Debarment of Company Auditor: A Cursory Death Note

[Shubham Nahata is a 3rd year student of Hidayatullah National Law University]

Chapter X of the Companies Act, 2013 contains provisions for regulating audit and auditors of the companies. Among other things, the chapter deals with the appointment, removal, disqualifications, and resignation of company auditors. Recently, the Bombay High Court in N. Sampath Ganesh v. Union of India dealt with the extraordinary power of removal and debarment of company auditors under section 140(5) of the Act. The Court adjudicated on the issue of the constitutionality of the said provision and determined the mode of exercise of powers of debarment under the second proviso of section 140(5). This post critically analyses the judgment of the Court in light of different provisions and safeguards provided against professional misconduct and fraud in the Act itself.

Factual Background

The dispute arises in the backdrop of a prayer made by the Union of India against the auditors of IL&FS Financial Services Limited (IFIN) for involvement in constant ever-greening of debts to its subsidiaries and third parties. In an unprecedented move, the Central Government invoked powers under section 140(5) to debar Deloitte Haskins & Sells Ltd. and BSR & Co. for their alleged role in concealing the true financial position of IFIN during their tenure as company auditors of IFIN. The auditors challenged the said petition before the High Court, primarily on the grounds of unconstitutionality of section 140(5) of the Act and the inability to invoke such provision against former statutory auditors of the company. Among other things, the Court also delved into the status of a report filed by the Serious Fraud Investigation Office (SFIO) under section 212 of the Act and the validity of the sanction ordered based on such report.

Statutory Scheme

Section 140 of the Companies Act, 2013 prescribes the procedure for removal and resignation of a company auditor. Under clause (5) of the section, if the National Company Law Tribunal (NCLT) is satisfied that the auditor of a company has acted fraudulently or colluded in any fraud by, or in relation to, the company or its directors or officers, then it may direct the company to change its auditors. The first proviso of the said clause prescribes that if an application is made by the Central Government and the NCLT is satisfied regarding the need to change the auditor of the company, it shall, within a span of 15 days of receipt of such application, make an order in that behalf. The second proviso of the clause provides that if a final order is passed against any such firm or individual he shall be debarred from being appointed as the auditor of any company for a period of five years and shall become liable for action under section 447 of the Act.

Fraud and professional misconduct have been specified under the Act under sections 447 and 132 respectively. If a person is convicted of an offence involving fraud, he becomes ineligible to be appointed as a company auditor for a period of 10 years from the date of such conviction. Hence, it can be seen that two different terms of debarment of a company auditor are prescribed under the scheme of the Act.

Ratio

While upholding the constitutionality of section 140(5), the High Court held that merely treating directors of a company and the company auditors on different footing under the Act cannot be a ground for challenging the constitutionality of the Section. The Court held that the directors and officers of a company form a distinct class as they are involved in the management of the company. A company auditor, on the other hand, is a third party who stands in a neutral position and is assigned to look after the financial propriety of the business. A chartered accountant who is bound by the rules and regulations of his professional conduct is in no manner subordinate to the company and cannot be equated with the directors and officers.

While dealing with two different punitive measures prescribed against an erring auditor, the Court held that it does not constitute double jeopardy as the second proviso of section 140(5) is a curative measure and the said debarment is not in relation to fraud. It held that disqualification under section 140(5) is different from punishment under section 447 of the Act and the doctrine of proportionality is not applicable to it. One of the primary reasons for the said disqualification is to maintain the sanctity of the corporate enterprise and it is not concerned with the fraud and professional misconduct of the auditor.

The ‘satisfaction’ of the NCLT in passing an order under section 140(5) was also challenged on the ground that it does not prescribe any procedure which forms the basis of such satisfaction. The Court held that the satisfaction so reached is a subjective satisfaction of a judicial authority, and that the NCLT under National Company Law Tribunal Rules, 2016 is capable of devising its own procedure to meet the ends of justice. While upholding the constitutionality of the section, the Court granted a sigh of relief to Deloitte and BSR and Co. as it held that an action under section 140(5) cannot be initiated against former company auditors as it is primarily for removal of present auditors of a company.

The application of the second proviso of section 140(5), which debars an individual or firm years from practicing as auditor of any company for a period of five was also explained by the Court. It held that the satisfaction reached by the NCLT needs to be respected by the auditor and the company. If the company auditor honours that satisfaction, there is no need to pass a final order. A final order under the scheme of section 140(5) is an order asking the company to change the auditor and will attract debarment. However, if an auditor recuses himself before such an order is executed, he does not attract any penalty under the second proviso. Whenever an auditor challenges the subjective satisfaction of the Tribunal and raises frivolous grounds of defence, harsher treatment is attracted under the second proviso, whereas if he recuses himself based on that satisfaction the auditor does not incur any prejudice.

The Court pointed out that section 140(5) does not deal with fraud and professional misconduct under the Act. The purpose behind the enactment of such a section is to break the unhealthy collusion between the company and the auditor. It held that a company auditor is a third party who is disinterested in the affairs of the company and is bound to perform his tasks in an impartial manner. If such an auditor opposes the direction of the NCLT, it means otherwise and the tribunal may pass a final order under the second proviso.

Critical Analysis

Professional misconduct on part of company auditors can be investigated by the National Financial Reporting Authority formed under section 132 of the Companies Act, 2013 as well as provisions under the Chartered Accountants Act, 1949 as well. Similarly, the offence of fraud and the punishment thereof has been prescribed under section 447 of the Companies Act. As the ground for subjective satisfaction of the NCLT under section 140(5) is fraud, it cannot be stipulated that the tribunal, while adjudicating on debarment, is not taking into account the relevant aspersions of fraud against the auditor. Moreover, the nature of final order passed under the second proviso of section 140(5) and the punishment under section 447 of the Companies Act are both punitive, as they debar the auditor from practicing its profession. Hence, the nature of the act and its consequences need to be looked into rather than its nomenclature.

Even though the NCLT possesses the power to determine its own procedure, but the subjective satisfaction of the tribunal, if based on incomplete and inconclusive reports, can deprive the auditor of the opportunity to practice his own business and profession. Although the said provision was included as a cautionary note in order to protect the interest of shareholders, the act of debarring the auditor completely for a period of five years is rather excessive and unreasonable. When different mechanisms have been provided under the Act to investigate professional misconduct and fraud, this provision bypasses the established procedures without following due process.

Moreover, the provision acts as a threat rather than a cautionary note for the company auditor, as it places the burden on the auditor to recuse himself before the NCLT passes a final order. These considerations can give rise to caprice in the adjudication process as the auditor is not even offered an opportunity to present himself properly before the Tribunal. This extraordinary power, if exercised by the NCLT, can not only cause loss of business for the auditor, but can also create a stigma that can hamper his future prospects. Hence, it is necessary to accompany such power with proper procedures and safeguards.

Conclusion

In light of different provisions governing fraud and professional misconduct on part of company auditor, the second proviso of section 140(5) is rather an extraordinary and unnecessary provision that acts as a death note for the company auditor. The exercise of such power needs to be substantiated with proper reasoning and procedural safeguards. If not regulated properly, the provision can become a ruse for the Government to fix responsibility in such circumstances without proper enquiry.

Shubham Nahata

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