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China Syndrome: SEC Ruling Hits Stocks

|Includes:Baidu, Inc. (BIDU), DATE, EDU, FXI, PTR, QIHU, SINA, TAL, TCEHY

China Syndrome: SEC Ruling Hits Stocks - By Zacks Investment Research

A ruling from Securities and Exchange Commission (SEC) trial judge Cameron Eliot has significantly impacted China stocks. The judgment prevents Chinese joint ventures of the world's Big Four auditing firms from auditing U.S.-listed Chinese companies for six months.

The Ruling

Judge Eliot said all four joint ventures: Ernst & Young Hua Ming, KPMG Huazhen, Deloitte Touche Tohmatsu and PwC Zhong Tian had failed to provide the SEC with audit working papers necessary to conduct investigations into possible financial fraud cases.

The audit firms say that these papers were not provided because doing so would mean violating Chinese law. As per Chinese law, such audit papers are considered to be state secrets and cannot be disclosed. However, by not producing the documents, the Big Four have violated the Sarbanes-Oaxley Act.

The Immediate Impact

The ruling had a negative impact on Chinese shares almost immediately. This is because Chinese companies trading on U.S. exchanges could have their listings suspended temporarily if the Big Four's appeal against this judgement is rejected.

The Bloomberg China-US Equity Index, which consists of the most heavily traded Chinese stocks on the NYSE, slumped 4.3% last week. The Hang Seng China Enterprises Index, which consists of Chinese stocks of companies from the mainland, slipped 2.6% at a particular point.

Major Losers

Stocks which suffered maximum losses include search engine giant Baidu, Inc. (BIDU - Trend Report), which dropped 6.8% as well as SINA Corp. (SINA - Trend Report) which lost 5.8%. Shares of China's largest company by market value, PetroChina Co. Ltd. (PTR - Trend Report), declined 3.7%.

In its steepest drop since August 2012, TAL Education Group (XRS - Trend Report) suffered a 8.5% drop. Meanwhile, online dating site International Ltd. (DATE - Trend Report) also slumped by 8.5%. Reflecting the market's mood, the iShares China Large-Cap (NYSEARCA:FXI) declined by 4.5% to $35.02. This was the steepest decline for the largest Chinese ETF since November 2011.

The Chinese Response

Chinese authorities responded strongly to the SEC ruling. The China Securities Regulatory Commission (CSRC) has cautioned the SEC about the "consequences" of such a move. The CSRC said the decision to ban these joint ventures for six months had "ignored" the progress made on cooperation measures between regulators.

In fact, this is an unexpected event given that the U.S. Public Company Accounting Oversight Board, China's Finance Ministry and the CSRC had reached an agreement last year. Market watchers were of the opinion that this was the end todisputes over accounting between the two countries.

Medium-Term Effects

The total market value of Chinese companies listed on the NYSE and Nasdaq exceeds $1.4 trillion. Since the stakes are so high, market watchers are naturally concerned.

A major company audited by Deloitte, Qihoo 360 Technology Co. Ltd. (QIHU - Trend Report) believes that the impact would be limited. A director of investor relations at the company, which saw its shares slide after the ruling said: "The ruling will take months to be finalized, and if the auditing firms appeal it could take years."

Many experts are of the view that the dispute can only be settled at the highest diplomatic levels. This is because of China's position on its secrecy act. In fact, providing expert testimony at the trial, former SEC Commissioner Paul Atkins said the dispute may have to be settled between the respective heads of state.

In Conclusion

Given that the Big Four have jointly said that they will appeal against the ruling, there will be no impact on the 2013 annual reporting of these Chinese stocks. This is not only because the appeal itself will take time but also since the judgement will take a long time to implement.

However, the ruling could go on to impact even U.S. companies with large units in China. Further, the bulk of the ruling has not been made public since this could impact diplomatic ties.

Clearly, we have not heard the last word on this issue. Not only have the Big Four suffered, further negotiations will be required to find a solution to this dispute between the largest economies in the world.

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