The Supreme Court on Monday ruled that the banks should give a personal hearing to borrowers before classifying their account as fraudulent, in accordance with the RBI’s Master Circular of July 1, 2016, noting that the action of classifying an account as fraud not only affects the business and goodwill of the borrower, but also the right to reputation.

The apex court accepted the contention that the action of the banks of classifying an account as “fraud” is stigmatic and further added that the “bar from raising finances could be fatal for the borrower leading to its ‘civil death’ in addition to the infraction of their rights under Article 19(1)(g) of the Constitution”.

A bench of Chief Justice of India D.Y. Chandrachud and Justice Hima Kohli said the apex court has consistently held that an opportunity of hearing ought to be provided before a person is blacklisted.

It noted that classification of a borrower’s account as fraud has the effect of preventing the borrower from accessing institutional finance for the purpose of business and it also entails significant civil consequences as it jeopardises the future of the business of the borrower.

The bench stressed that the principles of natural justice necessitate giving an opportunity of a hearing before debarring the borrower from accessing institutional finance under Clause 8.12.1 of the master directions on frauds. “The action of classifying an account as fraud not only affects the business and goodwill of the borrower, but also the right to reputation,” it observed.

However, the court clarified that no opportunity of being heard is required before lodging an FIR.

In a 59-page judgment, Chief Justice Chandrachud, who authored the judgment on behalf of the bench, said: “Principles of fair play require that borrower ought to be given an opportunity of being heard before classifying the account as fraud in accordance with the procedure laid down under the Master Directions on Frauds.”

The RBI and lender banks submitted that the requirement of natural justice is already fulfilled under the master directions on frauds as the borrower is allowed to participate during the preparation of the forensic audit report.

The top court refused to entertain appeals filed by both the RBI and the SBI-led consortium of lenders and upheld the Telangana High Court’s December 10, 2020 judgment which directed lenders to include principles of natural justice into the RBI’s ‘Master Direction on Frauds – Classification and Reporting by Commercial banks and select FIs’ so as to afford opportunity to the affected party/person to present their case.

The bench said: “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 (joint lenders’ forum) 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.”

The RBI and the lenders further argued that giving such an opportunity to the borrower before classifying and reporting loan frauds could defeat the very purpose of the 2016 circular, which is early detection of fraud and prompt reporting.

The borrowers’ counsel submitted that penal provisions under Clause 8.12 of the master directions on frauds are also applicable to the promoters, directors, and other whole-time directors. Once a bank account is classified as fraudulent, it carries significant consequences according to the Master Directions on Frauds such as filing of a complaint with the CBI and debarment of the promoters and directors from accessing institutional finance, the borrowers’ submitted.

The top court accepted borrowers’ submission that the action of the banks of classifying an account as ‘fraud’ is stigmatic, akin to blacklisting the borrower, which affects their right to reputation and there is a direct impact on the fundamental rights of the individuals concerned, as a consequence of the classification of an account as fraud.

The bench said: “Classification of the borrower’s account as fraud under the Master Directions on Frauds virtually leads to a credit freeze for the borrower, who is debarred from raising finance from financial markets and capital markets. The bar from raising finances could be fatal for the borrower leading to its ‘civil death’ in addition to the infraction of their rights under Article 19(1)(g) of the Constitution.”