The Supreme Court of India ("Supreme Court") in Pro Knits v. The Board of Directors of Canara Bank (Civil Appeal Nos. 8332 to 8337 of 2024) has held that the notification dated May 29, 2015 issued by the Central Government in exercise of the powers conferred under Section 9 of the Micro, Small and Medium Enterprises Development Act, 2006 ("MSMED Act"), notifying instructions for the Framework for Revival and Rehabilitation of Micro, Small and Medium Enterprises ("Notification"), has statutory force and is binding on all the banking companies.
Background
A group of petitions were filed before the High Court of Bombay ("Bombay HC"), under Article 226 of the Constitution of India, by borrowers who were registered under the MSMED Act ("Petitioners"), challenging the classification of their accounts as non-performing assets ("NPA") and the action taken under Section 13(2) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ("SARFAESI Act") by banks/ non-banking financial companies ("NBFCs"), without following the procedure of restructuring under the Notification ("Writ Petition"). The Petitioners argued that banks and NBFCs are mandatorily required to take steps towards restructuring as contemplated under the Notification before classifying any loan account as NPA.
However, the Bombay HC dismissed the Writ Petition. The Bombay HC noted that banks/ NBFCs are not mandatorily required to follow the restructuring process set out in the Notification and opined that it would be practically impossible for lenders to identify "incipient stress" or "stress that is beginning to come into being or to become apparent" without it being brought to the lender banks' notice by the borrower itself. The Bombay HC concluded that the Notification is to be applied only after the Micro, Small and Medium Enterprises ("MSME") itself approaches the bank/ NBFC with appropriate application and affidavit.
The Petitioners appealed before the Supreme Court against the above judgment of the Bombay HC.
Arguments of the Petitioner before the Supreme Court
The counsel for the Petitioner argued that the respondent banks could not have classified the loan accounts of the Petitioner as NPA without having followed the procedure laid down in the Notification. It was submitted that the Notification and subsequent instructions/ directions issued by the Central Government and the Reserve Bank of India ("RBI") are for the purposes of facilitating the promotion, development and enhancing the competitiveness of MSMEs. It was further submitted that it was incumbent upon the respondent banks/ NBFCs to identify incipient stress and non-observance of the Notification rendered all the subsequent actions under the SARFAESI Act as illegal and void ab initio.
Arguments of the respondent banks before the Supreme Court
The counsel for the respondent argued that the procedure provided for in the Notification is merely directory and that, by virtue of Section 35 of the SARFAESI Act, the SARFAESI Act overrides the provisions of any other enactment, including the MSMED Act. It was submitted that the process of restructuring and classification of borrower's account as NPA are two independent subjects. The Notification is merely directory and not mandatory nor does it have any statutory force.
Judgement by the Supreme Court
The Supreme Court noted that the object and purpose of the MSMED Act is to provide for facilitating the promotion and development and enhancing the competitiveness of MSMEs. As per Section 9 of the MSMED Act, the Central Government is empowered to frame policies for facilitating the promotion and the development of MSMEs and for enhancing competitiveness among them. Under Section 10 of the MSMED Act, the RBI is empowered to frame policies and practices in respect of the credit to the MSME to ensure timely and smooth flow of credit to such enterprises, minimize the incidence of sickness among them and enhance the competitiveness of such enterprises.
Reference was also made to Section 21 of the Banking Regulation Act, 1949 ("Banking Act") which empowers the RBI to control advances by banking companies and all banking companies are bound to follow the policies formulated by the RBI in this regard. Additionally, Section 35A of the Banking Act provides that the banking companies are bound to comply with directions issued by the RBI issued inter alia in public interest. The Supreme Court further noted that the framework under the Notification is in line with the existing regulatory guidelines on "Income Recognition, Asset Classification and provisioning pertaining to Advances" issued to the banks by the RBI.
In light of the above, the Supreme Court observed that the Notification is binding on all the Scheduled Commercial Banks. The Supreme Court further observed that the process of enforcement of security interest as contained in Chapter III of the SARFAESI Act could be initiated only when the borrower makes any default in repayment and the account is classified as NPA in view of Section 13(2) of the SARFAESI Act. The Supreme Court held that the process in the Notification is to be followed prior to classification of the borrower's account as NPA. However, the borrower is required to submit authenticated and verifiable documents before the account is classified as NPA. If the borrower fails to submit the relevant documents, then the banks would be entitled to take the recourse to Chapter III of the SARFAESI Act.
The Supreme Court allowed the appeals and held that the Notification has statutory force and binding on all the banking companies.
Implications of the Judgement
The implication of the said judgment is that banks and financial institutions are required to mandatorily follow the process laid down in the Notification before the relevant loan account is classified as NPA. Further, it is essential that the borrower ensures timely submission of authenticated and verifiable documents for substantiating its claim of being an MSME before its account is classified as NPA.
Please find a copy of the judgement here.
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