In the fiscal year of 2022-2023, Indian banks reported 13,530 fraud cases, with the financial implications reaching a staggering INR 30,252 crores. Behind each statistic lies a critical classification decision, and the businesses affected stand precariously on the brink. A single classification as ‘fraud’ can silently dismantle an enterprise. When a bank categorizes a borrower’s account as fraudulent under Clause 2.2 of the RBI’s (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016, known as the ‘Master Directions 2016’, the repercussions are immediate and far-reaching.
A company branded as fraudulent, along with its promoters and whole-time directors, finds itself ostracized from the banking system for five years, with all associated accounts coming under scrutiny. Criminal prosecution and insolvency proceedings loom large. For any Indian corporate entity, including multinationals and conglomerates, this classification can send shockwaves through subsidiaries and affiliates even before the charges are proven.
The Supreme Court’s Critical Judgment
The Supreme Court’s ruling in State Bank of India v. Amit Iron Private Limited is crucial in this context, as it endeavors to provide borrowers with the fairness they deserve under the RBI’s evolving guidelines and attempts to resolve a longstanding conflict between banks and borrowers.
The 2016 guidelines did not require that borrowers be heard before being classified as fraudulent, which led to a significant legal challenge in State Bank of India v. Rajesh Agarwal. The petitioners argued that this omission violated Article 14 of the Constitution, as borrowers suffered serious prejudice without a chance to defend themselves. The Supreme Court agreed, ruling that the Master Directions 2016 were unconstitutional under Article 14, mandating the RBI to integrate principles of audi alteram partem into the framework.
The Evolution of RBI Guidelines
Consequently, the RBI revised the framework, issuing the Fraud Risk Management in Commercial Banks (including Regional Rural Banks) and All India Financial Institutions Directions, 2024, or ‘Master Directions 2024’. These new directions introduced due process requirements before any fraud classification could be made. However, the debate was far from over, as the updated directions faced challenges in the Supreme Court in the recent Amit Iron case.
Master Directions 2016 and the Lack of a Hearing
The Master Directions 2016 aimed to establish an early detection and reporting system for fraudulent accounts to mitigate systemic risks. Once an account was labeled as fraud, consequences included a five-year ban on raising bank finance and restrictions on new credit or restructuring unless promoters were replaced. Yet, this framework overlooked the necessity of hearing the borrower before such severe actions were taken.
Integrating Audi Alteram Partem in the 2016 Framework
In Rajesh Agarwal, the Supreme Court addressed this oversight directly. Borrowers found their accounts classified as fraudulent without notice, opportunity to respond, or reasoned orders. The court recognized that principles of natural justice should be inherent in all governmental rules, including the Master Directions 2016. The absence of these principles would render the process arbitrary and unfair, violating Article 14.
The court ruled that before classifying an account as fraud, banks must issue a notice to the borrower, allow them to respond to the forensic audit report, provide for representation, and issue a reasoned order. However, the judgment did not clarify whether a personal or oral hearing was necessary, leading to varied interpretations across High Courts. This ambiguity set the stage for the Amit Iron case to further examine the extent of a borrower’s right to be heard.
The RBI’s 2024 Directions: A Codified Fair Process
The RBI’s Master Directions 2024 incorporated natural justice principles. Banks are now required to issue a show-cause notice (SCN) detailing the alleged fraud, provide at least 21 days for a response, and pass a reasoned order on classification. Importantly, before issuing a notice, banks must conduct a thorough internal audit, including a forensic audit, ensuring that audi alteram partem is formally integrated into the process.
The Supreme Court’s Stance in Amit Iron
In the Amit Iron case, the Supreme Court examined whether Rajesh Agarwal implied a right to a personal or oral hearing before classifying an account as fraud. The court found that the principles of audi alteram partem were satisfied when a bank served an SCN with a detailed forensic audit, allowed a written response, and issued a reasoned order. There is no inherent right to a personal or oral hearing.
Additionally, the Supreme Court mandated that the full forensic audit report, not just selective extracts, must be shared with the borrower alongside the SCN. If the report contains confidential information or involves third-party interests, banks may withhold those sections but must inform the borrower and allow them to seek access.
This ruling clarifies that a written response to the SCN, following the receipt of the complete forensic audit report, fulfills the requirements of audi alteram partem, negating the need for an oral hearing. However, practical issues remain unaddressed.
In Part 2 of this article, we will explore these gaps and propose reforms to enhance the framework, ensuring it is not only fair but also practical.
About the authors: Palash Taing is a Partner and Manaswi Kosuri is a Senior Associate at TLH, Advocates & Solicitors.
Disclaimer: The views expressed in this article are those of the authors and do not necessarily represent the opinions of Bar & Bench.
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