SAT order – quashing the SEBI order debarring PW from auditing listed companies:
Auditor’s duty is verification and not detection
“Justice will not be served until those who are unaffected are as outraged as those who are.” ― Benjamin Franklin
Time has probably passed long time back, when the CA fraternity needed to show their outrage and back Price Waterhouse (PW) in their time of distress – but like we all have got habituated to say (to hide their short comings) – “Better late than never”.
On 7 January 2009, the chairman of Satyam, Byrraju Ramalinga Raju, resigned, confessing that he had manipulated the accounts of Rs 14,162 crore in several forms.
The promoters allegedly inflated revenue, fabricated invoices, falsified accounts and income tax returns, and forged fixed deposit receipts to paint a rosy picture of the company’s financials.
PW served as independent auditors of Satyam Computer Services Limited (SCSL) (during the period 2000-2008), when the report of scandal in the account books of Satyam Computer Services broke. The global corporate community was said to be shocked and scandalised, and all hell broke loose on the audit firm.
On the basis of the above confession, SEBI carried out an investigation into the affairs of SCSL. The investigations found that certain directors and employees of SCSL had connived and collaborated in the overstatement, fabrication, falsification and misrepresentation in the books of account and financial statements of SCSL. The published books of accounts of SCSL contained false and inflated current account bank balances, fixed deposit balances, fictitious interest income revenue from sales and debtors’ figures. The investigation also noted that the statutory auditors of SCSL had connived with the directors and employees of SCSL in falsifying the financial statements of SCSL.
In January 2018 The Securities and Exchange Board of India (Sebi) late on Wednesday banned Price Waterhouse (PW) network from auditing listed companies for two years, after finding it guilty in the nearly decade-old Rs 7,136 crore fraud case in Satyam Computer Services Ltd.
The market regulator held the firm was complicit with the main perpetrators of the accounting fraud and did not comply with auditing standards. PW filed an appeal against the SEBI order with Securities Appellate Tribunal (SAT) questioning the legality and veracity of the impugned order.
On 9th September, 2019 – the Securities Appellate Tribunal (SAT) decided to quash the order of Securities and Exchange Board of India (SEBI) which had debarred the PW firms as well as the two auditors – S. Gopalakrishanan and Srinivas Talluri from auditing listed Companies. The SEBI directions to listed Companies not to engage any audit firm forming part of PW network has also been quashed.
Important aspects of the SAT order:
√ SEBI jurisdiction over Chartered Accountant (CA) was upheld by Bombay High Court:
The impugned order from SAT explained that the above Bombay High Court directions came with a caveat, namely, that unless and until the evidence on record established the “jurisdictional fact”, SEBI could not exercise any jurisdiction under the SEBI Act against a CA. “A “jurisdictional fact” is a fact which must exist before a Court, Tribunal or an Authority assumes jurisdiction over a particular matter. The jurisdiction of SEBI would depend upon the evidence which is available during such enquiry and if any material was found against a CA to the effect that he was instrumental in preparing false and fabricated accounts, then SEBI had the power to take any remedial measures or preventive measures in such a case. This evidence was never proved against PW (as explained in ensuing paragraph).
√ SEBI allegation against PW is baseless and not backed by evidence:
There is overwhelming evidence to show that the fabrication and falsification of books of accounts was done only by the top management of SCSL and that the engagement partners as well as the audit firm had no clue nor had any hand in this fraud.
There is no shred of evidence of any connivance or collusion nor there is any finding of actual collusion or connivance by the engagement partners and / or by the audit firm with the management of SCSL
√ Explanation of the duty and responsibility of an auditor – Auditors are watchdog and not bloodhound:
The auditor recognizes that because of the test nature and other inherent limitations of an audit, together with the inherent limitations of any system of internal control, there is an unavoidable risk that some material misstatement may remain undiscovered. Under AAS 4, the primary responsibility for the prevention and detection of fraud and error rests with both those charged with the governance and the management of an entity.
√ SCSL enjoyed good reputations and won various accolades:
SCSL was regarded as one of the top IT outsourcing firms in the world. The Company had won numerous awards and accolades. including in the areas of its internal audit and corporate governance.
SCSL was admired as one of India’s multinational companies. SCSL was also listed in the New York Stock Exchange in 2001 after necessary due diligence carried out by renowned merchant bankers including Merrill Lynch. SCSL was very much in the limelight on account of media and Analysts and there were no signs of adverse comments or suspicious remark on its performances or the management came to light. Moreover, PCAOB conducted an oversight inspection on SCSL as a US listed Company in 2006-07 and the inspection team did not find any negative in the performance of SCSL as a whole.
Under the above circumstance of the SCSL enjoying such good reputation for corporate governance, there was nothing wrong in accepting the bank statements and fixed deposits provided by SCSL. The same were on the letterhead of the Bank and there was no reason to suspect that the bank statement or the fixed deposits were not genuine.
√ Auditor’s duty is verification and not detection:
The auditor is required to employ reasonable skill and care but the auditor is not required to begin with suspicion or to proceed in the manner of trying to detect a fraud or a lie, unless some information has reached which creates suspicion. What is reasonable care and skill must depend upon the circumstance of each case. The duty of an auditor is verification and not detection.
The auditor must not be made liable for not tracking the carefully laid schemes of fraud when there was nothing to arouse their suspicion especially when the fraud is perpetuated by the top management of the Company and remain undetected for years.
√ Hindsight: It’s easy to know the right thing to do after something has happened, but it’s hard to predict the future.
One must keep in mind the facts available at the time of the alleged negligence by the auditors and one should not be cowed down by the facts that emerged after a scrutiny was carried out by the special audit.
√ Violation of the fundamental right to carry on business:
A remedial action is to correct a wrong, or a defect. Preventive measure can be issued in a given case of unfair trade practice or where fraud is proved. However, in the instant case, the direction to debar the auditor from auditing the books of a listed Company is neither remedial nor preventive. In fact, the direction is clearly punitive and violative of Article 19(1)(g) of the Constitution of India as it takes away the fundamental right to carry on its business
√ “It is better that ten guilty escape than one innocent suffer” – William Blackstone
It was contended that as on the date of the impugned order there were 98 partners in the ten firms out of which 70 are new partners who were not partners of the firms during the period 2000 to 2009 and thus banning them from doing audit work of listed Company merely because those are presently partners in PW firms is wholly arbitrary and illegal. “A person who is introduced as a partner into a firm does not thereby become liable for any act of the firm done before he became a partner.”
There is no evidence to indicate that the ten firms had any role to play in the audit of SCSL. These ten firms had nothing to do with the audit of SCSL. They had no knowledge of the day to day affairs of SCSL either directly or indirectly. There is not even a whisper of a finding in the impugned order against the ten firms about any connivance or collusion or intention or knowledge on their part in the audit of SCSL. The entire basis of debarring the ten firms is the resource sharing agreement, the brand PW and the networking of PW as a brand. In our opinion, the approach adopted by the WTM is patently erroneous and is flawed
√ SEBI in India is a completely different body compared to SEC and PCAOB in US:
The settlement orders have no precedential value in SEBI proceedings. If SEC and PCOAB are to be relied upon by SEBI, then they should have also issued similar measures and further allowing PW firms to continue with the existing audit arrangement instead of debarring them from auditing listed Companies. The appellants have denied the findings and observations in these orders and in our opinion are entitled to deny these findings in any other legal or regulatory proceedings. Whereas, SEC & PCAOB had jurisdiction over auditors of US listed Companies, the same is not the case with SEBI.
√ Subsequent strengthening of PW internal quality practises and its acceptance by SEC/PCAOB, should be considered by SEBI:
The show cause notice was issued on February 14, 2009 and August 26, 2009. The impugned order was passed on January 10, 2018. It took SEBI nine long years to complete the proceedings and the fault lay entirely on SEBI. During the pendency of the proceedings, the appellants were carrying on their business and auditing listed companies to the satisfaction of the shareholders and / or of the investors without any blemish. Over the last decade, the appellants have adopted extensive remedial measures as per SEC / PCAOB settlement orders. The independent monitors appointed by SEC / PCAOB have certified that remedial measures have been successfully implemented, meaning thereby that the audit quality met with the requisite standards.
√ Monetary penalty held justified:
We find that for this professional lapse, there has been a breach of duty and failure to maintain that standard of care. For this lapse / negligence, we are of the opinion that the appellants were not justified to retain this amount. In our opinion, the WTM was justified in disgorging the said amount along with interest.
Subsequent changes in the regulatory standards and the perception/behaviour impacting audit profession after Satyam fiasco:
The Satyam Scam in 2009, sent shock waves through India Inc and in its wake altered the corporate governance landscape in India permanently. The scam highlighted various loopholes in the Indian corporate governance structure – unethical conduct, fraudulent accounting, insider trading, oversight by auditors, and ineffectiveness of Board, failure of independent directors and non-disclosure of material facts to the stakeholders.
Several regulatory changes were introduced post the Satyam fiasco –
√ In 2015, SEBI framed the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”), applicable to all listed companies, and provided for stringent guidelines relating to reporting / disclosure of material events and actual and suspected fraud.
√ The Companies Act 1956 came to be repealed with the new Companies Act 2013 (Act). The new Act has made a clear departure from the old Act and has brought in several measures intended to benefit the larger stakeholder community. It clearly outlines the responsibility and accountability of auditors and independent directors, who are expected to play a more active role. The checks and balances introduced to ensure proper governance and management in the company require the hitherto passive actors to play a vital role, in the interest of the shareholders, creditors, vendors, customers and other stakeholders in the company. It provides for compulsory rotation of individual auditors after five years and audit firms after ten years to rule out malpractices and financial oversight and ensure independence of auditors. The auditors are also obligated now to report instances of fraud noticed by them during the performance of their duties.
√ The Institute of Chartered Accountants of India (ICAI) came out with a Guidance Note on Reporting on Fraud (ICAI Guidance Note, 2016). The Act also puts forth a stringent framework for related party transactions.
The SAT order has been very exhaustive in its explanation of the auditor’s role and its limitations thereof. Whilst its very clear that auditors are appointed for the protection of the shareholders and for ensuring that the financial statements “truly and fairly” reflect the financial performance and the financial position of the company – the inherent limitations of an audit are also to be kept in mind by all the stakeholders.
In the recent few years a flurry of high profile corporate fraud cases has stung the Indian economy, and the first one to take the blame has been the statutory auditors of the respective companies. This shareholders, MCA, SEBI and other regulators have come hard at the statutory auditors and have made them the easy scapegoats. This SAT order has been very lucid in explaining the expectation and the role of an auditor.
It is ripe time for ICAI to take initiative and show leadership in conveying and educating the investors, regulators and other stakeholders about the need to constructively assess the performance/review conducted by the auditor and then come to conclusion whether the auditors have failed to take reasonable procedures to identify the fraud. The auditor’s reputation and respect have been badly impacted in the last decade and I sincerely hope that this SAT order will set the ground clear for the upcoming future.