Banking on Banks for Natural Justice

In a judgement pronounced earlier this month, the Bombay High Court re-emphasized the requirements of natural justice to be followed by banks when designating a borrower who has defaulted on debt as a ‘willful defaulter’. This judgement is in line with the jurisprudence laid down by the Supreme Court and multiple High Courts on banks declaring borrowers as ‘willful’ defaulters in exercise of the powers conferred upon them by the Reserve Bank of India (‘RBI’). As the Court highlighted, a willful defaulter tag implies a near ‘civil death’ of a borrower in that such borrowers are not only frozen out of the capital (which includes the credit) market, but also subjected to other disqualifications, including possible criminal actions. While the willful defaulter designation power was conferred on banks in the late 1990s, more recently, the RBI similarly empowered banks to classify certain kinds of loan accounts as fraud accounts, which entails similar consequences as the willful defaulter tag, and some more. The ‘willful’ and ‘fraudulent’ defaulter tags attach not only to the borrowing entity, but in most cases, also to the borrower’s directors.

The judgement, and the overall jurisprudential trend towards the classification of borrowers as willful and fraudulent is noteworthy for legal scholars, the RBI as a banking regulator, and of course, banks, for three reasons.

Pushing the Boundaries of Due Process

Previous judgements on this subject have emphasized the importance of giving the borrower a hearing and reasoned orders when designating borrowers as willful defaulters. The recent judgement of the Bombay High Court pushes the boundaries of the due process expected of banks by requiring them to provide not only the information that they relied on in making their decision, but also the exculpatory information that might help the borrower redeem itself from such categorization. The judges noted: ‘[S]ince the purpose of disclosure of information targets both the outcome (reliability) and the process (fair trial and transparency), it would be insufficient if only the material relied on is disclosed…[A]s a default rule, all relevant material must be disclosed (emphasis supplied).’

Importantly, in doing so, the Court, for the first time, imported a standard of due process laid down for the conduct of enforcement proceedings undertaken by a regulatory authority, as laid down by the Supreme Court last year in connection with an enforcement proceeding undertaken by the Securities and Exchange Board of India (‘SEBI’). This implies that the standards of due process applicable to regulatory authorities in conducting in-house enforcement proceedings, are applicable to banks when designating borrowers as willful defaulters. Indeed, since banks are commercial entities accountable to no one but their shareholders, one could argue for a higher standard of due process to be applied by them when designating debt defaulters as willful or fraudulent, as compared to the standards applied by the State and its agencies in enforcement proceedings.

Implications for RBI’s Enforcement Strategy

The judgement is noteworthy for the RBI because it reinforces the fact of the casual – one might even call high handed – attitude with which banks make this designation. The RBI’s circulars that confer this power on banks requires banks to be ‘transparent’ in designating defaulters as willful. These circulars require banks to ensure that the ‘scope of such discretionary powers are kept to the barest minimum’. Despite these requirements, the Union Bank of India responded to the legal challenge in the court by arguing that RBI’s transparency requirements did not entail giving ‘any documents to the person who is proposed to be declared as a willful defaulter’, and that it was ‘for the person who is proposed to be declared as a willful defaulter to submit all the relevant documents to prove his innocence’.  The Court also noted that the bank’s order designating the defaulter as ‘willful’ did not record, much less deal with, the borrower’s submissions. The bank’s defence of their process has two implications for the RBI’s enforcement strategy towards banks.

First, a review of recent case law on this subject will show that this is not an isolated case. In 2023, the Supreme Court, while dealing with banks’ powers to designate borrowers as ‘fraudulent’ in exercise of similar powers conferred on them by the RBI, observed at least three instances where borrowers were not aware of them being designated as fraudulent by their banks. In these cases, the borrowers discovered this fact once criminal proceedings had begun against them. Thus, banks’ casual conduct in designating borrowers as ‘willful’ and ‘fraudulent’ ranges from not providing the borrower with supporting documents, not making reasoned orders, and at its worse, not communicating their decisions to the borrower. Notwithstanding our angst for defaulting borrowers, a casual approach towards wielding such powers should make the RBI circumspect about empowering banks through regulatory diktat.

Second, this, and a series of judgements on similar questions in the last few years, suggest that the RBI does not sufficiently enforce the transparency requirements that it has so explicitly built into its circulars conferring such powers on banks. Such instances ought to alert the RBI to ensure that the discretion that it has conferred on banks is wielded responsibly and in compliance with the RBI’s guidelines. If banks continue to undermine the transparency requirements stipulated by the RBI in letter and spirit, it is likely that richer and more resourceful defaulters will challenge banks’ decisions, thereby buying time in the process, but smaller borrowers will suffer the consequences of banks’ unwieldy discretion silently simply because they do not have the resources to approach a court to challenge a bank. In short, the RBI turning a blind eye to banks’ willfully ignoring the RBI’s requirement of transparency will likely favor the big defaulters and prejudice the smaller ones.

Defaulter Categorization as a Recovery or Prudential Tool

As mentioned above, the designation by a bank of a borrower as ‘willful’ or ‘fraudulent’ triggers several adverse consequences. They are debilitating for a borrower’s business and reputational capital virtually casting them as ‘financial untouchables’ (a term borrowed by me from a banker friend). If anything, these disqualifications further reduce the probability of any recovery by any creditor at all (not only the designating creditor). If this designation is not likely to yield better recovery, what might be the purpose of this power?

One could argue that the threat of such a designation will compel borrowers to pay their dues on time. That is, the tool will work as a deterrent to negotiate better recovery terms for banks. If that is the case, should this tool be classified as a recovery tool or a prudential tool of banks? If it is a recovery tool, a possible unintended consequence of allowing banks such power and discretion could be lax credit monitoring by banks. Bank officials who, knowing fully well that they can resort to the threat of designating defaulters as fraudulent or willful, might be incentivized to relax their ongoing monitoring efforts and even engage in forbearance.

If this power is instead classified as a prudential tool, one might argue that the enactment of such a power implies that the classic prudential regulation measures – credit evaluation, recognizing defaults on time, provisioning for them, and so on – are not sufficient for Indian banks. This, in turn, would suggest strengthening the prudential regulatory framework or the RBI’s supervisory capacity to ensure that banks are meeting prudential norms.

Given that these questions can be answered with data from banks’ behaviour, the RBI is well placed to undertake an evaluation of whether this tool is yielding the desired results, whether in terms of recovery of dues or otherwise.

Conclusion

A meta view of the jurisprudential trend will show a dialectic playing out in this area. The RBI, faced with increasing instances of egregious behaviour by borrowers, has expanded the willful and fraudulent ‘designation’ powers of banks over the years. Courts, on the other hand, are often faced with questions of due process, and have, in response, sought to constrain banks’ discretionary powers by fleshing out the details of the due process to be followed by them.

In some of these cases, borrowers have challenged the constitutionality of the RBI’s circulars empowering banks to inflict such consequences on private persons, as being violative of the freedom to trade and engage in business. While courts have almost always skirted the constitutional question by deferring to the RBI’s wisdom to decide ‘economic policy’, it is likely that this question will come up again before the courts. After all, banks, as private entities, have the prerogative to initiate criminal proceedings, withhold credit from such borrowers, downgrade their credit rating, file for insolvency under insolvency laws and impose other sorts of contractual penalties against egregious borrowers. Indeed, a well-functioning credit market will punish such borrowers anyway. How does one then explain the RBI empowering commercial banks to compulsorily ostracize a class of borrowers as an ‘economic policy’ issue, is a question worth asking scholars of constitutional law.