Supreme Court settles debate on personal hearing before fraud classification of bank accounts

The Supreme Court in State Bank of India v. Amit Iron Private Limited & Ors has clarified the scope of the principles of natural justice applicable to the classification of bank accounts as “fraud” under the Reserve Bank of India’s Master Directions.

The Reserve Bank of India (Frauds Classification and Reporting by Commercial Banks and Select FIs) Directions, 2016 (“Master Directions 2016”) has been a subject of persistent litigation on considerations of natural justice, with the said directions being silent on the subject. Following protracted litigations across High Courts, the judgment in State Bank of India v. Rajesh Agarwal held that the application audi alteram partem cannot be impliedly excluded under the Master Directions 2016. In addition, the Hon’ble Supreme Court concluded: (a) borrowers must be served a notice, given an opportunity to explain the conclusions of the forensic audit report, “allowed to represent by the bank”, followed by passing of a reasoned order by the bank; and (b) banks should “provide an opportunity of a hearing” to the borrowers before fraud classification.

Implementing Rajesh Agarwal (supra), the Reserve Bank of India (Fraud Risk Management in Commercial Banks (including Regional Rural Banks) and All India Financial Institutions Directions, 2024 (“Master Directions 2024”) were notified with effect from July 15, 2024 in suppression of the Master Directions 2016. The key change in the provisions was the requirement for compliance with natural justice through (a) issuance of a show cause notice with complete details of transactions/actions/events based on which declaration and reporting of a fraud is being contemplated; (b) reasonable time of 21 days to respond to the show cause; and (c) passing of a reasoned order.

Against this backdrop, two critical issues appeared for consideration of the Supreme Court in Amit Iron (supra) being:

1. Whether the borrowers are entitled to a personal hearing before fraud classification? Or, in other words, did Rajesh Agarwal (supra) recognize a borrower’s right to a personal hearing?

2. Whether the borrowers are entitled to the forensic audit report or only its conclusions?

The Court concluded that the earlier judgment did not recognise any right of the borrower to a personal hearing. The use of the words “reply and representation” in paragraph 75 of Rajesh Agarwal (supra) were held to mean a written reply and representation against the show cause notice, not an oral hearing. There were certain practical considerations of note, which the Court found persuasive in its determination, including:

(a) Large volume of cases: RBI data placed before the Court revealed that in FY 2024–25 alone, there were 23,953 fraud cases involving Rs. 36,014 crores. Further, though public sector banks accounted for 29% of the total cases, it accounted for 71.3% of the total quantum of fraud.

(b) Nature of evidence: Fraud classification is primarily based on documentary evidence such as financial statements, transaction records, stock statements and security valuations etc.

(c) Efficiency of public officials: Affording a personal hearing would encumber the working hours of bank officials as a personal hearing would be held during office hours.

On the question of disclosure, relying on paragraph 95 of Rajesh Agarwal, the Court held that the full Forensic Audit Report, not merely its findings and conclusions, must be furnished to the borrower wherever such reports are considered relevant by the bank. The Court reasoned that the findings and conclusions derive their meaning from the body of the report, and supplying conclusions alone would not meet the requirements of natural justice.

Further, taking note of the exceptions to disclosure in T Takano v. SEBI, the Court held that a bank may withhold those portions of report where a bank establishes, for recorded reasons, that parts of the report would impinge upon third-party rights. The Court, however, expressed the expectation that banks would not unreasonably exercise the power of redaction. Supply of reports in digital form was held to constitute valid compliance.

This decision provides a much-needed clarity on the procedural standards applicable to fraud classification. For banks, the Court takes into account the practical considerations for compliance with the administrative process of fraud classification. For borrowers, the ruling reinforces their right to access the full forensic audit report with limited exceptions, ensuring that the process of classification remains transparent.

About the authors: Anoop Rawat is a Partner and the National Practice Head - Restructuring & Insolvency, and Nimrah Alvi is a Principal Associate at Shardul Amarchand Mangaldas & Co.

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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