* HK financial hub dealt reputational blow by penny stock rout
* HK-China relationship in spotlight amid handover celebrations
* 60pct of HK companies from mainland, beyond legal reach
* Regulatory sources say co-operation between SFC, CSRC improving
HONG KONG, June 30 (Reuters) - Hong Kong's ever-closer relationship with mainland China may be good for business, but it poses growing corporate governance challenges for the former British colony, which this weekend marks 20 years since its return to Chinese rule.
The financial hub was shaken on Tuesday, after a rout mainly in small-cap Hong Kong stocks wiped HK$24 billion ($3.08 billion) off the market. The precise cause of the sudden sell-off remains unclear. The Securities and Futures Commission (SFC) said the stocks were all characterised by small public floats, concentrated shareholdings, thin turnover and cross-shareholdings that encourage volatility.
The sell-off has raised questions over Hong Kong's ability to enforce its rules, as the territory's relationship with China - whose companies dominate the Hong Kong market but remain beyond its legal reach - comes under the spotlight.
"The fundamental challenge you have, if you are sitting in Hong Kong, is managing accountability," said Keith Pogson, EY financial services lead based in Hong Kong.
"The company may have a chairman and board who are mainlanders and it's possible for them to run off to the mainland rather than stand here and be held accountable to global investors. For the Hong Kong exchange and the SFC, this remains a massive challenge."
Britain returned Hong Kong to Chinese rule on July 1, 1997, under a "one country, two systems" formula that allows Hong Kong to operate a separate, autonomous judicial system.
Since the handover, Chinese company listings have helped boost the Hong Kong stock exchange nine-fold, transforming the small territory of just 7.3 million people into a $3.7 trillion global market. Around 60 percent of companies listed in Hong Kong originate from the mainland.
Hong Kong scores relatively well for corporate governance compared with the rest of Asia, coming second out of 11 markets ranked by the Asian Corporate Governance Association (ACGA) on their rules, culture, enforcement, audit regime, and political environment.
But the dominance of Chinese firms means investors in the territory's stocks are exposed to much sloppier standards on the mainland, which the ACGA ranked ninth. China's overall scores have fallen since 2014 due to increased state interventions and it scores very low on general corporate governance culture.
Chinese companies listing in Hong Kong must comply with its rules and disclosure requirements, but the mainland's weak corporate governance culture still seeps across the border.
Of 15 main board companies whose shares were halted from trading by the SFC due to accounting irregularities or investigations since 2011, 13 are mainland Chinese, according to a Reuters analysis. They include two of the biggest scandals, China Huishan Dairy and Hanergy Thin Film. Other scandals involving companies that were de-listed, such as China Metal Recycling and Hontex International, were also mainland Chinese.
Punishing such companies with deterrent force can be tough, according to legal experts and regulatory sources. The company's main assets, audit working papers, and management typically reside on the mainland and can only be accessed with cooperation from the Chinese authorities.
In theory, Chinese courts should recognise rulings from Hong Kong courts on issues such as liquidations, but liquidators say it is difficult in practice to make them stick. Enforcing China Metal Recycling's liquidation order on the mainland has been a battle, according to one person with direct knowledge of the matter.
"Once a Chinese company is listed, the enforcement environment is working against the Hong Kong regulators. Other than throwing them off the exchange, or hoping the management will come to the table in Hong Kong, it can be very difficult," said Pogson, a member of the stock exchange's listing committee but who was speaking in a personal capacity.
Hong Kong and Chinese markets are only growing more integrated, with the launch of projects to connect their stock and bond markets. The Hong Kong exchange has wants to lure Chinese companies to a new board that would allow "pre-profit" companies or start-ups to list.
Regulatory sources said much closer cooperation between the SFC and the China Securities Regulatory Commission (CSRC) over the past two years had seen some successes. They include a landmark ruling this month forcing the former chairman and CEO of China's Greencool Technology to disgorge gains derived from overstating the company's profits.
In April, SFC CEO Ashley Alder said in a speech that the SFC and CSRC were "especially focused on the opportunities but also the risks associated with far greater cross-boundary market connectivity".
The regulatory sources said it was in the interests of the SFC and the CSRC to cooperate to protect Hong Kong.
"In the case of Hong Kong we do depend on cooperation by the mainland regulators and their court system," said David Webb, Hong Kong's leading investor activist who also called this week's small-cap rout.
"But that doesn't mean we shouldn't try, and it doesn't mean we can't win." (Reporting by Michelle Price; Editing by Bill Tarrant)