The Price Waterhouse Case: Determining Auditor Liability

Is SEBI’s conclusion in the Price Waterhouse-Satyam case robust enough, asks Umakanth Varottil.

(Source: Bloomberg)
(Source: Bloomberg)

Complacency or complicity? Omission or commission? Gross negligence or fraud?

The legal fate of Price Waterhouse India hangs in balance in the answers to these thorny questions. The Securities and Exchange Board of India, in a recent order, found that the conduct of Price Waterhouse and its partners in carrying out the audit of Satyam Computers could be nothing less than complicit, given the colossal nature of the fraud perpetrated within Satyam for over eight years, the period when Price Waterhouse audited the books of the company. Accordingly, SEBI castigated the audit firm by requiring it to disgorge the fees it received for auditing Satyam and to refrain from auditing listed companies for a period of two years.

But, the nub of the issue is whether SEBI’s conclusions, based largely on inferences, are sufficient to withstand appellate scrutiny in the absence of evidence, whether direct or circumstantial. Price Waterhouse has already indicated its steadfastness in seeking recourse against SEBI’s order where these issues are likely to emerge to the forefront.

In a rather curious way, SEBI’s jurisdictional competence to proceed against Price Waterhouse is intrinsically connected with the quality and measure of evidence available against the audit firm’s behaviour.

When Price Waterhouse had posed a challenge to SEBI’s jurisdiction to pass orders against audit firms, the Bombay High Court in 2010 recognised the market regulator’s role in reining in audit firms, but it did so conditionally. It found that SEBI’s jurisdiction will ultimately depend upon the evidence available with it on whether Price Waterhouse “with an intention and knowledge tried to fabricate and fudge the books of accounts” of Satyam. The court also ruled that if it is ultimately found that “there was only some omission without any mens rea or connivance with anyone in any manner”, then SEBI does not possess the power to issue directions.

Hence, SEBI’s burden is one of proving acts of commission on the part of Price Waterhouse and not merely omissions.

SEBI’s order against Price Waterhouse painstakingly establishes the existence of gaping holes in the audit practices and procedures relating to Satyam. It demonstrates that the auditors were asleep at the wheel when Satyam showed non-existent bank balances, inflated sales revenues and overstated debtors’ positions. In doing so, Price Waterhouse paid scant regard to their responsibilities under Company Law as well as relevant accounting standards, under which they were required to act with a great deal of professional skepticism. In view of a total abdication of duties by the auditors to follow minimum standards of care and diligence, SEBI was compelled to “draw an inference” as to the lack of good faith on the part of Price Waterhouse in the discharge of its responsibilities.

Is SEBI’s conclusion robust enough?

It must be tested against the touchstone of “fraud” as contained in SEBI’s regulations on fraudulent and unfair trade practices relating to the securities market. Granted that the expression ‘fraud’ is used by SEBI in a civil sense, which imposes a lower burden of proof on the regulator than criminal fraud, but it remains to be seen whether SEBI has indeed discharged that burden.

SEBI’s order conflates the concepts of gross negligence and fraud, and finds that as the auditors were to have been aware of the consequences of their omissions, the “accumulated and aggregated acts of gross negligence scale up to an act of commission of fraud” for the purposes of the relevant regulations. This is so because the auditors failed to establish that they had carried out their tasks with the requisite professional care and standard.

Throughout the 108-page order, SEBI has drawn inferential conclusions using deductive reasoning: given the magnitude of the accounting chicanery in Satyam, it could not have been accomplished without fraudulent conduct on the part of the auditors.

Whether such an approach is defensible, or whether it requires proof of positive conduct or intention on the part of Price Waterhouse is the key question.

To be sure, it is nobody’s case that Price Waterhouse’s conduct in the Satyam audit was above board or justifiable even to the bare minimum. The discussion rather surrounds the issue of just deserts it must endure, one which takes us to the nature and sophistication of the legal system to deal with such complicated issues. In several developed markets, auditor liability is determined on the basis of private legal actions brought by companies or their shareholders against auditors. Here, the question is whether the auditors were negligent in the provision of their services and, if found as such, damages are to be awarded to the victims without the need to prove intention or fraud. Such a victim-oriented approach was followed in the very Satyam instance where Price Waterhouse made a settlement payment of $25.5 million to investors. No such payment was made to investors in India based on private action.

In India, on the other hand, at least in case of public listed companies, regulatory actions by way of public enforcement constitute the fulcrum of enforcement measures. This action brought by SEBI is a manifestation of such approach. Not only does such an action require the regulator to prove more than just negligence, but the focus is largely on the transgressor.

It aims at deterring the wrongdoer rather than compensating the victims.

Ideally, consequences of wrongdoing must incorporate elements of both.

Even assuming that Price Waterhouse is able to punch holes in SEBI’s arguments, the damage may have already been done. From a corporate governance perspective, auditors and similar intermediaries are considered gatekeepers, whose reputational incentives would motivate them to perform their monitoring tasks in a diligent manner. Whatever the legal outcome may be, the task of obtaining a reversal of reputational fortunes is an arduous one.

Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.