Supreme Court's Clarification on Natural Justice in Fraud Declarations

The Hon’ble Supreme Court (SC) in State Bank of India & Ors. v. Rajesh Agarwal & Ors. emphasized the importance of upholding principles of natural justice when declaring any individual or entity as fraudulent. The SC highlighted the necessity of serving notice, providing the opportunity to submit representation, and passing a reasoned order before classifying any individual or entity as fraud.

RBI's New Guidelines on Fraud Risk Management

Following the SC's guidelines, the Reserve Bank of India (RBI) issued Master Directions on July 15, 2024, titled "Master Directions, 2024" (bearing no. DOS.CO.FMG.SEC.No.5/23.04.001/2024-25) on Fraud Risk Management in Commercial Banks (including Regional Rural Banks) and All India Financial Institutions (AIFIs). These new directives supersede the 2016 guidelines and aim to enhance the framework for preventing, detecting, and reporting frauds within the banking sector. RBI also issued revised Master Directions on Fraud Risk Management for Cooperative Banks and Non-Banking Finance Companies.

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Key Aspects and Implications of Master Directions 2024

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1. Scope of Directives:

??? - Individuals (including third-party service providers and professionals such as architects, valuers, chartered accountants, advocates) and entities, along with their promoters, whole-time, and executive directors, can be investigated for alleged fraud.

??? - Non-whole-time directors (such as nominee directors and independent directors) are generally not responsible for the conduct of business. Banks must provide substantial proof before proceeding against such directors.

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2. Treatment of Accounts Under Resolution:

??? - Post-resolution, banks have the discretion to retain the fraud classification of an entity with a change in management/control.

??? - Penal measures do not apply to entities post-resolution plan implementation under the IBC, but criminal action continues against former promoters/directors responsible for the entity's management.

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3. Penal Measures:

??? - Persons/entities classified as fraud are barred from raising funds or availing any further credit facilities for five years.

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4. Governance Structure for Fraud Risk Management:

??? - Banks must adopt a Board-approved Fraud Risk Management Policy for prevention and detection, reviewed every three years.

??? - A detailed show-cause notice (SCN) must be provided, with at least 21 days for the recipient to respond.

??? - Banks must maintain a systematic process for issuing SCNs, evaluating responses, and issuing reasoned orders on fraud classification.

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5. Framework for Early Detection of Frauds:

??? - Emphasis on early fraud detection through a robust Early Warning Signals (EWS) and Red Flagging of Accounts (RFA) framework.

??? - Integration of EWS with Core Banking Solutions for effective transaction monitoring.

??? - Systematic approach to identifying, investigating, and mitigating suspicious activities early.

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6. Red-Flagged Accounts and Reporting of Fraud:

??? - External and internal audits can be conducted on red-flagged accounts.

??? - Banks decide on red-flagged accounts' status and report to RBI’s CRILC platform within seven days.

??? - Fraud classification decisions should be made within 180 days of red-flagging.

??? - Banks must report fraudulent third parties or professionals to the Indian Banks’ Association after following natural justice principles.

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7. Reporting of Incidents of Fraud:

??? - Uniform categories for reporting frauds, such as misappropriation of funds, fraudulent encashment, and electronic banking/digital payment frauds.

??? - Reporting disputes and fraudulent transactions to the Central Payments Fraud Information Registry (CPFIR).

??? - Compliance with prescribed timelines for reporting fraud cases to RBI.

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8. Reporting and Investigation:

??? - Detailed instructions on reporting frauds to RBI and other authorities.

??? - Establishment of governance structures ensuring effective oversight and implementation of EWS and RFA frameworks.

??? - Formation of dedicated Data Analytics and Market Intelligence (MI) Units for fraud detection and prevention.

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9. Closure of Fraud Cases:

??? - Banks to close reported fraud cases post-completion of necessary actions and legal proceedings, maintaining records for future audits.

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10. Special Committee:

??? - Formation of a Special Committee of the Board for Monitoring and Follow-up of Fraud Cases (SCBMF), comprising at least three members, including independent/non-executive directors.

??? - The SCBMF monitors, reviews, and proposes a risk management framework to reduce fraud cases.

??? - Senior management is accountable for implementing the fraud risk management policy and reporting incidents to the Board or Audit Committee.

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11. Staff Accountability:

??? - Examination of senior management's staff accountability in fraud cases per internal policies and Central Vigilance Commission guidelines.

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12. Additional Directives:

?? - Banks to frame policies for availing information from the Central Fraud Registry.

??? - Reporting payment system disputes to the Central Payments Fraud Information Registry.

??? - Periodic legal audits of title deeds and related documents for credit facilities of Rs. 5 Cr and above until closure.

??? - Due diligence for fraud before transferring loan accounts to other lenders.

??? - Notification of fraudulent transactions by appointed auditors to senior management.

??? - Reporting theft, burglary, dacoity, and robbery incidents to RBI's Fraud Monitoring Group within seven days and quarterly reporting.

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Conclusion

RBI's new master directions on fraud risk management represent a comprehensive effort to strengthen the banking sector against fraud. By emphasizing early detection, stringent reporting, and robust governance structures, these directives aim to safeguard the financial system's integrity and mitigate fraud risks effectively.