Classification of fraud and reporting
Should borrower be given an opportunity of being heard?
-Rhea Shah, Executive | rhea@vinodkothari.com
Background
A recent ruling of the Supreme Court placed emphasis on the classification of an account as fraudulent and the consequences thereof. The ruling is in favour of incorporating the principles of natural justice during the process of declaring an account as fraudulent.
Fraud classification by banks and NBFCs is essentially guided by Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs[1] and the Master Direction – Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016[2], respectively (‘Fraud Directions’). However, there has been a certain extent of ambiguity as to the procedural aspects of the classification. While the basic purpose of such classification remains to ensure the early detection and reporting of a fraudulent transaction, it also entails significance in implementing a procedure that is fast and robust for the RBI to disseminate information regarding fraudulent borrowers and related parties.
The categorisation of frauds under the Fraud Directions is a wide concept wherein the term “fraud” essentially includes the various types of frauds as provided for in the Indian Penal Code such as misappropriation, cheating and forgery amongst others. Further, these guidelines streamline the process of fraud classification and reporting for the banks as well as ensure that the accountability for the same is fixed.
Classification of an account as fraudulent
While the fraud classification guidelines lay down the procedure for reporting and classification of fraudulent accounts, there are no specific provisions dealing with the role and rights of the borrower during the course of such classification. Infact the procedure of fraud classification under the Fruad Directions do not expressly provide the borrower with a right of being heard or make any representation before his/her account is classified as fraudulent or red-flagged. Essentially, since the consequences of an account being classified as such are serious, the borrower should ideally be given an opportunity to explain why such classification is not justified. It is further rightly pointed out in the ruling that the Master Directions are to be read in consonance with the principles of natural justice, primarily in conjunction with the principle of audi alteram partem[3], thereby securing for the borrower a reasonable opportunity of being heard before the final classification of the account as fraudulent.
Further, the procedural requirements of fraud classification as stipulated under the Fraud Directions provide for the conduct of a forensic audit of the borrower before the full and final classification of the account as fraudulent. In this regard, it is important that the borrower is given a reasonable opportunity of explaining the results and outcome of such forensic examination to the concerned authorities before such classification is finalised. Moreover, to serve the purpose and intention of the Fraud Directions, it is essential that the classification is made on the basis of a reasoned ground. The classification, when supported by a strong reasoning, not only justifies such classification but also enables the extent of its validity and stature before the RBI and other financial institutions that have so extended credit to such borrower.
Consequences of such classification
The classification of an account as fraudulent is a significant categorisation due to the fact that such classification leads to serious civil and penal consequences. The Fraud Directions provide for adequate measures for the reporting of an account as fraudulent, thereby making the borrower unscrupulous. Further, the applicability of consequences under the Fraud Directions also extend to the promoters and directors of the company in the same manner as they extend to the wilful defaulter itself. Moreover, such classification and red flagging shall also bar extending of any restructuring of accounts or other additional facilities to the borrower. In a case wherein the account of a company has been classified as fraudulent, any change in the promoters or management, where, typically the erstwhile promoters or directors are delinked totally from the company, shall have the effect of enabling the banks and JLF to decide upon the grant of restructuring facilities based on the viability of the account. However, criminal action and other consequences as may be stipulated on a case to case basis shall continue to accrue over the erstwhile promoters or management.
The Fraud Directions have stipulated that when the account of the borrower is classified as fraudulent, such borrower shall be debarred from raising finance from banks and other financial institutions as specified for a period of five years from the date of making good such default in full. Even beyond the period of such five years, the banks and financial institutions shall decide whether or not finance may be extended to such borrower. In this regard, it is seen that even after a sufficient time has elapsed from the making good of the default, the borrower shall still continue to be subject to the independent discretion of financial institutions for availing financial assistance.
The consequences of such classification are essentially equivalent to “black listing” of the borrower by the top most court of the country, including the filing of a report with the CBI which in turn leads to a virtual credit freeze for the borrower, leading to “civil death” as well as infraction of fundamental rights under Article 19 of the Constitution. Such black listing not only has the effect of reputational damage but also has a direct impact on the fundamental rights of the borrower so classified. The consequence is not merely such that can be nullified by the payment of a monetary penalty, but has serious civil and criminal consequences for the borrower classified as such. Further, on classification of the account of a borrower company as fraudulent, the repercussions shall accrue upon the promoters, directors as well as other whole time directors of such company in terms of raising finance from financial institutions as well as capital markets. Other third parties that may be linked to the borrower such as chartered accountants, builders, travel agents etc. may also be held liable, subject to having been given an opportunity of being heard, depending upon their involvement in the fraud, as may be assessed by the concerned reporting entity. Essentially, the consequences are not only serious but also have the capacity to cover under their ambit a very wide portion of the total fund raising capabilities of the company from a variety of sources.
Case laws and judicial precedents
With reference to various similar circumstances that have arisen in the past, the following course of action and decisions have been taken by the judiciary:
- In the case of Raghunath Thakur v. State of Bihar[4], the Supreme Court held that blacklisting of an account has serious civil consequences, thereby making it essential for a blacklisting order to be issued in adequate consideration of the principles of natural justice.
- In Gorkha Security Services v. Govt (NCT of Delhi), the Supreme Court held that, blacklisting being a stigmatic step, the service of a show cause notice before the same.
- In State of Maharashtra v. Public Concern for Governance Trust, the Supreme Court held that any decision taken by an authority that has the ultimate effect of reputational damage, principles of natural justice shall come into play.
By and large, affording a reasonable opportunity of being heard and making representations before the final classification of an account as fraudulent or red-flagged has been considered of utmost importance to ensure that the borrower’s defence is appropriately taken into consideration.
Necessity of giving an opportunity of being heard
The Directions do not specifically require the borrower to be heard or represented before classifying an account as fraudulent. Essentially, if the borrower is informed of the on-going proceedings against him, he may be likely to abscond thereby leading to hurdling of a fair investigation.
Why is it significant to give an opportunity of being heard?
Owing to the seriousness of the consequences of the classification of an account as fraudulent, affording an opportunity of being heard is essential before such classification is finalised. When consequences of the classification are essentially much more serious for the borrower than for third parties, it shall be unjust for the borrowers to not be given a reasonable opportunity of explaining their actions. Further, the fact that the Fraud Directions entail such an opportunity of being heard to third parties and not to the borrowers brings out arbitrariness in the nature of the Fraud Directions.
It is also to be noted that the principles of natural justice are not just legal formalities but are the principles that judicial, quasi judicial and administrative authorities are required to abide by during the course of decision making. These principles play the role of attaching guarantee against arbitrary action in terms of both procedural and substantive aspects of the decision. Procedurally, these principles require the affording of a reasonable opportunity of being heard and making representations. Further, substantively, these principles ensure that fairness and integrity is adequately rendered in decision making by the authorities.
The basic intent of the Fraud Directions, as seen earlier, is to effectively and efficiently ensure that frauds are classified and reported in a timely manner. However, the mere reason for the requirement to adhere to reasonable timelines does not justify or validate the exclusion of the principles of natural justice. Moreover, as it is understood from the Fraud Directions, there is no specific provision contained therein to ensure that the borrower is sufficiently involved during the course of the forensic audit. Since no such statutory provision exists, it is likely that the inclusion of the borrower in the process rests solely on the discretion of the concerned authority that undertakes such an audit. The non-inclusion of the borrower in the proceedings of the forensic audit is itself unjust and to top it up, the borrowers are, in most cases, not given an opportunity of explaining the results of the same, rather sometimes, they are not even sent a copy of the final report.
The requirement of affording an opportunity of being heard seems even more valid owing to the fact that the classification of an account as fraudulent calls for serious reputational damage for the borrower as well as affects indirectly the fundamental right of freedom to practise any profession or carry out any trade, business or occupation, as granted under Article 19 (1)(g) of the Constitution.
To render further clarification in this regard, an opportunity of being heard is not to be afforded at that point in time where the criminal law sets itself in motion, that is at the time of filing of an FIR. It is in the midst of that point in time where the results of the forensic audit report are published and the account is yet to be classified as fraudulent that such an opportunity is required to be given for the purpose of adequate representation of the borrower.
Concluding remarks
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 Fraud Directions. In addition, the decision classifying the borrower’s account as fraudulent must be made by a reasoned order. Since the Fraud Directions do not expressly provide an opportunity of being heard 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.
Read our other articles on the subject:
Fraud Reporting – Time To Act Now!
[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10477
[2] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10622
[3] hear the other side
[4] 1989 AIR 620, 1988 SCR Supl. (3) 867
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