In the context of right of creditors and right of borrower, the Supreme Court balances interest of parties under the RBI guidelines for declaration of account as fraud by Banks/Financial Institutions (FIs)
The Reserve Bank of India (RBI) as regulator of the banking system in India has laid down a robust system to deal with delinquent accounts/borrowers. RBI has, from time to time, issued various guidelines to the lenders in this regard – most importantly the guidelines to declare an account as Non-Performing Account (NPA), Red Flag Account, Non-Co-operative Account and Fraud as these issues have far reaching consequences. It goes without saying that these guidelines were necessitated in light of the behavior of the borrowers, to check misuse of banking systems. These guidelines also include a built-in early warning system to thwart possible threats posed by such delinquent borrowers. To keep record of such behaviors and to disseminate information to the players in the system, the RBI has also laid down reporting requirements for the lenders so that the system is not take for ride in the absence of authentic information about such borrowers. These arrangements have in fact helped and protected the banking system from possible attempts to access credit by such delinquent borrowers. Non-reporting and delay in reporting of fraud may attract penalties for the Bank and sever punishment for the banking staff.
While the systems are well settled and followed, the procedure laid down for declaring an account as ‘willful defaulter’ or as ‘fraud’ has come under scrutiny of the Hon’ble Supreme Court on account of consequences that it entails for the borrower and the impact it will have on the fundamental right to do business. In the matter of Jah Developers, the Hon’ble Supreme Court, while dealing with the issue of declaration of borrower as willful defaulter, held that Article 19(1)(g) of the Constitution of India is comes to the fore in such cases. The moment a person is declared to be a wilful defaulter, the impact on its fundamental right to carry on business is direct and immediate as no additional facilities can be granted by any bank/financial institutions, and entrepreneurs/promoters would be barred from institutional finance for five years.
Banks/financial institutions can even change the management of the wilful defaulter, and a promoter/director of a willful defaulter cannot be made promoter or director of any other borrower company. Under Section 29A of the Insolvency and Bankruptcy Code, 2016, a wilful defaulter cannot be a resolution applicant. Based on such serious consequences that follow declaration of declaration of an account as willful defaulter, the Apex court construed the Master Circular of the RBI on Willful Defaulters by harmonizing it with the principles of natural justice – by allowing the borrower the right to file a written representation before the Review Committee against the order of First Committee. The Court also laid down that the Review Committee must pass a reasoned order which must be provided to the borrower. However, the Court did not allow any representation through a lawyer before such committees of the bank on the grounds that these in-house committees are neither a tribunal nor vested with any judicial powers and their powers are only administrative in nature. They are not legally authorized to take evidence by statute, or subordinate legislation, as such no lawyer would have any right to appear before such committees.
RBI issued the Master Directions on Frauds on 01 July 2016 by consolidating earlier circulars on classification of fraud, reporting and monitoring mechanism. The Master Directions on Frauds were updated on 03 July 2017. Recently, the issue of declaration of an account as fraud by the Banks/FIs in terms of the RBI guidelines also came up before the Apex Court in the case of State Bank of India Vs Rajesh Agarawal. The Apex Court acknowledged the fact that the procedure which has been laid down in the Master Directions on Frauds is conceived in public interest and to protect the banking system. The Court however also noted that declaration of the account as fraud led to serious civil consequences including reporting to investigating agencies. Additionally, the Court noted that there is a consistent pattern of judicial thought that civil consequences entail infractions not merely of property or personal rights, but also of civil liberties, material deprivations, and non-pecuniary damages. Every order or proceeding which involves civil consequences or adversely affects a citizen should be in accordance with the principles of natural justice. The Apex Court, accordingly, held that the Banks need to serve a notice to the borrowers, and give them adequate opportunity to submit their reply and representation regarding the findings of the forensic audit report and before classifying their account as fraud.
In this context, it is noteworthy that the Supreme Court has been consistently recognizing the need to harmonize public interest and personal interest in light of Constitutional protection in the form of fundamental rights. The Court has reconfirmed the need to follow the settled principle of law that the rule of audi alteram partem applies to administrative actions. While the Court has recognized the authority of the RBI and Banks to deal with delinquent borrowers, at the same time, it has tried to ensure that such actions and procedures do not result in arbitrary and unilateral decision-making exercises. There have been numerous instances of mechanical exercise of such powers and in many cases the proprietary action of the banks/FIs were questioned -where accounts with proper track records of over twenty years were declared as fraudulent without a proper understanding of the explanations provided by the promoters.
Here, it may need to be noted that earlier the Hon’ble Supreme Court while dealing with the issue of publication of photograph of defaulters by the Banks/FIs, in the light of right to privacy, allowed publication of names and photographs on the grounds that Rule 8 framed under the SARFAESI Act specifically authorized the bank to publish the names and address of wilful defaulter/s and there is also no legal bar that prohibits them from publishing such information. The duty to maintain secrecy is superseded by a larger public interest as well as bank’s own interest under certain circumstances. The Supreme Court in the matter of Reserve Bank of India vs Jayantilal N. Mistry, also held that the RBI is obliged to disclose defaulters list, inspection reports, annual statement etc. related to banks under RTI Act (this issue is still before the Supreme Court).
It may be seen that the Apex Court has tried to harmonize individual rights in the light of the larger public interest. Industry, especially when it does business with borrowed funds, has a greater responsibility to conduct the business in a fair and lawful manner and nobody can claim to have any vested right to conduct business and operation in any manner harmful to public and the system. The rights of creditors in this regard are well recognized and protected under statutes. Under the earlier regime under Companies Act, 1956, Section 542 provided for criminal liability in instances where in the course of winding up of a company, it appeared that the business of the company has been carried on with an intent to defraud creditors or any other persons, or for any fraudulent purpose. Section 540 provided for penalties on officers ofsuch a companywho were involved in disposing off the property of the company or concealing it with the intent of defrauding the creditors of the Company. Similarly, section 543 provided accountability of promoters, directors and other officials for any money or property of the company, and for misfeasance or breach of trust. Section 538 too provided for criminal prosecution of officials of the Company for fraudulent acts and omissions. Under Companies Act, 2013, Sections 339, 340 and 341 deal with the fraudulent conduct of business. Section 339 provides that in case any director, manager, officer or any persons knowingly carried on the business with the intent to defraud creditors or for any fraudulent purpose, the Tribunal may order that such persons will be personally responsible, without any limitation of liability, for all or any of the debts or liabilities as the Tribunal may direct.
The provisions relating to fraudulent and wrongful trading have now been shifted to the Insolvency and Bankruptcy Code, 2016. Section 66 of the Code provides for liability on any persons who knowingly carry on of business with a dishonest intent to defraud creditors and make them liable to make contributions to the assets of the corporate debtor as per the order of the Adjudicating Authority.
To further strengthen the regime for protection of interest of Creditors, Section 143(12) of the Companies Act, 2013 provides for responsibility of auditors to report instances of frauds committed by officer(s) or employee(s) of the company, if during performance of duties, the auditor has reason to believe that an offence involving fraud has been committed against the company. This must be reported within sixty days of the fraud being detected, by following the procedure under Rule 13 of the Companies (Audit and Auditors) Rules, 2014. Non-compliance of Section 143(12) will attract penal action against the auditor by way of imposition of a fine and imprisonment for a term which may extend to one year.
One more principle which is aimed at protection of interest of the creditor and the public at large is “Piercing the corporate veil”. Under this rule the corporate veil could be lifted to pin the liability on the individual members for wrongful acts. The concept of corporate entity has evolved to encourage and promote trade and commerce, but not to commit illegalities or to defraud people. Where, therefore, the corporate character is employed for the purpose of committing illegality or for defrauding others, the court would ignore the corporate character and will look at the reality behind the corporate veil so as to enable it to pass appropriate orders to do justice between the parties concerned. The Supreme Courtaccepted fraud as an appropriate ground for piercing the corporate veil in Delhi Development Authority v Skiper Construction, where it was held that “if it is found that someone has acquired properties by defrauding the people and if it is found that the persons defrauded should be restored to the position in which they would have been but for the said fraud, the court can make all necessary orders. This is what equity means and in India the Courts are not only courts of law but also courts of equity.”
Thus, law gives precedent to the public interest and interest of the creditors over individual rights. Where such interest comes into conflict, the law has created ample avenue for creditors to pursue remedial measures not only to recover their dues but also to pursue remedies for fixing the liability of people responsible for conduct of affairs of the borrower. However, it is experienced that while the system has been proactively examining the cases from the point of view of compliance of the RBI guidelines for declaration of delinquent account as willful, red flag, non-co-operative or fraud, as the case may be, and initiating legal action for recovery of dues – it has been somewhat inactive as regards initiating actions against the responsible promoters/officials, be it under the Companies Act or otherwise. The reason could be two-pronged, one is lack of internal guidelines in Banks/FIs to deal with such situations and second lack of effective jurisprudence and delay in dealing with such matters in courts. On account of such issues, delinquent promoters and officials usually are not prosecuted by Banks/FIs (though actions are initiated based on guarantees, if provided, by such promoters) even though there are sufficient provisions in the relevant statutes for such actions. This one sided approach has not allowed any effective deterrent to be developed for delinquent borrowers and promoters in India where they continue to deal business of the firm with impunity with instances of willful default, misfeasance and fraud. Despite stringent provisions as regards to conduct of business during the twilight period, these borrowers and promoters continue to resist application of the creditor on the insolvency process on one pretext or the other, as they believe that neither the banking system nor the legal system would be eager to initiate action for infringement of their fiduciary duty towards creditors.
Therefore, there is a need to shift focus from the ‘compliance’ part to ‘action’ to bring the delinquent borrowers or promoters to the books under the existing available legal provisions. We may take a cue from UK’s Company Director Disqualification Act, 1986 and have a full-fledged legislation laying down the grounds for director disqualification, procedure for disqualification and consequences of contravention to strengthen the system and responsibilities of the promoters as regards conduct of the business as merely routine action of reporting in terms of RBI guidelines only serves a partial purpose.
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Mukesh Chand, Senior Counsel – Email – MukeshChand@elp-in.com
 In terms of the circular3 DBS.OSMOS. No.14703/33.01.001/2013-14 dated May 22, 2014 and subsequent amendments thereto, lenders are required to report credit information, including classification of an account as SMA to Central Repository of Information on Large Credits (CRILC), on all borrowers having aggregate exposureof ? 50 million and above. The CRILC-Main Report is to be submitted on a monthly basis. A weekly report of instances of default by all borrowers (with aggregate exposure of ? 50 million and above) by close of business on every Friday, or the preceding working day if Friday happens to be a holiday.
Lenders are also required to make disclosures in their financial statements, under ‘Notes on Accounts’, relating to implementation of resolution plan under ICA.
Banks / FIs should submit the list of suit-filed accounts and non suit filed accounts of wilful defaulters of Rs.25 lakh and above on a monthly or more frequent basis to all the four Credit Information Companies. This would enable such information to be available to the banks / FIs on a near real time basis.
In this context, Banks/FIs need not report the names of non-whole time directors (nominee directors / independent directors) in respect of whom they already do not have information about their complicity in the default / wilful default of the borrowing company. However, the names of promoter directors, even if not whole time directors, on the board of the wilful defaulting companies cannot be removed from the existing list of wilful defaulters. n the case of Government undertakings, names of directors are not required to be reported.
Frauds: In cases of individual frauds involving amounts of less than ? 1.00 lakh are not to be reported individually to the RBI, however, statistical data in respect of such frauds is to be submitted to RBI in a quarterly statement. The cases of individual frauds involving amounts of ? 1.00 lakh and above but less than ?.25.00 lakh are to be reported to the Regional Office of Department of Cooperative Bank Supervision of Reserve Bank of India, in the format given in FMR-1, within three weeks from the date of detection. The cases of individual frauds involving amounts of ? 25.00 lakh and above are to be reported to Central Frauds Monitoring Cell, Department of Banking Supervision, Reserve Bank of India Bengaluru, in the format given in FMR-1, within three weeks from the date of detection. Separate FMR-1 is to be furnished in respect of each, case without clubbing. A copy of FMR-1 should also be submitted to the Regional Office of Department of Cooperative Bank Supervision of Reserve Bank of India under whose jurisdiction the Head Office of the bank falls. This has to be followed by quarterly progress report.
 State Bank Of India vs M/S. Jah Developers Pvt. Ltd. Decided on 8 May, 2019
 Civil Appeal No. 7300 of 2022
 SLP No. 37726 /2013 in the matter of DJ Exim (India) Vs. State Bank of India
 Reserve Bank Of India vs Jayantilal N. Mistry decided on 16 December, 2015
Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein