The Supreme Court’s order of May 3, 2023, paving the way for criminal action against the auditors of IL&FS Financial Services Limited (or IFIN) – BSR & Associate, a KPMG affiliate and Deloitte – for alleged abetment and collusion in corporate fraud is a significant step forward as it stops auditors from getting away simply by resigning.

The IFIN auditors had precisely sought such an escape and the Bombay High Court, in its April 22, 2020 order, allowed it by quashing a five-year ban. Three years later, the Supreme Court has quashed the Bombay High Court order and upheld the constitutional validity of Section 104(5) of the Companies Act, 2013 – which allows the National Company Law Tribunal (NCLT) to remove as well as ban auditors found guilty of corporate frauds.

The IL&FS Group had collapsed in 2018, after a series of loan defaults led to its bankruptcy proceedings under the IBC of 2016 the same year. It was found that the group had falsified (“window dressed”) account books, hid massive debts and NPAs for four years up to FY18. It had a debt of ₹91,000 crore and 70% of its loans were NPAs. The IFIN, its financial arm giving loans to group companies as well as external entities, was found to have indulged in multiple irregularities for seven years between FY12 and FY18 by the Serious Fraud Investigation Office (SFIO) in 2019. The SFIO blamed not just the management and auditors, but also the independent directors and the RBI – which didn’t act tough despite its successive inspections finding fraudulent activities in FY16 and FY17.

Another development has taken place that promises stricter oversight of audit and auditors.

On May 3, 2023, the Finance Ministry notified and brought the activities of chartered accountants, company secretaries and cost and works accountants – who engage in accounting, auditing and related works – under the money laundering law, the PMLA of 2002. This change requires that these professionals maintain records of certain financial transactions, identify parties involved, verify these transactions and report “suspicious” ones to authorities. However, given that this has caused unhappiness among these professionals (involved in audit, accounting and other related activities) it remains to be seen how effective this would prove.

Nevertheless, both are steps in the right direction.

Relevance of Supreme Court order

A day before the Supreme Court’s May 3, 2023 order came, the Adani Group’s auditor Shah Dhandharia – named in the Hindenburg report – resigned as the auditor of Adani Total Gas; its status as the auditor of the flagship group company Adani Enterprises is not known.

When the SEBI’s investigations into the Hindenburg allegations are complete and if at all Shah Dhandharia is found guilty of auditing misconduct, it can no longer claim immunity from criminal prosecution by citing its resignation.

The Hindenburg report of January 2023 had called Shah Dhandharia “a tiny” firm with very young hands and “hardly seems capable of complex audit work”. It pointed to the enormity of auditing the Adani Group by flagging that (i) Adani Enterprises “alone has 156 subsidiaries and many more joint ventures and affiliates” and (ii) “Adani’s 7 key listed entities collectively have 578 subsidiaries and have engaged in a total of 6,025 separate related-party transactions in fiscal year 2022 alone, per BSE disclosures”.

One of the Hindenburg’s allegations was that the Adani Group violated the SEBI mandated 25% public- float or free-float. The global index services provider MSCI has cut down the Adani Total Gas’s free-float from 25% to 14% and that of Adani Transmission from 25% to 10% with effect from May 11, 2023.

Why auditors need strict regulations

Coming back to the Supreme Court’s May 3, 2023 order, what it essentially does is to make the second proviso of Section 104(5) applicable to the IFIN – that is, imposing a five-year ban on the KPMG affiliate and Deloitte.

The first proviso provides for removal of auditor from a firm if found to be involved in corporate frauds. Both the provisions, removal and imposition of ban is through the NCLT proceedings, were introduced in the Companies Act of 2013. The exercise to incorporate the first proviso was initiated through the Companies Bill of 2009 and the second proviso in the Companies Bill of 2011. The objectives were to make the oversight of auditing and auditors “more stringent” and but through a fair process (NCLT proceedings).

These changes came primarily because of the Satyam Computers scam of 2009.

Recall the enormity of audit failures in the iconic Satyam Computers.

Satyam Computers collapsed overnight in 2009, after the man behind it, Ramalinga Raju, wrote to the SEBI confessing that he had been cooking up the accounting and financial books for seven long years! His letter mentioned (a) “non-existent” bank deposits and interests accrued (b) “understated liability” and (c) “overstated debtors’ position”. Even a CA student undergoing “articleship” would have discovered the frauds by doing a very simple and basic task – matching Raju’s claims about bank deposits with the actual bank statements in any of those seven years. But its auditor, the famed global giant PricewaterhouseCoopers (PwC), failed to perform this basic task for seven years.

The PwC was banned for two years by the SEBI (along with disgorgement) in 2018 – 10 years later.

The ban was overturned by the Securities Appellate Tribunal (SAT) in 2019. This was stayed by the Supreme Court, which upheld the SEBI’s power to punish the auditor. In a parallel exercise, in February 2023, the SAT set aside the SEBI orders (of 2018) barring Raju and others from the securities markets for up to 14 years – 14 years after the scam hit. The CBI case against Raju and others, meanwhile, drags on while they are out on bail.

The PwC is one of the four global Big 4 audit firms – others being KPMG and Deloitte engaged by the IFIN mentioned earlier and Ernst & Yung. The Big 4 was once Big 5. The fifth one, Arthur Andersen, collapsed along with its client Enron in 2000 – for the same work of cooking up accounting books and financial statements to mislead investors and others.

It may sound strange for the KPMG affiliate and Deloitte to seek waiver from criminal prosecution after being found guilty of colluding in corporate fraud by the SFIO. Their basic argument was they had already resigned and hence, Section 104(5) didn’t apply to them. The Bombay High Court said it was satisfied with their resignations and the second proviso (ban for five years) of Section 104(5) was not applicable. It said the second proviso “is only attracted” when “despite” the application for ban, an auditor opposes it “frivolously”, inviting a final order under the second proviso. It also held that the SFIO investigation was “interim” and hence, can’t form the basis for seeking a ban. The Supreme Court, dismissed this by stating that the SFIO report was final insofar as the IFIN was concerned but given the “complex structure” of the IL&FS Group, it might provide supplementary evidence after investigating other group companies).

Notice how tough it is to punish an auditor for patent acts of corporate frauds, especially if it involves one of the Big 4. The long delays in investigation and follow-up action, multiplicity of authorities (the Institute of Chartered Accountants of India (ICAI) is yet another watchdog of accounting and auditing standards) and multiple, long-drawn legal battles. Surprisingly, however, none of these cases flagged an easy remedy: Dismantling an intrinsically flawed, self-certifying auditing system in India. India allows a firm to hire its own statutory auditor and pay for its audit work. When that happens, auditing can be a farce. Ask Raju or an IFIN executive.

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