While tweaking a 2016 master circular on frauds issued by the Reserve Bank of India (RBI), the Supreme Court ruled that a hearing must be allowed for borrowers before classifying their accounts as fraud. Since the classification of an account as fraud entails serious civil consequences for the borrower, RBI's directions must be construed reasonably by reading into them the requirement of observing the principles of natural justice, the apex court says.

A bench headed by chief justice DY Chandrachud affirmed an order passed by Telangana High Court (HC) and set aside the contrary view of the Gujarat HC.

In its order, the bench says, "Consistent with the principles of natural justice, the lender banks should provide an opportunity to a borrower by furnishing a copy of the audit reports and allow the borrower a reasonable opportunity to submit a representation before classifying the account as fraud. A reasoned order has to be issued on the objections addressed by the borrower. On perusal of the facts, it is indubitable that the lender banks did not provide an opportunity of hearing to the borrowers before classifying their accounts as fraud. Therefore, the impugned decision to classify the borrower account as fraud is vitiated by the failure to observe the rule of audi alteram partem."

"In the present batch of appeals, this court passed an ad-interim order restraining the lender banks from taking any precipitate action against the borrowers for the time being. In pursuance of our aforesaid reasoning, we hold that the decision by the lender banks to classify the borrower accounts as fraud is violative of the principles of natural justice. The banks would be at liberty to take fresh steps in accordance with this decision," it added.

Here are the apex court's summarised conclusions:

• No opportunity of being heard is required before a first information report (FIR) is lodged and registered.
• Classification of an account as a fraud not only results in reporting the crime to investigating agencies but also has other penal and civil consequences against the borrowers.
• Debarring the borrowers from accessing institutional finance under Clause 8.12.1 of the master directions on frauds results in serious civil consequences for the borrower.
• Such a debarment under Clause 8.12.1 of the master directions on frauds is akin to blacklisting the borrowers for being untrustworthy and unworthy of credit by banks. This Court has consistently held that an opportunity of a hearing ought to be provided before a person is blacklisted.
• The application of audi alteram partem cannot be impliedly excluded under the master directions on frauds. In view of the time frame contemplated under the master directions on frauds as well as the nature of the procedure adopted, it is reasonably practicable for the lender banks to provide an opportunity of a hearing to the borrowers before classifying their account as fraud.
• The principles of natural justice demand that the borrowers must be served a notice, given an opportunity to explain the conclusions of the forensic audit report and be allowed to represent by the banks/ JLF before their account is classified as fraud under the master directions on frauds. In addition, the decision classifying the borrower's account as fraudulent must be made by a reasoned order.
• Since the master directions on frauds do not expressly provide an opportunity of hearing to the borrowers before classifying their account as fraud, audi alteram partem has to be read into the provisions of the directions to save them from the vice of arbitrariness.

This order would be a significant relief to other parties who are similarly placed and affected by fraud classification by lenders without the principles of natural justice being followed. As per the RBI circular on fraud classification, lenders are to file the complaint with the central bureau of investigation (CBI) in the stipulated time.

The case is related to an Rs1,406 crore loan obtained from various banks by BS Ltd, engaged in power transmission and distribution, passive telecom infrastructure, renewable energy, and mineral resources. However, the company defaulted on repayment. All lenders formed a JLF with with State Bank of India (SBI) as the lead bank.

On 29 August 2016, the JLF company's assets as non-performing assets (NPA). The lender banks decided to adopt the sustainable structuring of the stressed assets scheme and suggested a forensic audit report and techno-economic viability (TEV) study in its meeting held on 11 July 2016.

Based on the conclusions of the forensic audit report, the JLF closed the issue, stating that there were no irregularities. However, based on the TEV study, it was concluded that the company was not eligible for the S4A scheme and requested to submit an alternative plan for the regularisation of its account.

Meanwhile, IDBI Bank—one of the lender banks—red-flagged the company's account. Additionally, proceedings under the Insolvency and Bankruptcy Code (IBC) were initiated against the company. On 15 February 2019, the JLF declared the company's account as fraud by invoking Clause 2.2.1(g) of the master directions on frauds.

Subsequently, the fraud identification committee (FIC) passed a resolution on 31 July 2019 identifying BS Ltd's account as fraud. The company filed a writ petition challenging both the decision of the JLF dated 15 February 2019, and the resolution of the FIC dated 31 July 2019 before the Telangana HC.

The HC directed the lender banks to give an opportunity for a hearing to the borrowers after furnishing a copy of the forensic audit report and to provide an opportunity for a personal hearing to the borrower before classifying their account as fraud.  

This decision was challenged by the lenders before the Supreme Court.

Earlier in April 2021, the apex court had refused to stay the order passed by the Telangana HC. The matter of SBI & others vs Rajesh Agarwal & others, the appeals of SBI and RBI were heard by the Supreme Court bench of justice RF Nariman, justice BR Gavai and justice H Roy.