NPA Classification ― Whether Opportunity of Prior Hearing Required?

The Supreme Court vide its judgment dated 27-3-2023 in SBI v. Rajesh Agarwal¹, has, while dealing with the requirement of the opportunity of hearing to be given to the borrowers before classification of their account as fraud, held that the principles of natural justice, particularly the rule of audi alteram partem, must be necessarily read into the Master Directions on Frauds to save it from the vice of arbitrariness. It has been observed by the Court that administrative proceedings which entail significant civil consequences must be read consistent with the principles of natural justice to meet the requirement of Article 14.² On similar footings a few years back, the Supreme Court mandated the requirement of the opportunity of hearing to the borrowers before classifying them as wilful defaulters.³ In view of these two judgments, the question that arises for consideration in this article is whether an opportunity of hearing needs to be given to the borrowers before the classification of their loan accounts as non-performing asset (NPA).

Regulatory framework

Master Circular – Prudential Norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances dated 1-4-2022⁴ issued by Reserve Bank of India (RBI) provides for the definition of NPA and lays the criteria for the classification of an account as NPA. Clause 2.1.1 of the Master Circular states that an asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. Clause 2.1.2 states that an NPA is a loan or an advance where:

(i) interest and/or instalment of principal remains overdue for a period of more than 90 days in respect of a term loan;

(ii) the account remains “out of order” as indicated at Para 2.2 below, in respect of an overdraft/cash credit (OD/CC);

(iii) the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted;

iv) the instalment of principal or interest thereon remains overdue for two crop seasons for short duration crops;

(v) the instalment of principal or interest thereon remains overdue for one crop season for long duration crops;

(vi) the amount of liquidity facility remains outstanding for more than 90 days, in respect of a securitisation transaction undertaken in terms of the Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021⁵; and

(vii) in respect of derivative transactions, the overdue receivables representing positive mark-to-market value of a derivative contract, if these remain unpaid for a period of 90 days from the specified due date for payment.

As per Clause 2.1.3, an account may also be classified as NPA in terms of certain specific provisions of this Master Circular, including inter alia Paras 4.2.4 (Accounts with temporary deficiencies), 4.2.9 (Accounts where there is erosion in the value of security/frauds committed by borrowers) and Part B2 (Prudential norms applicable to restructuring).

Clause 4 of the Master Circular deals with Asset Classification. Sub-clause 4.1 provides for the categories of NPAs and states that banks are required to classify non-performing assets further into the following three categories based on the period for which the asset has remained non-performing and the realisability of the dues: (i) substandard assets; (ii) doubtful assets; and (iii) loss assets. Sub-clause 4.2 lays down detailed guidelines for the classification of assets.

As per these guidelines, the classification of assets into aforesaid categories should be done considering the degree of well-defined credit weaknesses. In terms of these guidelines, banks should establish appropriate internal systems (including technology-enabled processes) for proper and timely identification of NPAs. These guidelines state that the availability of security or net worth of the borrower/guarantor should not be considered for the purpose of treating an advance as NPA or otherwise, except in accounts where there is erosion in the value of a security or in cases where frauds are committed by the borrowers. These guidelines also state that the classification of an asset as NPA should be based on the record of recovery. Bank should not classify an advance account as NPA merely due to the existence of some deficiencies which are temporary in nature. These guidelines also provide for the upgradation of loan accounts classified as NPAs on payment of entire arrears of interest and principal. In terms of these guidelines, asset classification must be done borrower-wise and not facility-wise. Various other situations such as asset classification of accounts under consortium, agricultural advances, advances against term deposits, etc. are also dealt with by these guidelines.

Judicial precedents

Whether an opportunity for a hearing or prior intimation needs to be given to the borrower before the classification of an account as NPA has been a bone of contention before various High Courts across the country and conflicting judgments have been passed by various High Courts.

In Stan Commodities (P) Ltd. v. Punjab & Sind Bank⁶, the Jharkhand High Court has held that the borrower was entitled to be informed and to get an opportunity to explain or represent against the intended classification of his account as NPA. Similarly, the High Court of Punjab & Haryana in Amar Alloys (P) Ltd. v. State Bank of India⁷ has held that notice was required to be issued to the borrower by the bank before classifying its account as NPA.

Contrary to these judgments, the Jharkhand High Court in Paritran Trust v. Punjab National Bank⁸, after considering its the earlier judgment in Stan Commodities⁹, has held that no opportunity of hearing is required to be afforded to the borrower before classification of account as NPA. Recently the Madhya Pradesh High Court (Jabalpur Bench) in Neelam Beverages v. State of M.P.¹⁰ has, after considering the judgment in Paritran Trust¹¹ as well as Amar Alloys¹², held that no prior notice is required to be issued before classifying the account of a person as NPA.

Analysis

In Rajesh Agarwal¹³, the Supreme Court, after considering various factors such as the necessity of opportunity of hearing in administrative proceedings which entail serious civil and penal consequences, implied/express exclusion of principles of natural justice, etc. ruled that an opportunity of hearing is required to be given to the borrowers before classifying their account as fraud. In order to answer the issue involved in the present article, it would be relevant to analyse the present issue in light of the factors culled out by the Supreme Court in Rajesh Agarwal¹⁴

Does the Master Circular dated 1-4-2022 provide similar civil and penal consequences as provided under Master Circular on Wilful Defaulters dated 1-7-2015¹⁵ and Master Directions on Frauds dated 1-7-2016?¹⁶

Master Circular on Wilful Defaulters dated 1-7-2015 and Master Directions on Frauds dated 1-7-2016 (as updated) provide for various civil and penal consequences to the borrower whose account has been classified as a wilful defaulter or fraud. In terms of Clause 2.5 of the Master Circular on Wilful Defaulters, a borrower whose account has been classified as a wilful defaulter entails the following consequences:

(a) no additional facilities to be granted by any bank/financial institution;

(b) entrepreneurs/promoters would be barred from institutional finance for a period of 5 years;

(c) any legal proceedings can be initiated, including criminal complaints;

(d) banks and financial institutions to adopt a proactive approach in changing the management of the wilful defaulter; and

(e) promoter/director of wilful defaulter shall not be inducted by another borrowing company.

Further, as per Clause 4, the lenders are entitled to initiate appropriate criminal proceedings against the wilful defaulters. As per Section 29-A¹⁷ of the Insolvency and Bankruptcy Code, 2016, a wilful defaulter cannot be a resolution applicant.

Clause 8.12 of the Master Directions on Frauds deals with the penal measures for borrowers whose account has been classified as a fraud. Clause 8.12.1 provides that penal provisions as applicable to wilful defaulters would apply to fraudulent borrowers, including the promoters and directors of the borrower company. In addition to the above consequences, no restructuring may be made in the case of fraud accounts (Clause 8.12.2) and no compromise on settlement involving a fraudulent borrower is allowed unless the conditions stipulate that the criminal complaint will be continued (Clause 8.12.3).

A perusal of the Master Circular dated 1-4-2022 shows that it does not provide any civil or penal consequences (except reporting of credit information to Central Repository of Information on Large Credits (CRILC) on all borrowers having aggregate exposure of Rs 5 crores and above). Thus, in the absence of such serious civil and penal consequences, no opportunity for a hearing is required to be given to the borrowers before classifying their accounts as NPA.

Whether civil consequences provided under the provisions of the SARFAESI Act, 2002¹⁸ have the same effect as that of Master Circular on Wilful Defaulters dated 1-7-2015 and Master Directions on Frauds dated 1-7-2016?

In terms of Section 13(2) of the SARFAESI Act, 2002¹⁹, a borrower, who is under a liability to a secured creditor under a security agreement, makes a default in repayment of secured debt or any instalment thereof, and his account in respect of such debt is classified as NPA, the secured creditor is entitled to issue a demand notice requiring the borrower to discharge in full his liabilities within a period of sixty days from the date of the receipt of the notice failing which the secured creditor becomes entitled to take recourse to measures provided under Section 13(4) of the SARFAESI Act, 2002 which include taking possession of the mortgaged property and sale thereof; taking over the management of the borrower, etc. Clearly, the provisions of the SARFAESI Act, 2002 do not provide any of the consequences as provided under the Master Circular on Wilful Defaulters dated 1-7-2015 and Master Directions on Frauds dated 1-7-2016.

In my view, the civil consequences provided under Sections 13(2) and (4) of the SARFAESI Act, 2002 are not as drastic as those provided in cases of wilful defaulters and/or fraud. At the same time, the consequences provided under SARFAESI Act, 2002 are well regulated at every step and sufficient checks have been put on the actions of the secured creditor. Even though no prior opportunity of hearing before classification of the account as NPA is provided under the provisions of SARFAESI Act, 2002 or Rules framed thereunder, the borrower has been given sufficient say and safeguard to raise objections qua NPA classification under Section 13(3-A) of the SARFAESI Act, 2002 and in such circumstances, the secured creditor becomes statutory bound to consider those objections and furnish a reasoned reply in case of rejection of such objections. In addition to Section 13(3-A), the borrowers can raise objections qua NPA classification under Section 17²⁰ of the SARFAESI Act, 2002.

Conclusion

In light of the analysis above, it is concluded that no opportunity for a prior hearing is required to be given to the borrowers before classifying their accounts as NPA since neither the Master Circular dated 1-4-2022 nor the provisions of the SARFAESI Act, 2002 and Rules framed thereunder provide for such prior notice or opportunity of hearing to the borrowers. It is also relevant to note that in cases of NPA classification and invocation of proceedings under the provisions of the SARFAESI Act, 2002 against the borrower, no such civil and penal consequences as provided under the Master Circular on Wilful Defaulters and the Master Directions on Frauds are attracted to the such borrower and therefore, for this reason also, the principles of natural justice cannot be read into cases of NPA classification.