Why Alibaba's CEO had to go

February 22, 2011: 1:46 PM ET

Alibaba says the fraud perpetrated on its users is minor and immaterial, fiscally, to its investors. But top leaders still fell on their swords to save the company's reputation where it really counts.

By Bill Powell, contributor

Alibaba CEO David Wei, who resigned yesterday

Alibaba CEO David Wei, who resigned yesterday

For several years now, the Internet firm Alibaba-Taobao has been one of the
 most prominent Chinese companies on the planet—thanks both to its
 success and to its brash, charismatic founder and chairman, "Jack O' (Yun)
Ma, who started the online commerce company in 1999. Its 
business-to-business platform, Alibaba.com, went public on Hong Kong's stock
 exchange in 2007 and raised $1.7 billion—at the time the second biggest 
Internet IPO ever, behind only Google (GOOG). Its online consumer sales company,
Taobao, went mano-a-mano with eBay (EBAY) and effectively ran the global 
giant out of China a few years ago.

Yesterday
 for the first time, Alibaba hit a big public bump in the road: It reported that 2,326 high volume sellers who 
pay a fee to the company to peddle their wares on the site – "gold 
suppliers," as they're called—defrauded customers over the course of two 
years, with the assistance of nearly 100 Alibaba.com employees. Ma said the
 sellers were organized "fraudsters." As a result of the scandal, Alibaba.com
 CEO David Wei, and his deputy, COO Elvis Lee, both resigned yesterday. 
Neither, the company stressed, are implicated in the fraud; both were 
falling on their swords to accept responsibility. (Japanese style corporate
 accountability comes to China.)

Wei, 40, had joined Alibaba in 2006 and oversaw the successful IPO. He also
helped Ma execute the vision of Alibaba.com as a destination for customers
 outside of China to buy from small and medium-sized companies operating
 inside the country. Ma, to be sure, has become as publicly associated with
 his company as Steve Jobs or Bill Gates have with theirs. (His company's
 annual "Alifest" is practically a revival meeting for Alibaba-Taobao users, 
and the waif-like Ma is their inspirational leader.) But Wei was his
 polished deputy, and he unfailingly projected an image of calm competence.

The scale of the fraud amounted to about $1,200 per incident (if each shill company was responsible for just one fraudulent transaction, a minimum estimate puts the loss around $2.8 million), and thus is "immaterial", as John Spelich, vice
 president for international corporate affairs says, from an earnings standpoint. That is probably the only bright spot in this scandal for Yahoo (YHOO), whose Chinese operations are run by Alibaba's parent company, of which it owns 39%. The Alibaba group's stock price in Hong Kong today fell more than 8%. Of course, what makes the scandal a huge deal for Alibaba—and why
 the company has gone to extraordinary lengths to snuff it out—is the 
apparent involvement of insiders on the sales staff in perpetrating the 
fraud. Either willfully or out of negligence, the Alibaba sales people 
"helped organized Chinese criminal rings establish Alibaba.com 'Gold
Supplier' storefronts so they could pose as legitimate businesses in order
 to defraud buyers," according to an account of the scandal the company 
published on a website it runs.

In an e-mail to employees, Ma went further. He said the company's internal 
investigation
 team members "knowingly allowed fraudsters to become [Gold Suppliers] so
 that they could 'make their numbers' and receive commission income.'' (It is
 unclear as of yet if any of the insiders received payments from any of the
 fraudsters.)

Garden variety fraud on e-commerce sites is not uncommon, of course.
 Yesterday, on a web site called Alibaba168.com, where buyers and sellers
 exchange information about their experiences on the site, there was an 
account of an Alibaba customer in Xinjiang, in far western China, who paid
 12,000 renminbi (about $1,846) to buy a bunch of walnuts from a supplier,
which he then hoped to turn around and resell at a profit. The buyer did not
 execute his transaction via Alipay, Alibaba's Paypal equivalent,
 instead forwarding the money direct to the seller. He was ripped off.

Alibaba says the scope of the fraudulent activity in the cases that led to Wei's resignation, which in many cases involved the "sale" of low-priced
 consumer electronics products, "appeared to be within the risk range for
e-commerce sites in general." The problem for the company is that all of the 
customers defrauded were outside of China, and, as Spelich says, the
 company's "raison d'être," its founding mission, was to link Chinese sellers 
with buyers abroad (Alibaba is now trying aggressively to lure sellers in 
India and elsewhere to use the site.)

Several years ago, the first time I ever interviewed Ma, he spoke in 
his usual passionate tone on the one issue he saw as key to whether
 e-commerce would take off in China in general, and at Alibaba-Taobao in
 particular: "Trust," he said. Meaning, customers had to trust in the
 quality of goods they were going to be able to buy online, but more
 importantly, they had to be confident they were not going to be fleeced by
 faceless sellers using the Internet to perpetrate their fraud. And all this 
in a country where, shall we say, business ethics are still something of a
 work in progress.

It turns out that fleecing is precisely what was happening for two 
years—with the aid of a handful of Ma's own employees. (Again, Alibaba employs 5000 sales people, and around 100 were involved in the fraud, the company says.) Which explains why the
 company has reacted so strongly, and so publicly, to an episode that, by the
 numbers, seems to be but a minor scandal. As Wei's stunning resignation
 yesterday demonstrates, it's not. As Jack Ma understood from the beginning,
 if the customers can't trust Alibaba, then Alibaba isn't going have many 
customers.

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