On 23 May 2014, the Court of First Instance ordered the Hong Kong office of Ernst & Young (“EY”) to produce, certain audit working papers and underlying accounting documents from its Chinese affiliate to the Securities and Futures Commission (“SFC”) pursuant to notices under section 183 of the Securities and Futures Ordinance (“SFO”). This case raises important issues on the legal obligations of accounting firms and other professional service providers to answer notices issued by regulators whilst balancing other legal risks to clients and offices in other jurisdictions.
Background
This case arose out of a stock exchange listing application which was withdrawn. In November 2009, Standard Water Limited (“Applicant”), a PRC company in the business of water supply and waste water treatment, applied for listing on the Hong Kong Stock Exchange. EY was formally engaged as its reporting accountant and independent auditor for this purpose although the audit field work on the Applicant was carried out in the PRC by EY’s Chinese affiliate Ernst & Young Hua Ming (“HM”). EY resigned in March 2010, citing inconsistencies in documentation which caused them to conclude that they could no longer act as the Applicant’s auditors. In the same month, the Applicant withdrew its listing application at the request of its joint sponsors.
Shortly thereafter, the SFC requested documents from EY in order to assess whether there was any implication of false accounting. When EY replied that it could not voluntarily provide the requested information, the SFC launched an investigation into whether any market misconduct may have been committed during the listing application.
Notices under SFO and Court Proceedings
Section 183 of the SFO empowers the SFC to issue notices to persons whom it believes may have information relevant to an investigation. In all, the SFC issued 9 such notices to EY (“Notices”) requiring, inter alia, an explanation of EY’s reasons for resigning and provision of all audit working papers, correspondence and a list of all staff involved in the Applicant’s listing application. EY did not fully comply with the Notices, alleging that it did not have access to the audit working papers which were created by HM, being a separate legal entity in the PRC. EY also argued that various PRC state secrecy laws imposed restrictions on production of such documents outside of the PRC.
Rather than prosecuting individuals for failing to provide the requested information, the SFC applied to the Court under section 185 for an order to compel EY to disclose the documents.
Agency Relationship
The first issue considered by the Court was whether the requested documents, such as audit working papers, were within EY’s possession. The court held that the relationship between EY and HM was one of agency of entrustment governed by PRC laws, similar to the concept of “principal and agent”. On the facts, HM must have known it was carrying out the audit field work on behalf of EY and as EY’s agent in the PRC. Therefore, EY had a right of continued access to those audit working papers, a right to make copies and also an enforceable legal right to demand production of those papers created by HM. HM accordingly also had a duty to produce all such documents to EY upon request.
Prohibitions under PRC Laws
Section 185 of the SFO allows for non-compliance with the Notices if a reasonable excuse is disclosed. EY argued that PRC laws restricted disclosure of such documents, especially if they contain “state secrets” of the PRC. As such, they have a reasonable excuse for not complying with the Notices. However, experts for both the SFC and EY agreed that the determination of state secrets is a fact-sensitive exercise and depends entirely on the contents of the documents in question. In this case, there was simply no evidence to support EY’s argument because none of the working papers had been presented to the experts or the Court to consider whether they contained state secrets.
EY also referred to several computer hard drives containing relevant audit working papers and had been brought from HM to EY in Hong Kong by mistake. EY argued that these hard drives were sent unlawfully, according to PRC law, and disclosure of their contents may expose EY and/or HM partners to criminal prosecution or administrative penalties in the PRC due to potential state secrets. The Court rejected this argument by noting that EY had not fully explained how this act of bringing the hard drives to Hong Kong was unlawful, and, once again, no evidence was presented to show that the hard drives contained state secrets.
As such, it was held that EY did not have any reasonable excuse for non-compliance with the Notices as it could not establish that any restrictions under PRC laws would apply and prohibit HM from passing the audit working papers in the PRC to EY.
Approval for Obtaining Documents
EY applied for a direction that the SFC should be the party responsible to liaise with the relevant PRC authorities to obtain clearance for the requested audit documents from HM. The Court refused EY’s application, noting that the SFC’s application under section 185 was only for inquiring into EY’s non-compliance with the Notices. The statute does not confer jurisdiction on courts to make any order or direction against the SFC and the SFC is free to decide whether to pursue alternative means of gathering information. Where prior approval is required under PRC laws, it was held that that EY should make the necessary application and not the SFC.
Conclusion
Having ruled that EY had no reasonable excuse for non-compliance, the Court ordered EY to comply with the Notices. Furthermore, the Court criticized EY’s conduct for deliberately withholding information which it knew was relevant to the Notices and awarded costs on an indemnity basis against EY.
This is the first ever case under section 185 of the SFO in which the court inquired into an auditor’s non-compliance with SFC notices and ordered compliance. It suggests that any excuse for non-compliance must be sufficiently supported by evidence. Therefore, one must be ready to present the documents with specific contents or sufficient details for the courts to determine whether state secrecy laws or other laws of another jurisdiction would apply. It cannot just vaguely claim that such documents potentially contain restricted state secrets. The court has made clear that it is up to the institutions and their legal advisers, in Hong Kong and in the PRC, to decide how best to comply with such notices from the SFC.
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