Youku is buying Tudou in a stock swap valued at about $825 million that was launched March 12. The deal exchanges Tudou shares for 1.595 of Youku shares. That valued Tudou at $28.85 per share Wednesday, down from about $32.75 a week ago. The deal spread has widened from about $1 to $1.50, or 5%.

The deal combines the two largest online video providers in China, but it is not subject to approval by the Ministry of Commerce of the People's Republic of China. The proxy must still be approved by the U.S. Securities and Exchange Commission and shareholders of both companies must approve the deal. The Tudou shareholder approval requires a two-thirds majority vote, but insiders representing 65% of the voting power have committed to approving the transaction. The Youku approval requires a majority of both Class A and B shares combined and a majority of the A shares. Youku shares representing 69% of the total vote are committed to the deal and 28.5% of the Class A shares are also contracted to vote in favor of the merger. So the Class A vote by Youku shareholders is the only vote that is not sewn up. The merger has an Aug. 31 termination date.

The latest proxy revision was filed July 6 by Youku and a shareholder vote date has not been set. A source said the companies expect the proxy to clear the SEC next week and a shareholder vote is to occur by mid-August. If the merger closes Aug. 25, the current spread represents an annualized return of about 40%. However, Youku shares are expensive to borrow for short sales, so it can cost up to 15% on an annual rate to take an arbitrage position in the deal. That would make the return somewhere closer to 25% annualized.

The wider spread is in part a reaction to reports out of China that its National Office Against Pornographic and Illegal Publications is planning a new effort to censure publications, including online outlets. The agency has been shutting publications recently, and apparently concerns about increased targeting of online media increased the risk profile for the merger.

Tudou and Youku were not available for comment. Youku said the new review by the pornography office is not expected to affect the merger, an arbitrage source said. The other recent event raising questions about the merger is the resignation this week of the Tudou chief operating officer Evelyn Wang, which appears oddly timed to the proximity of the anticipated deal close and some arbs may be concerned that it reflects some problem within Tudou. Tudou reportedly said the resignation was for personal reasons and the merger is on track.