Yet again, on October 12, the Securities Appellate Tribunal (SAT) set aside an order by SEBI taking penal action against the auditors for alleged false reporting. The rationale is the same as in earlier cases — that SEBI does not have the power to act against the auditors for gross negligence, false reporting/certification, etc. SEBI can act against the auditors only if they were actively engaged in the financial/accounting fraud.
The history of this goes back to 2010, when the Bombay High Court laid down a precedent for action by SEBI against auditors. It emphatically said that SEBI cannot take action against auditors for faulty reports unless it can show that the auditors were actually involved in financial/accounting fraud. In other words, SEBI cannot act against auditors even if the auditors were negligent or their reports or certificates were false.
This limitation of powers has been extended even under company law by a ruling of the NCLAT. The rationale for this limitation is clear. The Institute of Chartered Accountants of India (ICAI) regulates the profession, and can take action for negligent or otherwise faulty audit reporting, or certificates. This does help in avoiding multiple action by different regulators, which may result in contradictory approaches. This also ensures that the expert body set up for this purpose, and which understands the technicalities of the audit process is authorised to act. Further, there is a clear line between where SEBI can act (i.e. frauds, and the like), and where the ICAI can act (i.e. in case of negligence, or not complying with auditing standards).
Despite such clear ruling, SEBI has several times thereafter initiated action against auditors, and has passed adverse orders. Each time, it has found its orders getting reversed.
SEBI’s Overreach
In the recent SAT order, what allegedly happened was this: A listed company made a public issue. The auditor is required to give a certificate regarding utilisation of the IPO proceeds, and whether it was for the objects stated in the offer document. This gives assurance to the shareholders that the company utilised the monies raised from them for the purposes stated in the offer document.
SEBI analysed each item of use of funds for which the IPO was raised vis-à-vis the utilisation as per the auditor’s certificate. It was found, and even SAT agreed to this extent, that the certificate had false statements. SAT observed, “We find that the AO has only established that the appellants have falsely certified the Unqualified Utilization Certificate” (emphasis provided). The Adjudicating Officer of SEBI (the AO) held that the auditors have an unqualified certificate though he was allegedly aware of the facts. He stated that the auditors “falsely certified Unqualified Utilization Certificate, containing distorted information which they did not believe to be true but certified knowing that the same when published would be relied upon by the investors to be true and fair”. Thus, the AO levied a penalty of Rs 15 lakh on the auditors.
It is noteworthy to state that this certificate is required under securities laws. The auditors also give a comprehensive report on the financial statements. This report did contain certain reservations on the utilisation of the IPO funds. The certificate referred to the report.
Before SAT, the issue revolved around the core aspect. Did the auditors fabricate the accounts, or abet in it? Did they collude in it? SAT said that SEBI has not established this. Thus, applying the Bombay High Court ruling, SAT set aside the penalty order.
Splitting Hairs
SEBI may argue that this leaves it aggrieved, and powerless. Even if a certificate is required under a law that squarely comes under its jurisdiction, it cannot act against a person even if they have made a false statement or otherwise not exercised diligence. It can act against merchant bankers, brokers, portfolio managers, independent directors, etc., and even a member of the public. Of course, the fact also is that merchant bankers, etc. are registered with SEBI, while auditors are not.
Nothing stops SEBI from acting in case of fraud/manipulation engaged in by the auditors itself. Sure, the line between making a false statement while being aware of the truth (as alleged in this case), and actively engaging in falsification or fraud is hairline thin. This becomes even more confusing — like splitting the proverbial hair — when it is now well established by the Supreme Court that in case of frauds, the test that applies is of “preponderance of probability”. Thus, in civil proceedings like penalty, etc., if SEBI can show that it was more probable that a person was guilty of fraud than he was not, SEBI’s finding of guilt holds. The same principle should apply in case of auditors.
SEBI’s hands are further strengthened by a recent development. SEBI amended its regulations relating to frauds in 2020 and specifically included manipulation of books of accounts or financial statements. It is submitted that with a change in approach in the proceedings and in the order, SEBI could pass orders against auditors which would hold up in appeals. It may be remembered that auditors do not have any blanket immunity. The bar on action only holds against negligent audit, false statements, etc. The auditors (and, for that matter, chartered accountants generally) may be held liable for fraud, for insider trading, etc.
Stop Flogging The Dead Horse
But for this purpose, SEBI should stop flogging the dead horse of taking action for negligent auditing or even faulty audit reporting. It needs to focus on showing whether the auditors participated or abetted in the fraud. With the lower benchmark for establishing fraud laid down by the Supreme Court, and the explicit inclusion of accounting frauds in the regulations, SEBI’s job has become easier.
This, of course, brings up the question of multiple regulators. As we have also seen recently, the National Financial Reporting Authority (NFRA) has been very active and passing adverse orders against auditors and penalising them and/or debarring them. But arguably, these orders fall on the other side of the thin line, while SEBI could focus on frauds.
Conclusion
A reconsideration of perception is required when corporate financial and accounting frauds are detected. SEBI has its role cut out by law, as is now clear by several rulings. It cannot act against auditors even if there are false statements, gross negligence, etc. For that, there is ICAI/NFRA.
However, it also calls for a rethink in the proceedings, and orders passed by SEBI. The proceedings need to focus to show whether and how, applying also the relatively relaxed benchmark of ‘preponderance of probability’, the auditors themselves engaged in fraud or in fabricating the accounts.
SEBI’s orders need to record and demonstrate this in reasoned detail. This way, it will be seen as doing its role in keeping the capital markets clean of fraud, instead of passing the same orders against auditors again and again for negligence and faulty reporting and expecting different results in appeal.
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