Banking Reforms – How to Deal with Wilful Defaulters
In light of the Nirav Modi and other scandals, the Indian Government is contemplating action against wilful defaulters. First, the government has brought a bill that will give authorities power to impound the assets of fugitive offenders in economic offenses involving Rs100 crore or more. The government is also contemplating special action against 91 wilful defaulters seeking to prevent them from leaving the country. Such actions against wilful defaulters can very well turn into a witch hunt against all borrowers unless government takes proper care. So what is a “wilful defaulter”?
 
Wilful Default
 
The term “Wilful Default” has been defined in clause 2.1.3 of Reserve Bank of India (RBI) circular dated 1 July 2015. RBI states that a loan default will be “wilful default” when:
 
a) The defaulting borrower has failed to pay but it has the ability to pay. In other words, there is a lack of intention to pay. A default occurs because of a lack of ability to pay, a lack of intention to pay or both. 
b) The defaulting borrower has not utilised the funds for the purposes for which they were sought but has diverted the funds to other ends.
c) The defaulting borrower has siphoned off the funds out of the borrower company – i.e. funds are not available with the company in the form of other assets.
d) The defaulting borrower has disposed off or removed the collateral securing the loan without the knowledge of the bank or lender.
 
RBI has further clarified the definition of diversion or siphoning of funds in clause 2.2.1 and 2.2.2 respectively. The term ‘diversion of funds’ includes any one of the following:
 
(a) Using short-term loans for long-term purposes 
(b) deploying borrowed funds for purposes or assets other than those for which the loan was sanctioned
(c) transferring borrowed funds to the subsidiaries / Group companies
(d) routing of funds through unrelated banks without prior permission of the lender;
(e) investment in other companies without approval of lenders;
(f) deployment of less funds than amounts disbursed / drawn and the difference not being accounted for. 
 
The term ‘siphoning of funds’, implies that borrowed funds are utilised for purposes unrelated to the operations of the borrower, to the detriment of the financial health of the entity or of the lender. 
 
Who decides if the default is “wilful default” or not?
 
The decision is made by a Committee headed by an Executive Director or equivalent and consisting of two other senior officers of the rank of General Manager (GM) or Deputy GM. Once this Committee has formed its opinion, then it issues show-cause notice to the borrower (i.e. promoter, whole time directors of the borrower). The show-cause notice gives the borrower opportunity to present her case to the committee – both making documentary submissions and in a personal hearing. After hearing the borrower, the Committee must pass an order. This Order must record the facts and also reasons why the Committee has concluded that the default is in fact a “wilful default”. 
 
But this is not the end. This decision by the Committee is reviewed by another Committee headed by the Chairman of the bank and the Order becomes final only after it is confirmed by the said Review Committee. Whether the default is wilful, whether there has been a diversion or siphoning of funds is the judgement of the lender based on objective facts and circumstances.
 
The Effect of declaration as “Wilful default”
 
Once the default is declared as wilful default and order is confirmed by the Review Committee, various parts of resolution machinery get activated. The action can be pursued under four main legislations – Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFESI) Act, the Companies Act, Insolvency and Bankruptcy Code (IBC) and Indian Penal Code (IPC). There is impact through Securities and Exchange Board of India (SEBI)  action as well.
 
SARFESI Act allows the lender bank to take control of the management of the business. Companies Act provides for punishment for fraud and same can be made applicable. It allows for prosecution of the directors and includes jail term and fines. The Indian Penal Code also allows for punishment for fraud, particularly in terms of criminal misappropriation of property. IBC has mechanism for resolution of the default loan and also penal provisions and disqualifications of defaulters. SEBI disallows “wilful defaulters” from boards and they are restricted from raising capital.
 
The criminal provisions and negative consequences described above are not attracted in case the borrower default is not a “wilful default”. Thus, once declared as wilful defaulter, the borrower is severely constrained. The order of the Committee and confirmation of the Review Committee assume great importance. Any lacuna or deficiency in the procedure of the Committee or Review Committee shall create a serious setback.
 
The challenges
 
The relationship between borrower and lender is dynamic. Once the relationship breaks down the blame-game starts and in such a scenario banks hold unbridled bargaining power.  This leads to potential for abuse. 
 
Firstly, there is scope for conflicts of interest. First, lenders may be reluctant to admit their genuine mistake in appreciation of risks of the business. A normal default, however, does not bode well for those approving the loans. But unless collusion can be proved, the burden of “wilful default” falls entirely on the borrower. Thus, there is a subtle incentive to declare the defaulter to be “wilful defaulter”. 
 
Second, the definitions of diversion and siphoning, while well intentioned, can be misused. This is particularly true in case of subsidiaries and payments to related-parties. Many loan agreements do not clearly state the specific mechanism for application of funds. Thus, a company may not be able to create a subsidiary post-loan approval lest it be construed as siphoning or diversion.
 
Third, most companies taking loans do not foresee a default, in fact many do not provision for default in the loan agreements. When such agreements and promoter and director behaviour is evaluated post-default many corporate practices become questionable. And taken together even legitimate promoter and director behaviour seems to take sinister overtones. 
 
Fourth, the public needs to understand that lending by design involves risk. Thus, not all loans will be repaid despite the good intentions of the promoters. 
 
In India we have habit of declaring promoters guilty before understanding whether it was genuine business failure or malicious siphoning of funds. If the regulations are too oppressive then genuine risk-taking will get hurt. Conversely, if the regulations are too ambiguous the unscrupulous borrowers who cheat the system will get away.
 
Finally, even when the loan is termed as “wilful default” the attributing the default to specific directors and promoters may not be easy. After Gujarat High Court held the circular ultra vires insofar as it related to all directors, RBI clarified that non-whole-time directors will be tagged as wilful defaulters only in rare instances. However, according to RBI circular dated 9 September 2016, a guarantor who declines to pay may also be declared as “wilful defaulter”. Considering the habit of Indian Banks to evoke guarantors without following proper process this provision is open to abuse. 
 
The dilemma
 
The problem with “wilful default” is complicated. It is expeditious to use the lenders’ Committee to determine whether the default is wilful or not. Technically, the decision is taken with due care after review by senior officers. However, it does not fit with the incentive structure. Ideally, Debt Recovery Tribunal (DRT) or some such legal authority should adjudicate on Order of the Review Committee. However, this will introduce considerable delays in the process.
 
The law may include a provision for physical presence in such hearing and failing which a presumption of flight-risk can be drawn against promoters and directors. Further, guarantors should not be tagged as wilful defaulters unless due process is conducted in case of the guarantors as well. 
 
Government should take the help of industry to design better mechanism to assist between genuine and unscrupulous borrowers. Industry may resort to well-drafted, standardised loan agreements to ease compliance. It may also create an oversight board to give independent view on whether borrower is “wilful defaulter”. Such board’s recommendation may not be binding but will help exonerate genuine borrowers from the legal difficulties. These mechanisms can be designed quickly and improved iteratively. Industry, on its part, should also conduct a proper discussion or seminar and present the findings to the Government.
 
The clean up the credit culture in the country should not result in impairing the credit system of the country itself. In absence of deep bond markets, bank credit and consortium lending are critical for MSMEs and even larger borrowers to access lower cost capital. 
 
Notes:
 
RBI Circulars
 
1. DBR.No.CID.BC.57/20.16.003/2014-15 dated 1 July 2014 & updated 7 January 2015
2. DBOD.No.CID. 41/20.16.003/2014-15 dated 9 September 2014
 
(Rahul Prakash Deodhar is a lawyer, investor and author with experience spanning manufacturing, consulting, investment banking firms. He has advised a wide range of clients including Fortune 500 companies, public and private sector banks, hedge funds and private equity funds among others. He has developed econometric models for demand forecasting in real estate, metals, airlines, and shipping. He designed MIS and planning and budgeting systems, sales networks, and operations for large corporates. He has worked with Aditya Birla Group, CRISIL and Morgan Stanley. He is author of two books – Subverting Capitalism and Democracy and Understanding Firms. He can be reached at [email protected] or at his website www.rahuldeodhar.com.)
Comments
Dhananjaya Bhupathi
3 years ago

Thanks to Nirav Modi for pinpointing loop holes in the Banking system[s] looting thousands of crores with impunity for years together. Though a bad element, he gave a deep & effective shock to UFM/MOF/RBI/IBA/PSBs , who were in deep slumber. when thousands of crores were looted silently by circumventing the systems/procedures laid down. a century ago.
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