Introduction

The Supreme Court of India (Supreme Court) in an important judgment, in the matter of State Bank of India and Ors. v. Rajesh Awarwal and Ors.1 has held that principles of natural justice are not mere legal formalities and the principle of audi alteram partem must necessarily be read into the Reserve Bank of India (RBI) (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions 2016 (Master Directions/Directions) to save it from the vice of arbitrariness. Borrowers thus ought to be given an opportunity of being heard, before their accounts are classified as fraudulent.

Background Facts

The matter arose out of challenges to the Master Directions before different High Courts on the ground that no opportunity of being heard is provided to borrowers before classifying their accounts as fraudulent.

Borrowers assailed the Master Directions inter alia on the grounds that

  • Classification of their accounts as fraudulent carries serious civil consequences such as debarment of the promoters and directors from accessing institutional finance, black listing of the borrower, and penal provisions are also applicable to promoters, directors, etc.
  • Subjecting them to these roadblocks without an opportunity for a hearing is not only unconstitutional but also does not stand good on other facets of audi alteram partem.
  • The mere requirement of participation of the borrower during the preparation of the forensic audit report does not in itself fulfil the requirement of the principles of natural justice.

RBI defended the Master Directions inter alia on the grounds that

  • The procedure under the Master Directions as it currently stands would help timely detection and reporting of a fraud.
  • Once declared as a fraudulent account, it is the law enforcement agencies which conduct thorough investigations, and the ultimate decision is then rendered by a competent court of law.
  • Thus, it is unnecessary to grant an opportunity to the borrowers at the time of declaration of accounts as fraudulent, which effectively only sets the process of criminal action in motion.

Judgment and Analysis

The Supreme Court analyzed the regulatory framework under which the RBI is set up to secure monetary stability in the country along with the provisions of the Directions on Early Warning Signals and Red Flagged Accounts2. The Master Directions provide that penal provisions as applicable to 'willful defaulters' would apply to 'fraudulent borrowers', and debar fraudulent borrowers from availing banking finance from scheduled commercial banks, and other financial institutions, for a period of five years from the date of full payment of the defrauded amount, leading to a 'credit freeze.' Fraudulent borrowers are also denied restructuring or the grant of additional facilities by banks/financial institutions.

The Supreme Court observed that the principles of natural justice (i.e. nemo judex in causa sua- no person should be a judge in their own cause and audi alteram partem- a person affected by administrative, judicial or quasi-judicial action must be heard before a decision is taken) act as a guarantee against arbitrary action, both in terms of procedure and substance.

The Supreme Court clarified that the process of forming an informed opinion by banks under the Directions is administrative in nature to which the rule of audi alteram partem applies, apart from judicial and quasi-judicial functions3. It is also a settled position that it is mandatory to provide an opportunity of being heard when an administrative action results in 'civil consequences' to a person or an entity4, which entail infractions not merely on property or personal rights but also of civil liberties, material deprivations and non-pecuniary damages.

The Supreme Court recognized the effects of the classification under the Master Directions including the bar on raising finances, that affect goodwill and reputation. Since the Supreme Court has in the past consistently held that an opportunity of a hearing ought to be provided before a person is put on a blacklist5, the implementation of a decision to secure the health of banking companies "must comport with the due process of law."

The Supreme Court held that principles of natural justice can be read into a statute/notification where it is silent on granting an opportunity of a hearing to a party whose rights and interests are likely to be affected6. The Supreme Court opined that exigency of a situation is contextual and any exclusion must be confined to the narrowest possible limits and thus prior hearing can be excluded only where importing it would have the effect of paralyzing the process7. It was held that 6 months' timeline under the Directions for declaration by the consortium is enough time for the banks to deliberate and given an opportunity of hearing to the borrowers before classifying the account as fraudulent. It was also held that mere participation of a borrower during the course of preparation of a forensic report would not fulfil the requirements of natural justice.

Since the decision to classify an account as fraudulent involves due application of mind to the facts and law by the lender banks, therefore principles of natural justice demand that an opportunity to be heard must be granted. It was observed that any policy decision which contemplates serious civil consequences will be open to challenge for being arbitrary and unconstitutional, if the principles of natural justice are not applied.

Thus, lender banks should provide a copy of the audit reports to the borrowers, allow them a reasonable opportunity of representation, and a reasoned order has to be issued on the objections addressed by the borrower.

Conclusion

This judgment comes as a welcome relief to borrowers, giving debt laden companies a lifeline in cases where the intent may not have been to defraud the lenders. The verdict of the Supreme Court is significant as it ensures procedural fairness, while guaranteeing equal protection of the law. The process under the Master Directions will no longer remain mechanical, in genuine cases where debt restructuring is required. However, whether the provision of an adjudicatory mechanism at a banking level will clog the system, remains to be seen.

Footnotes

1 Civil Appeal No. 7300 of 2022

2 Clause 8.3

3 (1969) 2 SCC 262, (1988) Supp SCC 676, and (2009) 12 SCC 40

4 AIR 1967 SC 1269, (1978) 1 SCC 248, (1978) 1 SCC 405, (1993) 3 SCC 259, (2005) 6 SCC 321

5 (1975) 1 SCC 70, (1978) 3 SCC 36, (1989) 1 SCC 229

6. (1981) 1 SCC 664, (2004) 2 SCC 447

7 (1987) 4 SCC 431

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