Company Auditor's General Observation Not Adverse Remark, Can't Trigger Criminal Liability: Bombay High Court

The Bombay High Court at Goa on Monday quashed criminal proceedings initiated against the directors of a company under the Companies Act, 1956, holding that the auditor's remark was merely a general observation or recommendation and did not constitute a “reservation, qualification, or adverse remark” so as to attract penal liability.

A bench of Justice Ashish S. Chavan was dealing with a writ petition filed by the directors of Timblo Private Limited challenging the order of the Judicial Magistrate in Panaji taking cognizance and issuing summons in a complaint filed by the Registrar of Companies.

The complaint alleged violation of Section 217(3) of the Companies Act, 1956, which requires the Board of Directors to give the fullest information and explanations on any reservation, qualification or adverse remark in the auditor's report, with such non-compliance being punishable under Section 217(5).

The allegation stemmed from auditor reports dated September 12, 2007, September 20, 2008, and September 11, 2009, which noted that the company had an internal audit system that “needs to be strengthened.”

Based on this observation, the Registrar of Companies issued a show cause notice alleging that the Board of Directors had failed to furnish the fullest information or explanation on the auditor's remark. The petitioners sought time to file a detailed reply. However, the Registrar proceeded to file a complaint, pursuant to which the Magistrate took cognizance and issued a summons.

Notably, an earlier complaint on similar facts had been filed against the company and its directors, which was disposed of after the accused pleaded guilty and paid a fine.

Before the High Court, the petitioners contended that no offence was made out, as the auditor's remark was merely a general observation and not a “reservation, qualification or adverse remark” within the meaning of Section 217(3).

The Registrar of Companies, on the other hand, argued that the remark constituted a qualification or reservation and was not a routine observation. It further contended that its repetition across multiple years indicated a continuing deficiency in the company's internal audit framework.

Examining the scheme of Section 217, the Court held that the requirement to furnish explanations under sub-section (3) is directed towards shareholders and is to be complied with through the Board's report placed before the annual general meeting. It clarified that the provision does not envisage furnishing such explanations to the Registrar of Companies.

The Court further noted that the complaint was founded solely on the Registrar's dissatisfaction with the petitioners' reply to the show cause notice and held that criminal prosecution cannot be initiated merely on such subjective dissatisfaction.

Interpreting the auditor's remark, the Court observed that the first part of the remark was a positive statement acknowledging the existence of an internal audit system, while the second part was, at best, a general observation or recommendation for improvement.

“Such remarks are routinely made by Auditors as part of best governance practices and do not, by themselves, indicate any deficiency attracting penal liability,” the Court held, adding that the complaint did not disclose any offence under Section 217(3).

On limitation, the court noted that the alleged violations pertained to auditor reports from 2007 to 2009, whereas the complaint was filed only in 2014. It held the complaint to be time-barred and rejected the Registrar's contention that prior sanction was required, observing that no such statutory requirement existed.

The court also found that the Magistrate's order taking cognizance and issuing summons was passed without application of mind.

Holding that continuation of the proceedings would amount to an abuse of process of law, the Court quashed the impugned orders and all consequential proceedings.

For Petitioner: Senior Advocate Devidas Pangam and Advocates Shubham Priolkar and Parikshit Sawant

For Respondents: Advocate Raviraj Chodankar, Central Government Standing Counsel