The Securities and Futures Commission's (SFC) legal actions against Ernst & Young have called the one country, two systems approach into question and may test Hong Kong’s jurisdictional and judicial independence.
The proceedings against Ernst & Young for refusing to disclose Chinese water treatment company Standard Water’s records directly challenge China’s state secrecy laws, which classify corporate records as state secrets.
Sources are surprised that it has taken fifteen years for these issues to surface under the so-called one country, two systems policy implemented after the 1997 handover. Although there are hundreds of Chinese companies listed in Hong Kong, Standard Water marks the first legal proceeding that challenges compliance with the People’s Republic of China (PRC) state secrecy laws in Hong Kong.
Regulators worldwide have encountered a roadblock in obtaining corporate records in China’s state secrecy laws. In a comparable case, the Securities and Exchange Commission (SEC) sued Deloitte Touche Tohmatsu for nondisclosure of Chinese company Longtop Financial Technologies’ corporate records.
According to an SFC press release, Standard Water had applied to list on the Stock Exchange of Hong Kong (SEHK) in November 2009. Ernst & Young resigned as the company’s auditors after discovering inconsistencies in the company’s documentation in March 2010, and Standard Water withdrew its listing application.
When the SFC issued a formal notice to Ernst & Young for the work papers, the firm refused to comply with the request, saying that the relevant records were with its mainland partner. Furthermore, the firm said it would be illegal under the Regulations on Strengthening the Protection of Secrets and Archive Management related to Issuance and Listing of Securities Overseas, promulgated by the CSRC and State Secrets Bureau in October 2009, to hand the work papers over to the SFC without prior permission.
But Ernst & Young’s mainland partner refused to turn over the papers, even after the SFC coordinated with a mainland regulator.
A hearing is scheduled for September 11, when it will be decided whether Ernst & Young had a reasonable reason to refuse the SFC’s demands.
Corporate governance advocate David Webb told IFLR that the Standard Water case will hinge on whether it is reasonable for a Hong Kong auditor to subcontract work to a mainland auditor and not maintain paperwork copies in Hong Kong.
Given the importance of Hong Kong-listed Chinese companies to the SEHK, counsel are curious about how the hearing will play out, namely whether PRC secrecy laws will be applicable in Hong Kong, if at all.
But Webb commented that he would be surprised if a Hong Kong court decided to subordinate itself to a PRC law. He predicted it will rule that the papers should be accessible in Hong Kong in return for being allowed to file audits in the Hong Kong jurisdiction.
Comparable cases in the US
The SEC has encountered similar disclosure issues that stem from PRC state secrets laws. A raft of US-listed Chinese companies accused of accounting fraud, such as Longtop and Sino Forest Corporation, has drastically lowered investor confidence.
As in the Standard Water case, the Chinese government has denied the SEC access to corporate records, claiming state secrets could be revealed.
In September 2011, the SEC commenced legal actions against Deloitte Touche Tohmatsu regarding its refusal to produce documents related to Longtop’s alleged corporate fraud. Deloitte’s counsel said it was unable to comply due to fears of criminal penalties in China, including life imprisonment.
This July, Longtop’s case was stayed for six months as US regulators consult with PRC regulators.
Chinese companies listed in the United States are facing low valuations due to their provenance, as well as volatile market conditions. Sources fear that Chinese companies listed in Hong Kong could encounter the same drop in investor confidence, resulting in lower valuations and greater scrutiny surrounding corporate records.
Although the HKSE’s success is often credited to its popularity with Chinese companies, Webb concluded that regulators should be stricter about non-compliance due to PRC rules. “If China isn’t going to play ball, it will raise issues about having it both ways: while Chinese companies can raise capital in international markets, they can’t be subject to regulations,” he said.