When a loan account is tagged fraud: Borrower’s respite is bank’s worry

In June last year, Naresh Goyal and his wife Anita, the original promoters of Jet Airways, moved court, challenging a decision by the State Bank of India (SBI) to club them with the airline they founded in the list of ‘fraud accounts’. While the Goyals were neither guarantors nor direct borrowers, including them in the ‘fraud’ list could trigger criminal proceedings and put them under the lens of government investigative agencies.

The Goyals had said they were neither served show-cause notice nor heard by the bank. This part in the fraud classification of a loan account has changed now. Banks will have to give an opportunity to the borrower to respond before the account is classified as fraudulent, after a Supreme Court ruling in March this year.

The RBI’s fraud circular
Many think that the RBI’s master circular on fraud issued in 2016, titled ‘Master Directions on Frauds – Classification and Reporting by Commercial Banks and Select FIs’, which allows banks to tag loans as fraud, has been misused grossly. Banks’ random use of fraud classification of loan accounts has resulted in many cases of loan defaults being declared as frauds. These classification and reporting procedures have been challenged in courts.

A loan acocunt is categorised as a ‘fraud account’ after it is red-flagged on the basis of practices like fund diversion (even if there is no siphoning of money from the company). A bank is supposed to report the fraud to RBI within 21 days of its detection as well as report it to the CBI or the economic offences wing of the police depending on the amount involved.

Why the RBI issued the circular
The RBI’s circular came in the background of many big cases of bank fraud hitting the headlines even as banks struggled with high non-performing assets. Early detection of loan fraud and its timely reporting by banks were considered important for containing frauds.

All banks, across the board, had a problem with unscrupulous borrowers milking lapses and loopholes in the system, and defrauding them. But banks took years to even recognise that they were victims of an elaborate web of deception. Their reluctance of the banks stemmed from reputational risks, interference of probe agencies, and the instinct of self-preservation. Sometimes, even failure by the third-party ecosystem, such as credit rating agencies or auditors to highlight risks was also to blame.

The RBI circular stipulated time lines with the action incumbent on a bank. The timelines/stage-wise actions in the loan life-cycle were aimed at compressing the total time taken by a bank to identify a fraud and aid more effective action by the law enforcement agencies. The circular said the early detection of fraud and the necessary corrective action were important to reduce the quantum of loss which the continuance of the fraud may entail.The criticism of the RBI guidelines
The definition, inclusion and imposition of fraud are constitutionally vague and ambiguous, which has led to arbitrary and discriminatory proceedings, according to Sunil Kanoria, co-founder Srei Infrastructure Finance. Hence, it is open to interpretation by different investigative agencies, suited to its needs and wants.

“The RBI Circular, however, does not define the word ‘Fraud’ or ‘Fraudulent’, nor does the RBI circular rely on any other act like IPC or Contract Act to decide on the ‘classification of the borrowers’ account as Fraud Account. The Banks, therefore, seem to enjoy unbridled power and infinite liberty to declare a particular loan account as a fraud at a stage, time and occasion they chose,” Kanoria wrote in ET.

“Similarly, taking advantage of the ambiguity, banks use the RBI circular to blame, blackmail, chastise, and ruin the borrower by declaring the borrower’s account as fraud. This not only helps banks hide their inefficiencies—giving loans without adequate security—but also allows them to declare promoters and directors as ‘fraudsters’,” he wrote. “Classifying an account as fraud has the cascading effects of destroying a borrower’s creditworthiness and ruining the borrower’s reputation in businesses and society. The various courts have also noted the denial of the principles of natural justice even before declaring a loan account as fraud.”

The RBI circular also does not provide any provision for issuance of show-cause notice or affording a hearing to the affected party before the classification as fraud. This part is where the recent Supreme Court ruling will make a difference.

Various petitions had challenged the provisions of the RBI’s fraud circular. In March, the Supreme Court has said the bank must hear the borrower before the account is classified as fraud. The SC said that classifying a loan account as a fraud results in civil consequences for borrowers. It jeopardizes the business of the borrower as he is unable to access any credit from any agency, nor can have the option to restructure the loan. Hence, the SC said an opportunity for a hearing must be given to such persons.

The RBI’s conundrum
The Supreme Court ruled that the RBI’s master circular on fraud was in defiance of principles of natural justice or ‘audi alteram partem’ which means the other side must be heard.

Now banks cannot avoid providing the evidence to the borrower upon which they are planning to rely along with an opportunity to explain the evidence against it. The borrower will be allowed to represent why the proposed action should not be taken against it. However, providing an opportunity to the borrower may forewarn the defaulters and hamper the investigation by law enforcement agencies by way of disclosure of confidential and/or critical information, according to Himanshu Dubey, Designated Partner, Litigation, at S&A Law Offices.

“The disclosure of the entire material against the borrower, at this stage, would give an opportunity to the borrower to delay the investigation, destroy the evidence and abscond the country. This is more so since the forensic report which is (the) basis of the decision making is prepared based upon the documents supplied by the borrower themselves and in the process of forensic audit the borrowers’/representative do participate. Hence supplying relevant extract of the forensic auditor report would meet the ends of justice,” the SBI had said in its plea in the court.

Bankers might consider a middle path that will not hamper the recovery process while also incorporating the court’s observations. “For example, we may not share the full forensic report but only a part of it. This could ensure that the procedure is followed but at the same time we don’t drag the issue unnecessarily,” a banking sector official told ET recently.

The SBI is also seeking clarification from the court whether the ruling will apply prospectively or restrospectively. The retrospective application of the ruling might result in digging up of old cases.

Banks are considering a common framework for borrowers to respond before their loan accounts are classified as fraudulent, ET has reported citing sources. A committee will be set up soon to draw up the framework. It will detail the process of approaching borrowers, the documents to be submitted and reports to be given to them, along with timelines and the course of action.

The latest RBI data show that a total of ₹19,485 crore was embezzled from banks in the first half of FY23, although the amount is down from ₹36,316 crore a year ago. Fraud has decreased consistently and is down from a recent high of ₹1.85 lakh crore in FY20.