By Anne Marie Roantree and Rachel Armstrong
HONG KONG/SINGAPORE (Reuters) - Hong Kong's securities regulator, in an unprecedented move, took Ernst & Young to court after the audit giant failed to turn over accounting records related to a former China-based client.
The auditor now faces the dilemma of whether to comply with the order by the regulator and risk a possible breach of China's state secrecy laws or face regulatory sanctions in Hong Kong.
The case is the first of its kind in Hong Kong and mirrors one in the United States where Ernst & Young's rival Deloitte Touche Tohmatsu is fighting a request from U.S. regulators to hand over its audit work papers of Chinese computer company Longtop Financial Technologies.
Accounting scandals at mainland companies listed in America such as Longtop and Sino-Forest Corp have dented investor confidence in U.S.-listed Chinese stocks. The blow-ups have spurred regulators there to demand access to audit work papers kept in China and inspect mainland-based auditors.
"This risks throwing H-share and red chip companies into the same mess that all the U.S.-listed Chinese companies are in," Paul Gillis, professor of accounting at Peking University and author of the China Accounting Blog, said by phone on Tuesday.
Red chips and H-shares refer to companies operating in mainland China but listed in Hong Kong. Between them, they make up more than half of the city's stock market.
The U.S. Securities and Exchange Commission (SEC) last September asked a federal court to force Deloitte to produce records related to possible accounting fraud at Longtop, but Deloitte has resisted, citing Chinese secrecy laws.
That case has currently been postponed as the SEC said it is trying to reach a solution with Chinese regulators.
The Securities and Futures Commission (SFC) in Hong Kong said late on Monday it wants the Ernst & Young unit in the city to hand over its records from its audit work for mainland-based water provider Standard Water Ltd.
The SFC said the audit firm has claimed it does not have the relevant records, as they are held in mainland China by its joint venture partner Ernst & Young Hua Ming, and could not be produced due to restrictions under China's state secrecy laws.
"The secrecy rules are a fairly grey area -- the mainland authorities have made announcements reminding firms of their obligations under them in recent years, but have not gone on to define fully what they are," said Chris Joy, executive director at the Hong Kong Institute of CPAs.
The SFC said auditors should always be able to provide documents, especially since Standard Water applied to list in Hong Kong a few years ago.
"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 co-operation," the SFC said in a statement.
The regulator added that it already has consulted its mainland counterparts about the records and is working with them on this issue.
Ernst & Young said it was working to try and resolve the situation as soon as possible.
"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," the firm said in a statement on Tuesday.
"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," it said.
It also said that while it performed IPO audit work for Standard Water in 2009, it resigned in 2010 and did not issue an accountant's report on the company.
Ernst & Young resigned as auditor upon discovery of "inconsistencies in documentation" provided by the Chinese company, and Standard Water withdrew its Hong Kong listing application shortly after, according to the SFC.
Peking University's Gillis said the fact that the Hong Kong firm was acting as Standard Water's main auditor means it is in a difficult position to defy the SFC's request.
"If the Hong Kong firm is signing the reports, that are to be used in Hong Kong, then under auditing standards the majority of the work should have been done in Hong Kong and they should have evidence of that work," he said.
Under the action taken by the SFC, the Hong Kong court will inquire into why Ernst & Young has not complied with the regulator's request. It can order the auditor to hand the papers over if it is satisfied it does not have a reasonable excuse.
A date for the first hearing is yet to be set.
(Reporting by Anne Marie Roantree in HONG KONG and Rachel Armstrong in SINGAPORE; Editing by Ryan Woo)