Publication of defaulting borrowers' photos in SARFAESI notices

Publication of photographs of home loan borrowers in SARFAESI notices: Are we doing the right thing?

The title puts a question, and it is easy to imagine a counter question too – is the borrower defaulting on the bank’s money is doing the right thing? This article examines the wrong involved in defaulting on loan commitments,  but puts a bigger question before the society : are we rightly reacting to the borrower’s default? The article is particularly focused on home loans.

Before we get into the question – let us be aware of what is happening around us. The SARFAESI Act was enacted in 2002 presumably on the lines of the article 9 of US Uniform Commercial Code. The Act is, actually, nowhere even close to that Code. In fact, UCC deals with personal property and not real estate, and therefore, home loans are not at all covered by US UCC article 9. The Act was recommended before the Parliament as one which help reduce the burden of bank NPAs. The picture one got was those so-called “wilful” defaulters who habitually over-borrow from banks, siphon off money possibly even before the  loan repayment starts, and enjoy life at the cost of banks. In other words, the objective was to be stern against promoters of companies that go sick while promoters enjoy the pink of their own health. Little did the Parliamentarians who passed the law realise that the law will be used, as it is being done, vehemently to drag home loan borrowers out of their homes.

No one contends that a borrower should be allowed to go scot free after having borrowed money from a bank or housing finance company, even if it was purchase of a residential house. But is a default of a home loan a case of wilful default that was in the minds of the lawmakers when the SARFAESI Act was enacted? Is it difficult to envisage that there may be zillion reasons for which a borrower may be forced to default on loan EMIs? Once again, financial discipline is important, and it is a settled fact that home borrowers who are unable to pay their EMIs have to suffer foreclosure at some stage. There are hundreds of  thousands of such homes under foreclosure action today in the USA, and therefore, no one should shed tears if borrowers have to face a mortgage foreclosure on account of default of a home loan.

But then, the SARFAESI Act puts a non-judicial route to mortgage foreclosures. The way the section is worded, a  home borrower will first have to lose the roof over his head before he can run to his lawyer to take an action in a DRT. One just needs to take a practical stock of the situation – a person having a salary income of Rs 30000 pm takes a loan that has an EMI of Rs 10000 per month. The ratio works perfectly fine since a debt to income ratio of 33% is one of the best a lender can expect. Also, given that a household can easily manage living costs within a range of 10-15k per month, there is sufficient scope for the individual to pay his home loan without default. Now, say, he loses his job. It obviously will take a few months before he can get a replacement job, particularly in a market as the present one. So, 3 EMIs missing, and the bank classifies the loan as an NPA. The bank sends a loan recall notice, demanding not just 3 EMIs, but the whole of the loan. And in the meantime, the bank starts adding penal interest, which is much higher than the loan interest rate.

The  issue is, where does the individual, out of job and facing his own worries in life trying to find a new job, get the money from, to pay the bank? Not just the EMIs, but the lethal penal interest rate too. So, as would always happen – debt begets debt. He would possibly run to a usurious lender, and borrow at excessive interests to pay the bank off, but sooner or later, will get into a default at both the places.

Here comes the bank with a SARFSAESI notice – pay off the entire loan, along with penal interest and all other charges within 60 days, or face repossession.

The tragedy is, the individual can run to no one for rescue. He would often run with pleading face to the branch manager, but the manager would say – the matter is out of control now.

Now think of remedies available. Is it unlikely that the borrower may have questioned the very claim of the bank? Is it unlikely that the bank might have added wrongful costs or charges which the individual may be disputing? Thanks to the Supreme Court ruling in Mardia Chemicals, the law gives the borrower a right of representation, but the right of representation is a mere lipservice, as the representation goes to the very bank or bank manager with whom the borrower has an issue. The law does not even require the borrower’s grievance to be handled by a senior office who can examine the matter dispassionately. Invariably, if at all the borrower makes a representation, the answer from the bank is going to be mechanical – turning down the representation with a stereotyped rebuttal of whatever the borrower might have said.

So, can the borrower approach his lawyer and seek a redressal? Unfortunately, as the law seems to say, the borrower must first allow the bank to take action (read, take away the borrower’ house),  and go for redressal before a DRT. DRT action may stretch for months altogether. To add to the injury, the DRT may also pass an order for pre-deposit of a large part of the amount demanded by the bank before the application can proceed. Irony is – if the borrower had the money to pre-deposit, why would he let the loan default anyways? But law is merciless, regardless, and concern-less.

Banks are adding insult to the injury by publishing the borrowers’ photographs in the newspapers. This is simply outrageous. The matter was discussed in a Madras High Court ruling  where the High court affirmed of the practice, but the issue was mainly on the grounds of borrowers’ privacy rights, bank secrecy laws, and so on. Our Courts have still not got rid of the mindset that when a borrower defaults, he is not necessarily defaulting because he is not wanting to pay, but because he is unable to pay. Also, over the decades of the way the banking system has worked, courts are simply unable to appreciate the miseries of retail borrower failing to pay a  consumer loan. Therefore, it is a little surprise that the Hon. Judge in the Madras High court above said: “If borrowers could find newer and newer methods to avoid repayment of the loans, the Banks are also entitled to invent novel methods to recover their dues.” This indicates that the publication of the photo of the borrower is also a recovery device, whereas, it was not pointed out before the court that the photo is published only after the recovery action has been taken.

Repossession action having been taken, the question is – why would a bank at all want to do a further damage to the borrower by publishing his photograph too? Surely enough, it is  not the photo of an India’s-most-wanted terrorist to caution the public. If the idea is to caution other lenders, that is taken care of by CIBIL as the financial system is anyway entitled to CIBIL’s database. In any case, other lenders don’t lend by looking at the photo of the borrower. One would understand if default of a loan was a criminal offence, but first, a loan default is a civil wrong and not a criminal wrong, second, no one could hold a person liable of having done a crime other than a criminal court, let alone a commercial bank, and third,  even in criminal wrongs, for the most heinous crimes, courts do not go all out to publish photographs.

Irrespective of legality involved in such publication, what is happening currently is outright wrong. Our brethren who have fallen victims of bad times and are anyway deprived of the roof over their head are being further driven into ignominy by putting their photographs in papers. This is so very cruel, so very inhuman, at least in case of residential mortgage loans. RBI and NHB should put an end to this practice immediately.

Foreign investments in ARCs and security receipts

I have commented, several times, that the ARC model in India in unique and has nothing to do with similar models elsewhere in the world, in more senses than one. Special statutory powers have been conferred in India on ARCs, while ARCs in India are profit-driven shareholder companies unlike state-promoted special purpose vehicles in other countries. In India, the ARCs are nothing but a surrogate route to a special situations fund or a distressed debt fund, coupled with special powers of recoveries.

The special powers granted under the SARFAESI Act and under the Sick Industrial Companies Act are drastic, and at least in cases, seem to be exceeding the boundaries of well-settled public policies. For example, one of the provisions of the Sick Industrial Companies Act, recently interpreted by the Bombay High court , says that if any loan taken by a sick company is acquired by an ARC, then the reference of the sick company before the BIFR shall abate. Seemingly, the only purpose of constituting the BIFR is that entities which may be revived are sent to the nursing home and not the crematorium. But if any loan, irrespective of the amount of the loan, taken by such sick company, is acquired by an ARC, and that causes the reference before the BIFR to cede, the very philosophy of the revival of sick companies gets negated.

Same are the provisions in sec 9 of the SARFAESI Act about takeover of management. An ARC that has bought a loan taken by a defaulting borrower has the right to takeover the management of the business of the borrower. Notably, the loan was originally given by a bank, and the bank never had any such right of takeover of management. The ARC that buys the loan from the bank cannot have a better right than that of the bank. The bank had a security interest; security interest cannot imply the right of takeover of business.

There are also issues concerning workers’ interest which have not been properly appreciated: workers’ claims are recognised under SARFAESI proceedings only where the company is in liquidation. Sadly enough, the very repossession of assets by an ARC may leave the borrower with no substratum at all, and therefore, with no option but to go for liquidation. But by this time, as the core assets of the borrower would have been taken away by the secured lender, the question is – where do the workers get paid from?

These are generic concerns about the whole scheme of ARCs , which seem to have been pushed into legislation without a holistic approach to resolution of bankruptcies in the country.

However, the present policy about FDI in ARCs and the security receipts (SRs) issued by the ARCs may also be reviewed.

Currently, non-residents are allowed to invest in capital of ARCs, but FIIs are not allowed. As regards investments in SRs, FIIs are allowed to invest upto 49% of a single tranche of SRs, with a limit of 10% per FII.

As regards ARCs themselves, the 49% cap was perhaps devised to ensure ARCs may end up owning bad loans, and bad loans may (a) pertain to borrowers from sectors where there are current restrictions on foreign investments; and (b) be backed by real estate whereby foreign investors may end up owning immovable properties, which may be against the extant FDI policy.

These concerns may, however, be misplaced. First of all, most ARCs do not invest in bad loans themselves – they do it mostly by issuing SRs in the trust mode. Therefore, as long as there are prudent restrictions on investment in SRs, the restriction on equity capital of ARCs may not be necessary. Secondly, even if an ARC with, say, majority foreign ownership, ends up buying bad loans of a borrower where there are sectoral caps, this does not lead to creation of equity stakes in such sector. The acquisition of an NPL does not mean acquisition of equity or ownership of the business of the borrower. True, ARCs have the power to cause change of management or takeover the management as well, but the so-called takeover of management under SARFSAESI Act is not buyout of a business. The law says that the takeover shall be only for the purpose of realisation of the loans, and once the loans have  been realised, the business will be handed back to the original owners. Takeover of management of business is a rarity – ARCs have caused management change, but have never so far taken over management themselves.

It is to be noted that SRs are essentially in the nature of equity – since the returns on the SRs depend on the money realised on recovery of the underlying loans. Though the RBI’s directions to ARCs put a maximum time frame for realisation of loans acquired by ARCs, practically, the repayment of the SRs depends on the realisation of the underlying loans. Hence, investment in SRs is more like an FDI than ECB. However, it is an FDI into the loans, and not FDI into the business from where the loan emanates – thus, not conflicting with the current FDI policy.

How would investment in SRs help Indian economy? Currently, given the restriction of 49% on investment in SRs, most SRs are being subscribed either by the banks that sell the NPLs themselves, or domestic NBFCs that qualify as “qualified institutional buyers.” Internationally, distressed debt has attracted international investors – this is particularly true for China. SRs in India make more sense than distressed debt in China, as ARCs in India are vested with special powers.

Therefore, there is a strong case for relaxing the limit of 49% in case of SRs. Is this likely to attract lot of money into the country? Given the soaring amount of NPLs and loans undergoing restructuring, the amount of NPLs in India will rise sharply in time to come. This may be the right time to attract international investors.

If any ARC acquires an asset of a sick company, does reference before BIFR abate?

Yes, says the Bombay High court. 

In Paper Prints (India) Pvt. Ltd vs Phoenix Arc Pvt. Ltd http://indiankanoon.org/doc/57289971/ , a Division Bench of the Bombay High court interpreted the second proviso to section 15 (1) of the SICA to suggest that where any financial assets have been acquired by an ARC. The ruling says that the second proviso and third proviso to sec 15 (1) are independent, and there is no presumption as to taking of action by any particular percentage of secured creditors under the second proviso. Under the second proviso, once the “financial assets” have been acquired by an ARC, reference shall not be made at all.

Our comments: So, the SICA becomes completely irrelevant! If there is any philosophy at all behind the SICA, that purpose or philosophy is completely rendered redundant. The drafting of the second and third provisos to sec 15 (1) is as bad as the whole of the SARFAESI Act itself, but with the interpretation placed by the Hon’ble Court, just because any loan or facility extended to a borrower have been acquired  by an ARC, the very process of rehabilitation gets negated. This seems like saying – move over rehabilitation, realisation takes over!

In fact, the onus of making reference under section 15 (1) is on the borrower, that is, the sick company. The board of directors of the sick company needs to make a reference, if the entity has become sick. The reference e has a wholesome purpose, which has been discussed by lots of authorities in lots of cases. If entities become sick, it does not serve the cause of economic development if such entities are allowed to fall dead freely. If a person becomes sick, humanity cannot allow him to die. Death of economic entities is even more serious than death of persons – as livelihoods of lots of families depends upon an economic entity.

The transfer of a financial asset is a transaction between a lender and the ARC. The sick company is not a party to it at all.  In many cases, the sick company may not have been notified, or may be notified much later.

With the interpretation placed by  the Hon’ble High court, a sick company shall not make a reference, if financial assets have been sold by a creditor to an ARC. The law does not specify, which financial assets, or how much financial assets? Sure enough, the “financial asset” in question cannot be the asset of the sick company. In any event, the proviso is an exception to the mandatory requirement under section 15 (1) on making of a reference. Unlike third proviso, the second proviso does not say that a reference already made shall abate.

The correct interpretation of second proviso should have been – if all loans/financial assets pertaining to a sick company have been sold to an ARC, then there is no role of the BIFR in such a case, as a secured creditor under the SARFAESI Act has the right to proceed with repossession even in case of sick companies. But if what is sold is just a one of the many loans, there is no reason whatsoever as to the hope of revival of the company fading away. It is not at all proper to allow the wholesome process of revival of entities to be overshadowed by the self-centric provisions of SARFAESI Act.

Asset Reconstruction Companies – Making Good Misuse of the Law

Headline news in financial press today [here] carried a seemingly-sensational story about one of the leading asset reconstruction companies (ARCs) working under stress of its major shareholders, practices about breaches of law and regulations by the ARCs and so on. For those several people, including professionals, who would have some experience of dealing with ARCs, this is hardly surprising, because many would know that ARCs have been engaged in variety of practices including arm-twisting troubled companies into accepting loans at steep rates of interest from private lenders, allowing private lenders to enforce security interests on assets without satisfying the claims of banks and financial institutions, getting allotment of shares in troubled companies, forcing change in management in violation of RBI norms on takeover of management, etc. Many, however, many not know that ARCs have been vested with special legal powers that need to be deployed in strict compliance with the law, and therefore, many things that ARCs are doing currently are outright illegal.

In fact, in a larger context, the very institution of ARCs, vested with special powers of recovery, is as much a misconceived idea as the parent legislation under which the ARCs are created.

Models of ARCs: Indian model and international models:

While ‘asset reconstruction company’ may be a typical Indian expression, possibly due to the heritage of the Narsimham Committee referring to an asset reconstruction fund, the global model of dealing with non-performing assets is called asset management companies (AMCs). The first most important point to note is that AMCs are created to resolve the problem of NPAs that result from a systemic crisis. That is, if a systemic crisis leaves the banking system infested with bad loans, there has to be a one-time, central remedy to resolve the problem. AMCs are not envisaged, and intuitively cannot have been envisaged, to resolve the problem of loans that go bad due to bad lending.

Therefore, most countries brought about AMCs as a one-time measure with a sunset clause. The classic example is that of the Resolution Trust Corporation of the USA that acquired assets of savings and loans associations in the 1990s. Closer home, the Danharta of Malaysia is an example that took over loans that went bad due to the 1997 SE Asian crisis, and once the loans were resolved, it wound up its affairs.

Whether one-time or continuing, AMCs in most countries have taken the centralized AMC model – that is, one AMC formed to resolve a systemic crisis.

In India, our unique ARC model has lot of differences from the global models. First, there has not been any systemic crisis that the ARCs seek to resolve. Most of the bad loans in India are a product of bad lending – they represent what is called the flow problem, rather than the stock problem. Second and a key difference is that we have not envisaged a sunset clause for the ARCs – the SARFAESI Act envisages ARCs to be an ongoing business model. Hence, it could not have been a response to a systemic crisis. On a policy plane, it sounds completely counter-intuitive for an agency armed with special powers conferred by law to come and rescue a loan that goes bad due to bad lending. What are the insolvency laws, winding up laws and civil laws on recoveries are doing, if a special law had to come to resolve every loan that goes bad? Hence, the very concept of ARCs in India seems to be a paradox. It is easy to attribute the concept of ARCs to the Narasimham Committee, but the Narsimhan committee had not thought of profit-seeking companies fitting the bill of ARCs in the country.

That brings us to the third significant difference – a single AMC versus multiple ARCs. In India, over the years, several ARCs have come into existence. In fact, ARC has become a business model.

Vesting a profit-driven entity with special powers:

From a legal policy perspective, how does not envision a profit-driven, shareholder-wealth-maximising entity resolving the problem of bad loans? Sure enough, bad loan resolution is a business model, but such a business model has to fit into the overall regime of recovery of loans, enforcement of security interests, and so on. It would be hard to think of entities armed with special powers of the law that buy bad loans and resolve them. If power corrupts, then a special power would corrupt especially. Sure enough, there is no equity and justice on the part of a borrower who does not pay a loan, but then one cannot close eyes to the fact that lenders who foreclose loans quite often commit excesses. Assets are sold in opaque manner, at prices that do not represent fair values. Sure enough, one cannot expect a borrower-centric fair deal from an entity that has to focus on shareholder wealth.

Trust route: the easy escape route to regulation:

Another very unique feature of the Indian ARC model is that virtually all the NPAs are bought in the name of trusts, of which the ARC becomes the trustee. This is a simple device to wish away the regulation of the RBI. RBI regulations require capital adequacy, NPA treatment and income recognition norms in case of ARCs almost in the same tone as applicable to NBFCs. However, if the assets are bought in the name of ARCs, other than the mandatory investment requirement, much of the regulation is not applicable. This may sound real strange, as the legal privileges of the special powers are presumably available even where the assets are sitting in the books of the trusts.

In fact, this question – whether the powers of the ARCs are exercisable where the assets are sitting on trust books – is a significant question that has not been discussed adequately in legal forums. In order for exercise of the special powers, the asset must be an NPA in accordance with the directions of the RBI – the directions which are not applicable in case of trusts. So, the issue is, if the directions are not applicable to trusts, are the trust assets NPAs are per directions of the RBI?

ARCs – traveling much beyond their limited business:

ARCs have a very limited sphere of powers allowed by law – their powers are limited by the SARFAESI Act. Whatever else they do has to be incidental or ancillary to what they are permitted to do under the law. An ARC is not a normal business entity that can buy equity shares, takeover management of businesses, engage finance companies to acquire loans of the defaulting companies, and so on. However, in real world, ARCs are being run exactly as bania shops.

Sale of assets the opaque way:

Also, the sale of assets by ARCs, in spirit, is no different from the sale of assets by state finance corporations and others vested with special powers of recovery. Courts have, over the years, ruled that there is no scope for any lack of transparency in causing a sale of the borrower’s assets, because every single penny realized from the sale goes to the credit of the borrower. It is also clear in SARFAESI Act that the ARC acts as the trustee of the borrower in exercising the rights of sale of the property. Hence, any opaqueness in the sale is completely intolerable in law. There have been numerous instances where ARCs have sold assets by way of so-called private auctions, and simply served a notice on the borrower giving credit to the extent of sale proceeds. No account of how much was the sale proceed, who was the buyer, who were the competing bidders, how was the asset sold, how much were the expenses on sale, etc., have been provided to borrowers. ARCs have gone on record saying they are not obliged to disclose the particulars of the sale – this is completely erroneous.

Do trusts formed by Asset Reconstruction Companies have powers under SARFAESI Act? - Vinod Kothari

The asset reconstruction companies in India is a curious case in itself – the concept was conceived as a device for resolution of bad loans that arise out of a banking crisis, and in fact, it has become a business model by itself. I have discussed this issue elsewhere – see my note http://securitizationdossier.blogspot.com/2010/05/asset-reconstruction-companies-india.html. Recently, there has been a spurt in formation of asset reconstruction companies as there is apparently keen interest in buying distressed NPLs.

ARCs in India commonly buy the NPLs in the name of trusts, of which ARCs act as trustees. This practice sprung because RBI Directions and Guidelines on asset reconstruction companies exempted the assets acquired in the name of the trusts from several requirements of the SAFAESI Act and the Guidelines. Specifically, paragraphs 4, 5, 6, 9, 10(i), 10(iii) 12, 13, 14 and 15 of the Guidelines and Directions do not apply to trusts formed by the ARCs. This is quite strange of a regulator – imagine someone writing a list of rules, and in the next breath, writing an exception line that if you form a trust, then the list of rules that I just wrote will not be applicable. So, this is a clear invitation to exploit the exemption to the hilt because most of the rules that apply to assets bought by the ARCs on their own books do not apply when the NPLs are bought on the books of the trust.

And truly, asset reconstruction companies have exploited the trust route to the hilt. The 31^st March 2009 balance sheet of Arcil shows investments in security receipts of 344 trusts of which Arcil is the trustee. That would mean substantially all the NPLs that Arcil would have bought would be on the books of the trusts, with Arcil simply holding a fraction of the securities issued by the trusts.

And these trusts have been exercising powers under sec. 13 of the SARFAESI Act. Until recently, section 9 of the SARFAESI Act that empowers ARCs causing a takeover of the management of the borrower was lying in a dormant state as the RBI had not notified the guidelines on takeover, which it has now done.

Significant legal questions remain on the power of the trusts. Needless to say, the trusts are distinct from the ARC. The trust is not an asset reconstruction company – it is not a company at all. The books of the trust are different and those of the ARC are different. The assets of the trusts are not reflected in the balance sheet of the ARCs – if that were so, the whole purpose of forming the trusts would go away.

So, if the trust is not an ARC, neither a bank, does the trust have the right to exercise any of the powers granted to an ARC or a secured lender under the SARFAESI Act? People quickly look at the definition of “secured creditor” in sec. 2 (1) (zd) which includes exercise of powers by an ARC managing a trust set by the ARC.

But then, one should not overlook sec. 13 (2) which uses two significant words – “default” and “non-performing asset”. In order to invoke section 13 (2), there must have been a default, and the asset in question must have been characterized as a non-performing asset in the books of the secured creditor. The word “default” is defined in sec. 2 (1) (j) and “non performing asset” is defined in sec. 2 (1) (o). Reading both the provisions, it is clear that in order for constituting a default within the meaning of sec. 13 (2), the asset in question must have been classified as non-performing asset in the books of the secured creditor seeking recourse to the rights under sec. 13 (2).

Now, let us realize what happens in case of ARCs. There was originally a bank that held that asset. The asset was an NPA in the books of the bank. The bank sells the NPA to the ARC. In the books of the bank, the asset disappears – there in no question of the asset still being an NPA in the books of the bank. It cannot be said that the asset continues to be an NPA in the books of the buyer as well, since the RBI norms in case of sale of NPAs to financial system actually provide that where an NPL is sold by a bank, the buyer may treat it as a performing asset and observe the track record of recoveries versus expected recoveries. It is based on such track record that the asset may once again become an NPA in the books of the buyer, but surely, the NPA tag does not go with the asset. What is even more important is that the NPA classification norms are explicitly excluded in case of trusts of ARCs.

So, if the trust is not covered by the NPA norms of the RBI, it is clearly not possible for the trust to claim that the asset in question is characterized as an NPA in the books of the trust. If trusts use their discretion in doing so, it is still not an NPA as per directives of the RBI – which is mandatory to fall within the meaning of “default” under sec. 2 (1) (j).

That leads to the conclusion – the trusts have no power to exercise any of the rights under sec. 13 (2). And note that the powers under sec. 9 are not applicable to trusts at all, as the extended definition of “secured creditor” including the trusts is not applicable to sec. 9 – section 9 is limited to asset reconstruction company only.

Resultantly, neither sec 9 nor sec 13 (2) are available to trusts of ARCs. This may be quite a steep view to take – as thousands of crores of NPAs are sitting in these trusts. But when it comes to interpretation of law, it is not for the interpretor to cure the defects in language of the law – that is the job of the parliament. No one can contend that there was a great philosophy, discussed thread-bare, when the SARFAESI Act was drafted - actually, the very fact that clearly incompatible provisions of securitisation and enforcement of security interests were merged into a common law is a clear indication of lack of thinking. Nor can one contend that the powers that ARCs are enjoying in India is a globally accepted principle. So, if a fundamental challenge to the working of the ARCs forces a rethinking or rewrite of a very crude law, it should not be seen as legal vandalism.

Whether SARFAESI Act is applicable to derivatives dues of banks - Vinod Kothari

The Securitisation Act (SARFAESI Act) marks the swinging of the pendulum – law was against the lender and for the borrower prior to 2002; the SARFAESI Act swung the pendulum in favour of banks. Unfortunately, as the pendulum swings for one side to the other, it is still not a case of a balance.

The passing of the SARFAESI Act, banks and legal fraternity is taking a highly optimistic, and in the opinion of the author, a wrong view that all the debts of the bank against the borrower are covered by the SARFAESI Act. This is not a correct view as the Act is applicable only where the dues arise out of a “financial assistance”.

A derivatives contract is a trade between the bank and the borrower. Note that in accounting parlance, all derivatives deals are accounted for as trading assets/trading liabilities of the bank – they are not recognized as a part of the “banking book”. There is no question of the bank granting a “financial assistance” to the “borrower” when the bank enters into a derivatives deal with an entity. There is no question of an any “assistance”, as it is not that the bank is assisting, and the counterparty is assisted. No one knows for whom the derivative deal with turn out of the money. Hence, it is beyond any banking sense to take a derivatives deal as a borrowing-type transaction.

However, here is a curious case where not only has a derivatives deal been treated by a court as a “financial assistance”, the court has even invoked sec. 34 of the SARFAESI Act to block the action taken by the borrower in injuncting the bank from declaring the borrower as an NPA.

In State Bank of India v Sharda Spuntex P Ltd [1], an entity had been granted limit for purchase of forward contracts in foreign exchange. Upon the company failing to pay the dues of the bank, the bank characterized the account of the borrower as NPA. The borrower moved the civil court for a suit of injunction, which the lower court passed. The bank appealed to the High Court, citing sec. 34 of the SARFAESI Act as the reason to exclude the jurisdiction of the civil court in the matter. According to the bank, the amount owed by the borrower to the bank, albeit for purchase of foreign exchange, was debt owed to the bank, and that in the matter of recovery of debts, the jurisdiction of civil courts was excluded by sec. 34 of this Act. Analyzing the definition of “borrower”, the Rajasthan High court came to the conclusion that the grant of a limit for forward purchase of foreign exchange was a “financial assistance”, and the amount owed by the borrower was a “debt” and hence, the civil court had no jurisdiction in the matter.

With respect, the case is wrongly decided, on two counts. First, SARFAESI Act is limited to recovery of debts of the bank. In the instant case, the bank was not proceeding against the borrower for recovery of debt – instead, the borrower went against the bank claiming that the characterization of the debt as non-performing asset was wrongful. It is not even clear if the so-called forward purchase of foreign exchange by the borrower was backed by security interest – if not, the question of the bank using the SARFAESI Act for recovery of a derivative transaction did not arise at all. In any case, there was no proceeding under SARFAESI Act – hence, the question of bar of jurisdiction did not arise. Secondly, the forward purchase of foreign exchange is a derivatives transaction. The bank and the entity are two parties to a commercial transaction of purchase and sale. The bank is acting in its capacity as a derivatives dealer – it is not a case of grant of a financial assistance akin to a loan or credit facility. The Court went by the meaning of the term “debt”, without carefully analyzing the meaning of the term “borrower” and “financial assistance”. It is important to understand that the word “borrower” has no relevance unless the case is one of “financial assistance”. The word “financial assistance” has to be read ejusdem generis with other forms of financial assistance enumerated in sub-section (1) (k).

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[1] I(2010) BC 562 (Raj)

Asset reconstruction companies: India lacks thinking or reasoning

ARCIL, the first asset reconstruction company in India, started its operations in financial year 2003-4. As on date there are more than a dozen asset reconstruction companies registered with the Reserve Bank of India and most of them seem to have commenced operations. The Indian model of asset reconstruction companies differs substantially from the global model of companies formed to resolve systemically impaired loans. Briefly, the chief differences are:

Globally, asset management companies were formed to resolve loans that went bad because of a systemic crisis, not loans that went bad because of bad lending. In India, there is no finding that the loans that have gone bad in the past have suffered a systemic crisis. In fact, there is no evidence of a systemic or market crisis in India at all. Hence, the approach has had nothing to do with managing the evils of a system breakdown.
India is the only country where ARCs have sprung up as a business model, with special statutory powers granted by the lawmakers. There is no doubt that dealing with distressed assets is a global business, but in no other case have governments come forward to grant special incentives or special legal powers to profit-oriented asset management companies. In other words, where special powers were granted, as in case of Danaharta, Malaysia, the vehicle a singular brief – resolution of loans that went due to a system crisis. It is arguable whether asset reconstruction companies, which were envisaged as tool of resolving the problem of bad loans, could actually be a business model, and if it is a business model indeed, is there any justification for granting special statutory powers to them.
India is the only country where asset reconstruction companies do not have a sunset clause. In most other countries, such as USA, Malaysia, etc., asset management companies came in response to a crisis. Crisis resolution measures cannot be everlasting – they lose their meaning if they last forever.

Clearly, there has been no central thinking on the role and powers of ARCs. The Committee reports on whose recommendations the ARC model was initially mooted may have actually never envisaged an asset reconstruction business boom that India currently seems to have.