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Supreme Court: Borrower must be granted an opportunity of hearing before classifying the account as fraudulent

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In a recent ruling, the Supreme Court held that the financial institutions must provide an opportunity of hearing before classification of borrower’s account as fraudulent and furthermore, the order to classify the account as fraudulent must be a reasoned order. In holding so, the court relied on the principles of audi alteram partem (one of the basic principles of natural justice which means that no one shall be condemned unheard).

The Supreme court observed that the classification of an account as fraud not only results in reporting the crime to investigating agencies but also has other penal and civil consequences against the borrowers and therefore, the principles of audi alteram partem must be read into the provisions of the Reserve Bank of India’s (RBI) Master Directions on Frauds in order to save them from the vice of arbitrariness. [State Bank of India vs Rajesh Agarwal, Civil Appeal No. 7300 of 2022, Supreme Court]

Brief Facts

1. The borrower’s account was declared as a fraud by the SBI-led consortium in accordance with the RBI Master Directions on Frauds.
2. The borrower approached the High Court of Telangana seeking to declare the RBI Master Directions on fraud as arbitrary on the ground of violation of principles of natural justice as it allows the loan account to be classified and reported as a fraud without granting an opportunity of hearing to the borrower.
3. The High Court of Telangana vide its order dated December 10, 2020 allowed the writ petition of the borrower and held that the principle of audi alteram partem is to be read in Clause 8.9.4 and 8.9.5 of the Master Directions.
4. This order of the High Court was challenged before the Supreme Court by the bank as well as the RBI.

Issue before the Supreme Court

Whether the principle of audi alteram partem is to be read into the provisions of the RBI’s Master Directions on Frauds.

Rival Contentions

The borrower had argued that the provisions of the RBI’s Master Directions on Frauds are in the teeth of the basic principles of natural justice insofar as it does not grant an opportunity of hearing before classifying the loan account as a fraud which has serious repercussions on the borrower.

The bank and the RBI had argued that the 2016 Master Directions on Frauds were issued to ensure early detection of fraud and prompt reporting of the same and therefore, providing an opportunity of hearing to the borrower before classifying and reporting loan as a fraud would defeat the very purpose of the 2016 Master Directions.

Supreme Court’s Order

The Supreme Court confirmed the order of the Telangana High Court and held that the principle of audi alteram partem must be read into the provisions of the RBI’s Master Directions on Frauds to save the Master Directions from the vice of arbitrariness.

The court observed that the classification of an account as fraud has various penal and civil consequences. The court noted that the reporting of the fraud and subsequent debarment from access to institutional finance is a serious consequence which is similar to blacklisting of a borrower for being untrustworthy and unworthy of credits by banks.

The court therefore concluded that the application of audi alteram partem cannot be impliedly excluded from the Master Directions on Frauds. The principles of natural justice require the financial institutions to serve a notice to the borrower to explain the fraud related observations before the accounts are classified as a fraud. Thereafter, the loan account can be classified as a fraud through a detailed reasoned order.

Concluding Remarks

The Court’s ruling emphasizes the importance of fairness and transparency in the classification of loan accounts as frauds. The requirement of providing a notice to the borrower to explain fraud related observations before the accounts are classified as frauds is a vital safeguard against arbitrary classification. The Court has also emphasized that the order classifying a loan account as a fraud must be reasoned, which will provide clarity to the borrower about the basis of such classification.

This ruling will help promote greater transparency and accountability in the classification of loan accounts as frauds, which will ultimately benefit both borrowers and financial institutions.