'Wilful default' by the borrowers: Whether needs further stringent norms?

1. Introduction:

Loans and advances given to borrower becomes non-performing advances (NPA) for a bank, if it ceased to generate income for the bank. This may be for the variety of reasons like, poor credit discipline, Inadequate credit and risk management, diversion of funds by the promoters, funding of non-viable projects etc. In general, where interest and / or installment of principal remains overdue for a period of more than 90 days, that loan is to be treated as NPA in the books of the bank as per the guidelines issued by the RBI. There is a difference between the (i) inability to pay on the part of the borrower due to financial weakness and (ii) intentionally not paying the dues of the bank, even through having the financial means, which is called the wilful defaulters.

Recently there were news in the media and financial world about the wilful defaults by the big corporate and also to bring the guarantors in array of wilful defaulters when the principal borrower is wilfully not paying the dues of the bank. This paper is an attempt to cover all such issues about the controversy over the wilful defaults.

2. Wilful defaulters:

2.1. What is wilful default: Wilful default broadly cover, deliberate non-payment of the dues despite adequate cash flow and good networth; Siphoning off of funds to the detriment of the defaulting unit, Assets financed either not been purchased or been sold and proceeds have been misutilised;  Misrepresentation / falsification of records; Disposal / removal of securities without bank's knowledge; Fraudulent transactions by the borrower. RBI has defined the ‘wilful defaults’ as under[1]:

A "wilful default" would be deemed to have occurred if any of the following events is noted :-

(a) The unit has defaulted in meeting its payment / repayment obligations to the lender even when it has the capacity to honour the said obligations.

(b) The unit has defaulted in meeting its payment / repayment obligations to the lender and has not utilised the finance from the lender for the specific purposes for which finance was availed of but has diverted the funds for other purposes.

(c) The unit has defaulted in meeting its payment / repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilised for the specific purpose for which finance was availed of, nor are the funds available with the unit in the form of other assets.

(d) The unit has defaulted in meeting its payment / repayment obligations to the lender and has also disposed off or removed the movable fixed assets or immovable property given by him or it for the purpose of securing a term loan without the knowledge of the bank/lender.

It is to be mentioned here that the cut off limit for reporting of data by the banks to RBI is Rs 25 lacs or more.

2.2. Whether guarantors can also be declared as wilful defaulters:

Yes, the guarantors can also be declared as wilful defaulters. For the logic behind this we have to refer Section 128 of The Indian Contract Act, 1872. It provides that ‘ the liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract’. In other words, the obligation of a surety is the same as that of the principal debtors unless there is a contract to the contrary.   The RBI has issued a circular in this regard and have informed that when a default is made in making repayment by the principal debtor, the banker will be able to proceed against the guarantor/surety even without exhausting the remedies against the principal debtor. As such, where a banker has made a claim on the guarantor on account of the default made by the principal debtor, the liability of the guarantor is immediate. In case the said guarantor refuses to comply with the demand made by the creditor/banker, despite having sufficient means to make payment of the dues, such guarantor would also be treated as a wilful defaulter. It is clarified that this would apply only prospectively and not to cases where guarantees were taken prior to this circular. Banks/FIs may ensure that this position is made known to all prospective guarantors at the time of accepting guarantees.[2]

2.3. Position under the Companies Act, 2013:

The new Companies Act, 2013 do not directly deals with the concept of wilful defaulters. However, some of the sections of the act, viz section 74, 164, 447, 448,  if  referred,  will not be of  much relevant. Section 74 deals with the repayment of the deposits. This section relates  to the acceptance of the public deposits hence not relevant for the present study. Section 164 deals with the disqualifications for appointment as director and  doesn’t specifically provide for any disqualification on account of one being a wilful defaulter. However, sub-section (1)(e) of section 164 prescribes that a  person shall not be eligible for appointment as a director of a company, if an order disqualifying him for appointment as a director has been passed by a court or Tribunal and the order is in force. Further section 447, which specifies punishment for fraud,  states that without prejudice to any liability including repayment of any debt under this Act or any other law for the time being in force, any person who is found to be guilty of fraud, shall be punishable with imprisonment for a term which shall not be less than six months but which may extend to ten years and shall also be liable to fine which shall not be less than the amount involved in the fraud, but which may extend to three times the amount involved in the fraud. In this section also the word ‘wilful default’ has not been used while drafting the sentence.

2.4. What SEBI says:

2.4.1. SEBI is the regulator of capital market. The cut off limit of reporting of wilful defaulters list by the banks to RBI is Rs 25 lacs or more and the big corporate’s loan account comes under this category. For appointment of directors in the companies SEBI has suggested  criteria of ‘ fit and proper’ person under clause 3(1) of SEBI (Criteria for FIT AND PROPER person) Regulations, 2004. According to this for the purpose of determining as to whether an applicant or the intermediary seeking registration under any one or more of the relevant regulations is a ‘fit and proper person’, the Board may take account of any consideration as it deems fit, including but not limited to the following criteria, (a)  financial integrity; (b) absence of convictions or civil liabilities; (c) competence; (d) good reputation and character; (e) efficiency and honesty; and (f) absence of any disqualification to act as an intermediary as stipulated in these regulations. In the said clause the words ‘ financial integrity’ has been mentioned but it requires more elaboration on the concept of wilful defaulter companies for which the concerned person represent as director.

2.4.2. A news paper clipping was that the  Securities and Exchange Board of India (Sebi) might soon announce guidelines for those labelled wilful defaulters by banks. SEBI might deem wilful defaulters not ‘fit and proper’ from the perspective of accessing capital markets. The ban could be for a period of more than three years. The new framework will be applicable to those approaching the capital market for raising funds for the first time, as well as the listed companies and entities associated with it. Sebi and the Reserve Bank of India (RBI) are also planning increased coordination to ensure wilful defaulters are kept away from financial markets. Currently, RBI shares data on wilful defaulters with Sebi, credit rating agencies and Credit Information Bureau of India Ltd on a quarterly basis.[3]

2.4.3. Recently further news clipping was that the SEBI is likely to bar wilful defaulters from launching Initial Public Offers (IPOs), while their access to the secondary market is likely to continue.  An entity is tagged a wilful defaulter if he or it defaults despite having the ability to pay or uses the loan for purposes other than specified. The market regulator might only restrict such entities from accessing the primary market but not issue any major curbs on their secondary market activities, said three people in the know. SEBI also expected to issue a policy dealing with entities classified as wilful defaulters. The government and the Reserve Bank of India (RBI) have already started tightening the screws on such defaulters, as non-performing assets (NPAs) in the system are on the rise. [4]

3. Recent case laws:

3.1. Ionic Metalliks v. Union of India[5], the High  Court of Gujarat opined that RBI Master Circular relating to 'Wilful defaulters' is ultra vires and violative of article 19 of Constitution in so far as it is sought to be made applicable to all directors of company.

Facts: The petitioners ( total 4 petitioners, No.1 is a proprietors concern, No. 2 is a company, No. 3 is  director of the company, No. 4 guarantor as well and director in the company) took loan from the Union Bank of India (the Bank). After the loan account classified as NPA, the Bank issued show cause notices to petitioner-director to declare them as wilful defaulter as per the guidelines of Master Circular of RBI, on failure of company to repay loan amount. Petitioners challenged the Constitutional validity of Master Circular of RBI, the Bank without disclosing any reasons in the show cause notice, already taken a decision to declare the petitioners as wilful defaulters.

Held: The High Court of Gujarat opined that:

Having regard to the object with which the Reserve Bank of India issued the Master Circular and the policy decision to declare the promoters of the company as wilful defaulters, it could not be said that the same is an unreasonable restriction violating Article 19(1)(g) of the Constitution of India.

All the directors cannot be held liable for the default in repayment of the loan which might be for varied reasons beyond the control of such directors. Some element of arbitrariness is found in the policy of the Reserve Bank of India. This provision in the circular shatters the concept of the identity of a company different and distinct from its directors without providing any safeguards. It does not distinguish between a director who is involved in the day-to-day functioning of a company as against those who are not. The circular paints all directors with the same brush.

Therefore, the Master Circular, so far as it is sought to be made applicable to all the directors of the company is arbitrary and unreasonable. The Court is not questioning the power of the Reserve Bank of India to issue the Master Circular or even the policy decision regarding the same, but is only concerned with the unreasonable restriction imposed on all the directors of the company. An element of arbitrariness is found in such policy decision. To this limited extent it is held that the Master Circular is violative of Article 19(1)(g) of the Constitution of India and deserves to be struck down partially.

The show cause notice is absolutely vague and contains no factual or other materials. One fails to understand on what basis the bank has alleged in the show cause notice that the funds provided by the bank have been siphoned of and the same were used for the purpose other than the project for which the loan was sanctioned. If such are the nature of the allegations, then at least it is expected of the bank to provide some materials so that the petitioners can meet with the same. It has to be held that there is violation of the principles of natural justice. One of the facets of the principles of natural justice is fairness which, is not found on the part of the bank in the proposed action.

3.2. Kotak Mahindra Bank Ltd. v.Hindustan National Glass & Ind. Ltd.[6] the issue aroused whether a wilful default in meeting payment obligations to a bank under a derivative transaction will be covered under the Master Circular issued by RBI, dated 1-7-2008?

The Supreme Court held that the Master Circular covers not only wilful defaults of dues by a borrower to the bank but also covers wilful defaults of dues by a client of the bank under other banking transactions such as bank guarantees and derivative transactions.Thus, on judicial interpretation it is held that wilful defaults of parties of dues under a derivative transaction with a bank are covered by the Master Circular.

6. Summing up:

The RBI’s Master Circular on ‘wilful default’ issued on 1st July, 2014 is comprehensive and the subsequent amended circular dated 9th September 2014, has also bring the guarantors under the umbrella of ‘wilful defaulters’ list with prospective effect. However, in a recent news, the Calcutta High Court dismissed United Bank of India’s action against Kingfisher. The court observed that UBI's identification committee on wilful defaulters was comprised of four members, which was one more than prescribed in regulation 3(i) of the Reserve Bank of India's (RBI) master circular on wilful defaulters. "In such circumstances the decision arrived at by such identification committee is a nullity. Consequently, all steps taken by United Bank of India subsequent to such so-called identification are also a nullity," Justice Debangsu Basak said in his judgement on December 24, 2014. UBI is perhaps at fault for deviating slightly from the prescribed regulation, but many felt that the bank actually took more care in declaring Kingfisher a wilful defaulter by having an extra member in its wilful defaulter committees. It is also argued that RBI's master circular on wilful defaulter does not use the word "only" while specifying the number of committee members. While UBI is allowed to reinitiate the process of identification and declaration of Kingfisher a wilful defaulter, there is no doubt that there will be further delays in recovering the dues. Sometimes, if not always, justice delayed is justice denied. This case is certainly not a stray incident. There have been instances in the past when errant borrowers have successfully stonewalled lenders' legitimate recovery efforts.[7]

In the area of the capital market, the issues relating to funds raising through IPO/FPO/ Right Issue etc. be also bring at par with the guidelines of the ‘wilful default’ (as prescribed by the RBI) so as to give a clear cut message to the wilful defaulters, making it difficult to raise money from the public sources just for their own wealth creation.

Dr. Rajeev Babel,

ACS, MBA, Ph.D, LLB, AIIB,

M.COM, DBM, DFS, D T&D,

Company Secretary in Practice,

Email: babelrajeev@gmail.com