Supreme Court mandates hearing for borrowers before classifying accounts as fraud in banking cases (27 March 2023)

Date of the Judgment: 27 March 2023
Citation: Civil Appeal No. 7300 of 2022
Judges: Dr Dhananjaya Y Chandrachud, CJI, Hima Kohli, J
Can a bank declare a borrower’s account as fraudulent without giving them a chance to be heard? The Supreme Court of India recently addressed this crucial question, emphasizing the importance of natural justice in banking procedures. The court ruled that borrowers must be given a fair opportunity to present their case before their accounts are classified as fraudulent. This decision has significant implications for both banks and borrowers, ensuring transparency and fairness in the banking system.

Case Background

Several appeals were filed challenging the Reserve Bank of India’s (RBI) Master Directions on Frauds, specifically regarding the classification of borrower accounts as fraudulent. These directions, issued in 2016, outline the process for banks to identify and report fraudulent activities. The core issue was that the Master Directions did not explicitly provide borrowers with an opportunity to be heard before their accounts were classified as fraudulent, which has serious consequences for the borrowers.

The cases involved various companies and individuals who had availed loans from different banks. These borrowers were later classified as having fraudulent accounts by the banks, often based on forensic audit reports. Aggrieved by the lack of a hearing before the classification, they challenged these actions in different High Courts.

The High Court of Telangana had ruled that the principles of natural justice, particularly the rule of audi alteram partem (hear the other side), must be read into the Master Directions on Frauds. This decision was appealed by the RBI and lender banks, leading to the current Supreme Court judgment.

Timeline

Course of Proceedings

The High Court of Telangana initially ruled in favor of the borrowers, stating that the principles of natural justice should be applied. However, other High Courts dismissed similar petitions, citing the pendency of the matter before the Supreme Court. The Supreme Court, while hearing the appeals, also took up a writ petition challenging the Master Directions on Frauds.

Legal Framework

The case revolves around the interpretation of the Reserve Bank of India Act, 1934, and the Banking Regulation Act, 1949, which empower the RBI to issue directions to banks. The Master Directions on Frauds, issued by the RBI, provide a framework for banks to classify accounts as fraudulent.

Key provisions include:

• Section 35A of the Banking Regulation Act, 1949: This section empowers the RBI to issue directions to banking companies in the public interest or to prevent actions detrimental to depositors’ interests. The directions are statutory in nature.
• Clause 2.2.1 of the Master Directions on Frauds: This clause classifies frauds based on the provisions of the Indian Penal Code, 1860, including misappropriation, forgery, and fraudulent transactions.
• Clause 8.3 of the Master Directions on Frauds: This clause defines Early Warning Signals (EWS) and Red Flagged Accounts (RFA). An RFA is an account where a suspicion of fraudulent activity is raised by the presence of one or more EWS.
• Clauses 8.9.4 and 8.9.5 of the Master Directions on Frauds: These clauses outline the procedure for classifying a borrower’s account as fraud, including the role of the Joint Lenders Forum (JLF) and forensic audits.
• Clause 8.12 of the Master Directions on Frauds: This clause specifies the penal measures for fraudulent borrowers, including debarment from accessing institutional finance for a period of five years. “In general, the penal provisions as applicable to wilful defaulters would apply to the fraudulent borrowers including the promoter director(s) and other whole time directors of the company insofar as raising of funds from the banking system or from capital markets by companies with which they are associated is concerned, etc. In particular, borrowers who have defaulted and have also committed a fraud in the account would be debarred from availing bank finance from Scheduled Commercial Banks, Development Financial Institutions, Government owned NBFCs, Investment Institutions, etc., for a period of five years from the date of full payment of the defrauded amount.”

Arguments

The borrowers argued that the Master Directions on Frauds violate the principles of natural justice and Articles 14, 19, and 21 of the Constitution of India. They contended that:

• They are not given a notice or an opportunity to present a defense before their accounts are classified as fraud.
• The classification carries severe civil consequences, including debarment from accessing financial markets and reputational damage.
• The Master Directions are arbitrary for not providing a hearing to borrowers while providing it to third parties.
• The process does not adhere to the principles of audi alteram partem, including notice of allegations, evidence, and proposed penalties.

The RBI and lender banks argued that:

• The Master Directions are necessary to protect the interests of depositors and banks from fraud.
• The classification is done only for reporting to law enforcement agencies, and the ultimate decision on fraud is made by a court.
• Principles of natural justice do not apply at the stage of setting the process of criminal law in motion.
• Debarring fraudulent borrowers is a preventive measure to avoid further fraud.
• The procedure under the Master Directions is different from the procedure for classifying willful defaulters.

Issues Framed by the Supreme Court

The Supreme Court addressed the following key issues:

1. Whether the principles of natural justice should be read into the provisions of the Master Directions on Frauds.
2. Whether the classification of a borrower’s account as fraudulent under the Master Directions on Frauds entails civil consequences to borrowers.
3. Whether the Master Directions on Frauds impliedly exclude the right to be heard.
4. Whether the Master Directions on Frauds are arbitrary and unconstitutional.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues

Authorities

The Supreme Court considered the following authorities:

Judgment

The Supreme Court held that the principles of natural justice, particularly the rule of audi alteram partem, must be read into the Master Directions on Frauds. The court emphasized that the classification of an account as fraud has severe civil consequences for the borrower, including debarment from accessing institutional finance and reputational damage.

The Court also specified how certain authorities were viewed:

• State Bank of India v. Jah Developers [(2019) 6 SCC 787]*: The Court applied the principles laid down in this case, stating that the consequences of being declared a willful defaulter are similar to those faced by borrowers classified as fraudulent, impacting their fundamental right to carry on business.
• Erusian Equipment & Chemicals Ltd v. State of West Bengal [(1975) 1 SCC 70]*: The Court reiterated that blacklisting requires an opportunity to be heard, and the debarment of borrowers from accessing institutional finance is akin to blacklisting.
• Swadeshi Cotton Mills v. Union of India [(1981) 1 SCC 664]*: The Court relied on this case to emphasize that the principles of natural justice can be read into a statute, even if it is silent on granting a hearing.
• Union of India v. Tulsiram Patel [(1985) 3 SCC 398]*: The Court clarified that while the right to a prior hearing can be excluded in cases requiring prompt action, it is not applicable in this case as the Master Directions on Frauds provide sufficient time for a hearing.

What weighed in the mind of the Court?

The Supreme Court’s decision was heavily influenced by the need to balance the protection of the banking system with the fundamental rights of borrowers. The Court recognized that while the Master Directions on Frauds are essential for maintaining financial stability, they cannot be implemented at the cost of fairness and due process. The Court was particularly concerned about the severe civil consequences faced by borrowers, including debarment from accessing institutional finance and reputational damage.

The Court’s reasoning emphasized that the principles of natural justice are not mere formalities but substantive obligations. It highlighted that the rule of audi alteram partem is a crucial safeguard against arbitrary action and is an integral part of Article 14 of the Constitution. The Court also noted that while the Master Directions on Frauds aim to ensure timely detection and reporting of fraud, this objective cannot justify the exclusion of a fair hearing for borrowers.

The Court also considered various precedents to emphasize that any action that has civil consequences must be preceded by a fair hearing, particularly when it involves debarment or blacklisting. The Court also noted that the Master Directions on Frauds do not expressly exclude the right to be heard and the time frame contemplated under the Master Directions on Frauds as well as the nature of the procedure adopted, it is reasonably practicable for the lender banks to provide an opportunity of a hearing to the borrowers before classifying their account as fraud.

Logical Reasoning

The Court rejected the argument that the participation of the borrower during the preparation of the forensic audit report fulfills the requirement of natural justice. The Court clarified that the principles of audi alteram partem entail that an entity against whom evidence is collected must be provided an opportunity to explain the evidence against it, be informed of the proposed action, and be allowed to represent why the proposed action should not be taken.

The Court also rejected the argument that the Master Directions on Frauds are manifestly arbitrary because they stipulate an opportunity of a hearing to third parties, while denying the same to borrowers. The Court was of the view that the borrowers and the third parties stand on a different footing because the borrowers are the main perpetrators of fraud, while the third parties are merely facilitators.

The Court also emphasized that the reasons to be recorded need not be placed on the same pedestal as a judgment of a court. The reasons may be brief but they must comport with fairness by indicating a due application of mind.

The Court concluded that the decision by the lender banks to classify the borrower accounts as fraud, is violative of the principles of natural justice. The banks would be at liberty to take fresh steps in accordance with this decision.

The Supreme Court upheld the judgment of the Division Bench of the High Court of Telangana dated 10 December 2020 and set aside the judgments of the High Court of Telangana dated 22 December 2021 and 31 December 2021, and of the High Court of Gujarat dated 23 December 2021.

“The principles of natural justice demand that the borrowers must be served a notice, given an opportunity to explain the conclusions of the forensic audit report, and be allowed to represent by the banks/ JLF before their account is classified as fraud under the Master Directions on Frauds. In addition, the decision classifying the borrower’s account as fraudulent must be made by a reasoned order.”

“Since the Master Directions on Frauds do not expressly provide an opportunity of hearing to the borrowers before classifying their account as fraud, audi alteram partem has to be read into the provisions of the directions to save them from the vice of arbitrariness.”

“The classification of an account as fraud not only results in reporting the crime to investigating agencies, but also has other penal and civil consequences against the borrowers.”

KeyTakeaways

The Supreme Court’s judgment has significant implications for both banks and borrowers:

• For Banks: Banks must now ensure that borrowers are given a fair opportunity to be heard before their accounts are classified as fraudulent. This includes providing a notice, a copy of the forensic audit report, and an opportunity to respond. Banks need to revise their procedures to comply with the principles of natural justice.
• For Borrowers: Borrowers have gained a crucial right to be heard before being labeled as fraudsters, which can have serious financial and reputational consequences. This judgment ensures greater transparency and fairness in banking procedures.
• For the Banking System: The ruling promotes a more transparent and accountable banking system. It reinforces the importance of due process and natural justice in administrative actions, especially those with severe civil consequences.

This landmark decision by the Supreme Court underscores the importance of balancing regulatory objectives with the protection of fundamental rights. It serves as a reminder that even in matters of financial regulation, the principles of natural justice must be upheld to ensure a fair and equitable system.