The downfall of many Chinese companies in US exchanges can be pinned on the legal and accounting firms that helped them list

Back in 2008, I came to New York for an investment conference that focused on China. The room was packed. People were standing; everyone was pumped. After scanning the crowd, I said to one of the attendees sitting next to me, "Maybe it's overheated right now." He looked at me as if I was from another planet.

Fast forward to Spring of 2011. I came back to the Big Apple as an invited panelist for a similar investment conference. This time, the room wasn't packed, in fact, a third of the seats were empty. I joked with the audience that the conference was filled not too long ago and that maybe it's time to start looking at the Chinese companies who have taken a beating since their sky-high prices.

Many factors have contributed to the downfall of several Chinese companies listed in United States stock exchanges and their collective collapse is really no different from the boom-and-bust that have occurred throughout the history of US exchanges. Lured by past stories of exponential growth in China, many investors went all in chasing high returns.

Whenever the demand for Chinese stocks rises, Wall Street is the place where you will find these stocks. Many firms involved in this supply and demand chain, whether they are big or small, work hard to scout new, hot companies. Investment banks, financial advisories, legal and accounting firms as well as public relation shops all send their employees across the Pacific in the hopes of finding the next big company. They look into the quality of the company, the price that the company owner is willing to pay to go IPO and many other factors.

If the company is in good shape and willing to pay top dollar, then a straight IPO path is warranted. If there is room for improvement and the owner doesn't want to pay a large sum of money to go IPO, then a reverse-merger or other similar public transaction followed by a move later to a major exchange would be the cost-effective way to go. This move is also attractive to potential investors since an "upgrade" to a major exchange is a clear exit strategy.

The problem is that this international supply chain of companies dries up in a few years. This is a consequence all participants in the stock market have to face. What usually happens is that a company's management will face charges from the US Securities and Exchange Commission and lawsuits from shareholders. The company will be booted from major exchanges and fall back to the Over the Counter Bulletin Board. Their valuations will be decimated and funds will be wiped out. The investors who bought into the company will face huge losses and may join the shareholder lawsuits.

It is true that some of the companies' management teams are guilty of lying to investors. But it would also be a lie to say that some professional firms are not guilty of helping float these toxic assets into the public markets. Everyone knows these things happen. After all, many owners of these Chinese companies have never set foot in the United States and don't speak English, let alone know how the capital markets work in the US. These professional firms are equally guilty of being a part of the problem and they should be checked thoroughly during any related SEC investigation.

There are, however, some folks who manage to land in the winning column. Short-sellers are worth mentioning here. They are well known for taking down weak companies, but they also conduct specially organized efforts in an almost reversal of the typical "pump-and-dump" scheme. One might call it a "sell-and-yell" scheme.

We know the SEC watches out for pump-and-dump schemes and maybe it is worthwhile for the SEC to also take a look at sell-and-yell schemes because it is much easier to push a small company's share price down than to pump it up, especially in a bear market when most of the participants are in a sell-first-and-ask-later mode.

With more investors moving to sell, that tips the balance of the supply and demand chain. As a result, many Chinese stocks are pushed down along with many other companies in the market. Some are solid companies but are nonetheless punished severely. People always keep to the rationale of not "throwing the baby out with the bath water", but when people are selling and emotions take over, that baby certainly needs to go. Just like greed pushed Chinese stocks to an unsustainable valuation level a few years ago, fear is currently driving them into the ground with many below book value.

This huge downswing for Chinese companies in US exchanges has occurred before in the past decade. Back during the dot-com bubble, lots of Chinese stocks went through a similar roller-coaster ride. Some survived and became huge winners, some perished. It is possible that this will happen again, barring any really bad events. Furthermore, the current downswing may clear away the weaker Chinese companies quicker.

We could also try to dig into the issue deeper. Since China already has its own public markets and stocks are valued at a higher price, why are some Chinese companies taking the risk of crossing language and legal barriers to come to the US to secure a listing? The reasons might be that the two countries' IPO systems are designed differently and that the consequences for those being caught cheating or aiding in cheating is also different.

It is no secret that China has a high bar for companies to go public. The country's stock markets require an applicant company to be profitable for at least two consecutive years. Securing a listing on the ChiNext board requires a company to be growing at over 30 percent for three consecutive years. It is also true that China has a tough and long application process that often drags out over a year. The government puts a lot of resources into this process to verify applicant companies and weed out weak applicants.

The penalty of being caught cheating hopefully makes investors wary but the two countries mete out penalties differently. In China, if a company is caught lying on their IPO application, its management team and controlling stake-owner face severe legal charges. The professional helpers - lawyers, accountants and investment bankers - will also be charged.

The US system is nowhere near as stringent and penalties are certainly not as severe. Driven by greed, companies will certainly explore weaknesses in different systems from different nations.

The author is executive vice-president of Shenzhen Co-win Venture Capital Investment. The views do not necessarily reflect those of China Daily.

(China Daily 03/15/2013 page8)