The big idea: The number of companies moving from privately held to publicly traded dropped significantly during the past decade. China-based companies listed in the United States, however, have bucked this trend. In 2010 alone,
42 launched IPOs. In early 2011, 15 China-based companies — including some that had just gone public — were delisted.

The scenario: Shenzhen YPC was incorporated in China in 1999 and engaged in the design, manufacture and sale of micromotors. In 2009, a reverse takeover was consummated under U.S. law, whereby China Electric Motor became the parent company of Shenzhen YPC. A reverse takeover is a relatively quick and inexpensive way to become a public company. A promoter sets up a shell company, registers its shares, and files quarterly and annual reports with the SEC. With little activity in the shell company, investors are unable to find much to question. Eventually, the shell company acquires a legitimate business. Because the shell company is “public,” the acquired company is also public. AirTran and ABC Radio are among those that have used this approach.

WestPark Capital, a Los Angeles investment bank, led the China Electric reverse takeover. In January 2010, WestPark and another privately owned investment bank, ROTH Capital Partners, arranged a public offering of 5 million shares of China Electric at an average price of $4.50 each. China Electric’s common stock commenced trading on the Nasdaq (ticker: CELM) on Jan. 29, 2010. MaloneBailey was hired as the new external auditor.

China Electric seemed to hum along. In its financial statements, now publicly disclosed, the company reported compounded growth of 45 percent from micromotor sales in a three-year period. Gross margins were more than 28 percent. Debt levels were low and cash levels high. ROTH even issued five “buy” ratings on the stock. But little more than a year later, China Electric delayed its 10-K filing with the SEC because of possible financial-statement discrepancies. Trading in the stock was halted. MaloneBailey resigned as its auditor, claiming China Electric managers appeared unwilling to resolve audit issues related to cash. On Oct. 17, 2011, the Nasdaq delisted CELM. For investors, the company appeared to be a sham.

The resolution: U.S. investors lost millions, and lawsuits followed. Several other China-based firms using the reverse takeover process had also failed. The SEC warned investors to be alert for the potential abuse in China-based reverse takeovers.

The lesson: Frothy markets bring out opportunity — and also greater risk. The first question in this case is simple: Why would a Chinese company come to America for investor capital? Others are harder to answer: Who was protecting shareholder interests? What are the responsibilities of investment bankers, analysts, auditors and regulators? And how do we quantify the costs to legitimate Chinese firms that are now viewed with more skepticism?

Gerry Yemen and Paul Simko

Simko is associate professor of business and Yemen is senior researcher at the University of Virginia’s Darden School of Business.