Supreme Court uploads constitutional validity of 140(5) of Companies Act

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Supreme Court allows SFIO probe against auditors of IL&FS Financial Services. The company had an aggregate debt burden of more than Rs 91,000 crores, occurred between June to September, 2018, which threatened to collapse the money markets of India, besides putting pressure to corporate bond yields and sparking a sell off in the stock market

The Supreme Court has on Wednesday upheld the constitutional validity of Section 140(5) of the Companies Act 2013 which deals with removal and resignation of auditors, by declaring that the provision is not discriminatory, arbitrary or violative of Articles 14 (equality), 19(1)(g) of the Constitution (right to carry on profession).

A bench of Justices M R Shah and M M Sundresh found as “erroneous” and “unsustainable” a Bombay High Court's ruling of April 21, 2022 by which it had set aside the government's decision to ban former auditors of IL&FS Financial Services, BSR & Associates LLC and Deloitte Haskins and Sells LLP on the ground that the provisions cannot be applied to former auditors. 

The top court allowed Serious Fraud Investigation Office (SFIO) to carry on with criminal proceedings against the former auditors of IL&FS Financial Services for their role in the alleged financial irregularities at the firm. 

The bench said the enquiry or proceedings has to go to its logical end and subsequent resignation or discontinuance of an auditor shall not terminate it.

The court was not impressed with a submission against the five-year ban on auditors, saying they play very important role in the affairs of the company and, therefore, they have to act in the larger public interest and all other stakeholders including investors, etc.

The court also told the National Company Law Tribunal to decide the government’s plea for a five-year ban on the auditors for failing to red flag problems in IFIN as per the mandate of law.

Justice Shah, who authored the judgement, said the SFIO can proceed with its 2019 criminal complaint before a Greater Mumbai court on its own merits while setting aside the Bombay High Court judgment which had quashed criminal prosecution initiated against the two firms and their chartered accountants.

The financial affairs of IL&FS Group came under scanner in 2018 after it defaulted on short-term and long-term debt obligations to the tune of Rs 91,000 crore. 

IL&FS Financial Services (IFIN) was audited by BSR, a KPMG-affiliated firm, in FY19 and jointly by BSR and Deloitte in FY18. Deloitte was the sole auditor of the firm in FY16 and FY17.

The SFIO had then filed a criminal complaint against 30 parties in the IL&FS case, including Deloitte and BSR, alleging that the auditors colluded with officials of IFIN to conceal facts and fraudulently falsified the books of accounts, and financial statements from FY14 to FY18.

The SFIO had also claimed that audit firms had acted in breach of auditing standards and had failed to detect financial inconsistencies at IL&FS.

While allowing the probe, the bench clarified that it has not expressed anything on merits on the allegations against the auditors and it is ultimately for the NCLT to pass a final order.

The court rejected a contention that the automatic disqualification of auditors and the entire firm, including partners, and that too for five years is highly disproportionate.

It is ultimately for the legislature/Parliament to provide the debarment. On the principle of joint and severe liability, the auditors and the entire firm including partners shall be liable and, therefore, can be subjected to Section 140(5) and the consequences like five-year ban, the bench said.

The court also rejected the stand of the auditors that the disqualification is akin to civil death and as the removal provisions impinged upon their fundamental rights.

"Nobody can be permitted to say that despite acting fraudulently they had a right to carrying on their profession. It is a very serious misconduct and, therefore, the necessary consequence shall follow," the bench said.

Case Title: Union of India and Another vs. Deloitte Haskins and Sells LLP & Anr