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. 

Background

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:-

  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

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:

  1. 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;  
  2. 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  
  3. 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.