India: Statutory Auditors: The Hazy Line Between Removal And Non-Ratification Of Appointment

Independence of auditors is an important cornerstone of corporate governance. The provisions of the Companies Act, 2013 ('Act') ensure that the appointment and removal of auditors is subject to shareholders' approval and Central Government approval, to ensure that the tenure of an auditor is not subject to the whims of the management.

The provisions relating to removal of the auditor of an Indian company are primarily governed by Section 140 of the Act. According to Section 140(1) of the Act, an auditor of an Indian company can be removed before the expiry of its term, subject to the shareholders of the company approving such removal by way of a special resolution, and after obtaining the approval of the Central Government. The Act also necessitates the auditor to be given a reasonable opportunity of being heard before such removal.

The aforesaid provision essentially subjects any removal of the auditor of an Indian company to the prior approval of the Central Government. Other than the foregoing, there are no other provisions under the Act which specifically permit an Indian company to remove its auditor.

Having said that, interestingly, Section 139(1) of the Act requires auditors to be appointed for a period of 5 years, and such appointment is required to be ratified by the shareholders at every annual general meeting ('AGM'). Further, the Explanation to Rule 3(7) of the Companies (Audit and Auditors) Rules, 2014 ('Audit Rules') suggests that in case the appointment is not ratified by the shareholders at the AGM, the Board of Directors ('Board') shall appoint another individual or firm as its auditor or auditors after following the procedure set out in the Act in this regard.

Currently, under the Act, the procedure for appointment of an auditor of a company (not being a government company) is provided under Section 139(1) of the Act, whereby an auditor's appointment is subject to shareholders' approval at the AGM. Secondly, Section 139(8) of the Act suggests that in case of a "casual vacancy" in the office of an auditor, such casual vacancy can be filled by the Board, and if the casual vacancy is caused due to resignation of auditor, shareholders' approval would also be required.

Therefore, a conjoint reading of Sections 139(1) and Rule 3(7) of the Audit Rules, suggests that if the appointment of an auditor is not ratified by the members at any AGM, the Board will be required to fill such "casual vacancy" under Section 139(8)(i) of the Act by appointing a new auditor, who would be entitled to hold office till the next AGM. However, such an interpretation is based on the presumption that non-ratification of an auditor's appointment will result in a "casual vacancy" for purposes of the Act. Such an interpretation would also mean that the Explanation to Rule 3 (7) of the Audit Rules empowers the members to remove the auditor without prior approval of the Central government, which can be said to dilute the requirements under Section 140 of the Act.

An alternative interpretation of Rule 3(7) of the Audit Rules suggests that, even if the shareholders fail to ratify the appointment of an auditor at an AGM, the Board can appoint another auditor only after following the procedure prescribed under the Act for such purpose. However, the Act does not prescribe any procedure for removal of an auditor in case shareholders refuse to ratify the appointment of an auditor at the AGM. In fact, as discussed above, the only procedure prescribed for removal of an auditor, is by way of a special resolution and subject to the prior approval of the Central Government. Therefore, this would imply that even if the shareholders refuse to ratify the appointment of an auditor at an AGM, the Act appears to require the removal of an auditor to be approved once again by the shareholders by way of a special resolution, and subject such removal to the approval of the Central Government. In the considered view of the authors, it is doubtful whether the legislature intended such a process to be undertaken even in cases where shareholders refuse to ratify an auditor's appointment at an AGM.

Section 140(1) of the Act appears to prescribe a process where the Board proactively proposes to remove an auditor. In such a situation, it is reasonable to require the company to provide a hearing to the concerned auditor, and subject such removal to the special resolution of the shareholders and Central Government. Such a strict process would stand justified to ensure independence of the auditors and ensure that their removal is subject to a certain degree of checks and balances.

However, if the company has to follow the same process even in a situation where the shareholders refuse to ratify the auditor's appointment at an AGM; such a requirement would effectively tantamount to making the annual ratification requirement redundant as any subsequent removal is in any event subject to Central Government approval. Therefore, the auditor whose appointment is not ratified by the shareholders can continue to remain the auditor of the concerned company until such time the Central Government grants its approval for such removal.

Such an interpretation would also effectively render the Explanation to Rule 3(7) of the Audit Rules redundant which appears to suggest that the Board can appoint another auditor, in case the existing auditor's appointment is not ratified at an AGM.

Therefore, it is reasonable to state that in case shareholders refuse to ratify the appointment of auditors at the AGM, the Board will be entitled to appoint another auditor pursuant to Section 139(8) of the Act.

The issue of non-ratification of appointment of auditors leading to automatic removal was discussed by the Hyderabad bench of the NCLT in SPC & Associates v DVAK & Co and Anr1. In the aforesaid case, the statutory auditors of the company were removed as a result of non-ratification by shareholders in an AGM and new auditors were subsequently appointed. The auditor argued that if companies resort to non-ratification of the appointment of auditors for removal of auditors, the entire statutory protection and the prescribed procedure under Section 140 will become infructuous. On the other hand, the company contended that Central Government approval and special resolution of shareholders would not be required as it was not a case of removal of the auditor under Section 140 but that of non-ratification of appointment and thus, it would fall under the Explanation under Rule 3 of the Audit Rules. The NCLT bench rejected the company's arguments and held that the removal was improper as no justifiable grounds were provided for non-ratification of the auditor's appointment and the due procedure under Section 140 requiring Central Government approval and special resolution of shareholders was not followed.

The NCLT while delivering the order also discussed the proposed amendment to Section 139(1) of the Act which has been passed by the Lok Sabha on 27 July 2017 which seeks to remove the requirement for annual ratification of appointment/continuance of auditor by members.

In the considered view of the authors, the aforesaid judgment of the NCLT appears to effectively render Rule 3(7) of the Audit Rules and the leeway provided under Section 139(8) of the Act redundant. As explained above, the Act explicitly provides the right to the shareholders to refuse to ratify an auditor's appointment at an AGM. Therefore, in such an event, requiring the Company to once again follow the process set out in Section 140 of the Act could never have been the legislative intent, especially given the explicit right of the Board to fill a casual vacancy set out under Section 139(8) of the Act.

In any event, the requirement of a yearly ratification of an auditor's appointment has now been removed under the Companies (Amendment) Bill, 2016. Therefore, as a result, it appears that going forward, once the provisions of the Bill come into legal effect, any removal of auditors would require compliance with the procedures set out under Section 140 of the Act.

Footnote

1 Order dated 17 March 2017 in CP No 21/140/HDB/2016

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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