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Bad Debt Resolution Hits Judicial Roadblock

C P Chandrasekhar (cpchand@gmail.com) is with the Centre for Economic Studies and Planning, Jawaharlal Nehru University,  New Delhi.

With the Supreme Court having declared ultra vires the Reserve Bank of India circular directing banks to pursue bad debt resolution at any cost, the process of making banks alone pay for all-round errors has come to an end. The Court has required the government to specifically authorise each resolution exercise and not delegate blanket authority to theRBI. This would matter in cases such as in the power sector where a misplaced privatisation policy explains the non-performing assets, which the government would now have to take into account. The Court’s order also makes it difficult for theRBI to pretend that it had no role in the generation of theNPAs.

In a surprising and disruptive turn in the Supreme Court, the Reserve Bank of India’s (RBI) effort at penalising corporate defaulters and cleaning the books of India’s commercial banks has hit another roadblock. In early April, the Court struck down a circular issued by the RBI on 12 February 2018, which required banks to identify a loan account as a Special Mention Account (SMA) (Stage 1), even if the period of default on payments is one day. In addition, if the loan to a defaulting debtor is to the tune of ₹ 2,000 crore or more, the banks were required to agree on a resolution plan within 180 days as of 1 March 2018, if the default had already occurred or 180 days from the date of default, if that were later. A resolution plan required the agreement of all creditors. If a resolution plan cannot be agreed upon within that time frame, the company has to be taken to the bankruptcy court established under the terms of the Insolvency and Bankruptcy Code (IBC), 2016 within 15 days of completion of the specified period.

According to the RBI, the circular was based on the powers conferred on it by Sections 35A of the Banking Regulation Act as amended to include Sections 35AA and 35AB, besides an order from the finance ministry giving it blanket resolution powers. Despite the delays relative to prescribed timelines that this resolution process has experienced in practice, the process itself was seen as faster and more effective (in terms of the proportion of outstanding debt recovered) than the Debt Recovery Tribunals (DRTs), the Lok Adalats and the powers conferred by the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002, which were the means of recovery earlier. As a result, it was expected that the new resolution process would help resolve the bad debt problem with lower volumes of recapitalisation support from a cash-strapped government, and get credit moving once again. These expectations were only partially met, with the haircut required to be taken by the banks in some cases proving to be substantial.

But, that was not the reason why the process hit a roadblock. The Supreme Court verdict was related to cases brought by companies threatened with liquidation because of default resulting from problems that, in their view, were not of their own making. These companies felt that they were being treated unfairly when force-marched to liquidation. Moreover, the banks too wanted flexibility in dealing with the companies concerned because the haircut they would have to take if the companies were liquidated would be substantial.

Such problems were particularly acute in the power sector, where privatisation of production and distribution, with regulation and tariff setting by official, but ostensibly independent, regulators, was proving to be difficult to sustain. Cost-plus prices of power purchased by distributors are challenging the vulnerability of the latter. Power producers are finding it difficult to tie up power purchase agreements (PPAs) at reasonable prices, limiting their access to assured coal supplies because of the policy linking finalisation of PPAs to coal access. The Supreme Court struck down coal block allocations, worsening the coal supply situation. Competition and the desperation to sign PPAs are adversely affecting the viability of power production. In the event, private power projects financed with lending from the banks have either not got off the ground or not turned in profits that allow them to meet their interest and amortisation commitments. If these firms were driven to liquidation as the RBI insisted they should, private investors whom the government wants to incentivise as part of its “reform” agenda would lose confidence, banks would be forced to accept substantial haircuts, and consumers of power may face shortages.

The defaults resulting from problems faced by these and other similarly placed producers in other sectors cannot be equated to those of wilful defaulters or those engaging in fraud. Moreover, there seems to be a case for abjuring a “one-size-fits-all” approach and adopting a different yardstick when dealing with defaults in different sectors. That the banks were willing to do so was clear when they approached the RBI for additional time (beyond the prescribed maximum of 195 days between default and filing for liquidation) to restructure loans and resolve the bad debt problems in the power sector. The RBI refused
to oblige.

What the RBI had done was to declare non-performing assets (NPAs), resulting very often from exogenous shocks or even government policy as a problem of the banks. And it decided under Raghuram Rajan and then Urijit Patel to adopt a tough approach towards both recognising bad debt and resolving it. Interestingly, the RBI’s ability to adopt this approach was facilitated by the government which, initially by ordinance and subsequently through legislative amendment, inserted two new Sections (35AA and 35AB) after Section 35A of the Banking Regulation Act, 1949, which enabled it

to authorise the Reserve Bank of India (RBI) to direct banking companies to resolve specific stressed assets by initiating insolvency resolution process, where required.

The resolution was to be as per the guidelines included in the IBC, 2016. The RBI was also delegated the power to

issue other directions for resolution, and appoint or approve for appointment, authorities or committees to advise banking companies for stressed asset resolution.1

The very next day after the ordinance was promulgated the department of financial services of the Ministry of Finance issued an order (NoSO 1435[E]) that states:

In exercise of the powers conferred by Section 35AA of the Banking Regulation Act, 1949 (10 of 1949), the Central Government hereby authorises the Reserve Bank of India to issue such directions to any banking company or banking companies which may be considered necessary to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.2

What the Supreme Court has done is declare this blanket approach based on central bank direction ultra vires, as it takes too far the act of delegating powers of the government to the RBI. In view of the Supreme Court judges hearing the case (R F Nariman and Vineet Saran),

it is clear that the RBI can only direct banking institutions to move under the Insolvency Code if two conditions precedent are specified, namely, (i) that there is a Central Government authorisation to do so; and (ii) that it should be in respect of specific defaults.

In sum, the specifics of each case of default needs to be considered by the central government when authorising the RBI to direct banking institutions to start the resolution process and move for liquidation, if necessary, under the Insolvency Code.

One issue which arose is that while the Court’s judgment related to the interpretation of clauses in the Banking Regulation Act, the circular issued by the RBI applied to all creditors in any Joint Lenders’ Forum (JLF), which would include non-banking financial companies (NBFCs). But, on the grounds that it would be “difficult to segregate the non-banking financial institutions from banks so as to make the circular applicable to them even if it is ultra vires insofar as banks are concerned,” the judges decided that “the impugned circular will have to be declared as ultra vires as a whole, and be declared to be of no effect in law.”

The net effect is that any instance where debtors have been proceeded against as per the Insolvency Code only because of the application of the 12 February circular will be declared non est.

As a result, not only those whose pleas were included in the case just decided, but a host of others against whom the insolvency proceedings were pending or to be invoked, will now not be subject to the inexorable, clockwork resolution process prescribed by the RBI that is triggered once default is registered even for a day. The RBI would have to approach the government in each case, and the government, after due deliberation, would have to authorise initiation of the resolution proceedings. In the process, the government would have to consider the pleas of the debtors and the views of the lenders. The former would argue that their circumstances are special and not the result of mismanagement. The latter would like to hold out for a better deal if they fear that liquidation would entail a huge and unacceptable haircut. And the government too would consider whether it would be burdening the public sector banks (PSBs) with losses that would necessitate recapitalisation with funds from the exchequer which it cannot release. A quick and sharp reduction in NPAs is no more on the agenda.

This would inter alia (i) force the government to consider which factors give rise to NPAs, such as its own policies that affect both borrowing and lending behaviour and the macroeconomic environment with implications for corporate performance; (ii) require the RBI to exercise greater diligence when monitoring and disciplining banks; and (iii) pressure bank management to be cautious when increasing exposure to large capital-intensive projects. Such changes are desirable, because measures like these are more likely to rein in NPAs in the medium term, rather than an unthinking and hastily implemented resolution process. The downside is, of course, that wilful defaulters and fraudsters cannot only get themselves a breather, but may be able to manipulate outcomes under the new regime in their favour.

Notes

1Press note of the Ministry of Finance of 5 May 2017 issued by the Press Information Bureau (Release ID:161588).

2Quoted in Supreme Court judgment 42591_2018_Judgement_02-April-2018.pdf www.sci.gov.in.

Updated On : 12th Apr, 2019

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