Auditor acting in fraudulent manner, directly or indirectly is a very serious misconduct: SC

Supreme court in the matter of Union of India and Another vs Deloitte Haskins and Sells LLP has quashed and sat-aside order passed by the High Court quashing and setting aside the NCLT order holding that even after the resignation of the auditors, the proceedings under section 140(5) shall be maintainable.

The Apex Court held that the application/proceedings under section 140(5) of the Act, 2013 is held to be maintainable even after the resignation of the concerned auditors.

Relevant Text:

Analysis and Interpretation of Section 140(5)of the Companies Act, 2013:

5. Section 140(5) of the Act, 2013 titled as “Removal, Resignation of Auditor and Giving of Special Notice” appears in Chapter X of the Act which is titled as “Audit and Auditors”. Therefore, Chapter X is a special provision under the new Act with respect of “Audit and Auditors”. It cannot be disputed that the auditor plays a very important role so far as the affairs of any company are concerned and therefore he should be independent and above board. Companies Act, 2013 is the result of the culmination of detailed study after taking into consideration the Parliamentary Standing Committee on Finance Report as well as the recommendations of the Standing Committee by introducing Companies Bill, 2009 and Companies Bill, 2011. When the earlier Companies Bill, 2009 was introduced, it was a culmination of the growing corporate economy and past experiences of corporate fiascos too and one of the suggestions were to provide for stricter accountability for auditors. There was a long discussion on the role, responsibility, duties and regulation of auditors and the regulatory and enforcement provisions. Various suggestions were received to make the provisions pertaining to Audit and Auditors more stringent. It was suggested on Clause 123(10) of the 2009 Bill which provides for removal of an auditor by the NCLT on finding that there is a fraud and corresponds to Section 140(5) of the Act should be made more stringent and should contemplate that an auditor removed by the Tribunal should not be eligible to be appointed as an auditor of any company for a period of five years.

5.1 At this stage, it is required to be noted that Section 143 of the Act deals with the powers and duties of the auditors. Sub-section (12) of Section 143 specifically provides that in the event that the auditor has reason to believe that an offence of fraud is being or has been committed in the company, the auditor shall report the matter to the Central Government. The detailed procedure is provided under the Rules issued in this regard. Therefore, a statutory duty is cast upon the auditor to report the matter to the Central Government about the offence of fraud being committed in a company. To see that the auditor is not holding any post in the company and he acts independently, Section 144 of the Act provides that the auditor cannot provide certain services including the management services. The objective seems to be that the auditor should function as an independent person uninfluenced by any of its activities outside the scope of audit services. The auditor is prohibited from providing any management service to the company. Thus, the prohibition and restriction created under Section 144 of the Act is primarily to protect the interest of the company in question and other stakeholders such as lenders and investors and the public at large. Keeping inb mind the aforesaid provisions and the underlying public policy in the backdrop, Section 140(5) of the Act, 2013 is required to be interpreted and/or considered.

5.2 Section 140(1) of the Act provides for the procedure to remove an auditor by the company before the expiry of his term; section 140(2) and (3) of the Act deal with resignation of auditors and Section 140(4) of the Act deals with giving of special notice at an AGM for appointment of an auditor other than the retiring auditor and the process in that regard. However, Section 140(5) of the Act empowers the Tribunal (NCLT), either suo motu or on an application made to it by the Central Government or by any person concerned, to take action against the auditor who has acted in a fraudulent manner or is abetting or colluding in fraud with the management of a company. If on completion of an enquiry it is found by the Tribunal that an auditor of a company has, whether directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers, it may by order direct the company to change its auditors. Therefore, powers of the NCLT in first part of Section 140(5) is quasi-judicial in nature and the Tribunal would have the powers of a civil court to examine the role of auditors and adjudicate on their fraudulent conduct and abdication of their function. The first proviso to Section 140(5) confers power upon the Tribunal on the application made by the Central Government and if the Tribunal is satisfied that any change of the auditor is required, to remove such auditor and/or pass an order that such an auditor shall not function as an auditor (within 15 days of receipt of such application) and the Central Government may appoint another auditor in his place. Thus, the powers under the first proviso to Section 140(5) can be said to be interim or pro tem measure to prevent an existing auditor from continuing and substitute him with an auditor based on a prima facie satisfaction that a fraud has been perpetrated and when circumstances warrant the substitution. Such an order can be said to be an interim order akin to a temporary suspension during the pendency of the detailed enquiry as provided in Section 140(5) of the Act and before any final order is passed by the Tribunal.

5.3 Second proviso to section 140(5) of the Act further provides that an auditor, whether individual or firm, against whom final order has been passed by the Tribunal under section 140(5) shall not be eligible to be appointed as an auditor of any company for a period of five years from the date of passing of the order and the auditor shall also be liable of such action under section 447 of the Companies Act. Therefore, as such, second proviso to Section 140(5) can be said to be a substantive provision and it operates on the final order passed by the Tribunal under Section 140(5) (first part). At this stage, it is required to be noted that after taking into consideration the recommendations made by the previous Standing Committee in respect of Companies Bill, 2009 and the recommendations from various stakeholders, the Companies Bill, 2011 came to be introduced. The suggestion of the Standing Committee to clause 123(1) of the 2009 Bill (which provided for removal of an auditor by the NCLT on finding that there is a fraud) was to make the provision more stringent; and to provide for consequences for an auditor when such auditor is found to have been perpetrating a fraud and is removed by the NCLT for such fraud. The same has been done by way of second proviso to Section 140(5) of the Act, 2013. Therefore, the second proviso to Section 140(5) which, as observed hereinabove, is a substantive provision, is introduced after a detailed analysis and after taking into consideration the recommendations of the Standing Committee and with a view to make the provision more stringent and to provide for consequences for an auditor when such auditor is found to have been perpetrating a fraud and is removed by the NCLT for such fraud. It is required to be noted that on passing of the final order by the NCLT under first part of section 140(5) and if an auditor is found to have been indulged into fraudulent activities or abetting or colluding in a fraud with the management of the company, consequences provided under the second proviso to section 140(5) shall follow. Therefore, before second proviso of section 140(5) is attracted, there must be a detailed enquiry against an auditor of a company as per first part of section 140(5) and there must be a finding arrived at by the NCLT that the auditor of a company has, directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers.

6. By the impugned judgment and order, though the High Court has upheld the vires of Section 140(5) of the Act, 2013, however, the High Court has held that once the auditor resigns as an auditor or is no more an auditor on his resignation, thereafter Section 140(5) proceedings are no longer maintainable as the petition filed by the Union of India under section 140(5) has been satisfied by the subsequent resignation of the auditor. The view taken by the High Court is absolutely erroneous and is unsustainable. Subsequent resignation of an auditor after the application is filed under section 140(5) by itself shall not terminate the proceedings under section 140(5). Resignation and/or removal of an auditor cannot be said to be an end of the proceedings under section 140(5). There are further consequences also on culmination of the enquiry under section 140(5) proceedings and passing a final order by the Tribunal on the conduct of an auditor, whether such a auditor has, directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers, as provided under the second proviso to section 140(5) of the Act, 2013. Therefore, the enquiry/proceedings initiated under the first part of section 140(5) has to go to its logical end and subsequent resignation and/or discontinuance of an auditor shall not terminate the enquiry/proceedings under section 140(5). If the interpretation given by the High Court that once an auditor resigns, the proceedings under section 140(5) stand terminated and are no longer further required to be proceeded, in that case, an auditor to avoid the final order and the consequence of final order as provided under the second proviso to section 140(5) may resign and avoid any final order by the Tribunal. That cannot be the intention of the legislature.

6.1 As observed hereinabove, the second proviso to section 140(5) of the Act, 2013 is a substantive provision, though it is by way of a proviso, and the same shall operate and/or depend upon the final order to be passed by the Tribunal in the first part of section 140(5). If the interpretation given by the High Court that on subsequent resignation and/or discontinuance of an auditor, proceedings under section 140(5) stand terminated and/or the petition under section 140(5) by the Central Government is no longer maintainable is accepted, in that case, second proviso to section 140(5) would become nugatory and in no case there shall be any action under the second proviso to section 140(5). If such an interpretation, as interpreted by the High Court, is accepted, in that case, the object and purpose of incorporation of second proviso to section 140(5) shall be frustrated. The object and purpose of second proviso to section 140(5), as observed hereinabove, is to make the provision more stringent and to provide for consequences for an auditor when such an auditor is found to have been perpetrating a fraud and is removed by the NCLT for such fraud. At this stage, it is required to be noted that under the second proviso to section 140(5) on the final order being passed by the Tribunal that the auditor/firm has, directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers, he/it shall not be eligible to be appointed as an auditor of any company for a period of five years. The word “any” used in the second proviso to section 140(5) is significant. On the final order being passed by the Tribunal, such an auditor not only shall be removed or changed as an auditor of a company, but such an auditor/firm shall also be ineligible to be appointed as an auditor of any other company for a period of five years.

7. Therefore, on true interpretation and scheme of Section 140(5) of the Act, 2013, once the enquiry/proceedings is/are initiated under first part of section 140(5) of the Act, either suo motu by the Tribunal or on an application made to it by the Central Government or by any person concerned, it must come to its logical end and irrespective of the fact whether during such enquiry/proceedings the auditor has resigned or not, there must be a final order to be passed by the Tribunal on whether such an auditor has, in fact, directly or indirectly, acted in a fraudulent manner or not. Direction to the company to change its auditor as provided in the first part of section 140(5) is only a consequence to the finding recorded by the Tribunal that the auditor has, directly or indirectly, acted in a fraudulent manner. This is the first consequence of the final order under section 140(5) (first part). On passing the final order by the Tribunal that the auditor of a company has, directly or indirectly, acted in a fraudulent manner, the second consequence as mentioned in the second proviso to section 140(5) shall be attracted. Therefore, for any consequence as provided under the second proviso to section 140(5), there shall be a final order by the Tribunal on enquiry as per first part of section 140(5). Therefore, on true interpretation, even on resignation by an auditor of a company even during the enquiry/proceedings under section 140(5) or even prior to that, there shall not be any termination of the proceedings under section 140(5) as observed and held by the High Court. At the cost of repetition, it is observed that in a given case, an auditor, who in fact has, directly or indirectly, acted in a fraudulent manner, to avoid any further consequence under the second proviso to section 140(5), resigns to avoid any consequence under the second proviso to section 140(5), it cannot be permitted.

8. No so far as the submission on behalf of the respective auditors that even if section 140(5) would not have been there, in that case also, no auditor can get away with fraud, abetment of fraud or professional misconduct etc. and for that purpose the reliance placed upon sections 132, 141, 147, 245 and 447 of the Act is concerned, at the outset, it is required to be noted that all the aforesaid provisions and section 140(5) operate in different field. Section 140(5) has been enacted with a special object and purpose, as observed hereinabove. Second proviso to section 140(5) specifically provides that on final order being passed by the NCLT, such an auditor shall not be eligible to become an auditor in any other company for a period of five years. Therefore, merely because the auditor can be removed as an auditor of a company including the other provisions, section 140(5) which has been enacted with a special object and purpose cannot be said to be arbitrary and/or ultra vires.

9. Now so far as the reliance placed upon section 241(3) of the Act and the submission that even in a case where the auditor resigns, the auditor concerned can be proceeded against under section 241(3) of the Act and therefore the proceedings pursuant to section 241(3) of the Act would lead to the same result and the auditor would be held ‘not to be a fit and proper person’ to be appointed in any other office connected with the conduct and management of any company is concerned, at the outset, it is required to be noted that Section 241(3) of the Act speaks about the concerned company and not any other company. Section 241(3) of the Act has been introduced w.e.f. 14.08.2019 which authorises the Central Government to apply to the Tribunal to declare that the persons mentioned in section 241(3) of the Act are “not fit and proper persons” to hold the office of a director or any other office connected with the conduct and management of any company. Section 241(3) of the Act is required to be read along with Sections 243(1A) and 243(2). On a conjoint reading of the aforesaid provisions, it is clear that the reference specifically in Section 241(3) of the Act to “any other office connected with the conduct and management of any company” means those akin to manager, managing director or other director such as key managerial personnel and not an auditor. The words used in Section 241(3) of the Act are “conduct and management of the company”. As per the Scheme of the Act, 2013, more particularly Chapter X, the auditor acts as an independent examiner of accounts and cannot be said to be holding an office in the conduct and management of the company. Therefore, the submission that what could be achieved under section 140(5) of the Act, 2013 can be achieved by Section 241(3) even after the auditor has resigned has no substance.

10. At this stage, it is required to be noted that in section 140(5), it is specifically mentioned that “without prejudice to any action under the provisions of this Act or any other law for the time being in force”. Therefore, the intention of the legislature while enacting section 140(5) is very clear and the powers conferred upon the Tribunal under section 140(5) shall be without prejudice to any action under the provisions of the Companies Act, 2013 or any other law for the time being in force. Therefore, irrespective of any other provisions of the Act, 2013, the Tribunal is vested with the powers under Section 140(5) of the Act to pass a final order against the auditor on the allegation that such an auditor of the company has, directly or indirectly, acted in a fraudulent manner.

11. For the reasons stated above, the High Court has materially erred in holding that on resignation of auditors – BSR & Deloitte and on appoint of new auditors, application under section 140(5) shall not be maintainable. Consequently, the High Court has erred in setting aside the order(s) passed by the NCLT/NCLAT by which the NCLT/NCLAT held that despite the resignation of the auditors, enquiry/proceedings under Section 140(5) shall be maintainable and/or continued. As observed hereinabove, despite the subsequent resignation of the auditors and/or despite the resignation of an auditor even for the purpose of second proviso to section 140(5), the enquiry/proceedings/application under section 140(5) (first part) shall be maintainable and continued and on the final order being passed by the NCLT, as provided in section 140(5), consequence as provided under the second proviso to section 140(5) shall follow. As neither the NCLT nor the High Court have gone into the merits of the allegations against the respective auditors and the decision of the NCLT and the High Court is on the maintainability of the proceedings under section 140(5) after resignation of the auditors, we refrain from considering anything on merits of the allegations against the auditors as the allegations of fraud etc. are yet to be considered by the Tribunal on merits in an application under Section 140(5) made by the Central Government.

12. Now so far as challenge to the vires of Section 140(5) of the Act is concerned, at the outset, it is required to be noted that the High Court, as such, has upheld the constitutional validity/vires of section 140(5) against which the BSR has not filed any special leave petition. Even otherwise on merits also, when some of the writ petitioners have challenged the impugned judgment and order passed by the High Court on constitutional validity/vires of Section 140(5), we are of the opinion that section 140(5) cannot be said to be excessive and/or manifestly arbitrary, as contended. It was the case on behalf of the original writ petitioners on the constitutionality/vires of section 140(5) that section 140(5) is excessive and arbitrary as it provides unguided and untrammelled powers to NCLT for determination of a serious offence of fraud and consequence of mandatory disqualification with grave consequences akin to civil death. The aforesaid has no substance. As observed hereinabove, NCLT shall exercise the quasi-judicial powers under section 140(5) with all the powers akin to civil court. Ample opportunity shall be given by the NCLT before passing any final order.

13. Now so far as another submission that section 140(5) is violative of Article 14 of the Constitution of India and discriminates against the auditors unfairly in comparison to similarly placed alleged perpetrators, such as directors, management etc. It is required to be noted that the role of auditors cannot be equated with directors and/or management. Auditors play very important role in the affairs of the company and therefore they have to act in the larger public interest and all other stakeholders including investors etc. Chapter X of the Act specifically for the “Audit and Auditors” looking to the importance of the auditors. Therefore, section 140(5) cannot be said to be discriminatory and/or violative of Article 14 of the Constitution of India.

14. Now so far as the submission that the penalty in the form of automatic disqualification of auditors and of the entire firm including partners and that too for a period of five years to become the auditor of any other company is highly disproportionate is concerned, it is ultimately for the legislature/Parliament to provide the debarment. On the principle of joint and severe liability, the auditors and the entire firm including partners shall be liable and therefore can be subjected to section 140(5) and the consequences mentioned in section 140(5) of the Act, 2013. So far as the submission that the disqualification is akin to civil death and section 140(5) impinges upon BSR and its partners’ fundamental right to carry on its profession, as guaranteed under Article 19(1)(g) of the Constitution is concerned, nobody can be permitted to say that despite acting fraudulently, directly or indirectly, they had a right to continue and/or carrying on their profession. Acting in a fraudulent manner, directly or indirectly, by an auditor is a very serious misconduct and therefore the necessary consequence of indulging into such fraudulent act shall follow.

At this stage, it is required to be noted and as observed hereinabove, Section 140(5) of the Act has been enacted with the specific object and purpose as referred to hereinabove and the same has been enacted after due deliberations and taking into consideration the recommendations of the Standing Committee as well as the respective stakeholders. Therefore, taking into consideration the object and purpose for which section 140(5) of the Act is enacted, the same cannot be said to be arbitrary, excessive and violative of Article 14 of the Constitution of India and/or violative of fundamental rights guaranteed under Article 19(1)(g) of the Constitution of India, as alleged.

15. Now far as quashing and setting aside section 212(14) direction by the High Court by its impugned judgment and order is concerned, it appears that the High Court has set aside 212(14) direction mainly on two grounds, firstly, that the direction to prosecute was issued within 30 hours of report of the IFIN SFIO Report which demonstrates non-application of mind and secondly on the ground that IFIN SFIO Report was an incomplete report as investigation had not been completed and therefore 212(14) direction was incompetent.

15.1 From the reasoning of the High Court, it appears that the High Court has set aside the direction under section 212(14) terming the same as non-application of mind since it was improbable that report of about 750 pages and 32000 pages of annexures could have been considered in 30 hours. The High Court also observed that the relevant facts and documents to demonstrate application of mind have not been placed on record. With the above conclusion, the High Court has observed that even according to the investigating agency, SFIO Report was an interim report, even asked by the Central Government.

15.2 Now so far as the observations made by the High Court that issuance of the direction to prosecute within 30 hours of the receipt of IFIN SFIO Report demonstrates non-application of mind as it was improbable that report of about 750 pages and 32000 pages of annexures could have been considered in 30 hours is concerned, the observations made by the High Court cannot be accepted. Merely because the direction to prosecute was issued within 30 hours, by that itself, it cannot be presumed that there was a non-application of mind. A detailed note was prepared by the officer which was ultimately placed before the final authority who ultimately took a decision and issued a direction to prosecute. What was required to be considered was, whether there was any material to prosecute or not and whether the direction to prosecute was properly given or not. During the trial, the accused shall be given ample opportunity to put forward their case. Therefore, on the aforesaid ground, the High Court has materially erred in setting aside the direction to prosecute issued under section 212(14) of the Act.

Now so far as the observations made by the High Court that the relevant facts and documents to demonstrate application of mind have not been placed on record is concerned, it is required to be noted that a final order to prosecute was placed on record in which it has been specifically mentioned that having gone through the IFIN SFIO Report.

15.3 Now so far as another ground on which the direction/sanction to prosecute has been set aside by the High Court, namely, that it was an incomplete investigation report and therefore on such an incomplete investigation report, no direction/sanction to prosecute could have been issued is concerned, at the outset, it is required to be noted that the High Court has not properly appreciated that the SFIO IFIN Report was a report prepared by the SFIO on the completion of the investigation into the IFIN – one of the companies under investigation. It is required to be noted that by an order dated 30.09.2018, an investigation was directed to be conducted by the SFIO into IL&FS and its subsidiaries, which comprise of approximately 100-160 entities. So far as the IFIN is concerned, it was one of the subsidiaries in the IL&FS group and the financial services arm. It is the case on behalf of the Central Government that so far as the SFIO IFIN Report is concerned, it is a record in respect of IFIN, upon completion of investigation into IFIN. Merely because so far as the investigation with respect to other subsidiary companies of IL&FS group is concerned, the same might have been going on, cannot be a ground to observe that at this stage so far as the IFIN is concerned the report was incomplete report and for which the investigation was going on. The High Court has not properly appreciated the aforesaid and has wrongly treated the report as an interim report so far as the IFIN is concerned. At this stage, it is required to be noted that in the SFIO IFIN Report itself, it is observed that in light of complex structure of the IL&FS Group and the inter- linkages between entities etc, if any further instances or transactions are uncovered qua IFIN during the investigation of other group companies of IL&FS, then a further report will be filed. Therefore, the High Court has materially erred that the investigation in respect of IFIN is incomplete. It is required to be noted that as such the SFIO had submitted the report after a detailed and extensive investigation of IFIN. There are conclusive findings against each of the writ petitioners including Hari Sankaran pointing out multiple breaches, violations of statutory duties and fraudulent conduct. We are not elaborating the same in detail as the prosecution is yet to take place and the concerned persons are to be tried. The proceedings before the High Court were at the stage of direction under section 212(14) to allow the prosecution and the sanction to prosecute. Ample opportunity shall be available to the concerned accused against whom the prosecution was ordered for the offences punishable under section 447 of the Companies Act and other relevant provisions of the IPC. Therefore, the High Court has erred in setting aside the direction under section 212(14) to prosecute at this stage and on the aforesaid grounds.

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