Hong Kong: Criminal Liability - Hong Kong’s Auditors In The Firing Line

On 12 July 2012, the Companies Bill was passed by the Legislative Council marking a significant milestone in the development of Hong Kong's company law. The new Companies Ordinance which is expected to come into force in 2014 could signal the start of an uncertain period for Hong Kong's auditors as for the first time they will face exposure to criminal sanctions for "recklessness" in their audit reports.

The introduction of clause 399 raises a number of practical concerns for auditors. Questions that arise from the legislation, which many auditors may wish for clarity upon, include whether an auditor can be criminally liable for:-

  1. the acts and omissions of junior audit team members?
  2. failing to obtain all necessary information and audit evidence as a result of say completing the audit under huge time pressure?
  3. not carrying out certain audit procedures at the request of the client?
  4. placing excessive reliance on representations made by the client's management during the course of the audit?

Background

In mid-2006, the Hong Kong Government decided to undertake a comprehensive rewrite of the Companies Ordinance in order to modernise Hong Kong's company law and incorporate relevant law reforms from overseas jurisdictions. The rewrite was viewed as necessary given developments in company law since the last substantive review and amendment of the Ordinance took place in 1984.

The rewrite was led by the Companies Bill Team established under the Financial Services and the Treasury Bureau ("FSTB"). A Joint Working Group was also set up between the Government and the Hong Kong Institute of Certified Public Accountants ("HKICPA") to review the specific accounting and auditing provisions contained in the Companies Bill.

On 26 January 2011, the Companies Bill was introduced into the Legislative Council with the stated objectives of reforming Hong Kong company law with a view to enhancing corporate governance, ensuring better regulation, facilitating business operation, and modernising the law.

One of the more controversial aspects of the Companies Bill was the inclusion of clause 399 which introduced criminal sanctions for auditors. This clause was modelled on section 507 of the United Kingdom Companies Act 2006 and provides as follows:-

Clause 399 – Offences relating to the contents of auditor's report

1. Every person specified in subsection (2) commits an offence if the person knowingly or recklessly causes a statement required to be contained in an auditor's report under section 398(2)(b) or (3) to be omitted from the report.

2. The persons are –

a. if the auditor who prepares the auditor's report is a natural person –

i. the auditor, and

ii. every employee and agent of the auditor who is eligible for appointment as auditor of the company;

b. if the auditor who prepares the auditor's report is a firm, every partner, employee and agent of the auditor who is eligible for appointment as auditor of the company; or

c. if the auditor who prepares the auditor's report is a body corporate, every officer, member, employee and agent of the auditor who is eligible for appointment as auditor of the company.

3. A person who commits an offence under subsection (1) is liable to a fine of $150,000.

Clause 399 creates a criminal offence punishable by a HK$150,000 fine where an auditor or person eligible for appointment as an auditor "knowingly or recklessly" causes the omission of a statement in the auditor's report where (1) they are of the opinion that the financial statements of the company are not in agreement with the auditing records in any material respect, or (2) they have failed to obtain all necessary and material information or explanations for the purpose of the audit. The FSTB has clarified that this is a summary offence separate and distinct from the disciplinary proceedings under the Professional Accountants Ordinance.

Response from the Profession

The proposed introduction of criminal sanctions under clause 399 elicited widespread concern from the HKICPA and Hong Kong's accounting profession. As such, the HKICPA pushed for clause 399 to be removed from the Companies Bill during the consultation phase.

The main concerns raised by the HKICPA, and supported by a number of the major accounting firms in Hong Kong, included the necessity of imposing criminal sanctions when the HKICPA already has the power to discipline its members, the exercise of professional judgement in making the required statements, and exactly who will be liable to prosecution. Many questioned the disproportionate effect of a criminal record on the career of the auditor concerned.

In addition, the HKICPA highlighted the fact that s507 of the UK Companies Act 2006, on which clause 399 is based, was introduced as part of an overall package to reform auditors' liability in the UK which also included permitting auditors to contractually agree limits on their civil liability. In contrast, clause 399 was introduced into the Companies Bill as part of the overall reform of Hong Kong's company law and not as part of a tailored auditors' liability reform package.

Notwithstanding the concerns of the HKICPA and the wider accounting profession, the FSTB determined that the criminal sanctions under clause 399 were necessary for the enforcement of an auditor's duty to make the statements required under clause 398(2)(a) and (3) of the Companies Bill. This was a view supported by the Securities and Futures Commission which stated "As criminal sanctions will only come into play in the most egregious cases, in our view criminal sanctions act as an appropriate deterrent and are needed to ensure that Hong Kong has an effective regulatory regime for auditors".

What does "knowingly or recklessly" mean?

During the consultation phase, the HKICPA took the view that dishonest or fraudulent conduct should be the minimum requirement for imposing criminal sanctions rather than a test based upon "knowing or reckless". In particular, the HKICPA was concerned that "knowingly" could be satisfied by imputed knowledge and the drawing of inferences and that the subjective nature of determining "recklessness" created a great deal of uncertainty as to the threshold for the offence.

In response to the concerns expressed by the HKICPA, the FSTB provided clarification as to what would constitute "knowingly or recklessly". In relation to "knowingly", the FSTB stated that the prosecutor would be required to actually prove that the requisite mental state of the individual in question was present and that it would not be possible for knowledge to be imputed through the drawing of inferences.

In relation to "recklessness", the FSTB stated that the threshold for conviction would be very high and that mere negligence would not be enough. In order to establish recklessness the prosecutor would need to show that the individual concerned "was aware that an action or failure to act carried risks, that he personally knew that the risks were not reasonable ones to make, and that despite knowing that, he went ahead".

The FSTB also stated that "recklessness" under clause 399 would be determined in accordance with the current test for "recklessness" under the Crimes Ordinance as set out in the Court of Final Appeal's decision in Sin Kam Wah v HKSAR [2005] HKEC 792 as follows:-

"Henceforth, juries should be directed in terms of the subjective interpretation of recklessness upheld in R v G. So juries should be instructed that, in order to convict for an offence under s.118(3)(a) of the Crimes Ordinance, it has to be shown that the defendant's state of mind was culpable in that he acted recklessly in respect of a circumstance if he was aware of a risk which did or would exist, or in respect of a result if he was aware of a risk that it would occur, and it was, in circumstances known to him, unreasonable to take the risk. Conversely, a defendant could not be regarded as culpable so as to be convicted of the offence if, due to his age or personal characteristics, he genuinely did not appreciate or foresee the risks involved in his actions."

As set out in the passage above, the Court of Final Appeal adopted the House of Lord's subjective test for recklessness in R v G [2004] 1 AC 1034. In doing so, the Court of Final Appeal departed from the objective test in the English decision of Reg v Caldwell [1982] AC 341 which had previously been applied in Hong Kong and which was based on the standard of an ordinary prudent individual's appreciation of risk.

The UK Experience

Given that clause 399 is modelled on the UK equivalent, some insight can be gained from looking at the impact s507 of the Companies Act 2006 had on the accountancy profession in the UK when it was introduced and in particular, the way in which the test for "recklessness" was treated.

As in Hong Kong, the UK accountancy profession raised a number of concerns over the possible implications of introducing s507. These concerns included potentially increased costs for companies, an increase in the number of qualified audit reports, and the possibility that auditors could find themselves criminally liable as a result of making an honest mistake. In relation to "recklessness", there was concern that the inherently subjective nature of the judgements made by auditors in support of their audit opinions could result in merely negligent conduct being labelled "reckless".

In response, the UK Government stressed that recklessness had a significantly higher threshold than ordinary negligence, and that an individual could not be reckless inadvertently. The Government also stressed that prosecution of auditors under s507 was to be reserved for only the most serious cases.

During the course of the Company Law Reform Bill debates, the Government provided instructive examples of what would constitute "recklessness" for the purposes of the offence:-

"an example of recklessness would be an auditor who suspects that if he looked more closely at a particular area of a company's books he would discover a problem and therefore decides not to go further into that area. It will be necessary to establish that the auditor has decided to turn a blind eye for the offence to be proven. If he had merely overlooked the signs of problems through incompetence or laziness, that could be negligence, but he would not be guilty of this new offence.

A further, more extreme example would be the auditor who simply has a drink with the company's finance director and agrees to sign a clean audit report without seeing the accounts. That is clearly reckless."

"...There may be occasions where an auditor is tempted to draft a misleading report. If, for instance, he has no choice but to qualify his report because there are real problems with a company's accounts, he may not want to alienate the company directors and he may try to write a report that, while not false (wholly untrue) or deceptive (telling less than the whole truth), gives the impression that the qualification is merely technical."

[Lord Sainsbury of Turville, House of Lords Report stage, 10 May 2006, Hansard columns 1032 and 1033]

In February 2010, the UK Secretary of State issued guidance for regulatory and prosecuting authorities in relation to offences in connection with auditors' reports. This guidance was intended to help prosecutors in applying the relevant prosecutorial code and to decide whether prosecution or disciplinary action was appropriate. The guidance contained the following key points:-

a. In relation to the evidential test for recklessness, it was stated that "prosecutors should give particular consideration to evidence relating to the state of mind of the person connected".

b. In terms of public interest, "the decision whether to prosecute a case should always take into account the range of remedies that are available to regulators under the professional disciplinary system and consider whether those remedies are sufficient to meet the public interest".

c. "where the evidence of the offence concerns recklessness and the evidential test is met by relying on inference only, it is highly unlikely for a prosecution to be appropriate where the public interest may be met by diversion to disciplinary action on the part of the regulators".

As far as we are aware, no auditor has been prosecuted in the UK under s507 of the Companies Act 2006 since its introduction.

Practical concerns for auditors

As stated above, auditors may encounter issues in everyday practice which cause concern over their potential to face criminal liability under the new Companies Ordinance. In most instances, the potential to be held criminally liable will depend on the individual auditor's state of mind and their appreciation of the circumstances. Such everyday issues might include:-

1. Whether an auditor can be criminally liable for the acts and/or omissions of junior audit team members?

The statements made by the FSTB during the consultation phase indicate that prosecution of the offence will focus on the mental state of the particular auditor and that knowledge cannot be imputed to the individual in question. On that basis, it would appear that an auditor may only be criminally liable for omitting a required statement from the audit report where they actually knew or had reason to suspect the existence of the junior audit team member's acts and/or omissions.

2. Whether an auditor can be criminally liable for failing to obtain all necessary information and audit evidence as a result of completing the audit under time pressure?

In this situation, an auditor's potential criminal liability for failing to include a required statement in the audit report will depend on their state of mind. If the auditor was simply too busy trying to complete the audit on time and overlooked the need to obtain certain material information or evidence then it is more likely they will be found to have been "negligent", rather than (criminally) reckless.

3. Whether an auditor can be criminally liable for not carrying out certain audit procedures at the request of the client?

The potential for criminal liability will very much depend on what information or audit evidence is missing as a result of the auditor not performing the specific audit procedure. If the information or evidence is necessary and material for the purposes of the audit and the auditor is aware of this, the required statement will need to be included in the audit report otherwise the auditor will risk facing potential criminal liability for wilfully turning a blind eye.

4. Whether an auditor can be criminally liable for placing unquestioned reliance on representations made by a client's management during the course of the audit?

An auditor's potential criminal liability in this situation will also depend on their mental state. If the auditor has reason to suspect that the representations made by management are fraudulent, misleading or incomplete and they choose to rely on those representations without querying management or performing further investigations, then they may face criminal liability if a required statement is not included in the audit report.

Conclusion

When the new Companies Ordinance comes into force in 2014, there will inevitably be a period of uncertainty for Hong Kong's auditors in connection with the prosecution of offences under clause 399. At the outset, most attention will be focused on how prosecutors assess whether an auditor has "knowingly or recklessly" caused a required statement to be omitted from the audit report in determining whether to proceed with a prosecution.

Some reassurance can be taken from the guidance given by the FSTB that the threshold for prosecution will be very high and that clause 399 is not intended to criminalise negligence. Based on the statements made by the FSTB during the consultation phase and the test for recklessness in the Sin Kam Wah decision, it appears that the intended minimum grounds for prosecution are that the auditor must have caused a required statement to be omitted from the audit report and:-

a. personally have actual knowledge that (1) the financial statements of the company are not in agreement with the auditing records in any material respect, and/or (2) they have failed to obtain all necessary and material information or explanations for the purpose of the audit; or

b. fully appreciate that there is a real risk in the circumstances that (1) the financial statements of the company are not in agreement with the auditing records in any material respect, and/or (2) they have failed to obtain all necessary and material information or explanations for the purpose of the audit. Knowing this, the auditor must have actually made a decision not to take any further steps to investigate the risk.

While it seems reasonable to expect clause 399 to be interpreted in this manner, only time will tell whether prosecutions are reserved for the most egregious cases in which the auditor in question clearly has actual knowledge or has wilfully turned a blind eye. The subjective nature of the threshold for prosecuting the offence and the lack of any prosecutions in the UK make it difficult to know how clause 399 might operate in practice. The real concern here is where the line between negligence and recklessness will be drawn.

To a certain extent, the interpretation of clause 399 will remain in the hands of Hong Kong's judiciary to be governed by the prevailing test for "recklessness". This is a source of further uncertainty as it is unclear how the current test for "recklessness" would be applied in the context of an auditor failing to make a required statement in an audit report. In addition, the test could be subject to change given that it is less than 10 years since the Court of Final Appeal abandoned the objective test for "recklessness" in favour of the subjective test.

While there is much concern in Hong Kong's accounting profession at present over the introduction of criminal sanctions for auditors, this may ultimately prove unwarranted. If the UK experience is anything to go by, clause 399 may sit quietly in the statute books. The fear will be that a high-profile company collapse triggers the need for a prosecution of the relevant auditor, and no-one will want to be the "test case".

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Michael Maguiness
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