Banking Law and Debt Recovery

The social construct of earlier times ensured that borrowing was an act which was frowned upon. In fact, stringent measures were often taken if the person failed to honour his debt, often resulting in imprisonment, and at times, physical punishment. [1] In the times that followed, the zamindari system reared its ugly head. One needs to look merely at the fairy tales and popular stories, all of which had one character which was a poor person who was unable to pay off his debts. With rising interest rates, often generations of one family were deemed to be forever in servitude to the landlord or the money lender.

Then, the Industrial Revolution took place. This period in history came with the realisation that often business ventures needed greater capital than that that could be put together by merely the proprietors. It dawned upon enterprising businessmen that the only way to raise such vast amounts of money was to involve every day parties and use their money and if need be, make them part owners and then reward them for the permission to use the money in achieving the ends of their organisations. This mentality, along with the limited liability regime and the final cog, of altering the penal provisions in case of non – repayment, finally changed the debtor – creditor relationship for once and for all. [2]

Unfortunately, with the dawn of this new relationship, along came the problem of debt recovery. With lax laws regarding non–repayment, it got tougher and tougher for the creditor to ensure timely repayment. The increase in non-performing assets rendered this relationship tumultuous. It basically boiled down to the health of public banks and extending credit to nascent industries of free India. [3] Often loans were applied for one purpose, but then diverted for another. Loans extended towards infrastructure projects were never paid back on time because invariably, the budget would be exceeded, inordinate delays would occur and the banks’ inability to enforce securities ensured further delays which would reduce the sale prices of collaterals. [4]

In 2001-02, the gross non- performing assets of the Indian banking sector were to the tune of Rs. 70,905 crores which in effect means, that on advances to the tune of the mentioned amount, the banking sector makes no money whatsoever. [5]

Even the Narasimhan Committee on the Financial System warned that unless and until positive steps were taken, the entire financial health of the country could be affected. [6] The Reserve Bank of India responded with the implementation of stricter accounting standards, greater reporting requirements and asked banks to hold a higher proportion of outstanding loans so as to guard themselves from possible default. [7] While this can be done through loan restructuring or writing off these loans, the real improvement in the balance sheet of the bank will occur only when the loan amount is recovered.

Obviously there have been attempts. [8] Some banks offered concessions and rescheduled the repayment of debts. After this method was met with limited success, there was an attempt to ensure that all relevant financial information was to be presented before a loan could be granted. This moved on to the practice of lending only if one had an asset which could be used as collateral. However, this has not turned into an effective and efficacious remedy as one might have hoped.

Unfortunately for India, the judiciary is something which it cannot be proud of. Some academicians have even gone on to say that “the most effective method of dispute resolution in these courts may well be the out of court settlements, withdrawals and compromises by litigants attempting to avoid the inefficiencies in processing legal suits.” [9] Procedural loopholes in the Civil Procedure Code, which is an antique piece of legislation allows for numerous applications, counter applications, special leaves by both parties etc. [10] Evidence rules allow for further delays. Numerous attempts have been made to rectify this but to no avail.

To recover a loan, the creditor needs a money decree i.e. a decree by a court relating to money matters. A suit needs to be filed in a civil court requesting the court to direct the debtor to pay back the money borrowed. If the loan is secured, then the court will need to enforce the security and sell the collateral to realise the money and return the amount owed. If the loan is unsecured, then the court will have to liquidate the firm’s assets and wind up the company and distribute according to the priority of the claim. [11] The Indian judiciary has taken its own sweet time and thus, the success rate of such an attempt by the creditor has been low and cost has been high.

II

The Recovery of Debts due to Banks and Financial Institutions Act (hereinafter referred to as the ‘DRT Act’) was the result of the findings of the Tiwari Committee of 1981 and the Narasimhan Committee of 1991, both of which endorsed the idea that since banks faced numerous legal difficulties in recovering their money, a special tribunal should be established for the recovery of debt and these tribunals shall be governed by the principles of natural justice. [12] This Act allows for the establishment of Debt Recovery Tribunals (DRTs). The Act itself in its Statement of Objects and Reasons mentions the fact that as of 1990, there were around fifteen lakh cases pending which had been filed by public banks and a further 304 cases which had been filed by different financial institutions. These cases put together had resulted in the locking up of Rs. 6013 crores which could have been otherwise utilised for other purposes. [13]

Debt Recovery Tribunals are quasi legal in nature. They do nothing but deal with the recovery of debt as the name of the Act suggests. The presiding officer of the DRT is one who is the qualified to be a district judge [14] and lawyers qualified to appear in civil courts are the ones who can appear here as well. [15] Well, the aim of the DRT was to provide for an alternate forum in which the recovery of debts could be expedited and this would be rendered in fructuous if the procedure followed was the same as the normal courts. Hence, in order to avoid this obstacle, a procedure was developed which sought to ensure that the parties were acting quickly along with greater accountability and there was no need to restrict the working of the Tribunal by applying the Civil Procedure Code of 1904. [16]

This summary procedure included a thirty day period in which the defendant had to respond to the summons, counter claims had to be raised at the first hearing itself and also, the verdict would be carried out as soon as possible by the recovery officer since he had the power to attach and sell any property, appoint a receiver who would be the guardian of the defendant’s property and even at times, arrest and detain the non- complying defendant. [17] The DRT also had the powers to issue interim measures to ensure that the parties do not dispose the impugned asset and render the proceedings in fructuous. Appeals could be made to the Debt Recovery Appellate Tribunal (DRAT). [18] However, before one sought to exercise this option, 75% of the amount was to be deposited with the DRAT as a security. [19]

While this Act was a welcome step in the area of debt recovery, it was not long before it met its first hurdle. The Delhi Bar Association challenged the constitutionality of this Act on several grounds. It was argued, inter alia, that since the Ministry of Finance appointed the presiding officer, such a procedure was in violation of ‘separation of powers’ which was part of the Basic Structure Doctrine. While the Delhi High Court passed an interlocutory measure asking for the DRT to cease from operating, the special leave petition filed by Central Government was decided in the favour of the government by the Supreme Court. Along with certain amendments, notably one of which ensured that the Chief Justice of India would be the ex- officio Chair of the selection committee for the presiding officer post, the Act would side step the alleged violation of the separation of powers, and the executive would not be unduly interfering with the workings of the judiciary. [20]

III

While one cannot argue that the DRT Act was not beneficial, it did not achieve its full potential. Undoubtedly, the DRT Act showed that the legislature was heading in the right direction, but a little more was demanded. This need heralded in the Ordinance which was later made into an Act, called the Securitisation, Asset Reconstruction and Enforcement of Security Interests Act (hereinafter referred to as the ‘SARFESI Act’). As mentioned earlier, the rapid rise in non- performing assets was a situation to worry about. This Act marked a new turning point for the recovery of debt. [21]

So what exactly is securitisation? It is a process which involves the pooling and repackaging of homogenous but non- liquid assets into securities which can be marketed and have a claim over the incoming cash inflows. [22] The basic process of securitisation has been clearly laid down in Vinod Kothari’s book on the SARFESI on page 27 as follows: [23]

The originator (creditor) selects the receivables it wants to be securitised.

A special purpose vehicle (SPV) is formed for this purpose to which the receivable are transferred to at their discounted value.

This SPV will issue securities to the investors, either publicly or through private placement.

A servicer is appointed (usually the originator) who collects the receivables and pays the collection to the SPV. It also takes action against the debtor in case of default as an agent of the SPV.

The SPV may either choose to pay off the investors or reinvest the same and pay off the investors when it becomes due.

Usually at the end when only a few receivables are left outstanding, the originator buys back the leftovers to clean up the transaction.

Now arises the question why would anyone resort to securitisation? There are several reasons which back this process. [24] A company may want to raise finance when other avenues of financing are shut, iprove the return on their assets, reduce credit exposure, reduce risk and even achieve a regulatory advantage.

To determine whether an account is a non- performing asset or not, the Reserve Bank of India (RBI) issues guidelines on the same. Thus, the Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003 classifies an account as a non- performing one if a default has been made on the repayment of a debt (whether on the principal amount, interest or even any portion of the two) for a period of 180 days or more. [25]

The SARFESI Act in its aim to achieve “expedient and efficacious legal means of enforcing the security with the least possible judicial interference” [26] dictates that once a notice has been issued to the defaulter, and a waiting period of sixty days elapses, the creditor can without even approaching a court, take physical possession of the security and then take steps which allow for the recovery of debt. [27]

While the Indian scenario is ideal for securitisation since there is a huge potential for this process, major investors are actually willing to invest in the same, there exists a large debt market and data exists on economic cycles, there are also certain cons for the same like the fact that the legal system is still oblivious to this process, the stamp duty remains high and the tax inefficiency of the SPV remains a matter of concern holding back securitisation. [28]

Though this Act is often termed as revolutionary for providing a cheaper alternative to debt recovery, it has its own share of criticisms. [29] First, it is believed that one single act cannot and has not done justice to securitisation, asset reconstruction and enforcement of security interests. All the three are vastly different from each other in several aspects and expecting one act to cover all the three cannot be termed as prudent. Secondly, the Act fails to provide for a mechanism in which the defaulter can challenge the sale of the asset in cases where the creditor might have sold the asset at a price below the true market value causing a loss to the defaulter. Thirdly, there is no distinction between wilful and non- wilful defaults. It is often argued that the two should be treated differently. [30] Fourthly, there is no guarantee that once the creditor takes over the business of the defaulter, the creditor may actually be qualified to do the same. On the contrary, the creditor might cause irreparable damage to the business.

It was also felt at a certain level that political pressure hinders the application this Act to large defaulters and hence, it is only the small debtors who seem to be caught consistently in the net of the SARFESI Act. [31] And finally, this Act while promoting debt recovery, fails to address the root of the issue which is to prevent and reduce industrial sickness and non- performing assets. This short sighted vision might cause India dear, especially in light of the economic meltdown.

The abject lack of provisions of appeal was the ground on which the SARFESI Act was challenged in Mardia Chemicals v. Union of India. [32] While the defaulter is entitled to repossession as well as compensation in cases in which the creditor has wrongfully exercised his rights under this Act, the Supreme Court ruled that it was mandatory for allowing a fair hearing to the defaulter. Thus, physical possession of the assets can be undertaken only after the defaulter has received a notice and has been given a fair opportunity to be heard and then the defaulter has to be intimated that his representation has been rejected. It is only then that the creditor can take physical possession.

It is believed that such a judgment along with the requirements of certain amendments to the SARFESI Act will severely weaken and curtail the rights the banks and financial institutions which they enjoyed earlier.

IV

The SARFESI Act was a positive move undoubtedly. It attempts to create a stronger legal regime for creditors along with the fact; it reduces interference by the judiciary. However one needs to note that the Act is not meant to merely allow creditors to walk in and take over the management or the assets. It has even at times been referred to as the “POTA of Indian Banking” which may be a tad too harsh a label. [33] One should realise that the Act attempts to promote recovery of debts rather than penalise the defaulters.

After the amnesty scheme in which creditors allowed for large discounts so atleast a part of the debt could be recovered, and the attempt to create alternate forum in the form of the DRT, the SARFESI Act was the third trial and error method opted for, by the Government. The SARFESI Act sought to radically change the relationship between the debtors and creditors and did have an effect in its early years. The percentage of NPAs in overall assets came down from 14% in 1999-2000 to 9% in 2002-2003. [34]

While the ruling of the Supreme Court in the Mardia Chemicals Case has diluted its affect to a certain level, it is imperative that the government while amending the Act does not change the structure of the Act but merely ensures it removes the flaws which as enumerated above, seem quite a few.

However, as mentioned earlier, one needs to note the fact that debt recovery is still the second stage in improving the financial conditions of the Indian economy. The primary still remains in ensuring that NPAs itself are not encouraged and this can be done solely by ensuring there exists greater transparency and accountability. It remains to be seen what the government has in store in that aspect of policy making, especially after taking into consideration the N. L. Mitra Committee Report which discussed overhauling the bankruptcy code.