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
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
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
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
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
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
This July, Longtop’s case was stayed for six
months as US regulators consult with PRC
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
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.