Role of an auditor and liability in case of fraud/ negligence

1. The responsibilities of an auditor have been trenchantly well-known. An auditor is not bound to be a detective, or to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch- dog but not a blood-hound. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful ^1.
2. A person who practices a profession is bound to exercise the care and skill of an ordinary competent practitioner in that profession ². One of the early Indian cases on the aspect of liability of an auditor for certification subsequently found incorrect is the case of CIT v. G M Dandekar of Messers M K Dandekar & Co.³. In this case, the Income Tax Department found several discrepancies in the regular accounts of an assessee and the audited statements prompting it to file a complaint with the Institute of Chartered Accountants of India (ICAI) against the auditor of the assessee. The Disciplinary Committee of the ICAI found that the charge of negligence was made out. On a reference under Section 21 of the Chartered Accountants Act, 1949 (CA Act) to the High Court, the Court held that the auditor owed no duty to the Department to himself investigate the truth and correctness of the accounts of the assessee and since there was no charge against the auditor that he connived with the assessee to mislead the Department, the auditor was held not guilty of the conduct attributed to him.
3. An auditor owes a duty of reasonable care and skill in the discharge of his professional duties. In the Indian context, any deviation from the standards expected of him traditionally attracted disciplinary proceedings before the governing professional body⁴. An award of damages against an auditor in an action for tort is extremely rare in India. Even, suing an auditor for compensation for losses from incorrect certification is quite uncommon. This is even when the English judicial history from which our country has largely borrowed its jurisprudence is packed with cases as early as from the nineteenth century where compensation has been awarded against auditors for misfeasance or negligence. In one rare Indian case where the auditors were sued for compensation for excess taxes paid by the plaintiff-company due to overstatement of sales and the loss of reputation and goodwill due to its financial statements being manipulated, the Bombay High Court dismissed the suit filed by the plaintiff-company as the plaintiff was unable to establish at trial that the defendant-auditors were negligent in the discharge of their duties⁵. Experience tells us that with the standard of proof generally required by Indian Courts for decreeing a law suit, proving allegations of negligence by, or connivance of, auditors would indeed be an uphill task.
4. The Companies Act, 1956 (1956 Act) (now repealed) had provisions under which an auditor could be held liable for civil and criminal action for wrongdoing. The Companies Act, 2013 (2013 Act) also incorporated similar provisions in addition to incorporating additional provisions for tightening the noose around erring auditors. However, an auditor being criminally prosecuted and facing conviction in India for conniving in a fraud in relation to the financial statements of an auditee is also not very common.
5. In case the auditee whose books of accounts or financial statements contain misstatements as a result of fraud, falls within the regulatory purview of the Securities and Exchange Board of India (SEBI), SEBI often assumes jurisdiction under the Securities and Exchange Board of India Act, 1992 (SEBI Act) and the regulations framed thereunder. In addition to proceeding against the management of such company, SEBI is known to even initiate proceedings against the erring auditors of such company on the basis that the auditor concerned engages in an act/ practice which operates as a fraud in connection with listed securities⁶. However, in the case of Price Waterhouse & Co. and Ors. v. Securities and Exchange Board of India⁷, the Bombay High Court held that while exercising the powers under the SEBI Act, it was not open to SEBI to encroach upon the powers vested with the ICAI under the CA Act; however, in a given case, if there was material against the auditor to the effect that he was instrumental in preparing false and fabricated accounts in connivance with the management of the auditee, then SEBI was entitled to pass appropriate orders under SEBI Act in the interest of the investors or securities market. Relying on this judgement of the Bombay High Court, the Securities Appellate Tribunal (SAT) – to which appeals from orders passed by Whole Time Members of SEBI lie – has been consistent in holding that unless there is evidence to show involvement of the auditor in fabrication of books of accounts, the auditor could not be proceeded against under the provisions of the SEBI Act and the regulations thereunder. This view was taken by the SAT inter alia in the case of Price Waterhouse & Co. and Ors. v. Securities and Exchange Board of India⁸ and Mani Oommen v. Securities and Exchange Board of India⁹. The final decision regarding power and jurisdiction of SEBI in such matters is pending with the Supreme Court. While the Supreme Court has stayed certain observations of SAT in its judgement in Price Waterhouse & Co. and Ors.¹⁰ qua powers and jurisdiction of SEBI, the Supreme Court has stayed the full judgement of SAT in Mani Oommen¹¹.
6. Erring auditors, whether of listed companies or unlisted companies, often ended up facing only disciplinary proceedings before the ICAI in terms of the provisions of the CA Act. However, it has often been felt that the track record of ICAI in taking action against its member-auditors was poor.

   Strengthening mechanism for ensuring accountability of the auditor

7. Globally everywhere, unearthing of corporate frauds is a key factor in strengthening of statutory provisions and adoption of stricter measures for better corporate governance. For instance, the failure of Arthur Anderson, an American accounting firm, for its alleged complicity as an auditor in the Enron and Worldcom scandals was a factor in the enactment of the Sarbanes-Oxley Act of 2002 in the USA. In the last three decades, India has also witnessed multiple financial scams, such as the Satyam scandal, the insolvency of Dewan Housing Finance Corporation Limited, the payment default at IL&FS, to name a few, in which the auditors’ roles have invited intense scrutiny and criticism.
8. In the year 2008, in view of changes in the national and international economic environment and expansion and growth of economy of our country, the Central Government decided to repeal the 1956 Act and enact a new legislation to provide for new provisions to meet the changed national and international, economic environment and further accelerate the expansion and growth of our economy¹². The 1956 Act thus came to be replaced by the 2013 Act. The 2013 Act was first tabled as a Bill before the Parliament in August 2009, few months after the Satyam scandal broke.
9. In view of the large amendments to the Bill of 2009 arising out of the recommendations of the Parliamentary Standing Committee on Finance and suggestions of stakeholders, the Central Government decided to withdraw the Bill of 2009 and introduce a fresh Bill incorporating these recommendations and suggestions. The amendments made by Companies Bill, 2011 to the Bill of 2009 included a stricter and more accountable role for auditors and constitution of National Financial Reporting Authority (NFRA) with a mandate to inter alia oversee quality of service of professionals associated with compliance of accounting and auditing standards.
10. NFRA constituted under Section 132(1)¹³ of the 2013 Act is contemplated to be akin to the Public Companies Accounting Oversight Board (PCAOB) created by the Sarbanes-Oxley Act of 2002 in the USA and Financial Reporting Council (FRC) in the UK in its objective viz. independent statutory oversight of company auditors. Under Section 132(4), NFRA has the power to investigate into matters of professional or other misconduct committed by Chartered Accountants or firm of CAs in relation to audit of companies and recommend punishment including debarment of erring members of ICAI for a period not less than six months or such higher period not exceeding ten years. Furthermore, in terms of the proviso to Section 132(4)(a), the moment NFRA initiates investigation, ICAI loses its jurisdiction to initiate or even continue proceedings in matters of misconduct. In terms of Rule 3 of the National Financial Reporting Authority Rule, 2018, the NFRA has the power to initiate investigation of auditors of (i) listed companies, (ii) unlisted companies with paid up capital of Rs. 5 crore or more or annual turnover of Rs. 1,000 crore or more or aggregate outstanding loans, debentures and deposits of Rs. 500 crore or more in the immediately preceding financial year, (iii) insurance/ banking/ electricity-supply companies, (iv) companies governed by special enactments etc. Rule 10(3)(a) provides that the NFRA has the sole jurisdiction to initiate action in respect of cases of professional or other misconduct against auditors of the companies referred to in Rule 3. Thus, in case of companies where the stakeholders are larger in number or companies which can be regarded as important owing to its size or scale of operations, the jurisdiction to launch disciplinary proceedings against its auditors in respect of their audit function has been taken away from the ICAI and vested in the NFRA.
11. Another provision introduced in the 2013 Act for increasing the accountability of company auditors is Section 140(5). While the 1956 Act had provisions for removal of auditors on giving a special notice¹⁴ which have largely been retained in the 2013 Act, the new amendments introduced in sub-section (5) of Section 140 provides that if the National Company Law Tribunal (NCLT) is satisfied that an auditor has 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, either on its own or on an application made by the Central Government or by any person concerned, direct the company to change its auditors. In terms of the first proviso to Section 140(5), if the application under this Section is made by the Central Government and the NCLT is satisfied that any change of the auditor is required, it shall within 15 days of receipt of the application, pass an order directing that the auditor concerned shall not function as the company’s auditor and the Central Government may appoint another auditor in his place.
12. The language of sub-section (5) of Section 140 which empowered the NCLT to direct a change in the auditors of a company led to ambiguity over the applicability of this provision in the event the auditors resigned on their own.

    Supreme Court judgement dated 3rd May, 2023 in the case of Deloitte Haskins and Sells¹⁵ on the effect of resignation of an auditor on the applicability of Section 140(5)

13. This case arose on account of applications made by the Central Government before the NCLT under Section 140(5) of 2013 Act against the statutory auditors of the IL&FS group. Prior to the filing of these applications, the auditors of the respective IL&FS group companies had resigned as statutory auditors. Before the NCLT, these auditors challenged the maintainability of these applications on the ground that they had already resigned as auditors; since according to them, the objective of Section 140(5) of the Act was to effect a change in the auditors of a company, no further action could be taken by resorting to Section 140(5). The NCLT rejected these submissions and held the applications to be maintainable.
14. Assailing the orders of the NCLT, these auditors challenged the constitutional validity of Section 140(5) of the 2013 Act before the Bombay High Court and also the action initiated against them including criminal complaints filed against them for their alleged role in the IL&FS matter. In its final judgement dated 21st April, 2020, the Bombay High Court upheld the constitutional validity of Section 140(5) but held that once the auditors had resigned, no further action could be taken against them under Section 140(5) of the 2013 Act¹⁶. This judgement was challenged by the Central Government before the Supreme Court.
15. Before the Supreme Court, it was argued on behalf of the Central Government that the second proviso to Section 140(5) provided that an auditor against whom a final order has been passed by the NCLT under Section 140(5) shall not be eligible to be appointed as an auditor of any company for a period of five years and therefore merely because an auditor resigned, the proceedings could not come to an end since the provisions also contemplated further action in addition to the removal of the auditor¹⁷.
16. The Supreme Court analysed the role of an auditor in the affairs of a company interalia observing that he should be independent and above board. It considered the legislative history of Section 140(5) including the recommendations/ report of the Parliamentary Standing Committee on Finance¹⁸ and noted that one of the reasons for providing stricter accountability for auditors was the “past experiences of corporate fiascos”. The Supreme Court also noted the suggestion of the Parliamentary Standing Committee on the Bill of 2009 which was to make the provision more stringent and to provide for consequences for an auditor when such auditor is found to have perpetrated a fraud and is removed for such fraud.
17. Finally, reversing the view of the Bombay High Court that once the auditors had resigned, no further action could be taken against them under Section 140(5) of the 2013 Act, the Supreme Court held that the direction to remove an auditor could be said to be only an interim or pro tem measure to prevent an existing auditor from continuing and substitute him with an auditor based on a prima facie satisfaction that a fraud has been perpetrated and when circumstances warrant the substitution of such auditor. This interim or pro tem measure was meant to operate during the pendency of the detailed enquiry under Section 140(5) and before any final order is passed by the NCLT to find out whether or not the auditor 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 directors or officers. It was further held that powers of the NCLT in Section 140(5) were quasi-judicial in nature and it would have the powers of a civil court to examine the role of auditors and adjudicate on their fraudulent conduct and abdication of their function. Holding that the second proviso to Section 140(5) was a substantive provision, it was held that the consequences of debarment for a period of up to five years came into effect on the final order passed by the Tribunal under Section 140(5) if there was a finding that the auditor has indeed acted fraudulently. On these grounds, it was held that suo motu resignation of the auditor made no difference to the applicability of Section 140(5) of the 2013 Act.
18. Therefore, it is now clear that merely by resigning as an auditor, an auditor cannot escape the invocation of this provision for a period through which he was the company’s auditor. Section 447 of the 2013 Act is also a new provision which stipulates that any person found guilty of fraud, shall be punishable with imprisonment for a term of not be less than six months but which may extend to ten years and a fine. “Fraud” for the purposes of Section 447 includes any act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss ¹⁹. The definition is wide enough to include the misfeasance committed by auditors, in its ambit.
19. In my view, the standard of proof that would be required before the NCLT to establish a charge of fraud by an auditor should be no less than the standard of proof required by civil Courts for decreeing a law suit in an action on fraud. This is because a finding on whether a fraud has been perpetrated or not cannot be decided in summary proceedings without assiduous examination of evidence and its relevance. And, it would be unjust to render a finding in a hurried and summary manner. With NCLT exercising powers of a civil court in such adjudication viz. exercising powers to summon attendance of witnesses, examining them on oath, discovery, inspection, production of books and documents etc., the process is expected to be anything but quick especially considering the existing caseload on different benches of the NCLT.

    Recent amendments to the Prevention of Money Laundering law to cover certain professional activities

    20. Section 2(1)(sa)(vi) of the Prevention ofMoney Laundering Act, 2002 (PMLA) empowers the Central Government to designate persons carrying on certain notified activities as “person carrying on designated business or profession”. Pursuant to this, by Notification ²⁰ dated 3rd May, 2023, the financial transaction inter alia of creation, operation or management of companies, limited liability partnerships (LLPs) or trusts, and buying and selling of business entities carried out by “relevant person” on behalf of his client, in the course of his or her profession has been notified for the purpose of Section 2(1)(sa). A “relevant person” has been defined to include practicing Chartered Accountants, practicing Company Secretaries and practicing Cost and Works Accountants.

    21. A reporting entity under PMLA includes “person carrying on designated business or profession” and has the obligation to maintain the prescribed records and report suspicious transactions as prescribed in the Prevention of Money Laundering (Maintenance of Records)Rules, 2005. Thus, practicing Chartered Accountants, practicing Company Secretaries and practicing Cost and Works Accountants who, on behalf of their clients and in the course of their profession, create, operate or manage companies, LLPs or trusts, or buy and selling business entities are now required to maintain records and report suspicious transactions, if any, thereby significantly increasing their compliance, risk and even accountability.

    22. The Financial Action Task Force (FATF) ²¹, in its report on Professional Money Laundering (July, 2018), noted that professional service providers to set up corporate structures have often been used to launder money, and that accountants were favoured due to the range of skills and services that they may provide. Being a full-member nation of the FATF since 2010, India is under an obligation to continue to strengthen its anti-money laundering framework amid growing challenges of novel ways which unscrupulous persons adopt to launder money. It is perhaps due to this obligation and past experience that the Government has thought it fit to include certain professional activities carried on by professionals under the ambit of reporting requirements under the PMLA.

    23.  With these recent developments, the days of self-regulation for the profession of auditors/ accountants are virtually over. Auditors and accountancy professionals are often regarded as financial watchdogs; the watchdog is being made increasingly more accountable. Surely now, the watchdog has someone watching on him.

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1. In re Kingston Cotton Mill Company (No. 2), 1896 2 Ch. 279 (E)
2. Wong Kiong Hung v. Chang Siew Lan (f), [2009] 4 MLJ 183
3. AIR 1953 Mad 152
4. Institute of Chartered Accountants of India/ ICAI
5. Tri-sure India Limited v. A.F. Ferguson & Co. and Ors. (1987) 61 CompCas 548 (Bom.)
6. Regulation 3 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 prohibits any act or practice which operates as a fraud in connection with listed securities.
7. (2011) 2 Bom CR 173
8. 2019 SCC OnLine SAT 165
9. 2022 SCC OnLine SAT 60
10. Interim Order dated 18th November, 2019 passed in Civil Appeal Nos. 8567-8570 of 2019.
11. Interim Order dated 11th July, 2022 passed in Civil Appeal No. 3671 of 2022.
12. Refer Statement of Objects and Reasons of Companies Act, 2013.
13. Notified on 1st October, 2018 and NFRA was established on the same date.
14. Section 225 of the Companies Act, 1956.
15. Union of India & Anr. v. Deloitte Haskins and Sells LLP & Anr. 2023 SCC OnLine SC 557
16. N. Sampath Ganesh v. Union of India 2020 SCC OnLine Bom 782
17. Second proviso to Section 140(5) reads as follows: 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.
18. In setting out the guiding principles underlying the Companies Bill, 2009, the Parliamentary Standing Committee had noted as follows: “In light of the recent experiences in corporate mis-governance, process of audit and functioning of auditors to be made more independent and effective; stringent joint and individual liability prescribed; setting up of oversight body to set standards and supervise quality of audit recommended.”
19. Explanation (i) to Section 447 of the Companies Act, 2013.
20. S.O. 2036(E) issued by the Ministry of Finance (Department of Revenue).
21. FATF is an independent inter-governmental body set up in 1989 that develops and promotes policies to protect the global financial system against money laundering, terrorist financing and the financing of proliferation of weapons of mass destruction.