ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846
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The Judiciary and the Stressed Assets Resolution

M K Datar (mkdatar@gmail.com) is an economist by training, has worked in a bank and with the Indian Banks Association.

 

When defaulting borrowers are unable to pay their overdue amounts, the matter invariably lands up with the courts for settlement through a court-regulated process of lenders taking possession of assets and their sale. However, recently some borrowers have challenged the resolution scheme designed by the Reserve Bank of India. The outcome of the judiciary-led resolution processes in the past and the recent judicial intervention are examined.

It is a generally accepted view that the time-consuming processes and inevitable inordinate delays in disposal of cases have impaired lenders’ ability to collect their dues by taking over and sale of such assets owned by defaulting borrowers through court-administered mechanisms. Over the years, new laws were enacted and mechanisms introduced to remove this lacuna. Debt Resolution Tribunals (DRTs) were set up in 1993 for speedier disposal of disputes with a view to accelerate asset sale through courts for the collection of lenders’ dues. In 2002, the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act was passed to enable banks to take possession of assets owned by a defaulting borrower. This was hailed then as a revolutionary step necessary to restore balance between debtor–lender relationships. Simultaneously, the Reserve Bank of India (RBI) in 2001 introduced Corporate Debt Resolution (CDR) mechanism for voluntary restructuring of the dues by viable corporate entities outside the legal system through negotiation between the troubled borrower and all lenders.

Introduction of Bankruptcy Code

Despite all these efforts, the number of pending cases kept on increasing which pointed towards the ineffectiveness of the legal processes. With the fresh wave of non-performing assets (NPAs), mainly by large corporate loans after 2015, the Insolvency and Bankruptcy Code (IBC) was adopted in 2016. This provided for the design of court-directed resolution efforts collectively by all financial and operational lenders. If such a resolution plan failed then the company would undergo liquidation and assets would be disposed of through an auction. When this measure was introduced, it was hoped that while lenders would need to take heavy discount on existing large NPAs, going forward the IBC would be an effective tool to discipline borrowers, as resolution through the National Company Law Tribunal (NCLT) established under the IBC would necessarily result in a change of management even if liquidation is avoided.

While the spike in corporate NPAs witnessed since 2015 has multiple causes, the narrative of rich borrowers leaving the country defrauding depositor’s money gained currency in the wake of the ostentatious exit of Vijay Mallya, promoter of Kingfisher Airlines.He could leave the country even after being named a wilful defaulter. The exit of jeweller Nirav Modi was surreptitious, but equally effective in underlining the limitations of the crime prevention abilities of the executive branch as well. Political leadership preferred to use these instances to put the blame on the earlier coalition government. In such a vicious atmosphere, it was far from clear whether lending banks—where public sector undertaking (PSU) banks had significant exposure—would be able to effectively use the new “weapon,” namely the IBC.

RBI Directives to Banks

The Government of India (GoI), the owner of public sector banks, was perhaps uncomfortable in directly associating with the resolution of large corporate loans. So, instead, it chose to amend the RBI Act by introducing new sections, namely 35AA and 35AB which empowered the GoI to authorise the RBI to give specific directions to bank(s) to refer case/cases to the NCLT under the IBC.

Following its empowerment by the Department of Financial Services through its notification in May 2017, the RBI has identified several large stressed or NPA companies that banks were required to refer to the NCLT under the IBC in a time-bound manner. In June 2017, it identified 12 large accounts, which collectively owed nearly ₹ 2 lakh crore to banks
and non-banking financial companies (NBFCs) accounted for about 25% of total NPAs. Subsequently, additional 29 accounts were identified in October 2017 which aggregated to ₹ 1.36 lakh crore for reference to the NCLT in a time-bound manner. Reference to the NCLT should ideally be a lender’s decision and also responsibility. While the initial push from the RBI may have been justified to imitate a new mechanism, should a nudge from the RBI be a precondition for a reference to the NCLT is indeed a problematic issue.

In the wake of a worsening stressed assets scenario, the RBI itself has, over time, provided additional tools for “resolution.” These measures like CDR, Strategic Debt Restructuring, S4A, etc, were preferred alternatives for banks as such schemes entailed forbearances in terms of income recognition and/or provisioning requirements. There exists a view that banks were guided mainly by the immediate requirements of their own balance sheet management, rather than longer-term viability of resolution proposals.1

New Framework for Resolution

Against this background, on 12 February 2018 the RBI unveiled a new framework for resolution (NFR) of stressed assets and simultaneously scrapped all resolution schemes introduced earlier. The identification of stress was linked to an objective criteria, that is, payment default. Failure to pay scheduled interest or principal payment is treated as a default. Banks were required to make resolution efforts within 180 days after default.

The 12 February 2018 circular was important because it did take away regulatory forbearances bestowed by restructuring schemes approved by the RBI. While banks would get 180 days’ time to chalk out a resolution plan for a defaulting company, it would be classified as an NPA after a 90-day period and invoke resultant change in asset classification and provisioning, etc. Both lenders and borrowers sought relaxations in the proposed NFR. Banks sought relaxation in definition of default, similar treatment of term loans and, cash credit facilities, etc. Borrowers too were apprehensive and made representation to the RBI as also the goi. Borrowers from the power sector felt they would bear the brunt of the proposed new regime. Even the Ministry of Power demanded a special treatment for the power sector as many PSU entities under its control that are routinely late in meeting their payment obligations ran the risk of being named as defaulters. However, the RBI refused to grant any relaxations and such stiff stance was seen as among the sour points, which led to intense stressed relations between the RBI and the GOI.

It needs to be noted that the disciplining effect of the IBC depends on its inevitability and certainty. Even if the promoter is not responsible for project failure, there should be a mechanism to share the cost thereof among the different stakeholders, namely borrowing promoters, shareholders, lenders, workers, etc. At present the cost of failure is ultimately borne by employees and lenders. As the GOI owns major banks it is the society at large that shares the burden of bank recapitalisation without the promoter paying any price for their failed project. The IBC offers an alternative mechanism, wherein rescue efforts to revive finances of the troubled company/project involve seeking a resolution plan from other promoters/managers. If these efforts are not successful, the company would be liquidated and the sale proceeds would be shared among different stakeholders. In this process, promoters lose their control, lenders accept a haircut, and workers face disruption in employment. Though this is not an ideal arrangement, it ensures that the societal burden from failed business is shared by all stakeholders.

NRF Challenged in Courts

The Association of Independent Power Producers and several others challenged the NRF in various high courts. The Allahabad High Court stayed the circular and suggested concerted efforts may be made by the government to resolve the real issues affecting the power sector. While these efforts were going on, all these petitions were consolidated and taken by the Supreme Court.

Following the Supreme Court judgment on 2 April 2019 declaring the RBI circular ultra vires, apprehensions are expressed about the impact such a judgment may have on the pace of stressed assets resolution as also the efficacy of the IBC regime itself. Perhaps, as the RBI has stated that it would take a relook and may reissue the circular soon, such apprehensions have apparently subsided somewhat. However, this episode raises important issues about the role of the judicial system in the context of the stressed assets resolution.

The Supreme Court has rejected arguments made by the petitioner questioning the “one-size-fits-all” approach and the necessity to consider sector-specific issues, in particular the power sector, in designing any framework of resolution. Similarly, the plea questioning the constitutional validity of the RBI circular also failed to get the Court’s approval. It also granted that Section 35A which was inserted in 1956, may as well confer the power to issue directions in respect of the IBC, 2016 also. The Court also held that advising banks to take action under IBC was within the powers of the RBI. The Court conceded that Section 21, Sections 35, 35A, 35AB, etc, confer very wide powers to the RBI to give directions when it comes to the matters specified therein. Section 35AA enables the government to authorise the RBI to initiate proceeding under the IBC. Therefore, the Supreme Court felt that prior to the enactment of Section 35AA, the RBI could have issued directions regarding the reference to IBC under Sections 21 and 35A, but after Section 35AA has come into force, such guidance may be issued only under Section 35AA. Under Section 35 AA, only individual references are permissible and that too only after authorisation of/consultation with the GoI. The RBI’s argument that concurrent powers have been given to the RBI and GoI was not accepted by the Court because it held that when such powers are given there is a specific reference to that effect, a condition which is not fulfilled in the case of Section 35AA. The Court found that without prejudice proviso is mentioned with reference to Section 35A but not with respect to Section 35AA! Moreover, reference to the IBC can happen only when the power to be exercised under the authorisation of the central government requires “due deliberation and care” to refer to specific defaults. The net result is that while the Supreme Court has rejected weighty arguments against NRF, the circular is anyway quashed under procedural considerations.

There are other incidences where judicial interpretation of laws has hampered the lenders’ effort to recover their dues. For example, in September 2014, United Bank of India’s effort to declare Mallya as a wilful defaulter, were thwarted by a Calcutta High Court judgment which found that the grievance redressal committee had four members as against a three-member committee stipulated in RBI guidelines. It is besides the point that Mallya was declared a wilful defaulter by the State Bank of India subsequently in November 2015.2 Another instance relates to a National Company Law Apellate Tribunal order issued in February 2019 preventing banks from declaring loans to Infrastructure Leasing and Financial Services as NPAs without its permission! The NCLT has indeed recently given such permission but the moot point is what the role of judiciary is in a matter that concerns financial prudence.

In the present instance, the main issue is whether the RBI can issue general advice/guidance to corporate lenders about referring a defaulting company to the IBC. The Supreme Court has ruled the RBI can do so only in specific defaults and only after approval/consultation with the GOI. There have been media reports which have speculated about “concessions” the RBI may incorporate while reissuing its circular. Whether such relaxations would “satisfy” petitioners whose main plea was “sector specific issues”? But the Supreme Court was not convinced about the sector-specific issue-related arguments.

Implications of the Supreme Court Judgment

It needs to be noted that the GOI too is a related party. The circular issued by the RBI on 12 February 2018 would force all PSU entities to improve their financial management systems lest these be classified as defaulters. Late payments by government entities often affect the liquidity of many projects/engineering, procurement and construction contractors. Whether the GOI would prefer “special” treatment for PSU payments is not clear. But whether it would like to be publicly involved in each defaulting case being referred to the IBC is also interesting. It could be argued why any external instruction is required for lenders to take what essentially is a business decision. However, bankers as a group have not been able to look at the common interest of all lenders. While scrapping all its resolution schemes vide 12 February, the RBI circular has also scrapped Joint Lenders Forum (JLF) which was mandatorily constituted in the case of defaulting companies. JLF which was subject to certain decision rules was required to take all decisions about restructuring proposals. A case can be made out to revive JLF-type mechanism subject to decision rules which would decide whether or not a defaulting company needs to be referred to the IBC. If the GOI dislikes to involve itself in this business of reference to the IBC section, 35AB would need amendment.

Revised RBI Circular

The RBI issued a revised circular on 9 June 2019 in the light of the Supreme Court decision. It provides a review period of 30 days for lenders to consider various options for resolution either under the IBC framework or outside the IBC framework. All lenders would need to enter into an Inter Creditor Agreement (ICA) during this review period; the lenders could finalise a solution plan with acceptance by 75% of borrowers (in terms of outstanding borrowings) and 60% in terms of numbers. After 180 days since the end of the review period, if review period is not implemented, banks would need to make additional provisions of 20%, and after completion of 365 days further provision of 15% would be required. Thus, while the RBI is not mandating a reference to the IBC, requirements of additional provisions will be as if a reference is made to the IBC. The revised circular would necessitate additional provisions if a review period outside the IBC is chosen by lenders. It also leaves the field open to issue case-specific reference to the IBC in consultation with the GOI.

By introducing the review period, the RBI has imparted some flexibility in default definition instead of its earlier one-day default stand. This will help public sector borrowers to avoid the NPA tag for short payment delays. Whether this new arrangement will ensure the use of the IBC route in appropriate cases will be known only over time.

It is well recognised that judicial delays have affected court directed resolution efforts. However, there are occasions where legislations have been subjected to judicial review which necessitates in laws or regulation procedures. Both these have impacted implementation/application of laws in the Indian context. As a result, existing defaulting promoters cannot participate in the liquidation (auction) process. Home loan buyers are also treated as financial creditors. Recently the accepted hierarchy of claims among secured and unsecured creditors has been questioned by NCLAT. This matter is also likely to reach the Supreme Court for final decision. Judicial processes thus seem to affect the nature of laws as also the speed of recovery efforts.

Notes

1 Instead of deep surgery, the banks could apply band aids, they could “extend and pretend,” lending the promoter the money he needs to make loan payments. Raghuram Rajan (2016) Financial Sector Reforms in India: The Past and the Future, NCAER, New Delhi, p 10.

2 India Today, 28 March 2016.

Updated On : 22nd Nov, 2019

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