DCS structures unless under exceptional circumstances. Li also highlighted that the exchange is not ready to "bend existing rules just for one applicant".

Between a Rock and a Hard Place -HKEx'sDilemma

"It is very important for HKEx to not make exceptions and to maintain marketintegrity,especiallyinlightofwhathashappenedwithChinese companies in recent years... There are plenty of companies in Hong Kong and China that would want to do similar things, so making an exception creates a very difficult scenario." -ArjanVanVeen,AnalystatCredit Suisse. "Losing one or two listing candidates is not a big deal for Hong Kong; but losing a generation of companies from China's new economy is. And losing it without a proper debate is even more unacceptable." -Li, CEO of HKEx AlthoughitmightseemthatAlibaba'sproposedIPOshouldhavebeena straightforward accept or reject situation, the deliberation process was anything but simple.

Painful Deliberation Process

Throughout the year leading up to the rejection of the IPO, Alibaba and HKSFC held privatediscussionsrelatedtothelisting.Duringthisperiodofnegotiation,HKSFC opposed Alibaba's proposed partnership structure and both parties could not come to a consensus. Reportedly, HKEx submitted a consultation draft to HKSFC regarding changesinlistingrules.HKSFChassincesentbackthepaperwithaseries of adjustments. In late September 2013, HKEx rejected Alibaba'sIPO. However, the following month, HKEx's listing committee kick-startedadiscussionaboutthetypesofshareholding structurethattheexchangeshouldoffer.Theydecidedthatapublicpollmaybe required in the near future to decide on the appropriate direction on the matter and onanyissuesthatrequirepublicinput.Therelevantauthoritieshaverepeatedly emphasisedthattheirdebatesregardingsharestructureswerenotaresultofthe Alibaba IPO incident but a response to the ever-changing economic climate in H.K.Yetatthesametime,Lisaidthatthe"Alibaba'sproposalhaspropelledthe management to review" their existing operating model, and that "the eventual loss may be even larger" if they do not "undergo reforms".

A Mix Up of Motivations

Beingtheregulatorandfrontlineenforcerofstockexchangelistingrules,the regulatoryarmofHKExhastoensurecompaniesabidebytheirlistingrules.These powers and responsibilities extend to taking action against companies that flout any rules or regulations so as to maintain the financial integrity of the country's financial system66,andtomakesurethatthelistingdirectivesandproceduresareduly followed. On the other hand, the business promotion arm of HKEx is charged with the task of attracting more companies tolist on their exchange. HKEx has toidentify profitable companieswithgrowthpotential andmaximisetherevenuegeneratedthroughthe stock exchange. Ultimately, HKEx is a business with bottom line considerations and has its own set of financial duties and obligations to deal with. It has to consider both the benefits of potential listings, and attract these profitable companies to list on the stock exchange, which in this case is Alibaba. Should the listing of companies such as Alibaba be construed as a violation of listing rules and a regulatory lapse or as a means of promoting their business?

A new pasture

With no further progress apropos any changes to the listing framework in H.K., Alibabaissued a statement on 16 March 2014 about its decision to embark on a U.S. listing. They returned to the drawing board and were expected to file an IPO with either NYSE or NASDAQ within the next few days.

Epilogue

Following the announcement of Alibaba's intention to list on a U.S. stock exchange, NYSE and NASDAQ stepped up their wooing efforts, in a bid to attract the largest tech listing.Finally,NYSEemergedas thewinner,andAlibabalauncheditsIPOon21 September 2014. The listing held the record of biggest IPO, and raised a total of US$25 billion. On its first trading day, the stock soared more than 35% over its IPO price of US$6871tocloseatUS$93.8972,andfelljustslightlybelowUS$90onthesecond tradingday.Ontheotherhand,aftertheconsultationdraftsexchangedbetween HKSFC and HKEx, the HKEx decided to further the discussion on listing rules changes. Afteracomprehensiveroundofpublicconsultation,itappearsthattheExchange would allow for weighted voting rights structures, with more details to be released in thethirdoffourthquarterof2015.However,on25June,theHKSFCsaidthatit opposes the plan to offer dual-class shares75. This probably killed the proposal.