On March 27, 2023, the Supreme Court of India in the case of State Bank of India v. Rajesh Agarwal, (2023 SCC Online 342), has held that the principles of natural justice, particularly the rule of audi alteram partem, are necessarily required to be observed while classifying an account as ‘fraud’ under the Reserve Bank of India (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016 (“Master Directions”) issued on July 1, 2016 (updated on July 3, 2017).  

Background:  

The batch of civil appeals were filed by the Reserve Bank of India (“RBI”) and other lender banks challenging the judgement dated December 10, 2020 passed by the High Court of Telangana, inter-alia, holding that the principles of natural justice must be read into the provisions of the Master Directions to ensure that the entire process is not arbitrary and does not violate fundamental rights of the borrower. Some appeals were also filed by the borrowers against the decisions of various High Courts, inter-alia, holding that personal hearing is not contemplated under the Master Directions.

In all these cases, a forensic audit was conducted into the business affairs of the respective borrowers and the accounts were declared as ‘fraud’ under the Master Directions without affording an opportunity of hearing to the borrower(s) and/or without providing a copy of the decision declaring such accounts as ‘fraud’.

 Issue:

The issue before the Hon’ble Supreme Court was whether the principles of natural justice are required to be followed by a lender prior to declaring the account of a borrower as ‘fraud’ under the Master Directions. If yes, whether the rule of audi alteram partem can be read into the Master Directions to save them from the vice of arbitrariness.

Contentions of the borrowers:

The borrowers contended that the procedure for classifying an account as ‘fraud’ under the Master Directions is illegal, inter-alia, for the following reasons:

1. Under Clauses 8.9.4 and 8.9.5 of the Master Directions, no notice is given to the borrowing company or its promoters and directors including whole-time directors. They are not given an opportunity to present a defense and even a copy of the final decision is not provided to them.
2. The classification of borrowers’ bank accounts as ‘fraud’ carries serious civil consequences.  Once an account is classified as fraudulent, it carries significant consequences such as filing of a complaint with the investigative agencies and debarment of the promoters and directors from accessing institutional finance. Further, the action of classifying an account as ‘fraud’ is stigmatic, akin to blacklisting the borrower, which has a direct impact on the fundamental rights of the concerned party.
3. The Master Directions is violative of Articles 14, 19, and 21 of the Constitution of India as they debar a company and its promoters and directors from accessing financial and credit markets for a period of five years without even providing a show cause notice or an opportunity of being heard.
4.  According to the procedure laid down under the Master Directions, a company or its promoters and directors are not even informed that they have been classified as fraud and that a penalty has been imposed upon them. This violates the rule of audi alteram partem.
5. The Master Directions is silent on whether or not the borrower is entitled to an opportunity of being heard after the receipt of forensic audit report and before deciding whether the borrower’s account should be classified as fraud. Since decision to classify the account as fraud entails significant civil consequences, principles of natural justice ought to be read into the Master Directions.
6. The participation of the borrower during the forensic audit does not in itself fulfil the requirement of the principles of natural justice under the Master Directions. In some cases, the borrower may be completely excluded from the forensic audit process.

Contentions of the RBI/ lenders:

The RBI/ lenders submitted that the challenge to the Master Directions on the ground of a violation of the principles of natural justice is meritless, inter-alia, for the following reasons:

1. The clauses of the Master Directions must be interpreted in light of their purpose and objective, that is, timely detection and dissemination of information and reporting about the fraud. RBI is duly empowered to take pre-emptive measures in public interest to ensure that fraudulent borrowers are brought to justice and loss caused to the banks is mitigated.
2. The Master Directions must be construed keeping in mind the thresholds of (i) justness; (ii) fairness towards the parties aggrieved; (iii) reasonability; and (iv) proportionality between the mischief and the corrective measure. Considering that the Master Directions is an economic policy decision, the Court must exercise greater latitude while construing its provisions.
3. The procedure for classifying an account as fraud under the Master Directions is not arbitrary. The classification is done only for reporting the matter to law enforcement agencies. The ultimate decision on fraud is rendered by a competent court of law.
4. The principles of natural justice are not applicable at the stage of setting the process of criminal law in motion. Since the lender bank is an injured party in case of fraudulent accounts, it has the right to report the crime to the law enforcement agencies without giving an opportunity of being heard to the fraudulent borrower.
5. The requirement of notice or prior hearing could be excluded if it impedes the taking of prompt action. It is not an inviolable rule that personal hearing ought to be given in all cases.

Decision:

While answering the question, the Supreme Court delved into the regulatory framework of the Master Directions and the consequences ensuing therefrom. The Supreme Court while referring to clauses 8.11 and 8.12 of the Master Directions observed that classification of a borrower’s account as ‘fraud’ under the Master Directions has difficult civil consequences for the borrower including reporting of such ‘fraud’ to law enforcement agencies. The Supreme Court also relied on the judgement of State Bank of India v. Jah Developers, [(2019) 6 SCC 787)], to hold that any classification of the account as a ‘fraud’ shall impact the fundamental right to carry on business and therefore, it is elementary that the person impacted should be given an opportunity of being heard. The Supreme Court also relied on various judgements to hold that where a decision taken by any authority affects the right of reputation of any person, such decision must be taken after following the principles of natural justice.

The Supreme Court also negated the contention of RBI/ lenders that the Master Directions impliedly exclude the right to be heard. The Supreme Court observed that the principles of natural justice can be read into a statute or a notification where it is silent on granting an opportunity of hearing to a party whose rights and interests are likely to be affected. It was further held that the rule of audi alteram partem entails that an entity against whom evidence is collected must (i) be provided an opportunity to explain the evidence against it; (ii) be informed of the proposed action, and (iii) be allowed to represent why the proposed action should not be taken. Hence, the mere participation of the borrower during the course of the preparation of a forensic audit report would not fulfil the requirements of natural justice.

The Supreme Court summarized the observations as below:

1. No opportunity of being heard is required before an FIR is lodged and registered;
2. 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;
3. Debarring the borrowers from accessing institutional finance under Clause 8.12.1 of the Master Directions results in serious civil consequences for the borrower;
4. Such a debarment under Clause 8.12.1 of the Master Directions is akin to blacklisting the borrowers for being untrustworthy and unworthy of credit by banks. This Court has consistently held that an opportunity of hearing ought to be provided before a person is blacklisted;
5. The application of audi alteram partem cannot be impliedly excluded under the Master Directions. 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;
6. 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. In addition, the decision classifying the borrower’s account as fraudulent must be made by a reasoned order; and
7. Since the Master Directions 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.

Conclusion:

This judgment reaffirms the applicability of the rule of audi alterm partem in every decision-making process, whether judicial, quasi-judicial, administrative and or quasi-administrative. By reading the principles of natural justice in the Master Directions, the Supreme Court has obviated the possibility of any mechanical decision making on the part of lenders to classify the accounts as ‘fraud’. In fact, after hearing affected parties, the lenders shall have to pass a reasoned order which ensures fairness and transparency in the entire process. This is significant considering that classification of an account as ‘fraud’ has serious consequences on the borrower company and its directors (including criminal actions). The judgement, however, may also lead to delays in classifying accounts as ‘fraud’ which may have its own complications including the possibility of assets/properties being alienated by fraudulent borrowers.

Please find attached a copy of the judgement.

Please find a copy of the Master Directions, here.

This update has been contributed by Ranjit Shetty (Senior Partner) and Rahul Dev (Principal Associate).

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