[By Gunjan Hariramani & Pooja Arora]
The author is a student of Maharashtra National Law University, Mumbai and ILS Pune.
Introduction
In India, the role of an auditor affects the corporate governance of the company by promoting accountability, representing interests of the stakeholders, managing financial crises and assessing risks. However, an auditor must exercise reasonable care in the discharge of their duty. This ensures that a company or its directors do not defraud its shareholders and other stakeholders. A number of corporate scams including the Satyam scam, could have been prevented if there had been stricter guidelines and severe penalties on the auditors.
Recently in the case of Union of India v. Deloitte Haskins and Sells LLP. [“the Deloitte’s case”], the constitutionality of 140(5) of the Companies Act, 2013 [“the Act”] which provides for removal of the auditors when they commit fraudulent activities was upheld. The Supreme Court held that it was not violative of Article 14 and 19(1)(g) of the Constitution.
In this article, the authors have attempted to analyse the extent of auditor’s responsibility in light of the principles of corporate governance. Further, an analysis of the Deloitte’s case where the Supreme Court had ruled that an auditor’s resignation could not be the taken as a ground to escape from the liability stated under Section 140(5) of the Act, has been provided.
Brief Facts
In the present case, there were defaults faced by the IL&FS Financial Services Limited [“IFIN”], which amounted to over Rs. 91,000 crores in debt. These defaults occurred between June 2018 and September 2018.
To address the situation, the Department of Economic Affairs, Ministry of Finance issued an Office Memorandum on September 30, 2018 requesting the Ministry of Corporate Affairs to take action under the Act. The memorandum highlighted the magnitude of the debt of the IFIN, attributing it to the failures of corporate governance and the presence of window-dressed accounts. Further, it also emphasized that the defaults could have severe consequences on the financial markets and the Indian economy.
In response to the defaults, the Ministry of Corporate Affairs filed a Company Petition before the National Company Law Tribunal [“NCLT”] seeking the removal of the existing Board of Directors of IFIN and the appointment of a new board. The NCLT, in an interim order on October 1, 2018 superseded the existing board and appointed a new Board of Directors to take charge of IFIN.
Deloitte Haskins and Sells LLP [“Deloitte”] and BSR and Associates LLP [“BSR”] were appointed as the statutory auditors of IFIN. Consequently, IFIN issued a notice under Section 140(1) of the Act to BSR and Deloitte, seeking their removal as auditors. BSR denied the allegations, and a hearing was held on May 29, 2019. Subsequently, the Ministry filed a petition under Section 140(5) of the Act, on June 10, 2019, seeking the removal of BSR and Deloitte as auditors, as well as other related actions. BSR resigned as the auditor and both BSR and Deloitte challenged the maintainability of the petition filed under Section 140(5) before the NCLT. The NCLT upheld the maintainability of the petition. In the writ filed by BSR before the High Court, it upheld the validity of Section 140(5) and set aside the NCLT’s order also quashing the petition filed under Section 140(5) and the related directions from the Ministry of Corporate Affairs.
An appeal against the High Court’s decisions was filed before the Supreme Court.
Judgment of the Supreme Court
The Supreme Court interpreted Section 140(5) of the Act in light of other provisions of the Act i.e., Section 143(12) and Section 144. The Court highlighted that Section 140(5) explicitly states that its provisions are “without prejudice” to any actions under the Act or any other prevailing law. Thus, the legislative intent behind enacting Section 140(5) is clear, and the Tribunal has the authority to issue a final order against an auditor who has acted fraudulently, irrespective of other provisions in the Act. The Court emphasized that the powers of the NCLT under Section 140(5) are quasi-judicial in nature and must be exercised with due process and by providing opportunity to both the parties involved.
The Court, while examining the question of violation of Article 14 and Article 19(1)(g) of the Constitution, ruled that the auditors cannot be equated with directors or management. Auditors have a crucial role in protecting the public interest and stakeholders. Chapter X of the Act specifically addresses the importance of auditors; therefore, Section 140(5) cannot be deemed discriminatory or in violation of Article 14 of the Constitution. The court observed that it would not be correct that despite a fraudulent conduct by a person, they could claim the right to freedom of trade and profession under Article 19 of the Constitution.
The Court also dismissed the claim that the penalty of automatic disqualification, including partners, for a five-year period is disproportionate or akin to civil death. It observed that auditors and their firms bear joint and several liability, and Section 140(5) serves as a consequence for acting fraudulently. The Apex court, therefore, set aside the High Court’s judgment that quashed the proceedings under Section 140(5) on the grounds that it was not maintainable after the auditors’ resignation.
Scope of Section 140(5) of the Act vis a vis the principles of corporate governance
The recent trends have shown that Indian Courts are opting to choose a stringent model of corporate governance in the wake of corporate scams. Corporate governance necessitates the establishment of a structured framework focused at maintaining an effective control and governance over the business corporations, thereby ensuring the proper distribution of rights and duties of every participant in the corporation. Auditors are one of the participant groups in the corporation that are held responsible to show an unbiased analysis of the financial statements to the shareholders and prevent or report any fraud within the corporation.
Auditor’s scams and frauds in the past showed the failures within the structure of corporate governance. Satyam Scam was a glaring example of auditor’s fraudulent practices. Satyam Scam was the biggest accounting fraud of India and is often compared to America’s Enron Scam. After the scandal, the law makers laid emphasis on the inadequacies of the corporate governance standards and called for stringent duties of the auditors.
Therefore, the Supreme Court in the Deloitte’s ruling highlighted the significance of the auditor’s duty to detect and prevent the audit frauds within the corporations. The foremost duty of the auditor must be to assess internal controls within the corporation. While external audit is a compulsory legal requirement to meet the acceptable financial reporting standards, internal audit is an optional audit restricted to the governance of a corporation, management controls over the operations of the corporation and risk management. Internal controls require continuous monitoring of financial statements, cash books, ledgers and reports of the corporation as a part of internal audit. Hence, auditors are accountable for evaluating the effectiveness of internal control systems to identify areas vulnerable to fraud. Further, auditors must perform a comprehensive risk assessment to identify potential fraud risks and tailor audit procedures accordingly. In the present case, Deloitte and BSR failed to establish an effective internal controls mechanism and risk assessment strategy that led to default of Rs. 91,000 crores. If they had identified any existence of fraud or other irregularities in the audit process, the company would not have committed a default in repayment of debts.
Moreover, a misrepresentation of a factual matter, that should have been disclosed, with the intention of deceiving another individual, and causing them legal harm within the tenure cannot allow the auditors to resign from their posts without any legal consequences. In the current case, the company committed the default between June 2018 and September 2018, and both Deloitte and BSR had jointly conducted the company’s audit for the financial year 2017-2018 which highlighted that a misrepresentation of financial accounts happened when they were within their tenure.
The Court explained the consequences of fraud by throwing light on Section 140(5) of the Act. The Section provides that NCLT may either suo motu, or on an application by Central Government or any concerned person is satisfied that the auditor of the corporation is engaged in any fraudulent practice can direct the company to change its auditor. Additionally, the second proviso states that when the order has been passed against the previous auditor, they would not be eligible to become an auditor in any organization for five-years and would also face punishment under Section 447 of the Act. The Supreme Court clarified that the penal consequences of the fraud under section 140(5) of the Act cannot be avoided by mere resignation. Further, it clarified that the provisions of Section 140(5) of the Act are neither discriminatory nor arbitrary as the main aim of the section is to hold the people accountable for their negligent or fraudulent behavior.
The Section has been given a wide connotation. The golden rule of Interpretation of Statutes is the rule of purposive construction. The principle of “purposive construction” implies that the court should assign a meaning to the legal provision which serves the purpose behind such provision. This principle is followed to not limit the scope of the Act. In the present case also, the legislative intent of the section was taken into consideration, and therefore, the proceedings were not terminated by mere resignation of the auditors.
Auditors play a critical role in upholding the principles of transparency, accuracy, and accountability in financial reporting, which are paramount for maintaining public trust in financial systems. Although auditors may not perceive themselves as directly accountable for fraudulent activities, it is essential to recognize that the public and the legal system hold them responsible for safeguarding their interests, particularly in cases involving public money.
Conclusion
Once again, in a bid to prevent scams and fraud, the Supreme Court, guided by the accepted principles of corporate governance, adopted a stringent approach in the Deloitte’s case, addressing the potential loopholes that the auditors might have exploited to engage in the fraudulent activities. This ruling establishes the fact, that the auditors cannot evade the consequences for the fraudulent actions through a simple resignation. The strong stance by the court serves as a deterrent against the auditors’ wrongdoings.
In line with the principle of joint and severe liability, it is advisable to hold both the auditors and the entire auditing firm, including partners, accountable for any fraudulent activities conducted within their tenure. As a result, auditors should be subjected to Section 140(5) of the Act and the corresponding consequences outlined therein.