Supreme Court upholds the constitutional validity of Section 140(5) of the Companies Act, 2013, which inter alia imposes statutory bar on the auditor(s) for a period of five years

The Hon’ble Supreme Court of India (“Supreme Court”), in the case of Union of India v. Deloitte Haskins and Sells LLP and Another [Criminal Appeal Nos. 2305-2307/2022] (“Judgement”), has upheld the constitutionality of Section 140(5) (Removal, resignation of auditor and giving of special notice) of the Companies Act, 2013 (“Companies Act”), which inter alia renders the auditor(s) ineligible from acting as auditors for any company for a period of five years.

Facts

The Department of Economic Affairs, Ministry of Finance issued an office memorandum dated September 30, 2018 (“Office Memorandum”) requesting the Ministry of Corporate Affairs (“MCA”) to take actions against IL&FS Financial Services Limited (“IL&FS”) under the Companies Act against the alleged series of defaults with an aggregate debt burden of more than INR 91,000 Crores. The MCA directed the Serious Fraud Investigating Officer (“SFIO”) to conduct the investigations. SFIO submitted its interim-report to the MCA on November 1, 2018 (“Interim Report”).

The National Company Law Tribunal (“NCLT”), on a petition filed by the MCA under Section 130 (Re-opening of accounts on court’s or Tribunal’s orders) of the Companies Act basis the Interim Report, directed the re-opening and recasting of the accounts of IL&FS. The auditors BSR & Associates LLP (“BSR”) and Deloitte Haskins and Sells LLP (“Deloitte”) (collectively referred to as “Respondents”) were given notice of the said petition.

Meanwhile, the Reserve Bank of India also initiated an inspection of the IL&FS group, and submitted its inspection report dated March 22, 2019, to the new board of directors of IL&FS. Subsequently, SFIO completed its investigation and submitted its final report to the MCA, on the basis of which MCA filed a petition under Section 140(5) of Companies Act on June 10, 2019 before NCLT against BSR & Deloitte inter alia, for their removal, and barring them to take up audit activities of any company for next five years (“Petition”). The NCLT upheld the maintainability of Petition.

Thereafter, BSR filed a writ petition before the High Court of Bombay (“High Court”) inter alia challenging the constitutionality of Section 140(5) of the Companies Act and challenging the maintainability of the Petition. The High Court upheld the constitutionality of Section 140(5) of the Companies Act, however it set aside the order of NCLT to the extent it had held that the Petition was maintainable against the auditors, primarily on the ground that once the auditor resigns as an auditor or is no more an auditor on his resignation, the proceedings against such auditors stands terminated.

Being aggrieved by the order of High Court, Union of India (“Appellant”) preferred the present appeal before the Supreme Court.

Issues

• Whether Section 140(5) of the Companies Act is constitutional.
• Whether a petition under Section 140(5) of the Companies Act is maintainable against an auditor who is no more an auditor of a company.

Arguments

Contentions of the Appellant:

The Appellant submitted that the purpose and legislative intent behind Section 140(5) of the Companies Act was based on the recommendation of the J.J. Irani Committee and the Parliamentary Standing Committees’ Reports and it was to make the role of an auditor more independent, yet accountable. The Appellant relied on the judgement of the Supreme Court in Devas Multimedia Private Limited v. Antrix Corporation Limited and Another [(2023) 1 SCC 216], to contend that the public policy behind Section 140(5) of the Companies Act is to prevent an auditor who has been found to perpetrate fraud or colluding from undertaking statutory audits for a period of five years.

It was also submitted that the second proviso to Section 140(5) of the Companies Act was a substantive provision which is automatically activated on the final order by the NCLT’s satisfaction of fraud or collusion by the auditor company. Yet, in case the NCLT did not find any element of fraud or collusion by the auditor company in its final order, the auditor could be re-instated. It was further submitted that in case Section 140(5) of the Companies Act would cease to apply in case of resignation by the auditor, the entire scheme of Section 140(5) of the Companies Act and Chapter X (Audit and Auditors) of the Companies Act would become nugatory, which was not the legislative intent.

Contentions of the Respondents:

The Respondents submitted that Section 140(5) of the Companies Act was meant to only ensure that a recalcitrant auditor resigns and thus when the auditor had so resigned, the Petition was subsequently not maintainable against such auditor.

It was also contended that the second proviso to Section 140(5) of the Companies Act was arbitrary, harsh and burdensome and ought to be read down as being violative of Articles 14 and 19 of the Constitution of India (“Constitution”). In this regard, it was also contended that the ineligibility to act as an auditor of any company prescribed under the second proviso to Section 140(5) of the Companies Act could only extend to the audit partners concerned and not to the entire firm and the other audit partners who were not connected with such fraudulent acts.

Observations of the Supreme Court

The Supreme Court observed that Chapter X of the Companies Act is a special provision through which the legislators intended to make the provisions for the auditors more stringent and for removal of auditor by the NCLT where there is a fraud committed by such auditor and contemplated that such auditor shall not be eligible to be appointed as an auditor of any company for a period of five years.

The Supreme Court further observed that the power of NCLT under Section 140(5) of the Companies Act is quasi-judicial in nature and it would have the power of a civil court to examine the role of the auditors and adjudicate on their role, more particularly whether it was fraudulent or not. The first proviso to Section 140(5) of the Companies Act provides power to the NCLT to, suo-moto or an application made by the central government, remove such auditor and appoint a new auditor. The measure was in the nature of pro-tem or interim order, based upon the NCLT’s satisfaction that there is a fraud that has been perpetrated and the circumstance requires substitution of the auditor.

The Supreme Court observed that the second proviso to Section 140(5) of the Companies Act was a substantive provision which gets triggered automatically when a final order has been passed by the NCLT after a detailed enquiry to the effect that the auditor of a company has, directly or indirectly, acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to, the company or its director or officers. To the corollary, it also observed that the High Court had erred in its interpretation of Section 140(5) of the Companies Act when it held that the proceedings under the section was not maintainable once the auditor had resigned or was no more an auditor for any reason. The Supreme Court also cautioned that such interpretation would have the consequence where every auditor would resign in order to save itself from the stringency of Section 140(5) of the Companies Act and continue perpetrating fraud.

With regards to the constitutionality of Section 140(5) of the Companies Act, the Supreme Court observed that the provision was not discriminatory against the auditors since the role of an auditor is vital in the affairs of the company and therefore, they have to act in larger public interest. In so far as the contention that the ‘automatic effect’ of penalty envisaged under the section was concerned and the contention that it was highly disproportionate, Supreme Court took the view that it was for the legislative wisdom to decide upon the quantity of penalty and how it would take effect. The Supreme Court also observed that Section 140(5) of the Companies Act did not fall within the purview of Article 19 of the Constitution since an auditor’s and its partners’ fundamental right to carry on its profession could not be permitted where it had acted fraudulently, whether directly or indirectly. Such a fraudulent act was a serious misconduct which has to be dealt with sternly and therefore, automatic penalty under Section 140(5) of the Companies Act was a natural consequence of indulging into such misconduct.

Decision of the Supreme Court

The Supreme Court held that resignation of the auditors did not terminate the power of NCLT to take action against them and from attracting penalty envisaged under Section 140(5) of the Companies Act read with Section 447 of the Companies Act. The Supreme Court also upheld the constitutional validity of Section 140(5) of the Companies Act vis-à-vis Articles 14 and 19 of the Constitution.

VA View:

The Supreme Court has rightly upheld the vires of Section 140(5) of the Companies Act. It has given a purposive interpretation to the section in consonance with the legislative intent, that resignation of an auditor or its partner, could not terminate the proceeding under Section 140(5) of the Companies Act if the final order to the NCLT’s satisfaction found element of fraud or collusion, whether directly or indirectly.

The Supreme Court has rightly trisected Section 140(5) of the Companies Act into: (i) the quasi-judicial power of NCLT to adjudge on the role of the auditor; (ii) the power of NCLT to remove the auditor in case of a prima facie satisfaction of fraud, in the nature of an interim order; and (iii) upon a detailed enquiry, if the NCLT finds commission of fraud, to debar the auditor from undertaking audit for a period of five years.

This is a forward looking judgement which will instill confidence in the stakeholders, especially the investors and will act as a deterrent for the defaulting auditors.

For any query, please write to Mr. Bomi Daruwala at [email protected]

Supreme Court: Secured creditor not categorized as either financial creditor or operational creditor is entitled to retain security interest in pledged shares

The Supreme Court, by a judgment pronounced on May 4, 2023, in the matter of Vistra ITCL (India) Limited and Others v. Mr. Dinkar Venkatasubramanian and Another [Civil Appeal No. 3606 of 2020], has held that by virtue of a security created by a corporate debtor in favor of a lender to secure the loan facility advanced to a third-party, even though the lender would be considered as a secured creditor of the corporate debtor, however the lender would not be considered as a financial creditor and would not form part of the Committee of Creditors (“CoC”) of the Corporate Debtor. Nonetheless, in the present case, the Supreme Court has directed that the Appellants will be entitled to retain the security interest in the pledged shares, in order to secure the ends of justice.

Facts

Amtek Auto Limited (“Corporate Debtor”) approached KKR India Financial Services Limited (“Appellant No. 2”) and L&T Finance Limited (“Appellant No. 3”) to extend a short-term loan facility of INR 500 Crores to its group companies namely, Brassco Engineering Limited (“Brassco”) and W.L.D. Investments Private Limited (“WLD”), for the ultimate end use of the Corporate Debtor. As per the Appellants, it was an understanding that the Corporate Debtor will create a first ranking exclusive security by way of pledge over 16,82,06,100 equity shares having face value of INR 2/- each of JMT Auto Limited (“JMT”) held by the Corporate Debtor.

A security trustee agreement was executed on December 28, 2015, between Vistra ITCL (India) Limited (“Appellant No. 1”) and WLD for an amount of INR 1,50,00,00,000/-. Further, a security trustee agreement was executed between Appellant No. 1 and Brassco for INR 1,50,00,00,000/-. Thereafter, another security trustee agreement was executed between Appellant No. 1 and Brassco for INR 2,00,00,00,000/-. Thereafter, an amended and re-instated pledge agreement was executed on July 05, 2016 (“Pledge Agreement”), between the Corporate Debtor, WLD, Brassco and Appellant No. 1, whereby the Corporate Debtor pledged 66.77% of its shareholding in JMT to secure the term loan facilities availed by WLD and Brassco from Appellant No. 2 and Appellant No. 3.

On July 24, 2017, Corporate Insolvency Resolution Process (“CIRP”) was initiated against the Corporate Debtor under the provisions of the Insolvency and Bankruptcy Code, 2016 (“IBC”) wherein Mr. Dinkar T. Venkatasubramanian (“Respondent No. 1”) was appointed as the interim resolution professional and he was subsequently confirmed as the resolution professional.

On November 2, 2017, Appellant No. 1 filed its claim as a secured financial creditor of the Corporate Debtor for a principal amount of INR 500 Crores. However, the aforesaid claim was rejected by the Respondent No. 1 in 2017 and such rejection was not challenged by the Appellants before the National Company Law Tribunal, Chandigarh (“Adjudicating Authority”).

Further, the Respondent No. 1 had received two resolution plans from entities namely, Liberty House Group Private Limited (“LHG”) and Deccan Value Investors (“DVI”) respectively. However, DVI withdrew its resolution plan and the revised resolution plan submitted by LHG was approved by the CoC of the Corporate Debtor on April 2, 2018, with majority voting shares of 94.20%. Thereafter, the aforesaid resolution plan submitted by LHG was approved by the Adjudicating Authority on July 25, 2018. However, thereafter, LHG failed to fulfil its obligations as committed in terms of the approved resolution plan and the Adjudicating Authority passed an order directing the CoC to reconsider the resolution plan of DVI.

Thereafter, the Appellants filed an application before the Adjudicating Authority claiming their right on the basis of pledged shares. However, the Adjudicating Authority dismissed the aforesaid application filed by the Appellants. Thereafter, upon approaching the National Company Law Appellate Tribunal, New Delhi (“Appellate Authority”), the Appellate Authority dismissed the appeal. While dismissing the appeal, the Appellate Authority observed that the claim form submitted by Appellant No. 1 as a secured financial creditor was rejected by Respondent No. 1 in 2017 and it was not challenged before the Adjudicating Authority at that time and therefore, the Appellants are not entitled to raise the same issue in 2020. Further, the Appellate Authority had also observed that the Appellant No. 1 has not lent any money to the Corporate Debtor and reiterated the view of the Adjudicating Authority that the Appellant would not come within the purview of financial creditor.

Aggrieved by the aforesaid decision of the Appellate Authority, the Appellants preferred a civil appeal before the Supreme Court.

Issue

Whether in case of third-party security created by a corporate debtor, the lender who is a secured creditor qua the corporate debtor but neither considered as financial nor operational creditor qua the corporate debtor, would be entitled to retain the security interest in the asset created by the corporate debtor.

Arguments

Contentions of the Appellants:

The Appellants contended that the observation made by the Appellate Authority, that the Appellant have challenged the rejection of claim by Respondent No. 1 after a delay of nearly three years, is erroneous since it is a case of continuing cause of action. It was further contended that no limitation is prescribed for challenging the categorization of the creditors in a wrongful category.

Further, the Appellants contended that they had challenged their non-inclusion in the CoC as secured financial creditor on February 11, 2020, which is nearly five months prior to the date of approval of resolution plan by the Adjudicating Authority (that is, July 09, 2020).

Further, the Appellants contended that there exists a creditor-debtor relationship between the appellants and the Corporate Debtor. It was submitted that debt arising out of pledge of shares amounts to financial debt by virtue of the definition of “security interest” envisaged under Section 3(31) of the IBC.

Contentions of the CoC:

CoC raised the issue of the Appellants challenging the rejection of claim by Respondent No. 1 by approaching the Adjudicating Authority after a delay of nearly three years and further submitted that even in the numerous correspondences addressed to Respondent No. 1, Appellant No. 1 never raised the aforesaid grievance, but merely requested to Respondent No. 1 to ensure that the pledged shares are not dealt with in any manner without the prior written consent of Appellant No. 1. CoC further submitted that the Appellants had filed the application before the Adjudicating Authority on February 11, 2020 not to challenge the claim rejection, but for seeking admission into the CoC.

Further, the CoC placed reliance on judgment delivered by the Supreme Court in the matter of Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited [(2020) 8 SCC 401] (“Anuj Jain Case”) and Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel [(2021) 2 SCC 799] (“Phoenix Case”) to substantiate its contention that the Appellants cannot be considered a financial creditors of the Corporate Debtor by virtue of a third-party security created by the Corporate Debtor in the form of pledged shares with respect to the amounts advanced by Appellant No. 2 and Appellant No. 3 to the group companies of the Corporate Debtor.

Observations of the Supreme Court

The Supreme Court observed that in Anuj Jain Case the court held that even though the lenders of Jaypee Associates Limited are secured creditors of Jaypee Infratech Limited (“JIL”) within the realms of IBC, they cannot be considered as financial creditors of JIL and would not form part of the CoC of JIL merely by virtue of third-party security creation. Further, relying upon its previous judgment in the matter of Anuj Jain Case, the Supreme Court in Phoenix Case held that Phoenix ARC Private Limited cannot be considered a financial creditor of Doshion Limited and Doshion Veolia Water Solutions Private Limited by virtue of third-party security creation. The Supreme Court observed that even in the present case, the liability to repay the financial facility was on the group companies of the Corporate Debtor who had availed the facility and not on the Corporate Debtor.

Thereafter, the Supreme Court examined whether the resolution plan can dilute, negate or override the Pledge Agreement because a resolution plan to such effect has been approved by the CoC. In this regard, Supreme Court observed that certain amendments were made in Section 30(2) of the IBC to secure the interests of operational creditors and dissenting financial creditors. However, in so far as creditors like Appellant No. 1, who are secured creditors but neither financial creditors nor operational creditors, a highly peculiar situation would arise wherein such creditors will be left remediless in terms of the amounts allocated to them upon implementation of an approved resolution plan since such creditors would neither avail the benefit available to the financial creditors nor the benefit available to the operational creditors. Hence, the Supreme Court observed that Appellant No. 1, not being a secured financial creditor is neither in a position to opt to realize its security interest in terms of Section 52(1)(b) (Secured creditor in liquidation proceeding) of the IBC nor it is in a position to receive sale proceeds at a relatively higher priority in the event of relinquishment of security interest to the liquidation estate.

In view of the above-mentioned issue, the Supreme Court considered two possible solutions. The first was to treat the secured creditor as a financial creditor of the Corporate Debtor to the extent of the estimated value of the pledged share on the date of commencement of the CIRP, which would make it a member of the CoC and give it voting rights equivalent to the estimated value of the pledged shares. However, this would lead to reconsideration of the earlier judgments in the matters of Anuj Jain Case and Phoenix Case and require reference to a larger bench of the Supreme Court. In view of the aforesaid reason, the Supreme Court observed that the first solution is not feasible.

Therefore, Supreme Court decided to treat Appellant No. 1 as a secured creditor in terms of Section 52 read with Section 53 of the IBC. The Supreme Court gave the option to DVI to treat Appellant No. 1 as a secured creditor, who will be entitled to retain the security interest in the pledged shares and would be entitled to retain the security proceeds on the sale of the said pledged shares under Section 52 of the IBC read with Rule 21A of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016. The Supreme Court further clarified that the aforesaid direction would not be a ground for DVI to withdraw the resolution plan which has already been approved by the Appellate Authority as well as the Supreme Court. The Supreme Court further observed that the aforesaid recourse would be equivalent in monetary terms for Appellant No. 1 and would be a fair and just solution in the interest of justice.

Decision of the Supreme Court

In view of the above-mentioned findings, the Supreme Court partly modified the impugned judgment of the Appellate Authority, holding that Appellant No. 1 would be entitled to all rights and obligations as applicable to a secured creditor in terms of Sections 52 and 53 of the IBC and in accordance with the Pledge Agreement. Accordingly, the Supreme Court disposed of the present appeal without any order as to costs.

VA View:

By way of the present judgment, the Supreme Court has settled a highly pertinent question of law. As such, lenders to group company having security over assets of corporate debtor are left remediless since such lenders would neither be able to avail the benefit available to the financial creditors nor the benefit available to the operational creditors.

In order to address this peculiar situation as evident from the facts of the present case, the Supreme Court directed that such lenders will be entitled to retain the security interest in the asset created by the corporate debtor. By providing an out of the box solution, the Supreme Court has endeavored to strike a fine balance to secure the ends of justice and equity.

For any query, please write to Mr. Bomi Daruwala at [email protected]