Ruling Complicates Global Fight on Auditing of Chinese Firms; Hong Kong Says EY Must Turn Over Papers Related to Former Client, But Firm Cites Beijing Law

Ruling Complicates Global Fight on Auditing of Chinese Firms

Hong Kong Says EY Must Turn Over Papers Related to Former Client, But Firm Cites Beijing Law

DINNY MCMAHON

Updated May 23, 2014 10:06 a.m. ET

BEIJING—A Hong Kong court threw new uncertainty into an accounting dispute involving Chinese companies traded abroad that has put global auditors at the heart of a struggle to assert control over those companies.

The court on Friday ruled that accounting firm EY must turn over audit documents related to a former China-based client to Hong Kong securities regulators within 28 days. It rejected the accounting firm’s contention that turning over the documents would violate China’s state-secret laws.

“As this court sees it, the objection based on state secrets or commercial secrets is a complete red herring,” the court said in its decision.

The Hong Kong ruling centers on a Chinese company called Standard Water Ltd. EY was Standard Water’s auditor when the Chinese firm applied to list shares on the Hong Kong stock exchange in 2009, but resigned in early 2010 citing problems with the company’s documentation. Standard Water withdrew its bid to list shares.

The episode prompted Hong Kong’s Securities and Futures Commission to launch an investigation. After EY declined to turn over documents, the regulators in August 2012 launched legal actions against the accounting firm. The Chinese company couldn’t be reached for comment Friday.

“Auditors should not withhold information which is in their possession and sought by the SFC in connection with suspected misconduct in Hong Kong’s markets,” said Ashley Alder, the SFC’s Chief Executive Officer in a statement Friday.

A spokesman for EY said in a statement that the company would consider the Hong Kong judgment carefully before deciding whether to appeal. The firm—formerly Ernst & Young—said it “continues to support close working relationships between regulators on all matters of public interest.”

The decision sets up a clash with Chinese regulators, who have sought to keep a tight grip on Chinese corporate information.

Last month, China’s Ministry of Finance proposed rules that Chinese companies listed overseas must be audited by an accounting firm registered in China. The proposed rules would end a quirk in Chinese regulations that allowed Hong Kong-based firms to come into China on a temporary basis to audit Chinese companies traded abroad.

The new rules are “in order to guarantee the safety of national economic information, and to protect the public interest,” the ministry said.

“The issue is, will China allow Hong Kong to regulate Chinese companies listed in Hong Kong, or will the mainland be the sole regulator?” said Paul Gillis, a visiting professor of accounting at Peking University’s Guanghua School of Management.

It isn’t clear what dispute means for the hundreds of Chinese companies traded in Hong Kong or for companies that are audited out of Hong Kong, such as Alibaba Group Holding Ltd. The Chinese e-commerce giant—which is seeking a massive initial public offering in the U.S.—is audited by PricewaterhouseCoopers in Hong Kong, though it isn’t subject to Hong Kong securities regulators.

“The decision will certainly turn up the heat on China-based firms and regulators to find a solution to this ongoing issue,” said Jason Flemmons, Washington, D.C.-based senior managing director at FTI Consulting and a former SEC enforcement official.

The decision is part of a broader dispute that also involves U.S. regulators who want greater ability to scrutinize the books of Chinese companies with U.S.-traded shares. The U.S. Securities and Exchange Commission had sought audit-work papers from the firms to assist its investigations of some of the 130-plus Chinese companies trading on U.S. markets that have encountered accounting and disclosure questions in the past few years.

The Chinese affiliates of the Big Four accounting firms—PricewaterhouseCoopers, Deloitte Touche Tohmatsu, KPMG and EY—have declined to hand over the documents, arguing that their auditors could be thrown in jail if they cooperated without the Chinese government’s blessing.

In January an administrative law judge ruled the firms should be suspended from auditing U.S.-traded companies for six months, though that decision hasn’t taken effect amid an appeal.

The SEC declined to comment on the Hong Kong ruling.

Alibaba indicated in its IPO filing this month that if the Chinese affiliates lose their appeal and are suspended, it would need to consider the “alternate support arrangements” that PwC Hong Kong would need in auditing Alibaba’s operations on the mainland.

No ruling on the U.S. appeal is expected soon. After the SEC rules on the appeal, the firms can then appeal further to the U.S. federal courts. Meanwhile U.S. and Chinese officials have been in talks about how to resolve the issue. In 2013 the U.S. and Chinese authorities reached an agreement for the audit firms to turn over some documents by funneling them through Chinese regulators first.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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