Dirty secrets

Hong Kong raises stakes in US-China audit battle

Hong Kong has raised the stakes in a global accounting spat. Its regulator is suing Ernst & Young for failing to hand over documents relating to a suspect client. The audit firm says Chinese secrecy rules prevent it from complying. The case mirrors a broader US complaint about Chinese accounting frauds. But Hong Kong has more at stake.

The trial, which started on March 27th, centres on E&Y's work for a Chinese company called Standard Water. E&Y resigned as auditor in 2009, forcing the company to abandon its plans for a Hong Kong listing. The local Securities and Futures Commission launched an investigation and repeatedly asked E&Y for its records. The accounting firm refused, arguing that its Chinese affiliate - which did most of the work - is bound by rules preventing mainland auditors from handing over documents to other regulators. The SFC also appealed to Chinese authorities, apparently without success.

Chinese regulators may feel that helping the SFC would weaken their hand in a broader battle with the United States. The US Securities and Exchange Commission has targeted the Chinese affiliates of five big accounting firms for failing to hand over information on their clients. If the dispute isn't resolved, the SEC could refuse to recognise Chinese auditors - effectively forcing all Chinese companies with U.S. listings to abandon the country's exchanges. So far, China has refused to bend.

This puts Hong Kong in a bind. It can hardly take a similarly hard-line approach and force Chinese companies to delist: they make up more than half of the value of Hong Kong-listed stocks. But backing down would undermine both the SFC's reputation and Hong Kong's standing with international investors.

China, too, has little to gain from cutting off access to Hong Kong: with domestic stock markets effectively closed to new entrants, the former colony is one of the few outlets for mainland companies seeking to raise capital. That suggests that China and Hong Kong will eventually work out some kind of compromise. But as long as the U.S. standoff remains unresolved Hong Kong - and Ernst & Young - could be in an uncomfortable spot.