With the passage of the Holding Foreign Companies Accountable Act in the Senate, Congress takes perhaps it's most decisive step yet in removing non-compliant Chinese companies from the U.S. exchanges.

The bill is aimed at bringing Chinese companies listed on U.S. exchanges into compliance with Public Company Accounting Oversight Board policies. The Board is looking to review company audits.

It sounds like a fairly simple demand, and it is, but this excerpt from the China Law blog demonstrates why this has become a hot button issue.

These regulations are applied with rigor against U.S. and European companies that list in the U.S., but Chinese companies are entirely exempted from such oversight.

This exemption from oversight is a product of Chinese government regulation. The Chinese government takes the position that allowing a foreign agency like the U.S. Securities and Exchange Commission (SEC) or the PBOC to audit Chinese companies on Chinese soil is an offense against Chinese government sovereignty. The initial response to this position was for the SEC/PBOC to say: fine, then just send the audit reports to us in the U.S. and we will audit over here. The Chinese then shut that option down by taking the position that the audit reports of Chinese companies constitute a Chinese government state secret. As a state secret, the audit reports cannot be allowed to leave China.

The U.S. is basically saying that if you want to be listed on our exchanges, then you have to abide by the rules that are applied to all other companies. China said no. Now, we have a standoff and, if the Senate bill ultimately becomes law, the U.S. is ready to crack down.

The bill has bipartisan support so there is a consensus that China has gotten away with this for long enough.

Stocks, such as Alibaba (BABA) and Baidu (BIDU), fell on the news, but how much of it was really justified and what would the impact of a delisting be?

In the short-term, the impact is very little. It's not until further down the road that it may become an issue.

What Happens If A Stock Gets Delisted?

If you own shares of a stock that gets delisted, nothing really changes. You still have your ownership share in the company, but the means of trading your shares and the value of your shares could be drastically different.

Delisting comes with a scarlet letter. Most stocks get delisted because their share prices have fallen to less than $1 and they no longer meet exchange listing requirements. These companies are generally considered either failed, speculative or unviable altogether. That means they'd typically draw little interest from the investing public. You could potentially trade shares in the less regulated OTC market, however, so there is still an outlet if you wish to buy or sell.

A company like Alibaba, however, isn't your typical delisted stock. If it's removed from the U.S. exchanges, there's little doubt that the market for shares drops considerably and the value probably falls significantly. These companies would probably just list their shares on a different exchanges, but a much smaller pool of buyers and sellers affects the potential value.

If I Own Chinese Stocks Or ETFs, Are These At Risk Of Plummeting In Value?

In the near-term, no. Sure, these stocks can decline in value on the rumor or possibility that a delisting could occur, but understanding the real risk of this involves understanding the bill itself.

The law would punish companies who have not successfully allowed themselves to be audited for three consecutive years or have not been able to adequately prove that they aren't under state control. If those conditions are met, the company would, in theory, be delisted from U.S. exchanges.

In other words, dozens of companies would not suddenly be delisted the day after the bill becomes law. Companies would be given adequate time to come into compliance before any delisting would occur.

Given that, I believe any short-term impact to China stocks and China ETFs would be minimal.

The impact to China ETFs might be even less. The iShares MSCI China ETF (MCHI) has more than 600 holdings, but just a dozen of them account for 1% or more of the fund. Alibaba and Tencent (TCEHY) alone account for 1/3 of the entire portfolio.

If something happens to Alibaba, then, yes, the impact would be significant. If a group of modestly weighted stocks were to be delisted, the impact would be significant. If most companies agree to come into compliance with the law and there are just a few delistings, the impact is probably minimal.

In summary, don't go selling your China equity positions because of this law just yet. It seems likely to pass at some point, but companies will be given plenty of time to get themselves into compliance, and I suspect most will.

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