The Bombay High Court (‘BHC’), through its order dated April 21, 2020, has quashed the actions initiated by the Ministry of Corporate Affairs, Union of India (‘MCA’) and the Serious Fraud Investigation Office (‘SFIO’) before the National Company Law Tribunal, Mumbai (‘NCLT’) and the Special Court, respectively, against the erstwhile auditors of IL&FS Financial Services Limited (‘IFIN’), including BSR & Associates LLP (‘BSR’). In doing so, the BHC has given a restrictive interpretation to Section 140(5) of the Companies Act, 2013 (‘Act’). Further, the BHC has also considered the scope of the sanction to be issued by the MCA in terms of Section 212 of the Act. This Client Alert sets out the key observations made by the BHC in its judgment.

A.       BRIEF FACTS

1.      BSR and Deloitte Haskins and Sells LLP (‘Deloitte’) were the joint statutory auditor of IFIN, a subsidiary of IL&FS Limited (‘IL&FS’), for the Financial Year 2017-18. Mr. N. Sampath Ganesh was the partner in charge of the audit on behalf of BSR. Prior to this, Deloitte had been the sole auditor of IFIN for nine years (i.e. for the Financial Years 2007-08 to 2016-17). Deloitte retired as a statutory auditor of IFIN by rotation after its audit for the Financial Year 2017-18. Thereafter, BSR continued as the sole statutory auditor of IFIN.

2.       In view of alleged delayed provisioning, constant ever-greening of debts, etc. by IL&FS, the MCA directed the SFIO to conduct an investigation into the affairs of IL&FS and its subsidiary companies. Pursuant thereto, the SFIO submitted two interim reports; one on November 30, 2018 and the other on May 28, 2019. The latter report pertained to the investigation carried out with respect to the affairs of IFIN. Basis the second interim report, the MCA issued a sanction order on May 29, 2019 (‘Sanction Order’). The Sanction Order inter alia directed the SFIO to initiate prosecution against the auditors inter alia under Section 447 of the Act. The Sanction Order also directed the initiation of proceedings under Section 140(5) of the Act against the auditors.

3.      Pursuant to the Sanction Order: (a) the SFIO filed a criminal complaint CC No. 20 / 2019 (‘Criminal Complaint’), before the Special Court, Mumbai; and (b) the MCA filed a Company Petition bearing No. 2062 / 2019 (‘Company Petition’) before the NCLT under Section 140(5) of the Act against the auditors.

4.      BSR tendered its resignation as statutory auditor of IFIN on June 19, 2019. The causal vacancy caused by the resignation of BSR was subsequently filled by IFIN by appointing M/s Mukund M Chitale (‘MMC’) at its extra-ordinary general meeting dated July 11, 2019.

5.        The maintainability of the Company Petition was challenged by the auditors before the NCLT on the ground that Section 140(5) of the Act is not applicable to erstwhile auditors. This challenge was dismissed by the NCLT by way of its order dated August 9, 2019 (‘First Impugned Order’).

6.        BSR along with its partner-in-charge for the mandate Mr. N. Sampath Ganesh, filed a writ petition before the BHC on August 14, 2019 against the MCA and the SFIO (‘Writ Petition’), challenging: (a) the vires of Section 140(5) of the Act; (b) the jurisdiction of the NCLT under Section 140(5) of the Act as against BSR, given that it had resigned w.e.f. June 19, 2019, and the First Impugned Order; and (c) the legality of the Sanction Order and the consequent Criminal Complaint filed before the Special Court. BSR amended the Writ Petition to also challenge a subsequent order of the NCLT dated October 18, 2019 in the Company Petition, wherein the NCLT directed that the appointment of MMC will be considered as an appointment under the first proviso of Section 140(5) of the Act (‘Second Impugned Order’).

7.       Various other petitions were filed by Deloitte and its partners challenging the vires of Section 140(5) of the Act as well as the Sanction Order. A petition was also filed on behalf of Hari Shankaran, an erstwhile director of IFIN, challenging the Sanction Order. These petitions were also heard along with the Writ Petition.

8.       All the aforesaid petitions were decided by the BHC by way of a common order and judgment dated April 21, 2020 (‘Judgment’).

B.       KEY FINDINGS

Challenge to the Sanction Order and Criminal Complaint

Re: MCA’s power to issue the Sanction Order:

1.      BSR had contended that prosecution can be initiated by the SFIO under Section 212(14) of the Act only on the basis of an “investigation report”, issued upon completion of investigation as per Section 212(12) of the Act. It was further contended that such an investigation report is different from an “interim report” under Section 212(11), which is issued when the investigation is still pending. Further, it is the investigation report, which is deemed to be report under Section 173 of the Code of Criminal Procedure, 1973 (‘CrPC’) and can be relied upon for initiating criminal prosecution.

2.        In the present case, the SFIO had referred to its report dated May 28, 2019 as the “second interim report” and from the Sanction Order as well as the report itself, it was evident that the investigation was not yet complete as the cross linkages and transactions of IFIN with other group companies was yet to be investigated. In view thereof, it was contended that the SFIO’s report could not be considered an “investigation report” and hence, no prosecution could have been initiated on the basis of this report.

3.        BHC made the following observations:

(a)     Prosecution can be initiated on the basis of an interim report or an investigation report, insofar as the report is sufficient to support a charge. It is this report, submitted by the SFIO to the Special Court for the purpose of framing charge that needs to be recognized as a report under Section 173 of the CrPC as per the deeming fiction under Section 212(15) of the Act. However, if such a report points out the possibility of change of conclusions therein due to subsequent investigation, it cannot be seen as a report for framing the charge as the definite charge cannot be framed or founded on it;

(b)      The word “interim” may not always imply that the conclusions of SFIO are tentative or provisional and likely to change as the investigation progresses. However, in the present case, the burden was on the MCA / SFIO to demonstrate that there was at least one final determination in the report. However, MCA / SFIO have failed to show any one transaction as an illustration of full investigation that is complete in all respects and is sufficient to sustain the charges for which the prosecution is directed;

(c)      The MCA / SFIO further failed to show that the investigation by SFIO into affairs of other companies or into cross-linkages cannot have any impact on the present report. In fact, the report itself indicates need of further investigation into cross-linkages and cross-check of transactions with other companies.

4.       In view of the aforesaid, the Court held that SFIO report dated May 28, 2019 could not have been a report under Section 212(14) of the Act. Hence, no prosecution could have been initiated on the basis thereof.

Re: Validity of the Sanction Order:

5.      BSR had also challenged the validity of the Sanction Order on the ground of non-application of mind on part of the MCA. It was also contended that the MCA has shown undue haste with a view to defeat the statutory right of bail which might have accrued to one of the directors.

6.        After considering the contentions of the parties, the Court observed as under:

(a)     Non-application of mind vitiates sanction itself and the consequential prosecution falls to the ground. The sanctioning authority has to consider the entire relevant material which implies application of mind. Its order must disclose that exercise;

(b)      The superior nature of responsibility cast upon that officer / authority and the degree of care to be taken by them while directing initiation of prosecution under Section 212(14) is demonstrated by the provision made by the Parliament for obtaining legal advice;

(c)      It is not the case of the MCA / SFIO that the officer who prepared the processing note had already worked on the case and as such, it was possible for him to prepare that note within short time;

(d)      The contention of the MCA that the processing note and the SFIO report running into 32,000+ pages was considered by two officers within 30 hours, that too, one after the other, appears to be highly improbable;

(e)     The processing note would not absolve the concerned officer of his obligation to apply his mind personally and therefore verify the correctness of the appreciation in the processing note itself;

(f)       A copy of the processing note has not been given to the petitioners and as such an adverse inference needs to be drawn in present facts. The haste with which direction to lodge prosecution was given in less than 30 hours after receipt of a 732 page report of SFIO with about 32,000 pages as annexures, indicates the lack of application of mind;

(g)       As the MCA / SFIO have failed to plead on an affidavit and bring on record the basic facts to indicate a possibility of due application of mind by the authority granting “direction” to prosecute, no disputed question arise in relation to such process. Thus, there is no scope for claiming that arguments about non-application of mind raise a disputed question which can be examined during trial.

7.         In view of the above, the Court held that the Sanction Order suffers from non-application of mind and is void.

Challenge to the First Impugned Order

8.        At the very outset, the Court rejected the objection of the MCA that the challenge to the First Impugned Order is not maintainable in view of availability of the alternate remedy. The Court observed that when a challenge is raised against the wrong assumption of jurisdiction by a Court or a Tribunal, the availability of an alternate remedy cannot operate as a bar in exercising writ jurisdiction by the High Court.

9.       As regards the challenge to the First Impugned Order, BSR had contended that the heading as well as the plain language of Section 140(5) indicates that the object of the provision is removal or change of existing auditors and not to penalise the auditors for any alleged fraud. Thus, the NCLT has the power to only direct the company to “change” its auditor under Section 140(5). The NCLT could not have upheld its jurisdiction to maintain an action under Section 140(5) of the Act against past auditors, by introducing a deeming fiction in absence of any legislation to this effect or the power to do so.

10.       It was further contended that as per the second proviso, once a final order i.e. an order directing “change” in auditors is passed by the NCLT, the 5 year disqualification kicks in automatically, without exercise of any discretion by the NCLT. This shows that the proviso is merely an in terrorem provision imposed by operation of law, in the event an auditor chooses not to resign and forces upon himself a final order under the Section 140(5). It further shows that the object of the section is not to punish an auditor for fraud. In any case, there are various other provisions under the Act, such as Sections 132 and 447, whereby an auditor can be proceeded against in case of any fraud or misconduct.

11.      Keeping in view the aforesaid contentions, the BHC interpreted Section 140(5) as under:

(a)     The object of Section 140(5) is only to prohibit the apprehended mischief further and is not to find guilt or punish the company or its auditors. While the National Financing Reporting Authority has been given power under Section 132 to consider cases under professional misconduct and the Special Court has the power to conduct criminal trial in case of offence under Section 447, the NCLT has not been given any power to debar or disqualify or impose any punishment on the auditor;

(b)      Section 140 deals with removal and resignation of an auditor and not punishment. Section 140(5) has been enacted to infuse confidence in the public in corporate sector and to prevent abuse of the position by company to the detriment of its shareholders. Thus, in a situation where a company does not exercise its power to remove an auditor under Section 140(1) and the auditor does not resign himself, the NCLT can step in under Section 140(5) to remove the unholy nexus between the company and the auditor by directing the company to change its auditor;

(c)     To reach the “satisfaction” required under Section 140(5), NCLT has power to inquire into such involvement of an auditor into fraud. However, it is for limited purpose of reaching the subjective satisfaction for the need to change an auditor and not to punish or to debar the auditor. Even after reaching such a satisfaction, the NCLT has the discretion to pass the final order;

(d)       As per the scheme of Section 140, the auditor has an option to resign even after NCLT has initiated an action under Section 140(5). In fact, an auditor can resign even after the satisfaction has been reached by the NCLT and before a final order is passed. Any self-respecting and reasonable auditor who recuses himself by accepting the satisfaction of NCLT cannot be visited with debarment under second proviso to Section 140(5);

(e)      In case a person has ceased to be an auditor of the company, final order cannot be passed against him as he cannot be changed. Thus, the NCLT cannot assume jurisdiction by taking recourse to the deeming fiction about the auditor continuing in office despite being rotated out or having resigned and such an interpretation would violate the language and the object of the section. A deeming fiction can only be created by the legislature and not by a Tribunal or a Court;

(f)      The auditors who have defrauded the company but have completed their term and left can be tried for professional misconduct under Section 132 or under the Chartered Accountants Act & are therefore not amenable to Section 140(5);

(g)      The debarment under the second proviso follows automatically after a final order and the NCLT has no discretion in that respect. The debarment operates to avoid any unsubstantiated defences being raised by an auditor after the NCLT reached the satisfaction that an auditor needs to be changed. Thus, the purpose of the same is to inculcate more responsibility in the auditor and law expects the auditor to rise to the occasion by not opposing the proposed change by urging frivolous or roving grounds;

(h)     Further, as regards the interpretation of the first proviso to Section 140(5), the Court rejected the MCA’s contention that once the proceedings under Section 140(5) of the Act are initiated, only the Central Government is authorized to appoint or change the auditors under the first proviso. The Court observed that the power give to the Central Government under the first proviso to Section 140(5) does not take away the power of the concerned company to appoint an auditor of its choice.

12.       In view of the above, the BHC held that the exercise of jurisdiction by the NCLT upon BSR, a past auditor, by applying the theory of deemed continuation, is an error apparent which ought to be corrected in exercise of the extraordinary jurisdiction by the Court. In view of the decision of the BHC regarding non-application of Section 140(5) to the erstwhile auditors, the challenge to the Second Impugned Order also stood decided in favour of BSR.

Challenge to Constitutional Validity of Section 140(5) of the Act

13.      It was BSR’s contention that Section 140(5) of the Act, as being interpreted and used in its current form, by the NCLT and the MCA, is violative of Article 14 of the Constitution of India. BSR challenged the vires of this Section on inter alia the ground that it is discriminatory and manifestly arbitrary as it: (a) fails to prescribe a procedure to be followed by NCLT for arriving at a finding of fraud; (b) treats auditors unequally vis-à-vis the directors of the company, by subjecting the auditors to a summary procedure in case of fraud, while the directors and other officials of the company, who may be actual perpetrators are granted protection of a full trial under the CrPC; (c) permits authorities to pick and choose between remedies as well as application of the remedies against the auditors; (d) leads to double jeopardy as the auditor suffers automatic disqualification for the same offence of fraud, once under the second proviso to Section 140(5) after finding of fraud by NCLT and again under Section 141(h)(3) after conviction under Section 447 by the Special Court; (e) is disproportionate as the NCLT has no discretion to alter the period of disqualification.

14.      As discussed above, the BHC accepted the interpretation of Section 140(5) as submitted by BSR. Accordingly, the BHC read down the scope of Section 140(5) from what was alleged by the MCA and accepted by the NCLT. In view of the interpretation placed by the Court it upheld the constitutionality of Section 140(5) and made the following observations:

(a)     The scope of Section 140 (5) is not to punish but only direct a change in the auditors. Such a power is discretionary upon reaching a “satisfaction” which being quasi-judicial in nature and is assailable as per law;

(b)      NCLT has its own rules that enable it to devise a suitable procedure to meet the principles of natural justice and the opportunity to cross examine and submit integral documents is unwarranted at the stage. Further, the element of subjective satisfaction under Section 140(5) rules out the need of a full-fledged inquiry;

(c)       Director of a company or its officers (paid servants of company) forms a distinct class and are to be seen as part of the establishment of the Company. However, a statutory auditor stands on an entirely different footing and cannot be seen as an officer of or subordinate to a company in any manner. The directors or the officers must identify themselves with the company’s affairs while the statutory auditors have to be aloof and neutral. Thus, there is no similarity or equality amongst them and argument based on discrimination is misconceived;

(d)    Debarment of the auditors under Section 140(5) does not lead to double jeopardy as the same is not for the offence of fraud. Further, principles of double jeopardy do not apply to disqualification which is different from punishment and is generally for a fixed term prescribed by the legislation;

(e)      Debarment cannot be perceived as disproportionate to the scheme of Section 140(5) as its purpose is to inculcate more responsibility in the auditor by requiring the auditor not to oppose the proposed change once a satisfaction is reached by the NCLT;

(f)      Since the powers under Section 140(5) is different from Section 132 or Section 447 there is no question of “pick and choose” in the present case.

C.        RELIEFS GRANTED

1.        In view of its findings with respect to the Sanction Order, the BHC held the same to be unsustainable. Consequently, it set aside the Sanction Order as well as the criminal prosecution launched by way of the Criminal Complaint. However, upon a request made on behalf of the MCA, the BHC stayed the operation of the judgment, to the extent it quashes the Sanction Order and the Criminal Complaint, for a period of 8 weeks. At the same time, the High Court also extended the protection of interim order dated September 4, 2019 (insofar as it directed the MCA / SFIO to not take any coercive steps qua the Petitioners in the Criminal Complaint) for a period of 8 weeks.

2.      Further, while upholding the constitutionality of Section 140(5) of the Act, the BHC held that the Section is not applicable to the past auditors. Accordingly, the BHC quashed the First Impugned Order of the NCLT and held that the proceedings undertaken by the MCA under Section 140(5) of the Act to be untenable with respect to BSR.