Audi alteram partem to be read into RBI’s Master Directions on Frauds – Classification and Reporting
By Bhargav Mitra, on July 20, 2023
POSTED IN White Collar Crime/Regulatory,
The Reserve Bank of India (RBI) had on July 1, 2016 issued the Master Directions on Frauds – Classification and Reporting by Commercial Banks and Select FIs, 2016 (“Master Directions”). The directions provided that commercial banks and certain financial institutions may classify any borrower’s bank account registered with them as fraudulent directly, in the event the borrowers do not comply with the Master Directions.
The Master Directions was first challenged by way of a writ petition before the High Court of Telangana (Writ Petition No. 19102 of 2019), on the basis that borrowers were not given a chance to be heard before having their accounts flagged as fraudulent.
The Telangana High Court in the case of Rajesh Agarwal v. Reserve Bank of India (2020 SCC OnLine TS 2021) stated that the RBI’s Master Directions, which dealt with classifying accounts as fraud accounts, should incorporate the principles of natural justice. According to the Telangana High Court, the account holder must be given a chance to be heard before being branded a “fraudulent borrower” or “holder of a fraudulent account.” Further, the Telangana High Court observed that the Master Directions of the RBI would be ambiguous if the principles of natural justice were not incorporated into it. On the principles of natural justice, the Telangana High Court noted that, “The principles of natural justice rein in arbitrary, discriminatory and irrational decisions. They protect an individual from the might of the State, or its instrumentalities. They provide a succour to the common man; they assure the common man that justice not only appears to be done, but is being done to his/her cause… Not only the three branches of the State, but the State itself rests and progresses on the faith of its people. For, when the faith of the people is shaken, the people may demolish the very foundation of the State.”
An appeal was filed before the Supreme Court of India (“Supreme Court”) by the State Bank of India challenging the writ petition in the case of State Bank of India v. Rajesh Agarwal,  (SCC OnLine 342 (SC)). The Supreme Court upheld the judgement of the Telangana High Court in the case of Rajesh Agarwal v. Reserve Bank of India, stating that the Master Directions of RBI must necessarily incorporate the principle of audi alteram partem to protect it from the vice of arbitrariness.
Analysis of the judgment of the Supreme Court
Borrowers criticised the Master Directions on the following grounds:
a. If their accounts are labelled as fraudulent, substantial civil repercussions may flow, including prohibiting the promoters and directors from obtaining institutional financing, placing the borrower on a blacklist, and applying criminal penalties to promoters, directors, etc.
b. It is not only unlawful to subject people to these obstacles without giving them a chance to be heard, but also undermines other aspects of audi alteram partem, such as [xyz].
c. The mere requirement of participation of the borrower during the preparation of the forensic audit report does not in itself fulfil the requirement of the principles of natural justice.
RBI along with the State Bank of India defended the Master Directions, on the following grounds:
a. The Master Directions approach as it is now written would aid in the prompt discovery and reporting of fraud.
b. Once declared as a fraudulent account, it is the law enforcement agencies which conduct thorough investigations, and the ultimate decision is then rendered by a competent court of law.
c. Therefore, it is not required to provide the borrowers a chance to be heard before declaring their account as fraudulent, as doing so simply initiates criminal procedure.
The Supreme Court considered the terms of the Master Directions regarding Early Warning Signals and Red Flagged Accounts as well as the legal framework under which the RBI was established to ensure monetary stability of the nation. According to the Master Directions, fraudulent borrowers would be subject to the same legal sanctions as ‘wilful defaulters’ and would not be permitted to obtain bank financing from scheduled commercial banks or other financial institutions for a period of five years following the date on which the defrauded amount was fully repaid. This would result in a ‘credit freeze’. Banks and other financial organisations also refuse to restructure their debt or provide further credit to such persons.
The Supreme Court noted that the natural justice principle of ‘nemo judex in causa sua’ (that is, no one should adjudicate their own case), and ‘audi alteram partem’ (that is, anyone who will be impacted by administrative, judicial, or quasi-judicial action must be heard before a decision is made) serve as safeguards against arbitrary action. The Supreme Court ruled that when a legislation or notification is silent about giving a party whose rights and interests are likely to be impacted the chance to be heard, the principles of natural justice should be read into such statute or notification. According to the Supreme Court, context determines how urgent a situation is, and any exclusion must be kept to a minimum. As a result, past hearings can only be omitted when bringing them up would effectively paralyse the process. It was decided that the six-month window provided to the banks to classify and declare any account as fraudulent is sufficient for the banks to analyse the case at hand and allow the borrowers a chance to be heard. It was also held that mere participation of a borrower during the course of preparation of the forensic audit report do not fulfil the requirements of natural justice.
The principles of natural justice require that a person be given a chance to be heard since the lending banks’ classification of an account as fraudulent entails a careful consideration of the facts and the law. It was noted by [xyz] that if the standards of natural justice are not implemented, every policy that considers substantial civil repercussions will be vulnerable to challenges on grounds of being arbitrary and unconstitutional. The Supreme Court determined that the principles outlined in SBI v. Jah Developers ((2019) 6 SCC 787) with regard to wilful defaulters directly apply to the classification of an account as fraudulent under the Master Directions because fraud carries serious civil and criminal repercussions. Therefore, before a borrower’s accounts are labelled as fraudulent under the Master Directions, it must be sent a notice, given the chance to respond to the findings of the forensic audit report, and permitted to represent itself. The Court observed that “Classification of the borrower’s account as fraud under the Master Directions on Frauds virtually leads to a credit freeze for the borrower, who is debarred from raising finance from financial markets and capital markets. The bar from raising finances could be fatal for the borrower leading to its ‘civil death’ in addition to the infraction of their rights under Article 19(1)(g) of the Constitution. Since debarring disentitles a person or entity from exercising their rights and/or privileges, it is elementary that the principles of natural justice should be made applicable and the person against whom an action of debarment is sought should be given an opportunity of being heard.”
The Supreme Court held that the application of audi alteram partem cannot be impliedly excluded under the Master Directions on Frauds. In view of 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. The Supreme Court further observed that “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/ Joint Lenders Forum before their account is classified as fraud under the Master Directions on Frauds.”
The Supreme Court stated that the reading the principles of natural justice as a part and parcel of the Master Directions will ensure that the same are staved off from the challenge of arbitrariness. Ensuring that a reasoned order is passed prior to such classification will provide a borrower with an opportunity to contest the classification and also place a check on the arbitrary exercise of power by banks and financial institutions under the terms of the Master Directions. Apart from judicial and quasi-judicial powers, the Supreme Court made it clear that the procedure by which banks must develop an informed opinion in accordance with the Master Directions is administrative in character and is subject to the norm of audi alteram partem. It is also widely accepted that when an administrative action has ‘civil consequences’ for a person or an entity, such as violations of civil liberties, material deprivations, or non-pecuniary damages, it is necessary to give that person or entity a chance to be heard.
The Supreme Court directed that the decision classifying the borrower’s account as fraudulent must be made by a reasoned order as
(a) “a reasoned order allows an aggrieved party to demonstrate that the reasons which persuaded the authority to pass an adverse order against the interests of the aggrieved party are extraneous or perverse”; and
(b) “the obligation to record reasons acts as a check on the arbitrary exercise of the powers. The Court, however, made clear 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 Supreme Court recognized the effects of the classification under the Master Directions including the bar on raising finances, that affect goodwill and reputation. Since the Supreme Court has in the past consistently held that an opportunity of a hearing ought to be provided before a person is put on a blacklist, the implementation of a decision to secure the health of banking companies “must comport with the due process of law.”
Therefore, lending banks must give borrowers a copy of the audit reports, give them a fair chance to be heard, and make a reasoned ruling on the objections raised by the borrowers.
The Hon’ble High Court of Bombay, recently, in the cases of Pankaj A. Ranka v. Reserve Bank Of India, June 2023, [Writ Petition (L) No. 15119 OF 2023] and S.S Hemani v. Reserve Bank of India [Writ Petition (L) No. 15240 OF 2023] has passed stay orders till the month of September relying on the Supreme Court’s judgment in the case of State Bank of India v. Rajesh Agarwal. This decision by the Supreme Court provides debt-ridden businesses with a lifeline in situations when the intention may not have been to mislead lenders, in a great relief for the debtors. The Supreme Court’s decision is crucial because it protects procedural fairness and equal protection under the law. When debt restructuring is actually necessary, the Master Directions’ mechanical method will no longer apply. It has to be seen, though, if adding an adjudicatory process at the banking level will cause the system to clog. Companies undertaking debt restructuring will find comfort in this decision since it ensures that the process of labelling loan accounts as fraudulent does not happen automatically and that borrowers have a right to be heard. Even if banks or other financial institutions were to label a company’s bank accounts as fraudulent, this would not happen until the borrower in question has had the chance to argue its case and explain any favourable conditions that would provide a semblance of justice to the entire process. It is a positive development in the jurisprudence pertaining to this field of law because the Supreme Court places focus on a borrower’s fundamental rights by allowing the inclusion of the principles of natural justice in the Master Directions.