By Jayant M. Thakur
Chartered Accountant
SEBI’s Order – whether and when mere
negligence amounts to connivance to fraud?
SEBI’s order in Price Waterhouse’s case (of
10th January 2018) is a worrisome precedent not just for auditors,
but also for almost every person associated with securities markets including
independent directors and CFOs from whom certain standards of care are expected
in the discharge of their duties. The issues are :
1. When can a person be held
to have committed fraud?
2. Does not holding a person
guilty of fraud require a much higher and stricter benchmark of proving `mens
rea’ (i.e. guilty mind/wilful act) beyond reasonable doubt? SEBI has
held that in case of auditors, under certain circumstances proving `mens rea’
is not required.
Let us put this in a different way. What
would be the consequence to a person who has exercised less than `due care’
whilst performing his duties? The issue is : Would he be liable of negligence
or fraud? This is because the consequences for both would be different and they
can be more severe for fraud.
SEBI has effectively held that a series of
such negligent acts would amount to fraud under certain circumstances. This is
by applying a lower benchmark and test of ‘preponderance of probabilities’,
instead of proving mens rea beyond reasonable doubt.
The effect of this is far reaching. Take
another category, that is directors/independent directors. The Companies Act,
2013 and the SEBI LODR Regulations both provide for comprehensive duties of
directors. Will a director who performs his duties short of `due care’ be held
to have participated in `fraud’.
SEBI’s order is of course under challenge
and it could be some time before a final resolution as to whether the findings
in the order are upheld or reversed. However, considering that SEBI has relied
on relevant rulings of the Supreme Court and the Bombay High Court, it will be
necessary to examine the findings in the order and the reasoning for the
punishment. Needless to emphasise, for the purpose of this article, the
findings in the SEBI’s order are presumed to be true and the focus is on the
principles enunciated.
Brief background
While the Satyam case is widely known, SEBI
summarises some of its findings in the order. It is stated that a more than Rs.
5000 crore shown as cash/bank balances in balance sheet of Satyam was
non-existent and hence fraudulently stated. Similarly, the revenues and profits
too were overstated for several years, which resulted in over statement of
cash/bank balances. The question before SEBI was : whether the auditors were
aware of such falsification and connived with the management? or whether their
non-detection of such falsification was on account of being merely negligent?
Negligence vs. connivance
Why does it matter whether the role of the
auditors of Satyam (“the Auditors”) was of being merely negligent or whether
they had connived in such falsification? When SEBI initiated action against the
auditors, seeking to, inter alia, debar them from acting as auditors for
a specified period, the jurisdiction of SEBI to act against auditors was
challenged before the Bombay High Court. It was contended that only the
Institute of Chartered Accountants of India could act against auditors who are
chartered accountants, for not carrying out their duties in accordance with
professional standards, and not SEBI. However, the Bombay High Court rejected
this argument, but with a condition. It effectively held that if it was a mere
case of not adhering to prescribed professional standards while carrying out
the audit, SEBI may not have any jurisdiction. However, if it could be shown
that the auditors had knowingly participated or connived in the fraud, then
SEBI could have jurisdiction.
The Bombay High Court observed in Price
Waterhouse & Co. vs. SEBI ([2010] 103 SCL 96 (Bom.)), “If it is
unearthed during inquiry before SEBI that a particular Chartered Accountant in
connivance and in collusion with the Officers/Directors of the Company has
concocted false accounts, in our view, there is no reason as to why to protect
the interests of investors and regulate the securities market, such a person
cannot be prevented from dealing with the auditing of such a public listed Company.”
It further said, “In a given case, if
ultimately it is found that there was only some omission without any mens rea
or connivance with anyone in any manner, naturally on the basis of such
evidence the SEBI cannot give any further directions.” Thus, it is not
enough to show that the auditors had not followed the prescribed professional
standards but it is also necessary to establish that they had done this in
connivance with and in collusion with the management.
Supreme Court on “connivance” vs.
“negligence”
In SEBI vs. Kishore R. Ajmera ([2016] 66
taxmann.com 288 (SC)), the Supreme Court had examined this issue in context
of role of stock brokers vis-à-vis acts of their clients. Stock brokers
too have to follow certain norms and code of conduct. Stock brokers are of
course, unlike auditors, registered and regulated directly by SEBI. The
observations and conclusions of the Court on when negligence becomes connivance
are applicable in the present case too. The Court observed as follows (emphasis
supplied):
“Direct proof of
such meeting of minds elsewhere would rarely be forthcoming. The test, in our considered view, is one of
preponderance of probabilities so far as adjudication of civil liability
arising out of violation of the Act or the provisions of the Regulations framed
thereunder is concerned. Prosecution under Section 24 of the Act for violation
of the provisions of any of the Regulations, of course, has to be on the basis
of proof beyond reasonable doubt. ……Upto an
extent such conduct on the part of the brokers/sub-brokers can be attributed to
negligence occasioned by lack of due care and caution. Beyond the same,
persistent trading would show a deliberate intention to play the market.”
The Court thus laid down certain important
criteria. Firstly, it made a distinction between proceedings for adjudication
of civil liability and for prosecution. The present case, it may be
recollected, was not of prosecution. The Court said that the criteria here is
`preponderance of possibilities’. It also generally explained that to some extent,
a default can be attributed to negligence. But persistence of negligence will
show a deliberate intention to do so. This is the criteria SEBI applied in
SEBI’s Order.
How did SEBI hold the auditors to have acted
in connivance with management?
SEBI found that the Auditors had not carried
out the audit in accordance with the prescribed standards. The issue is : Does
this amount to mere negligence or does this amount to acting this in connivance
with the management? SEBI examined the audit process followed from time to time
and made the following pertinent observations and conclusions:
1. “There can be only two
reasons for such a casual approach to statutory audit – either complacency
or complicity.”
2. “I find that while the
Noticees have justified their acts by selectively quoting from various AAS, the
marked departures from the spelt-out Auditing standards and Guidance Notes are
too stark to ascribe the colossal lapses on the part of auditors to mere
negligence. It is inconceivable that the attitude of professional skepticism
was missing in the entire exercise spanning over 8 long years.”
3. ?”All these factors turn the needle of suspicion away from negligence
to one of acquiescence and complicity on the part of the auditors.”
4. “The preceding paragraphs
have unambiguously shown that there has been a total abdication by the auditors
of their duty to follow the minimum standards of diligence and care expected
from a statutory auditor, which compels me to draw an inference of malafide and
involvement on their part.
5. “The auditors were well
aware of the consequences of their omissions which would make such accumulated
and aggregated acts of gross negligence scale up to an act of commission of
fraud for the purposes of the SEBI Act and the SEBI (PFUTP) Regulations.”
Making the above observations, and recording
a finding of repetitive non-observance of certain professional auditing
standards, SEBI held that the acts/omissions were not merely negligence but
amounted to connivance in the commission of fraud. It thus issued directions of
debarment, disgorgement of fees, etc. against the Auditors.
Conclusion and relevance for other persons
associated with the securities markets
Though this is not the first case to be
dealt with in this manner, it is obvious, considering the detailed analysis and
the stakes involved, that those involved with listed companies are being
closely examined. Further, the principles now well settled will surely be
followed in future cases.
There are many persons – some registered
with SEBI and some not – who may need to take note of this. Any person who is
expected to observe some standards of behaviour whilst performing his duties in
relation to securities markets will have to take, if one may say, a little more
than `due care’.
Directors of companies, particularly
independent directors, are one such group of persons. The Companies Act, 2013
and the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015
prescribe the role of the Board/directors/independent directors in great detail.
A director may not have actually participated in a fraud, but if he does not
perform his duty with diligence expected of a person of his
background/expertise and if this happens repeatedly, he may be subject to such
action by SEBI.
Registered intermediaries of various types
such as stock brokers, portfolio managers, investment advisors, etc. all
too would have cause for concern.
Compliance Officers and CFOs are yet another
category who have a prescribed role under various SEBI Regulations. Defaults by
them may make them subject to action by SEBI.
Needless to emphasise, much will also depend
on the facts of the case.
It needs to be reiterated for emphasis
that, for initiating prosecution, a higher standard of proving mens rea beyond
reasonable doubt is still required. However, the consequences of SEBI orders of
debarment/disgorgement by itself can be harsh enough in terms of loss of
livelihood, monetary loss and loss of reputation. _
