Dr.

Ram Manohar Lohiya

National Law University,
Lucknow.

FINANCIAL MARKET REGULATION PROJECT

Analysis of Deloitte Haskins & Sells LLP v. UOI

Under The Guidance Of: Submitted by:

Dr. Visalakshi Vegesna
Associate Professor (Law), HOD
Utkarsh Khandelwal
Enrollment No.-160101162
Utkarsh Kumar
EnrollmentNo.-160101163
9th Semester

Acknowledgement
Firstly, I would like to thank our Financial Market Regulations teacher Dr. Visalakshi
Vegesna for giving us such a golden opportunity to show our skills through this project. The
project is a result of an extensive research study, hard work and labour, that is put into to
make it worth reading.
I wish to acknowledge that in completing this project I had full support of my friends as well
as my teacher. This project would not have been completed without the help of our
university’s library Dr. Madhu Limaye library and through the university’s internet.
Table of Contents
Introduction..............................................................................................................................4
The infrastructure Leasing and Financial Services Limited...........................................4
Problem of Illiquidity...........................................................................................................5
An Overview of the Dispute....................................................................................................7
Last line of defence...............................................................................................................8
Solvency crisis.......................................................................................................................9
Limited line of sight.............................................................................................................9
THE JUDICIAL JOURNEY.................................................................................................10
ISSUE wise analysis:..............................................................................................................12
1. Jurisdictional Issue: Challenge to the Sanction Order of the MCA......................12
a. MCA’s power to issue the Sanction Order:.............................................................12
b. Validity of the Sanction Order:................................................................................13
2. Challenge to the NCLT Order dated 09.08.2019 (Impugned Order)....................14
3. Challenge to Constitutional Validity of Section 140(5) of the Companies Act,
2013......................................................................................................................................16
CONCLUSION.......................................................................................................................19
 INTRODUCTION

THE INFRASTRUCTURE LEASING AND FINANCIAL SERVICES LIMITED

It is a systemically important non-banking financial company, has defaulted on its debt

repayments. The Infrastructure Leasing and Financial Services Ltd (IL&FS). From being a
top rated company, it has hurtled towards bankruptcy. In the process, it has roiled the
financial markets and created serious problems for the NBFC sector as well as the small and
medium enterprises (SME) sector, which relies heavily on borrowings from NBFCs. The
IL&FS has for long been a mover and shaker in the field of infrastructure. Its role as a lender
and arranger of finances has been less important than its role as a promoter of infrastructure
projects, often in collaboration with state governments. Its combining of the two roles made it
a rather unique company. The IL&FS enjoyed a triple-A rating from the rating agencies.
To the shock and dismay of the financial world, in early September, it defaulted on a short-
term loan of ₹ 1,000 crore to Small Industries Development Bank of India (SIDBI). In the
weeks that followed, some of its subsidiaries also defaulted on payments. The borrowings of
the IL&FS were quickly downgraded to default and its other arms suffered downgrades of
several notches. Various events followed in quick succession. The media made scathing
comments about the role of management and the board of IL&FS and hinted at serious
irregularities as more defaults followed.

Suppose we agree or admit that all of these are true, then CEOs staying on for too long is not
healthy for companies. And, cronyism between the corporate world and the bureaucracy is a
problem. However, these and the other issues mentioned above cannot by themselves explain
the particular problems that have arisen at the IL&FS.
Take, for instance, the long tenure of Parthasarathy. We have a major player in the financial
sector, Housing Development Finance Corporation (HDFC) Bank, where the CEO has been
around for close to 25 years without his stay inviting serious questions. Cronyism is not
unique to the IL&FS. It has been a feature of capitalism always, and everywhere. It cannot be
cited as a cause of failure of the IL&FS. If anything, well-managed cronyism can be said to
explain the success of several companies and groups in India.
However, we must seek the fundamental causes of failure elsewhere. The IL&FS, as we have
noted, spread its wings wide, over the infrastructure sector. Initially, it relied on long-term
finance from banks. Following the problems faced in infrastructure sector in recent years,
banks chose to reduce their exposure to it. Accordingly, many would not roll over long-term
loans made to the IL&FS. As a result, the IL&FS had to resort to short-term borrowings,
including commercial paper, in order to keep its ongoing projects afloat.
This highlights a fundamental problem of infrastructure financing in India: in the absence of
long-term corporate bonds, infrastructure is financed through short-term liabilities. Banks
have access to a stable source of short-term funds, namely, deposits, but not NBFCs. So,
managing the asset–liability mismatch is more of a problem for an NBFC that ventures into
the infrastructure sector.
In a 34-page affidavit filed with the NCLT, Hari Shankaran, ex-managing director of the
IL&FS, has rebutted all charges of wrongdoing. He outlines the sequence of events that led
the IL&FS into difficulties (Dave 2018). In 2015, when IL&FS faced problems of refinancing
loans, it had proposed a merger with the Piramal group, which has a strong presence in the
financial sector. The merger was expected to result in funds of ₹ 8,500 crore in the merged
entity.
PROBLEM OF ILLIQUIDITY
The IL&FS had a net worth of nearly ₹ 7,000 crore as on 31 March 2018. Thus, it was far
from being insolvent. Its problem was illiquidity arising from the deployment of short-term
funds in long-term assets. We know that, in financial firms, a problem of illiquidity can
quickly turn into insolvency when confidence in a firm evaporates as lenders want their
money back. Lacking liquidity, the firm tries to dispose of assets. A distress sale of assets can
lead to assets being sold below book value. Insolvency soon follows.
The IL&FS has precisely suffered this fate. As news of the impending bankruptcy spread,
various consequences followed. The rights issue was delayed. When it finally happened, it
elicited negligible subscription from its shareholders. Lenders were unwilling to roll over
debt. Defaults, until the first week of October, rose to nearly ₹ 5,000 crore.
The cash infusion required to cover short-term repayments in the coming few months is
estimated to be at least ₹ 25,000 crore. The existing shareholders, notably SBI and LIC, are
in no mood to invest in the IL&FS given the allegations of fraud and the prospect of
insolvency.
There is a case for the central government to bail out IL&FS. Many of the infrastructure
assets at the IL&FS involve the participation of state governments and the IL&FS has been
categorised as “systemically important.” The possible bankruptcy of the IL&FS has
implications for the NBFC sector and the financial markets.
There is a crisis of confidence in the NBFC sector. Banks have cut back on lending to NBFCs
or are not in a position to lend, given their own liquidity position. Mutual funds want to dump
commercial papers of NBFCs that they are holding. Investors in mutual funds are rushing to
redeem their investments, forcing mutual funds to liquidate stocks and other securities. This
has caused the stock market to fall in recent weeks. The SMEs face a shortage of funds as
NBFCs are big lenders to them.
The likely bankruptcy of the IL&FS, thus, carries substantial costs to the economy at large,
apart from the direct costs to the central government through its exposure to banks. There is,
thus, a case for a government bailout of the IL&FS. However, the prospects of such a bailout
appear to be dim. The government is wary of bailing out a private firm in the run-up to the
general elections in 2019 and of reneging on its fiscal deficit commitment for 2018–19.
Unless the IL&FS can find a buyer willing to plough in the required amount, assets will have
to be sold in order to pay back lenders. By common reckoning, lenders will have to take a
haircut of at least 25%–30% on their exposure. The failure to address the IL&FS’s liquidity
needs through merger or infusion of equity by shareholders, is now leading on to insolvency.
The government is keen to limit the impact on NBFCs and SMEs, and on the financial
markets. It is trying to do so by leaning on banks to increase liquidity support to the NBFC
sector. Public sector banks that will suffer losses on exposure to NBFCs will be duly
recapitalised.
IL&FS is the most recent example of corporate scandal that puts great scrutiny on the
importance of corporate governance, especially the role of independent directors. Corporate
governance is a set of relationships between a company’s management, board, shareholders
and other stakeholders. Corporate governance principles are designed to provide a roadmap
for how companies protect the interests of their long-term shareholders, and in doing so, also
protect those of other stakeholders—employees, customers, suppliers, stockholders,
management and the community at large.

The Companies Act, 2013, and the Securities and Exchange Board of India (Listing
Obligations and Disclosure Requirement) Regulations, 2015, provide a regulatory framework
for corporate governance and other disclosures required for related third-party transactions,
accounting and remuneration of directors. The Companies Act mandates that one-third of all
directors in listed public companies be independent, with independence defined as having no
material pecuniary relationship or transactions with the company, its promoters, its
management or its subsidiaries. In the case of unlisted companies with more than Rs 10 crore
in capital, at least two directors should be independent. The issue of board composition—that
is, its size and level of independence—has been a subject of considerable academic debate.
 AN OVERVIEW OF THE DISPUTE

Every time there is corporate scam, audit firms and auditors are the first ones to be blamed.
This time, too, after the Infrastructure Leasing and Financial Services Ltd (IL&FS) crisis, the
auditors, especially the “big three"—EY, Deloitte and KPMG—are in the dock. Yet, larger
questions remain about the changing role of the Institute of Chartered Accountants of India
(ICAI), besides India’s auditing rules.
As things stand, IL&FS and its vast network of subsidiaries has now become a PR nightmare
for the big three. Last September, IL&FS had defaulted on its debt obligations, triggering a
liquidity crisis in the financial services market. IL&FS and its subsidiaries owe ₹99,354
crore. The government was swift to act and replaced the IL&FS board with hand-picked
nominees in October. Subsequently, protracted rounds of investigation by agencies, a forensic
audit, the board’s own research and analysis to understand the depth of the rot, and the
government’s recourse to the legal route to resolve the crisis followed.

The affiliates of Deloitte Haskin and Sells Llc, KPMG India, and EY India Ltd were auditors
of IL&FS and its subsidiaries—IL&FS Financial Services Ltd (IFIN) and IL&FS
Transportation Networks Ltd (ITNL). Probe agencies, including the Serious Fraud
Investigative Office (SFIO) and National Financial Regulatory Authority (NFRA), are also
probing the role of auditors. In a recent interview, ministry of corporate affairs (MCA)
secretary Injeti Srinivas said the auditors have a lot to answer for: “We are not expecting an
auditor to detect a needle in a haystack, but if an elephant is in a room, they ought to find it."
Separately, the ICAI, the accounting regulator, initiated action against a KPMG affiliate, BSR
and Co. Llp, for professional misconduct under the Chartered Accountants Act, 1949.
“Professional or other misconduct" is described as an act of omission by auditors, whose job
is to provide a true picture of a company’s accounts. According to the ICAI, the auditors did
not highlight the Reserve Bank of India’s (RBI’s) inspection report, which had labelled IFIN
as over-leveraged, besides failing to report negative cash flows and adverse key financial
ratios. A copy of the notice was reviewed by Mint.

BSR approached the Delhi high court even before the ICAI could start proceedings, and the
court stayed the order on 25 February on the ground that the ICAI had relied on media reports
and did not possess any findings of its own. The protracted legal battles and the charges of
fraud (former IL&FS vice-chairman Hari Sankaran was arrested in April) show the wide-
ranging magnitude of the fallout. Can external auditors really be trusted to tell the truth about
a company if they are also angling for consultancy work from the same entity? Can a
corporate behemoth, which has hundreds of group entities, be trusted to not hide shady
transactions in its subsidiaries? Can existing regulations be trusted to catch up with an erring
company before the problem blows a ₹1 trillion hole in the economy? Well, essentially, the
question in the aftermath of the IL&FS crisis is all about trust—concerning auditors and
regulators, as well as the corporate entity. Even the ICAI’s inordinate urgency to act against
BSR has come under suspicion, since it is being viewed as a manoeuvre to assume
jurisdiction on IL&FS’s audit lapses. “With (the) NFRA coming into existence last year, the
government wants to use the watchdog and its powers to not just penalize individuals
involved in the audit, but also audit firms. There were questions about who should examine
the role of auditors, but now it is more or less settled that it should be (the) NFRA," said a
government official. So, the question is: Was the ICAI trying to shield the firms from penalty
or debarment?
After all, only the NFRA has the powers to penalize individual auditors and firms, under the
Companies Act, 2013, a provision that is missing in the Chartered Accountants Act. The
penalty for an individual auditor is ₹1 lakh to five times the audit fee. For firms, it is ₹10
lakh to 10 times the audit fee.
The NFRA can also debar an individual or a firm for six months to 10 years—the biggest
source of concern for audit firms. However, debarment, or any penalty, would first need to
pass the MCA’s smell test. After the MCA’s approval, the proposed penalty would need to be
approved by the National Company Law Tribunal. At this stage, the auditor can present its
case to prevent penal action.
The new IL&FS board has issued a show-cause notice to the auditors for alleged negligence,
and can seek damages from them. An IL&FS spokesperson, however, declined to comment.
After a series of interactions with various stakeholders, Mint has tried to piece together what
went wrong in the IL&FS and IFIN audits. The answer is not that straightforward. But one
thing is clear: No company collapses merely due to an auditor or an audit failure, but an audit
failure does contribute significantly to the collapse of a company.

LAST LINE OF DEFENCE

External auditing is the fourth line of defence…the others are the operating management, the
risk and compliance board, and internal audit. “External auditors are appointed only because
the other lines of defence may not be fully trusted," said R. Narayanaswamy, a professor of
finance and accounting at the Indian Institute of Management, Bangalore.
There are a host of allegations against the auditors, from missing out on the sprawling IL&FS
subsidiary empire and not highlighting the asset-liability mismatch on the company’s books,
to inappropriate valuation of assets, poor recognition of non-performing assets (NPAs), and
non-detection of circular rotation of funds between group entities.
The glaring failures prompted the government to set an example with this case. “Do the
auditors work for the management or for stakeholders. Can auditors blindly accept the
version of the management and rely on comfort from management?" asked a senior SFIO
officer.
In an emailed response, a BSR spokesperson said: “We transitioned into the audit of IFIN as
joint auditors only recently in FY18. We were not the auditors for IL&FS or any other
material subsidiary of IL&FS. We stand by our audit, which was performed in line with the
applicable auditing standards and regulations, and are fully committed to cooperating with
the regulatory authorities."
Deloitte, which was the auditor of the three companies for almost a decade (see graphic),
said: “The investigation on the company (IL&FS group) is in progress and we are
cooperating fully."
EY declined to comment, but said it is cooperating with investigators.
“There was hardly any audit work done. It is a sheer case of gross negligence," said Amarjeet
Chopra, former president of the ICAI. Due to such suspicion, the MCA is now looking at
reopening and recasting IL&FS’ accounts to get a clearer picture and to fix accountability.
After taking over as the government-appointed chairman of IL&FS, Uday Kotak had said the
number of subsidiaries at IL&FS (348) was much higher than the reported 169. “Many of
these additional subsidiaries are special purpose vehicles (SPVs) in the manufacturing and
road building sector. The auditors had limited visibility on these," said an auditor with the big
three, requesting anonymity.
Here is where rubber meets the road: Can the principal auditor look into the audit of
subsidiaries to figure out the financial position of group entities that are intentionally hidden
behind convoluted structures? Well, there are grey areas.
The ICAI-prescribed regulations do not allow the principal auditor to look into the audit of
subsidiaries. “We can only go by the audit report made by the auditor of those subsidiaries.
So, if the subsidiary reported lesser number of subsidiaries, we cannot comment due to the
lack of direct line of sight. We can make an inquiry, but not a re-audit," the auditor added.
International laws are clear on this. The principal auditor is expected to review even the
subsidiaries. Armed with this hindsight, the Securities and Exchange Board of India has now
issued a circular, mandating listed entities to conduct a limited review of the audit of all the
entities/companies whose accounts are to be consolidated with it. This is to ensure that, in
future, principal auditors of listed companies have a certain degree of say in the audit of
subsidiaries.
The entire IL&FS network had over 35 audit firms, which audited subsidiaries, joint ventures,
and associate firms. For instance, IFIN’s principal auditors Deloitte Haskin & Sells and BSR
had to rely on reports of eight auditors, such as MP Chitale and Co., Sharp and Tannan,
Manubhai and Shah Llp, among others.

SOLVENCY CRISIS
Initially, the IL&FS problem seemed to be an asset-liability mismatch because borrowings
were for a shorter period relative to the cash flows from grounded infrastructure projects. It
looked like a liquidity problem, which was manageable through an interim lifeline from
lenders. However, the company’s books are now revealing a full-blown solvency crisis. It
means that the auditors should have raised questions about the asset quality.
“While the accounts for multiple years showed the assets as good and properly valued, the
valuation of assets seemed inappropriate (in hindsight)," said Dinesh Kanabar, chief
executive, Dhruva Advisors, a tax consultancy.
“Asset-liability mismatch and highlighting them falls under the purview of RBI norms. The
auditors do not look at mismatches, but raise concerns when the RBI limit is breached.
However, when some issues were highlighted (to IL&FS), the risk management and audit
committees were comfortable with the mismatch and (therefore) we had no basis to highlight
it," said the auditor quoted above.

LIMITED LINE OF SIGHT

The limited exposure to subsidiaries has been a major hurdle: The inability to detect diversion
or misuse of funds.
After taking over as chairman, Kotak had said 90% of the receivables were NPAs, which
included arbitration cases and instances of round-tripping. The arbitration cases included road
assets commissioned by the National Highway Authority of India. There were also instances
of ever-greening and round-tripping involving funds given to third-party borrowers, but
mysteriously found their way back, through circuitous routes, as loan repayments by group
companies.
 THE JUDICIAL JOURNEY

BSR & Associates LLP (“BSR”) along with Deloitte Haskins and Sells LLP (“Deloitte”) was
the joint Statutory Auditor of IL&FS Financial Services Limited (“IFIN”), a subsidiary of
IL&FS, for the financial year FY 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 auditors of IFIN for
nine years i.e., for the period FY 2007-08 to 2016-17. Deloitte retired as a Statutory Auditor
of IFIN by rotation after its audit report for the period FY 2017-18. BSR continued as the sole
Statutory Auditor of IFIN. In view of alleged delayed provisioning, constant ever-greening of
debts, etc., by IL&FS, the Ministry of Corporate Affairs, Union of India (“MCA”/ “UOI”)
directed the SFIO to conduct an investigation into the affairs of IL&FS and its subsidiary
companies. Pursuant thereto, the Serious Fraud Investigation Office (“SFIO”) submitted two
interim reports, one on 30.11.2018 and the other on 28.05.2019. The latter report, which ran
into approximately 32000 pages (including annexures), pertained to the investigation carried
out with respect to the affairs of IFIN.

Basis the second interim report, the Ministry of Corporate Affairs (“MCA”) issued a Sanction
Order on 29.05.2018 (“Sanction Order”). The Sanction Order inter alia directed the SFIO to
initiate prosecution against the auditors inter alia under Section 447 of the Companies Act
2013 (“Act”). The Sanction Order further directed for initiation of proceedings under Section
140(5) of the Act against the auditors.

Based on the directions in 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. 2062/2018 (“Company Petition”) before the National
Company Law Tribunal, Mumbai (“NCLT”) under Section 140(5) against the auditors. BSR
tendered its resignation as Statutory Auditor of IFIN on 19.06.2019. The causal vacancy
caused by the resignation of BSR was subsequently filled by IFIN by appointing M/s
Mukund M Chitale (“MMC”) at its EGM dated 11.07.2019. 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. The said challenge was
dismissed by the NCLT vide its order dated 09.08.2018 (“Impugned Order”). BSR along with
its partner-in-charge for the mandate, Mr. N. Sampath Ganesh, approached the Hon’ble
Bombay High Court on 14.08.2019 (being Writ Petition (Crl) No. 4145/2019 and 4144/2019
(“Writ Petition”) against the MCA and the SFIO.

In the Writ Petition, BSR challenged:

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 19.06.2019, and the Impugned Order;
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
18.10.2019 in the Company Petition, wherein the NCLT directed that the appointment of
MMC shall be considered as an appointment under the 1st proviso of Section 140(5) of the
Act (“2nd Impugned Order”).

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, assailing the Sanction Order. The said petitions
were also heard along with the Writ Petition.

All the aforesaid petitions were decided by the BHC by way of a common order and
judgment dated April 21, 2020 (“Judgment”).
 ISSUE WISE ANALYSIS

JURISDICTIONAL ISSUE: CHALLENGE TO THE SANCTION ORDER OF THE MCA

a. MCA’s power to issue the Sanction Order:

BSR had contended that the 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.1 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.2 Further, it is the investigation report, which is
deemed to be report under Section 173 of the CrPC and can be relied upon for initiating
criminal prosecution.

In the present case, the SFIO had referred to its report dated 28.05.2018 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.3 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 the said report. 4

The Hon’ble Court upon examining the relevant statutory provisions as well as the facts of
the present case, made the following observations:

- 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 CrPC as per the deeming fiction under
Section 212(15) of the Act.5 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;6

1
Nagindas Ramdas vs. Dalpatram Ichharam,
2
(1973) 3 SCC 581 : Union of India and Ors. Vs. Messrs. Rai Singh Dev Singh Bist and
Ors (paragraph 6).
3
 (2019) 5 SCC 266 : Serious Fraud Investigation Office Vs. Rahul Modi and another.
4
(2012) 10 SCC 517 : Manharibhai Muljibhai Kakadia and another Vs. Shaileshbhai
Mohanbhai Patel and Ors.
5
Karnataka High Court in ILR 1994 KAR 2391 : Dorai Vs. State of Karnataka
paragraphs 19, 21, 23 and 24
6
(1981) 2 SCC 277 : Capt. Dushyant Somal Vs. Smt. Sushma Somal and another,
paragraphs 1, 2 and 5 thereof.
 - The contention of the SFIO that the reference in the pleadings to report of SFIO as an
“interim” report is an inadvertent one is not supported by any affidavit; 7

- The word “interim” may not always imply that the conclusions of SFIO are tentative
or provisional and likely to change as the investigation progresses.8However, in the
present case, the burden was on the MCA/SFIO to demonstrate that there was at least
one final determination in the report.9 However, they have failed to even 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;10

- 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 &
cross-check of transactions with other companies.11

In view of the aforesaid, the court held that SFIO Report dated 28.05.2019 could not have
been a report under Section 212(14) of the Act. Hence, no prosecution could have been
initiated on the basis thereof.

b. Validity of the Sanction Order:

BSR had also challenged the validity of the Sanction Order on the ground of non-application
of mind on part of the MCA.12 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.13

After considering the contentions of the parties, the court observed an under:

- 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;14

7
(1997) 7 SCC 622: Mansukhlal Vithaldas Chauhan Vs. State of Gujarat (paragraphs 18
and 19)
8
Pasupuleti Venkateswarlu vs. The Motor and General Traders:(1975) 1 Supreme Court
Cases 770, (paragraph No.2 and 4)
9
Ramesh Kumar vs. Kesho Ram: 1992 Supp (2) Supreme Court Cases 623, (paragraph
6).
10
Beg Raj Singh vs. State of U.P. and Ors: (2003) 1 Supreme Court Cases 726;
11
Mohinder Prasad Jain vs. Manohar Lal Jain: (2006) 2 Supreme Court Cases
12
(2019) 5 SCC 266 : Serious Fraud Investigation Office Vs. Rahul Modi 
13
2007) 1 SCC 1 : Prakash Singh Badal and another Vs. State of Punjab and another
14
Dinesh Kumar Vs. Chairman, Airport Authorty of India and another, (2015) 16 SCC
163.
 - The superior nature of responsibility cast upon that officer/authority & 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;15

- 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;16

- The contention of the MCA that the processing note and the SFIO report running into
750 pages was considered by two officers within 30 hours, that too, one after the
other, appears to be highly improbable;17

- The processing note would not absolve the concerned officer of his obligation to
apply his mind personally & therefore verify the correctness of the appreciation in the
processing note itself;18

- Admittedly, 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;19

- 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.20

In view of the above, the court held that the Sanction Order suffers from non-application of
mind. The court further observed that the Sanction Order is void and not existent as in the
present case the power to grant sanction was abused and the colourable exercise was
apparent. Thus, the court held that the action initiated on the basis is also void and
unsustainable.

15
Director, Central Bureau of Investigation and another Vs. Ashok Kumar Aswal and
another and (1974) 3 SCC 72 
16
The State of Rajasthan Vs. Tarachand Jain.
17
(1973) 3 SCC 581 : Union of India and Ors. Vs. Messrs. Rai Singh Dev Singh Bist and
Ors (paragraph 6).
18
 Vinubhai Ranchhodbhai Patel vs. Rajivbhai Dudabhai Patel and Ors.: (2018) 7 SCC
743 
19
 State of Bombay vs. S. L. Apte and Another: AIR 1961 SC 578
20
An Advocate vs. Bar Council of India -1989 (supp) 2 SCC 25
CHALLENGE TO THE NCLT ORDER DATED 09.08.2019 (IMPUGNED ORDER)
At the very outset, the court rejected the objection of the MCA that the challenge to the
Impugned Order is not maintainable in view of availability of the alternate remedy.21 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.22

As regards the challenge to the 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).23 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.

It was further contended that as per the 2nd proviso, once a final order i.e. an order directing
“change” in auditors is passed by the NCLT, the five-year disqualification kicks in
automatically, without exercise of any discretion by the NCLT.24 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, including but not limited to Section 132,
447, etc.,25 whereby an auditor can be proceeded against in case of any fraud or misconduct.

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

- 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 (“NFRA”) 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;26

21
Whirlpool Corporation vs. Registrar of Trade Marks, Mumbai and Ors. :(1998) 8
Supreme Court Cases 1, (paragraph 15)
22
Maharashtra Chess Association vs. Union of India and Others : 2019 SCC Online SC
932, (paragraph 20 to 24)
23
Forward Construction Company vs. Prabhat Mandal, paragraph-33. Paragraphs 55 & 63
24
 Union of India vs. Sanjay Kumar Jain-(2004) 6 SCC 708
25
 Nathi Devi vs. Radha Devi Gupta-- (2005) 2 SCC 271
26
Union of India vs. Sanjay Kumar Jain-(2004) 6 SCC 708 paragraph No.11.
 - Section 140 (of which subsection 5 is a part) 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 & 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;

- 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 a
discretion to pass the final order;

- 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 2nd proviso to S.
140(5);

- 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
o ice 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 even a court;

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

- The debarment under the 2nd 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 him to rise to the occasion
by not opposing the proposed change by urging frivolous or roving grounds.

In view of the above, the NCLT 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 this Court.
In view of the decision of the BHC regarding non-application of Section 140(5) to the
erstwhile auditors, the challenge to the 2nd Impugned Order also stood decided in favour of
BSR. 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.

CHALLENGE TO CONSTITUTIONAL VALIDITY OF SECTION 140(5) OF THE COMPANIES ACT,

2013
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 the said Section on inter alia the ground that the said
section is discriminatory and manifestly arbitrary as it (a) fails to prescribe a procedure to be
followed by NCLT for arriving at a finding of fraud27; (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 2nd 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.

The respondents averred that in order to pass the test of permissible classification, two
conditions must be fulfilled, namely, (1) that the classification must be founded on an
intelligible differentia which distinguishes persons or things that are put together
from others left out of the group, and ( 2) that the differentia must have a rational
relationship to the object sought to be achieved by the statute in question. 28

As brought out herein above, the Court accepted the interpretation of Section 140(5) as
submitted by BSR. Accordingly, the Court read down the scope and intent 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:

- 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;

27
Maneka Gandhi vs. Union Of India--- 1978(1) SCC 248 paragraph No.1 179, 180, 143
and 147, 5,6 , 201, 202, 82, 84 and 173.
28
State of Rajasthan v. Mukan Chand, (1964) 6 SCR 903 : AIR 1964 SC 1633
 - 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;

- 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 o icer of or
subordinate to a company in any manner. The directors or the o icers must identify
themselves with its a airs while the statutory auditors have to be aloof and neutral.
Thus, there is no similarity or equality amongst them and argument based on
discrimination are misconceived;

- 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;

- 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 not requiring him
not to oppose the proposed change once a satisfaction is reached by the NCLT;

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

In view of its findings qua the Sanction Order, the High Court held the same to be
unsustainable. Consequently, the High Court set aside the Sanction Order as well as the
criminal prosecution launched vide the Criminal Complaint in pursuance thereof. However,
upon a request made on behalf of UOI, the High Court 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
04.09.2019 (insofar as it directed the UOI/SFIO to not take any coercive steps qua the
Petitioners in the Criminal Complaint) for a period of 8 weeks.

Further, in view of the aforesaid, the High Court, while upholding the constitutionality of
Section 140(5) of the Act, held that the said Section is not applicable to the past auditors.
Accordingly, the High Court quashed the Impugned Order (dated 09.08.2019) of the NCLT
and held that the proceedings undertaken by the UoI under Section 140(5) of the Act, to be
untenable qua BSR.
 CONCLUSION

The Hon’ble High Court, the NCLAT and the NCLT seemed to miss out on striking the
problem at the root and the auditor fraternity in India remains exposed to being penalised
even in absence of any conclusive proof of their guilt.
The reasoning given by the Court seems to allow the tribunal to debar an auditor under
Section 140(5) of the Act only in cases the where the suspected auditor chooses not to resign
and remains with the company, and otherwise, the tribunal does not have the power to debar
the auditor. It further held that debarment under Section 140(5) of the Act is a punishment for
not resigning as the auditor of the concerned company and unnecessary contest of auditor’s
removal, and, interestingly, not for the alleged fraud, hence it does not violate the rule against
double jeopardy.

The aforesaid reasonings are not only erroneous but are more of a reason to hold the
provision unconstitutional. It would not be wrong to suggest that debarring an auditor for five
years is almost equal to his civil death. The mere acknowledgment that legislature intends to
inflict such punishment on an auditor only because he chooses to contest his removal makes
the provision ex facie violative of the basic principle of proportionality of punishment.
Moreover, it is perhaps unknown in law to recognize a legally absurd legislation that triggers
the power of a judicial authority to inflict punishment only if the suspect chooses to contest it.
Needless to say, legislation overshadowing a suspect’s right to defence is violative of the
basic principles of natural justice.