SEBI’s Order against PwC: A Questionable Approach towards Mens Rea

[Sanchit Varma is a 4th year BA.LL.B (Hons) student at NALSAR University of Law, Hyderabad]

The nearly decade-old Satyam controversy has left a lasting impact on the Indian corporate sphere, raising dormant issues of corporate governance and the need for stricter regulatory control over listed entities. The fallout from the scam especially affected Satyam’s auditors, who were hauled up in equal measure as the company’s executives to answer for the apparent fudging of the company’s accounts and financial statements. The extent to which the auditing firm, PricewaterhouseCoopers (‘PwC’), was apparently complicit in the scam became evident in an order passed by the Securities and Exchange Board of India (‘SEBI’) in January 2018, through which it barred PwC’s network entities from issuing audit certificates to any listed company in India for two years, in addition to directing the firm to disgorge the wrongful gains from the scam. In this context, this post will examine the order passed by SEBI by locating it within the broader history of litigation around PwC’s culpability, with particular emphasis on how SEBI addressed the mens rea requirement imposed on it by the Bombay High Court in 2010, as a necessary prerequisite for establishing PwC’s liability.

Beginnings of the controversy

The history of litigation surrounding PwC’s involvement in the Satyam scam can be traced to certain show cause notices (‘SCNs’) issued to it by SEBI on account of Ramalinga Raju’s admission of financial irregularities in Satyam’s statements of accounts. Consequently, PwC filed a writ petition in the Bombay High Court questioning, inter alia, the jurisdiction of SEBI to inquire into PwC’s conduct. The question of SEBI’s jurisdiction before the High Court boiled down to the interpretation of section 11 of the SEBI Act, 1992, which gave SEBI the authority to take a number of remedial measures in the interest of investor protection against an array of entities and persons, but did not specifically include auditors.

On this issue, the Bombay High Court noted that section 11 of the SEBI Act confers sweeping powers on the regulator for the protection of the investors’ interests.  Therefore, the Court held that it cannot be said that SEBI does not have jurisdiction to enquire into the conduct of a chartered accountant in order to safeguard the interests of Satyam’s investors and shareholders. Further, the Court stressed that if the evidence on record suggests that there was deliberate fabrication and fudging of records, which indicates knowledge, intention or mens rea on part of PwC, then SEBI can pass appropriate orders as envisaged under sections 11 and 12 of the SEBI Act. As a corollary, if the adjudicatory process yields that there was only an omission on PwC’s part, without any mens rea or intention behind such an omission, then SEBI would be barred from giving any further directions in this regard. Therefore, mens rea was held to be an essential element of the case against PwC, which must necessarily be established by SEBI before any remedial steps can be taken by the regulator.

SEBI’s Order

In a 108 page order, SEBI has elaborately outlined a series of omissions on the part of PwC, demonstrating how the auditor deviated from standard auditing practices prescribed by the Institute of Chartered Accountants of India (‘ICAI’). To this end, the regulator relied upon the opinions of experts and judicial precedent to elucidate how PwC’s omissions and conduct amounted to gross negligence, and how the accumulated sum of omissions pointed to the willful blindness of the auditor in carrying out its duties. In response, PwC claimed that they had followed standard accounting practices which were in line with the standards prescribed by the ICAI.

A crucial point of conflict between the parties was over the requirement of mens rea, which was required to be established by SEBI before any directions could be passed against the auditor. On this point, PwC claimed that since the regulator had only provided instances of omissions, without adducing positive evidence to prove that the violations were intentional, it had failed to satisfy the strict threshold for mens rea prescribed in the 2010 order, and consequently it was estopped from passing any direction against PwC. The regulator differed on this issue by stating that mens rea in the criminal sense of the term is not relevant to be established in the case, and instead applied the preponderance of probabilities’ test to establish PwC’s culpability. In doing so, SEBI diluted the standard of mens rea required to prove that PwC’s violations were intentional.

The mens rea debate

In its appeal against SEBI’s decision to the Securities Appellate Tribunal (‘SAT’), the auditor has claimed that SEBI has failed to establish that the alleged violations were intentional, and therefore its order runs counter to the 2010 dictum of the Bombay High Court. In essence, PwC is arguing for a strict interpretation of the 2010 order to impose a higher burden on the SEBI for proving its case.

In this context, there are two possible interpretations for the mens rea requirement imposed in the 2010 order. First, as a general prescription, wherein it must be proved that the violations were intentional in nature. Second, as a specific conception of mens rea in context of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003, (‘PFUTP Regulations’), the provisions of which PwC has allegedly violated. It is, however, pertinent to note that the Bombay High Court’s order does not provide that the mens rea requirement has to be construed in context of the PFUTP Regulations. In PwC’s case, SEBI preferred the second interpretation, and has relied upon the case of SEBI v. Kanaiyalal Baldevbhai Patel, Nilesh Kapadia v. SEBI, and SEBI v. Cabot International Corporation to establish that mens rea is not an indispensable requirement under the PFUTP Regulations, and instead the preponderance of probabilities test is the correct test for establishing a violation under the regulations.

The approach adopted by SEBI in dealing with this issue is questionable, since the Bombay High Court’s mens rea prescription was general in nature and entirely divorced from the PFUTP Regulations. Consequently, SEBI’s reliance upon the Kanaiyalal and Kapadia cases to dilute the standard of mens rea appears misplaced, since these cases held that mens rea is not an indispensable requirement, but only in context of the PFUTP regulations. Further, SEBI’s treatment of mens rea as a dispensable requirement, a consequence of its reliance on the Kanaiyalal and Cabot International cases, runs counter to the 2010 order, wherein the Court had unequivocally stated that no order can be passed by SEBI unless it is demonstrated that the alleged violations were deliberate in nature, indicating knowledge or intention, i.e., mens rea is an indispensable requirement in the proceedings against PwC.

Another factor in favour of PwC in this regard is that the judicial precedents relied upon by SEBI to dilute the mens rea threshold are not squarely applicable to the instant case, since the proceedings in those cases were initiated against persons who were already covered under section 11(2) of the SEBI Act, whereas in PwC’s case SEBI’s jurisdiction to initiate proceedings against the auditor was read into the legislation, on account of the potential impact the practices of an auditor can have on the securities market.

On a separate note, while SEBI’s treatment of the mens rea requirement may be questionable, it is nevertheless incumbent upon the auditor to justify why anything less than a high threshold for mens rea is problematic and, further, why the preponderance of probabilities test adopted by SEBI is not appropriate for establishing PwC’s liability. In this context, a possible argument could be that a strict standard of proof is necessary in PwC’s case because unlike other entities under SEBI’s jurisdiction, auditors are not directly related to the securities market, and accordingly the auditor’s remoteness from the market should require the regulator to discharge an inherently higher burden for proving mens rea. However, its case for a strict standard of proof may be significantly weakened by the fact that PwC’s remoteness from the market was held to be immaterial in deciding whether SEBI could initiate proceedings against it, in the 2010 order. Moreover, the issue of remoteness becomes rather inconsequential if the auditor is anyway able to influence the market. Accordingly, if PwC’s remoteness from the market is deemed irrelevant, then there is no principled reason to justify why the preponderance of probabilities test should not be used in the case against it, other than the unimaginative argument that the Bombay High Court has prescribed a high threshold in its 2010 order. A principled reason in this regard would be necessary for PwC to sustain a substantive claim before the SAT; however, such a reason remains elusive for the time being.

Conclusion

The mens rea debate in PwC’s case essentially revolves around an interpretation of the Bombay High Court’s order, and while it is a technical aspect amidst the substantive claims in the case, it is nevertheless likely to have a significant bearing on its outcome.

– Sanchit Varma

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