Banks must hear Borrowers before classification of accounts as fraud: Supreme Court verdict on SBI v. Rajesh Agarwal

[By Pranay Bhattacharya]

The author is a is a lawyer focusing on banking & finance and insolvency & bankruptcy laws.


  • Introduction

In a significant ruling, the division bench of the Supreme Court (“SC”) in State Bank of India & Ors v. Rajesh Agarwal & Ors, (Civil Appeal No. 7300 of 2022) on 27 March 2023 considered the long pending issue that whether the principles of natural justice should be read into the provisions of the Reserve Bank of India’s (“RBI”) Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs dated 1 July 2016 (“Master Direction”).

The SC disposed of a bunch of petitions challenging the orders before several High Courts on the contention that no opportunity of being heard is given to borrowers before classifying their accounts as fraudulent.

  • Background of the Case

In Rajesh Agarwal v. Reserve Bank of India and Others (writ petition no 19102 of 2019) (“Rajesh Agarwal case”) dated 10 December 2020, the Telangana High Court allowed a writ filed by the chairman and managing director of BS Limited under Article 226 (Power of High Courts to issue certain writs) of the Constitution of India, 1949 (“Constitution”) on the contention that the principles of natural justice must be read into the Master Direction and an opportunity of hearing should be given to a borrower before the declaration of its account as fraudulent.

As a background, the BS Limited engaged in the business of power transmission failed to meet its payment obligations to lender banks, thereby defaulting in repayment of credit facilities. In accordance with the Master Direction, the lender banks formed a joint lenders forum with SBI as the lead bank and declared the assets of BS Limited as non-performing assets (“NPA”) by invoking Clause 2.2.1 (Classification of Frauds) of the Master Directions.

  • Judgment of the Telangana High Court

In view of the above, the Telangana High Court directed the lender banks: (i) to give an opportunity of a hearing to the borrowers after furnishing a copy of the forensic audit report; and (ii) to provide an opportunity of a personal hearing to the borrower before classifying their account as fraud. However, this judgment was challenged by the banks before the Supreme Court and the order that a personal hearing be given was stayed by the SC.

It is to be noted that the Telangana High Court in Yashdeep Sharma vs. Reserve Bank of India and Ors. dated 31 December 2021 took a contrary view of the above judgment underling that the Master Direction already provides a comprehensive mechanism on fraud classification with the participation of the borrower and the banks. Further, it was also observed that the forensic audit prepared by the auditor is based upon the documents supplied by the borrower and the fraud classification is not a unilateral exercise on part of the forensic auditor of the bank. Therefore, the court took a contrary opinion from the earlier judgments highlighting that the manner of classification of fraud under the Master Direction is in line with the due process of law. As against the Rajesh Agarwal case, this judgment created a dichotomy for banks and lenders for grant of opportunity of hearing before classification of account as fraud owing to the fact that the Master Direction is silent on the issue.

  • SC Judgment

The SC made the following observations upholding the Rajesh Agarwal case:

1. Violation of principles of natural justice: Principles of natural justice are not mere legal formalities but are substantive obligations that need to be followed by the decision making and adjudicating authorities. Therefore, principles of audi alteram partem has to be read into the Master Direction to save it from the vice of arbitrariness.

SC placed reliance on Union of India v. Col. J N Sinha dated 12 August 1970, stating that the rule of audi alteram partem applies to administrative actions, apart from judicial and quasi-judicial functions as applicable in this case. SC also relied on State of Orissa v. Dr (Miss) Binapani Dei dated 7 February 1967 wherein it held that every authority which has the power to take punitive or damaging action has a duty to give a reasonable opportunity to be heard”. Further, an administrative action which involves civil consequences must be made consistent with the rules of natural justice. Therefore, in view of nature of the procedure adopted by the banks, it is practicable for the lenders to provide an opportunity of a hearing before classifying borrowers account as fraud.

2. No implied exclusion of audi alteram partem: Master Direction does not expressly exclude the right of hearing to the borrowers before classification of an account as fraudulent. The principles of natural justice can be read into a statute or a notification where it is silent on granting an opportunity of a hearing to a party whose rights and interests are likely to be affected by the orders that may be passed.

3. Civil and Criminal Consequences: Classification of an account as fraud may lead to serious civil and criminal consequences against the interest of borrowers even though the Master Direction is conceived in public interest. It amounts to “blacklisting” a borrower from availing any credit and affect an individual’s CIBIL score.

SC also opined that the judgment in State Bank of India v. Jah Developers dated 9 May 2019 will be squarely applicable in the present case since the effect of declaring a borrower as wilful defaulter under Master Circular on wilful defaulters dated 1 July 2015 has similar consequences when the borrowers accounts is classified as fraud under the Master Direction.

4. Violation of Article 19(1)(g) of the Constitution: Classification of an account as fraud debars the borrower from raising institutional finances, thus, adversely affects the fundamental rights of a promoter/director to carry on a trade or a business, which is guaranteed under Article 19(1)(g) of the Constitution. Therefore, unilateral power to banks to declare a person/company as ‘a fraudulent borrower’ violates Article 19(1)(g) of the Constitution.

In view of the above findings, the SC upheld the order passed by the Telangana High Court stating that a “reasoned order” and “an opportunity for hearing” should be given before classification of an account as fraudulent.

  • Analysis and Conclusion

A borrower account is declared as fraud based on the findings of a forensic report where interest or principal payment is overdue for 90 days, which results in classifying a loan as an NPA. Further, the Master Direction cites Indian Penal Code provisions, including misappropriation, fraudulent transactions, cheating and forgery, for the classification of accounts as fraud. Therefore, the judgment is significant for the banking sector as it affects the right of borrowers as well as the concerns of lenders against default. As banks have the unilateral power to take classify accounts as fraudulent, SC judgment will have ramifications for banks to curtail the same. This will also ensure that the goodwill and reputation of the borrowers are protected.

Further, the decision will ensure safeguarding the right of being heard before a negative classification of the borrower and will ensure an opportunity to explain the conclusions arrived at by the bank by their internal policy for fraud risk management and fraud investigation. That said, the judgment may have certain negative consequences for banks as ‘fraudulent borrowers’ will now have the ability to delay the process followed by banks.


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