NFRA must separate Audit Quality Review and Disciplinary functions: Delhi High Court upholds Section 132, quashes SCNs for predetermination and structural bias

Introduction

On 7 February 2025, the Delhi High Court (Division Bench: Justice Yashwant Varma and Justice Dharmesh Sharma) delivered a landmark judgment in a batch of writ petitions led (among others) by “SNEHAL N. MUZOOMDAR v. Union of India & Anr.”, addressing foundational questions about the National Financial Reporting Authority (NFRA), the ambit and operation of Section 132 of the Companies Act, 2013 and the NFRA Rules, 2018. Petitioners included large audit firms and individual chartered accountants (CAs), while respondents were the Union of India and NFRA.

The petitions raised four big questions:

Constitutionality of Section 132(4) and NFRA Rules (especially Rules 3, 8, 10, and 11).
Whether Section 132 operates retroactively on audits completed before 1 October 2018 (the date NFRA was constituted) and whether Article 20(1) is violated.
Whether Section 132 creates impermissible “vicarious liability” for LLP firms and their partners.
Whether NFRA’s procedure—and in particular, the Executive Body’s combined role in authoring Audit Quality Review Reports (AQRRs) and triggering disciplinary action—violated natural justice by predetermination and reasonable likelihood of bias.

The Court upheld the validity of Section 132 and the NFRA Rules, rejected the challenges on vicarious liability, retroactivity and Article 20(1), but quashed the impugned show cause notices (SCNs) and final orders on a crucial structural ground: NFRA’s Executive Body had authored the AQRRs and then itself decided to initiate disciplinary proceedings, breaching the requirement of separation of functions and creating a reasonable likelihood of bias. The Court directed NFRA to start afresh from the SCN stage before a differently composed division, and it clarified that AQRR findings are only prima facie and cannot pre-judge guilt.

Summary of the Judgment

Constitutionality: Section 132(4) and the NFRA Rules were upheld. The Court recognized Parliament’s choice to move from peer regulation to independent oversight aligned with global best practices (PCAOB/FRC).
Vicarious liability: Rejected. A firm and its partners form an indivisible professional unit for audit mandates; liability can legitimately attach to both (Companies Act Sections 139–147; LLP Act Section 27(2)); this is not arbitrary or unconstitutional.
Retroactivity and Article 20(1): Section 132 can apply to pre-October 2018 audits for individuals without violating Article 20(1), since Section 132 imposes civil regulatory consequences and adopts “professional or other misconduct” as defined in the CA Act (Section 22). NFRA’s own statement to limit monetary penalties for pre-2018 audits to the pre-existing CA Act ceiling (INR 5 lakh) and not to proceed against firms for pre-2018 audits was recorded; consequently, the Court did not decide the firms’ retroactivity challenge on merits.
Procedure and fairness: A “summary procedure” is not per se unfair; cross-examination is not a default right when NFRA relies on audit documentation (audit file) and not on oral testimony. Standard of proof is preponderance of probabilities (disciplinary, not criminal proceedings). The inquiry can lawfully be confined to the audit file (SAs and SQC 1 require comprehensive documentation; SA 230’s A5 indicates oral explanations cannot substitute documentation).
Separation of functions and bias: The most significant ruling: NFRA’s Executive Body authored AQRRs with definitive findings and then decided to issue SCNs based on the same material. This conflation violates the statute’s “division-based” model (Companies Act Section 132(1A), (3A), (3B); NFRA Rules consistently refer to “concerned division”) and the principles against predetermination and reasonable likelihood of bias (nemo judex in causa sua). The SCNs and final orders in the batch were therefore quashed.
Remand with roadmap: NFRA may recommence proceedings from the SCN stage; AQRR findings are only prima facie; the decision to initiate disciplinary action must be taken by a different complement (division) not involved in the AQR.

Key Issues and Parties

The petitions were filed by individual CAs and audit firms (including prominent firms engaged in the IL&FS group audits), with NFRA and the Union of India as respondents. The writs challenged SCNs and, in some cases, final NFRA orders, while also mounting broader constitutional challenges.

The central issues traversed:

Whether Section 132 retrospectively penalizes past conduct.
Whether holding LLP firms responsible for their partners’ audit work is arbitrary vicarious liability.
Whether NFRA’s process is unfair—restricting defence to the audit file, denying cross-examination, requiring “in person” hearing without legal representation (NFRA later allowed representation by counsel).
Whether the same NFRA body can author AQRRs and simultaneously decide to discipline based on those AQRRs.

Analysis

1) Precedents Cited and How They Shaped the Decision

Bias and separation of roles: The Court applied principles from L.K. Ratna (ICAI’s disciplinary architecture—those who prepare an inquiry report should not determine guilt), Ratan Lal Sharma, State of W.B. v. Shivananda Pathak, Kumaon Mandal Vikas Nigam, and comparative insights akin to PCAOB/FRC frameworks. It emphasized the “reasonable likelihood of bias” test and the dangers of predetermination (“useless formality”/“appeal from Caesar to Caesar’s wife”).
Retroactivity vs. retrospectivity and vested rights: Relying on Zile Singh, Shanti Conductors, State Bank’s Staff Union, Howrah Municipal Corporation and other classic expositions (Garikapati, Hitendra Vishnu Thakur), the Court reiterated: laws are presumed prospective; however, new forums/procedures and curative/clarificatory provisions may operate to past acts if no vested right is impaired. “Professional or other misconduct” under CA Act Section 22 predates Section 132; Section 132 imports this definition; hence, no “new offence” was created.
Article 20(1) (ex post facto): Following T. Barai, Shiv Dutt Rai, SEBI v. Ajay Agarwal, Yogendra Kumar Jaiswal, the Court held Article 20(1) applies to criminal offences/punishment; NFRA’s disciplinary consequences are civil-regulatory. NFRA’s voluntary undertakings (cap penalties at INR 5 lakh for pre-2018 audits; not proceed against firms for pre-2018) underscored proportionality and obviated certain constitutional concerns.
Firm–partner liability: The Court drew on CIT v. R.M. Chidambaram Pillai, Dulichand Laxminarayan, Companies Act Sections 139–147 (esp. Section 147(5), “jointly and severally”), LLP Act Section 27(2), to hold that a firm (including LLP) acts through partners; audit engagements are firm appointments; partners’ acts in course of business tie back to the firm—this is not unconstitutional vicarious liability.
Procedural fairness, audit file, and summary procedure: The Court placed heavy reliance on SAs and SQC 1 (SA 230, SA 220, SA 500, SA 570), and on case law limiting cross-examination rights where the record is documentary and oral testimony is not the foundation (Kanugo & Co., Hyderabad Vanaspati, Transmission Corporation). It reaffirmed the civil standard of proof (Mukesh Gang): preponderance of probabilities, not “beyond reasonable doubt”.

2) The Court’s Legal Reasoning

A) Section 132 and NFRA Rules are constitutionally valid

Global realignment and public interest: Post-Enron and Satyam, India’s shift from self-regulation (ICAI) to an independent regulator (NFRA) mirrors PCAOB (US) and FRC (UK). Section 132’s architecture (adopted in 2013; operationalized in 2018) is a policy choice firmly rooted in public interest to assure audit quality and investor confidence.
No “new offence” and no Article 20(1) issue: “Professional or other misconduct” existed under CA Act. Section 132 does not create a new crime; it provides a new forum and powers. Article 20(1) is engaged only by retroactive criminal liability, which this is not.

B) Vicarious liability argument rejected

Organic unity of firm and partners: The Court invoked an “organic theory”: a firm, appointed as auditor, acts through partners. Statutory scheme (Companies Act/LLP Act) recognises joint and several liability where partners’ wrongful acts occur in course of firm’s business. Thus, attaching liability to the firm is neither irrational nor disproportionate.

C) Retroactivity of Section 132 is permissible for individuals

NFRA’s undertakings recorded: For audits concluded pre-1 October 2018, NFRA will not levy > INR 5 lakh penalty (aligning with the CA Act ceiling), and will not proceed against firms. The Court therefore considered the individuals’ retroactivity challenge, not the firms’.
No vested right to avoid discipline: Auditors cannot claim a vested right to be tried under an older forum or to be immune from discipline for past misconduct; Section 132 adopts CA Act definitions and imposes regulatory oversight to protect public interest.

D) Procedure is fair even if “summary”, but structural neutrality is mandatory

Audit-file centric adjudication is lawful: Standards demand comprehensive documentation; oral explanations cannot replace documentation (SA 230). Cross-examination is not a default right unless NFRA relies on oral testimony.
Standard of proof: Preponderance of probabilities (disciplinary proceedings), not criminal standard.
Separation of functions is non-negotiable: The Act/Rules contemplate operation through “divisions”; the same executive cohort cannot author AQRRs (that often contain conclusive findings) and then “decide” to discipline based on those very conclusions. This offends nemo judex in causa sua and the reasonable likelihood of bias test. The Court drew comparisons to PCAOB/FRC models (Chinese walls between inspection/investigation/enforcement/adjudication).

3) The Court’s Directions and Practical Roadmap

SCNs and final orders quashed: All impugned SCNs and orders in the batch are set aside.
Fresh start from SCN stage: NFRA may recommence proceedings from the notice stage; AQRR findings are to be treated as prima facie; no predetermination.
Different division to decide initiation: The decision to initiate disciplinary proceedings must be taken by a complement of NFRA not involved in AQR/AQRRs.
Procedural guideposts reaffirmed: SCNs must contain specific allegations, evidence relied upon and the standards allegedly breached; provide meaningful opportunity to respond; hearings “in person” can include legal representation (NFRA’s subsequent policy change recorded); cross-examination only if NFRA relies on oral testimony.

Impact

Regulatory Architecture

NFRA’s internal design must change: The Court has effectively constitutionalised the “separation of functions” within NFRA—e.g., distinct divisions/teams (AQR/Inspection, Enforcement/Prosecution, Adjudication/Hearing), with firewalls and non-overlapping personnel. This aligns the Indian model with PCAOB/FRC practice, improving perceived and actual neutrality.
AQRRs reframed as prima facie: AQRRs should not read like final verdicts on misconduct; their evaluative role is to feed into (but not predetermine) enforcement decisions.

For Audit Firms and CAs

Audit documentation is king: Defence will universally pivot on the audit file. SA 230/SQC 1 compliance must be robust; weaknesses in IT audit tools, version control, maker-checker logs, or archival integrity can be fatal.
Standard of proof and procedural expectations: Expect disciplinary proceedings to remain documentary, swift and focused. Cross-examination is exceptional, not routine.
Retroactivity tempered: Individuals may face Section 132 scrutiny for pre-2018 audits, but with penalty caps per NFRA’s undertaking; firms are insulated for pre-2018 audits per NFRA’s statement.

For Investors and Markets

Greater independence and credibility: By insisting on functional separation within NFRA, the Court enhances the perceived fairness of enforcement—bolstering market confidence in the audit oversight regime.

Complex Concepts Simplified

Retroactivity vs. retrospectivity: Retroactivity often means a new rule applies to future proceedings based on prior facts. Retrospectivity means the new law changes legal consequences of past actions. The Court approved retroactive application for individuals—no vested right was impaired because “misconduct” already existed under CA Act.
Article 20(1): This only bars retroactive criminal punishment. NFRA’s sanctions are civil-regulatory; hence Article 20(1) does not apply.
Reasonable likelihood of bias: Even if the decision-maker believes they are fair, the law asks: would a fair-minded informed observer think there is a real possibility of bias? If yes, the process is invalid. AQR authors should not decide whether to discipline on the same material.
Summary procedure: A fast, documentary proceeding is lawful if it provides adequate notice, disclosure, and an opportunity to respond. Cross-examination is not essential unless oral testimony is relied on.
Organic theory of firm liability: A firm appointed as auditor acts only through its partners/employees; statutory schemes validly attach responsibility to both.

What NFRA Must Do Now

Build and document Chinese walls: Create and notify clear “divisions” under Section 132(1A) and Rule 2(g)—e.g., (i) AQR/Inspection Division; (ii) Enforcement/Prosecution Division; (iii) Adjudication/Hearing Division. Avoid overlapping personnel across these functions in the same matter.
Re-issue SCNs through a different division: Treat AQRRs as prima facie. The “concerned division” for Rule 11 should not include any person who worked on AQR/AQRR in that matter.
Codify procedural safeguards: Articulate a Model Disciplinary Procedure clarifying: scope of SCNs; disclosure norms; timelines; hearing mechanics (including representation by counsel); circumstances warranting cross-examination; reasoned orders.
Strengthen AQR content: Avoid conclusive language; stick to findings of non-compliance and evidence; reserve final guilt findings for the disciplinary stage.

Practical Guidance for Audit Firms and CAs

Documentation hygiene: Ensure audit tools preserve version history, review sign-offs, time stamps, and user-level edits; preserve 7+ year archives; follow SQC 1 rigorously.
Independence mapping: Maintain clear, consolidated registers of network relationships and non-audit services (direct and indirect, Section 144 explanations), especially at the “network” level.
Going concern & ROMM: Evidence professional skepticism; tie risk assessment to concrete responses; communicate with those charged with governance (SA 260) and document it.
EQCR role: Separate, contemporaneous EQCR documentation; avoid “tick-box” reviews.

Conclusion

This decision is a watershed for India’s audit oversight. The Court has validated NFRA’s statutory mission and powers, rejected major constitutional attacks, and clarified that audit discipline is documentary, summary and civil. But it also laid down a clear constitutional boundary: NFRA must separate its audit oversight and disciplinary functions. The Executive Body cannot be both author and adjudicator. AQRRs cannot pre-judge guilt; they are evidence, not verdicts.

The judgment’s twin legacies are institutional and procedural. Institutionally, NFRA must realign to a “divisions” model with internal firewalls, echoing PCAOB/FRC. Procedurally, SCNs must flow from a neutral division; hearings must be meaningful; final orders must be reasoned. For the profession, the message is firm: compliance with SAs/SQC 1 and audit-file integrity are paramount; failures will be disciplined—now through a reformed, demonstrably fair process.

In sum, the Delhi High Court has ensured that the journey towards rigorous audit oversight proceeds on the twin rails of effectiveness and fairness—thereby serving both investor confidence and the rule of law.