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On 23 May 2014, Hong Kong’s High Court (Court of First Instance) handed down an unprecedented judgment, ordering Ernst & Young Hong Kong (“EY”) to produce to the SFC accounting records and audit papers (“the Documents”) relating to its work as reporting accountants and auditor for Standard Water Limited (“SW”), a company carrying on business in the PRC. SW had engaged EY for the purpose of its intended IPO and listing of its shares on the Stock Exchange of Hong Kong (“the Stock Exchange”).
The case raises important issues in relation to the legal obligations of Hong Kong accounting firms to disclose information about listing applicants carrying on business outside Hong Kong. It is the first case under section 185 of the Securities and Futures Ordinance (“SFO”) where the court has been asked by the SFC to inquire into a Hong Kong auditor’s non-compliance with statutory notices (“Notices”) issued by the SFC (under section 183 of the SFO) and to order compliance with such.
As reported in our , EY had resigned as SW’s auditor, citing inconsistencies in SW’s documentation, meaning that it could no longer act as its auditor and EY informed the Stock Exchange of its resignation. SW subsequently withdrew its listing application and the SFC requested EY to provide documents and information relevant to its assessment of whether there was any implication of false accounting in SW’s listing application.
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:-
EY did not dispute the validity of the Notices, but argued that:-
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:-
The Court’s Findings
The Court’s findings were as follows.
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
One of the major issues in this case which is of interest is whether contravention of PRC state secrets law (or more broadly, any applicable PRC legal law 1) is capable of constituting a reasonable excuse for EY’s non-compliance with the SFC Notices.
On this issue, the Court cited Bank of Valletta v National Crime Authority (1999) 164 ALR 45 (Hely J) and (1999) 165 ALR 60 (upheld on appeal by the Full Court) and distilled the following principles:
However, in this case, while setting out the principle, the Court did not really decide whether contravention of foreign law is capable of constituting a reasonable excuse. This is because no one (neither the Court, nor SFC’s PRC law expert or EY’s PRC law expert) had actually reviewed the audit working papers and on the evidence EY could not establish to the Court’s satisfaction that the audit working papers contained state secrets/commercial secrets. Accordingly, the question of whether contravention of PRC state secrets law could constitute a reasonable excuse was left open by the Court.
Transferring Data into Jurisdiction and Diligent Searches
EY said it had discovered, just the day before the hearing: (1) the hard drive of the laptop used by the ex-partner Mr Yam had been sent from the PRC to the forensic division of EY in Hong Kong for the purpose of creating a physical image of it in February 2011; (2) the email server back up tapes of Hua Ming in the PRC had previously been extracted by an IT staff member of Hua Ming and sent to EY in Hong Kong for preservation in 2011. These materials were responsive to the SFC Notices. The SFC Notice was first issued on 12 April 2010.
There two points which are worthy of note. First, when an external investigation is underway, one must be careful to consider the implications arising from transferring documents / transmitting data from one jurisdiction to another jurisdiction. As we have seen in this case, materials which were originally outside the jurisdiction could come within the possession, custody and power of a party if they were transferred / transmitted to the jurisdiction.
Secondly, when responding to SFC notices, in-house counsel should carry out diligent searches of materials which are responsive to the SFC notices. Electronic data is often the easily left out category. Electronic data which is in the company’s possession can be located in the server, in the staff’s laptop computers provided by the company, and in the back up tapes.
 Namely, art. 19 of CPA Law (Law on Certified Public Accounts), Archives Law, Regulation 29 (Regulation on Strengthening Confidentiality and Archives Administration Relating to Overseas Issuance and Listing of Securities (Circular  No. 29 dated 20 October 2009)), Reply letter dated 26 Oct 2011 issued by the Accounting Department of the CSRC, and the Localization Regulation promulgated on 2 May 2012 governing the conversion of sino-foreign joint venture firms into partnerships
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