The fog is pretty dense out there regarding XML, XSL and character encoding. But maybe [link|http://groups.google.com/groups?hl=en&threadm=OJ7Za1ioAHA.1320%40tkmsftngp04&rnum=20&prev=/groups%3Fq%3DSystem%2Bdoes%2Bnot%2Bsupport%2Bthe%2Bspecified%2Bencoding%2BUTF-16%26hl%3Den%26start%3D10%26sa%3DN|this] is related to what is happening on your end. After all, the 40th character is past the closing ">"
If I read the ng's right, the 'encoding="UTF-16"' bit implies the entire XML document is UTF-16 encoded. If that's not the case, the parser will not like it.