In the year 2022-2023, the banks in India reported 13,530 fraud cases involving INR 30,252 crores. Behind each of these numbers lies a classification decision, and behind each classification, a business teetering on the edge. A single word, ‘fraud’, can quietly shut down an enterprise. The moment a bank classifies a borrower’s account as fraudulent under Clause 2.2 of the RBI (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016 (“Master Directions 2016”), the consequences are swift and severe. The borrower company, its promoters and whole-time directors can be shut out of the entire banking system for five years, the group’s other accounts are pulled in for scrutiny, and there are prospects for criminal prosecution as well as insolvency proceedings. For an Indian corporate, including multinational corporations and conglomerates, a single classification can ripple across subsidiaries and affiliates before the accused is even heard on the charges against them.
This is precisely why the Supreme Court’s recent judgment in State Bank of India v. Amit Iron Private Limited is pertinent: it offers borrowers the fairness they are due under the RBI’s evolving Master Directions and seeks to settle a decade-old tussle between banks and borrowers.
The Master Directions 2016 said nothing about hearing the borrower before classifying them as fraudulent. This was challenged before the Supreme Court in State Bank of India v. Rajesh Agarwal as a violation of Article 14 of the Constitution on the ground that borrowers faced serious prejudice without being given an opportunity to be heard. The Supreme Court held the Master Directions 2016 violative of Article 14 and directed the RBI to read the principles of audi alteram partem into the framework.
Thereafter, the RBI amended the framework and issued the Fraud Risk Management in Commercial Banks (including Regional Rural Banks) and All India Financial Institutions Directions, 2024 (“Master Directions 2024”). These directions made due process a precondition to any fraud classification. However, that did not end the debate. The Master Directions 2024 were challenged before the Supreme Court, on grounds strikingly similar to Rajesh Agarwal, in the recent Amit Iron matter.
The Master Directions 2016 built a framework to detect and report fraudulent accounts early, the better to contain the systemic risk they pose. As soon as a bank account is classified as fraud, among other things: (a) a five-year ban on the borrower, its promoters and whole-time directors from raising bank finance, counted from the date the defrauded amount was fully repaid, in effect cutting an entire corporate group off from institutional credit across the Indian banking system, and (b) a bar on fresh credit and on restructuring, unless the promoters were replaced. At the time, these were considered as potent tools for protecting the financial system. However, the framework carried a glaring blind spot as it said nothing about hearing the borrower before imposing consequences this drastic.
In Rajesh Agarwal, the Supreme Court addressed that blind spot head-on. The borrowers’ accounts had been classified as fraudulent with no notice, no chance to respond and no reasoned order. The borrowers argued that the principles of natural justice must be read into every governmental rule and direction, including the Master Directions 2016. As soon as an account is classified as fraudulent, it freezes access to both domestic and cross-border funding, damages reputation across the corporate group, and can foreclose any prospect of revival.
The Supreme Court held that natural justice cannot be excluded from the Master Directions 2016; its absence would render the process arbitrary, unfair and violative of Article 14. Before classifying an account as fraud, a bank must therefore (a) serve a notice on the borrower, (b) allow the borrower to explain the conclusions of the forensic audit report, (c) permit a representation, and (d) pass a reasoned order.
But Rajesh Agarwal left one question unanswered: did an opportunity of being heard’ include a right to an oral or personal hearing? The judgment did not address this aspect, and various High Courts took divergent positions. This judicial divergence set the stage for testing the scope of a hearing in the Amit Iron matter.
RBI incorporated the principles of natural justice into the new regime. Under the Master Directions 2024, a bank must now (a) issue a show-cause notice (“SCN”) setting out the full particulars of the alleged fraud, (b) give the borrower a reasonable period, no less than 21 days to reply, and (c) pass a reasoned order on classification. Significantly, before that notice can even go out, the bank must complete an internal audit of the account, including a detailed forensic audit. In short, “audi alteram partem” was no longer bolted on judicially; it was written into the directions themselves.
In this matter, the apex court took up a challenge to the very framework built to comply with its earlier ruling. The three key issues to be determined were: (a) whether Rajesh Agarwal had recognised an inherent right to a personal or oral hearing before an account is classified as fraud; (b) whether a written reply to the SCN, as prescribed by the Master Directions 2024, by itself satisfies the test of natural justice; and (c) whether lender banks must disclose the entire forensic audit report to the borrower.
No Inherent right to a personal hearing
The Supreme Court held that “audi alteram partem” stands satisfied once a bank (a) serves an SCN along with a detailed forensic audit, (b) gives the borrower an opportunity to file a written reply, and (c) passes a reasoned order. There is no inherent right to a personal or oral hearing.
Full forensic audit report must be disclosed
While upholding the RBI’s 2024 framework, the Supreme Court held that the entire forensic audit report, and not merely its conclusions or selective extracts, must be furnished to the borrower along with the SCN. However, where the report contains any third-party interests or confidential information, the bank may withhold those parts. The bank ought to disclose such information to the borrower and afford an opportunity to seek access to them. The reasoning is clear; the real case against the borrower lies in the contents of the report, and no person can effectively rebut findings that have never been disclosed to them.
With this recent judgment by the Supreme Court, the main issue is settled, i.e., a written reply to the SCN, filed after a person has received the complete forensic audit report, will satisfy the ingredients of audi alteram partem, and as such, there is no inherent right to an oral hearing. However, several practical questions remained unresolved.
In Part 2 of this Article, we examine those gaps and set out the reforms needed to make the framework not merely a fair process, but practical too.
About the authors: Palash Taing is a Partner and Manaswi Kosuri is a Senior Associate at TLH, Advocates & Solicitors.
Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.
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