India: Treatment Of Wilful Defaulters: Analysis Of The Proposed Changes By RBI

The Reserve Bank of India (RBI) recently issued Draft Master Directions on the Treatment of Wilful Defaulters and Large Defaulters dated September 21, 2023 (Draft Directions) for comments.¹ The Draft Directions seek to capture the jurisprudence over the Master Circular on Wilful Defaulters, last updated on July 1, 2015 (Master Circular).³ It proposes some significant changes to the Master Circular which include a revised definition of 'lenders' and a widened ambit of actions or omissions of borrowers that can be classified as 'wilful default', when the outstanding amount is equal to or more than Rs. 25 lakhs (Rupees twenty five lakhs).

Revised Definition of Lenders

The Master Circular defines 'lenders' as "all banks / FIs to which any amount is due, provided it is arising on account of any banking transaction." This is a broad definition, wherein 'financial institutions' cover 'non banking financial institutions' in terms of Section 45 I (c) of the Reserve Bank of India Act, 1934. The said interpretation was also accepted by the Honorable High Court of Telangana in the case of Mr. Dumpala Madhusudhana Reddy v. REC Limited.³

The Draft Directions on the other hand, specifically capture non-banking financial companies (NBFCs) in the middle layer, upper layer and top layer of the Scale Based Regulatory Framework within the definition of 'lenders'. This leaves the NBFCs in the base layer out of the ambit, thus narrowing down the existing definition.

Widened Ambit

While tightening the norms for classification of wilful defaulters, the RBI has proposed to reign in the defaults both in size and will. In pursuance of the same, the Draft Directions have envisaged an additional category of 'large defaulters' having outstanding dues of Rs. 1 crore (Rupees one crore) and above, and whose account is classified as 'doubtful' or 'loss' in terms of the Master Circular on Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances dated October 1, 2021.⁴ Large defaulters can be classified by any entity regulated by the RBI, irrespective of whether it falls within the definition of 'lender' or not.

The Draft Directions also widen the definition of 'wilful default' to include failure of the promoter to infuse equity in its special purpose vehicle, on the basis of which lenders sanctioned credit facilities to the borrower. This is particularly significant in the domain of project financing, wherein lack of long-term finance in the form of equity leads to undertaking short term debts and refinancing leading to spiraling debt. Consequently, having an adverse impact on the capacity of the lenders to recover their dues.

Standing the ground on Compromise Settlements

The RBI earlier in the year, permitted compromise settlements between lenders and wilful defaulters, which resulted in lenders taking haircuts for a full and final loan repayment.⁵ This move was widely criticized for being unfair to borrowers who are timely meeting their obligations on the loan agreements, and was touted to become a moral hazard for borrowers in the future. Notwithstanding the above criticism, RBI has decided to reiterate its position on compromise settlements by its inclusion in the Draft Directions. This policy decision seems to be stemming from the concern around reducing recovery rate stuck at approximately 30% (thirty percent) and increasing delays under the Insolvency and Bankruptcy Code, 2016 in Q1 FY24.⁶ Thus it is deemed essential that the compromise settlement system is used effectively by the lenders using their commercial prudence.

Key Issues Addressed

The Master Circular and the Draft Directions provide a structure comprising two committees. At the first level, Identification Committee examines the evidence and determines whether the borrower should be classified a wilful defaulter. Then a second committee, that is the Review Committee reviews the decision of the Identification Committee which classifies the borrower as wilful defaulter.

Within this structure, the practice of authorized representatives of the lender issuing show cause notice or written orders on behalf of the Identification Committee under the Master Circular, was a contentious issue discussed and debated in a catena of judgements of the Honorable High Courts of various states.⁷ The Master Circular is silent on whether such delegation of power is permitted, thus allowing the scope for raising the defense of procedural irregularity. However, the Draft Directions addressed this issue by expressly stating in the explanation to paragraph 4 that "Lenders shall formulate the guidelines, based on their board-approved policy, for nominating authorized officers, who would issue the show cause notice and serve written order on behalf of the Identification Committee and Review Committee respectively" while the power of examining the evidence and confirming the classification of a borrower as a wilful defaulter remains with the respective committees. It is further clarified that "The show-cause notice and the order served by the authorised officers shall clearly state that this has the approval of the competent authority i.e., Identification/Review committee."

The Draft Directions have also been updated to reflect the decision of the Honourable Supreme Court in State Bank of India v. Jah Developers Private Limited and Ors.⁸ which held that an opportunity for personal hearing should be mandatorily provided before the Review Committee against the decision of the Identification Committee. This has been provided in addition to written representation before the Identification Committee under the Draft Directions. Whereas, the extant Master Circular only envisages a personal hearing before the Identification Committee at its discretion. Given the financial and other implications of such classification of a borrower, this is a welcome change.

Way Forward

Some proposed changes like the provision on debarment of institutional finance to all entities in which a wilful defaulter (being a natural person) is a director, will need to be further clarified as a 'director' is a very broad classification which may include directors in 'non-executive capacities' including independent directors. This provision would be unreasonably harsh on such entities. Having said that, the Draft Directions go a long way in streamlining the provisions of the Master Circular in an attempt to reduce litigation and complete the classification process within a period of 6 (six) months from the account being classified as a non-performing asset. This is likely to bring in greater transparency and stability in the credit policy of the country.

Footnotes

1. Reserve Bank of India, Draft Master Direction- Treatment of Wilful Defaulters and Large Defaulters, September 21, 2023 available at https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=4318 (Last accessed on October 6, 2023).

2. Reserve Bank of India, Master Circular on Wilful Defaulters, July 1, 2015 available at https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9907 (Last accessed on October 6, 2023).

3. Mr. Dumpala Madhusudhana Reddy v. REC Limited, Telangana High Court, Writ Petition No.s 1420, 1421 and 1428 of 2019.

4. Reserve Bank of India, Master Circular on Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances, October 1, 2021 available at https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=12171 (Last accessed on October 10, 2023).

5. Reserve Bank of India, Framework of Compromise Settlements and Technical Write-Offs, June 8, 2023, available at https://www.rbi.org.in/scripts/FS_Notification.aspx?Id=12513&fn=2755&Mode=0 (Last accessed on October 9, 2023).

6. Care Edge Ratings, Debt Recovery Rate Stuck at ~30% while Timelines Continue to Increase, available at https://www.careratings.com/uploads/newsfiles/1694608937_Insolvency%20and%20Bankruptcy%20Code%20Update_June%202023.pdf (Last accessed on October 10, 2023).

7. Ritebanc Green Agro Solutions Pvt. Ltd and Ors. v. Central Bank of India and Ors., Madhya Pradesh High Court, MANU/MP/2123/2023; Atlantic Projects Ltd and Ors. v. Allahabad Bank and Ors., Calcutta High Court, (2019) 3 Cal LT 491.

8. State Bank of India v. Jah Developers Private Limited and Ors., Supreme Court of India, (2019) 6 SCC 787.

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