Introduction

In the recent judgment in State Bank of India v. Amit Iron Private Limited & Ors. (“Judgment”), the Hon’ble Supreme Court of India (“Supreme Court”), inter alia, clarified that the Reserve Bank of India (Fraud Risk Management in Commercial Banks (including Regional Rural Banks) and All India Financial Institutions Directions, 2024) (“Master Directions, 2024”) do not contemplate a ‘personal hearing’ or ‘oral hearing’ for borrowers before their accounts are classified as ‘fraud’. The Supreme Court further clarified that even in its earlier judgment in State Bank of India & Ors. v. Rajesh Agarwal & Ors^[1]. (“Rajesh Agarwal judgment”), there was no direction requiring lender banks to provide a ‘personal hearing’ to borrowers before classifying accounts as ‘fraud’.

By way of background, the Reserve Bank of India (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016 (“Master Directions, 2016″), which governed the earlier framework for classification of accounts as fraud, did not provide any mechanism for inviting representations or responses from borrowers before classification of accounts as ‘fraud’. In view of the absence of an express incorporation of the principles of natural justice and audi alteram partem, the Supreme Court, in the Rajesh Agarwal judgment, issued certain directions, including affording borrowers an opportunity to respond to the notice issued by the lender banks.

Following the Rajesh Agarwal judgment, the Reserve Bank of India (“RBI”) notified the Master Directions, 2024, which provide a mechanism for classification of accounts as ‘fraud’, while incorporating the principles of natural justice and granting borrowers an opportunity to submit their response to the show cause notice issued by lender banks.

The questions that arose for consideration before the Supreme Court in the Judgment were, inter alia, as follows:

(i)         whether the Rajesh Agarwal judgment recognized an inherent right in the borrower to a ‘personal hearing’ before an account is classified as ‘fraud’ under the Master Directions, 2016 and/or the Master Directions, 2024;

(ii)       whether the mechanism set out in the Master Directions, 2024, namely, issuance of a show cause notice by the lender bank, an opportunity to file a reply/ submissions by the borrower, and the passing of a detailed order by the lender bank, satisfies the principles of natural justice; and

(iii)      whether lender banks are obligated to supply copies of forensic audit reports/audit reports to borrowers before classifying an account as ‘fraud’.

Background

Factual background

The Judgment concerns two separate Special Leave Petitions, which were decided by way of a common order. The first Special Leave Petition arises out of a judgment passed by the Calcutta High Court, wherein the writ petition filed by the borrower challenging the action of the lender bank in classifying the account as fraud, without affording an opportunity of ‘personal hearing’, was allowed. The second Special Leave Petition arises out of a judgment passed by the Delhi High Court in a similar situation, where the borrower had assailed the action of the lender bank in classifying the account as fraud without a personal hearing, and merely on the basis of a show cause notice issued by the lender bank and the borrower’s reply thereto.

Both the Calcutta High Court and the Delhi High Court interpreted the Rajesh Agarwal judgment as including an imperative requirement of a ‘personal hearing’ or ‘oral hearing’ before classification of an account as ‘fraud’.

Aggrieved by the aforesaid judgments of the two High Courts, the lender banks filed two separate Special Leave Petitions before the Supreme Court.

Purpose of the Master Directions

Before dealing with the submissions made by the borrowers, RBI and the lender banks, it is pertinent to briefly set out the purpose of the Master Directions, 2016 and the Master Directions, 2024.

The purpose of these Master Directions is to provide a framework for lender banks to detect and report frauds at an early stage and to take timely consequential action. This includes, inter alia, reporting to investigating agencies, examining staff accountability, and ensuring effective fraud risk management.

Various instances fall within the ambit of ‘fraud’, including, inter alia: (a) fraudulent encashment through forged instruments; (b) misappropriation of funds and criminal breach of trust; (c) cheating by concealment of facts or cheating by impersonation; (d) wilful falsification, destruction, or alteration of any book, record, or paper with intent to defraud; and (e) fraudulent transactions involving foreign exchange.

The Master Directions also deal with Early Warning Signals (“EWS”) and red-flagging of accounts. Lender banks are also at liberty to engage auditors, including forensic auditors, to examine potential fraudulent activity.

Issues before the Supreme Court

The questions that fell for consideration before the Supreme Court were essentially two-fold. First, whether the Master Directions, 2024, or the Rajesh Agarwal judgment mandate that a ‘personal hearing’ or ‘oral hearing’ be granted to borrowers before classification of an account as fraud, especially when borrowers have already been granted a right of representation through an opportunity to file their reply/ submissions. Second, whether the borrowers have a right to access audit reports/forensic audit reports relied upon by lender banks in relation to the proposed fraud classification.

Findings of the Supreme Court

Submissions by the parties

Counsel for the lender banks and RBI contended before the Supreme Court that the ‘opportunity of a hearing’ or ‘opportunity of being heard’, as contemplated in the Rajesh Agarwal judgment, does not in any manner translate into a right to a ‘personal hearing’ or ‘oral hearing’. It was submitted that since the Master Directions, 2016 did not expressly provide for issuance of a show cause notice and an opportunity to reply, these requirements were read into the framework by the Rajesh Agarwal judgment in order to ensure compliance with the principles of natural justice.

It was further submitted that a ‘personal hearing’ or ‘oral hearing’ would be impracticable and could become a tool for borrowers to delay and derail the process. By way of example, it was contended that the process could be frustrated if each director of a borrower company were to claim a ‘personal hearing’ as a matter of right. Such delay, it was argued, may also enable borrowers to dissipate assets or destroy material evidence.

On the other hand, counsel for the borrowers contended that the Rajesh Agarwal judgment specifically interpreted audi alteram partem to include ‘an opportunity to explain the evidence against it’. It was also contended that in the absence of a personal hearing, borrowers would be prejudiced because the accusations levelled against them would effectively be presumed to be correct without giving them an adequate opportunity to explain the same. It was further submitted that classification of an account as ‘fraud’ results not only in civil consequences but also in far-reaching criminal consequences for borrowers.

Observations and findings

At the outset, the Supreme Court rejected the borrowers’ contention that the words ‘reply’ and ‘representation’ must be read separately, and that a reply by the borrower must necessarily be followed by a ‘personal hearing’ or ‘oral hearing’.

The Supreme Court further held that since the Master Directions, 2016 were silent on the principles of natural justice, it had intervened in the Rajesh Agarwal judgment to read those principles into the framework. However, the Supreme Court categorically observed that the Rajesh Agarwal judgment nowhere held that borrowers have a right to a ‘personal hearing’ or ‘oral hearing’.

The Supreme Court also observed that the Master Directions, 2024 specifically provide a mechanism whereby a show cause notice is issued to borrowers, followed by an opportunity to submit their reply within a period of 21 days, and culminating in a detailed and reasoned order. According to the Supreme Court, this mechanism satisfies the principles of natural justice and audi alteram partem.

Insofar as the supply of audit reports/forensic audit reports relied upon by lender banks for classifying an account as ‘fraud’ is concerned, the Supreme Court held that such disclosure is mandatory, and borrowers are entitled to receive copies of the same. However, this entitlement is subject to the caveat that disclosure should not impinge upon the rights or privacy of third parties.

Our analysis and conclusion

The Judgment brings much-needed clarity on the issue of the right to a ‘personal hearing’ or ‘oral hearing’. We agree with the Supreme Court’s observations that, since the Master Directions, 2016 did not provide a mechanism for issuance of a show cause notice and a reply thereto by borrowers, the Rajesh Agarwal judgment came to be delivered so as to incorporate a right to reply/ representation before a borrower’s account is classified as ‘fraud’.

Thereafter, the Master Directions, 2024 were notified, laying down a proper mechanism to be followed by lender banks before accounts are classified as ‘fraud’. A relevant aspect, borne out from the Judgment, is that the borrowers in whose favour the Calcutta High Court and Delhi High Court judgments were passed did not challenge the vires of the Master Directions, 2024. Therefore, there was no challenge before the Supreme Court insofar as the contents of the Master Directions, 2024 were concerned. In our view, once the guiding framework itself is not under challenge, it ought to be applied as it stands.

Moreover, the practical difficulties highlighted by counsel for RBI and the lender banks in relation to ‘personal hearing’ or ‘oral hearing’ are plausible. The Master Directions, both 2016 and 2024, were introduced with the specific objective of identifying EWS and red-flagging accounts so that fraudulent actions by borrowers may be met with prompt restrictive measures. If delay in taking cogent action is not avoided, it may lead to serious financial consequences.

We must, however, add that the Judgment should be followed with caution by lender banks. These observations ought not to be treated as conferring unfettered powers on lender banks in matters of ‘fraud classification. The principles of natural justice and audi alteram partem enshrined in the Master Directions, 2024, as read with the Judgment, must be given full and meaningful effect.

We will continue to monitor developments in the implementation of the Master Directions, 2024 and the evolving judicial approach to fraud-classification proceedings…watch this space for more…

Endnotes:

[1] (2023) 6 SCC 1, judgment dated March 27, 2023