SFC wins Hong Kong case against EY, but future problems loom
PUBLISHED : Tuesday, 28 July, 2015, 12:30am
Beijing’s state secrets law will lead to further legal disputes unless procedures are clarified
The Securities and Futures Commission has won a five-year legal battle with EY as the accounting firm has finally handed over the audit papers of a mainland Chinese client to the commission. But this does not mean other accountants will automatically follow EY’s lead.The Ministry of Finance announced this month that from July 1, a new rule bans all auditors from taking any papers out of the country due to the state secrets law.
China’s state secrets law has a much wider scope than overseas markets and covers accountants’ working papers, examination papers and even the results of agricultural harvests.
EY pointed to the state secrets law and the SFC put things up to the Hong Kong courts. The Court of First Instance last year ruled in favour of the SFC. EY appealed. But the saga ended since the appeal is now “academic” as EY has already handed over the documents.
EY officials last week refused to comment on why the firm bowed to the SFC while the commission statement gave a vote of thanks to the assistance of the China Securities Regulatory Commission.
As such, it looks like the CSRC worked behind the scenes to help attain the papers.
But next time there is a similar case, will the CSRC help again or will the Ministry of Finance – which issued the ban in the first place – handle it.
In announcing its victory result last Thursday, the SFC reminded all audit firms to produce working papers upon SFC request and that it was “their obligation to identify records held in the mainland and to seek their clearance with the auditor.”
The SFC is eager to access such documents to crack down on market malpractices. The problem though is that accountants do not fall under SFC jurisdiction.
It is the Hong Kong Institute of Certified Public Accountants that issues licences for accountants and the Financial Reporting Council that handles alleged auditor failures.
The SFC can only remind but not order auditors around. If the accountants do not listen to the regulator, the SFC may well need to go to court again. The EY-SFC saga is bound to repeat itself.
What we need are clear guidelines on who is doing what. Should auditors fill in a form from the Ministry of Finance to apply to get papers for the SFC, or would this all be done through the CSRC in the future?
Only clear procedures can prevent future legal disputes.
Ernst & Young produces audit working papers in Hong Kong and appeals order over Mainland papers
23 Jun 2014
The Securities and Futures Commission (SFC) notes that, on 20 June 2014, Ernst & Young (EY) filed a Notice of Appeal in respect of the court order to produce documents held by its Mainland affiliate, EY Hua Ming (EYHM), having produced a disc of documents it held in Hong Kong (Note 1).
The disc of documents produced to the SFC last Friday were found by EY on various hard drives in its Hong Kong office on the eve of the trial in this case, in March 2013, when production of the documents were refused by EY on the basis that the hard drives belonged to EYHM.
EY now informs the SFC that it needs another five weeks to complete its search of the hard drives in its Hong Kong office to find additional documents required to be produced to the SFC.
EY’s Notice of Appeal relates to documents held by EYHM, EY’s agent in carrying out specific audit activities as part of EY’s engagement as reporting accountant and auditor of Standard Water Limited.
EY had argued during the trial that it was prevented from producing audit working papers held by EYHM because of restrictions under PRC law. The SFC argued and the court accepted that PRC law does not prohibit the production of these documents and there is no blanket prohibition against their production under PRC law.
The SFC also argued that EY had not done anything to follow the process under PRC law for obtaining clearance of these documents. EY has informed the SFC that it has now provided these documents to the China Securities Regulatory Commission as part of this process.
EY’s Notice of Appeal contends that the court was wrong in respect of the documents held by EYHM in the Mainland.
The SFC is investigating the materials contained in the disc produced last Friday to determine whether EY has fully complied with the court order and whether any further action needs to be taken against EY.
No date has been set for the hearing of EY’s appeal.
Please see the judgment (HCMP1818/2012) which is available on the Judiciary’s website (www.judiciary.gov.hk) and the SFC’s press releases dated 27 August 2012, 7 September 2012, 20 September 2012, 12 October 2012 and 23 May 2014.
SFC commences legal proceedings against Ernst & Young over access to accounting records
27 Aug 2012
The Securities and Futures Commission (SFC) has commenced proceedings in the Court of First Instance against Ernst & Young Hong Kong (Ernst & Young) for failing to produce to the SFC specified accounting records.
The records relate to its work as the reporting accountant and auditor for Standard Water Limited (Standard Water) (Note 1).
The SFC issued a formal notice to Ernst & Young seeking the audit working papers and underlying accounting documents relating to Standard Water. Ernst & Young did not comply with this request and claimed that it did not have the relevant records which were held in the Mainland by its joint venture partner in the Mainland, Ernst & Young Hua Ming (EY Hua Ming), whose staff were the ones involved in the engagement.
On following up the non-compliance, Ernst & Young then claimed the documents could not be produced because of restrictions under PRC law (Note 2).
The SFC then sought the assistance of the relevant authority in the Mainland using its standing arrangements for mutual assistance in investigatory matters. However, EY Hua Ming also failed to produce the records to the relevant Mainland authority as requested.
Given Ernst & Young was the reporting accountant and EY Hua Ming was Ernst & Young’s agent, the failure to produce these records to the relevant Mainland authority on the SFC’s request is a matter of serious concern.
Accounting and audit working papers relating to private companies applying for listing in Hong Kong must be capable of being produced either directly to the SFC or via the relevant Mainland authority under the standing arrangements for cooperation, especially where the SFC is investigating suspected misconduct.
The SFC is invoking section 185 of the Securities and Futures Ordinance which empowers the Court of First Instance to inquire into the circumstances of Ernst & Young’s non-compliance with the SFC’s request for these records. The Court can order Ernst & Young to comply with the SFC’s request if it is satisfied that Ernst & Young does not have any reasonable excuse for not complying.
The SFC has brought this proceeding after consulting the relevant Mainland authority about access to these records and the SFC and the relevant Mainland authority are continuing to work closely together in relation to this issue.
Standard Water applied for listing to the Stock Exchange of Hong Kong (SEHK) on 9 November 2009. In March 2010, Ernst & Young suddenly informed the SEHK of its resignation as reporting accountants and auditors of Standard Water upon discovery of certain inconsistencies in documentation provided by the company. Shortly afterwards, Standard Water also withdrew its listing application.
As a result of a joint statement issued by PRC authorities on 20 October 2009, accounting records, including audit working papers, may be the subject of claims of state secrecy under PRC law and that all Hong Kong accountants are required to obtain the consent of the relevant Mainland authorities before handing over any accounting records to regulators like the SFC even if the records are kept in Hong Kong.
Ernst & Young ordered to produce accounting records and audit papers to the SFC
China, Hong Kong September 16 2014
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 February 2014 newsletter, 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 plainly must have known the reason for its resignation and details of the inconsistencies in SW’s documentation.
EY was in “possession” of the Documents, whether in Hong Kong or the PRC.
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.
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 did not dispute the validity of the Notices, but argued that:-
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.
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.
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.
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.
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.
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:-
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.
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.
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.
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.
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.
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.
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.
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
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:
Whether a breach of foreign law constituted a reasonable excuse depended on the court balancing all the consequences of the refusal, including the adverse consequences to the inquiry if the questions were not answered or documents not produced; and the adverse consequence to the witness if he or she was compelled to answer a question or produce a document;
If the public interest in the investigation outweighed the public or the witness’s private interest in not breaching foreign law, then the possibility that the witness would be exposed to criminal liability under foreign law would not constitute a reasonable excuse for not complying with the notice; and
If there were alternative means to obtain the documents without materially adverse consequences to the investigation, then a real and appreciable risk of prosecution under foreign law if the documents were produced would constitute a reasonable excuse for non-production.
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.
To view all formatting for this article (eg, tables, footnotes), please access the original here.
Can regulators require accounting firms to provide documents for investigations?
28 February 2014 , Newsletter , Litigation & Dispute Resolution , Joseph Kwan
In May 2011, the U.S. Securities and Exchange Commission (“the SEC”) issued a subpoena against Deloitte Touch Tohmatsu CPA Ltd (“DT”), requiring Deloitte Touche Shanghai (“DT Shanghai”) to produce documents to assist it in its investigation of possible fraud and other violations concerning the securities of Longtop Financial Technologies Ltd (“Longtop”), a foreign private issuer, the securities of which are registered with the SEC and traded on U.S. markets. DT Shanghai had audited Longtop’s financial statements for several years, before it resigned as auditor in May 2011, after discovering numerous financial improprieties.
Notwithstanding that D&T Shanghai acknowledged that it was in possession of a vast number of documents responsive to the subpoena, it did not produce the same to the SEC, meaning that the SEC could not gain access to information critical to its investigation, which had been authorized for the protection of public investors. Accordingly, in September 2011, the SEC filed a subpoena enforcement action against DT for failing to produce the documents. Pursuant to its application, the SEC sought a court order directing DT Shanghai to show cause why the court should not order DT Shanghai to produce documents responsive to the subpoena.
On 27 January 2014, the SEC and DT filed a joint motion with the court to dismiss (without prejudice) SEC’s subpoena enforcement action against DT because the SEC had recently received a substantial volume of documents required by the subpoena, including DT audit work papers and various other documents relating to Longtop. The documents were produced by the China Securities Regulatory Commission (“the CSRC”) in response to the SEC’s request for its assistance and after the CSRC had obtained the documents from DT.
In view of the substantial volume of documents produced, the cooperation provided by the CSRC to the SEC and DT’s statement that it would continue to cooperate with the CSRC’s requests for Longtop related documents, the SEC considered that it did not currently need the court’s assistance. The SEC and DT agreed that dismissal of the motion should be “without prejudice”, meaning that the SEC can always go back to court and seek it’s assistance in future, if it needs to. Accordingly, on 28 January 2014, the court dismissed (without prejudice) the SEC’s subpoena enforcement action.
The resolution of the disputes, whilst good news for the parties, mean that there is no determination by the US court on the issue of whether a PRC company, like DT Shanghai, is obliged to provide documents to US regulators even though that party was allegedly prohibited from doing so under state secrecy law in the PRC.
In Hong Kong, there are similar proceedings before the Court of First Instance, by the Securities and Futures Commission (“the SFC”) against Ernst and Young Hong Kong (“Ernst and Young”) for failing to produce accounting records relating to its work as reporting accountant and auditor for Standard Water Ltd, before it resigned as that company’s auditor in March 2010. Ernst and Young resigned citing “inconsistencies in documentation in a number of areas that lead us to the conclusion that we can no longer continue as auditors”.
The SFC issued statutory notices to Ernst & Young, under section 183 of the Securities and Futures Ordinance (Cap 571) (“the SFO”), seeking the audit working papers and underlying accounting documents relating to Standard Water, which the SFC needed in respect of its investigation of Standard Water’s failed IPO. Ernst & Young did not comply with this request, claiming that it did not have the relevant records, which were held in the PRC by its joint venture partner, Ernst & Young Hua Ming (EY Hua Ming), whose staff were the ones involved in the engagement. Ernst & Young subsequently claimed that the documents could not be produced because of restrictions under PRC law.
The SFC sought the assistance of the relevant authority in the PRC, using its standing arrangements for mutual assistance in investigatory matters. However, EY Hua Ming also failed to produce the records to the relevant PRC authority as requested. Accounting and audit working papers relating to private companies applying for listing in Hong Kong must be capable of being produced either directly to the SFC or via the relevant PRC authority under the standing arrangements for cooperation, especially where the SFC is investigating suspected misconduct.
The SFC is invoking section 185 of the Securities and Futures Ordinance, which empowers the Court of First Instance to inquire into the circumstances of Ernst & Young’s non-compliance with the SFC’s request for the records. The Court can order Ernst & Young to comply with the SFC’s request, if satisfied that Ernst & Young does not have any reasonable excuse for not complying. The SFC brought the proceedings after consulting with the relevant PRC authority about access to the records and the SFC and relevant PRC authority are working closely together in relation to this issue.
The court hearing was part heard in March 2013 and resumed in May 2013. The court has not yet handed down its judgment.