Saturday, February 28, 2015

Constitutionality of the Amended Definition of “Non-Performing Asset” Upheld

[The following post is contributed by Prachi Narayan of Vinod Kothari & Company. She can be contacted at prachi@vinodkothari.com.]

The Supreme Court in its judgment dated January 28, 2015 in Keshavlal Khemchand & Sons Pvt Ltd & Ors v. Union of India disposed off seventy petitions challenging the validity of the amended definition of Non Performing Asset (“NPA”) provided under section 2(1)(o) of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002  (the “Act”). 

The Case

The core issue on appeal to the Supreme Court was whether the definition of NPA as amended by Act 30 of 2004 is constitutionally valid and is not violative of Article 14 of the Constitution.

The constitutionality of the amended definition was the subject matter of challenge before the High Court of Gujarat (“Gujarat HC”) as well as before the Madras High Court (“Madras HC”). It further involved the question whether the power of prescribing guidelines endowed upon the Reserve bank of India (“RBI”) from time to time, with respect to classification of NPA would tantamount to excessive delegation.

Parliament by amending the definition of NPA made it possible for different sets of guidelines made by different regulators to be followed by creditors depending upon the administering or regulating authority of such creditor. The question thus for consideration before the court was whether such delegation of legislation amounts to excessive deletion by the legislature.

Judgment

The Supreme Court while taking into consideration the ratios of both the High Courts held that laying down of norms regarding classification of an account as NPA is not essentially a legislative function as it requires expertise in public finance and banking and may require periodic revision and a constant monitoring of financial system.

With regard to the question involving excessive delegation with respect to definition of NPA the court held that “if the Parliament chose to define a particular expression by providing that the expression shall have the same meaning as is assigned to such an expression by a body which is an expert in the field covered by the statute and more familiar with the subject matter of the legislation, the same does not amount to any delegation of the legislative powers. Therefore, the submission that the amendment of the definition of the expression ‘nonperforming asset’ under Section 2(1) (o) is bad on account of excessive delegation of essential legislative function, in our view, is untenable and is required to be rejected.”

Author’s Analysis

The judgment aims to redress certain basic and important questions: (a) whether the amended definition of NPA is violative of Article 14 of Constitution; (b) whether the power to define or prescribe norms with regard to NPA from time to time amounts to excessive delegation by legislature; and (c) if the answers to the above are in affirmative, is it possible to have a universal definition of NPA applicable to all cases?

Article 14 of the Constitution ensures equality before law. It states that:

“The State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India”

The article deals with two aspects: (a) equality before law; and (b) equal protection of laws. What Article 14 aims to achieve is that every person, in similar circumstances shall be treated alike. The article empowers the State to recognize a certain class and accordingly have separate set of legislation for them. Of course, this may come across as inequality to other classes; however, law recognizes that based on the needs and demands of society a classification based on “intelligible differentia”, which is not arbitrary or evasive may be permitted. Further, the definition on NPA underwent an amendment subsequent to the decision of Apex Court in Mardia Chemicals wherein the constitutionality of the Act was upheld. Accordingly, the basis of challenge in the instant case was that according to certain parties the amended definition tried to create two classes of NPA, which according to such parties was arbitrary and evasive in light of equal protection of laws.

Moving to the question of excessive delegation, Black’s Law Dictionary defines ‘delegation’ as ‘the act of entrusting another with authority or empowering another to act as an agent or representative’. The Dictionary further defines ‘Doctrine of Delegation’ as “the principle (based on the Separation of Powers Concept) limiting Legislature’s ability to transfer its legislative power to another Governmental Branch, especially the Executive Branch.

In case of Ajoy Kumar Banerjee & Ors vs Union Of India & Ors, the Apex Court held that:

The principle which has been well-established is that legislature must lay down the guidelines, the principles of policy for the authority to whom power to make subordinate legislation is entrusted. The legitimacy of delegated legislation depends upon its being used as ancillary which the legislature considers to be necessary for the purpose of exercising its legislature power effectively and completely. The legislature must retain in its own hand the essential legislative function which consists in declaring the legislative policy and lay down the standard which is to be enacted into a rule of law, and what can be delegated is the task of subordinate legislation which by very nature is ancillary to the statute which delegates the power to make it effective provided the legislative policy is enunciated with sufficient clearness a standard laid down.

Therefore, in light of the above, it can be safely assumed that delegation of legislative powers is permissible only when legislature has adequately laid down the framework of law. The delegate only has the power to make such a policy laid down by legislature effective and enforceable. The legislature lays down the broad tenets of law and confers the power of rule making on the Government or upon such bodies and agencies of its choice. Applying similar rationale here, the legislature passed the broad framework of the Act covering general principles relating securitization, assets reconstruction and enforcement of security interests and conferred the power to define and prescribe guidelines for classification of NPA on RBI.

Delegation becomes excessive, when the essential legislative functions are delegated to executives. The term “essential legislative function” would mean determination or choosing of the legislative policy and thereby enacting that policy into a binding rule of conduct. It is open to the legislature to formulate the policy as broadly as and with as little or as much details as it thinks proper. The legislature may then choose to delegate the rest of the legislative work to a subordinate authority who will work out the details and fill in the gaps within the framework of that policy.

The very intent to empower RBI to prescribe guidelines on classification of NPA was that the concept of NPA itself is dynamic - it changes with the changes in the financial regime and thus requires continuous monitoring and updating. Providing a static definition from the very time when the enactment came into force would have created a lot of confusion and disparity with regard to the classification norms being changed every time. And more so, legislative amendments as evident is a time consuming process as compared to the functions performed by the executive or specialised bodies.

The Act further empowers the secured creditor to be the sole authority to adjudge the amount due and outstanding from a borrower. However, such a grant of power to the secured creditor to evaluate the outstanding amount is not unfettered and comes with proper checks and balances in the Act by way of obligations cast under section 13 and the right to appeal under section 17 of the Act. It is apt to mention herein that ascertainment of outstanding amount by the creditor does not grant the creditor the right to initiate proceedings against the borrower but the creditor has to also undertake the obligation to classify such an account of the borrower as NPA in line with the directions of RBI. The intent behind casting an additional obligation on the creditor to classify accounts as NPA is the very fact that this classification subsumes utmost importance in the process of recovery and is further important for the decision making process of the creditor. This is further important to protect larger interests of society or those associated with the secured property. Had such fetter not been there and a direct possession was envisaged, this would have been detrimental to interests of other people associated with secured property. Further, this is also important from the secured creditors point of view wherein these balances force the creditor to reassess whether the default in repayment by the borrower is due to any factor, which is a temporary phenomenon, and that the same could be managed by the borrower if some room is given.

This is also corroborated by the fact that even before the enforcement of the Act, creditors were classifying accounts as NPA in line with directions of RBI. Further, the classification of NPA is not direct or one- the guidelines provide for a 4-stage classification depending upon the length of time for which they remain non-performing and the type of institution classifying the same, before an action under 13(4) is resorted.

Thus, the very nature and character of classification of NPA differs from one secured creditor to the other. For example, asset reconstruction companies have different guidelines to follow for classifying account as NPA while banks and financial institutions have different. Therefore, to make an attempt to codify a universal definition for NPA applicable to all cases would not only be an impracticable task but could also paralyze the entire recovery system thereby producing results which are counter productive to the object and the purpose sought to be achieved by the Act.

Conclusion

The Act was brought into the Indian legal regime keeping in mind the financial health of the country and to speed up the sluggish recovery process, which to larger extent also suffered the brunt of inefficient legal machinery. Before an action is initiated by the secured creditor, a secured creditor is under an obligation to evaluate and assess a borrower as defaulting borrower on several factors as the magnitude of the amount due and outstanding in a given case, the reasons which prompted the borrower to default in the repayment schedule, the nature of the business carried on by the defaulting borrower, the overall prospects of the defaulter’s business, national and international market conditions relevant to the business of a defaulter. So the spirit of law herein is that before an action is finally taken, a good measure of logical and rational consideration and reconsideration are to be undertaken by the secured creditor.

However, what seems prevalent in practice is something very opposite to what the intent of law is in paper.The initial steps of issue of demand notices and the replies to the representations of the borrowers in many cases just do not seem to come across as a reasoned decision of bank. It is many a times comes as a hasty piece of hasty pertaining only to recovery.  The spirit of law has to be shown in action too to uphold the real intent of this piece of legislation.

- Prachi Narayan 

Budget 2015: Some Preliminary Thoughts

The Finance Minister today announced India’s Budget 2015-2016. The Budget documents, including his speech are available here.

It is significant that this Budget comes during a period of upturn in the economy after a few preceding years of perceived gloom and doom, especially from the perspective of foreign investors. Other features attributable to the current macroeconomic environment include slowing inflation. As the Finance Minister notes in his Budget speech:

5. ... In November, 2012, CPI inflation, stood at 11.2%, the current account deficit by the first quarter of 2013-14 had reached 4.6% of GDP, and normal foreign inflows until March 2014 were $15 billion. …

6. We have come a long way since then. The latest CPI inflation rate is 5.1%, and the wholesale price inflation is negative; the current account deficit for this year is expected to be below 1.3% of GDP; based on the new series, real GDP growth is expected to accelerate to 7.4%, making India the fastest growing large economy in the world; foreign inflows since April 2014 have been about $55 billion, so that our foreign exchange reserves have increased to a record $340 billion; the rupee has become stronger by 6.4% against a broad basket of currencies; and ours was the second-best performing stock market amongst the major economies.

(On a related note, two pieces (here and here) in last week’s Economist magazine echo this trajectory make a strong case for India’s economic prospects)

The Budget proposals are hence made in the context of a rebound in the economic growth with great expectations and prospects for the future. The proposals touch upon a number of areas, and the key highlights are available here. While we hope to deal with some of the more specific proposals relating to the subject matter of this Blog in a series of subsequent posts, in this I set out some of the key philosophical overtones and policy goals that are evident in the Budget.

From a corporate or business perspective, one of the major focus areas of the Budget relates to the “ease of doing business”. This is not surprising given that the policy paralysis in the past has driven away foreign investors and has also set up hurdles for domestic businesses and entrepreneurs. The Budget has a close eye on reversing this trend. The Government has also undertaken measures in the past in this direction, particularly with a view to enhancing India’s position in the World Bank’s Doing Business rankings.

Related to this is the topic of “Make in India” that finds a prominent place in the Budget. Several reforms focus on enhancing manufacturing and other business activities in India. In order to enable capital raising for Indian business (including in the small and medium sector), there has been an effort in streamlining foreign investment norms and also a push towards enhancing the utility of domestic funding mechanisms such as alternative investment funds. The domestic push is also evident in the emphasis on the infrastructure sector, which requires a major fillip to support other sectors and enhance domestic industrial productivity.

Overall, there appears to be a lot in the Budget to stimulate economic growth fuelled by further investments (both domestic and foreign). Coupled with other reforms that have taken place recently, including a revamp of the Companies Act, these are likely to have a significant (and arguably positive) impact on the corporate sector in India.

We will address some of the more specific topics emanating from the Budget in future posts.


[Update (March 1, 2015): The link to the Budget speech above does not appear to carry the complete version (with some pages missing). For accessing from an alternative location, please see here]


Tuesday, February 24, 2015

RBI’s New Diktat: Lending to a Subsidiary

[The following post is contributed by Nivedita Shankar, who is a Senior Associate at Vinod Kothari & Company. She can be contacted at nivedita@vinodkothari.com]

The Reserve Bank of India (RBI) on January 7, 2015[1] has modified the Master Circular on Wilful Defaulters (Master Circular) with a view to usher in greater transparency and accountability in the process for identification of wilful defaulters. However, in its zeal to clamp down on the number of wilful defaulters, the RBI has inadvertently or purposefully added further to the woes of doing business in India.

Companies look to expand their businesses by establishing subsidiaries and joint ventures and undertaking expansions through them. These ventures are nothing but off shoots or subsets of the parent companies. The new regulations of the Master Circular, however, now will completely scuttle any effort of parent company to provide financial aid to its subsets. This is because providing borrowed funds to the subsidiaries/ group companies either through fund-based or non-fund based modalities can henceforth be construed to mean ‘diversion of funds’ or more aptly described as “siphoning of funds”.

Meaning of ‘diversion of funds’ or ‘siphoning of funds’

Para 2.2.1 defines ‘diversion of funds’ as follows:

(a)          utilisation of short-term working capital funds for long-term purposes not in conformity with the terms of sanction; 

(b)          deploying borrowed funds for purposes / activities or creation of assets other than those for which the loan was sanctioned;

(c)          transferring funds to the subsidiaries / Group companies or other corporates by whatever modalities;

(d)          routing of funds through any bank other than the lender bank or members of consortium without prior permission of the lender

(e)          investment in other companies by way of acquiring equities / debt instruments without approval of lenders;

(f)           shortfall in deployment of funds vis-à-vis the amounts disbursed / drawn and the difference not being accounted for.

Further, Para 2.2.2 of the Master Circular defines ‘siphoning of funds’ as follows:

Siphoning of funds, referred to at para 2.1(c) above, should be construed to occur if any funds borrowed from banks / FIs are utilised for purposes un-related to the operations of the borrower, to the detriment of the financial health of the entity or of the lender. The decision as to whether a particular instance amounts to siphoning of funds would have to be a judgement of the lenders based on objective facts and circumstances of the case.

As discussed above, any subsidiary being a sub-set of the holding company will of course look up to it for financial aid. However, by leaving the discretion completely on the RBI, the Master Circular has made the provision of financial aid by holding companies a cautionary step. In this regard, one needs to also direct attention to the consequences of diversion of funds, which are listed out in para 2.5 and enumerated below:

1. No additional facilities would be granted by any bank / FI to the listed wilful defaulters. Additionally, the entrepreneurs / promoters of companies where banks / FIs have identified siphoning / diversion of funds, misrepresentation, falsification of accounts and fraudulent transactions would be debarred from institutional finance from the scheduled commercial banks, Development Financial Institutions, Government owned NBFCs, investment institutions etc. for floating new ventures for a period of 5 years from the date the name of the wilful defaulter is published in the list of wilful defaulters by the RBI.

2. Lending banks have been given full authority to initial criminal proceedings against wilfull defaulters, where necessary

3. Banks and FIs have also been advised to adopt a pro-active approach for a change of management of wilfully defaulting unit.

4. The Master Circular also advises inclusion of a covenant in the loan agreements that the borrowing company will not induct a person who is a promoter or director on the Board of a company which has been identified as a wilful defaulter. Where a company already has such a person on board, it will take expeditious steps to remove him.

Thus should the parent company default in its payment to lenders and if in case the lender is of the view that the disbursed funds were diverted for some other purpose than the purported end-use, then the borrower will not be granted additional credit facilities. To worsen matters, the restriction on providing additional credit facilities has been extended to other banks as well. So, once the borrower is declared as a wilful defaulter, not only will the lending bank cease to provide facilities, any other bank will also not grant any credit facilities.

Analysis

Para 2.2 requires that the banks should keep the track record of the borrower and the decision to declare as wilful defaulter should not be based on isolated transactions. The Master Circular has left it to the lender’s will to view any default as being intentional, deliberate and calculated before classifying it as ‘wilful’. Further, para 2.3 also relaxes the penal measures mentioned in para 2.5 in case of outstanding balance of less than Rs. 25.00 lakhs. However, by allowing very little opportunity to represent since the right to personal hearing by promoter/ whole-time director has also been left to the discretion of the Committee set up by the lender, there is hardly any scope for the borrower/guarantor company to represent its stand or voice its concerns.

With the Companies Act, 2013 making it difficult for companies to enter into related party transactions, the Master Circular has further added to the woes. Not only does the Master Circular cover fund-based transactions, it also contains specific references to a guarantee provided by any group company. There is of course no restriction on providing guarantees to the group company. However, as per para 2.6 of the Master Circular, once invoked, if the guarantees are not honoured, then the group company will be considered as a wilful defaulter. The Master Circular has also made a reference to section 128 of the Indian Contract Act, 1872 to state that banks can proceed against the guarantor without first exhausting all remedies against the borrower. In this regard, one may refer to the provisions of SARFAESI Act, 2002, which was enacted with the intention to help banks to speedily enforce security interest. Even under SARFAESI Act, 2002, the borrower (which also includes a guarantor) has been given the right to represent. However, RBI has completely overlooked the right of any defaulter to explain its stand and has placed sweeping powers in the hands of the lenders.

It is in common knowledge that lenders are concerned about lending to any newly incorporated company since, its ability to repay is questionable. It is under such circumstances, that the parent company steps in as the guarantor. Since, a subsidiary or a joint venture company is nothing but a sub-set of the parent company, it is but obvious that it will look up to the parent company to act as the guarantor. However, the Master Circular will make any lending company think twice before it makes any financial commitment. Possibly, the only good news from the Master Circular is that it is not retrospectively effective. With penal measures such as reporting to SEBI, CIBIL, possibility of change of management, companies may have to exercise due care and caution before entering into lending transactions.

- Nivedita Shankar


Tuesday, February 17, 2015

Committee to Suggest Monitoring Measures for CSR

Readers will recall the debates in the lead up to the Companies Act, 2013 as to whether the provisions relating to corporate social responsibility (CSR) ought to be mandatory or voluntary. Finally, a compromise position was arrived at that largely amounts to a “comply-or-explain” approach. Since the CSR provision (section 135) was brought into effect from April 1, 2014, its impact (particularly on CSR spending) will be known only when companies begin reporting their expenditure and other details in their annual reports for the financial year ending March 31, 2015.

In the meanwhile, indications from the Government are that the CSR compliance will be closely monitored, both at the individual company level and also on an overall basis. Towards this end, the Ministry of Corporate Affairs earlier this month constituted a committee to suggest measures for improved monitoring of the implementation of the CSR policies by companies under section 135 of the Companies Act, 2013. The terms of reference of the committee include suggesting measures for adoption by companies for systematic monitoring of CSR initiatives, and also mechanisms for providing feedback to the Government regarding efficacy of the CSR expenditure and quality of compliance.

This step indicates that the Government continues to place considerable importance on CSR measures. Although structured largely on a “comply-or-explain” basis, the intention seems to be to ensure maximum compliance.