Auditor’s professional lapses not fraud

By Karthik Somasundram and Sneha Jaisingh, Bharucha & Partners

In January 2018, the Securities and Exchange Board of India (SEBI) banned the accountancy firm Price Waterhouse (PW) from auditing listed companies for a period of two years due to lapses in the audit of Satyam Computer Services Limited (Satyam). The order was successfully challenged in the Securities Appellate Tribunal (SAT), (Price Waterhouse & Co. & ors. v SEBI).

In January 2009, the chairman of Satyam disclosed that audited statements were inflated and showed non-existent cash and bank balances. SEBI investigated and accused PW of gross negligence and recklessness in conducting the audit. It issued show cause notices (SCN) in 2009 and 2010, under the SEBI Act and SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (PFUTP regulations). The SCNs were challenged in the Bombay High Court on the grounds that SEBI was exceeding its powers and usurping the jurisdiction of the Institute of Chartered Accountants of India (ICAI).

Karthik Somasundram
Bharucha & Partners

In August 2013, the court disagreed with PW but ruled that SEBI could not encroach upon the powers of ICAI. SEBI could only pass orders against PW where the facts of falsifying and fabricating accounts were established. The court restricted the enquiry by SEBI to the charges of conspiracy and involvement of PW in perpetrating fraud, and excluded the allegations of professional negligence.

In January 2018, after further enquiry SEBI concluded that the failure to seek external confirmation of bank balances and fixed deposits, and a failure to detect fake invoices because PW had not adopted the rigorous procedures laid down by the ICAI, meant that the grounds of gross negligence and involvement in the forging of Satyam’s accounts, were established. SEBI held that gross negligence amounted to the commission of fraud for the purposes of PFUTP regulations. PW was sanctioned as above and 10 other accounting firms associated with PW were also banned. PW challenged the orders in the SAT.

Sneha Jaisingh
Managing associate
Bharucha & Partners

PW argued that charges under PFUTP regulations could be brought only to curb market manipulation, and that such manipulation must be related to securities and by persons dealing in securities. PW was the auditor to a listed company and did not deal in securities, directly or indirectly. There was no evidence to show that it had fabricated, falsified or distorted the books of accounts of Satyam in collusion with the company’s top management. Negligence, carelessness or recklessness alone were not sufficient to establish the probability of PW colluding or conniving with the top management of Satyam to commit fraud. The Supreme Court in the Kanaiyalal (2017) case had ruled that it must be proved that there was inducement to commit fraud for the PFUTP Regulations to apply. The SAT agreed, holding that there was no direct evidence to demonstrate the involvement of PW in the fabrication of the books of accounts. The chairman of Satyam had also stated that PW had played no role in the forging of the books of accounts and had been kept in the dark.

The SAT noted that there was overwhelming evidence to show that only the top management of Satyam had fabricated and falsified the books and that PW did not take part in the fraud. SEBI had not proved that PW had knowingly and with intent connived with the management to fabricate the books of accounts. PW could not be accused of fraud merely on the balance of probabilities due to recklessness and carelessness in the discharge of its duty. Intent and mens rea (a guilty mind) are integral to fraud and SEBI had not made those findings.

Findings regarding non-adherence to auditing standards issued by the ICAI would at best prove professional misconduct, and are to be determined by the ICAI. Relying on the Supreme Court judgment in the case of Jacob Mathew (2005), the SAT observed that negligence in discharge of professional duties, would not amount to professional misconduct. Professional misconduct requires an element of moral delinquency, which was not established by SEBI.

Sections 11 and 11B of the SEBI Act provide powers to protect the interests of investors and therefore SEBI could adopt measures which are remedial or preventive. The SAT ruled that a direction barring a chartered accountant from auditing a listed company is neither remedial nor preventive. The SAT also criticized the sanctions imposed upon the 10 associated firms that had not audited Satyam. There was no finding of connivance or collusion or intention to defraud. The 10 firms used the PW name as authorized by PricewaterhouseCoopers International Limited, but they were neither a network nor one consolidated entity. The SAT set aside the banning order.

Karthik Somasundram is a partner and Sneha Jaisingh is a managing associate at Bharucha & Partners.

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