Delhi High Court upholds Section 132 Companies Act, NFRA's powers to proceed against auditors

The Delhi High Court recently upheld the constitutional validity of Section 132(4) of the Companies Act, 2013, which grants the National Financial Reporting Authority (NFRA) the power to investigate and penalise auditors for professional misconduct [Deloitte Haskins & Sells LLP Vs Union of India]..A Division Bench comprising Justices Yashwant Varma and Dharmesh Sharma held,“On an overall conspectus, we uphold the validity of Section 132 and the NFRA Rules. We find no merit in the challenge based on the arguments of vicarious liability, retroactive operation and a violation of Article 20(1) of the Constitution."However, the Court also identified serious procedural shortcomings in the NFRA's handling of cases related to audits completed before its establishment on October 1, 2018.The Bench raised concerns about whether due process was followed in such matters and whether there were sufficient safeguards against possible bias in such cases. This was on account of the fact the authority which conducting the disciplinary proceedings was the same authority that conducted audit review. The Court held that these functions should have been performed by two separate divisions of the NFRA. "However, the NFRA clearly acted contrary to the command of the legislation which obliged it to bear in mind the division of functions and which clearly mandates a separation of roles that the authority is called upon to discharge under the Companies Act and the NFRA Rules," the Court observed. .The judgment was delivered in a batch of petitions filed by prominent Chartered Accountants (CAs) and auditing firms, including Deloitte Haskins & Sells LLP, challenging NFRA's disciplinary actions. The petitioners contended that Section 132(4) of the Companies Act, 2013 and certain NFRA Rules (notably Rules 3, 8, 10, and 11) were unconstitutional and arbitrary. A major point of contention was the retroactive application of these provisions, with the petitioners arguing that audits completed before the NFRA's inception should not fall under its purview.The NFRA had penalised these firms for alleged acts of misconduct prior to its formation on October 1, 2018. Additionally, the petitioners highlighted lack of procedural safeguards, asserting that NFRA's actions violated their rights under the Chartered Accountants Act, 1949 (CA Act)..Challenges to NFRA's Disciplinary ProcedureThe petitioners argued that NFRA's summary disciplinary procedure under Rule 11(5) denied parties procedural safeguards, lacked codified procedural guidance thereby, violating the principles of fairness and natural justice. A key point of contention was the difference in procedures between the CA Act and the NFRA Rules. The petitioners highlighted the CA Act involved a detailed process in disciplinary cases - involving written statements, rejoinders, hearings with rights to be represented, framing of charges, responses, recording of pleas, examination of witnesses, document production, evidence presentation, cross-examination and arguments as well as opportunities for hearing before sanctions.They argued that the NFRA's summary procedure deprived parties of these crucial rights. In particular, they challenged a rule which limited the presentation of evidence to whatever is recorded in the audit file.The petitioners argued that this restriction curtailed their ability to defend themselves properly against misconduct allegations. They pointed out that even Auditing Standards, namely SA 230, acknowledged that it was impractical to document every professional judgment in the audit file..NFRA’s ResponseThe NFRA countered by arguing that the audit file restriction binds them as well, meaning that the authority too cannot go beyond the audit file while examining allegations of misconduct. The authority emphasised the importance of maintaining a comprehensive audit record by citing paragraph 5 of SA which says that oral explanations are not adequate to support an auditor's work. It also argued that a summary procedure doesn't automatically mean that natural justice principles would be violated. The NFRA further differentiated its role (quality monitoring) from the ICAI's role (handling complaints against members), arguing that the NFRA's proceedings are not necessarily adversarial.Thus, the NFRA is not required to incorporate all procedures incorporated by the ICAI in its proceedings..Court’s Analysis.Section 132(4) - The Core of the Dispute: The Court addressed concerns about the NFRA's powers being applied retrospectively by clarifying that Section 132 does not create new categories of misconduct. Rule 11(5) - Summary Procedure vs. Natural Justice: The Court observed that a "summary procedure" is not a license to disregard natural justice altogether. Rather, it only allows for a less formal process than a full court trial. Even a summary procedure must adhere to the principles of natural justice, the Court said. Section 132(4)(b) and Rule 8(3) - Scope of Investigation: The petitioners pointed out that these provisions grant the NFRA broad investigatory powers, including access to various documents and the ability to examine witnesses. On the other hand, auditors facing disciplinary proceedings can only rely on audit files to present their defence. The Court acknowledged the breadth of NFRA's investigation powers but did not expressly rule on whether the audit file restriction was contradictory. Instead, it focused on the application of the NFRA's powers, emphasising that the NFRA's internal procedures should not create an unfair disadvantage for the accused.Interplay between the CA Act and NFRA Rules: The Court observed that the ICAI and NFRA had different roles, with the NFRA focusing on systemic quality control rather than individual complaints. The Court said that the NFRA was therefore not mandated to replicate the procedures laid down in the CA Act."Division" of functions: The petitioners argued that the law envisioned separation of functions between audit review and disciplinary actions of the NFRA. The NFRA countered that its Executive Body could fulfil both roles. The Court sided with the petitioners, emphasising that the same body that conducted the audit review and identified potential misconduct should not then initiate disciplinary proceedings. Otherwise, there is an unacceptable risk of bias, the Court said..Court's Key Conclusions.LiabilityAudit firms can be held liable for the acts of the partners they engage, the Court held. Firms cannot disavow the actions of their members, the Court reasoned. Fixing separate liability for the firm and its partners are impractical and incompatible with auditing's collaborative nature, the Court held. Section 132's vicarious liability is constitutional and not arbitrary, it concluded. .RetrospectivitySection 132 is not retrospective since it does not create new misconduct categories, the Court found. Rather, it uses the existing definition of misconduct under Section 22 of the CA Act. Section 132 merely addresses a regulatory gap by bringing India's auditing framework in line with global standards, it further said. Article 20(1) (criminal law cannot be retrospectively applied) of the Constitution would not apply to civil penalties under Section 132, the Bench further held. .NFRA ProcedureThe NFRA's summary procedure under Rule 11 requires adherence to natural justice principles, including hearings when necessary, the Court found. The NFRA must provide details of allegations and evidence, it noted. The restriction of proceedings to the audit file is valid, the Court added, as SAs emphasize the audit file's comprehensiveness..NFRA Divisions and BiasSection 132 of the Companies Act contemplates that the NFRA should function through divisions. Its Executive Body cannot conduct both the audit quality review (AQRR) and then decide on disciplinary action based on that review, the Court said. This is to avoid any likelihood of bias.It, therefore, also quashed certain show cause notices and final orders passed against the petitioners for violating this requirement. It allowed the NFRA to initiate fresh proceedings instead from the stage of notice. .The petitioners were represented by Senior Advocates Kapil Sibal, Arun Kathpalia and Jayant Mehta..The Union of India was represented by Central Government Standing Counsel (CGSCs) Ravi Prakash, Shiva Lakshmi and Vikram Jetley.NFRA was represented by Advocates Zoheb Hossain, Vivek Gurnani, Abhipriya Rai, Vivek Gaurav, Kartik Sabharwal and Radhika Puri..[Read Judgment]