Setback for lenders as SC says borrowers must be heard before an account is classified as fraud

Upholding the 2020 Telangana High Court Judgment, the Supreme Court said there should be no unilateral declaration of fraud by banks without a hearing. The Supreme Court amended the RBI’s main circular by adding “hearing” and “reasons to be recorded for declaring an account a fraud”.

“The declaration of fraud entails criminal and civil consequences, is equivalent to blacklisting access to institutional financing… The banking order must state the reasons for the declaration of fraud, the reasons will prevent banks from exercise powers arbitrarily,” the court said in its verdict.

The 2016 RBI Circular Deal

The RBI issued a master circular in 2016, allowing banks to unilaterally classify accounts of willful defaulters as fraudulent. The main ‘Fraud – Classification and Reporting’ circular was issued under Section 35A of the Banking Regulation Act 1949. It was updated on July 3, 2017.

The circular was challenged in the Telangana High Court. In 2020 the High Court ruled that lenders would be required to hold a hearing before classifying an account as fraudulent.

The SBI and RBI moved the Supreme Court. They challenged the high court’s order for a hearing and argued that the circular’s declaration of fraud was subject to detailed criteria.

The aggrieved borrowers argued that the circular violated the principles of natural justice and claimed that they “impaired the ability to obtain new credit after the declaration”.

Meanwhile, lenders have argued that the circular is aimed at early detection of fraud. He said the classification is limited to interbank communication to enable the exercise of due care required by lenders.

In an interview with CNBC-TV18, Sunil Mehta, Managing Director of the Association of Indian Banks, said, “As a banking system, we fully understand that the Supreme Court judgment is based on the principle of natural justice. which must be accessible to all citizens of the country. However, it is not that the banks overnight declare the account as fraud. There is a system process that has been established by the regulator. In this process, it there is an early warning signal that indicates embezzlement or misuse or embezzlement of funds.Based on the early warning signals, bankers ask the borrower these questions and then they flag the account in their books. Thus, informal opportunities are offered to the borrower even today.Thus saying that the bankers had no consultation with the borrower is wrong as the borrower is in regular contact with the ban system. cairo so the system is already in place the only thing is that it is not documented in the form of legal proceedings.”