Contributed by Vismita Rathi

Abstract

The Supreme Court in a recent decision found the Reserve Bank of India’s (RBI) Master Circular on Fraud in defiance of principles of natural justice, popularly known as audi alteram partem. The author delves into the intricacies of the arguments made by both the banks and the borrowers, while analysing the final decision rendered by the apex court in light of the current banking scenario in India.

Introduction

On 27^th March 2023, a two-judge bench of the Supreme Court of India in the landmark judgement of State Bank of India & Ors. v. Rajesh Agarwal & Ors., observed that in order to give borrowers a chance to be heard before their accounts are labelled as fraudulent by banks and financial institutions, the principles of natural justice, particularly audi alteram partem, must be read into the provisions of the Reserve Bank of India’s Master Directions on Fraud.

The civil appeals arose out of a challenge to the Reserve Bank of India (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016. These directives have been contested over the years before various High Courts, especially on the grounds that borrowers are not given the chance to be heard before their accounts are labelled as fraudulent. Given this context, the court had to decide whether the Master Directions on Frauds’ provisions should be interpreted in accordance with the principles of natural justice or not.

Contentions of the parties

On behalf of RBI and the banks, the counsel argued that the Master Directions on Frauds are a preventative measure issued in public interest that aim to safeguard depositors and banks from rising fraud cases by guaranteeing prompt information sharing and fraud reporting. The values of justice and fairness towards the harmed party, reasonability, and proportionality between the wrongdoing and the remedial action should all be considered when interpreting such laws. At such an early stage, when the Master Directions on Frauds only set the criminal justice process in action, the issuance of a show cause notice as demanded by the borrowers, may warn dishonest and fraudulent individuals in advance and give them an opportunity to evade the situation. Therefore, the principles of natural justice are not relevant in the current scenario and could lead to disastrous consequences.

In contrast, the borrowers claimed that the Master Directions on Frauds are unlawful since the accounts of borrowers are labelled as fraudulent, having substantial civil repercussions, without the borrowers being informed or given the chance to defend themselves. The borrower is further prevented from accessing the financial markets without even having received a show-cause notice or given a chance to be heard, resulting in arbitrariness and discrimination, which subsequently results in the violation of Article 14 of the Indian Constitution. Furthermore, Article 19 of the Constitution is also violated as the moment a person is declared to be a wilful defaulter, the impact on his fundamental right to carry on business and trade is direct and destructive. In addition to the above, as per the provisions stipulated under the master directions, the banks are not required to inform the borrowers of the fraud categorization and the resulting penalty, thus causing a grave violation of the principles of natural justice. The arguments put forward by the banks based on prompt identification and reporting of fraud to law enforcement authorities cannot justify excluding the applicability of these principles at any cost.

Decision of the court

The apex court, while deciding in favor of the borrowers, justified that the actions of the banks have serious civil and criminal repercussions since they prevent the borrower from obtaining credit, effectively ending up getting blacklisted. Audi alteram partem is one of the principles of natural justice that must be integrated into the Master Directions because the aforementioned activity is an administrative action. Thus, the Hon’ble Supreme Court ruled that the Master Directions should be interpreted in accordance with the principles of natural justice. It also ruled that the banks must provide a reasoned order after giving a borrower the chance to argue that their accounts should not be deemed fraudulent.

The Court further ruled that the Master Directions will be protected from claims of arbitrariness if the principles of natural justice are interpreted as being an integral component of them. If a reasoned order is issued prior to the categorization, the borrower will have the right to contest it, ending the arbitrary exercise of power by banks and financial organizations under the Master Directions. The Court determined that the principles outlined in State Bank of India v. Jah Developers regarding willful defaulters directly apply to the Master Directions’ classification of an account as fraudulent because fraud has serious civil as well as criminal repercussions. Therefore, before a borrower’s accounts are labelled as fraudulent under the Master Directions, he/she must be served with a notice, given the chance to respond to the findings of the forensic audit report, and permitted to represent his/her interests.

Analysis

Although it is understandable that the Master Circular’s goal is to prevent fraud in the financial system by detecting it as quickly as possible and reporting it to the RBI and the law enforcement authorities. However, the action has serious civil repercussions as well that could negatively affect the accused person’s fundamental rights, such as their ability to engage in trade or business. For this reason, the aforementioned circumstances cannot be used as a justification for excluding the application of natural justice principles from the Master Circular.

Numerous borrowers whose accounts have been flagged as fraudulent by banks in accordance with the Master Directions have been feeling greatly relieved by this decision. However, it is also a major source of concern for banks, who lend money to these debtors and have to safeguard public funds. The moral conundrum that the SC faced was to choose between defending the interests of a few dishonest borrowers or defending those of banks and the general public. Instead of taking a utilitarian stance in this situation, the SC chose to take a deontological approach.

In its wisdom, the RBI, which oversees the Indian banking industry, had developed the Master Directions to reduce the rising number of cases of fraud committed by borrowers all over the country. The RBI defended the lack of a provision that would have allowed borrowers to request a hearing before being subject to harsh civil penalties by arguing that the Master Directions on Frauds were created to help the RBI quickly alert other banks to frauds, dishonest borrowers, etc. so that internal checks could be put in place and care could be taken when dealing with such borrowers.

Conclusion

In conclusion, the Supreme Court’s ruling regarding audi alteram partem in the context of RBI’s Master Directions on Frauds is a significant development in the legal and financial sectors. It reinforces the importance of fairness and due process in the investigation and reporting of frauds, which is essential for maintaining public trust in the financial system. While upholding the principle of natural justice, the court has set an important precedent for future cases and it will be fascinating to observe how the newly modified framework plays out in light of this verdict.