Recently, Vijay Mallya shifted his base from India to London and news has been filled with news items such as “Vijay Mallya tagged as Willful defaulter”, “PNB Declares UB as Willful Defaulters”. After reading all these headlines, the questions that crop up are: Who is a willful defaulter? In what circumstances the default becomes willful? Who has the authority to label a corporation or an individual as willful defaulter? The concept of ‘Willful Defaulter’ was introduced back when the Reserve Bank of India (RBI) (in order to curtail the increasing menace of Non-Performing Assets (NPAs) of the Banks), as per its power under Sections 21 and 35A of the Banking Regulation Act, 1949, issued the Master Circular which defined Willful Defaulter and detailed the measures to be adopted by the Banks and Financial Institutions (FIs) to adjudge the instances of default i.e. whether the same is a willful default or not.
The Master Circular specifically mentioned the instances of willful default i.e. where a borrower does: i) not meet his obligations even when he has the capacity to do so, ii) not utilizes the funds for specific purpose they have been availed for, iii) siphon the funds neither for the purpose they were availed for nor have it in other form of assets, iv) dispose the property or assets which were given for securing the loan without the knowledge of the lender, v) misrepresentation and falsification of reports, and vi) fraudulent transactions.
RBI has laid down the guidelines to be followed by the Banks or FIs to declare a borrower as a willful defaulter. The procedure is as follows:
- A committee which is composed of higher functionaries headed by Executive Head or a person of equal rank of the concerned Bank/FI and two General or Deputy General Managers shall examine the occurrence of willful default by the company or its whole time director.
- Thereafter, the committee will issue the show cause notice to the borrower for their submission and may be followed by a personal hearing, if necessary.
- Only after considering the submissions, the committee will issue an order of willful default. The order should be well documented, reasoned and encompass evidence for the scenario/ instance for which the borrower has been declared as a willful defaulter.
- This order shall be further reviewed by the Review Committee headed by the Chairman, Managing Director or CEO of the Bank/FI and two independent directors of the Bank/FI. The order identifying the borrower as a willful defaulter will be final if the Review Committee is of the same view.
RBI requires the Bank/FI to adhere to the prescribed procedure for labeling a borrower as a willful defaulter and the order identifying the borrower as a willful defaulter must be informed. The Hon’ble High Court of Calcutta in the case of Santanu Ghosh and Ors. vs. The State Bank of India and Ors. (MANU/WB/0516/2013), observed that the consequences of a borrower being labeled as willful defaulter is grave and the borrower if labeled as willful defaulter would unlikely qualify thereafter to be able to obtain any credit facilities from Bank/FI. Therefore, in view of such serious consequences, RBI makes a two-fold procedure and in any case, the procedure has to be adopted with every opportunity to be afforded to a borrower sought to be labeled as a willful defaulter to question the basis for the formation of the opinion that default by the borrower is willful and meet the conditions mentioned under the master circular for classification of willful defaulter.
RBI has not only set the strict rules for the Banks and FIs whereby restricting the willful defaulters from raising any fresh funds but also instructed the market regulators to keep them away from raising any money from the public. Reacting to this SEBI also issued a notification barring willful defaulters from raising any money from the public through stocks, bonds and from setting up any market intermediaries such as mutual funds and brokerage firms. Moreover, a director of the entity declared as willful defaulter is not allowed to take board position at listed companies. This move by SEBI drew the significance from Vijay Mallya’s resignation from the Chairmanship and Directorship of United Spirits Ltd. but holding the board position of some other companies. Now, as per this notification of SEBI, if the Director is labeled as willful defaulter then he cannot hold the board position of any other company.
The questions are raised on the powers of RBI to issue the said master circular and it was well observed by the Hon’ble High Court of Gujarat in the case of Ionic Metalliks vs. Union of India (MANU/GJ/0683/2014), where the Hon’ble High Court was of the view that RBI is “empowered to regulate the banking system and certain regulatory functions have been assigned to it by the provisions of the Reserve Bank of India Act, 1934 and the Banking Regulations Act, 1949”. The application of legal maxim “nemo judex in causa sua” which means that no one can judge a case in which they have an interest was also pressed and in that relation, the Court said that the bank itself will be a judge in its own case is completely misplaced and a mere possibility or likelihood of abuse of power does not make the provision ultra vires or bad in law.
The Court also considered the issue of making every director responsible without considering the role of each of the directors and held it as unreasonable and arbitrary and was of the view that it is ultra vires the powers of the RBI and is violative of Article 19(1)(g) of the Constitution of India. The Court said that the company is a juristic person and “for all acts of the company each and every director need not be held responsible. It would depend upon the role of each of the directors so far as the day-to-day management and affairs of the company are concerned.”
Now, the master circular says that the Bank/FI cannot label a non whole time director as willful defaulter unless it is conclusively established that the said director was “aware of the act of willful default by the borrower by virtue of any proceedings recorded in the Minutes of the Board or a Committee of the Board and has not recorded his objections to the same, or willful default by the borrower had taken place with his consent or connivance.” Also, the Bank/FI has to follow the same process as prescribed for the borrower to classify a non promoter and non whole time director as a willful defaulter.
Moreover, in accordance to Section 128 of the Indian Contract Act, 1872 which talks about the guarantor’s liability, and states that “the liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.”, gave the power to Banks/FIs to go to the guarantor if the principal borrower defaults in his obligations even before exhausting the remedies against the principal borrower. If the claim is made by the Bank/FI against the guarantor and the said guarantor does not fulfill his obligations despite his capacity to do so, then such guarantor shall also be treated as a willful defaulter. It is well established that the liability of the guarantor is co-extensive with that of the principal borrower, but without adjudicating the case of the principal borrower, it is wrong to label the guarantor as a willful defaulter. This shifts the burden of risk analysis and due diligence on the guarantors, whereas Banks/FIs are primarily responsible for this and have better access to monitor the use of funds by the principal borrower.
Label of ‘willful default’ has draconian consequences and it cuts the inflow of funds from every possible source and finally leads to cessation of business. After all these strict set of rules in place, there is a huge list of companies which are labeled as willful defaulter.
One possible explanation to this would be that the legal machinery in India for recovery of bad debts is too lax and time consuming. As per reports, it takes 4.5 years on an average to resolve insolvency in India which is 1 year in UK and 1.5 years in USA. Moreover, in India only 20% of loan is recovered in case of insolvency which is 70 % in developed countries. One potential source of loan in India is loan against collateral security which in case is safe also as the amount of loan is lesser than the value of the security but in India the laws are too default-friendly that this has become one of the potential source of default as borrower can easily dispose off the secured property without informing the lender and thus, hide the proceeds.
In light of alarming number of willful default and NPA cases, the Indian Government brings up the new bankruptcy law in place i.e. Insolvency and Bankruptcy Code, 2016. This step was much awaited as India has liberalized its banking system but there was no effective and efficient law in place to back it up. This Code aimed to provide timely resolution for bankruptcy and insolvency cases.
The Code lays down the similar process for individuals and companies to resolve insolvency in maximum of 180 days time period (can be extended to another 90 days only in exceptional cases), which is to be conducted by the experts defined under the Code as “Insolvency Professionals”. It put an end to time consuming and overlapping jurisdictional issues due to presence of multiple forums and established a single window to deal expeditiously with the matters of insolvency.
The increase in cases of willful default is not only because there is no effective legal recourse available with the lenders. It has been observed that Indian Banks and FIs follow a uniform set of guidelines and rules for lending to every project and sector. This need to change and lending mechanism should be customize as per the project requirements and only after evaluating the peculiarities of that particular sector.
An effective lending mechanism should be accompanied by an efficient monitoring mechanism which will raise an alarm as soon as there is any discrepancy or neglect on the part of the borrower. And these should be accompanied by an easy exit route which is to adopt if both lending mechanism and monitoring system fail to catch the default.
In conclusion, it is pertinent to point out that it is not enough to have such strict rules as laid down by the RBI because sometimes the default may be due to circumstances beyond the borrower’s control. It is more important to evaluate the risk associated with the project before lending and develop the lending after deep study of the project, sector and borrower. A continuous monitoring of lending may help in detecting the default during initial stages and if there is default then that may thereafter be resolve by an effective resolving process or schemes like Strategic Debt Reconstructing.
Therefore, in spite of such stringent rules in place and severe consequences of label ‘willful defaulter’ there is a huge list of willful defaulters in India. These rules if combined with proper lending and monitoring mechanism may help in dealing with the situation. An introduction of Insolvency and Bankruptcy Code, 2016 is a right step in right direction but there is a long way to go.
Published on September 12, 2016
Author: Suraj Choudhary, Associate
Samisti Legal LLP