Loophole in section 139 of Companies Act, 2013

The legislature in their wisdom decided to plug loopholes of the erstwhile Companies Act, 1956 by inclusion of various new provisions to prevent frauds in the Companies Act, 2013 which were not a part of the erstwhile Companies Act. The noble intention behind bringing new preventive provisions is to bring more transparency in day to day companies’ affairs and make management of the companies more accountable and reduce resultant litigation.

One of such provisions is sub-section 2 of section 139 in Chapter X of Companies Act 2013 which inter­alia provides mandatory rotation of auditors of the company by the listed companies and specified class of companies as specified by the central government. It is a new provision, which provides that the auditor of listed and specified companies cannot be reappointed for the second consecutive term of five year in case of an individual and ten year in case of a firm, if the auditor has held office for consecutive five years as individual and ten years as a firm in the first term. This can be understood with the help of following example:

Example (If auditor is an Individual and not taken advantage of loophole)

Suppose Mr. X is appointed as an auditor for first term of five years in the 1^st AGM till the conclusion of 6^th AGM in ABC limited (Listed Company).

If Mr. X will hold the office of auditor till conclusion of the 6^th AGM, then by virtue of section 139(2) Mr. X shall not be reappointed for another term of five years neither in the 6^th AGM nor in the any subsequent AGM unless five years have passed from the end of 6^th AGM, as he has held office for five consecutive years. In other words it can be said the Mr. X will have to get through a cooling off period of five years as per the statutory provisions.

Example (If auditor is a Firm and not taken advantage of loophole)

Suppose M/s. XYZ Chartered Accountants is appointed as the auditor for first term of ten years in the 1^st AGM till the conclusion of 11^th AGM in ABC limited (Listed Company).

If M/s. XYZ Chartered Accountants will hold the office of auditor till conclusion of the 11^th AGM, then by virtue of section 139(2) M/s. XYZ Chartered Accountants shall not be reappointed for another term of ten years neither in the 11^th AGM nor in the any subsequent AGM unless five years have passed from the end of 11^th AGM, as the firm has held office for ten consecutive years. In other words it can be said the M/s. XYZ Chartered Accountants will have to get through a cooling off period of five years as per the statutory provisions.

The legislature was not oblivious of the situation where removal of an auditor becomes necessary therefore under section 140 they provided that by a special resolution and with the prior approval of the Central Government an auditor can be removed.

The aforesaid statutory provision regarding rotation of auditors if contravened is punishable as per section 147 of the Act. However, the rotation of auditors and penal provisions contained in section 147 may be avoided by strict interpretation of the aforesaid statutory provisions and by creating an artificial disqualification as per section 141 of the Act.

An artificial situation may be created by the management and auditor in collusion with each other for their mutual benefit and for re-appointment of a desired individual or a firm as auditor for the second term with cooling off period of one year instead of five years at the cost of other stakeholders. This may be possible by getting the desired auditor disqualified before the expiry of statutory period of five years which will result in a deemed casual vacancy as per the deeming fiction contained in section 141 of the Act. The casual vacancy that has arisen on disqualification of the desired auditor may then be filled by the Board of Directors of the company as the company will not be required to pass a special resolution and obtain prior approval of the Central Government as required under section 140 of the Act.

The said disqualified auditor after remedying the disqualification immediately before the AGM in which the auditor filling the casual vacancy will left auditor’s office would be eligible for re-appointment as his appointment is not specifically ruled out within the statutory provisions contained in Chapter X of the Act. In this way instead of going through a statutory cooling off period of five years only a period of one year or even less would suffice for re-appointment of a desired auditor by the company for mutual benefit of auditor and the company as stated above.

The main argument in support of appointment of a desired auditor shall be that since he/it has not completed the statutory period of five years and has held office for less than the five years as individual and ten year as firm then there is no legal requirement in law for them to go through the cooling off period of 5 years. There shall be no impediment legal or otherwise and the auditor (either individual or a company) could be appointed for a second term by not completing the first term intentionally. In other words a break of a year in the statutory term of an individual or a firm as stated above shall have potential to defeat the basic intention of the legislature with respect to the rotation of the auditor to prevent collusion of the auditors with the management of the company. This may also be taken as a possible route to bye-pass the statutory provisions contained in section 140 of the act. This can be understood with the help of following above example continued:

Example (If auditor is an Individual and taken the advantage of the loophole)

If Mr. X will hold the office of auditor till conclusion of the 5^th AGM i.e. he left office of the auditor just before completion of consecutive term of five years by mode of a creating casual vacancy by making himself disqualified by purchasing the securities of the company as specified in clause d of 141(3) and for the period ranging from conclusion of 5^th AGM to conclusion 6^th AGM (as by virtue of section 139(8) casual vacancy can be filled till conclusion of next AGM only) Board of Director arranges to fill casual vacancy arises in auditor’s office. Then for the appointment of Mr. X in the 6^th AGM section 139(2) cannot be invoked as Mr. X has not held office of auditor for a consecutive five years period since he held less than that and he after remedying the disqualification just before the 6^th AGM by selling the earlier purchased shares shall become eligible to be appointed for five more years from 6^th AGM to 11^th AGM. Thus by escaping the office for one year though legal route Mr. X able to defeat intention behind section 139(2) and saved from cooling off period of five years by planned sacrifice of one year. In nutshell, not only five years cooling off is avoided but also there was no requirement of passing a special resolution and obtaining prior permission of the Central Government.

Example (If auditor is a Firm and taken the advantage of the loophole)

If M/s. XYZ Chartered Accountants will hold the office of auditor till conclusion of the 10^th AGM i.e. it left office of the auditor just before consecutive term of ten years by creating casual vacancy by making them disqualified by purchasing the securities of the company as specified in clause d of 141(3) and for the period ranging from conclusion of 10^th AGM to conclusion 11^th AGM (as by virtue of section 139(8) casual vacancy can be filled till conclusion of next AGM only) Board of Director arranges to fill casual vacancy arises in auditor’s office. Then for the appointment of M/s. XYZ Chartered Accountants in the 11^th AGM section 139(2) cannot be invoked as the firm has not held office of auditor for consecutive ten years but it held less than that and the firm will be remedying the disqualification just before the 11^th AGM by selling the earlier purchased shares hence M/s. XYZ Chartered Accountants can be appointed for ten more years from 11^th AGM to 21^st AGM. Thus by escaping the office for one year though legal route M/s. XYZ Chartered Accountants able to defeat intention behind section 139(2) and saved from cooling off period of five years by planned sacrifice of one year. In nutshell, not only five years cooling off is avoided but also there was no requirement of passing a special resolution and obtaining prior permission of the Central Government.

The Section 139(2) clearly provides for a cooling off period of five years to avoid the possible collusion between auditors and the company personnel which can result in fraud prejudicial to the stakeholders. One can use the above loophole resulting in fraud and defeat the intention of the legislature.

Therefore this loophole needs to be plugged by amending the section 139(2) so that the actual intent of the legislatures can be secured litigations resulting from above loophole may be avoided.

The relevant bare sections 139(2), 140(1), 141(4), 147(1), and 147(2) are reproduced below:

Section 139 (2)

No listed company or a company belonging to such class or classes of companies as may be prescribed, shall appoint or re-appoint–

(a) an individual as auditor for more than one term of five consecutive years; and

(b) an audit firm as auditor for more than two terms of five consecutive years:

Provided that–

(i) an individual auditor who has completed his term under clause (a) shall not be eligible for re-appointment as auditor in the same company for five years from the completion of his term;

(ii) an audit firm which has completed its term under clause (b), shall not be eligible for re-appointment as auditor in the same company for five years from the completion of such term:

Provided further that as on the date of appointment no audit firm having a common partner or partners to the other audit firm, whose tenure has expired in a company immediately preceding the financial year, shall be appointed as auditor of the same company for a period of five years:

Provided also that every company, existing on or before the commencement of this Act which is required to comply with provisions of this sub-section, shall comply with the requirements of this sub-section within three years from the date of commencement of this Act:

Provided also that, nothing contained in this sub-section shall prejudice the right of the company to remove an auditor or the right of the auditor to resign from such office of the company

Section 140(1)

The auditor appointed under section 139 may be removed from his office before the expiry of his term only by a special resolution of the company, after obtaining the previous approval of the Central Government in that behalf in the prescribed manner:

Provided that before taking any action under this sub-section, the auditor concerned shall be given a reasonable opportunity of being heard.

Section 141(4)

Where a person appointed as an auditor of a company incurs any of the disqualifications mentioned in sub-section (3) after his appointment, he shall vacate his office as such auditor and such vacation shall be deemed to be a casual vacancy in the office of the auditor.

Section 147(1)

If any of the provisions of sections 139 to 146 (both inclusive) is contravened, the company shall be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees and every officer of the company who is in default shall be punishable with imprisonment for a term which may extend to one year or with fine which shall not be less than ten thousand rupees but which may extend to one lakh rupees, or with both.

Section 147(2)

If an auditor of a company contravenes any of the provisions of section 139, section 143, section 144 or section 145, the auditor shall be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees:

Provided that if an auditor has contravened such provisions knowingly or willfully with the intention to deceive the company or its shareholders or creditors or tax authorities, he shall be punishable with imprisonment for a term which may extend to one year and with fine which shall not be less than one lakh rupees but which may extend to twenty-five lakh rupees.