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Context to the Supreme Court Order on stressed assets of banks

The increasing Non-Performing Assets (NPAs) in the Indian banking sector has recently been the subject of much discussion and scrutiny.  Yesterday, the Supreme Court struck down a circular dated February 12, 2018 issued by the Reserve Bank of India (RBI).  The RBI circular laid down a revised framework for the resolution of stressed assets.  In this blog, we examine the extent of NPAs in India, and recent events leading up to the Supreme Court judgement.

What is the extent and effect of the NPA problem in India?

Banks give loans and advances to borrowers. Based on the performance of the loan, it may be categorised as: (i) a standard asset (a loan where the borrower is making regular repayments), or (ii) a non-performing asset. NPAs are loans and advances where the borrower has stopped making interest or principal repayments for over 90 days.

As of 2018, the total NPAs in the economy stand at Rs 9.6 lakh crore.  About 88% of these NPAs are from loans and advances of public sector banks.  Banks are required to lend a certain percentage of their loans to priority sectors.  These sectors are identified by the RBI and include agriculture, housing, education and small scale industries.[1]  In 2018, of the total NPAs, 22% were from priority sector loans, and 78% were from non-priority sector loans. 

In the last few years, gross NPAs of banks (as a percentage of total loans) have increased from 2.3% of total loans in 2008 to 9.3% in 2017 (see Figure 1). This indicates that an increasing proportion of a bank’s assets have ceased to generate income for the bank, lowering the bank’s profitability and its ability to grant further credit.

Figure 1: Gross NPAs (% of total loans)

Source: Reserve Bank of India; PRS

What has been done to address the problem of growing NPAs?

The measures taken to resolve and prevent NPAs can broadly be classified into two kinds – first, remedial measures for banks prescribed by the RBI for internal restructuring of stressed assets, and second, legislative means of resolving NPAs under various laws (like the Insolvency and Bankruptcy Code, 2016).

Remedial Measures

Over the years, the RBI has issued various guidelines for banks aimed at the resolution of stressed assets in the economy. These included introduction of certain schemes such as: (i) Strategic Debt Restructuring (which allowed banks to change the management of the defaulting company), and (ii) Joint Lenders’ Forum (where lenders evolved a resolution plan and voted on its implementation).   A summary of the various schemes implemented by the RBI is provided in Table 1. 

Table 1: Non-legislative loan recovery framework

Loan restructuring

  • Banks internally undertake restructuring of loans, if the borrower is unable to repay the amount.  This involves changing the terms of repayment, which includes altering the payment schedule of loans or interest rates.

Corporate Debt Restructuring

  • Allows for restructuring of a borrower’s outstanding loans from more than one bank.  This mechanism is available if the borrower’s outstanding loans are more than Rs 10 crore.[2]

Joint Lender's Forum

  • Lenders evolve an action plan to resolve the NPA of a defaulter.[3]  If 60% of the creditors by value, and 50% of the creditors by number agree, a recovery plan will be implemented.[4]

5:25 Scheme

  • Banks can extend loan term to 25 years based on cash flow of projects for which the loan was given.  Interest rates and other terms of the loans may be readjusted every five years.[5]

Strategic Debt Restructuring

  • Banks convert their debt into equity to hold a majority of shares in a company.  This allows banks to change the management of the defaulting company.[6]

Sustainable Structuring of Stressed Assets

  • Allows for conversion of a part of the outstanding debt to equity or preference shares if: (i) project for which loan was taken has commenced operations, and (ii) borrower can repay over 50% of the loan.[7]

Sources: RBI scheme guidelines; Economic Survey 2016-17; PRS.

Legislative Measures

  • The Insolvency and Bankruptcy Code (IBC) was enacted in May 2016 to provide a time-bound 180-day recovery process for insolvent accounts. When a default occurs, the creditors or debtor may apply to the National Company Law Tribunal for initiating the resolution process. Once the application is approved, the resolution process will have to be completed within 180 days (extendable by 90 days) from the date of approval.  The resolution process will be presided over by an insolvency professional to decide whether to restructure the loan, or to sell the defaulter’s assets to recover the outstanding amount.  If a timely decision is not arrived at, the defaulter’s assets are liquidated.
  • The Banking Regulation (Amendment) Act, 2017: The amendment allows RBI to direct banks to initiate recovery proceedings against defaulting accounts under the IBC.  Further, under Section 35AA of the Act, RBI may also issue directions to banks for resolution of specific stressed assets. 

In June 2017, an internal advisory committee of RBI identified 500 defaulters with the highest value of NPAs.[8]  The committee recommended that 12 largest non-performing accounts, each with outstanding amounts greater than Rs 5,000 crore and totalling 25% of the NPAs of the economy, be referred for resolution under the IBC immediately.  Proceedings against the 12 largest defaulters have been initiated under the IBC. 

What was the February 12 circular issued by the RBI?

Subsequent to the enactment of the IBC, the RBI put in place a framework for restructuring of stressed assets of over Rs 2,000 crore on or after March 1, 2018.  The resolution plan for such restructuring must be unanimously approved by all lenders and implemented within 180 days from the date of the first default.  If the plan is not implemented within the stipulated time period, the stressed assets are required to be referred to the NCLT under IBC within 15 days.  Further, the framework introduced a provision for early identification and categorisation of stressed assets before they are classified as NPAs.

On what grounds was the RBI circular challenged?

Borrowers whose loans were tagged as NPAs before the release of the circular recently crossed the 180-day deadline for internal resolution by banks. Some of these borrowers, including various power producers and sugar mills, had appealed against the RBI circular in various High Courts. A two-judge bench of the Allahabad High Court ruled in favour of the RBI’s powers to issue these guidelines, and refused to grant interim relief to power producers from being taken to the NCLT for bankruptcy. These batch of petitions against the circular were transferred to the Supreme Court, which issued an order in September 2018 to maintain status quo on the same.

What did the Supreme Court order?

The Court held the circular issued by RBI was outside the scope of the power given to it under Article 35AA of the Banking Regulation (Amendment) Act, 2017.  The Court reasoned that Section 35AA was proposed by the 2017 Act to authorise the RBI to issues directions only in relation to specific cases of default by specific debtors.  It held that the RBI circular issued directions in relation to debtors in general and this was outside their scope of power.  The court also held that consequently all IBC proceedings initiated under the RBI circular are quashed. 

During the proceedings, various companies argued that the RBI circular applies to all corporate debtors alike, without looking into each individual’s sectors problems and attempting to solve them.  For instance, several power companies provided sector specific reasons for delay in payment of bank dues.  The reasons included: (i) cancellation of coal blocks by the SC leading to non-availability of fuel, (ii) lack of enough power purchase agreements by states, (iii) non-payment of dues by DISCOMs, and (iv) delays in project implementation leading to cost overruns.  Note that, in its 40th report, the Parliamentary Standing Committee on Energy analysed the impact of the RBI circular on the power sector and noted that the ‘one size fits all’ approach of the RBI is erroneous. 

 

 

[1]Priority Sector Lending – Targets and Classification’ Reserve Bank of India, July 2012, https://rbi.org.in/scripts/NotificationUser.aspx?Id=7460&Mode=0

[2] Revised Guidelines on Corporate Debt Restructuring Mechanism, Reserve Bank of India, https://www.rbi.org.in/upload/notification/pdfs/67158.pdf

[3]Framework for Revitalising Distressed Assets in the Economy – Guidelines on Joint Lenders’ Forum (JLF) and Corrective Action Plan (CAP)’, Reserve Bank of India, February 26, 2016, https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=8754&Mode=0

[4] Timelines for Stressed Assets, Press Release, Reserve Bank of India, May 5, 2017, https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10957&Mode=0

[5] Flexible Structuring of Long Term Project Loans to Infrastructure and Core Industries, RBI, July 15, 2014, https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=9101&Mode=0

[6] Chapter 4, The Economic Survey 2016-17, http://unionbudget.nic.in/es2016-17/echap04.pdf

[7]RBI introduces a ‘Scheme for Sustainable Structuring of Stressed Assets’’ Press Release, Reserve Bank of India, June 13, 2016, https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=37210

[8] RBI identifies Accounts for Reference by Banks under the Insolvency and Bankruptcy Code (IBC), Reserve Bank of India, June 13, 2017, https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=40743

Chit funds: Q & A

These are challenging times for chit fund operators. A scam involving the Saradha group allegedly conning customers under the guise of a chit fund, has raised serious questions for the industry. With a reported 10,000 chit funds in the country handling over Rs 30,000 crore annually, chit fund proponents maintain that these funds are an important financial tool. The scam has also sparked responses from both the centre and states: the Finance MinistryMinistry of Corporate Affairs and SEBI have all promised to act and the West Bengal Assembly has passed The West Bengal Protection of Interest of Depositors in Financial Establishments Bill, 2013, with Odisha and Haryana considering similar legislation. What is a chit fund? A chit fund is a type of saving scheme where a specified number of subscribers contribute payments in instalment over a defined period.  Each subscriber is entitled to a prize amount determined by lot, auction or tender depending on the nature of the chit fund.   Typically the prize amount is the entire pool of contribution minus a discount which is redistributed to subscribers as a dividend. For example, consider an auction-type chit fund with 50 subscribers contributing Rs 100 every month. The monthly pool is Rs 5,000 and this is auctioned out every month.  The winning bid, say Rs 1000, would be the discount and be distributed among the subscribers. The winning bidder would then receive Rs 4,000 (Rs 5,000 – 1,000) while the rest of subscribers would receive Rs 20 (1000/50).  Winners cannot enter the auction again and will be liable for the monthly subscription as the process is repeated for the duration of the scheme.  The company managing the chit fund (foreman) would retain a commission from the prize amount every month.  Collectively, the subscribers to a chit fund are referred to as a chit group and a chit fund company may run many such groups. What are the laws governing chit funds? Classifying them as contracts, the Supreme Court has read chit funds as being part of the Concurrent List of the Indian Constitution; hence both the centre and state can frame legislation regarding chit funds.  States like Tamil Nadu, Andhra Pradesh and Kerala had enacted legislation (e.g The Kerala Chitties Act, 1975 and The Tamil Nadu Chit Funds Act, 1961) for regulating chit funds. Chit Funds Act, 1982 In 1982, the Ministry of Finance enacted the Chit Funds Act to regulate the sector.  Under the Act, the central government can choose to notify the Act in different states on different dates; if the Act is notified in a state, then the state act would be repealed[i].  States are responsible for notifying rules and have the power to exempt certain chit funds from the provisions of the Act.  Last year the central government, notified the Act in Arunachal Pradesh, Gujarat, Haryana, Kerala and Nagaland. Under the Act, all chit funds require previous sanction from the state government.  The capital requirement for establishing chit funds is Rs 1 lakh and at least 10% of profits should be transferred to a reserve fund.  The amount of discount (i.e. the bid) is capped at 40% of the total chit fund value.    States may appoint a Registrar who would be responsible for regulation, inspection and dispute settlement in the sector. Any grievances over decisions made by the Registrar can be subject to appeals directed to the state government. Chit fund managers are required to deposit the entire value of the chit fund (can be done in 50% cash and 50% bank guarantee) with the Registrar for the duration of the chit cycle. Prize Chits and Money Circulation Schemes (Banning) Act, 1978 The Prize Chits and Money Circulation Schemes (Banning) Act, 1978 defines and prohibits any illegal chit fund schemes (e.g. schemes where auction winners are not liable to future payments).  Again, the responsibility for enforcing the provisions of this Act lies with the state government. Reports suggest that the government is discussing amendments to this Bill in the wake of the chit fund scam. West Bengal Protection of Interest of Depositors in Financial Establishments Bill, 2013 Last month the West Bengal Assembly passed the West Bengal Protection of Interest of Depositors in Financial Establishments Bill, 2013. This was a direct response to the chit fund scam in West Bengal. While not regulating chit funds directly, the Act regulates and restricts financial establishments to curb any unscrupulous activity with regards to deposits.  Chit funds are specifically included under the definition of deposits. The state government will appoint a competent authority to conduct investigations. What is the role of RBI and SEBI? The Reserve Bank of India (RBI) is the regulator for banks and other non banking financial companies (NBFCs) but does not regulate the chit fund business. While chit funds accept deposits, the term ‘deposit’ as defined under the Reserve Bank of India Act, 1934 does not include subscriptions to chits. However the RBI can provide guidance to state governments on regulatory aspects like creating rules or exempting certain chit funds. As the regulator of the securities market, SEBI regulates collective investment schemes.  But the SEBI Act, 1992 specifically excludes chit funds from their definition of collective investment schemes. In the recent case with Sarada Group, the SEBI investigation discovered that Sarada were, in effect, operating a collective investment scheme without SEBI’s approval.


[i] The central act repeals the Andhra Pradesh Chit Funds Act, 1971; the Kerala Chitties Act, 1975, the Maharashtra Chit Funds Act, 1974’, the Tamil Nadu Chit Funds Act, 1961 (applicable in Chandiragh and Delhi), the Uttar Pradesh Chit Funds Act, 1975,  Goa, Daman and Diu Chit Funds Act, 1973 and Pondicheery Funds Act, 1966.