China's Standard Water at centre of row

A case involving a portfolio company's records and PRC state secrets should make private equity more aware of potential pitfalls with China accounting practices.

Hong Kong’s Court of First Instance has today granted Ernst & Young a time extension to prepare its response on the Standard Water auditing case, according to an E&Y spokeswoman.

Standard Water, a water treatment company headquartered in Beijing, applied for a listing in Hong Kong in 2009 and Ernst & Young was brought in as auditor. However, E&Y resigned in early 2010, citing “inconsistencies” in the company’s documents, and Standard Water pulled its Hong Kong listing shortly after.

In December 2010, Themes Investment Partners, a China-focused private equity firm entered the picture and led a $110 million all-equity deal to acquire 70 percent of Standard Water.

However, the previous accounting problem did not go away. Even though Standard Water had pulled its listing application, Hong Kong's Securities and Futures Commission (SFC) was charged with investigating a possible violation of Hong Kong law, such as a fraudulent application. The SFC tried to obtain E&Y’s auditing records of Standard Water, but E&Y refused on the grounds that disclosure would be a violation of China’s state secrecy laws.

In August 2012, the SFC filed legal action against E&Y to obtain the records. 

According to an SFC statement, E&Y claimed that it did not have the relevant records which were held in the PRC by its joint venture partner in the mainland, Ernst & Young Hua Ming, whose staff were the ones involved in the engagement.

Paul Gillis, professor of international business at Peking University, who has studied the case, believes the Hong Kong E&Y office signed off on the audit, but the work was actually completed by E&Y’s mainland joint venture partner. Thus, the accounting records could not be taken out of the mainland.

“It’s actually commonplace in Hong Kong auditing — they sign off on work they didn’t do. And in this case the investors got burned,” Gillis said. If the audit had been done by the Hong Kong branch, Gillis believes the inconsistencies would've been uncovered early on and the private equity investors would not have invested in Standard Water in later rounds.

Both E&Y and Themes Investment Partners declined to comment on details of the case.

The SFC's August 2012 legal action against E&Y has exposed several weaknesses in Chinese company auditing that private equity firms should be aware of, industry sources say. 

“Private equity firms need to understand the role of the auditor, and know who is actually auditing their companies,” said Gillis. “That is ultimately critical for exits.”

The Standard Water case only highlights how cautious private equity firms need to be when investing in Chinese companies, according to an accounting industry source. “They may be sitting on the board, but they may not be able to obtain the company records.”

Gillis believes that it will be very hard to get E&Y to hand over the company’s documents, because the ramifications for the firm in China would be severe.

“The downside in China is much greater than anything the Hong Kong regulators can do to them. This needs a diplomatic solution.”

For private equity firms, however, this may represent “another frustrating obstacle to exiting in China”, he added.