The recent Delhi High Court ruling on the National Financial Regulatory Authority (NFRA) has created a flutter.
Since its formation on October 1, 2018, the NFRA has issued around 80 orders recommending disciplinary action against audit firms and auditors. The disciplinary action recommended by the NFRA was usually a monetary penalty and in some instances, a monetary penalty coupled with a debarment.
Most of these orders have been against the auditors of Dewan Housing Finance Ltd and Café Coffee Day. Section 132(4) of the Companies Act, 2013 empowered NFRA to do all the above. The first bunch of cases decided by the NFRA against the auditors of IL&FS pertained to audits that were conducted prior to the date of formation of NFRA.
The Auditors filed a writ petition before the Delhi High Court stating that NFRA could only investigate audits done after their formation. Rule 11(1) of the NFRA rules read “Based on the reference received from the Central Government or findings of its monitoring or enforcement or oversight activities, or on the basis of material otherwise available on record, if the Authority believes that sufficient cause exists to take actions permissible under sub-section (4) of section 132, it shall refer the matter to the concerned division, which shall cause a show-cause notice to be issued to the auditor”.
In the same writ petition before the Delhi High Court, the auditors claimed that the audit quality as well as the disciplinary action recommended were done by the same division at NFRA and not separate divisions as envisaged by Rule 11(1).
They also argued that Section 132(4) should be invalidated since it imposes a vicarious liability on individuals who would not have had anything to do with the audit. To make their arguments complete, they also argued that the procedure adopted by NFRA was against the principles of fairness and natural justice.
Delhi HC order
The Delhi High Court reserved its judgment in July 2024 and pronounced its final judgment over 476 pages and 343 paragraphs in February 2024. The Court upheld the validity of Section 132 and the NFRA Rules and found no merit in the challenge based on the arguments of vicarious liability, retroactive operation and a violation of Article 20(1) of the Constitution.
The Court also stated that it was unable to sustain the challenge that the NFRA procedures suffered from the vice of manifest arbitrariness and deprivation of a fair procedure. The prescription of a summary procedure for trial of disciplinary matters neither obviates nor relieves the NFRA from adhering to a procedure which is in consonance with the principles of fairness and natural justice.
However, the Delhi High Court observed that 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 assessment of whether circumstances warranted a disciplinary enquiry being initiated was statutorily liable to be undertaken by a unit of the NFRA separate from the one which drew up those reports. The procedure which NFRA chose to follow in these cases clearly lacked attributes of neutrality and a dispassionate appraisal.
In its ruling, the Delhi High Court provided a solution to the NFRA for the cases under dispute — they could draw proceedings afresh by an independent set of members.
The Impact
The decision of the Delhi High Court may tempt other auditors to file petitions on similar grounds.
They could possibly add in an argument that Rule 12(5) of the NFRA rules states that the Division shall dispose of the show-cause notice within a period of 90 days of the assignment — a timeframe that has elapsed. NFRA could respond that since the Delhi High Court has blessed drawing proceedings afresh, it invalidates the time-barred doctrine.
NFRA should quickly constitute a Disciplinary Committee which should be separate from the Audit Quality Committee, and recommend disciplinary action in all cases henceforth.
The writer is a chartered accountant