On Monday, the United States SEC filed administrative proceedings against the China affiliates of each of the Big Four accounting firms for refusing to provide audit work papers related to China-based companies under fraud investigations. This news sent US-listed Chinese shares plummeting. Baidu, Inc (BIDU), one of the largest Internet companies in China, went down 5.90%; SINA Corporation (SINA), another Internet company, dropped 7.4% and New Oriental Education & Technology Group (EDU), an education service provider, plummeted more than 10%.
The SEC charge potentially has a negative impact on the Chinese companies listed on the U.S. exchanges. If the U.S. court issues negative rulings against these accounting firms, the Public Company Accounting Oversight Board (PCAOB) may revoke their registration and thus make them ineligible to conduct auditing work for listed companies. This may lead to massive delisting of Chinese companies from the U.S. market because of the lack of auditors.
However, I believe investors overreacted to this news. The resulting panic selling creates a great opportunity for investors to step in and buy high quality Chinese companies at very attractive prices.
The SEC charge for sure has created short-term uncertainty and volatility, but I believe at the end of the day, most likely the U.S. and China will both make compromises and come to some sort of agreement to solve this situation.
Reasons for Optimism
First of all, as the second largest economy in the world and growing at more than 8% a year, China is just too important to the U.S. Wall Street simply cannot be a true global financial market if it closes its doors to Chinese companies.
Also, China needs the U.S. as much as the U.S. needs China. China is trying to transition its economy into a more innovative and consumer-driven one, and its Technology, Media & Telecommunication (TMT) companies will play an important role in this process. Take a look at the companies listed in the U.S. and you will notice that most of China's important technology companies are listed on the U.S. exchanges. These companies rely heavily on the U.S. financial markets to grow their businesses.
The SEC and the PCAOB have been in talks with Chinese authorities over the past two years, but achieved very little because of the cross-border legal complications. The U.S. ran into similar legal obstacles in Europe as well, but recently, most of these obstacles in Europe were resolved or are in the process of being resolved. This will put additional pressure on Chinese authorities to step up their efforts.
The performance of China's domestic stock market, or the A share market, has been quite depressing so far in 2012. The Shanghai A share index just broke the physiologically important 2000 mark and more than half of investors suffered losses. Many investors blamed the authorities for not being able to protect them. So the perception of the Chinese authorities is very low and I believe the Chinese authorities will do all they can to avoid messing up their U.S. listed companies at this moment.
Finally, China just underwent a major leadership change in November. The new leadership seems to be much more open and pragmatic when dealing with issues facing China. This will also help China to be more flexible in its negotiations with the U.S.
The PCAOB has been quite successful in solving similar legal complications in Europe. The success may be due in part to the higher level of trust between the U.S. and the European countries. The U.S. has entered into cooperative agreements with regulators in several European countries such as Spain, the United Kingdom, the Netherlands, and Germany. Its arrangement with Spain covers both a framework for conducting joint inspections and a mechanism for the exchange of confidential information between the Spanish regulators and the PCAOB.
The level of trust seems to be lower between the U.S. and China. Negotiations between the PCAOB and the Chinese authorities have not achieved much so far; hence, the SEC lawsuit. I believe filing the lawsuit is a calculated move by the U.S. to assert more pressure on China. The U.S. understands that China cannot afford to lose access to the U.S. financial market.
After feeling the heat, most likely China will try to maintain an open dialogue and establish closer working relationships with the PCAOB in the following months. The U.S. may also take a softer stance in the negotiations because of China's strategic importance. After both sides make compromises, quite possibly they can come up with a framework for confidential information sharing between the two countries. This alone can satisfy the SEC's demand for auditing documents.
Joint inspections of auditors between the U.S. and China may take longer to achieve. China believes this kind of inspection by foreign regulators interferes with its sovereignty. But if the U.S. is able to build trust with China during the information-sharing phase, China may become more open to this possibility.
In summary, I believe at the end of the day the U.S. and China will come to terms to end the current standoff simply because the danger of not finding a solution is too great for both countries to bear.
The SEC lawsuit creates volatility and uncertainty, but it's a "non-event" for long-term investors. The charge does not alter the fundamentals of the Chinese companies listed on the U.S. exchanges; rather, it creates a great buying opportunity.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.