The resilience of a growing economy is tested and determined when its banking system is put to the test. Despite being relatively stable throughout a series of recessions, the Indian banking industry contains a series of vulnerabilities which have been left unaddressed, increasingly becoming gaping black holes and tarnishing the image of the banking sector.
While the recent downgrade to the lowest Investment Grade by Moody's and a negative outlook for India (sovereign) as a whole may be temporary and (partly) cyclic in nature, what cannot be swept under the carpet is the problem of burgeoning Non Performing Assets ("NPAs"). It is revealing, in itself, that India is the global leader in bad loans. As per the statement of Union Minister of State for Finance's statement in Lok Sabha1, the NPAs of the Public Sector Banks ("PSBs") stood at Rs. 7.27 Lakh Crore as on September 30, 2019. The gross NPAs of PSBs, as per Reserve Bank of India ("RBI") data on global operations, rose from Rs 2,79,016 Crore as on March 31, 2015, to Rs 6,84,732 Crore as on March 31, 2017 and Rs 8,95,601 Crore as on March 31, 2018. RBI, in its Financial Stability Report ("FSR") released on December 27, 2019, has estimated that the gross NPA ratio of banks may increase to 9.9% by September, 2020. The FSR has further estimated that in PSBs, gross NPA ratios may increase to 13.2% by September 2020 from 12.7% in September 2019, whereas for private banks it may climb to 4.2% from 3.9%, under the prevailing stressful scenario and foreign banks' gross bad loans may increase to 3.1% from 2.9% in September 2019. The FSR attributes this carnage to change in macroeconomic scenario, marginal increase in slippages and the effect of declining credit growth. Owing to the COVID - 19 pandemic outbreak, the picture is expected to get murkier. In a country of India's size, private sector participation in the banking and finance sector has been slow and confined to a few large players. While part of this is due to the robust and largely successful prudential regulations issued from time to time by the RBI together with India's commitment to adopt global standards (Basel norms), it has left the NPA curve heavily skewed in favour of the PSBs.
PSBs have long been the repository for public money, and conventional and conservative wisdom has driven the masses (especially the middle class Indian) to leave their money in PSBs in fixed deposits. With rising NPAs, not only are the balance sheets of PSBs under stress, it means increased risk exposure for the public at large as well as reduced income for the Government from PSBs where copious amounts of money has been invested by the Government towards equity capital and recapitalizations. This, obviously, has knock on effects in terms of inflationary and other macroeconomic trends as one stream of Government's income has been dwindling over the last decade or so.
While the issue of NPAs is deep rooted, yet, widely reported, what is still spoken about in hushed tones is the dual problem of evergreening by PSBs and private lenders alike and fraud, wilful default and other similar aspersion casting and unscrupulous methods that plague lending-borrowing relationships in the Indian economy. These are cases where the image of PSBs is tarnished the most while also reducing public and investor confidence and eroding general market sentiment. That said, the RBI has been proactive and focused in its approach through some prudent regulatory measures such as:
- RBI's directions on Disclosure in the "Notes to Accounts" to the Financial Statements Divergence in the asset classification and provisioning bearing reference number RBI/2018- 19/157 DBR.BP.BC.No.32/21.04.018/2018-19 dated 01.04.2019;
- RBI's Master Directions on Frauds - Classification and Reporting by commercial banks and select FIs bearing reference number RBI/DBS/2016-17/28 DBS.CO.CFMC.BC.No.1/23.04.001/2016-17 dated 01.07.2016 (updated on 01.07.2017) ("Fraud Circular");
- RBI's Master Circular on Wilful Defaulters bearing reference number RBI/2015-16/100 DBR.No.CID.BC.22/20.16.003/2015-16 dated 01.07.2015 ("Wilful Default Circular"); and
- RBI's Master Circular - Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances bearing reference number RBI/2015-16/101 DBR.No.BP.BC.2/21.04.048/2015-16 dated 01.07.2015.
Timely detection and early reporting of cases of misfeasance are incentivized leading (atleast) to escalation of the deep rooted issue so that suitable remedial measures can be implemented by the RBI/Government while unscrupulous borrowers are brought to book early. In a 5 part series, we cover law and judicial precedents through a series of questions and summaries that compel a deep analysis of lending borrowing relationships where such misfeasance and unethical practices have crept in leading to enactment and evolution of laws and judicial precedents. In this Part (Part I), we cover the law on banking frauds.
BRIEF OVERVIEW OF RBI'S FRAUD CIRCULAR
Issued on July 1, 2016 and last updated on July 3, 2017, the RBI's Fraud Circular is applicable to all Scheduled Commercial banks (except Regional Rural Banks) and All India Financial Institutions ("AIFI"), which are (i) Export-Import Bank of India, (ii) National Bank for Agriculture and Rural Development, (iv) National Housing Bank and (v) Small Industries Development Bank of India. The Fraud Circular broadly covers the following:
- Classification of various kinds of frauds;
- Quarterly and annual review of frauds and closure of fraud cases;
- Mechanism of reporting of fraud to the Board of Directors of the respective banks and the RBI; and
- Guidelines of reporting of fraud to law enforcement agencies;
- Framework for Loan Frauds - Early detection and reporting by banks (both as sole lenders and under consortium arrangement), staff empowerment, role of auditors, complaints to law enforcement agencies and penal measures for fraudulent borrowers.
In respect of loan frauds, in terms of the Fraud Circular, banks are armed with significantly potent (and, as we will learn later in this Notebook, significantly vulnerable) tools under Chapter VIII. Paragraph 8.3 of the Fraud Circular refers to red flagged account ("RFA") and early warning signals ("EWS") in a loan account, the appearance of which mandate banks to put an account on alert immediately while triggering reporting requirements. Further, paragraph 8.9.4 of the Fraud Circular, whether on mere detection of EWS or otherwise, allows banks to classify any account as RFA or Fraud straightaway, without providing for any opportunity of representation to the borrower, and report the same to RBI and investigation agencies such as Central Bureau of Investigation. It is also an established position of law that RBI circulars carry statutory force and as such are binding on all banks. Following the aforesaid mechanism, RBI has confirmed in its Annual Report of 2018-19 that in the Financial Year ("FY") 2018-19, banking sector reported 6,801 frauds involving a total Rs. 71,542.93 Crores as against 5,916 cases involving Rs. 41,167.04 Crores reported in FY 2017-18. The amount involved in frauds has gone up by 73.8% in a span of one year. The Annual Report also stated that among bank groups, PSBs, who collectively represent the dominant market share in bank lending, have accounted for the bulk of frauds reported in 2018-19.
While the numbers pose a grim picture and make a more robust framework imperative for tackling the menace of fraud, we cannot lose sight of the fact that reporting in such large numbers could also be a consequence of the fact that banks can now straightaway report an account as fraud, in the absence of a specific and binding requirement to conduct any preliminary enquiry to ascertain such fraud.
In its attempt to strengthen the framework and equip banks with powers to proceed swiftly against certain borrowers, RBI appears to have failed in ensuring adherence to the basic tents of the Constitution of India. Prima facie it appears that the Fraud Circular is manifestly arbitrary and in violation of the principles of natural justice in view of the fact that there are no provisions in the Fraud Circular requiring giving of show cause notice, opportunity of personal hearing and representation by banks to the borrowers before banks declare their accounts as fraud and report the same with RBI and other law enforcement agencies. However, it would be incorrect to assume that RBI is oblivious of the significance of the opportunity of hearing/representation to the ones indicted. In the Fraud Circular itself, paragraphs 8.12.3 and 8.12.4 provide for opportunity of hearing/representation to any third party (other than the borrowers) before holding them accountable for any alleged fraudulent transaction, in the following words:
"8.12.4 In addition to above borrower-fraudsters, third parties such as builders, warehouse/cold storage owners, motor vehicle/tractor dealers, travel agents, etc. and professionals such as architects, valuers, chartered accountants, advocates, etc. are also to be held accountable if they have played a vital role in credit sanction/disbursement or facilitated the perpetration of frauds. Banks are advised to report to Indian Banks Association (IBA) the details of such third parties involved in frauds.
8.12.5 Before reporting to IBA, banks have to satisfy themselves of the involvement of third parties concerned and also provide them with an opportunity of being heard. In this regard the banks should follow normal procedures and the processes followed should be suitably recorded. On the basis of such information, IBA would, in turn, prepare caution lists of such third parties for circulation among the banks."
The RBI directive in the Fraud Circular is distinct and clear that banks are required to satisfy themselves of the involvement of third parties first and are also required to provide them with opportunity of hearing/representation before proceeding against them in respect of any alleged fraudulent transaction. However, the Fraud Circular is arbitrary and discriminatory qua borrowers, without so much as a whisper of such rights to them in the entire scheme.
Resultantly, the constitutionality of the Fraud Circular has been assailed in the matter of Apple Sponge and Power Limited & Ors., vs. RBI, W.P. (C) No. 306/2019 before the Hon'ble Delhi High Court and in the matter of AGR Steel Strips Pvt. Ltd. vs. RBI & Ors., C.W.P. No. 34297/2019 which are currently pending before the Hon'ble High Court of Delhi and the Hon'ble High Court of Punjab & Haryana. Both Courts have issued notice in the matters and granted interim protection to the Petitioners (being, inter alia, the respective borrowers, who have been at the receiving end of the lenders' actions under the Fraud Circular). The Fraud Circular confers upon the banks unbridled powers to declare any account as fraud and, consequently, step into the shoes of an adjudicator, without so much as providing borrowers an opportunity of hearing or representation.
Time, perhaps, for the RBI to revisit the provisions of the Fraud Circular and introduce appropriate safeguards for the borrowers with a view to ensure their constitutional rights guarantees are not impacted.
Our analysis on the Fraud Circular is split into 2 (two) Parts as follows:
- Part A - Summary Analysis of the Fraud Circular with certain aspects, capable of being challenged, also noted therein; and
- Part B - Analysis of various contentious issues emanating from, or linked to, the Fraud Circular and judicial disposition regarding the same.
|PROVISION OF FRAUD CIRCULAR||PARTICULARS/IMPACT OF THE PROVISION||POTENTIAL GROUNDS FOR MOUNTING CONSTITUTIONAL OR OTHER LEGAL CHALLENGE|
|Classification of Fraud - Paragraph 2.2 of the Fraud Circular read with Annexure II (enlisting the EWS, which may be used as basis to report Fraud).||
The Fraud Circular provides that, in order to have uniformity in reporting by banks and financial institutions governed by the Fraud Circular, the following are classified as instances of fraud, based mainly on the provisions of the Indian Penal Code, 1860 ("IPC"):
There are 42 Early Warning Signals which have been set out indicatively in Annex II to the Fraud Circular. As mentioned previously, these could trigger reporting requirements in terms of the Fraud Circular. The Early Warning Signals range from resignation of key managerial personnel to issues in stock audit report to non-production of original bills for verification.
|Reporting of Frauds to RBI - Paragraph 3.2||
||Fraud Circular does not require the banks to provide a copy of FMR or any other incriminating material to the concerned borrower. Analogy can be drawn from the relevant criminal laws which require mandatorily that the accused ought to be provided with the copy of the FIR.|
|Guidelines for Reporting Frauds to Police/Central Bureau of Investigation ("CBI") - Paragraph 6||
Banks can lodge complaint with different law enforcement agencies in respect of fraud cases on the basis of the amount involved. The categorization is as follows:
|Under the Fraud Circular, before reporting the suspected cases of fraud to the law enforcement agencies, there is no pre-requisite to conduct any internal inquiry and ascertain the veracity of suspicions or to provide any opportunity of representation/hearing to the borrower as opposed to same being provided to the third party suspects under the Fraud Circular as well as the same being present in the scheme of RBI's Wilful Default Circular.|
|Early Detection and Reporting - Paragraph 8.4||
The grounds for mounting challenge basis this provision are mentioned in Part B of this Notebook under points (II) and (III) and have not been repeated here for the sake of brevity.
|EWS and RFA - Paragraph 8.3||
|Penal Measures for Fraud - Paragraph 8.12||
The grounds for mounting challenge basis this provision are mentioned in Part B of this Notebook under points (II) and (III) and have not been repeated here for the sake of brevity.
- Banks also bound by the directions of the Central Vigilance Commission ("CVC").
- CVC's Office Order No. 14/3/05 dated 05.04.2005 read with Office Order No. 3/1/08 dated 03.01.2008 and Circular No. 30/8/10 dated 17.08.2010 sets out procedures to be followed by the PSBs for reporting cases involving financial frauds to various investigative agencies and to pursue further recovery measures.
- As per CVC's Office Order No. 06/08/19 dated 21.08.2019, Advisory Board for Banking Frauds ("ABBF") functions as the first level of examination of all large fraud cases before recommendations/references are made to any investigative agencies.
- Large fraud cases above Rs. 500 million are referred to ABBF and on receipt of its recommendation/advice, the concerned public sector bank takes further action in such matters.
PART B - ANALYSIS OF JUDICIAL DISPOSITION ON CONTENTIOUS ASPECTS EMANATING FROM FRAUD CIRCULAR
|PROPOSITION OF LAW||LEGAL POSITION BASED ON JUDICIAL PRECEDENTS AND OTHER SUBSTANTIVE LAWS IN FORCE||RELEVANT CASE LAW / SUBSTANTIVE PROVISION OF LAW|
|Statutory force of RBI Circulars||
||Canara Bank vs. P.R.N. Upadhyaya & Ors., (1998) 6 SCC 526|
||Corporation Bank vs. D. S. Gowda & Ors., (1994) 5 SCC 213|
||B.O.I. Finance Ltd. vs. The Custodian & Ors., 1997 (2) SCP 539: (1997) 10 SCC 488|
||Sardar Associates vs. Punjab & Sind Bank, (2009) 8 SCC 257|
||Central Bank of India vs. Ravindra, AIR 2001 SC 3095|
|Absence of the provisions of opportunity of representation to the borrowers under Fraud Circular before reporting of an account as 'Fraud'||Unlike provisions of the IPC, CrPC or the Evidence Act (where the burden of proof as regards alleged fraud is on the person alleging the fraud), in terms of the Fraud Circular, lenders can straightaway trigger penal and punitive consequences.||Paragraph 8.9.4 of the Fraud Circular|
|There is no provision for furnishing a Show Cause Notice or other mechanism (which is built in to other RBI Circular on a similar subject - Wilful Default) providing for an opportunity for the borrower to represent its case before the Bank or any other authority.||Paragraph 8.12 of the Fraud Circular|
||Section 447 of the Companies Act|
||Union of India vs. M/s Chaturbhai M. Patel & Co., AIR 1976 SC 712|
The substantive law in respect of 'fraud' does not, straightaway, hold a person guilty or accountable, without trial or opportunity of hearing, at the very least. However, any such mechanism is absent in the Fraud Circular, which empowers lenders to declare an account as 'fraud' straightaway, and is therefore liable to constitutional challenge due to absence of this provision. The law is clear that: (i) every person is innocent until proven guilty; and (ii) no one can be condemned unheard.
|he constitutional validity of Sections 212(6)(ii), 212(7) and 212(8) of the Companies Act was assailed before the Hon'ble Delhi High Court in the matter of Neeraj Singal vs. Union of India & Ors., W.P. (Crl.) No. 2453 of 2018. However, the Hon'ble Supreme Court transferred the matter to itself vide its order dated 04.09.2018 in SFIO vs. Neeraj Singal & Anr., SLP (Crl.) No. 7241 of 2018 with SLP (Crl.) No. 7242 of 2018 and is now being heard before the Hon'ble Supreme Court along with The Directorate of Enforcement vs. Karti P. Chidambaram, Diary No. 9360 of 2018.|
|Constitutional validity of the Fraud Circular||
In both the matters, notice has been issued, interim protection has been granted to the borrowers, and matters are pending final adjudication.
||Abl International Limited & Anr. Export Credit Guarantee of India Ltd., (2004) 3 SCC 553|
||State Bank of India vs. Jah Developers Pvt. Ltd., (2019) 6 SCC 787|
|In view of various judgments of the Hon'ble Supreme Court, the adherence to the principles of natural justice has been treated as fundamental to the system established by the Rule of Law and under the common-law doctrines on criminal offences and justice. Any action taken or order passed without complying with the same is liable to be declared void being against the principles of natural justice, fairness and the guarantees enshrined under the Constitution of India.||
- Office Memorandum No. 25016/31/2017-Imm. on issuance of Lookout Circular ("LOC") in respect of Indian citizens and foreigners dated 27.10.2010 ("O.M. dated 27.10.2010") has been amended by the confidential (not in public domain) Office Memorandum ("O.M.") dated 12.10.2018 and, when read with Press Release dated 24.07.2019 issued by Ministry of Home Affairs (directions issued by the Government to deal with fraud, wilful bank loan defaulters or fugitive economic offenders), empowers Chairmen/Managing Directors/Chief Executive Officers of PSBs to request issuance of the LOC against fugitive economic offenders/wilful defaulters/fraudsters.
- Under any law in force in India, any bank, which is essentially a commercial institution engaged in private commercial transactions, does not have the authority or power to conduct trial or act as an adjudicator and consequently take coercive measures, like causing issuance of LOC against any person, nor can such power be read inherently vide an office memorandum (such as the O.M).
- Even by way of amending the substantive laws, i.e. the BR Act, powers equivalent to 'adjudication' cannot be conferred upon banks which are merely body corporates engaged in private commercial transactions of lending and borrowing with other body corporates.
- As such any LOC issued basis an office memorandum (such as O.M.), which leads to deprivation of the liberty of any individual, without affording such individual fair trial, cannot be held as 'due process of law' and is, therefore, liable to be struck down as being violative of Articles 14 and 21 of the Constitution ofIndia.
- As such, issuance of the 2018 amendment to the O.M. dated 27.10.2010 conferring upon banks the power to request issuance of LOC, is also liable to be struck down. This amendment to the O.M. dated 27.10.2010 is amenable to constitutional challenges on various grounds which have been dealt with in detail in Part-V of this Notebook containing overview of Law on Look-Out Circulars.