Constitutionality and Scope of Section 140(5) Companies Act 2013: Debarment of Company Auditors
A Company Auditor is a person appointed and responsible for preparing independent audit reports of the company. Every company must get their financial statements audited by the auditor. Chapter X of the Companies Act 2013 contains provisions dealing with appointing and removing auditors. The Supreme Court, in the case of the Union of India and Another vs. Deloitte Haskins and Sells LLP & Anr, upheld the constitutional validity of section 140(5) Companies Act 2013, which dealt with the debarment or removal of auditors while dealing with the question of law pertaining to the interpretation of section 140(5) and observed that “provision is neither arbitrary nor violative of article 14, 19(1)(g) of the constitution”. The court further stated that proceedings under this section would continue even after the resignation of the auditor. This article attempts to analyse the Supreme Court’s decision by considering various legal provisions and safeguards implemented within the act to prevent professional misconduct and fraud.
Matrix of Facts
The present case is a batch of appeals filed by the parties, particularly the Union of India, challenging the directions of the Bombay High Court in the case of N. Sampath Ganesh v. Union of India, where though the court upheld that section 140(3) is constitutional but set aside the direction issued under section 212(14) by the central government to the Serious Fraud Investigation Office (SFIO).
The dispute started from a legal action brought by the central government against IL&FS Financial Services Limited (IFIN) auditors, who were accused of hiding debts owing to subsidiaries and third parties on a continuous basis. In an unprecedented move, the Central Government, through the Ministry of Corporate Affairs, used its authority under section 140(5) to disqualify the auditors in question, Deloitte Haskins & Sells Ltd. and BSR & Co., for their alleged involvement in concealing IFIN’s actual financial position during their tenure as company auditors. The auditors filed a petition in the High Court, arguing primarily against the constitutionality of section 140(5) and its application to former statutory auditors. SFIO filed the case against, among others, Deloitte and BSR, ex-auditors of the IFIN under section 447 and other provisions of the company law for fraudulent activities. The Court later examined the status report SFIO submitted under section 212 of the Act. The court assessed the validity of the sanction based on that report.
Section 140 elucidates the process of removal or resignation of an auditor. Sub-clause (5) of this section states that if the tribunal, either sou motu or on an application made by the central government, is satisfied that the fraudulent activities conducted by the auditor, either itself or in collusion with the directors or officer. The tribunal may direct the company to change its auditor. Suppose the tribunal is satisfied with the requirement to change the auditor on an application made by the central government. In that case, the tribunal shall order within 15 days of such application to restrain the auditor from performing its functions, and the central government can appoint another person as an auditor. The second proviso of the said clause prescribes that an auditor, whether individual or firm, if debarred from performing its function by final order, shall be ineligible for appointment as an auditor of any company for five years, and such auditor will be liable under section 447 of Companies Act.
Section 447 outlines the penalties for engaging in fraud and professional misconduct. If a person is proven guilty of fraud or convicted of a related offence, they will face imprisonment ranging from a minimum of six months to a maximum of ten years, in addition to the fine. After examining both provisions, it can be inferred that the act specifies two different terms for disqualifying an auditor.
The Supreme Court found the Bombay High Court judgment erroneous and unsustainable. The High Court upheld that section 140(5) is constitutional; However, after the auditor resigns, subsequent section 140(5) proceedings are no longer maintainable. The Supreme Court, while disagreeing with the view, concluded that if the interpretation given by the high court is followed, then, in that case, the auditor may resign to evade the repercussions of the final order as provided in the second proviso of the section. Therefore, proceedings or inquiries initiated under section 140(5) must reach their conclusion, and subsequent resignation or discontinuance of an auditor will not bring an end to the ongoing proceedings. It is unlikely that the legislature intended for auditors to avoid the whole proceedings. Such an outcome is inconsistent with the purpose of the provision as outlined in the second proviso to Section 140(5).
While upholding the constitutionality of section 140(5), the court held that section 140(5) is not violative of article 14 of the constitution as the auditors cannot be placed on an equal pedestal with the company’s directors or officers. Directors and officers of the company form distinct classes as they are involved in the management of the company. In contrast, an auditor is a third party who functions as an independent agency uninfluenced by any of the company activities except audit services. Previous economic fiasco and past experiences also suggest stricter rules for the auditor.
Section 140(5) is consistent with article 19(1)(g) of the constitution. The court was unimpressed by the argument that disqualification is akin to civil death and impinges upon the fundamental right to carry on its profession. No person shall be allowed to continue or carry on their profession despite acting fraudulently. Fraudulent activities done by the auditor is serious misconduct, and repercussion has to be borne by the auditor.
The Supreme Court has also permitted the Serious Fraud Investigation Office (SFIO) to proceed with criminal proceedings against the former auditors of IL&FS Financial Services for their alleged involvement in financial irregularities at the company.
Fraud, as per the explanation provided in section 447, is defined as any action, omission, or deliberate concealment of information by a person, either independently or in collusion with another person, intending to deceive or gain unfair advantages by misusing their position. The Companies Act 2013 explicitly provides guidelines on procedures to establish the culpability of an accused person. Section 447 not only punishes but also works as deterrence. The National Financial Reporting Authority, under section 132(4), is given powers to investigate professional misconduct by the auditor. Under section 140(5), the final order removal is passed on the subjective satisfaction of the grounds of fraud by the NCLT. As sections 140(5) and 447 are both punitive in nature; thus, the offence of fraud or misconduct must be proved beyond any reasonable doubt. The tribunal has the duty to examine the nature of the act committed and its consequences rather than focusing solely on the terminology used to describe it.
After being found guilty of fraud, the statutory scheme of debarring the auditor entirely for five years is neither excessive nor unreasonable. The public policy behind section 140 (5) is to prevent an auditor found to perpetrate fraud from undertaking any statutory audit. Further, clause (5) uses the word ‘may’ and gives discretion to the tribunal on removing the auditor. The fixed five-year prohibition period activates only in case of a finding of fraud by the NCLT in terms of the statutory scheme and public policy. The principle of proportionality cannot be raised to a level where the extent of fraud must be examined. Otherwise, the very deterrent effect of the provision would get diluted, and more importantly, it would perpetuate fraud in connection with other companies.
This provision, after the Supreme Court judgement, unclouds the position that even after the resignation of auditors, they cannot escape liability for their professional misconduct. It will act as a warning to those auditors engaged in fraudulent activities. However, the powers given to the tribunal to determine serious fraud are not untrammelled and unguided. NCLT exercises the quasi-judicial powers under section 140(5), akin to a civil court. They should provide the plenteous opportunity to the auditor to explain its position and give proper reasoning in their final order for the debarment of the auditor. Failure to implement appropriate procedures and safeguards when exercising this exceptional power could potentially lead to adverse consequences, such as losing business for auditors. Therefore, it is imperative to establish comprehensive procedures and safeguards to accompany such powers.
It is submitted that the auditor plays a vital role in the affairs of the company, and their conduct should not be in a manner so as to affect the larger public interest and all other stakeholders. After deliberate discussion, this section has been enacted with a specific object and purpose. Therefore, the aforementioned provision provides extraordinary measures to protect those interests. However, before attracting such provisions, ensuring sufficient justification and procedural safeguards is of the utmost importance when exercising such authority. Otherwise, this provision can be vulnerable to exploitation by the government as a way to shift responsibility in such circumstances without conducting a proper and thorough investigation. Consequently, the auditor could unjustly bear the blame for fraudulent actions committed by anyone, including company directors or officers.
Keywords: Auditor, Companies Act, Corporate Governance