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Hear borrowers before declaring accounts 'fraud': Supreme Court

December 2020 judgment of Telangana High Court upheld

Supreme Court (Photo: Wikipedia)

Supreme Court (Photo: Wikipedia)

Bhavini Mishra New Delhi
The Supreme Court on Monday said a borrower should be allowed to be heard before a bank declared the person’s account “fraudulent”. In this matter, the Bench of Chief Justice of India D Y Chandrachud and Justice Hima Kohli upheld the judgment of the Division Bench of the High Court of Telangana of December 10, 2020.

The judgment has come on the appeal of State Bank of India (SBI). The Reserve Bank of India (RBI) issued a master circular in 2016, allowing banks to classify accounts of wilful defaulters as fraudulent without hearing them. 

The Master Circular, “Frauds —Classification and Reporting”, was issued under Section 35 A of the Banking Regulation Act, 1949. This circular was challenged in the Telangana High Court, which held in 2020 that borrowers would be heard before the classification of an account as fraudulent. SBI and the RBI then moved the Supreme Court against this order.

“The application of ‘audi alteram partem’ (hearing both sides) cannot be impliedly excluded under the Master Directions on Frauds. In view of the timeframe 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 for a hearing to the borrowers before classifying their account as fraud,” the court held. 

The “Master Directions on Frauds” provide a regulatory framework for attempted fraud, cheque-related fraud, loan fraud, theft, burglary, bank robberies, etc.

The court said no opportunity of being heard was required before an FIR (First Information Report) was lodged and registered. The judgment of the Gujarat High Court in this regard has been set aside. The court said the classification of an account as “fraud” not only resulted in reporting the crime to investigating agencies, but also had penal and civil consequences for borrowers.

Under Clause 8.12.1, the borrower, including promoters and directors of a company, are debarred from availing themselves of credit from financial markets and credit markets for five years, and possibly even beyond.

Meanwhile, the RBI and lender banks said such a restriction had to be perceived from the perspective of public interest.

“While acknowledging that the procedure, which has been laid down in the Master Directions on Frauds, is conceived in the public interest (and) to protect the banking system, we cannot ignore the serious civil consequences which emanate to the borrowers,” the court said.

Manavendra Mishra, partner, Khaitan and Co, said the judgment had brought about much-needed clarity and change to the manner in which defaulting companies were dealt with under the Master Directions of Fraud.

“It provides an opportunity for the borrower to explain the findings of forensic audit, which is often the precursor to the FIR. We have seen findings copy pasted as the complaint and FIR and, thus, getting clarifications and an opportunity to be heard will go a long way,” he said.

The court said lender banks should provide an opportunity to a borrower by furnishing a copy of audit reports and allow the borrower an opportunity to submit a representation before classifying the account as “fraud”.

“The principles of natural justice demand borrowers must be served notice, given an opportunity to explain the conclusions of the forensic audit report, and (be allowed to be given a representation) to the banks/Joint Lender’s Forum (a dedicated body of lender banks that is formed to speed up decisions when an asset of more Rs 100 crore or more turns out to be a stressed asset) before their account is classified as fraud ... In addition, the decision classifying the borrower’s account as fraudulent must be made by a reasoned order,” the court said.

Samarjit Pattnaik, partner, Karanjawala & Co, said: “After this decision, if any bank decides to classify any account/ borrower as fraud, it has to issue notice to borrowers and give them an opportunity to explain the conclusions in the forensic audit report and also they will be able to give a representation before banks and the joint lenders’ forum as to why their account should not be classified as fraud. If at all the bank concludes and classifies any account/borrower as fraudulent, then a reasoned order has to be passed.”

In conclusion, the court said since the Master Directions on Frauds did not expressly provide an opportunity of hearing to the borrowers before classifying their accounts as fraud, an opportunity for them to be heard had to be read into the provisions of the directions to save them from the “vice of arbitrariness”.

“This order will possibly reduce the number of fraudulent accounts and the misuse of discretionary powers by banks,” said Tushar Agarwal, advocate, Supreme Court.
What Bench said
  • Principles of natural justice demand that borrowers must be served notice
  • They must be given opportunity to explain conclusions of forensic audit report
  • Decision classifying borrower’s account fraudulent must be made by a reasoned order
  • Giving borrowers a hearing to be read into RBI’s Master Directions on Frauds
  • Opportunity of hearing not required before an FIR is lodged
  • Classification of an account as fraud has penal and civil consequences for borrowers
  • Debarment under Master Directions on Frauds akin to blacklisting borrowers

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First Published: Mar 27 2023 | 1:49 PM IST

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