Telangana High Court: Natural justice principles to be followed before declaring borrower’s account as fraudulent February 23, 2021
Published in: Between The Lines
Disclaimer: While every care has been taken in the preparation of this Between the Lines to ensure its accuracy at the time of publication, Vaish Associates Advocates assumes no responsibility for any errors which despite all precautions, may be found therein. Neither this bulletin nor the information contained herein constitutes a contract or will form the basis of a contract. The material contained in this document does not constitute / substitute professional advice that may be required before acting on any matter. All logos and trademarks appearing in the newsletter are property of their respective owners.
The Telangana High Court (“THC”) by its judgement dated December 10, 2020 in the matter of Mr. Rajesh Agarwal v. Reserve Bank of India and Others (Writ Petition No: 19102 of 2019) allowed the writ petition filed by a director of a company under Article 226 (Power of High Courts to issue certain writs) of the Constitution of India, 1949 (“Indian Constitution”) on the grounds, inter alia, that principles of natural justice had not been followed in respect of ‘Master Directions on Fraud’ (“Master Circular”) dated July 1, 2016, issued by the Reserve Bank of India (“RBI”).
The petitioner, Rajesh Agarwal, was the chairman and managing director (“Petitioner”) of M/s. B.S. Limited (“Company”). During 2006-2014, the Company availed loan facility amounting to INR 1406 crores from several banks, many of which banks were respondents in this writ petition (hereafter, “Respondent banks”). In 2013, the Madhya Pradesh Power Transmission Company Limited (“MPPTCL”) awarded the contract for certain infrastructure work to the Company (“Works”). As per MPPTCL, there was delay in execution of Works and shortage of working capital, as a result of which the said contract with the Company was terminated. MPPTCL, thereafter, also encashed bank guarantees of INR 140 crores. Upon contract cancellation and encashment of bank guarantees, the Company suffered a huge financial blow and could not repay its loan amounts. As per the circular guidelines of the RBI, respondent no.1, all lender banks formed a ‘Joint Lenders Forum’ (“JLF”) with the State Bank of India, respondent no.2, (“SBI”) acting as the lead bank.
As per the ‘Scheme for Sustainable Structuring of Stressed Assets’ announced by the RBI (“S4A Scheme”) by way of circular dated June 13, 2016, the JLF, on July 11, 2016 decided to adopt the S4A Scheme and conduct a ‘Forensic Audit and Techno-Economic Viability (“TEV”). On June 29, 2016, the Company’s account was declared by the JLF as non-performing asset. Basis the forensic audit report dated August 29, 2016 (“First Audit Report”), the JLF on August 31, 2016, observed that “there were no irregularities, with regard to fraudulent transactions pointed out in the Forensic Audit Report‘”. However, in furtherance to the TEV report dated September 14, 2016, the JLF observed that the Company was ineligible for S4A scheme as there were no minimum prescribed free cash flows by the Company. Therefore, the JLF requested the Company to submit an alternative plan for regularization of its account. The Company thereafter, proposed a ‘One-Time Settlement’ scheme (“OTS”). In February 2018, the OTS was rejected by the JLF. Thereafter, IDBI Bank, respondent no. 9 herein, being one of the member-banks of the JLF, declared the company’s account as “Red Flagged Account”. Basis a second forensic audit report dated April 06, 2018, (“Second Audit Report”), on April 21, 2018, IDBI Bank called for an explanation from the Company. Even though the Company responded that no irregular transactions had taken place in the audit period, IDBI Bank sought further clarifications from the Company to which the latter duly responded. Meanwhile, SBI filed a petition under Section 7 (initiation of corporate insolvency resolution process by financial creditor) of the Insolvency and Bankruptcy Code, 2016 before the National Company Law Tribunal, Hyderabad Bench (“NCLT”). The NCLT by an order passed on November 01, 2018, admitted the aforesaid application, and appointed a Dr. K.V. Srinivas as ‘interim resolution professional’ (“IRP”). However, when a resolution plan could not assist in revival of the Company, the NCLT by order dated November 04, 2019, directed the winding up of the Company and appointed a liquidator (“Liquidator”) in respect thereof. On February 15, 2019, the JLF invoked Clause 2.2 (classification of frauds) (1)(g) of the Master Circular, and declared the Company account as ‘fraud’ (“JLF Order”). The ‘Fraud Identification Committee’ (“FIC”) of SBI, on July 31, 2019, also resolved to identify the Company’s account as ‘fraud’ (“FIC Order”). It is noteworthy that both aforesaid decisions were taken prior to appointment of Liquidator by the NCLT.
Contentions of the Petitioner
As per Clause 8.12 (penal measures for fraudulent borrowers) sub clause (1) of the Master Circular, the penal provisions would also affect the Petitioner. Directors would be debarred from availing bank finance from ‘Scheduled Commercial Banks’, ‘Development Financial Institutions’, ‘Government owned NBFCs’, ‘Investment Institutions’, etc., for a period of five years from the date of full payment of the defrauded amount. Even after the lapse of five years, discretion is given to the financial institutions to decide whether to lend money to the concerned director(s) of a company. Therefore, the Petitioner would perhaps be denied the right to borrow finances for the rest of his life. This would impact the Petitioner’s fundamental right to carry on a trade or business and as a corollary, affect his right to life.
Even if a Liquidator has been appointed by the NCLT, in sum, the Petitioner’s fundamental rights were being affected. Therefore, the Petitioner had sufficient locus standi right to challenge the JLF Order and FIC Order. Moreover, the Company account was declared as ‘fraud’ by both the JLF and FIC without giving either the Company, or the Petitioner an opportunity of hearing. The opportunity had been denied to the Petitioner and the Company ostensibly on the ground that the Master Circular does not include the right of hearing in its scope and ambit. Therefore, the Petitioner had a right to challenge the constitutional validity of the Master Circular. Furthermore, the Petitioner had raised seminal constitutional issue with regard to the interpretation and legal validity of the Master Circular. Hence, the writ petition should be allowed.
The Master Circular had statutory force and despite being elaborate, did not provide for an opportunity of hearing to the borrower before declaration of an account as fraudulent. As soon as a borrower is declared as a fraudster, criminal and civil consequences would follow. This would not merely impact the goodwill in the market, but also affect the fundamental and civil rights of a borrower. Further, as per the Master Circular, even third parties are provided with an opportunity of hearing, that is those parties remotely related to the alleged fraud are also provided an opportunity. If the principles of natural justice were not read into the Master Circular, it would bestow the JLF and the FIC with unbridled power.
Dealing with the factual matrix, it was contended that the Second Audit Report and transaction audit report (prepared by IRP) were never furnished to the Petitioner or the Company. As far as IDBI Bank was concerned, it had merely paraphrased the Second Audit Report in its letters to the Company. The Petitioner had therefore been denied a substantive opportunity of hearing both by IDBI Bank and JLF. As far as minutes of the meeting held on February 15, 2019 were concerned, there were three different items on which JLF had sought clarification from the forensic auditor. The JLF was of the opinion that “if no clarification is sought from the Forensic Auditor”, the account will be classified as “fraud”. However, before actually declaring ‘fraud’ the JLF should have awaited clarification from the forensic auditor. It was unjustified in declaring the Company’s account as ‘fraud’, until all evidence was available. The FIC had also referred to a report submitted by the IRP, which had never been seen by either the Company or the JLF. The Master Circular was also confusing and vague. Clause 8.12 of the Master Circular states that the procedure for declaring a borrower as a wilful defaulter should be followed. Moreover, according to the Hon’ble Supreme Court of India (“SC”) in the case of SBI v. Jah Developers(2019) 6 SCC 787, before a borrower can be declared as a ‘wilful defaulter’, the borrower has to be given an opportunity of hearing by the JLF. Yet, the Master Circular dealing with fraud account denies such an opportunity of hearing to a borrower who may be declared as holder of fraud account. Moreover, in the JLF Order, the JLF has not just declared the Company as holder of a fraud account, but more so has declared the Company as a ‘wilful defaulter’. Therefore, even before declaring the Company as a wilful defaulter, an opportunity of hearing had to be given. It could also not rely on any findings of the NCLT, as the JLF decision was taken before NCLT findings.
Contentions of SBI (objections in respect of Petitioner’s locus standi)
The SBI had approached the NCLT for declaring the Company as insolvent. Since the IRP could not resurrect the Company despite best efforts, the NCLT appointed a Liquidator. As a consequence, the Petitioner no longer had a role to play in the Company’s affairs. The Petitioner, therefore, lacked the locus standi to challenge the JLF Order and FIC Order, and to challenge the legal validity of the Master Circular. Further, once the Company’s account is declared as ‘fraud’, the civil and criminal consequences will be faced by the Company, and not by the Petitioner. Therefore, the Petitioner was not justified in claiming that his fundamental and civil rights were being adversely affected by the JLF Order and FIC Order.
Contentions of RBI and SBI
In consonance with the goal for expediency of the Master Circular, the JLF had to take decisions at the earliest and report the same to RBI, and to expeditiously initiate the criminal investigation. If decisions weren’t taken expeditiously, or not reported to RBI or to the investigating agency, fraudsters would continue their illegal activity and endanger the banking sector. It is in the interest of the public that the decisions be taken without wastage of time. Therefore, the Master Circular did not provide for an opportunity of hearing to a borrower.
The very title of the Master Circular, “Classification and Reporting…” indicated that there are two purposes of the Master Circular, namely (i) to classify an account as ‘fraud’, and (ii) to report the decision both to the RBI and to the law enforcement agencies. Since the decision and investigation needed to be fast paced, the requirement of principles of natural justice should not be read into the Master Circular. Further, the meeting of the JLF is not an adjudicatory process; it is merely an administrative function. Therefore, the principles of natural justice cannot be read as part and parcel of the procedure to be adopted by the JLF. Moreover, the purpose of reaching the conclusion is only to set the criminal law into motion by reporting the fraud to the investigating agencies. Therefore, there was no legal requirement of giving an opportunity of hearing to the alleged accused. The application of principles of natural justice is also not universal. Indeed, there are circumstances where the said principles can be ignored. Even so, the IDBI brought the Second Audit Report to the notice of the Company byits letter and the Company had also replied to the same. It could not be said that the Company was denied an opportunity of hearing. According to an order passed by the Income Tax Department on November 29, 2017, the department had already noticed that some sham transactions were carried out by the Company. Moreover, in its order dated February 27, 2018, the NCLT had noticed the fact that the Company had huge trade receivables. Yet, it could not release/recover any of the outstanding trade receivables. Therefore, apparently, the Company had played fraud. Lastly, the FIC has considered the entire material which was placed before it, and had legally concluded that the Company was holder of a ‘fraud’ account.
Observations of the Telangana High Court
On perusal of Clause 8.12 sub-clauses 1 and 2 of the Master Circular, the THC observed that the Petitioner was well justified in claiming that the JLF Order and FIC Order would adversely affect his civil and fundamental rights, and therefore, he had the right to access justice under Article 226 of the Indian Constitution. Even if the Liquidator had been appointed by the NCLT, it did not pre-empt the Petitioner from challenging the JLF Order, FIC Order and the Master Circular. It was notable that the Liquidator was appointed after the decisions were taken by the JLF and FIC. Therefore, mere appointment of the Liquidator would not dilute the impact of the aforesaid clauses.The THC, whilst referring to a foray of past decisions of the SC, concluded that while interpreting the Master Circular, the principles of natural law would have to be borne in mind. The principles of natural law are applicable to both administrative and quasi-judicial decisions. But while seeing the existence of urgency, the court is required to balance between ‘hurry’ and ‘hearing’. The hearing can be short but substantive, prompt but effective. Merely because the title of the Master Circular is “fraud classification and reporting….”, it does not necessarily mean that the function of the JLF and FIC are limited merely to discovery of fraud, and its reporting by the commercial banks. A perusal of Clause 1.3 (purpose) of the Master Circular would reveal that the purpose was not just to discover a fraud being committed on a bank, but also to alert the other banks to take necessary safeguards/preventive measures against such parties who may be declared as ‘fraudster’. Moreover, the purpose is to initiate the investigation through investigating agencies. The THC rejected the contention that the urgency demanded that principles of natural justice should not be read into the Master Circular. A holistic review of the Master Circular would go to show that a complete elaborate safety system had been prescribed, including system of checks/investigations at different stages of loan’s life cycle, triggering of early warning signal, etc. Moreover, evidence to be read against a party needs to be furnished to the party. The party has to be given an opportunity to explain, or to challenge the evidence. Thus, the argument of urgency cannot be accepted for jettisoning the applicability of principles of natural justice.
Further, there was a notable gap of 4 ½ months between the decision of the JLF and the FIC. Therefore, it could not be said that the decision to declare the Company account as fraud has been taken on an ‘urgent’ basis. Furthermore, if the requirement of principle of nature justice is not read into the Master Circular, it would suffer from vagueness. For, on the one hand, provisions of the Master Circular, that is, Clause 8.9 (Lending under Consortium or Multiple Banking Arrangements) (sub-clauses 4 and 5) prima facie seem to deny the opportunity of hearing to the borrower, yet, Clause 8.12.1 of the Master Circular clearly states that the procedure for declaring a borrower as a willful defaulter has to be followed. Therefore, to erase the self-contained contradiction, and to save the Master Circular from the virus of vagueness, the principles of natural justice perforce would have to be read into Clause 8.9 (sub-clauses 4 and 5) of the Master Circular.
Pursuant to the application of the provisions of Master Circular, among other things, both fraudulent borrower and promoter/director(s), and other whole-time director(s) would be debarred from raising funds from banking system for a period of five years. Thus, once branded as ‘a fraudster’, or ‘a fraudulent borrower’, or ‘holder of a fraud account’, the stigma will continue for a considerable time. Such a stigma would, thus, adversely affect the fundamental rights of a promoter/director to carry on a trade or a business, which is guaranteed under Article 19(1)(g) (to practise any profession, or to carry on any occupation, trade or business) of the Indian Constitution. Therefore, such a classification would have grave civil consequences for promoter/director of a borrowing company. Further, since right to livelihood is part and parcel of fundamental right to life under Article 21 (Protection of life and personal liberty) of the Indian Constitution, the fundamental right can be deprived only by a reasonable procedure established by law. Thus, the Master Circular, as interpreted by the RBI, would be in violation of Article 21. Therefore, to save Clause 8.9 (sub-clauses 4 and 5) of the Master Circular from being declared as unconstitutional, it is essential to read the principles of natural justice into the said clauses. Classification of an account as ‘fraud’ has devastating impact on the life of a person as civil and criminal consequences would subsequently follow. Presently, unbridled power has been given to the JLF for declaring a person/company as ‘a fraudulent borrower’. Such an absolute power could not have been intended by the RBI while promulgating the Master Circular.
Decision of the Telangana High Court
The principles of audi alteram partem will have to be incorporated into Clause 8.9 (sub-clauses 4 and 5) of the Master Circular even if the said clauses are silent. Such an interpretation cannot be said to be farfetched. The party should be given a chance to challenge the evidence. Copies of report such as those submitted by IRP were never furnished to the Petitioner or the Company. Even though the IDBI bank report supposedly paraphrased the contents of Second Audit Report, complete copy of the forensic auditor report was never submitted along with the said letter. Many observations/items against the Company were closed not only on the basis of the Second Audit Report, but also on the basis of clarification / information submitted by the Company to the forensic auditor. Yet, the same opportunity to explain to the JLF was not given to the Company, or to the Petitioner. Hence, the JLF Order is legally invalid. Instead of awaiting clarifications from the forensic auditor, in respect of several other items, the JLF simply declared the account to be treated as fraud. But till it had heard from the forensic auditor, one way or the other, it could not have jumped the gun.
As far as the FIC was concerned, it had relied on the report submitted by the IRP. Here again, neither the Company nor the Petitioner had any information or knowledge about a report which was going to be read against them. However, this crucial step which is a part of audi alteram partem is conspicuously missing in the present case. It was noted that in respect of several items, the JLF had also decided that “in case no clarification is received from the Forensic Auditor, only then it will treat the account as fraud”. Once it has decided to wait till further clarification is submitted, the JLF is not justified in concluding that “the account be treated as fraud”. In fact, the JLF was legally required to wait for further clarification, or non-clarification from the forensic auditor.
Thereafter, the court ordered that: (i) the principle of audi alteram partem, part of the principles of natural justice, is to be read in Clause 8.9 (sub-clauses 4 and 5) of the Master Circular; (ii) FIC Order and JLF Order be set aside; (iii) JLF is directed to give an opportunity of hearing by furnishing copies of both reports (IRP’s Report and Second Auditor Report); (iv) JLF is directed to give an opportunity of personal hearing both to the Petitioner and to the Liquidator before taking any decision on the issue whether the account should be classified as ‘fraud’ or not; (v) After the JLF has taken its decision, the FIC is directed to pass its resolution whether the decision of the JLF should be confirmed or not; and (vi) said exercise shall be carried out by the JLF within a period of three months from the date of receipt of the certified copy of this judgment. Furthermore, the subsequent exercise by FIC shall be carried out within two months from the date of the decision of the JLF.
Vaish Associates Advocates View:
At the outset, application of Clause 8.9 (sub-clauses 4 and 5) of the Master Circular would deny justice to borrowers. Even if a decision has to be taken expediently, the principles of natural justice could be adopted to ensure that the borrower is given a chance to not only access all materials that have been used against him, but also given a chance to explain his case.
In this instance, the Company did not have precise knowledge about the information that was going to be read against them. In addition to the same, they were also denied a proper chance of explanation. As far as the point of urgency was concerned, it was rightly noted by the court that not even urgency could be substantial argument to jettison the principles of natural justice. Such unilateral decisions would set off grave penal consequences for the borrower, from which, a situation reversal would be very difficult. Any such mechanism and the consequences flowing from it would therefore clearly be a reproach to natural justice. It was apt for the THC to balance foresight and administration of justice in interpreting the object of the Master Circular.
For more information please write to Mr. Bomi Daruwala at [email protected]