The Increasing Accountability of Auditors for Fraud

Introduction

Statutory auditors play a significant role in ensuring the accuracy and reliability of financial information provided by companies. The work done by auditors is essential for investors, stakeholders, and the general public to make informed decisions. Legislators, courts, and regulators across the world have repeatedly discussed and assessed the extent of responsibility and accountability of statutory auditors. The discussion has further gained centre stage on multiple occasions on the back of various corporate scams and large-scale financial misgovernance issues in the past 10–15 years. The global landscape demanded a change towards a more stringent liability regime for statutory auditors, especially in cases of corporate fraud.

In India, the Satyam scandal served as a catalyst for important changes in the accountability of auditors and the way they are regulated. Traditionally, statutory auditors in India were self-regulated only through the Institute of Chartered Accountants of India (ICAI), governed by the Chartered Accountants Act, 1949 (“CA Act”). The need to introduce an independent body for regulating statutory auditors was discussed by a parliamentary committee as far back as 2009. A subsequent parliamentary committee recommended giving the independent regulator quasi-judicial powers to ensure better accountability through independent oversight. The Supreme Court of India in S Sukumar v Secretary, ICAI and Ors, (2018) 14 SCC 360 directed the government to consider implementing appropriate legislation for oversight of statutory auditors in line with the Sarbanes-Oxley Act, 2002 and Dodd Frank Wall Street Reform and Consumer Protection Act, 2010 in the US. As a result, the Indian Parliament established an autonomous regulatory body, the National Financial Reporting Authority (NFRA), in October 2018. This marked a significant step toward ensuring independent and effective oversight of statutory auditors in India, fostering transparency and accountability in the corporate sector.

The Companies Act, 2013 (the “Act”) also introduced several provisions aimed at enhancing auditor accountability in order to improve the detection of corporate fraud and promote transparency within the corporate sector. For instance, statutory auditors are mandated to report fraud if they suspect or have reasonable grounds to believe that a fraudulent act has occurred within the company under Section 143(12) of the Act. Sub-section (5) of Section 140 of the Act introduced a significant deterrent on statutory auditors to reinforce the commitment to support the highest standards of corporate governance and financial probity. Section 140(5) emphasises the importance of statutory auditors acting as watchdogs to safeguard against financial misconduct and corporate fraud by adding an automatic disqualification of five years if the auditor 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.

Recent development: Supreme Court’s Judgment

Recently, the Supreme Court re-emphasised India’s adoption of the global trend toward greater accountability for statutory auditors in its recent judgment in a batch of matters titled Union of India v Deloitte Haskins and Sells LLP, (2023) 8 SCC 56 (“Judgment”).

The Judgment is a first-of-its-kind verdict on Section 140(5) of the Act and represents a significant development in the realm of statutory audits. With this Judgment, the interpretation and application of Section 140(5) appears to differ from the provision’s limited text and is expanded in light of the mischief the provision set out to protect against – ie, punish past and present statutory auditors for any involvement in fraudulent activities. The application of Section 140(5) now entails automatic disqualification of statutory auditors encompassing a broad spectrum of potential circumstances covering both past and future statutory audits. The Supreme Court, in interpreting Section 140(5) based on its objective rather than its text, has reinforced the global trend of increasing accountability of statutory auditors.

In this article, the authors delve into the consequences of the Judgment on the statutory auditors, shedding light on the essential ingredients of Section 140(5) that may result in an auditor’s five-year disqualification. This exploration not only dissects the nuances of Section 140(5) within the context of the Judgment, but also illuminates its broader implications on auditor liability.

Furthermore, we explore additional facets within the Judgment, which, while not directly tied to Section 140(5), bear significant relevance from a fraud detection perspective. One such facet was the directions issued by the government pursuant to the Serious Fraud Investigation Office (SFIO) report. In this regard, the Judgment highlighted that non-application of mind cannot be presumed merely because the direction to prosecute the statutory auditors was issued in less than 48 hours.

Through this discussion, we aim to provide a comprehensive understanding of how the Judgment reshapes the landscape for disqualification of auditors involved in frauds and underscores the evolving global emphasis on statutory auditors improving fraud detection and prevention.

The text of Section 140 of the Act

Section 140 of the Act primarily deals with the procedures and processes related to the appointment, resignation, and removal of statutory auditors for companies in India. It outlines the steps for altering a company’s auditor, including the process for changing an auditor through a court. In essence, this provision outlines the mechanisms through which alteration in a company’s statutory auditors can be seamlessly orchestrated within the framework of the law.

Sub-section (5) of Section 140 enables the National Company Law Tribunal (“Tribunal”) to direct a company to replace its auditor under specific circumstances – ie, where the Tribunal determines that the company’s auditor 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. The essential ingredients mandated under this provision are (i) the existence of fraud affecting the company, and (ii) the auditor’s direct involvement in either committing or aiding such fraudulent activities. In essence, it empowers the Tribunal to change a company’s auditor in situations where the company’s auditor and management are partners in crime.

Under the first proviso to Section 140(5), the Tribunal may prohibit a statutory auditor from continuing as the auditor for a company. Instead, the Tribunal can instruct the central government to appoint a replacement auditor if it deems such a change in the auditor is necessary. This provision underscores the Tribunal’s power to immediately address issues of integrity and effectiveness of auditing within a company.

The second proviso to Section 140(5) provides that an auditor against whom a final order is passed becomes ineligible to serve as a statutory auditor for any company for a duration of five years. This restriction applies to both audit firms and individual chartered accountants. This five year disqualification is an automatic consequence arising from the Tribunal’s order directing a company to change its auditor.

The fundamental rationale behind Section 140(5) of the Act is to prevent an auditor who has been identified as being involved in fraud or collusion in one company from engaging in any statutory audits for a five-year period, regardless of the company in question. This provision seeks to encourage fraud detection and reporting by statutory auditors and aims to increase the integrity of auditing practices by penalising statutory auditors connected to fraudulent activities.

The Judgment’s context – relevant background and key issue

The Judgment is an offshoot from the crisis that hit Indian markets due to the inability of Infrastructure Leasing and Financial Services Limited (ILFS) and its group companies to meet their debt obligations. The ILFS crisis highlighted the vulnerability in the shadow banking sector and impacted the stability of the entire Indian financial market as the ILFS group had a debt of approximately USD12.8 billion.

The ILFS crisis raised questions about corporate governance, regulatory oversight, and the need for better risk assessment in the financial sector. The government tasked SFIO with investigating into the affairs of ILFS and its subsidiary companies. SFIO’s first conclusive investigation report related to one of ILFS’s largest subsidiaries – ie, IL&FS Financial Services Limited (IFIN).

SFIO conducted a detailed investigation resulting in a report adding up to 32,000 pages. SFIO raised concerns regarding the conduct of statutory auditors associated with IFIN. SFIO’s assessment discovered discrepancies in the audit work by IFIN’s auditors potentially indicating that the statutory auditors were involved in the fraud by IFIN’s management. In response, the government took steps based on SFIO’s findings. The steps were brought out in a sanction order issued (“Sanction Order”) in less than 48 hours of the 32,000-page report being tabled by SFIO before the government. One significant action against IFIN’s auditors, specifically Deloitte Haskins & Sells LLP (“Deloitte”) and B S R & Associates LLP (BSR), was under Section 140(5) of the Act (“140(5) Petition”). This was in addition to the criminal proceedings initiated under Section 212 of the Act for offences of fraud under Section 447 of the Act.

The government, through the 140(5) Petition, sought directions from the Tribunal to “change” BSR and Deloitte as IFIN’s auditors. This was accompanied with consequential disqualification of both audit firms and their partners who worked on IFIN’s audit for five years.

Deloitte had served as the statutory auditor of IFIN since the fiscal year 2008–9 and had completed the maximum statutory tenure of ten years in this role, which concluded with the fiscal year 2017–18. BSR was appointed as the co-auditor alongside Deloitte for the fiscal year 2017–18, but subsequently resigned from their position as IFIN’s statutory auditor.

Naturally, both sets of auditors asserted that the 140(5) Petition was not maintainable as an order to “change” them as IFIN’s auditors under Section 140(5) of the Act could not be passed since they were no longer the statutory auditors of IFIN. The Tribunal did not agree with the maintainability challenge.

Consequently, BSR and Deloitte challenged the constitutionality of Section 140(5) and the maintainability of the 140(5) Petition before the High Court of Bombay. This legal dispute centred around the fundamental question of whether Section 140(5) could be enforced against statutory auditors who were no longer the statutory auditors of a company.

In addition to the above, BSR and Deloitte also challenged the Sanction Order on multiple grounds, including the grounds of non-application of mind and haste given that the Sanction Order could not have considered a 32,000-page report in less than 48 hours.

The Bombay High Court affirmed the constitutionality of Section 140(5) of the Act. However, it interpreted this provision in a strict and limited manner. The Bombay High Court held that Section 140(5) does not extend to statutory auditors who have formally resigned from their positions or are no longer serving as auditors for the company. The government challenged the Bombay High Court’s verdict before the Supreme Court.

The Judgment – scope of Section 140(5) of the Act

The Supreme Court upheld the constitutionality of Section 140(5) of the Act. It observed that auditors have to act in larger public interest and therefore the law is justified in imposing harsher consequences on statutory auditors who are found to have abetted the fraud rather than the main perpetrators of fraud.

On the interpretation and application of Section 140(5), the Supreme Court held that the provision can be invoked against auditors who were no longer the statutory auditors of the company. It upheld the Tribunal’s power to examine the allegations of fraud against auditors under Section 140(5) of the Act despite resignation and/or discontinuation of the auditors. The Supreme Court clarified that the punishment of disqualification for five years under Section 140(5) is not limited to statutory auditors who resist relinquishing their role but also encompasses statutory auditors from the past who may have already resigned or retired.

Clarifying that the second proviso to Section 140(5) is a substantive provision, the Supreme Court reasoned that the punishment of disqualification was added by parliament to (i) make the provisions against statutory auditors acting in a fraudulent manner more stringent, and (ii) impose inevitable consequences on such auditors. Statutory auditors consequently cannot avoid the final order and consequence of such final order under the second proviso to Section 140(5) by resigning after an application is filed. The Supreme Court held that once a proceeding is initiated under Section 140(5) against a statutory auditor (either past or present), the proceedings need to be taken to their logical end – ie, a determination as to whether the auditor was/is involved in any instance of fraud and, if so, the consequences that should follow.

In order to possibly balance the rights of statutory auditors, the Supreme Court clarified that the disqualification under Section 140(5) of the Act may be imposed only once (i) the Tribunal conducts a comprehensive inquiry on the allegations of fraud by the statutory auditor given that it has all the powers of a civil court to take upon a detailed inquiry, and (ii) the Tribunal determines that the auditor, either directly or indirectly, engaged in fraudulent activities or actively supported or colluded in any fraud connected to the company or its directors or officers. This sets out prerequisites for adjudication of any application seeking disqualification of statutory auditors under Section 140(5) and mandates a procedural framework for assessing statutory auditors’ culpability in cases of alleged fraud.

Additional takeaway from the Judgment – statutory auditors are treated differently than the management of a company

The Judgment highlights the role of an auditor which entails a crucial point of reference and clarity. The Supreme Court underscored the distinctive role of statutory auditors within the framework of the Act. Specifically, it re-emphasised that statutory auditors function as independent examiners of a company’s financial accounts and should not be regarded as holding a position in the company’s administration or management.

This distinction in the roles of statutory auditors compared to the company’s management serves to provide valuable clarity regarding the applicability of other provisions of the Act. These provisions are primarily oriented towards regulating the company itself, its members, board of directors, shareholders, or other individuals actively engaged in the company’s operations. Importantly, this distinction explains that the legal provisions designed to punish the company’s management and regulate its affairs cannot be invoked against statutory auditors.

Additional takeaway from the Judgment – reports issued by SFIO

The Supreme Court in the Judgment clarified that it cannot be presumed that there was a non-application of mind in passing the Sanction Order on the basis of a 32,000-page report of SFIO merely because the direction to prosecute was issued in less than 48 hours.

Another question before the Supreme Court was whether any action could be taken based on SFIO’s report into the affairs of IFIN when SFIO’s larger investigation into the affairs of the entire ILFS group was still ongoing.

The Act distinguishes between two types of reports.

• An interim report – issued by SFIO while an investigation is ongoing.
• A final report – released upon the conclusion of the investigation.

The Supreme Court upheld the validity of the government’s directions based on SFIO’s report on IFIN. This validity holds even though SFIO’s investigation into other aspects related to IFIN and the broader ILFS group are still ongoing.

The Supreme Court explained that SFIO’s report comprehensively addressed the issues within its purview and provided conclusive findings for each of these issues. Therefore, it cannot be considered an incomplete or “interim report” merely because SFIO’s investigations into other aspects or group companies are still pending. This distinction ensures that the government and SFIO can take appropriate actions based on the final findings of SFIO available without having to wait for the entirety of the investigation to conclude.

Conclusion

The courts in India have held that an auditor’s role is that of a watchdog, and not a blood hound within the corporate ecosystem. Their primary responsibility is to safeguard the interests of a company’s shareholders by ensuring that the financials of a company bring out the true and fair picture of the financial conditions of a company. In doing so, the auditors are to detect and prevent fraud committed by the company’s directors and officers. Any evaluation of the extent to which statutory auditors can be held accountable for instances of fraud within a company has to keep in mind this established role of statutory auditors.

The Judgment is a pivotal shift in the application of Section 140(5) and carries substantial implications with heightened accountability for statutory auditors. The key takeaway from the Supreme Court’s interpretation of Section 140(5) of the Act is that the provisions serve not only to facilitate the replacement of a statutory auditor in cases of fraudulent activities but also to impose punitive measures. Importantly, these measures apply not only to currently serving statutory auditors but also extend to former auditors who may have been involved during the period under investigation. The ramifications resonate with the global trend of detailed regulatory rigour and enhanced accountability of statutory auditors involved in corporate frauds as it underscores the seriousness with which fraudulent activities in auditing need to be treated.

This is all the more important because there are various other laws in India which also hold people liable for fraud. One such provision contained in the Act itself is Section 447. This provision provides for criminal liability for all those people who are found guilty of fraud, including auditors. Therefore, the ramifications under Section 140(5) are in addition to other prosecutions, penalties, and liabilities that may fall upon an errant auditor who is involved in fraudulent activities.

The Judgment does aim to strike a potential balance in safeguarding the rights of statutory auditors. The disqualification of five years under Section 140(5) of the Act can be imposed only once the Tribunal, after conducting a detailed inquiry into the allegations, arrives at a conclusive determination that the auditor was directly or indirectly involved in fraudulent activities. Any judicial or quasi-judicial forum assessing allegations of fraud needs to examine complex questions of fact. Thus, the Tribunal needs to adopt a thorough and reliable procedure which safeguards the rights of the statutory auditors while conducting the detailed inquiry under Section 140(5) of the Act. The exact procedural framework that the Tribunal adopts for such matters remains to be seen.

Lastly, the Judgment reinforces the outlook and approach of the government on reports issued by SFIO. It highlights a presumption of diligence for swift actions taken by officers analysing a report from SFIO, despite the voluminous nature of the report. The affirmation that the government can take action based on SFIO’s conclusions, even if broader investigations are ongoing on related topics, indicates that a similar approach is likely to be followed in other investigations, especially those into large-scale corporate fraud which require timely action.