Ernst & Young ordered to produce accounting records and audit papers to the SFC

Whilst it was EY who had contracted with SW to be their reporting accountant and independent auditor for the purpose of the intended listing, EY had used its affiliate, Ernst & Young Hua Ming LLP (“Hua Ming”), a PRC entity, subject to PRC laws, to conduct the field work for the audit.

The SFC’s Case

The SFC’s case was that EY was in possession of the Documents and had failed to provide any reasonable excuse for not complying with the Notices, specifically that:-

1. EY plainly must have known the reason for its resignation and details of the inconsistencies in SW’s documentation.
    
2. EY was in “possession” of the Documents, whether in Hong Kong or the PRC.
    
3. In so far as the Documents were contained in hard drives in Hong Kong, EY had failed to demonstrate any applicable restrictions under PRC laws which prohibited them from disclosing them to the SFC in Hong Kong.
    
4. In so far as the Documents were in Hua Ming’s possession in the PRC, EY had failed to establish any restrictions under PRC laws which prohibited Hua Ming from providing them to EY to enable them to comply with the Notices.     

EY’s Case

EY did not dispute the validity of the Notices, but argued that:-

1. The reasons for its resignation were very much tied to the Documents and without the Documents, it was unreasonable to expect anyone at EY to be able to state accurately and comprehensively what had happened.
    
2. All on-site audit field work had been undertaken by Hua Ming at SW’s Beijing office and the Documents kept by Hua Ming in Bejing. The Documents therefore belonged to Hua Ming and EY had no rights over them.
    
3. EY had already provided the SFC with all information and documents that it was able to and the further documents requested where physically in the PRC and not in EY’s possession and EY had to comply with guidelines issued by the Hong Kong Institute of Certified Public Accountants (HKICPA), which required it to comply with all relevant PRC laws.
    
4. PRC laws restricted cross-border transmission of audit working papers and direct production of them to overseas regulators and so EY did not have a presently enforceable legal right to Hua Ming’s documents.
    
5. The appropriate channel for the SFC to obtain the papers was through the China Securities Regulatory Commission (CSRC) pursuant to the cooperation mechanism for mutual assistance between the SFC and CSRC.
    
6. In respect of three hard drives that EY had in its possession in Hong Kong, Hua Ming had asserted a proprietary interest in them and demanded their return. The hard drives came to be in Hong Kong by mistake and handing them over or disclosing their contents to the SFC may breach PRC laws and put EY and its partners at risk of criminal and/or administrative sanctions.

The Court’s approach to applications under s.185 of the SFO

The Court said that the proper approach for dealing with the application under s.185 of the SFO was for it to determine:-

1. Whether (on a balance of probabilities) the Documents were in EY’s “possession”, which includes custody, control and power, the latter being the presently enforceable legal right to obtain the document.
    
2. If so, whether EY had a reasonable excuse for not having complied with the SFC’s request for the Documents, such as having physical or practical difficulties in providing them or a right privilege or immunity recognized by law not to produce them. 
    
3. Whether in the event of finding that EY was in possession of the documents and had no reasonable excuse for not producing them, the court should exercise its discretion to order production of the Documents.

The Court’s Findings

The Court’s findings were as follows.

1. EY’s factual witness (a partner of EY responsible for quality and risk management, but not personally involved in SW’s audit) was not of much assistance and no weight could be placed on his evidence that EY had already fully complied with the Notices.
    
2. As agreed by the SFC’s and EY’s PRC legal experts, under PRC law (which they agreed applied), the relationship between EY and Hua Ming was that of principal and agent. Accordingly, EY not only had a right of access to all books and documents in Hua Ming’s hands relating to the engagement (even though Hua Ming had created them), but also a presently enforceable legal right to demand production of them from Hua Ming. Further, EY, as principal, was entitled to have continuing access to and make copies of Hua Ming’s records relating to acts done on its behalf, even after termination of the agency. The Documents were therefore in EY’s power and therefore in their possession.
    
3. Again, as agreed by the parties’ PRC legal experts, there was no blanket prohibition on cross-border transmission of audit working papers to overseas securities regulatory authorities.
    
4. The question was whether there were any legal restrictions on cross-border transmission of audit working papers and other relevant documents from the PRC to Hong Kong which rendered EY’s right not a “presently enforceable” one and served as a “reasonable excuse” for them not to produce them to the SFC. The answer was “no”.  EY had failed to establish any applicable restrictions under PRC laws prohibiting Hua Ming from passing the documents in the PRC to EY with a view to complying with the SFC’s Notices.
    
5. One of the legal restrictions raised by EY was based on “state secrets” or commercial secrets. It was common ground between the PRC legal experts that whether audit working papers constituted state secrets/commercial secrets was  fact-sensitive and therefore depended highly on the contents of the documents in question, However, since the audit working papers were not actually in evidence before the Court and had not been seen  by the legal experts, there was no way that EY could establish to the Court’s satisfaction that the audit working papers contained state secrets/commercial secrets. The objection based on state secrets/commercial secrets was therefore a complete red herring.

The Court’s Conclusion

In the absence of an innocent explanation, the Court was compelled to draw the adverse inference that EY had deliberately withheld information in its knowledge which was responsive to at least three of the Notices. Further, it was inherently improbable that EY, as SW’s reporting accountant, did not have any records in its files in Hong Kong in relation to its engagement and its decision to resign, over and above those already provided. Accordingly, the Court ordered EY to comply with the Notices within 28 days (or such other time as agreed with the SFC) and pay the SFC’s costs on an indemnity basis.  

The Court said that in the event of its finding being wrong (i.e. its finding that there were no legal restrictions under PRC law on cross-border transmission of the Documents) and prior approval from the CSRC being required, it was EY (either directly or indirectly through Hua Ming), and not the SFC, who should make the applications. The Court therefore dismissed EY’s application for a direction that the SFC should take all necessary steps to liaise with the CSRC to obtain a complete set of the audit working papers.

The Court made it clear that its decision was only concerned with EY’s obligations as a Hong Kong firm to comply with the Notices, as part of Hong Kong’s law. Hua Ming had never been issued with any of the Notices and there was no question of Hua Ming being compelled by the SFC or the Court to directly produce to the SFC the Document that were in the PRC. In this regard, the Court said, that s.183 of the SFO did not have any extraterritorial effect in the same way that U.S. legislation did, which enabled the U.S. Securities and Exchange Commission (SEC) to commence proceedings against accounting firms in the PRC for the direct production of audit papers to the SEC (see our February 2014 Newsletter in relation to such a case).   

Since this judgment, EY has produced to the SFC a disc of documents that it held in Hong Kong and which it had discovered on the eve of the trial in March 2013 and which at that time had refused to produce on the basis that the hard drives belonged to Hua Ming. EY informed the SFC that it required a further five weeks to complete its search of hard drives in its Hong Kong office for any additional documents required to be produced to the SFC.

EY’s Appeal in respect of documents in the PRC

On 20 June 2014, EY filed a Notice of Appeal in respect of the order requiring it to produce documents held by Hua Ming in the PRC.   

Analysis and Lessons

Reasonable Excuse