Ensuring Fairness: The Borrower’s Right to be Heard Before Fraud Classification

By: Shaveer Ahmed on 1st November, 2024

 

Regulatory Framework

The Reserve Bank of India (“RBI”) has been issuing ‘master directions’ on diverse issues since 2016. These directions provide comprehensive instructions on specific subjects and are updated whenever policy changes occur, with the updates reflected on the RBI’s website. Under the authority granted by Section 35A of the Banking Regulation Act, 1949, the RBI released the Master Directions on “Frauds” on July 1, 2016, consolidating and revising seven earlier circulars related to fraud classification, reporting, and monitoring, which were issued between June 2009 and January 2016. These directions were further updated on July 3, 2017 and the latest being July 15, 2024.

The purpose of the Master Directions is extracted below:

“1.3 Purpose

These directions are issued with a view to providing a framework to banks to enable them to detect and report frauds early and taking timely consequent actions like reporting to the Investigative agencies so that fraudsters are brought to book early, examining staff accountability and do effective fraud risk management. These directions also aim to enable faster dissemination of information by the Reserve Bank of India (RBI) to banks on the details of frauds unscrupulous borrowers and related parties, based on the banks’ reporting so that necessary safeguards / preventive measures by way of appropriate procedures and internal checks may be introduced and caution exercised while dealing with such parties by banks.”

The Master Directions on Frauds establish a regulatory framework addressing various types of fraud, including loan frauds, which are specifically covered under Chapter VIII. The framework for dealing with loan frauds was put in place by a circular dated 07 May 2015 which enumerated that the framework aims to ensure early detection, prompt reporting of fraud to the RBI and investigative agencies, and timely staff accountability, without disrupting normal banking operations. Clause 8.12 of these directions imposes severe penalties on borrowers whose accounts are classified as fraudulent. These penalties include being debarred from availing of financial resources from any financial institution for five years, criminal investigations, and other civil consequences.

Chapter VIII of the Master Directions on Fraud outlines the specific procedures banks must follow before deciding to file a criminal complaint against borrowers.

Identification of Early Warning Signals (EWS) and Red Flagged Accounts (RFA)

      • Banks are required to closely monitor loan accounts for EWS that might indicate suspicious activity.

      • If such signals are detected, the account is designated as a Red Flagged Account (RFA).

      • This classification triggers further investigation, including forensic audits.

    Reporting to RBI and Law Enforcement

        • Once a bank classifies an account as fraud, it must report this to the RBI within 21 days.

        • A complaint must also be lodged with the Central Bureau of Investigation (CBI) or other law enforcement agencies.

      Timeline for Forensic Audit and Investigation

          • Within 15 days of classifying an account as RFA or fraud, the bank must convene a meeting of the Joint Lenders Forum (JLF) (in cases of multiple lending banks).

          • A forensic audit must be completed within 3 months from the JLF meeting that authorized it.

        Joint Lenders Forum (JLF)

            • If a borrower has loans from multiple banks, the largest lender or consortium leader must take the lead in initiating a forensic audit.

            • Based on the forensic audit, the JLF will reconvene within 15 days to make a final decision regarding the classification of the account as fraud.

          Lodging Complaints with Law Enforcement

              • Following the forensic audit, the bank must file a complaint with the CBI within 30 days of reporting the fraud to the RBI.
             
             

            Key Legal Issue: Application of Natural Justice and “Audi Alteram Partem”

            The right of a borrower to be heard before their account is classified as fraud has been a significant legal issue, particularly highlighted by the Supreme Court of India’s judgment in State Bank of India & Ors. v. Rajesh Agarwal & Ors[1] (Civil Appeal No.7300 of 2022) The crux of the dispute was whether the principles of natural justice, specifically the right to be heard, should be read into the RBI master directions and must be applied before classifying a borrower’s account as fraud.

            The principle of “audi alteram partem” is a cornerstone of natural justice, meaning “listen to the other side” or the right to be heard. This principle is embedded in Article 21 of the Indian Constitution, which guarantees the right to life and personal liberty, including fair procedure.

            The Supreme Court in this case was primarily tasked with determining whether “audi alteram partem” should be read into the Master Directions. The banks and the RBI argued that the process of fraud classification was an administrative function and did not necessitate a hearing, as the classification was meant to protect the banking system and aimed at protecting public interest, preventing fraud, and facilitating quick reporting to law enforcement agencies. They claimed that a prior hearing would delay urgent measures required to protect the banking system.

            On the other hand, borrowers argued that the classification of an account as fraud had severe civil and penal consequences. Under Clause 8.12 of the Master Directions, borrowers labeled as fraudulent were barred from accessing credit from banks and financial institutions for a period of five years, among other penalties. Borrowers contended that such punitive measures demanded a fair hearing before any decision was made. in Article 21 of the Indian Constitution, which guarantees the right to life and personal liberty, including fair procedure.

            Two fundamental principles of natural justice are entrenched in Indian jurisprudence: (i) nemo judex in causa sua, which means that no person should be a judge in their own cause; and (ii) audi alteram partem, which means that a person affected by administrative, judicial or quasi-judicial action must be heard before a decision is taken. These principles are substantive obligations in Indian law, ensuring protection against arbitrary actions by judicial, quasi-judicial, and administrative authorities.

             

            Supreme Court’s Analysis

            The Supreme Court, led by Chief Justice D.Y. Chandrachud and Justice Hima Kohli, conducted an in-depth analysis of the regulatory framework, the principles of natural justice, and prior rulings on related matters. The Court acknowledged that the Master Directions on Frauds were designed to protect the banking system and public interest. However, it emphasized that classifying an account as fraud had significant adverse consequences for borrowers, including their reputation, creditworthiness, and ability to conduct business.

             

            Impact on Fundamental Rights

            The Court also connected the issue to fundamental rights under Article 19(1)(g) of the Constitution, which guarantees the right to practice any profession, trade, or business. It noted that barring borrowers from accessing institutional finance for five years, as stipulated under Clause 8.12, directly affected their ability to carry on business. This, the Court held, triggered the need for reasonable restrictions and procedural safeguards, including the right to be heard.

            Citing the Maneka Gandhi vs Union of India[2]case, which is one of the most significant rulings concerning the interpretation of natural justice and due process where a seven-judge bench of the Supreme Court expanded the scope of Article 21 of the Indian Constitution, which guarantees the right to life and personal liberty, to include procedural fairness. The Court held that any action that impacts fundamental rights must be “right, just, and fair,” ensuring that individuals are given an opportunity to be heard.

            Further in the State of Orissa v. Dr. (Miss) Binapani Dei[3], the Supreme Court held that even administrative actions that have civil consequences must adhere to the principles of natural justice. This ruling was crucial in the context of the fraud classification case because it established that administrative actions, such as the classification of a borrower’s account as fraud, which severely impacts a borrower’s civil and economic rights, must comply with natural justice principles.

             

            Civil Consequences of Fraud Classification

            The Court observed that the classification of an account as fraud went beyond mere administrative action and had direct civil consequences for borrowers. It likened the consequences of such classification to blacklisting, which affects a borrower’s reputation and restricts their ability to access financial markets. Citing precedents like Erusian Equipment & Chemicals Ltd. v. State of West Bengal[4], the Court noted that blacklisting or debarring individuals or entities from accessing financial resources requires adherence to natural justice principles.

            The constitution bench in Mohinder Singh Gill v. Chief Election Commissioner[5]  emphasized that “civil consequences” extend beyond mere property rights to include a wide range of personal and professional rights, including business and livelihood. The Court held that any action that infringes upon these rights necessitates adherence to natural justice principles.

            The court also relied upon Raghunath Thakur v. State of Bihar[6] wherein the Court reiterated that the principles of natural justice are implicit in actions that have civil consequences, even if not expressly mentioned in the statutory framework and when applied to the present case held that even if the Master Directions did not explicitly provide for a hearing, the principles of natural justice must be implied, given the severe consequences for borrowers.

            The Court in the Rajesh Agarwal case relied heavily on the precedent set in State Bank of India v. Jah Developers[7]drawing parallels between the classification of wilful defaulters and fraudulent borrowers. The case directly dealt with the RBI’s Master Circular on Wilful Defaulters, which similarly to the fraud classification process, involves severe penal and civil consequences. The Supreme Court, in this case, held that principles of natural justice should be read into the process of declaring a borrower as a wilful defaulter. Since both processes resulted in severe penalties, the Court concluded that natural justice, including a right to be heard, must be observed in fraud classification as well.

             

            Key Takeaways and Directives of the Judgment

            The Supreme Court eventually upheld the Telangana High Court judgment dated 10.12.2020 passed in Writ Petition No. 19102 of 2019, set aside the High Court judgments from Telangana and Gujarat in 2021, and disposed of all civil appeals and the writ petition with no costs ordered and issued the following key directives:

                • No hearing before FIR: There is no requirement for a borrower to be heard before the filing and registration of an FIR.

                • Fraud classification consequences: Classifying an account as fraud results in serious penal and civil consequences, including reporting to investigating agencies and debarring access to institutional finance.

                • Debarment akin to blacklisting: Debarring borrowers from accessing institutional finance under Clause 8.12.1 is similar to blacklisting, and a hearing must be provided before such an action.

                • Audi alteram partem applies: The principle of natural justice (audi alteram partem) cannot be excluded under the Master Directions on Frauds. Lender banks must provide a hearing to borrowers before classifying their accounts as fraud.

                • Notice and representation required: Borrowers must be given a notice, the opportunity to explain the forensic audit report, and the chance to represent themselves before their account is classified as fraudulent. The decision to classify must be made by a reasoned order.

                • Natural justice must be read into the Directions: Since the Master Directions do not expressly provide for a hearing, the principles of natural justice must be read into them to prevent arbitrary actions.

              The judgment in State Bank of India & Ors. v. Rajesh Agarwal & Ors. represents a crucial development in Indian banking law, affirming that natural justice principles, particularly the right to be heard, must be integrated into the process of classifying loan accounts as fraudulent. In line with the directions of the said judgment, on July 15, 2024, the Reserve Bank of India (RBI) issued new Master Directions, 2024 (“Master Directives”) bearing no.DOS.CO.FMG.SEC.No.5/23.04.001/2024-25 on Fraud Risk Management for commercial banks, regional rural banks, and All India Financial Institutions. These guidelines replace the 2016 directives and aim to strengthen the mechanisms for fraud prevention, detection, and reporting across the banking sector. Additionally, the RBI introduced updated Master Directions for fraud risk management in Cooperative Banks and Non-Banking Finance Companies (NBFCs), further enhancing the sector’s overall fraud management framework.

              [1] 2023(6) SCC 1

              [2] (1978) 1 SCC 248

              [3] AIR 1967 SC 1269

              [4] (1975) 1 SCC 70

              [5] (1978) 1 SCC 405

              [6](1989) 1 SCC 229

              [7](2019) 6 SCC 787