Compliances with the Companies Act and Rules thereunder have become more stringent in recent days. Thanks to the regulatory agencies for this change. As the complexities of provisions are rising, interpreting the provisions and applying them is becoming challenging day by day. Notably, it is cardinal to interpret and apply the law in its letter and spirit.
The appointment, removal and role of an auditor in companies under the Companies Act 2013 depends on a variety of factors such as the business type of company and the audit requirement. Generally, an auditor is appointed by the company’s board of directors or shareholders to audit the financial statements and other related documents of the company. This is done under Section 139 of the Companies Act 2013. The auditor’s appointment, removal and role may be affected by various factors, such as a change in management or ownership of the company.
Auditor plays important role in the management and administration of the Company. He acts as watchdog of the members who reports them in his Audit Report about the health and irregularities in the management of the Company’s affairs so the members can take thoughtful actions in such regards. Auditor ensures that the Financials give true and fair view of the Company’s affairs.
Today we are going to discuss on the topic of applicability of Section 139 in respect of rotation of Auditor. For easy understanding and in attempt to make it crisp and clear, the discussion is in question and answer mode by taking an example.
Facts as an Example:
A Private Limited Company (the “Company”) is having paid up share capital less than Rs. 50 Crores.
The Company has appointed Auditor Firm in the AGM held in the year of 2019 for the period of 5 Years in accordance with Section 139(1). Further, the Company is having multiple borrowings including public borrowings from financial institutions, banks etc.
Such borrowings exceeded in the Financial Year 2021-22 to Rs. 50 Crores but the Company has repaid some amount out of that and such total borrowings stands approx. to Rs. 49 Crores on the date of 31st March 2022.
The questions for consideration are as follows:
1. Whether the Company needs to appoint another Auditor in the place of current Auditor in the AGM to be held in the year of 2022 pursuant to Section 139(2)? To ascertain applicability of rotation, whether latest audited Financial Statements to be referred or any other financial statement?
2. Since the threshold had exceeded in the FY 2021-22, whether the Company is required to Comply with the provisions requiring rotation of Auditor under Section 139(2) when the term of current Auditor Firm ends; or in the future despite the Company has ceased to fall in the threshold limit?
3. Considering the above situation of borrowings, whether it is required to establish and keep in place Vigil Mechanism in line with Rule 7 of the Companies (Meetings of Board and Its Powers) Rules, 2014?
Let us discuss these questions one by one-
For the question No. 1:
At the outset, it is pertinent to mention that primary rule of interpretation i.e. ‘Literal Rule of Interpretation’ applies to the provisions of Section 139(2) because it is the first rule to be applied and only in case of ambiguity or absurdity other rules of interpretation to be applied.
The rule of interpretation states that when language of the law is clear and unambiguous which shows intensions of the legislators, there is no need to go beyond the words stated therein and their natural meaning to be taken and to be complied with. Further, no word to the provisions to be added or removed and each and every word has significance for the interpretation.
Title to the Section 139 is ‘Appointment of Auditors’.
While going to the background, before amendment to the Sub-Section (1) in 7th May 2018, appointment of Auditor made for 5 years was subject to ratification by members every year in the AGM. This provision appears to be quasi-appointment of Auditor in every AGM. Means, if the members do not ratify the appointment of auditor in any AGM, the Auditor ceases to be Statutory Auditor and casual vacancy arises. Hence, we can opine that the ratification was nothing but yearly re-appointment. Now, the provisions stand amended effectuating omission of requirement of yearly ratification w.e.f. 07th May 2018. Henceforth, in case of Auditor appointed post amendment, ratification of appointment of Auditor in every subsequent AGM will not be mandatory during his tenure; Provided, resolution and terms of appointment does not warrant ratification.
Further, for an instance, Section 196 which talks about appointment of Managing Director (“MD”), employs words ‘shall appoint or continue the employment’ with respect to stating conditions relating to appointment and continuation of MD. Accordingly, Company shall ensure that at the time of appointment the person fulfills the conditions of Section 196(3) and he continues to fulfill the conditions during his tenure as MD and shall vacate the office upon breach of any applicable condition.
Interestingly, Section 139(2) employs phrase ‘shall appoint or re-appoint’ and its first proviso also deals with ‘appointment’ of the Auditor. There is no mention about continuation of appointment of Auditor similar in case of MD. If the intension of legislators was to prescribe such conditions for continuation of Auditors, they could have provided the same expressly similar in line with Section 196.
With the application of Literal Rule of interpretation, it is evident that we cannot ignore the words ‘appoint’ and ‘reappoint’ and we can’t insert any word like ‘continuation’ or any other similar word/phrase by ourselves.
And hence in my opinion, Section 139(2) and Rule 5 of the Companies (Audit and Auditors) Rules 2014 which derives powers from Section 139(2) requires to be complied with at the time of appointment or reappointment of the Auditor and does not warrant replacement of current Auditor during his tenure in case of crossing threshold. Hence different Auditor in the place of current Auditor is not required to be appointed in the AGM to be held in the year of 2022.
As we discussed earlier, if the amendment to the Section 139(1) had not taken place, the question of appointment of different Auditor in the place of current Auditor (in AGM to be held in the year 2022) could have come into picture.
Further, there is absence of clarity in the Section or Rules thereunder in respect of whether latest Audited financial statements to be referred or not in order to ascertain rotation of Auditor. Taking the note of practice being followed by many Companies including listed Companies and unlisted Companies having Audit Committee preparing Financial Statements quarterly basis, it seems to be gray area under the law which is causing ambiguity.
In furtherance, it is notable that:
1. Rule 3 and Rule 4 of the Companies (Appointment and Qualification of Directors) Rules 2014 which provides threshold for appointment of Woman Director and Independent Director respectively and
2. Rule 9 of Companies (Appointment and Remuneration of Managerial Personnel) Rules 2014 which provides attaching Secretarial Audit Report to the Boards Report:
Provide for referring the ‘latest audited financial statements’ to ascertain triggering point for applicability of compliance.
On the other hand Section 135(1) and Rule 4 of the Companies (Cost Records and Audit) Rules, 2014employ phrase ‘Immediately preceding financial year’ which trigger Compliance omitting to use words similar to ‘latest audited financial statements’ . This omission seems to be intentional.
Apart from these, there are numerous rules where threshold limit is mentioned but no reference to financial statements including Rule 5 of the Companies (Audit and Auditors) Rules 2014 has been made.
Hence it is evident that there is ambiguity to interpret such Rules and hence Literal Rule of Interpretation will not apply due to such debatable piece of law.
Here, in my opinion, in such cases, purposive rule of interpretation to be applied to fetch the intensions of the legislators.
An idea of the purpose of any particular thing gives a direction and a set of general guidelines that must be taken into account in the application or operation of such a particular thing. On a similar note, it can be inferred that any legislation which has been enacted by the legislature must have been so enacted, keeping into consideration a particular objective or purpose for the fulfilment of which such legislative exercise took place.
Among the various rules of interpretation, the one which gives the highest priority to the object of the legislation and advances such interpretation of statute, which helps in the fulfilment of the object of such statute, is the rule of purposive interpretation of statute.
In the celebrated case of Workmen of Dimakuchi Tea Estate v. Management of Dimakuchi Tea Estate, the Hon’ble Supreme Court of India held that the words of a statute, whenever there is a doubt about their meaning, have to be understood in the sense in which they best harmonize with the subject of the enactment and the object which the legislature has in its view. It was stated that “the meaning of the statute is not found in a strict grammatical or etymological propriety of language, nor even in its popular use, as in the subject or in the occasion on which they are used, and the object to be attained.” It has been recognized by the Supreme Court of India on multiple occasions that whenever two interpretations are feasible the court will prefer such interpretation which advances the remedy and suppresses the mischief as it was envisioned by the legislature. It has been provided that the Court should adopt an object-oriented approach keeping in mind the principle that legislative futility is to be ruled out so long as interpretative possibility permits. Thus, it can be inferred that to the extent to which there is interpretive flexibility, the Court must seek to give such an interpretation to the statute which helps in the fulfilment of its ultimate objective and thereby prevents the same from becoming futile.
It is worth notable that, Company appoints Auditor pursuant to Section 139(1) to conduct Audit for 5 financial years and he gives yearly Audit Report to the shareholders. Further, Auditor conducts audit for at least one financial year if he is appointed as Auditor in case of casual vacancy pursuant to Section 139(8). This implies that nature of his appointment is on a yearly basis. Hence it will be prudent to refer Financial Statements prepared for latest closed financial year and not quarterly or any periodic report.
Considering the above discussions and in attempt to ascertain the intension of the legislators, in my opinion, at the time of appointment, it would be suitable to refer financial position of the Company as on 31st March of immediately preceding financial year irrespective of its getting audited.
Further, contrary to this, if someone argues that when it is required to check the threshold at the time of appointment of the Auditor and management of the Company considers prudent to refer financial position at the end of latest quarter or on the day of Board meeting held for recommending appointment of Auditor for the purpose of considering applicability of Section 139(2), then it wouldn’t be wrong and could be held valid in the eyes of law by the court due to gray area appearing in the law due to ambiguity.
For the question No. 2:
It is considerable that Rule 5(c) employs words ‘having public borrowings’ and as we discussed above, these threshold limits need to be considered at the time of appointment. Appointment of different Auditor will be required only if, at the time of appointment, the Company falls into the threshold. Hence, no need to comply with the provisions of Section 139(2) if, at the time of appointment of Auditor, the Company does not fall into the threshold irrespective of its falling into the threshold in past.
For the question No. 3:
Rule 7 of the Companies (Meetings of Board and its Powers) Rules, 2014 contemplates establishing of ‘Vigil Mechanism’ by the Companies falling in the criteria mentioned therein.
Since the Rule 7 does not make clear whether latest audited balance sheet to be considered or not for establishing the Vigil Mechanism in the Company and hence it has become challenging to determine the triggering point to establish Vigil Mechanism. In absence of such clarification, it would not be perfect to consider the financial statements only.
It is notable that, establishment of Vigil Mechanism is not the compliance of annual nature as compared to Auditor appointment and hence triggering point for compliance could be any day during the year and hence daily check is needed.
As per discussions, by application of purposive interpretation and in consideration of the words employed in Rule 7, it would be proper to say that:
Every Company, whether it is Public or Private which falls into the criteria of
1. Listed Company or
2. Company which accepts deposits from public or
3. Falls into threshold of 50 Crore borrowings.
Requires to comply with the provisions on the first day of its falling into the criteria irrespective of preparations of Financial Statements and since no time period mentioned therein to comply with the requirements, it shall establish Vigil Mechanism within reasonable period.
Further, ‘Reasonable Period’ has been determined by High Courts and Supreme Court in their various judgments which range from 15 days to 6 months depending upon the circumstances. So, establishment of Vigil Mechanism is expected as earlier as possible but within minimum 90 days from the day the threshold is breached. Similarly, Company is not required to comply with the provisions from the day it ceases to fall into the criteria irrespective of its falling into the criteria in past.
Author Bio
Very good article which clearly emphasis importance interpretation of statutes. Kindly give this kind of articles frequently sir! it will enhance our ability to read statute.
good one