In this landmark case the Hong Kong Court of First Instance was asked to inquire into non-compliance by a Hong Kong CPA firm, Ernst & Young (“EY”), with notices issued by the Securities and Futures Commission (“SFC”). Importantly EY contended that it could not disclose such documents by reason of legal impediments under PRC laws, including those pertaining to State secrecy.
The court found in favour of the SFC and directed EY to comply with the notices on the basis that the documents sought were found to be in EY’s possession and there was no reasonable excuse for EY to not comply with them. Importantly the court concluded that the restrictions under PRC laws cited by EY in its defence, including the laws on State secrets, were inapplicable in this case.
In its application for listing on the Hong Kong Stock Exchange, Standard Water Limited (a Cayman Island company) (“Company”) engaged EY as its reporting accountant and independent auditor in August 2009. Thereafter, EY engaged the services of Ernst & Young Hua Ming LLP (“HM”) to conduct the field work of the audit of the Company in the PRC. HM is a special general partnership between Hua Ming Certified Public Accountants and EY, and is a separate legal entity subject to PRC laws.
In March 2010, while the Company’s listing application was still pending, EY resigned as reporting accountant and independent auditor citing “inconsistencies in documentation in a number of areas that lead us to the conclusion that we can no longer continue as auditors”. The Company withdrew its listing application shortly thereafter.
The Securities and Futures Commission (“SFC”) began investigation into possible market misconduct offences and issued various notices under section 183(1) of the Securities and Futures Ordinance (“SFO”) requiring EY to provide, amongst other things, a detailed explanation of its resignation and all audit working papers relating to the Company’s listing application (“Notices”).
EY only disclosed limited documents under the Notices. Specifically, EY did not disclose the audit working papers claiming that they were created by HM and EY was unable to compel HM to disclose such documents by reason of legal impediments under PRC laws. As a result, the SFC made an application under section 185 of the SFO asking the court to inquire into the case and to order compliance with the Notices if it is satisfied that EY has no reasonable excuse for non-compliance.
The day before the substantive hearing of the proceedings, EY disclosed that a hard drive of the laptop used by the engagement partner in charge of this matter (who has left EY) and his emails (together “Hard Drives”) contained audit working papers and other archives which were responsive to the Notices. EY stated that these had been brought to Hong Kong by mistake.
A summary of the parties’ respective positions is as follows:
- HM owns the audit working papers which were generated and kept in Beijing.
- The further documents sought by the SFC that are in the PRC were in the possession of HM but not EY.
- PRC laws prohibit cross-border transmission of audit working papers and prohibit direct production of them to overseas regulators, and EY does not have a presently enforceable right to HM’s papers.
- The SFC should seek to obtain HM’s papers through China Securities Regulatory Commission (“CSRC”) under the cooperation mechanism for mutual assistance in place between the SFC and CSRC.
- HM has asserted proprietary interest in the Hard Drives (which were then in EY’s possession) and demanded their return, hence disclosing their contents to the SFC may expose EY and its partners to risk of criminal/administrative sanctions.
The SFC’s Position
- EY is in possession of the audit working papers and other relevant materials, whether in Hong Kong or in the PRC.
- EY has failed to demonstrate any applicable restrictions under PRC laws that:
- prohibit it from disclosing the materials contained in the Hard Drives in Hong Kong (insofar as they are responsive to the Notices) to the SFC; and
- prohibit HM from disclosing the audit working papers (which it possesses) to EY to enable it to comply with the Notices.
The Key Issues
The parties adduced expert evidence on PRC laws and three broad issues were identified:
- Whether EY has a right enforceable under PRC laws to demand from HM the documents sought in the Notices;
- Whether there is an applicable prohibition under PRC laws against the transmission from or the disclosure of the contents of documents sought in the Notices by HM to EY; and
- Whether there are steps under PRC laws that may be taken by EY or HM to obtain permission for transmitting the documents in the PRC to EY, or disclosing the contents of such documents to EY for handing over to the SFC.
The Court’s Ruling
- EY’s rights to the documents from HM
The relationship between EY and HM was held to be governed by PRC laws as one of agency of entrustment. When entering into such arrangement with EY, HM must have known that the audit working papers it generated should be regarded as generated by HM employees in their capacity as EY’s agents, such that the audit working papers are owned, managed and controlled by EY, and HM (as agent) must hand over the audit working papers to EY as its principal upon demand. It follows that EY has a presently enforceable legal right under PRC laws to demand the production of the audit working papers from HM.
- Prohibition under PRC laws
EY claimed that it was prohibited under PRC laws from disclosing the documents sought under the Notices, thereby giving rise to a reasonable excuse for non-compliance. Specifically, it contended (amongst others) that the documents sought contained State secrets, which cannot be disclosed under PRC laws.
The court rejected this argument and held that whether the audit working papers constitute State secrets depends entirely on the contents of such documents. As the expert witnesses were not shown the audit working papers, there is no evidence that the audit working papers did contain State secrets under PRC laws.
The court also found that other restrictions under PRC laws which EY claimed to have prohibited HM from passing the audit working papers in the PRC to EY are inapplicable.
- Application for approval
The court dismissed EY’s application for direction that the SFC should take all necessary steps to liaise with the CSRC to obtain the audit working papers. When dealing with an application under section 185, the court is empowered to inquire into EY’s non-compliance with the Notices and to make appropriate orders against EY in the absence of a reasonable excuse for non-compliance, but it has no jurisdiction to make an order against the SFC. In the event that prior approvals are required under PRC laws, the court held that it is up to EY to make the necessary applications.
The court granted an order directing EY to comply with the Notices as the documents sought are found to be in EY’s possession, and there is no reasonable excuse for EY to not comply with the Notices.
As EY was held to have deliberately withheld from SFC information in its knowledge which is responsive to the Notices, the court awarded costs on an indemnity basis against EY.
- Be sure to conduct all necessary internal investigations before responding to any notice issued by the SFC seeking disclosure of documents.
- Ensure no information in the company’s possession is withheld from the SFC unless there is a reasonable excuse for doing so.
- The court will not accept bare assertions as grounds for resisting compliance with SFC notices. The party resisting compliance must discharge burden of proving that there are reasonable grounds for doing so.