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Supreme Court ruling could improve accountability in loan fraud cases

By saying that borrowers must get a chance to defend themselves before having their accounts frozen on fraud charges, the court has offered the government a chance to strengthen corporate governance and include more safeguards in state-owned banks

Punjab National Bank was allegedly defrauded to the tune of  ₹14,356 crore by Nirav Modi and his uncle Mehul Choksi (Photo: Mint)Premium
Punjab National Bank was allegedly defrauded to the tune of 14,356 crore by Nirav Modi and his uncle Mehul Choksi (Photo: Mint)

The Punjab National Bank fraud case featuring Nirav Modi and his uncle Mehul Choksi – both of whom fled India – was first reported more than six years ago. It triggered a chain of events, including the labelling of hundreds of loan accounts as fraudulent.

Now a counter-balance could well be in the offing. This week the Supreme Court ruled that the principles of natural justice must be applied to borrowers, who should be given a hearing before banks classify loan accounts as fraudulent.

The Supreme Court has made it clear that banks have to mandatorily provide their borrowers an opportunity of a personal hearing after a notice and to hear them out. The court also said the decision to classify a loan as fraudulent should be made by a reasoned order, given the potentially serious civil consequences. This is warranted, the court explained, because it leads to “civil death" of such borrowers and impairs their ability to raise money.

Bankers are bound to be upset, as are the Reserve Bank of India, the government – which owns several banks – and investigative agencies.

There are two aspects to this. A raft of laws enacted over the past two decades, including the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (Sarfesi) Act, 2002, haven’t quite helped Indian banks recover their money thanks to a weak enforcement system.

But, under pressure after the outrage over a slew of bank frauds and the involvement of top businessmen in 2016, lenders took recourse to the RBI’s Master Circular of July 1 that year to label several accounts as fraudulent. By FY20, the numbers had risen significantly, with the money locked in such accounts across several banks topping six figures.

In such an environment, amid widespread calls for the resignation of the then finance minister, trigger-happy central probe agencies jumped in, prompting many banks to take the safer route by simply classifying as fraudulent as many defaulter accounts as they could. The supervisors of the RBI may have added to this by red-flagging loan after loan as potentially fraudulent as they tried to control the damage after coming under fire.

Back then many borrowers had protested, saying banks were unilaterally classifying accounts as fraudulent without evidence. This led to many court cases.

There is a thin line between establishing intent to defraud – as the Indian Penal Code defines it – and inability to repay. This means bankers and forensic audit firms will have to put in the hard yards to ensure they have a strong case.

These arguments may not cut ice with the central bank and bankers in general. After he left the RBI, Urjit Patel, who was the governor during all of this, wrote in his book, ‘Overdraft: Saving the Indian Saver’, that cases of substantive economic significance had remained open or not achieved closure for years. Because of that, the overall enforcement mechanism did not provide enough of a deterrent relative to the potential gains from such frauds.

Bankers are sure to endorse this view afresh, considering the average time resolution under the insolvency law now takes close to 700 days and requires a huge haircut.

Against this backdrop, the Supreme Court ruling offers the government a fresh opportunity to further strengthen the corporate governance processes in state-owned banks and put in more safeguards. For the government, there is now the comfort of knowing the balance sheets of most of the banks it owns are cleaner than they were, and that they have adequate capital buffers.

It is not that private banks have not been hit by such fraud, but the market’s punishment is far more severe as it affects their ability to raise capital. This corrective force does not apply to government banks as they are funded by taxpayers and thus less accountable than private banks.

Given the country’s huge development spending needs, there are moral issues involved in setting aside large amounts of taxpayer money for such banks. That makes it even more important for banks, regulators, the government, its agencies and the judiciary to ensure that the gains from the clean-up of bank balance sheets are not frittered away.

Cases of alleged bank fraud drag on for years and rarely is a lender or borrower held accountable. The SC ruling may lead to fewer cases of fraud being registered but could also lead to more accountability and punishment in such cases. Given the situation, even a small improvement on this front would be a huge step.

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Updated: 31 Mar 2023, 02:20 PM IST
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