The Hon’ble Supreme Court of India (“Hon’ble SC”) in its recent judgment dated March 27, 2023, in State Bank of India & Ors. v. Rajesh Agarwal & Ors.[i], has conclusively decided on the question of whether the principles of natural justice should be read into the provisions of the Reserve Bank of India (“RBI”) (Fraud Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016[ii] (“Master Directions on Frauds”). The question, which has been pending before various High Courts and was raised before the Hon’ble SC in numerous appeals, has now been answered in the affirmative by the Hon’ble SC by holding that the principles of natural justice, particularly the rule of audi alteram partem, has to be necessarily read into the Master Directions on Frauds to save it from vice of arbitrariness as classification of an account as fraud entails serious civil consequences for the borrowers.
The appeals before the Hon’ble SC had similar conspectus of facts, wherein, the account of the borrower was red flagged by its lender, leading to the consortium of lenders initiating a forensic audit of the borrower. Thereafter, based on the result of the forensic audit, the consortium of lenders of the borrower had declared the account of the borrower as fraud, by invoking Clause 2.2.1(g) of the Master Directions on Frauds, without providing an opportunity of hearing to the borrower or intimating the borrower. Aggrieved by such fraud classification, without consultation, the borrowers moved various High Courts, challenging the constitutionality of the Master Directions on Frauds. The decision by the High Courts came to be challenged before the Hon’ble SC by way of the now decided appeals.
On behalf of the borrowers, it was argued that the Master Directions on Frauds suffers from illegalities as the accounts of borrowers are classified as fraud, leading to serious civil consequences, without any notice to the borrower or the opportunity to defend or present their side of the story. The declaration of fraud is akin to blacklisting the borrower and is violative of Articles 14, 19 and 21 of the Constitution of India as the borrower is debarred from accessing financial and credit markets without even a show cause notice or opportunity of being heard. In fact, the Master Directions on Frauds does not even require banks to inform borrowers about the fraud classification and the penalty consequently imposed. Speedy detection and reporting of fraud to law enforcement agencies cannot justify excluding the applicability of the principles of natural justice.
On the other hand, the RBI and the banks contended that the Master Directions on Frauds is a pre-emptive measure in public interest, with the objective of protecting depositors and banks from growing instances of fraud by ensuring timely dissemination of information and reporting of fraud. It is important to read the provisions in light of the principles of justness, fairness towards the aggrieved party, reasonability and proportionality between the wrongful act and the corrective measure. The Master Directions on Frauds simply sets the criminal law process in motion while final adjudication is only by a competent court of law, hence, principles of natural justice are not applicable at such an early stage where issuance of show cause notice may forewarn fraudulent borrowers and hamper the investigation. Further, the process under the Master Directions on Frauds is distinct from the process of classification as wilful defaulter under the RBI Master Circular on Wilful Defaulters, 2015[iii], hence, the principles under the latter are not applicable.
The Hon’ble SC arrived at the present judgement after undertaking a detailed analysis of the framework of the Master Directions on Frauds and the expansive jurisprudence on the principles of natural justice. It was clarified at the outset that the principles of natural justice are not applicable at the stage of reporting a criminal offense.[iv] The rule of audi alteram partem applies to administrative actions and under the Master Directions on Frauds, the process of forming an informed opinion is administrative in nature. It is an established position of law that any action that entails civil consequences must be in accordance with the principles of natural justice.[v] A perusal of Clause 8.12 of the Master Directions on Frauds shows that the classification of a borrower’s account as fraud by banks under the Master Directions on Frauds has difficult civil consequences for the borrower and its promoters and directors.
While the procedure for declaration of a wilful defaulter is different from that under the Master Directions on Frauds, by virtue of Clause 8.12.1, the consequences are similar as the penal provisions applicable to wilful defaulters also apply to fraudulent borrowers. Thus, the observations in State Bank of India v. Jah Developers[vi] squarely apply and the Master Directions on Frauds has to be harmonised with the principles of natural justice. The debarment of a borrower is akin to blacklisting[vii] it from availing credit, which could lead to its ‘civil death’, in addition to violating its rights under Article 19(1)(g) of the Constitution. As blacklisting has civil consequences, the principles of natural justice necessitate giving an opportunity of a hearing to the borrower before being debarred under Clause 8.12.1.[viii]
Further, the classification also affects the right to reputation of the borrower, which has serious civil consequences.[ix] Also, the right to hearing is not expressly excluded from the Master Directions on Frauds, thus, the principles of natural justice can be read into it, and the timeline under Clause 8.9.6 is wide enough to provide adequate opportunity of hearing to the borrower before classifying it as fraud.[x] To make the Master Directions on Frauds compliant with the principles of equality and non-arbitrariness envisaged under Article 14 of the Constitution, the rule of audi alteram partem ought to be read in.[xi] In conclusion, “principles of natural justice demand that the borrowers must be served a notice, given an opportunity to explain the findings in the forensic audit report, and to represent before the account is classified as fraud under the Master Directions on Frauds”. Thereafter, a reasoned order has to be issued by the banks while classifying the account as fraudulent.
This judgment undoubtedly comes as a huge relief for scores of borrowers whose accounts have been declared as fraud by the various banks in terms of the Master Directions on Frauds. However, it is also a cause of much disquiet for banks who are lenders to such borrowers and have public monies to protect. Whilst there is no denying that it is an established position of law that any person who is prejudicially affected by a decision entailing civil consequences must be given an opportunity of being heard first, but the situation here was perhaps rather unique and an exception could have been carved out.
The Master Directions on Frauds evidently triggers serious civil consequences for the borrowers, including their promoters and directors, as they are barred from availing credit from financial markets and credit markets for a period of five years or more, however, this is done with the objective of protecting public interest. The quandary faced by the Hon’ble SC between protecting the interests of a few fraudulent borrowers versus protecting the interests of banks and the public at large, is akin to the age-old moral dilemma presented by the infamous Trolley Problem[xii]. The Hon’ble SC decided to adopt a deontological approach to this predicament instead of going down the path of utilitarianism.
The RBI in its wisdom, as the regulator of the banking sector in India, had introduced the Master Directions on Frauds to curb the increasing incidents of fraud by individual borrowers and in loan portfolios across India. The absence of any provision providing hearing opportunity to borrowers before they are made to suffer severe civil consequences was justified by the RBI on the ground that the Master Directions on Frauds was aimed at faster dissemination of information by the RBI to other banks on the details of frauds, unscrupulous borrowers, etc., so that internal checks may be introduced, and caution exercised while dealing with such borrowers. However, with this judgement, it will be interesting to see how the now modified framework of the Master Directions on Frauds will pan out. That is a tale only time will tell.
[i] Civil Appeal No. 7300 of 2022
[iv] Relied on Union of India v. W N Chadha, 1993 Supp (4) SCC 260 and Anju Chaudhary v. State of UP, (2013) 6 SCC 384
[v] Relied on State of Orissa v. Dr (Miss) Binapani Dei, AIR 1967 SC 1269; Maneka Gandhi v. Union of India, (1978) 1 SCC 248; Mohinder Singh Gill v. Chief Election Commissioner, New Delhi, 7 (1978) 1 SCC 405; D K Yadav v. J M A Industries, (1993) 3 SCC 259 and Canara Bank v. V K Awasthy, (2005) 6 SCC 321
[vi] (2019) 6 SCC 787
[vii] Relied on Black’s Law Dictionary, 5th edn (1979); P Ramanatha Aiyar and ‘The Law Lexicon: The Encyclopedic Law Dictionary’ (1997 edn);
[viii] Relied on Erusian Equipment & Chemicals Ltd v. State of West Bengal, (1975) 1 SCC 70; Joseph Vilangandan v. Executive Engineer, (1978) 3 SCC 36; Raghunath Thakur v. State of Bihar, (1989) 1 SCC 229 and Gorkha Security Services v. Govt (NCT of Delhi), (2014) 9 SCC 105
[ix] Relied on State of Maharashtra v. Public Concern for Governance Trust, (2007) 3 SCC 587
[x] Relied on Swadeshi Cotton Mills v. Union of India, (1981) 1 SCC 664 and Mangilal v. State of Madhya Pradesh, (2004) 2 SCC 447
[xi] Relied on Cantonment Board v. Taramani Dev, 1992 Supp (2) SCC 501 and Delhi Transport Corporation v. DTC Mazdoor Congress, 1991 Supp (1) SCC 600