Hong Kong’s Securities and Futures Commission has begun legal proceedings against Ernst & Young Hong Kong for failing to produce work papers and accounting records related to its audits of a former China-based client, Standard Water Limited.

The records relate to E&Y Hong Kong’s work as the reporting accountant and auditor for the water company. Standard Water applied for a listing on the Hong Kong Stock Exchange in November 2009. In March 2010, Ernst & Young suddenly informed the stock exchange of its resignation as reporting accountants and auditors of Standard Water upon discovering certain inconsistencies in the documentation provided by the company. Shortly afterwards, Standard Water also withdrew its listing application.

The Hong Kong securities regulator issued a formal notice to Ernst & Young’s Hong Kong member firm seeking the audit work papers and underlying accounting documents relating to Standard Water. Ernst & Young did not comply with the request, according to the Hong Kong Securities and Futures Commission and claimed that it did not have the relevant records, which were held in Mainland China by its joint venture partner in the Mainland, Ernst & Young Hua Ming, whose staff were the ones involved in the engagement.

On following up on the noncompliance, Ernst & Young then claimed the documents could not be produced because of restrictions under the laws of the People’s Republic of China. As a result of a joint statement issued by PRC authorities on Oct. 20, 2009, accounting records, including audit working papers, may be the subject of claims of state secrecy under Chinese law and all Hong Kong accountants are required to obtain the consent of the relevant Mainland authorities before handing over any accounting records to regulators like the SFC, even if the records are kept in Hong Kong.

The SFC then sought the assistance of the relevant authority in the Mainland using its standing arrangements for mutual assistance in investigatory matters. However, EY Hua Ming also failed to produce the records to the relevant Mainland authority as requested.

Given the fact that Ernst & Young was the reporting accountant and EY Hua Ming was Ernst & Young’s agent, the failure to produce these records to the relevant Mainland authority on the SFC’s request is “a matter of serious concern,” the Hong Kong SFC noted.

Accounting and audit working papers relating to private companies applying for listing in Hong Kong must be capable of being produced either directly to the SFC or via the relevant Mainland authority under the standing arrangements for cooperation, especially where the SFC is investigating suspected misconduct, the SFC added.

Ernst & Young said it was trying to comply with both its obligations to Hong Kong's securities regulator and the Mainland Chinese authorities. "Ernst & Young performed IPO audit work for Standard Water in 2009 and resigned in March 2010. We did not issue an Accountant's Report for the IPO," the firm said in a statement forwarded by a spokesperson. "The Hong Kong Securities and Futures Commission (SFC) requested workpapers from Ernst & Young in relation to our work on Standard Water. We understand our obligations to the SFC and endeavor to fully comply, while also meeting our compliance obligations with mainland China’s laws and regulations. Ernst & Young supports close working relationships between Hong Kong and mainland China audit regulators on matters of public interest. We will work closely with the relevant regulators, and trust that there will be a quick resolution to enable our full compliance with applicable laws and regulations. As legal proceedings are underway, it would be inappropriate for us to comment further."

The SFC is invoking Section 185 of the Securities and Futures Ordinance, which empowers the Court of First Instance to inquire into the circumstances of Ernst & Young’s noncompliance with the SFC’s request for these records. The court can order Ernst & Young to comply with the SFC’s request if it is satisfied that Ernst & Young does not have any reasonable excuse for not complying.

The SFC said it had brought the proceeding after consulting the relevant Mainland authority regarding access to these records and the SFC and the relevant Mainland authority are continuing to work closely together in relation to this issue.

The case is reminiscent of one in the U.S. involving another Big Four firm, Deloitte, in which the Securities and Exchange Commission filed charges in an enforcement action after Deloitte’s Shanghai affiliate refused to produce work papers and other auditing documents for another Chinese client (see SEC Charges Deloitte with Refusing to Produce Chinese Work Papers and SEC Presses Deloitte’s Shanghai Firm for Audit Documents).

The Public Company Accounting Oversight Board has been seeking access to inspect Chinese auditing firms that audit the records of U.S.-listed companies and has been meeting with Chinese securities officials to gain access (see PCAOB Sees Progress in China Inspection Talks). However, the PCAOB still has not been able to reach an accord with Chinese officials.

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