Accounting Firms Seek Immunity in IL&FS Fraud Case Before NCLAT

Audit Firms in India Seek Immunity from Liability in IL&FS Fraud Case

Three of the four largest audit firms in India, including BSR & Associates, a KPMG network firm, SRBC, a network firm of EY, and Deloitte Haskins & Sells, have filed appeals with the National Company Law Appellant Tribunal (NCLAT) seeking immunity from liability in the IL&FS fraud case.

The case revolves around Section 339 of the Companies Act, which gives powers to the National Company Law Tribunal (NCLT) to implead any directors, employees, or associates of a company if their company acted with the intent of defrauding creditors and other stakeholders. The NCLT had allowed proceedings against the auditors under Section 339 and held that watchdogs cannot be excluded from proceedings in its order dated March 24.

The case was heard on May 26, when the tribunal provided a breather to the auditors by ordering no coercive action will be taken in the matter until NCLAT renders its verdict. The case is next posted for June 15, according to the NCLAT website.

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The implications of this case are significant, as it opens up large audit firms to unlimited liability in cases of corporate fraud by their clients. According to legal experts, these cases would have a massive impact on India's large audit firms.

Section 339: Piercing the Corporate Veil

In normal cases, companies or Limited Liability Partnerships (LLPs) are responsible for wrongdoing, and liability on individuals like promoters and directors is limited. However, Section 339 allows the tribunal to "Pierce the Corporate veil," placing the full liability on key people of the company who are in control.

Audit Firms Argue Section 339 Does Not Apply to Them

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The Companies Act section does not explicitly mention if auditors are covered under the rule. However, it says that such proceedings can be initiated against any persons who are directors or managers of the company along with any other persons "who were knowingly parties to the carrying on of the business." Audit firms are taking a view that the section is intended for promoters and employees and not auditors.

According to an auditor privy to the development, "The section says carrying on the business and auditors are not parties to carrying on business. Their limited scope is to check and certify accounts. Yes auditors are accountable for statements they sign but through Section 141 of the Companies Act not Section 339."

Section 141 of the Companies Act contains comprehensive rules on auditors of a company, including who can be appointed, what process is to be followed, and conditions for disqualification of auditors. This section places limited liability on the auditors and disqualification is the only action that can be taken against the professionals.

The IL&FS Fraud Case

In 2018, a debt crisis at IL&FS triggered a systemic risk as the company defaulted on Rs 91,000 crore worth of bank loans. Further probes into the case by various regulators showed the company had manipulated the books and window-dressed financial statements to paint a picture that the company was doing well. This fraud raised questions on the audit practices of these large network companies as they failed to flag liquidity mismatches, mounting bad loans, and high debt-to-equity ratios.

The IL&FS fraud case, along with the Satyam case, eventually prompted the central government to form the National Financial Reporting Authority (NFRA), whose primary job is to keep a vigil on balance sheets and auditors of large public interest companies.