Lender Banks Required To Provide Audit Reports To Borrowers & Allow Representation Before Classifying Accounts As Fraud: Gujarat High Court

The Gujarat High Court while partly allowing a special civil application has emphasized the importance of lender banks affording borrowers the opportunity to review audit reports and present their case before categorizing an account as fraudulent. The court stressed the need for lenders to provide a copy of audit reports and allow a reasonable window for borrowers to submit representations. Furthermore, the court mandated that lenders must issue a reasoned order addressing any objections raised by the borrower.

The petitioners were aggrieved by the decision of the respondent banks taken in the Joint Lenders Meeting dated 29.09.2020 declaring the account of M/s Syntex Industries Limited as fraud.

The petitioners, who are promoters, suspended directors, and shareholders of the company, were involved in a case where the company was placed under Corporate Insolvency Resolution Process (CIRP) as per the Insolvency and Bankruptcy Code, 2016, via an order dated 06.04.2021. Around 04.07.2020, the company became aware that one of the consortium banks, the South Indian Bank, had initiated actions to declare fraud in relation to the company's loan account.

During meetings held on 18.08.2020 and 29.09.2020, discussions were held regarding forensic audit reports dated 11.08.2020 and 18.09.2020, along with various related issues, including the South Indian Bank's declaration of fraud concerning the company's account.

On 29.09.2020, based on the forensic audit reports, the company's account was declared fraudulently. Subsequently, the petitioners learned about similar declarations by other banks, such as Punjab National Bank, Punjab & Sind Bank, and Karnataka Bank Limited, on different dates.

In response, the petitioners filed writ petitions before the Hon'ble Delhi High Court challenging the banks' actions in declaring fraud. The court issued a stay order on the implementation of the fraud declaration. Later, the petitioners withdrew all proceedings, preserving their rights to pursue other legal remedies, without conceding their stance.

The petitioners raised a contention that they were not afforded the opportunity to address the findings of the forensic audit report and its supplementary version, as mandated by the recent judgment in the case of State Bank of India and Others v. Rajesh Agarwal and Others (reported in (2023) 6 SCC 1).

The Court acknowledged that apart from sharing the draft forensic audit report's observations with the petitioners, neither the actual forensic audit report nor its supplementary version were provided to them. This point was not disputed by the respondents' counsel, particularly the respondent lender banks. Hence, solely on this basis, the writ petition in question was deemed deserving of allowance by the Court.

The Court highlighted the Master Directions of 2016 concerning frauds, specifically Chapter VIII titled "Loan Frauds – New Framework," which outlines the procedure for declaring an account as a fraud account.

Moreover, the Court noted Clause 8.9.4, which dictates the decision-making process for classifying any standard account or Non-Performing Asset (NPA) account as Red Flagged Account (RFA) or Fraud, placing the responsibility on the bank to report such status on the CRILC platform to alert other banks.

Additionally, the Court observed Clause 8.9.5, which mandates the completion of forensic audits within a specified timeframe. It also stipulates that if the decision is to classify the account as fraudulent, the RFA status must be updated to fraud across all banks, with reporting requirements to the Reserve Bank of India and on the CRILC platform within a designated period.

The Court observed that the Master Direction of 2016 on frauds, was subject matter of challenge before various High Courts on the ground that no opportunity of being heard is envisaged to the borrowers before classifying the account as fraudulent. The judgment rendered by the High Court of Telangana was subject matter of challenge before the Apex Court wherein, it was held that the principles of natural justice must be read into the provisions of Master Directions of 2016 on frauds.

The issue before the Apex Court was as to whether the principles of natural justice should be read into Master Directions of 2016 on frauds. The Apex Court, held and observed that the principles of natural justice and more particularly, rule of audi alteram partem has to be necessarily read into the Master Directions on frauds to save it from the vice of arbitrariness.

It was held that classification of an account as fraud entails serious civil consequences for the borrower, and the directions must be construed reasonably by reading into them the requirement of observing the principles of natural justice.

The Apex Court, therefore, held that audi alteram partem, therefore, entails that an entity against whom evidence is collected must: (i) be provided an opportunity to explain the evidence against it; (ii) be informed of the proposed action, and (iii) be allowed to represent why the proposed action should not be taken. It has also been held and observed that mere participation of the borrower during the course of the preparation of a forensic audit report would not fulfil the requirements of natural justice.

The decision to classify an account as fraud involves due application of mind to the facts and law by the lender banks. The lender banks, either individually or through a JLF, have to decide whether a borrower has breached the terms and conditions of a loan agreement, and based upon such determination the lender banks can seek appropriate remedies.

It was also held and observed that therefore, principles of natural justice demand that the borrowers must be served a notice, given an opportunity to explain the findings in the forensic audit report, and to represent before the account is classified as fraud under the Master Directions on Frauds.

The High Court observed, “Clearly, rule of audi alteram partem has been read into clauses 8.9.4 and 8.9.5 of the Master Directions of 2016 on frauds. The Apex Court has also directed that consistent with the principles of natural justice, the lender banks should provide an opportunity to a borrower by furnishing a copy of the audit reports and allow the borrower a reasonable opportunity to submit a representation before classifying the account as fraud coupled with passing of a reasoned order on the objections addressed by the borrower.”

“Undisputedly, in the present case, no such steps have been taken by the respondent lender banks and therefore, on this limited ground of violation of principles of natural justice, the decision of the respondent banks declaring the account of the company as fraud is hereby quashed and set aside,” the Court further observed.

The Court remitted the matter and directed the respondents concerned, after furnishing the copies of the forensic audit report and supplementary forensic audit report, a reasonable opportunity to the petitioners to submit the representation, complete the proceedings by passing order.

“The aforesaid exercise, shall be undertaken in conformity with the principles laid down by the Apex Court in the above referred judgment and within a period of six months from the date of the receipt of the copy of this order. This Court, has not expressed any opinion as regards criminal proceedings, if any,” the Court concluded while partly allowing the petition.

Case No.: R/Special Civil Application No. 19008 Of 2022

Case Title: Amit Dineshchandra Patel Versus Reserve Bank Of India

LL Citation: 2024 LiveLaw (Guj) 19

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