2025 (2) TMI 379 - HC - Companies Law

Delhi HC validates NFRA's power under Section 132(4) to discipline auditing firms but rules same body cannot investigate and prosecute

Delhi HC upheld the constitutional validity of Section 132(4) of the Companies Act, 2013, empowering NFRA to initiate disciplinary proceedings against ... Professional Misconduct - Constitutional validity of Section 132 (4) of the Companies Act, 2013 - power of NFRA to initiate disciplinary proceedings not just against individual partners and CAs’ but also auditing firms in respect of any audit - validity of Rules 3, 8, 10 and 11 of the National Financial Reporting Authority Rules, 2018 - seeking an appropriate declaration to the effect that Section 132 (4) of the Companies Act as well as Rules 3, 8 10 and 11 of the NFRA Rules be held not to apply to any audit completed before 01 October 2018 - applicability of provisions to audits that may have been completed prior to the introduction of Section 132 in the Companies Act and thus avoid a declaration of invalidity being rendered. Appointment and engagement of an auditor - Vicarious liability of pertners of the firm - HELD THAT:- An individual, a partnership firm or an LLP can be appointed as an auditor of a company. The appointment, prescriptions and the nature of services which could be rendered by it are further prescribed and regulated by Section 144 of the Companies Act. The Explanation to Section 144 proceeds to explain and provide a definition to the expression “directly or indirectly” as appearing therein - It will be wholly incorrect to hold that Section 132 creates a liability which is foreign to or uncontemplated by the various other provisions forming part of that statute. The Companies Act clearly contemplates a firm suffering a liability as a consequence of the action of its Engagement Partners and constituents who may be involved in the conduct of the audit. Thus, both the audit firm as well as its individual partners would be exposed to a statutory liability if Sections 139 to 146 were found to have been violated. The appointment of the firm as an auditor naturally encompasses the actions of its members. The engagement of members in the conduct of an audit is not an independent or isolated act but is inherently derivative of the firm's appointment as the auditor. The firm acts as the central organ, and its members function as its limbs, carrying out its obligations and responsibilities. The firm’s designation as the auditor inherently extends to its members, who act on its behalf. The relationship between a firm and its members while delivering auditing services is one of complete integration, where roles and responsibilities overlap to ensure the highest levels of professional service. The nature of such services does not permit a firm to distance itself from the actions of its partners, especially when those actions are performed in furtherance of the firm’s obligations. Therefore, liability, whether incurred by the firm or its members, cannot operate in silos but is instead a shared and unified responsibility that reflects the cohesive nature of their engagement. Such an arrangement is neither supported by the provisions contemplated within the LLP Act as well as the Companies Act. There are no merit in the contention that Section 132 of the Companies Act is liable to be held as unconstitutional basis the audit firm or its individual partners and members becoming vicariously liable. In light of the above, the challenge to the constitutionality of Section 132 on the grounds of vicarious liability is without merit - Section 132 is neither an overreach nor can it be said to be arbitrary; it is a necessary mechanism to enforce professional accountability. The expression “engagement team” is defined by the SQC to mean all persons contracted and engaged by the firm in connection with that engagement. The argument of Section 132 thus creating a vicarious liability which is otherwise not contemplated or envisaged is thoroughly misconceived. Section 132 and its Retroactive Operation - HELD THAT:- The challenge to Section 132 (4) and its retrospective application too would thus have to be appreciated on the assertion of certain rights, procedural or substantive, which could be said to have become absolute and fixed. The petitioners had essentially contended that the creation of penalties as well as the shifting of the adjudicatory function from the Council to the NFRA in respect of audits conducted prior to October 2018 would lead one to necessarily come to the irresistible conclusion that the statute impacts rights retrospectively. Vested rights were explained to mean those which would remain unimpacted by any future change in the legal position. Regard must be had to the fact that if the right hinges on an unsecured or contingent foundation, susceptible to modification by a change in the legislative scheme, then such a right was never truly vested, as it lacked the essential characteristics of being absolute, fixed, or immune to future alteration. While delving on the subject of retrospectivity of a legislation the Supreme Court had pertinently observed that while it is true that an enactment would not be construed as having retrospective operation unless such be the position which could be countenanced either on account of an express provision or by implication, merely because the statute takes into consideration a past act or event, that would not necessarily lead one to conclude that it be said to operates retrospectively. The argument of retrospectivity is unmerited is the facet of professional misconduct having remained unaltered and only the manner and ambit of the inquiry having been amended for a particular class of audits. The argument of retrospectivity is liable to be rejected also because it does not introduce new categories of misconduct or liabilities. Instead, it relies on the pre-existing definition of 'professional or other misconduct' under Section 22 of the CA Act. Since the legal characterization of misconduct remains unchanged, the only discernible difference is the manner and scope of the inquiry under Section 132. On a consideration of the legislative history preceding the introduction of Section 132 clearly suggests a pre-existing regulatory deficiency or gap was sought to be addressed through the introduction of Section 132 aligning with the broader objective of strengthening oversight mechanisms and enhancing the quality of professional services rendered by audit firms. This measure was implemented not to create new liabilities but to bridge an existing gap in enforcement, ensuring that standards of professional conduct and accountability evolve in tandem with global best practices. The present case does not fall within the ambit of Article 20 (1) as it neither involves the creation of a new offence nor the imposition of a criminal penalty with retrospective effect. The disciplinary consequences for professional misconduct had always existed under the CA Act and Section 132 merely reinforces and formalizes the enforcement framework without altering the substantive nature of misconduct. Since Article 20 (1) applies exclusively to criminal offences and punishments, and the present case pertains to civil and regulatory disciplinary proceedings, its invocation is clearly misconceived. Moreover, professional misconduct was always subject to scrutiny and Section 132 does not introduce an unprecedented liability but only refines the mechanism for inquiry and enforcement. Thus, the challenge based on Article 20 (1) is without merit. While it is true that the monetary penalties that are imposed by Section 132 (4) could exceed those which were prescribed under the CA Act, the challenge so raised in any case remains of little significance that no monetary penalties exceeding INR 5 Lakhs would be imposed in respect of any audit conducted prior to 2018. Lack of procedural safeguards - HELD THAT:- The validity of Section 132 (4) as well as the procedure adopted by the NFRA was then assailed on the ground of the latter having deprived the petitioners of various significant rights and procedural safeguards which were otherwise provisioned for under the CA Act and the subordinate rules governing the conduct of disciplinary proceedings. It was submitted that the Act as well as the NFRA Rules merely provide for that authority evolving such procedure as may be considered expedient in the facts of a particular case. The statute, the petitioners argued, neither lays in place a codified procedure for the conduct of disciplinary proceedings nor do its provisions provide any guidance to the NFRA to adhere to a procedure which would be commensurate with the constitutional imperatives of fairness and natural justice. Rule 11 of the NFRA Rules, it becomes apparent that the statute clearly commands that authority to ensure that the disciplinary proceedings are undertaken in accordance with the principles of natural justice including where deemed necessary and appropriate by providing an opportunity of hearing to the charged entity in person. By virtue of Rule 11(5), the division of the NFRA is obliged to pass an order after considering all submissions made and taking into account the material on record as well as all other relevant facts and circumstances. The NFRA Rules, however, do not speak of or appear to envisage oral testimony being recorded in the course of proceedings that may ensue. Separation of functions - HELD THAT:- From section 132 of the Companies Act, there appears to be no doubt in mind that the provision did and always contemplated the NFRA performing and discharging its functions through such divisions as may be constituted. While it is true that Rule 2(g), while defining the word ‘division’ includes one headed by a Chairperson or a full time Member, the Executive Body cannot possibly be construed to be a division in itself. A conjoint reading of sub-sections (3)(a) and (3)(b) appearing in Section 132 alongside the NFRA Rules, leads us to the irresistible conclusion that the statute clearly contemplated the discharge of functions enumerated in Rules 7 and 8 being undertaken by independent units or divisions of the NFRA. A body must not only be fair and impartial, but it should also not be burdened by a predisposition or a predetermined state of mind. This aspect assumes significance insofar as we are concerned in light of a common complement of persons having rendered findings of alleged professional misconduct and thereafter sitting upon that very opinion to consider commencement of disciplinary action. A person charged by such an authority could be reasonably said to apprehend a reasonable likelihood of the opinion so formed being tainted by the proscription of a reasonable likelihood of bias. It is not intended to suggest that the NFRA was obliged to punctiliously follow or adopt an identical structure, what we seek to highlight is that regulatory bodies appear to have universally formulated and attempted to adhere to a procedure which would meet the test of due process, of a fair opportunity being afforded to the person charged and above all justice appearing to have been truly served. These are surely not principles foreign to our jurisprudence. They are above all the command of Article 14 itself. The proceedings impugned, however, clearly falter and fall when tested on the aforenoted basic postulates. The scar of predetermination - HELD THAT:- It was the Executive Body which in the first instance came to record findings of guilt and violation of the SAs’. Those reports had come to conclude in no uncertain terms that the petitioners had violated the ethics standards required to be maintained and having acted in violation of the SAs’ which applied. That very body proceeded to take a decision to commence disciplinary action based not an independent review of the facts that obtained but solely on the strength of what had been found in the AQRR. The composition of the body which penned the AQRR and that which issued the SCN remained unaltered. The proceedings have thus come to be stigmatized beyond repair and cannot in law be salvaged or saved. The Executive Body could not have discharged the dual role of rendering findings of guilt and violation of the SAs’ while authoring the SQARR/AQRR and thereafter don the mantle of the division which is contemplated under Rule 11. The assessment of whether circumstances warranted a disciplinary enquiry being initiated was statutorily liable to be undertaken by a unit of the NFRA separated from the one which drew up those reports - The doctrine of necessity has also been found to be inapplicable since it was open for the NFRA to have constituted separate units which could have discharged the functions statutorily envisaged. Since the body of persons which penned the reports and took a decision to initiate proceedings under Rule 11 was one and the same, the procedure is found to be in clear violation of the reasonable likelihood of bias test. An informed observer would be justified in alleging predisposition, predetermination and an inclination to affirm against that body. Conclusion - The validity of Section 132 and the NFRA Rules upheld. There are no merit in the challenge based on the arguments of vicarious liability, retroactive operation and a violation of Article 20(1) of the Constitution. Petition allowed. Scope of adjudicatory power under Section 132 and NFRA Rules - upheld but subject to fair process - The Court upholds the constitutional validity of Section 132 of the Companies Act, 2013 and the NFRA Rules insofar as they empower an independent statutory authority to monitor and enforce compliance with accounting and auditing standards and to initiate disciplinary action for 'professional or other misconduct' defined by reference to the Chartered Accountants Act. The provision does not create a new species of misconduct; it adopts the pre-existing statutory definition and changes the enforcement forum and mechanism (Ratio). Vicarious / entity-level liability - lawful within statutory scheme - The Court rejects the contention that Section 132 imposes an unconstitutional vicarious liability on audit firms or their non-involved partners. The Companies Act already envisages liability attaching to firms and partners (including civil and, in defined circumstances, criminal liability); an auditor-firm acts through its partners and engagement-team members and cannot disown their acts. Liability of a firm and its partners for audit failures is consistent with statutory purpose and professional quality-control obligations (Ratio). Retrospective operation / vested rights - Section 132 not impermissibly retrospective - The Court rejects the claim that Section 132 (or the NFRA Rules) operate retrospectively so as to infringe vested rights or Article 20(1). 'Professional or other misconduct' pre-existed and Section 132 chiefly changes forum, oversight and enforcement; it does not criminalise previously-innocuous conduct or impose retrospective criminal punishment. A statutory scheme altering enforcement forum or strengthening penalties will be prospective unless the Legislature's intent to operate retrospectively is plain; on the facts no such unconstitutional retrospectivity is established (Ratio). Article 20(1) challenge - inapplicable to regulatory disciplinary civil penalties - Monetary penalties and debarment under Section 132 are regulatory/disciplinary in character and do not attract the narrow protection of Article 20(1) against ex-post-facto criminal laws. The Court reiterates established distinctions between criminal punishment and civil/regulatory sanctions (Ratio). Procedural safeguards and standard of proof - summary process compatible with natural justice in context - Rule 11(5)'s 'summary procedure' is not per se unconstitutional. Disciplinary proceedings under NFRA are regulatory (not criminal) and may adopt streamlined procedures; the standard of proof is of preponderance (civil/disciplinary standard) rather than proof beyond reasonable doubt. Nevertheless, statutory and constitutional principles of fairness (audi alteram partem) and reasonable notice, disclosure of allegations and material, and opportunity to be heard must be observed (Ratio). Limits of 'audit-file only' evidentiary approach - permissible but bounded - The NFRA may rely primarily on audit working papers and records (consistent with auditing standards which emphasise audit documentation), and may restrict evidence to the audit file where investigations originate from oversight/review rather than an adversarial complainant. However, such limitation binds both the Authority and the charged person; oral testimony and cross-examination become necessary only if the Authority relies upon oral statements or testimonial material that materially affects the case (Reasoning / Obiter). Division of functions / separation of roles - statutory separation required in practice - Although Section 132 and the Rules contemplate the Authority operating through divisions, the separation has a substantive purpose: to avoid concentration of investigative, prosecutorial and adjudicatory functions in the very same persons and thus prevent reasonable apprehension of bias. Administrative convenience is not a licence to collapse those functions where that collapse produces a demonstrable risk of predetermination (Ratio). Predetermination / reasonable apprehension of bias - standard and application - The correct test is objective: would a fair-minded and informed observer conclude there is a real possibility of bias or predetermination? Where the same decision-makers both authored definitive review reports (AQRR/SAQRR) containing conclusive findings and then approved or issued show-cause notices and presided over the corresponding disciplinary process, a reasonable likelihood of predetermination exists and procedure is vitiated (Ratio). Factual finding: investigative/adjudicative overlap in practice - The NFRA's own disclosure showed the Executive Body/EB participated in preparing Audit Quality Review Reports, reviewing them, drafting and approving show-cause notices and conducting oral hearings in the impugned matters. The Court finds that, in these matters, the body that produced the review reports effectively acted as both accuser and adjudicator, creating an appearance of pre-determination (Fact and Conclusion). Remedial outcome - quash and fresh process requirement - Because the Executive Body performed both the investigative/review and the disciplinary role in the impugned cases, the Court quashes the issued show-cause notices and impugned final orders in the affected matters. The Authority is permitted, however, to reopen matters and re-examine the audit-quality findings and, if warranted, to issue fresh notices and proceed, provided (a) the decision to initiate disciplinary action is taken by a different and independent complement/division not involved in the review that produced the AQRR/SAQRR, and (b) the NFRA follows a fair procedure consistent with natural justice and Rule 11(5) (Ratio / Disposition). Scope and limits of new procedure on remand - what is required of the Authority - Any re-consideration or fresh disciplinary initiation must be (i) by a division or panel independent of the team that conducted the AQR; (ii) supplied with full disclosure (detailed allegations, evidence relied on, extracts of review reports and documents); (iii) provide adequate time and opportunity to respond, including representation (NFRA indicated it will permit legal representation); and (iv) adhere to preponderance-of-evidence standards while ensuring a fair hearing (Reasoning / Direction). Publication and transparency - NFRA's functions and public interest - The Court notes the legislative and policy background evidencing an express governmental intent to strengthen independent oversight of auditors for public and investor protection. Publication of findings and transparency subject to legitimate confidentiality are consistent with statutory objectives and international practice (Obiter). Interaction with Chartered Accountants Act and professional standards - coordination not displacement - Section 132's enforcement for specified classes of entities displaces parallel institute action only where NFRA has initiated an investigation; otherwise the professional disciplinary jurisdiction under the CA Act continues to operate for matters outside NFRA's scope. The statutory design is to converge on enforcement while maintaining existing definitions of 'professional or other misconduct' (Reasoning). Dissuasive penalties and proportionality - observation - The Court notes NFRA's assurance (recorded in proceedings) that monetary penalties exceeding previous limits will not be imposed for pre-2018 audits and that debarment must be proportionate. The Court emphasises proportionality and the availability of appellate review as safeguards for individuals and firms (Obiter). Remedies and appeal - administrative and judicial oversight preserved - Orders disposing of show-cause proceedings under NFRA Rules remain subject to the statutory appellate route and judicial review. The Court emphasises that fresh disciplinary steps must leave intact the accused's right to lodge appellate challenges and to pursue judicial remedies (Obiter / Direction). Overall rule: enforceability plus procedural fairness - The Court's ratio balances two fundamental propositions: (a) Parliament lawfully enhanced regulatory oversight by creating NFRA and vesting it with investigatory and disciplinary powers over specified classes of audits; and (b) the exercise of those powers must be implemented through organisational and procedural structures that secure impartiality and the appearance of fairness. Where the statutory design is followed, enforcement is valid; where an investigating body becomes the accuser and adjudicator, the process must be set aside and reconstituted (Ratio / Disposition).