Most recently, in the matter of Union of India v. Deloitte Haskins and Sells LLP and Another [Criminal Appeal Nos. 2305-2307/2022], the Hon’ble Supreme Court of India (“Supreme Court”) has affirmed the constitutionality of Section 140(5) of the Companies Act, 2013 (“Act”). This provision, among other things, renders auditors ineligible to serve as auditors for any company for a duration of five years.
The Bench, comprised of Justice MR Shah and Justice MM Sundresh, has determined that Section 140(5) of the Act, which pertains to the removal, resignation of auditors, and the issuance of special notices, is not discriminatory, arbitrary, or in violation of Articles 14 and 19(1)(g) of the Constitution of India (“Constitution”). Furthermore, the Court has clarified that the subsequent resignation of an auditor, subsequent to the filing of an application under Section 140(5), does not automatically terminate the proceedings initiated under Section 140(5) of the Act. This article analyses the case law and its implications on the Indian corporate governance system.
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Section 140(5) of the Act: What was at stake?
Section 140(5) of the Act empowers the National Company Law Tribunal (“NCLT”), either on its own initiative or in response to an application from the Central Government or an interested party, to take action against an auditor involved in fraudulent activities or collusion with a company’s management. Upon completion of an inquiry, if the NCLT determines that an auditor, directly or indirectly, engaged in fraudulent activities or abetted or colluded in fraudulent conduct related to the company, its directors, or officers, it may issue an order directing the company to replace its auditors.
It’s essential to note that the NCLT’s authority under the initial part of Section 140(5) is quasi-judicial in nature, granting it powers akin to those of a civil court to investigate the actions of auditors and rule on their involvement in fraudulent conduct or dereliction of duty. The authority conferred by the first proviso to Section 140(5) serves as an interim or provisional measure aimed at preventing an incumbent auditor from continuing in their role. This measure allows for the substitution of the auditor based on prima facie satisfaction that fraud has occurred and that circumstances necessitate such action. This order functions as an interim suspension while the comprehensive inquiry, as stipulated in Section 140(5) of the Act, is pending, preceding any final determination by the NCLT.
The second proviso to Section 140(5) of the Act extends further consequences. It states that an auditor, whether an individual or a firm, against whom a final order has been issued by the NCLT under Section 140(5) shall be ineligible for appointment as an auditor for any company for a five-year period from the date of the order. Additionally, such an auditor may also face legal action under Section 447 of the Act. The activation of the second proviso is contingent on a detailed inquiry against an auditor of a company, as per the provisions of the first part of Section 140(5), and a finding by the NCLT that the auditor, directly or indirectly, engaged in fraudulent activities or abetted or colluded in fraudulent conduct related to the company, its directors, or officers.
Factual Matrix of the Case
The Department of Economic Affairs within the Ministry of Finance issued an office memorandum (“Office Memorandum”) on September 30, 2018. This memorandum requested the Ministry of Corporate Affairs (“MCA”) to take action against Infrastructure Leasing & Financial Services (“IL&FS”) under the Act. The action was in response to a series of alleged defaults by IL&FS, which had accumulated a substantial debt burden exceeding INR 91,000 Crores.
The MCA subsequently instructed the Serious Fraud Investigating Officer (“SFIO”) to carry out investigations into the matter. The SFIO presented its interim report to the MCA on November 1, 2018 (“Interim Report”).
Upon reviewing the Interim Report, NCLT received a petition from the MCA under Section 130 of the Act. This petition requested the reopening and recasting of IL&FS’s accounts. Notice of this petition was provided to the auditors, BSR & Associates LLP (“BSR”) and Deloitte Haskins and Sells LLP (“Deloitte”), collectively referred to as the “Respondents.”
Meanwhile, the Reserve Bank of India (“RBI”) conducted an inspection of the IL&FS group and submitted its inspection report on March 22, 2019, to the new board of directors of IL&FS. Subsequently, the SFIO completed its investigation and submitted its final report to the MCA. Based on this final report, the MCA filed a petition on June 10, 2019, under Section 140(5) of the Act before the NCLT. This petition sought the removal of BSR and Deloitte from audit activities for a period of five years, among other actions (“Petition”). The NCLT confirmed the admissibility of the petition.
Following this, BSR filed a writ petition before the High Court of Bombay (“High Court”). In this petition, BSR challenged the constitutionality of Section 140(5) of the Act and the admissibility of the petition. While the High Court upheld the constitutionality of Section 140(5) of the Act, it set aside the NCLT’s order regarding the maintainability of the petition. The primary basis for this decision was that once an auditor resigns or is no longer an auditor due to resignation, proceedings against such auditors should be considered terminated.
Dissatisfied with the High Court’s decision, the Union of India (“Appellant”) has filed the current appeal before the Supreme Court.
Issues in Point
- The constitutional validity of Section 140(5) of the Act.
- The admissibility of a Section 140(5) petition against a former auditor of a company.
The Battle of Arguments
Contentions of the Appellant
The Appellant contended that Section 140(5) of the Act aligns with the recommendations of the J.J. Irani Committee and the Parliamentary Standing Committees’ Reports. Its fundamental objective is to foster auditor independence while upholding their accountability. To support this argument, the Appellant referenced the Supreme Court’s judgment in Devas Multimedia Private Limited v. Antrix Corporation Limited and Another [(2023) 1 SCC 216]. According to this precedent, the public policy underlying Section 140(5) is to bar auditors found engaged in fraud or collusion from conducting statutory audits for a five-year duration.
Additionally, it was asserted that the second proviso to Section 140(5) of the Act constitutes a substantive provision that automatically comes into effect when the NCLT issues a final order affirming auditor company fraud or collusion. Conversely, if the NCLT’s final order does not establish any wrongdoing or collusion by the auditor company, reinstatement of the auditor is feasible. The Appellant emphasized that should Section 140(5) cease to apply in cases of auditor resignation, the entire framework of Section 140(5) and Chapter X (Audit and Auditors) of the Act would lose its purpose, which contradicts the legislative intent.
Contentions of the Respondents
The Respondents argued that the primary purpose of Section 140(5) of the Act was to compel non-compliant auditors to resign. Consequently, once an auditor had voluntarily resigned, the petition could no longer be maintained against that auditor.
Furthermore, it was contended that the second proviso to Section 140(5) of the Act was deemed arbitrary, unduly severe, and onerous. Therefore, it was suggested that this provision should be interpreted in a manner that aligns with the principles of fairness and in accordance with Articles 14 and 19 of the Constitution. In this context, it was further argued that the disqualification from acting as an auditor for any company, as stipulated in the second proviso to Section 140(5) of the Act, should apply solely to the relevant audit partners implicated in fraudulent activities. This disqualification should not extend to the entire audit firm or other audit partners not connected to such fraudulent conduct.
Supreme Court’s Findings and Observations
Erroneous and Unsustainable: Challenging the High Court’s Stance
The Bombay High Court had upheld the validity of Section 140(5) of the Act. However, it has taken the position that once an auditor resigns or ceases to be an auditor, the Section 140(5) proceedings are no longer sustainable. This was on the premise that the Union of India’s petition under Section 140(5) was deemed satisfied by the subsequent auditor’s resignation. The Supreme Court, in contrast, firmly rejected this view, deeming it entirely flawed and unsustainable.
The Supreme Court arrived at this conclusion by noting that if the High Court’s interpretation were accepted, auditors could evade the final order and the associated consequences outlined in the second proviso to Section 140(5) simply by resigning to avoid the NCLT’s judgment. Such an outcome, the Supreme Court reasoned, could not align with the legislative intent.
The Supreme Court further clarified that the resignation or removal of an auditor should not be regarded as the conclusion of Section 140(5) proceedings. Instead, the Court emphasized that these proceedings must progress to their natural conclusion. The Court underscored that additional consequences arise upon the culmination of the inquiry under Section 140(5) and the issuance of a final order by the NCLT. These consequences are stipulated in the second proviso to Section 140(5) of the Act. Consequently, the initial inquiry and proceedings under the first part of Section 140(5) must persist, and subsequent auditor resignation or discontinuation should not prematurely terminate the Section 140(5) inquiry and proceedings.
Not Excessive or Arbitrary: The NCLT’s Power in Perspective
The Court also took note of the explicit provision within Section 140(5), which states, “without prejudice to any action under the provisions of this Act or any other law for the time being in force.” This unequivocally demonstrates the legislature’s clear intent when enacting Section 140(5). The powers bestowed upon the NCLT under Section 140(5) are intended to operate independently and without prejudice to any actions that may be initiated under the Act or any other concurrent laws in effect.
Therefore, regardless of other provisions within the Act, the NCLT possesses the authority under Section 140(5) of the Act to issue a final order in cases where an auditor of the company is alleged to have, either directly or indirectly, engaged in fraudulent conduct.
The challenge to the constitutionality and vires of Section 140(5) was grounded in the assertion that it grants excessive and arbitrary authority to the NCLT in determining serious offenses involving fraud, with mandatory disqualification having severe repercussions akin to civil death. The Court, however, dismissed this argument and affirmed that the NCLT is to exercise quasi-judicial powers under Section 140(5) with the full range of powers akin to those of a civil court. Moreover, the NCLT is obligated to afford ample opportunity for hearings before rendering any final orders.
Not Discriminatory: Aligning with Article 14
It was argued before the Court that Section 140(5) of the Act is in violation of Article 14 of the Constitution as it unfairly discriminates against auditors when compared to individuals in similar positions, such as directors and management. The Court, however, rejected this argument and made the observation that auditors cannot be placed on an equal footing with directors and management.
The Court emphasized the pivotal role that auditors play in a company’s operations and their responsibility to act in the broader public interest and in the best interests of all stakeholders, including investors. Considering the significance of auditors, Chapter X of the Act is entirely dedicated to “Audit and Auditors.” Therefore, the Court concluded that Section 140(5) cannot be deemed discriminatory or in violation of Article 14 of the Constitution.
Penalty of Automatic Disqualification Rejected: No Violation of Article 19(1)(g)
The Court dismissed the argument that the penalty, involving the automatic disqualification of auditors and the entire firm, including its partners, for a duration of five years from acting as auditors for any other company, was unduly severe. It emphasized the principle of joint and several liability, affirming that auditors and the entire firm, along with its partners, are collectively liable and can thus be subjected to the provisions of Section 140(5) and its attendant consequences, as outlined in the Act.
Furthermore, the Court was unswayed by the contention that this disqualification equated to a form of civil death and that Section 140(5) encroached upon the fundamental right to pursue one’s profession, as safeguarded under Article 19(1)(g) of the Constitution. The Court noted that no one can assert a right to continue practicing their profession when engaged in fraudulent conduct, whether directly or indirectly. Such fraudulent behavior by an auditor constitutes grave misconduct, and therefore, the requisite consequences of such fraudulent actions must follow.
In light of the objectives and purposes for which Section 140(5) of the Act is enacted, the Court concluded that it cannot be deemed arbitrary, excessive, or in violation of Article 14 of the Constitution. Additionally, it was not found to infringe upon the fundamental rights guaranteed under Article 19(1)(g) of the Constitution, as alleged.
Case Comments and Analysis
The Supreme Court has rightly upheld the vires of Section 140(5) of the Act. It has given a purposive interpretation to the section in consonance with the legislative intent that the resignation of an auditor or its partner could not terminate the proceeding under Section 140(5) of the Act if the final order to the NCLT’s satisfaction found an element of fraud or collusion, whether directly or indirectly.
The Supreme Court has rightly trisected Section 140(5) of the Act into:
- the quasi-judicial power of NCLT to adjudge on the role of the auditor;
- the power of NCLT to remove the auditor in case of a prima facie satisfaction of fraud in the nature of an interim order; and
- upon a detailed inquiry, if the NCLT finds a commission of fraud, to debar the auditor from undertaking an audit for a period of five years.
This is a forward-looking judgment that will instill confidence in the stakeholders, especially the investors, and will act as a deterrent for the defaulting auditors.
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