The Companies Bill recently passed in the Legislative Council renders auditors criminally liable if they knowingly or recklessly omit certain information from their reports. On the face of it, the scope and application of the bill appear unprecedented. All certified public accountants connected to the preparation of an auditor’s report could conceivably be exposed to criminal sanction - without even intending to omit anything.
In this legal update we discuss this important new development and its intended and possibly unintended consequences. We also examine the current increasingly intense regulatory trends, and expect the Securities & Futures Commission to act swiftly to push through similar changes in the regime for sponsors.
The current position
The Companies Ordinance (“CO”) currently provides for statutory duties of auditors, such as the requirement under section 141D(1)(e) that an auditor’s report shall state whether the auditors have obtained all the information and explanation required, and that the balance sheet has been drawn up to reflect a true and correct view of the state of the company’s affairs.
What the CO does not do is to make the breach of such provisions a criminal offence. Rather, “enforcement” is left to parties to engage in civil litigation, and to the accountants’ own professional body. The Financial Reporting Council has certain powers to investigate but has no power to impose criminal sanction.
There have been a few high profile cases in recent years where auditing firms were sued. These cases involved very substantial sums and, to date, have tended to settle leaving no real corpus of authority on the extent and nature of liability. There is no statutory cap on liability. Practitioners will be familiar with the cases involving the liquidations of Akai Holdings and Moulin Global Eyecare.
The Companies Bill
The Companies Bill Phase I was recently passed in the Legislative Council and will take effect after the Government passes supporting subsidiary legislation. This Phase essentially covers all matters aside from topics such as winding-up, prospectuses, and the disqualification of directors. Of particular interest, clause 399 of the Bill introduces criminal liability for auditors in Hong Kong.
Duties and Consequences
Under Clause 398 of the Bill, auditors must include the following in an auditor’s report, if applicable:
- An opinion that adequate accounting records have not been kept by the company;
- An opinion that the financial statements are not in agreement with the accounting records, in any material respect;
- The fact that all the information or explanations, to the best of the auditor’s knowledge and belief, which are necessary and material for the purpose of the audit have not been obtained.
Clause 399(1) makes it an offence to “knowingly or recklessly” omit any of the information required under Clause 398 from the auditor’s report. The controversial part of Clause 399 is the scope of the offence. While legislators have publicly stated that the intention of this increased regulatory intensity is to keep an eye on “senior staff ” as opposed to “ junior staff ”, the distinction between the two is unclear. There is no indication as to what factors may be considered, such as the years of relevant experience or the years an individual has spent practicing. As it stands, the Bill provides that any partner, employee, or agent of the auditing firm or individual, who is eligible to be “appointed as an auditor”, may be liable. In other words, any certified public accountant who has been involved with the preparation of the report, and therefore in a position to “cause” information to be omitted, is potentially exposed to criminal liability.
During the legislative process, an attempt was made by the legislator representing the accounting profession to remove the “reckless” limb from the offence, but this failed. Further, unlike section 40A of the current CO, there is no defence of “reasonable belief” available under the provisions. The end result is that an auditor may well be convicted of a crime even though he or she had no criminal motives or intentions.
Restrictions on Scope?
The Government has indicated that the purpose of Clause 399 is not to punish “honest mistakes” of auditors, even though in our view, the wording as passed manages to cover honest mistakes as well, as long as the auditor was reckless.
To that end, the Government is willing to consider, but has not made any promises, to issue a joint circular by the Companies Registry and the Department of Justice to outline how this rather vague criminal offence will be prosecuted. In the United Kingdom, for example, official guidelines state that prosecution under the “recklessness” limb is “highly unlikely to be appropriate”, if the public interest can be met by disciplinary action by regulators. Until our Government issues similar guidelines, significant uncertainty will remain.
The stakes have been raised in this newly intensive regulatory regime. Any auditor who makes a material misstep under the old system may face civil liability and disciplinary action. Under the new regime, those missteps may well become criminal, leading to permanent damage to their reputation and track record, and very likely an increased chance of suspension or even expulsion from the profession.
As we have previously discussed in SFC Consults the Market about Increased Responsibilities for Listing Sponsors, the Consultation Paper on the Regulation of Sponsors (“Consultation Paper”), published by the Securities and Futures Commission (“SFC”), sets out proposed reforms as part of a broader drive to improve corporate governance and market transparency after problems with several companies emerged after listing, with IPO sponsors and auditors in the spotlight.
Sponsors have traditionally played a unique and critical role in the Hong Kong IPO market. By leading the IPO process, sponsors are centrally involved in the conduct of due diligence on the company. This essentially turns sponsors into key gatekeepers of market quality and integrity.
With such important role comes regulation: given a relatively non-litigious IPO environment in Hong Kong, there has always been a regulatory focus on sponsors.
Sponsors’ prospectus liability
The prospectus liability of sponsors had in fact been discussed in an earlier SFC consultation back in 2005, where it was considered premature to proceed given the then new non-statutory sponsor regulatory regime had yet to be fully implemented. It appears that auditors’ criminal liability has progressed nonetheless.
A key theme underlying the Consultation Paper is the SFC’s concern that standards of sponsor work have fallen short of reasonable expectations. In light of such concern, the Hong Kong regulator is now consulting the market on, among other things, the extent to which sponsors may be held civilly and criminally liable for untrue statements, including material omissions, in a prospectus alongside others such as directors of the issuer.1 Such clarification has been stated by the SFC to be necessary given the lack of Hong Kong case law on whether sponsors are subject to sections 40 and 40A of the CO which impose civil and criminal liability on parties “who [have] authorized the issue of the prospectus”.
While the deadline for submissions has been extended to 31 July 2012, the SFC has, according to reports, made it clear that the extension should not be viewed as a sign of a softening in the SFC’s determination to move ahead with prospectus liability reform. Given the new position on auditors’ liability, it is much more possible that the SFC will push ahead with its controversial plan, which is likely to be met with fierce opposition and hard lobbying from the investment banking community.
The imposition of civil and criminal liability on top of existing licensing, listing and conduct requirements will create yet another layer of regulatory burden which significantly impacts on the exposure of sponsors as well as other professional advisors.
Tougher regulatory times are still to come.