In a landmark decision on September 4, 2019, the Securities Appellate Tribunal (SAT) lifted the ban imposed by SEBI on Price Waterhouse (PW) from auditing listed companies for a period of two years. The ban was imposed by SEBI on PW for its role as statutory auditor during the large-scale manipulation in the books of accounts of Satyam Computers Services Limited (SCSL).
In its order dated January 10, 2018, SEBI held that the failure of PW to seek external confirmation of the bank balances, fixed deposits, failure to detect fake invoices without adopting the rigorous procedure mandated by accounting standards draws an inference of gross negligence and inference of involvement in the fudging of the accounts. We had written about this order here. According to SEBI, such gross negligence amounted to an act of commission of a ‘fraud’ for the purposes of the SEBI Act, 1992 (SEBI Act) and SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (PFUTP Regulations).
On appeal, SAT set aside the SEBI order on the ground that SEBI does not have the jurisdiction to bar statutory auditors from providing their services to listed companies unless they are found to be in collusion with entities perpetrating securities fraud. SAT held that SEBI has found no evidence that PW or its engagement partners were part of the conspiracy and that they deliberately prepared false and fabricated accounts of SCSL.
The judgment throws light over the jurisprudence of ‘fraud’ under the PFUTP Regulations and the jurisdiction of SEBI for fraud in matters related to securities. Some of the important highlights of the judgment are discussed below:
Dealing in securities a pre-requisite for securities fraud:
It was held that as a general rule, if a person is not dealing in securities, either directly or indirectly, then Section 12A of the SEBI Act and Regulations 3 and 4 of the PFUTP Regulations, which deal with fraud, would not be applicable to such person. In the instant case, PW was acting as statutory auditor of SCSL and there existed no charge that they were dealing in securities.
Inducement to deal in securities:
As an exception to the general rule, ‘fraud’ under the PFUTP Regulations covers an act or omission, even without deceit, if such act or omission had the effect of inducing another person to deal in securities. However, SEBI is required to prove the conclusion of ‘inducement’ with proven and admitted facts. In the absence of any finding or cogent evidence that PW had induced someone to deal in securities, it was held that PW cannot be charged with ‘fraud’.
Gross negligence in professional conduct does not amount to securities fraud:
SEBI had found PW liable for ‘fraud’ on the ground of gross negligence while conducting the audit of SCSL. Overturning this finding, SAT held that professional negligence of auditors would amount to misconduct, which should be taken up by the Institute of Chartered Accountants of India (ICAI) as prescribed under the Chartered Accountants Act, 1949. It held that in the absence of any direct evidence to show that PW or its engagement partners were directly involved in the fabrication of the books of account, they cannot be held liable for ‘fraud’ by SEBI.
Mens rea in securities fraud:
SEBI had held that there is no requirement to prove ‘mens rea’ or ‘malicious intent’ of the auditor, and mere ‘gross negligence’ would amount to ‘fraud’ for the purposes of PFUTP Regulations. However, SAT held that ‘mens rea’ is not required to be proved by SEBI in cases where a person who was directly or indirectly dealing in securities has been charged with fraud. For example, in case of a charge of circular trading, market manipulation etc., ‘intent’ to manipulate the securities market is not necessary to be proved. However, where there is a charge that the person has ‘induced’ others to deal in securities, SEBI must prove with direct evidence that the person charged had the intent to defraud the securities market. It was further held that SEBI has merely found irregularities in the auditing standards, which can be best described as professional negligence amounting to misconduct and not securities fraud, and there was no evidence of collusion and conspiracy on part of the auditors to manipulate the books of accounts.
Jurisdiction of SEBI:
The issue of jurisdiction of SEBI over auditing firms / other professional agencies has been the subject of considerable debate in the past. SAT relied upon the earlier decision of the Bombay High Court dated August 13, 2010 in the matter, where PW had challenged the jurisdiction of SEBI to impose liability on auditors. The Bombay High Court had held that SEBI can exercise jurisdiction over auditors, who are not market participants dealing in securities, only when there is direct evidence that they were complicit or instrumental in the act of fraud. It was held by SAT that non-adherence to the auditing standards issued by ICAI, would at best, amount to a lapse in the professional work of the auditor which can be a ground for professional misconduct to be taken up strictly by the ICAI and not by SEBI.
Powers of SEBI under Section 11 and 11B:
SAT opined that the power of SEBI under Sections 11 and 11B of the SEBI Act is to only issue preventive and/or remedial action against the violators of securities laws but not punitive actions. However, in cases involving persons such as auditors, who are not securities market participants, SEBI can only take remedial actions (remedy of past harm) and not preventive actions (prevent future harm) under Sections 11 and 11B. In the instant case, SAT held that the direction to debar the auditor from auditing the books of a listed company is neither remedial nor preventive but was clearly punitive, and therefore, violative of Article 19(1)(g) of the Constitution of India as it takes away the fundamental right of the auditor to carry on its business.
Role of Auditors:
The SAT order also provides guidance on the role of statutory auditors in auditing companies. SAT opined that an auditor is not required to sniff like a bloodhound and proceed with an attitude of professional scepticism. An auditor is required to employ reasonable skill and care but the auditor is not required to begin with suspicion or to proceed in the manner of trying to detect a fraud or a lie, unless it receives some information which creates suspicion. What is reasonable care and skill must depend upon the circumstances of each case. The auditor is not required to perform the functions of a detective. The auditor is a watchdog and not a blood hound. The duty of an auditor is verification and not detection.
Disgorgement of fees by SEBI permitted:
SAT, while overturning SEBI’s decision to debar PW for two years, in a strange move, upheld the order of SEBI to disgorge fees earned by PW for auditing SCSL amounting to over Rs. 130 million. SAT opined that there was a professional lapse on part of the auditors in conducting the audit, especially their failure to seek direct confirmation from the banks relating to bank balances and fixed deposits. These lapses amounted to negligence, breach of duty and failure to maintain that standard of care, for which SEBI has requisite powers under Sections 11 and 11B to disgorge the professional fees earned by the auditors.
Finsec view
The SAT order should be seen as a red-herring for SEBI in matters where charges of fraud are casually levelled against professional firms, that are not market participants and otherwise do not deal in the securities market. This order establishes that persons not dealing in securities markets can be held liable for fraud only when there is direct evidence that they were complicit in the fraud.
However, the later part of the order where SAT permitted disgorgement of fees on the ground of professional negligence is in contradiction with the stand taken by SAT that SEBI does not have jurisdiction over professional misconduct by auditors.
