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of 1. Whether the declaration of a person as a 'wilful defaulter' under Clause 2.1.3 of the RBI Master Circular on Wilful Defaulters, 2015, was legally sustainable based on the alleged diversion or siphoning of funds by the borrower or associated persons.
2. Whether the funds invested by the borrower company in its subsidiaries and related entities constituted 'borrowed funds' and, if not, whether such investments could amount to diversion or siphoning of funds under the Master Circular.
3. Whether the Identification Committee and Review Committee of the bank complied with the procedural and substantive requirements of the Master Circular, including objective examination and application of mind before declaring a wilful default.
4. The evidentiary value and role of the Forensic Audit Report (FAR) prepared by independent auditors in the process of declaring a wilful defaulter.
5. Whether the classification of the borrower company under the Corporate Debt Restructuring (CDR) scheme (Class-B vs. Class-C) was relevant and indicative of the existence or absence of diversion or siphoning of funds.
6. The extent of scrutiny and standards to be applied by the bank's Identification and Review Committees in declaring wilful default, including the requirement of intentional, deliberate, and calculated default.
7. Whether the respondent's exit from the borrower company's management prior to the alleged diversion or siphoning of funds affects liability for wilful default.
8. The impact of prior knowledge and acceptance by lender banks of the investments and transactions alleged to constitute wilful default.
9. The legal consequences of a wilful defaulter declaration and the necessity for strict compliance with the Master Circular to avoid miscarriage of justice.
2. ISSUE-WISE DETAILED ANALYSISIssue 1 & 2: Applicability of the Master Circular and Definition of Diversion/Siphoning of Funds
- The Master Circular defines wilful default as occurring only when 'borrowed funds' are diverted or siphoned off for purposes other than those for which the loan was sanctioned (Clauses 2.1.3(b) and (c)).
- Diversion of funds includes transferring borrowed funds to subsidiaries or group companies without lender approval; siphoning involves use of borrowed funds for unrelated purposes detrimental to borrower or lender (Clauses 2.2.1 and 2.2.2).
- The Court emphasized that the fundamental prerequisite for wilful default is that the funds involved must be borrowed funds; investments made from internal accruals or other non-borrowed funds do not fall within the scope of diversion or siphoning under the Master Circular.
- The Final Restructuring Scheme (FRS), a document prepared by the lender banks themselves, acknowledged that investments made by the borrower company in its subsidiaries were funded from substantial cash surpluses generated in earlier years and from Foreign Currency Convertible Bonds (FCCBs), not from borrowed funds.
- The Forensic Audit Report (FAR), relied upon by the bank for declaring wilful default, explicitly acknowledged that it did not verify the source of funds for investments in subsidiaries.
- Consequently, the issuance of show cause notices and declaration of wilful default based solely on alleged diversion of funds was found to be legally unsustainable as the investments were not from borrowed funds.
Issue 3 & 6: Compliance with Procedural and Substantive Requirements of the Master Circular
- Clause 3 of the Master Circular mandates a multi-tiered process: examination by Identification Committee, issuance of show cause notice, consideration of borrower's response, and final decision by Review Committee.
- The Identification Committee and Review Committee are required to apply their minds objectively, examining all relevant facts and circumstances, including the borrower's track record, before declaring wilful default.
- The Court found that the Identification Committee's decision was based solely on the FAR without independent application of mind or detailed reasoning.
- The Minutes of Meeting of the bank revealed no substantive examination or reasons justifying the conclusion of wilful default prior to issuance of the show cause notice.
- The Review Committee merely affirmed the Identification Committee's findings without addressing critical factual and legal points raised by the respondent.
- The Court held that such mechanical and superficial exercise fell short of the procedural safeguards and substantive standards mandated by the Master Circular.
- The stringent requirement that wilful default must be 'intentional, deliberate and calculated' was not satisfied, as the investments were initially considered strategic and viable by lenders and no evidence of mens rea was established.
Issue 4: Evidentiary Value and Role of the Forensic Audit Report (FAR)
- The FAR is an expert opinion and not conclusive proof of wilful default; it must be corroborated by objective facts and subjected to independent scrutiny by the bank's committees.
- The FAR in this case was found to be incomplete and lacking credibility, particularly as it did not verify the source of funds invested in subsidiaries and contained disclaimers about limitations of its review period and data availability.
- The Court emphasized that issuing show cause notices and declaring wilful default solely on the basis of such a report without further inquiry or verification was improper and legally untenable.
- The Court cited precedent holding that forensic audit reports are not conclusive proof and must be treated as evidence subject to examination and challenge.
Issue 5 & 8: Relevance of CDR Classification and Prior Knowledge of Lenders
- The borrower companies were classified as Class-B under the CDR scheme, which pertains to corporates affected by external factors and not involved in diversion or siphoning of funds. Class-C classification applies to entities found to have diverted funds.
- The lenders, including the bank, were aware of and had accepted the investments in subsidiaries as strategic and viable at the time of CDR approval and in subsequent internal documents (FRS, Flash Reports).
- No objections or concerns were raised by the lenders at the time regarding these investments, nor were any management changes or forensic audits ordered during the CDR process.
- The Court found that the bank's later characterization of these investments as diversion or siphoning was inconsistent with its earlier acceptance and classification of the borrower as Class-B, undermining the wilful defaulter declaration.
Issue 7: Liability of the Respondent after Exit from Management
- The respondent had resigned as Executive Director and ceased to be associated with the day-to-day functioning of the borrower company prior to the period during which alleged diversion or siphoning of funds occurred.
- The Court noted that wilful default requires involvement or control over the acts constituting diversion or siphoning, which was not established in the respondent's case post-resignation.
Issue 9: Consequences of Wilful Defaulter Declaration and Need for Strict Compliance
- Declaration as a wilful defaulter results in severe consequences including bar on future loans, reputational damage, and potential criminal proceedings, effectively amounting to a 'financial death knell.'
- The Court underscored the necessity for strict and scrupulous adherence to the Master Circular's procedural and substantive requirements to prevent miscarriage of justice.
- The Supreme Court's precedent was noted emphasizing reasonable construction of the Master Circular and caution in declaring wilful default.
- The Court held that failure to comply with these standards vitiates the wilful defaulter declaration and warrants quashing of such orders.
Additional Observations
- The Court observed that the TRA (Trust and Retention Account) mechanism mandated that all financial transactions of the borrower be routed through monitored accounts under lender supervision, negating the possibility of diversion of borrowed funds during the review period.
- The Court found that the bank's reliance on isolated transactions without considering the overall track record and financial health of the borrower was contrary to the Master Circular's mandate.
- The Court noted that multiple forensic audits conducted over years did not find evidence of wilful default or diversion, reinforcing the conclusion that the wilful defaulter declaration was unfounded.
- The discharge of the respondent and others in associated criminal proceedings further supported the conclusion that wilful default was not established.
Conclusions
- The declaration of the respondent as a wilful defaulter was quashed and set aside for non-compliance with the Master Circular's requirements, absence of diversion or siphoning of borrowed funds, lack of objective and reasoned decision-making by the bank's committees, and reliance on an incomplete and inconclusive forensic audit report.
- The bank's actions were found to be legally unsustainable, arbitrary, and unreasonable.
- The procedural safeguards and substantive standards prescribed by the Master Circular must be strictly observed before declaring wilful default given the grave consequences involved.
- The CDR classification and lender banks' prior acceptance of investments negated the possibility of wilful default based on those investments.
- The appeal(s) challenging the quashing of wilful defaulter declaration were dismissed, affirming the detailed and well-reasoned judgments of the Single Judge.
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