Reserve Bank of India’s Master Direction on Fraud Risk Management

The “Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs” (“Master Direction”)[1] issued by the Reserve Bank of India (“RBI”) in July 2016 (subsequently updated in July 2017), provided a framework to enable early and prompt detection and reporting of frauds to investigative agencies. However, it did not provide for any notice to the borrower or its promoters and directors of the: (i) allegations levelled; (ii) evidence collected; and (iii) penalty proposed in relation to the classification of an account as fraud. Further, the borrower was not provided the: (i) opportunity to present a defense prior to the account being classified as a red-flag account by the relevant bank or present its defense following the forensic audit or when the bank decided to declare the account as fraud; and (ii) copy of the final decision of the bank.

This Master Direction was challenged, before the Supreme Court in the case of State Bank of India and Ors. v. Rajesh Agarwal and Ors (2023)[2], as being unconstitutional as it failed to observe principles of natural justice while classifying an account as fraud. The Supreme Court held that: (i) although principles of natural justice are not applicable at the stage of reporting a criminal offence, the classification of borrower’s account as fraud is not merely reporting of criminal offence to the enforcement authorities, but also entails serious civil and penal consequences for the borrowers; (ii) rule of audi alteram partem (i.e., no decision must be taken without hearing the affected party) must be read into the Master Direction since being classified as fraud results in serious civil consequences like debarring the borrowers from accessing institutional finance for a period of 5 years and prohibition on restructuring or compromise on settlement; (iii) the borrowers must be served a notice, given an opportunity to explain the conclusions of the forensic audit report, and be allowed to make representation to the banks before their account is classified as fraud; and (iv) such a decision to classify the account as fraud must be supported by a reasoned order and such reasons must be based on relevant facts indicating a due application of mind.

Following the Supreme Court ruling, in a welcome move, the RBI has recently released three revised “Master Directions on Fraud Risk Management for the Regulated Entities” (“Revised Master Directions”)[3] which provide that: (i) banks are now required to issue a detailed show cause notice (including specific transaction details forming the basis for the allegation and reporting of fraud under the Revised Master Directions) to the borrower, its promoters and directors against whom the allegation of fraud is being scrutinized; (ii) the borrower should be given at least 21 days to respond; (iii) banks must provide a reasoned order to the borrower conveying its decision including the relevant facts relied upon, the borrower’s responses and the reasons for declaring the account as fraud; and (iv) principles of natural justice must be strictly observed before classifying an account as fraud. 

This is a progressive step taken by the RBI incorporating the Supreme Court’s decision and striking a balance between fraud risk management and adhering to the principles of natural justice. 

Forming an opinion under the Master Direction as well as the Revised Master Directions is an administrative process which must at all times adhere to principles of natural justice including the rule of audi alteram partem. Since the borrowers will now be heard before classifying their accounts as fraud, it will reduce the number of decisions being challenged as being arbitrary. The Revised Master Directions provide the necessary safeguards to protect borrowers from unilateral and arbitrary decisions by the banks.

Shinoj Koshy and Radhika Malpani are Partner and Associate, respectively, at Luthra and Luthra Law Offices India.