Wednesday, December 19, 2012

Willful Defaulters and Derivatives Transactions

The Supreme Court was recently confronted with a question as to whether a company that had entered into a derivatives transaction with a bank could be categorized as a “willful defaulter” under the Reserve Bank of India’s Master Circular on Willful Defaulters on account of non-performance of payment obligations. More specifically, the question was whether a bank could be treated as a “lender” in respect of such derivatives transactions. The derivatives were foreign exchange derivatives in which either party could be obligated to make payment to the other depending upon the relative movements of specified currencies over a period of time.

While there were differences of opinion between two High Courts, the Supreme Court in Kotak Mahindra Bank v. Hindustan National Glass & Industries Limited (and related matters) ruled last week that banks could invoke the willful defaulter provision even in case of unfunded transactions such as derivatives and guarantees, and that the said scheme was not confined to funded transactions such as customary lending and borrowing of sums of money.

The appeals arose out of three different cases. In one case, the Calcutta High Court held that the Master Circular applied only to borrowing and lending transactions. Since the transactions in questions were foreign exchange derivatives, it held that there was no borrower and lender and hence the derivatives counterparty (client) could not be treated as a willful defaulter. In the other two cases, the Bombay High Court came to the opposite conclusion. After considering the Master Circular and various other circulars relating to the banking industry, the Court held that counterparties of banks in derivatives transactions will fall within the purview of the Master Circular, and that banks could name them as willful defaulters (so long as they followed principles of natural justice).

On appeal, the Supreme Court was required to interpret the Master Circular. The term “willful default” is defined in the Master Circular with reference to a unit that has “defaulted in meeting its payment/repayment obligations to the lender”. The difficulty arose due to the use of the expressions “payment/repayment obligations” and more specifically the expression “lender”. A literal interpretation would mean that only customary lending and borrowing transactions would be covered. However, the Supreme Court instead adopted a purposive interpretation, keeping in mind the objective of the Master Circular. The Supreme Court’s decision was influenced by the broader objectives of the Master Circular. This is evident from the following extracts from the Supreme Court’s judgment:

34. When we look at the Master Circular, we find that the purpose of the Master Circular is "to put in place a system to disseminate credit information pertaining to willful defaulters for cautioning banks and financial institutions so as to ensure that further bank finance is not made available to them". Hence, the purpose of the Master Circular is to have a system to disseminate credit information pertaining to willful defaulters amongst banks and financial institutions so that no further bank finance is made available to such willful defaulters from such banks and financial institutions. …

35. Keeping in mind the mischief that the Master Circular seeks to remedy and the purpose of the Master Circular, we interpret the words used in the definition of 'willful default' in clause 2.1 of the Master Circular to mean not only a willful default by a unit which has defaulted in meeting its repayment obligations to the lender, but also to mean a unit which has defaulted in meeting its payment obligations to the bank under facilities such as a bank guarantee. …

36. The scheme of Collection and Dissemination of information on cases of willful default of Rs.25 lakhs and above was framed by the RBI in the year1999 when the derivative transactions were not part of the country's economy. … Such derivative transactions may not involve a lender-borrower relationship between the bank and its constituent, but dues by a constituent remaining unpaid to a bank may affect the credit policy and the credit system of the country. Information relating to defaulters of dues under derivative transactions who intend to take additional finance from the bank obviously will come within the meaning of credit information under Section 45A(c)(v) of the 1934 Act. …

Although the companies challenging the banks’ decision to treat them as willful defaulters raised several other issues, the Supreme Court did not set out its views on those. These include issues pertaining to the constitutionality of the Master Circular, which was not directly challenged in these appeals.

Given this interpretation of the Supreme Court, the Master Circular on willful defaults will have wider applicability beyond customary borrowing and lending transactions, and would extend to unfunded transactions as well where the obligor has any kind of payment obligation towards the banks. Among these, the Supreme Court has specifically listed out derivatives transactions as well as guarantees.

At a broader level, this decision is one among the line of cases where courts are keen to adopt more purposive reasoning to give effect to traditional legislative provisions as they apply in the context of more modern financial transactions such as derivatives and securitization. In this type of an approach, the courts seem keen to uphold the sanctity of contracts in such type of banking transactions in the interest of the overall banking and credit environment in the country. Other examples of this pro-bank approach that we have previously discussed on this Blog include the Supreme Court’s decision in ICICI Bank Limited v. Official Liquidator of APS Star Industries Ltd. and Rajshree Sugars & Chemical Ltd. v. Axis Bank Ltd.


vswami said...

The court's verdict on the proposition has been summed up as under:

.....the Court held that counterparties of banks in derivatives transactions will fall within the purview of the Master Circular, and that banks could name them as willful defaulters (so long as they followed principles of natural justice.

The verdict , as observed, has been rendered by following / adopting the well known principle of 'purposive interpretation'.However, one is not quite clear on the finer point as to in what circumstances a 'default' in 'payment or repayment' could be rightly considered as 'wilful'. In other words,the doubt is this: Do the bracketed words, "so long as they followed principles of natural justice" are adequately clear so as to be of definitive guidance for courts to apply and follow the verdict, objectively,in all such or similar types of cases requiring adjudication in future.To put it differently, what precisely are the relevant "principles of natural justice" spoken of in the given context.

May be,the experts will be in a position to clarify and elucidate!

vswami said...

For further comment, see >!/2012/12/icl-wilful-default.html