Academic journal article Northwestern University Law Review

Development and Distrust: A Critique of the Orthodox Path to Economic Prosperity

Academic journal article Northwestern University Law Review

Development and Distrust: A Critique of the Orthodox Path to Economic Prosperity

Article excerpt

[P]roperty rights belong legally to individuals, but their real function is social, to benefit vast numbers of people who do not themselves exercise these rights.[dagger]

INTRODUCTION

Would you buy a house if the deed remained in someone else's name? What if your right to live in it was exclusively contractual? What if your ability to earn money from its sale was the same? Would it change your mind if the underlying contracts were unenforceable? What if they were illegal? Consideration of the following example is illuminating.1

On September 19, 2014, a bell rang and Alibaba went public.2 The Initial Public Offering (IPO) shattered the record books, valuing the company at over $200 billion,3 raising $25 billion in capital,4 and creating thousands of millionaires.5 It was an unequivocal financial success. On that day and every day since then, however, investors have not exchanged dollars for stock of Alibaba. Instead, they have purchased something far more amorphous-stock in a Cayman Islands entity that has contractual rights designed to mirror ownership of Alibaba without actually providing for it.6 In other words, investors bought the benefit of a contract, not a piece of a company.

The Alibaba IPO and the increasing number of events like it raise serious questions about the dominant strain of law and development theory by questioning the core assumption that property rights are a necessary condition for economic development. Alibaba is listed through a structure called a variable interest entity (VIE). The VIE is, at its core, a series of contracts designed to mimic "true" ownership. The structure is a brilliant slight of hand calculated to circumvent strict regulations on the foreign ownership of Chinese companies located in sensitive industries. While certainly a relatively new phenomenon,7 it has grown exponentially in popularity such that today "[a]ll of China's major Internet companies that list on U.S. exchanges use the VIE structure."8

The VIE structure works by utilizing two types of contracts: one set secures control of the company and the other secures a right to the economic benefit of the company. The actual mechanics of this are more complicated. First, a parent company is incorporated in a tax haven, often the Cayman Islands.9 The parent company then creates a Wholly Foreign Owned Enterprise (WFOE) in China.10 Next, the WFOE enters into a series of contracts with the local Chinese target,11 the VIE, and the VIE's owners.12 These contracts provide a right to any and all profits, and deliver a semblance of control. Generally, as discussed further below, the right to profits is secured through exclusive service and asset licensing agreements, while the right to control is ensured through a call option, an equity pledge, a voting rights, and a loan agreement.13 Cumulatively, these contracts allow for the VIE to be incorporated into the parent company's accounting statements under generally accepted accounting principles (GAAP).14 It is important to note, however, that under this arrangement, all of the relevant assets and licenses remain in the hands of the Chinese owners-the investor simply does not own a part of the company.15

In striking contrast to the economic boom in the Chinese technology space fostered through the proliferation of VIEs and their weak property rights, the dominant strain of law and development theory contends that property rights are a necessary condition for economic growth.16 In particular, the academy has come to believe that "[p]roperty rights encourage productive activity by allowing people to reap the rewards of their labor," creating growth.17 A more nuanced conception contends that "[l]egally created titles and stock certificates generate investment; clear property records guarantee credit; documents allow people to be identified and helped; company statutes . . . pool resources for recovery; mortgages raise money; [and] contracts solidify commitments. …

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