Unable to investigate further into accounting fraud at nine US-listed Chinese companies, the SEC reached a breaking point on Dec. 3. While the government has gone after specific companies in the past, this time, the SEC is going after the accountants. In effect, the SEC is drawing a line in the sand, and closing China off from Wall Street: We may soon see the market-wide delisting of all Chinese companies from U.S. stock exchanges.
Here's what you need to know, and what it means for your portfolio.
The SEC's roundabout fight with China
On Monday, the SEC accused Chinese affiliates of the "Big Four" accounting firms – Deloitte, Ernst & Young, KPMG, and PwC – and another firm, BDO, of breaking U.S. securities laws. Specifically, they were charged with failing to produce accounting documents related to nine Chinese companies.
According to the Financial Times, this move throws these accounting firms into a Catch-22: "The US says [the accounting firms] must share audit documents from foreign countries, while China bars that practice." While the auditors agree, and cite that this is a diplomatic failure between China and U.S. regulations, there is little they can do. Without government-to-government agreement, the result seems quite clear.
The SEC could bar each auditor's Chinese affiliates from practicing before the SEC temporarily or permanently. Consequently, that move would de-legitimize their audits and filings for public companies, and the U.S.-listed, Chinese companies would be without auditors. In turn, the SEC would delist the companies.
How serious is the situation?
Looking to capitalize on China's growth, some U.S. investors have rushed to buy into U.S.-listed Chinese companies in recent years. As often happens when people act on greed, those investors got burned -- they lost billions. Recognizing the difficulties investors face, the SEC has since de-registered nearly 50 China-based companies, and has charged 40 others with fraud.
Given its history, the SEC's current threat seems real. And Paul Gillis, a professor of accounting at Peking University (the "Harvard" of China), believes that diplomatic relations will not be reached. He doesn't think China will let foreign governments regulate domestic companies – "[it's] too fundamental an issue."
In response, the Bloomberg China-US Equity Index (CH55BN) dipped 0.1% yesterday. While that doesn't look like much, 41 of the top 55 U.S.-listed Chinese equities in the index declined. And within that index, China's tech stocks took an outsized beating.
There may be two reasons for Chinese tech's decline. First, some investors may fear that the technology sector is filled with fraud, making those stocks more likely to get delisted. However, this reaction is unfounded. As mentioned before, all U.S.-listed Chinese stocks are at the same risk of delisting, because the SEC is going after the auditors.
The second and more plausible hypothesis is that the tech sector is coming off high expectations. In the past, many investors may have flocked to Baidu, Sina, and Qihoo -- probably because anyone can glimpse their businesses online. Put another way, it's much easier as a Google user to understand how Baidu functions, as opposed to a coal company. Now, with SEC's announcement that the regulators don't quite understand what's going on, investors have realized that Baidu may not be as transparent as they first thought.
What will happen to my de-listed stock?
If the U.S. and China can't reach an agreement, the SEC will probably delist your Chinese investments.
The good news is that you'll still own your stocks; you'll still be part owner in those businesses. The intrinsic value of the company and your shares won't change. Since the company will now trade on over-the-counter exchanges, you'll get to buy and sell at lower fees, and with less tax. As you'll transact directly with the other party, you'll also have greater freedom to negotiate and customize each transaction. And, if you hold long enough, your company can be relisted – meaning you might see a nice pop when, and if, it returns to a U.S. exchange.
However, the very fact that your company was delisted will sink the stock's share price. And, in the over-the-counter market, the company won't have to report to, or follow any sanctions from, the SEC (which is why it'll charge you lower fees). You may also have to pay Chinese taxes on your holdings – meaning you'll have to figure out Chinese tax laws. Perhaps the biggest pain is that the media might stop covering these companies, leaving you to decipher newspapers and annual reports in Chinese.
Some think it's a risky move to hold onto delisted stocks, but it all comes down to what you think. And we like Fools who think for themselves. For now, the best thing to do is to follow the coverage as you consider whether or not to cut your losses.
If you're thinking about pulling out of your Chinese stocks, that doesn't mean you have to pull out of China. Profiting from our increasingly global economy can be as easy as investing in your own backyard. Our free report, 3 American Companies Set to Dominate the World, details three companies with growing operations in China, three companies that won't delist. To get your free copy before it's gone, click here.
Fool contributor Kevin Chen has no positions in the stocks mentioned above. Follow him on Twitter @k2chen. The Motley Fool owns shares of Baidu. Motley Fool newsletter services recommend Baidu and SINA. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.