Home » Between The Lines » Supreme Court upholds the constitutional validity of Section 140(5) of the Companies Act, 2013, which inter alia imposes statutory bar on the auditor(s) for a period of five years

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The Hon’ble Supreme Court of India (“Supreme Court”), in the case of Union of India v. Deloitte Haskins and Sells LLP and Another [Criminal Appeal Nos. 2305-2307/2022] (“Judgement”), has upheld the constitutionality of Section 140(5) (Removal, resignation of auditor and giving of special notice) of the Companies Act, 2013 (“Companies Act”), which inter alia renders the auditor(s) ineligible from acting as auditors for any company for a period of five years.

Facts

The Department of Economic Affairs, Ministry of Finance issued an office memorandum dated September 30, 2018 (“Office Memorandum”) requesting the Ministry of Corporate Affairs (“MCA”) to take actions against IL&FS Financial Services Limited (“IL&FS”) under the Companies Act against the alleged series of defaults with an aggregate debt burden of more than INR 91,000 Crores. The MCA directed the Serious Fraud Investigating Officer (“SFIO”) to conduct the investigations. SFIO submitted its interim-report to the MCA on November 1, 2018 (“Interim Report”).

The National Company Law Tribunal (“NCLT”), on a petition filed by the MCA under Section 130 (Re-opening of accounts on court’s or Tribunal’s orders) of the Companies Act basis the Interim Report, directed the re-opening and recasting of the accounts of IL&FS. The auditors BSR & Associates LLP (“BSR”) and Deloitte Haskins and Sells LLP (“Deloitte”) (collectively referred to as “Respondents”) were given notice of the said petition.

Meanwhile, the Reserve Bank of India also initiated an inspection of the IL&FS group, and submitted its inspection report dated March 22, 2019, to the new board of directors of IL&FS. Subsequently, SFIO completed its investigation and submitted its final report to the MCA, on the basis of which MCA filed a petition under Section 140(5) of Companies Act on June 10, 2019 before NCLT against BSR & Deloitte inter alia, for their removal, and barring them to take up audit activities of any company for next five years (“Petition”). The NCLT upheld the maintainability of Petition.

Thereafter, BSR filed a writ petition before the High Court of Bombay (“High Court”) inter alia challenging the constitutionality of Section 140(5) of the Companies Act and challenging the maintainability of the Petition. The High Court upheld the constitutionality of Section 140(5) of the Companies Act, however it set aside the order of NCLT to the extent it had held that the Petition was maintainable against the auditors, primarily on the ground that once the auditor resigns as an auditor or is no more an auditor on his resignation, the proceedings against such auditors stands terminated.

Being aggrieved by the order of High Court, Union of India (“Appellant”) preferred the present appeal before the Supreme Court.

Issues

  • Whether Section 140(5) of the Companies Act is constitutional.
  • Whether a petition under Section 140(5) of the Companies Act is maintainable against an auditor who is no more an auditor of a company.

Arguments

Contentions of the Appellant:

The Appellant submitted that the purpose and legislative intent behind Section 140(5) of the Companies Act was based on the recommendation of the J.J. Irani Committee and the Parliamentary Standing Committees’ Reports and it was to make the role of an auditor more independent, yet accountable. The Appellant relied on the judgement of the Supreme Court in Devas Multimedia Private Limited v. Antrix Corporation Limited and Another [(2023) 1 SCC 216], to contend that the public policy behind Section 140(5) of the Companies Act is to prevent an auditor who has been found to perpetrate fraud or colluding from undertaking statutory audits for a period of five years.

It was also submitted that the second proviso to Section 140(5) of the Companies Act was a substantive provision which is automatically activated on the final order by the NCLT’s satisfaction of fraud or collusion by the auditor company. Yet, in case the NCLT did not find any element of fraud or collusion by the auditor company in its final order, the auditor could be re-instated. It was further submitted that in case Section 140(5) of the Companies Act would cease to apply in case of resignation by the auditor, the entire scheme of Section 140(5) of the Companies Act and Chapter X (Audit and Auditors) of the Companies Act would become nugatory, which was not the legislative intent.

Contentions of the Respondents:

The Respondents submitted that Section 140(5) of the Companies Act was meant to only ensure that a recalcitrant auditor resigns and thus when the auditor had so resigned, the Petition was subsequently not maintainable against such auditor.

It was also contended that the second proviso to Section 140(5) of the Companies Act was arbitrary, harsh and burdensome and ought to be read down as being violative of Articles 14 and 19 of the Constitution of India (“Constitution”). In this regard, it was also contended that the ineligibility to act as an auditor of any company prescribed under the second proviso to Section 140(5) of the Companies Act could only extend to the audit partners concerned and not to the entire firm and the other audit partners who were not connected with such fraudulent acts.

Observations of the Supreme Court

The Supreme Court observed that Chapter X of the Companies Act is a special provision through which the legislators intended to make the provisions for the auditors more stringent and for removal of auditor by the NCLT where there is a fraud committed by such auditor and contemplated that such auditor shall not be eligible to be appointed as an auditor of any company for a period of five years.

The Supreme Court further observed that the power of NCLT under Section 140(5) of the Companies Act is quasi-judicial in nature and it would have the power of a civil court to examine the role of the auditors and adjudicate on their role, more particularly whether it was fraudulent or not. The first proviso to Section 140(5) of the Companies Act provides power to the NCLT to, suo-moto or an application made by the central government, remove such auditor and appoint a new auditor. The measure was in the nature of pro-tem or interim order, based upon the NCLT’s satisfaction that there is a fraud that has been perpetrated and the circumstance requires substitution of the auditor.

The Supreme Court observed that the second proviso to Section 140(5) of the Companies Act was a substantive provision which gets triggered automatically when a final order has been passed by the NCLT after a detailed enquiry to the effect that the auditor of a company has, directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its director or officers. To the corollary, it also observed that the High Court had erred in its interpretation of Section 140(5) of the Companies Act when it held that the proceedings under the section was not maintainable once the auditor had resigned or was no more an auditor for any reason. The Supreme Court also cautioned that such interpretation would have the consequence where every auditor would resign in order to save itself from the stringency of Section 140(5) of the Companies Act and continue perpetrating fraud.

With regards to the constitutionality of Section 140(5) of the Companies Act, the Supreme Court observed that the provision was not discriminatory against the auditors since the role of an auditor is vital in the affairs of the company and therefore, they have to act in larger public interest. In so far as the contention that the ‘automatic effect’ of penalty envisaged under the section was concerned and the contention that it was highly disproportionate, Supreme Court took the view that it was for the legislative wisdom to decide upon the quantity of penalty and how it would take effect. The Supreme Court also observed that Section 140(5) of the Companies Act did not fall within the purview of Article 19 of the Constitution since an auditor’s and its partners’ fundamental right to carry on its profession could not be permitted where it had acted fraudulently, whether directly or indirectly. Such a fraudulent act was a serious misconduct which has to be dealt with sternly and therefore, automatic penalty under Section 140(5) of the Companies Act was a natural consequence of indulging into such misconduct.

Decision of the Supreme Court

The Supreme Court held that resignation of the auditors did not terminate the power of NCLT to take action against them and from attracting penalty envisaged under Section 140(5) of the Companies Act read with Section 447 of the Companies Act. The Supreme Court also upheld the constitutional validity of Section 140(5) of the Companies Act vis-à-vis Articles 14 and 19 of the Constitution.

VA View:

The Supreme Court has rightly upheld the vires of Section 140(5) of the Companies Act. It has given a purposive interpretation to the section in consonance with the legislative intent, that resignation of an auditor or its partner, could not terminate the proceeding under Section 140(5) of the Companies Act if the final order to the NCLT’s satisfaction found element of fraud or collusion, whether directly or indirectly.

The Supreme Court has rightly trisected Section 140(5) of the Companies Act into: (i) the quasi-judicial power of NCLT to adjudge on the role of the auditor; (ii) the power of NCLT to remove the auditor in case of a prima facie satisfaction of fraud, in the nature of an interim order; and (iii) upon a detailed enquiry, if the NCLT finds commission of fraud, to debar the auditor from undertaking audit for a period of five years.

This is a forward looking judgement which will instill confidence in the stakeholders, especially the investors and will act as a deterrent for the defaulting auditors.

For any query, please write to Mr. Bomi Daruwala at [email protected]

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