Supreme Court Upholds Section 140(5) of Companies Act, 2013: Auditors’ Resignation Doesn’t Halt Fraud Inquiry (3 May 2023)

Introduction

Date of the Judgment: 3 May 2023

Citation: Not Available in the Source

Judges: M.R. Shah, J. and M.M. Sundresh, J.

Can an auditor escape scrutiny for fraudulent activities by simply resigning? The Supreme Court of India recently addressed this critical question, clarifying the scope and applicability of Section 140(5) of the Companies Act, 2013. This judgment settles the interpretation of the provision and its implications for auditors involved in fraud. The court held that an auditor’s resignation does not halt proceedings under Section 140(5), emphasizing the need for a thorough inquiry into auditor misconduct. The bench comprised Justices M.R. Shah and M.M. Sundresh, with the judgment authored by Justice M.R. Shah.

Case Background

The case originated from a series of defaults by the IL&FS Group between June and September 2018, which had a debt burden of over ₹91,000 crores. This financial crisis threatened the Indian money markets, increased corporate bond yields, and triggered a stock market sell-off. The Department of Economic Affairs, Ministry of Finance, issued a memorandum on 30 September 2018, to the Ministry of Corporate Affairs, highlighting the debt crisis, corporate governance failures, and window-dressed accounts within the IL&FS Group. The Ministry of Corporate Affairs, upon receiving a report from the Registrar of Companies under Section 208 of the Companies Act, 2013, directed the Serious Fraud Investigation Office (SFIO) to investigate the affairs of IL&FS and its subsidiaries.

On 1 October 2018, the Ministry of Corporate Affairs filed a Company Petition against IL&FS and its then Board of Directors before the National Company Law Tribunal (NCLT). The NCLT superseded the existing Board of Directors with a new one on the same day. The new Board submitted a progress report on 30 October 2018. The SFIO submitted an interim report after being directed by the Ministry of Corporate Affairs. Based on this interim report and a prima facie opinion from the Institute of Chartered Accountants, the Ministry filed a petition under Section 130 of the Companies Act, 2013, before the NCLT, seeking to reopen and recast the books of accounts of IL&FS, IFIN, and IL&FS Transportation Networks Limited (ITNL). The NCLT ordered the reopening and recasting of accounts for the past five financial years on 1 January 2019. The Reserve Bank of India (RBI) also initiated an inspection of IL&FS and IFIN under Section 45N of the RBI Act, 1934, submitting its report on 22 March 2019. IFIN issued a notice to BSR seeking their removal as auditors on 13 May 2019. The SFIO submitted its investigation report on IL&FS Financial Services Limited (IFIN) after the office order dated 30 September 2018.

The Ministry of Corporate Affairs requested the Regional Director and the SFIO to initiate prosecution on 29 May 2019. The SFIO filed a criminal complaint on 30 May 2019, against, among others, the auditors/ex-auditors of IFIN. On 10 June 2019, the Ministry filed a petition under Section 140(5) of the Companies Act, 2013, against the auditors of IFIN, namely BSR & Associates LLP and Deloitte Haskins & Sells LLP, and their engagement partners. BSR resigned as auditors on 19 June 2019. Both BSR and Deloitte challenged the maintainability of the Section 140(5) petition, which was upheld by the NCLT. The Bombay High Court, while upholding the constitutionality of Section 140(5), set aside the NCLT’s order and quashed the Section 140(5) petition and the criminal proceedings. This led to the present appeals before the Supreme Court.

Timeline

Legal Framework

The Supreme Court analyzed several key provisions of the Companies Act, 2013, to understand the context of Section 140(5). Section 140 of the Companies Act, 2013, titled “Removal, resignation of auditor and giving of special notice,” outlines the procedures for removing or resigning an auditor. Section 140(1) provides the procedure for a company to remove an auditor before the expiry of their term. Sections 140(2) and (3) deal with the resignation of auditors, while Section 140(4) deals with special notices at an Annual General Meeting (AGM) for appointing an auditor other than the retiring one.

Section 140(5) of the Companies Act, 2013, is at the heart of this case. It states, “Without prejudice to any action under the provisions of this Act or any other law for the time being in force, the Tribunal either suo motu or on an application made to it by the Central Government or by any person concerned, if it is satisfied that the auditor of a company has, whether directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its directors or officers, it may, by order, direct the company to change its auditors.” This section empowers the NCLT to act against auditors involved in fraud.

The first proviso to Section 140(5) states, “Provided that if the application is made by the Central Government and the Tribunal is satisfied that any change of the auditor is required, it shall within fifteen days of receipt of such application, make an order that he shall not function as an auditor and the Central government may appoint another auditor in his place.” This allows for an interim measure to replace an auditor suspected of fraud. The second proviso states, “Provided further that an auditor, whether individual or firm, against whom final order has been passed by the Tribunal under this section shall not be eligible to be appointed as an auditor of any company for a period of five years from the date of passing of the order and the auditor shall also be liable for action under section 447.” This imposes a five-year ban on auditors found guilty of fraud, along with liability under Section 447 of the Companies Act, 2013, which deals with punishment for fraud.

Section 143(12) of the Companies Act, 2013, mandates that if an auditor has reason to believe that an offense of fraud is being or has been committed in the company, the auditor shall report the matter to the Central Government. Section 144 of the Companies Act, 2013, prohibits an auditor from providing certain services, including management services, to maintain independence. The court also referred to Section 447 of the Companies Act, 2013, which defines and penalizes fraud, and Sections 212(14) and 212(15) of the Companies Act, 2013, which deal with the powers of the SFIO and the Central Government to initiate prosecution based on investigation reports.

Arguments

Submissions on behalf of the Union of India:

• The High Court misinterpreted Section 140(5) of the Companies Act, 2013, by stating that its purpose is only to break the collusion between the auditor and the company. Once the unholy bond is broken, the purpose is fulfilled.
• The High Court erroneously held that Section 140(5) is only attracted when an auditor opposes the petition and invites a final order.
• The High Court erred in quashing the Section 140(5) petition after the auditor’s resignation.
• The High Court incorrectly concluded that there was a non-application of mind by the Central Government in issuing the direction to prosecute, simply because it was done within 30 hours of the receipt of the SFIO report.
• The High Court erroneously held that the SFIO report was incomplete and lacking, without going into the same.
• Section 140(5) empowers the NCLT to inquire into the conduct of an auditor involved in fraud and reach a satisfaction regarding the auditor’s fraudulent conduct.
• The first proviso to Section 140(5) is an interim measure to prevent an existing auditor from continuing.
• The second proviso to Section 140(5) activates on an order recording the NCLT’s satisfaction of fraudulent conduct and debars the auditor from being an auditor in any company for five years.
• The essence of Section 140(5) is the determination of fraudulent conduct of the auditor, not merely the change of auditor.
• The legislative history of Section 140(5) shows that the intent was to prevent auditors found guilty of fraud from undertaking statutory audits for five years.
• The SFIO report was a complete report on IFIN and not an interim one.
• The direction to prosecute under Section 212(14) was issued after due consideration of the SFIO report.

Submissions on behalf of the Auditors (BSR & Deloitte):

• Section 140(5) is only to incentivize a recalcitrant auditor into resigning.
• If an auditor resigns after the filing of a petition under Section 140(5), the purpose behind the provision is fulfilled.
• Continuing a proceeding against an auditor under Section 140(5) after resignation would mean reading in a proviso into Section 140(5).
• The second proviso to Section 140(5) is arbitrary and should be read down to make it constitutional.
• The ineligibility to act as an auditor should only extend to the audit partners concerned, not the entire firm.
• The Act provides a holistic scheme for regulation and punishment of Auditors, and no auditor can escape by way of resignation or termination of tenure.
• Section 140(5) only serves the purpose of removal of an auditor and is not a standalone substantive provision to disqualify auditors.
• Section 140(5) cannot apply where the auditor has ceased to hold the position.
• The NCLT cannot direct the removal of past auditors.
• Section 140(5) is excessive and arbitrary, providing unguided powers to the NCLT.
• The penalty of automatic disqualification is disproportionate and violates Article 19(1)(g) of the Constitution.
• The SFIO report was an interim report, and thus, the direction to prosecute was invalid.
• The direction to prosecute was issued without application of mind.

Issues Framed by the Supreme Court

The Supreme Court considered the following key issues:

1. Whether the High Court has correctly interpreted Section 140(5) of the Companies Act, 2013.
2. Whether the resignation of an auditor during the pendency of proceedings under Section 140(5) terminates the proceedings.
3. Whether the direction to prosecute issued under Section 212(14) of the Companies Act, 2013, was valid.
4. Whether the SFIO report was an incomplete report.
5. Whether Section 140(5) of the Companies Act, 2013, is constitutionally valid.

Treatment of the Issue by the Court

Authorities

Cases Relied Upon by the Court:

• Devas Multimedia Pvt. Ltd. v. Antrix Corporation Ltd. & Anr, (2023) 1 SCC 216 – The court relied on this case to support the principle that the public policy behind Section 140(5) is to prevent auditors found to be perpetrating fraud from undertaking statutory audits for a period of five years.
• Raichurmatham Prabhakar v. Rawatmal Dugar, (2004) 4 SCC 766 – This case was cited to emphasize that a heading is a condensed name to collectively indicate the characteristics of the subject matter covered by a section.
• NEPC Micon Ltd. v. Magma Leasing Limited (1999) 4 SCC 253 – This case was cited to emphasize that an interpretation that renders a provision a dead letter should be rejected.
• Madras Bar Association v. Union of India 2021 SCC Online SC 463 – This case was cited to support the principle that apprehension or misuse of a provision cannot be a ground to test the constitutional validity of the provision.
• An Advocate v. Bar Council of India (1989) Supp 2 SCC 25 – This case was cited to support the principle that proceedings which may result in disqualification would be of a quasi-criminal nature and have to be strictly construed.
• ICAI v. LK Ratna & Ors. (1986) 4 SCC 537 – This case was cited to support the principle that proceedings which may result in disqualification would be of a quasi-criminal nature and have to be strictly construed.
• Dharani Sugars and Chemicals Ltd. v. Union of India, (2019) 5 SCC 480 – This case was cited to emphasize that something may be done only in the manner prescribed by the law and in no other manner.
• Dr. Jaishri Laxmanrao Patil v. Chief Minister and Others, (2021) 8 SCC 1 – This case was cited to support the principle that courts should be reluctant to hold that Parliament has achieved nothing by the language it used, when it is tolerably plain what Parliament wished to achieve.
• State of Maharashtra v. Shri Vile Parle Kelvani Mandal & Ors. (2022) 2 SCC 725 – This case was cited to support the principle that purposive interpretation can be given only when there is some ambiguity in the language of the statutory provisions or it leads to absurd results.
• SEBI v. Sunil Krishna Khaitan, (2023) 2 SCC 643 – This case was cited to support the principle of doubtful penalization, which requires that if two reasonable constructions can be put on a provision, the court must lean in favor of the construction which exempts the subject from penalty.
• Tolaram Relumal v. State of Bombay. (1955) 1 SCR 158 – This case was cited to support the principle of doubtful penalization, which requires that if two reasonable constructions can be put on a provision, the court must lean in favor of the construction which exempts the subject from penalty.
• Bhuwalka Steel Industries Ltd & Anr v. UOI, (2017) 5 SCC 598 – This case was cited to support the principle that courts and tribunals do not have the power to create a deeming fiction by judicial interpretation when the statute does not provide for it.
• Sant Lal Gupta v. Modern Cooperative Housing Society Ltd., (2010) 13 SCC 336 – This case was cited to support the principle that courts and tribunals do not have the power to create a deeming fiction by judicial interpretation when the statute does not provide for it.
• B. Himmatlal Agrawal v Competition Commission of India, AIR 2018 SC 2804 – This case was cited to support the principle that NCLT, being a creature of statute, has to act within the domain prescribed by law.
• Cellular Operators Association of India v. Union of India, (2003) 3 SCC 186 – This case was cited to support the principle that NCLT, being a creature of statute, has to act within the domain prescribed by law.
• Pasupuleti Venkateswarlu v. Motor & General Traders, (1975) 1 SCC 770 – This case was cited to support the principle that a proceeding may not be maintainable by reasons of a post-filing event.
• Carona Ltd. v. Parvathy Swaminathan & Sons, (2007) 8 SCC 559 – This case was cited to support the principle that a “jurisdictional fact’ is a sine qua non or the condition precedent to the assumption of jurisdiction by a court.
• Arun Kumar v. Union of India, (2007) 1 SCC 732 – This case was cited to support the principle that a “jurisdictional fact’ is a sine qua non or the condition precedent to the assumption of jurisdiction by a court.
• Balram Garg v. SEBI, (2022) 9 SCC 425 – This case was cited to support the principle that the foundational fact must be established before a presumption is made.
• Serious Fraud Investigation Office v Rahul Modi (2019) 5 SCC 266 – This case was cited to support the principle that the Central Government can direct the SFIO to initiate prosecution only after examination of the investigation report.
• P.M.C Mercantile Private Ltd. v. The State 2014(3) MWN (Cr.) 454 – This case was cited to support the principle that where an investigation report itself states that the investigation is incomplete, then such an investigation report does not meet the obligatory requirements of law.
• Pravin Chandra Modi v. The State of Andhra Pradesh, Crl. App. No. 49, 1964 – This case was cited to support the principle that where an investigation report itself states that the investigation is incomplete, then such an investigation report does not meet the obligatory requirements of law.
• Hari Chand & Ram Pal v. State Crl. Misc. (M) 99 & 111 of 1977 – This case was cited to support the principle that where an investigation report itself states that the investigation is incomplete, then such an investigation report does not meet the obligatory requirements of law.
• Kamal Lochan Sen v. State of Orissa (1982) 54 CLT 509 – This case was cited to support the principle that Section 173(8) of the CrPC does not enable the inspector to submit an incomplete or preliminary report and later on submit a final report.
• AV Dharma Reddy v. State of A.P. & Ors., 2011 CriLJ 185 – This case was cited to support the principle that Section 173(8) of the CrPC does not enable the inspector to submit an incomplete or preliminary report and later on submit a final report.
• Mansukhbhai Vithaldas Chauhan v. State of Gujarat (1997) 7 SCC 622 – This case was cited to support the principle that the order of sanction must disclose both adequacy of material as well as consideration of the relevant facts.
• K.K Mishra v. State of Madhya Pradesh, (2018) 6 SCC 676 – This case was cited to support the principle that the decision of the Central Government must be reasoned and must be made with proper application of mind.
• Anirudhsinhji Karansinhji Jadeja v. State of Gujarat (1995) 5 SCC 302 – This case was cited to support the principle that the decision of the Central Government must be reasoned and must be made with proper application of mind.
• T.Takano v. SEBI, (2022) 8 SCC 162 – This case was cited to support the principle relating to duty of disclosure.
• Gokulchand Dwarkadas Morarka v. The King, (1947-48) 75 IA 30 – This case was cited to support the principle that a mandatory prerequisite to jurisdiction is the existence of a valid sanction.
• Yusofalli Mulla Noobbhoy v. The King, 1949 Cri LJ 889 – This case was cited to support the principle that a mandatory prerequisite to jurisdiction is the existence of a valid sanction.
• Mohd. Iqbal Ahmed v. State of Andhra Pradesh (1979) 4 SCC 172 – This case was cited to support the principle that a mandatory prerequisite to jurisdiction is the existence of a valid sanction.

Decision

The Supreme Court set aside the judgment of the Bombay High Court and upheld the constitutional validity of Section 140(5) of the Companies Act, 2013. The Court held that the resignation of an auditor does not terminate proceedings under Section 140(5). The Court further held that the SFIO report was a complete report on IFIN and that the direction to prosecute was issued after due consideration of the SFIO report. The Supreme Court observed that the High Court had misinterpreted the provisions of Section 140(5) and the legislative intent behind the provision.

The Supreme Court emphasized that the purpose of Section 140(5) is not merely to change the auditor but to determine the fraudulent conduct of the auditor and to impose penalties as prescribed in the second proviso to Section 140(5). The Court held that the NCLT has the power to inquire into the conduct of the auditor and reach a satisfaction regarding the auditor’s fraudulent conduct. The Court also held that the second proviso to Section 140(5) is a substantive provision and operates on the final order of the NCLT. The Court further held that the first proviso to Section 140(5) is an interim measure to prevent an existing auditor from continuing. The Court held that the proceedings under Section 140(5) must continue to their logical end, irrespective of the auditor’s resignation, to determine fraudulent conduct and apply the second proviso.

Flowchart of Section 140(5) Proceedings

Key Takeaways

The Supreme Court’s judgment has significant implications for corporate governance and auditor accountability:

• Auditors Cannot Escape Scrutiny: Auditors cannot evade scrutiny for fraudulent activities by simply resigning. Proceedings under Section 140(5) will continue regardless of resignation.
• Emphasis on Fraud Determination: The primary purpose of Section 140(5) is not just to change auditors but to determine if they have engaged in fraudulent conduct.
• Five-Year Ban: Auditors found guilty of fraud will face a five-year ban from auditing any company, reinforcing accountability.
• Constitutional Validity Upheld: The Supreme Court has affirmed the constitutional validity of Section 140(5), strengthening its legal standing.
• SFIO Reports: The judgment underscores the importance of SFIO reports and the Central Government’s power to initiate prosecution based on these reports.
• NCLT Powers: The judgment clarifies the powers of the NCLT to inquire into auditor conduct and take appropriate action.
• Corporate Governance: The ruling reinforces the need for robust corporate governance practices and auditor independence.