Banking Law

[By Suprabh Garg and Arshit Kapoor] The authors are third and second year students of National Law University, Odisha BACKGROUND The Reserve Bank of India (“RBI”) has finally released the much-awaited circular for dealing with stressed assets named Prudential framework for Resolution of Stressed Assets (“Framework”) [[i]]. This circular is a replacement for the earlier circular on Resolution of Stressed Assets dated 12th February 2018 (“Earlier Circular”) [[ii]]. The earlier circular had been struck down by the Hon’ble Supreme Court in Dharani Sugar and Chemical Ltd. v. Union of India [[iii]]. The Framework is released by the RBI with a view for providing early recognition, reporting and time bound resolution of stressed assets. This Framework and Direction is issued by the RBI without prejudice to Section 35 AA of The Banking Regulation Act, 1949 which empowers the RBI to direct banks for initiation of insolvency proceedings against specific borrowers [[iv]]. APPLICABILITY The Framework has expanded the scope of applicability and covers in the definition of “lenders”: Scheduled Commercial Banks All India Term Financial Institutions Small Finance Banks; and Systemically Important Non- Deposit taking Non- Banking Financial Companies (NBFC-ND-SI) and Deposit taking Non-Banking Financial Companies (NBFC-D). MODUS OPERANDI-FRAMEWORK FOR RESOLTION OF STRESSED ASSETS The modus operandi of the Framework can be fragmented into the following systematic and sequential steps as under: Early Identification and Classification Of Stresses Assets The lenders, upon default have to recognize and classify the emerging-incipient stress in loan accounts and classify them into Special Mention Accounts (“SMA”). The word ‘default’ has been assigned the same meaning as defined under Section 3 (12) of IBC The classification of debts into Special Mention Accounts shall be done as per the following categories: In case of stress other than revolving credit facilities like cash credits, the SMA sub-categories will be as follows: SMA Sub- Categories Basis for Classification- Principal/ Interest Payment/ Any other amount wholly or partly overdue between SMA-0 1-30 Days SMA-1 31-60 Days SMA-2 61-90 Days   Whereas in case of stress revolving credit facilities like cash credits, the SMA sub-categories will be as follows:     SMA Sub- Categories Basis for Classification- Outstanding balance remains continuously in excess of the sanctioned limit or drawing power, whichever is lower, for a period of: SMA-1 31-60 Days SMA-2 61-90 Days   Reporting Of Stresses Assets The lenders have to then, report to the Central Repository of Information on Large Credits (“CRILC”) regarding the credit information, including the classification into SMA, of all borrowers having an aggregate exposure of ₹ 5 crores or more, with them. The lenders in this regard have to submit CRICL-Main Report on monthly basis and a weekly report of the instances of default by all borrowers having an aggregate exposure of ₹ 5 crores or more, with them. Resolution Plan As per the Framework all the lenders have to place a board RP which would contain the action, plan and reorganization of stressed assets. The RP may also include the reorganization of the accounts by payment of all over dues, sale of exposures to other entities, change in ownership, restructuring etc. All the RPs have to be well-documented by all the lenders concerned [[v]]. Review Period In cases, where any default is reported by any of the Scheduled Commercial Banks, All India Term Financial Institutions or Small Finance Banks, they have to take a prima facie review of the borrower account within thirty days of such default. (“Review Period”). The Framework has given complete discretion to the lenders to decide on the resolution strategy, the nature of the resolution plan and the approach for implementation of resolution plan. Inter-Creditor Agreement The lenders have to then enter into an inter-creditor agreement (“ICA”) during the Review Period to finalize the ground rules and their strategy for implementation of RP.  Furthermore, the ICA has to inter-alia provide for rights and duties of majority lenders, duties and protection of dissenting lenders etc. The Framework provides the threshold of 75% by value of total outstanding credit facilities and 60% of lenders by numbers, for the decision to be binding on all the concerned lenders. Time Period for Implementation The Framework mandates the implementation of RP within 180 days from the end of review period. Further, with respect to existing defaults, the review period shall commence from 7th June, 2019 for all the defaults having an aggregate exposure of ₹ 2,000 crores and 1st January, 2020 for all the defaults having an aggregate exposure between ₹ 1,500 crores to ₹ 2,000 crores. Additional Provision For Delayed Implementation of Resolution Plan The Framework has provided for mandatory making of ‘additional provision’ of 20% by the lenders in cases where a viable RP is not implemented within the stipulated time i.e. 180 days from the end of review period and a further 15% (i.e. total of 35%) if the delay crosses a time limit of 365 days from the end of review period. These additional provisions have to be made above the already held provision or provisions required to be made as per the status of the asset classification of the borrowers account, whichever is higher. Situations Where Additional Provision May Be Reversed The framework provides that when the RP involves restructuring or change in ownership outside IBC, the additional provisions may be reversed upon implementation of the RP. However, the additional provision may also be reversed in cases where RP involves payment of overdues by the borrowers and the same has been cleared. Further, where RP is pursued under IBC, half of the additional provision made may be reversed upon filing of insolvency proceedings under Section 7 [[vi]] and another half may be reversed upon the same being admitted by the respective NCLT. Furthermore, in all cases where assignment of debt or recovery proceedings are completed, the additional provisions may be reversed. ANALYSIS OF THE FRAMEWORK FOR RESOLTION OF STRESSED ASSETS Striking a Balance The Framework not only gives liberty and ample discretion to lenders to strategize and proceed with the

[By Himani Singh] The author is an Advocate enrolled at Bar Council of Maharashtra and Goa Introduction ‘Non-banking Financial Companies’ (NBFCs) are financial institutions registered under the Companies Act, 1956(now Companies Act, 2013) and may engage in businesses such as loans and advances, acquisition of marketable securities, leasing, hire-purchase, insurance etc. To operate as an NBFC, the company must also have a valid registration under Section 45-IA of the Reserve Bank of India Act, 1934. Based on the type of business carried out, NBFCs can be classified into: deposit taking, non-deposit taking, non-deposit taking but with acquired securities in their group/holding/subsidiary company(ies). On the basis of their asset size, NBFCs can be classified into: systemically important (asset size above Rs. 500 Crore) and non-systemically important NBFCs. NBFCs or the Shadow Banks in India The gamut of NBFCs in India is exquisitely flavored – from housing finance and corporate lending to the more exotic infrastructure finance, promoter finance and core investment companies; and several distinct shades in between. The most attractive fragment of NBFCs that distinguishes them from traditional banks and attracts borrowers from around the world is the peer-to-peer lending segment. Just as NBFCs differ on their business, risk and leverage profiles, there are also multiple regulations and regulators governing them. But essentially, NBFCs are institutions that occupy the interstices in financial intermediation unfulfilled by banks; much like the shadow banks in United States and United Kingdom. The shadow banking system is made up of a multitude of banking and financial operators linked to each other by financial intermediation chains of varying lengths and degrees of complexity – from hedge funds, asset managers and pension funds to insurers, money market funds, real estate funds and many others.[i] The shadow banks perform the financial intermediation function in the same way as the traditional banking system. The main distinguishing characteristics of the shadow banking system are looser supervision and greater fragmentation between operators at each link in the intermediation chain.[ii] NBFCs were tagged as ‘shadow banks’ in India by Paul McCulley, the famous American economist, given their easy money lending nature and a separate regulatory framework governing them, distinct from the laws and regulations that govern banks. The shadow banking sector contributed significantly to the economic downturn and eventual financial crisis of the global economy in 2007-08. The crisis occurred since the shadow banks were largely unregulated. The minimal regulation resulted in negligible notice and left everyone blindsided even when shadow banks progressed towards a crisis. In India, the IL&FS fiasco and DSP offloading on DHFL[iii] sparked a similar fear like that of 2007-08 crisis and stressed on the fact that NBFCs were subject to lighter regulation in comparison to their traditional counterparts i.e. Banks. Regulation of NBFCs – Progress so Far For past few years, the Indian banking sector is facing multiplying systemic risks and there is a lack of supervision in the functioning of financial institutions especially the NBFCs. The disruptive challenges arising from technological advances and overarching impact of globalization add to the trouble. The Reserve Bank of India (RBI) has brought multiple reforms to regulate the NBFCs since the 1990s and the process is still underway. Between 1995 – 1998, the Reserve Bank of India (RBI) came up with several regulations such as exposure limits for lending by NBFCs, prudential regulations for their governance and also restricted raising deposits from public to an extent. Further, NBFCs were categorized based on their business model into deposit taking, non-deposit taking and core investment companies; along with specific directions regulating each category. In 2000, audit requirements for NBFCs were introduced and certain exemptions were also granted to NBFCs for charitable purposes (companies registered under Section 8 of the Companies Act, 2013 ( Section 25 of 1956 )), potential Nidhi Companies as well as government companies, from applicability of core RBI Act provisions. In 2001, the concept of asset management was brought in. In 2004, several associations formed a self-regulatory group called ‘Finance Industry Development Council’. In 2006, RBI devised a method to regulate NBFCs functioning on a large scale and identified systemically important and non-systemically important NBFCs wherein NBFCs with asset size above Rs. 100 crore were recognized as systemically important. Nearly 10 years later, in 2016, RBI increased the threshold of systemically important NBFCs to asset size of Rs. 500 Crores and also released master directions to govern each class of NBFC. In the interim, in 2008, the government had also set up a ‘Stressed Asset Stabilisation Fund Trust’ to address the liquidity freeze caused by global financial crisis. The Trust Fund was set up to purchase short term loans from eligible NBFCs, thereby increasing the liquidity. Next Steps As of 2018, there are approximately 12,000 NBFCs registered with RBI and they continue to operate on uneven grounds. The government has brought in several reforms in the financial framework governing NBFCs in the past. However, in comparison to traditional banks, the issue of regulation of NBFCs is only obliquely addressed and therefore, there is a need for further reforms in the array of NBFCs in India. It is important to re-visit the already registered NBFCs and check for qualification requirements. The license for any NBFC that does not meet the minimum eligibility criteria should be cancelled immediately. Further, it is pertinent to increase the threshold for minimum capital, especially for micro-finance institutions and asset reconstruction companies. The regulations should not be limited to asset size but also be inclusive of streamlining the liabilities of NBFCs. NBFCs with large assets sizes, especially the systemically important NBFCs should be exposed to standard statutory liquidity ratio and liquidity coverage ratios, set for NBFCs, amongst other things. The prudential norms concerning income recognition, asset classification and provisioning must be applicable to and tightened for all NBFCs to address the systemic risk plaguing the sector for long. The fair practices code and corporate governance norms of NBFCs should also be strengthened. Additionally, a uniform mode of risk management and settlement process should also be

The Law of Bank Guarantees: Important Tools of Modern Day Commercial Transactions. [Rangeet Poddar] The author is a 4th year B.A.LLB(Hons.) student of WBNUJS, Kolkata. Introduction According to Section 126 of the Indian Contract Act, a contract of guarantee is a contract to perform the promise, or discharge the liability of a third person in case of his default.[1] A bank guarantee is a contractual assurance that is given by the bank to a third party creditor. By virtue of this commercial instrument, the concerned bank undertakes liability on behalf of the principal debtor to fulfill his contractual obligation in the event of default.  This secures the transaction by ensuring that no detriment is caused to the creditor. The nature of obligations of the principal debtor is primary while the obligations of the bank are secondary. By issuing a guarantee, a bank ordinarily undertakes to pay the amounts specified in the guarantee agreement to the beneficiary on demand made by him in accordance to predetermined terms and conditions.[2] The object of a bank guarantee is to ensure the due performance of certain works contracts. The guarantee can also be towards security deposit for a contract or of any kind.[3] In the case of State Trading Corp. of India Ltd. v. Jainsons Clothing Corp.[4], the Supreme Court held that the bank guarantee is a trilateral contract in which the bank has undertaken to unconditionally and unequivocally abide by the terms of the contract. It is an act of trust with full faith to facilitate free flow of trade and commerce in domestic or international trade or business. It creates an irrevocable obligation to perform the contract in terms thereof. On the occurrence of events mentioned in the guarantee contract, the bank guarantee becomes enforceable.[5] There are two types of guarantees: A conditional performance guarantee is one where the surety becomes liable to the party, claiming under the guarantee upon proof of breach of terms of the underlying contract, or on proof of both breach as well as the loss occurring from the breach. Under unconditional guarantee, the guarantor becomes liable to pay the beneficiary the stated amount whenever the demand is made in the manner provided for in the guarantee, without the need for that beneficiary to prove any breach or loss; the guarantor is bound to immediately perform the contract of guarantee without further requirements. The object of unconditional bank guarantees or on demand bank guarantees are to secure hassle-free commercial transactions. Where the bank unconditionally and irrevocably promises to pay on demand, the amount of liability undertaken in the guarantee without ‘demur or dispute’ under the terms of the guarantee, the liability of the bank is considered to be absolute and unequivocal.[6] An on-demand bank guarantee consists of three separate and substantially independent but formally accessory agreements, namely: The underlying transaction or main agreement The indemnity agreement between the account party or principal and the guarantor The on-demand instrument between the guarantor and the beneficiary[7] The question whether the guarantee is a conditional or an unconditional one payable on demand, is a matter of construction in each case from the terms of the bond.[8] Independent nature and encashment of the bank guarantee In Ansal Engineering Projects v Tehri Hydro Development Corporation[9], it was held by the Supreme Court of India that the bank guarantee is an independent and distinct contract between the bank and the beneficiary and is not qualified by the underlying transaction and the validity of the primary contract between the person at whose instance the bank guarantee was given and the beneficiary.[10] The question whether the express terms of the guarantee give rise to the contract of guarantee to be enforced will be the limited enquiry for deciding the rights and obligations flowing from such a guarantee. Bank guarantees are independent in nature.[11] It is a separate autonomous contract between the bank and the beneficiary and is not qualified by the underlying transaction and the primary contract between the beneficiary and the person at whose instance the bank guarantee is given.[12] In a bank guarantee it is not necessary to go beyond the guarantee contract between the creditor and the surety bank and one must not look at any other contract including the underlying or primary one. However the underlying contract comes into the picture only if the guarantee itself makes its encashment, subject to proof of performance of underlying contract as it happened in the Hindustan Construction case[13]. In that case, the bank guarantee was for securing mobilization advance given by State of Bihar and it was provided in the terms of the guarantee that the beneficiary would not have the unfettered right to invoke the guarantee in the event the obligations expressed in the clause of the original contract were not fulfilled by the contractor. In such exceptional scenarios, the bank guarantee loses its autonomous character and depends upon the result of inquiry to the underlying contract. [14] Besides such cases, the court does not interfere with the enforcement of bank guarantees and guarantee contracts are not qualified by underlying transactions.[15]Where the bank guarantee is unconditional and payable on demand or demur, the liability of the bank is absolute and does not depend on the ultimate decision of a pending case in a court or tribunal. The bank only has to ascertain the amount claimed within the terms of the guarantee.[16]The question of encashment of the bank guarantee is entirely upto the beneficiary to invoke the guarantee at any time as he deems to be proper.[17] The National Highways Authority v Ganga Enterprises and Another[18] case laid down that that bank guarantees furnished in the form of security for not withdrawing a bid is fundamentally different from withdrawal of offer before acceptance as per the statutory provisions of the Indian Contract act. In such cases, when a person withdraws his offer within a stipulated time, he has no right to claim the earnest money that he has given in the form of a bank guarantee.

Bail-In Clause in the FRDI Bill: Is the Hysteria Justified? [Ayushi Singh] The author is a third-year student at National Law University, Jodhpur. “I can assure you, my friends, that it is safer to keep your money in a reopened bank than it is to keep it under a mattress.” – Franklin D. Roosevelt (March 12, 1933) The Financial Resolution and Deposit Insurance Bill, 2017, approved by the Cabinet, has been in the ring of fire, drawing protests from the opposition, regulatory bodies and citizens. Mamata Banerjee has vociferously asked for the withdrawal of the Bill, currently under consideration by the Joint Parliamentary Committee, calling it “the biggest assault on the financial security of the poor and middle class of the country.” The point of contention is the bail-in clause under section 52 of the Bill. The said provision is aimed at rescuing a financial institution on the brink of failure by making its creditors and depositors take a loss on their holdings.[1] The Finance Minister, Arun Jaitley, has tried to allay the fears of the public and has hinted that review and correction of the Bill will take place post-release of the Parliamentary Report. The implications of this clause on the deposits made by citizens added with the lack of clarifications from the Government have inflamed the fears of the people as majority of their savings are deposited in banks. ASSOCHAM Secretary General DS Rawat has also asked for withdrawal of this clause due to chances of the trust in the banking system being eroded. He opined that the clause may induce citizens into making bank-runs or scare them into withdrawing their deposits and protecting them in unproductive avenues like real estate, gold, jewellery and even in the unorganised and informal financial markets run by unscrupulous persons.[2] The bail-in clause is not a new concept; in fact, it may have been introduced with a view to keep up with the trends in the World Bank’s financial resolution policies. The Financial Stability Board, which acts as a regulatory body for banking systems globally, have endorsed the bail-in clause as a tool for resolution of financial bodies.[3] In 2014, the EU introduced the bail-in clause in its Bank Recovery and Resolution Directive under which 8% of an institution’s liabilities must be wiped out before any taxpayer support can be provided. This wipe-out has to be done via bail-in of deposits according to a fixed hierarchy as given in article 34 of the Directive.[4] The objective behind introduction of the bail-in clause was to prevent the colossal failure of the bail-out resolution process used during the 2008 financial crisis. The bail-out of “too-big-to-lose” financial corporations shifted the burden of their failure on the taxpayers; this is what these bodies are trying to avoid through the bail-in clause. The drive to accommodate the bail-in clause was validated when it was used successfully during the 2011 economic crisis in Denmark. The resolution was successfully accomplished through a well-formulated bank-package such that the resolution was completed over a weekend with no negative effect on ordinary customers.[5] Failures of the Bail-In Clause However, the implementation of bail-in has not always been rosy. During the 2013 crisis in Cyprus, the insured deposits of citizens were transferred for resolution while the deposits of financial institutions and government entities were fully repaid back. Depositors lost almost 50 per cent of their savings when a bail-in was implemented.[6] Post introduction of bail-in clause in the EU Directive with the hierarchy of deposits, Portugal’s bail-in package for Banco Espirito Santo in 2016 used five of the 52 senior bonds for resolution of its liabilities. Investors who had to suffer losses had threatened lawsuits, accusing the country of discriminating against holders of the same level of bonds and violating the pari passu principle of equal treatment to protect domestic bondholders.[7] In May 2017, the Economy Minister of Italy Pier Carlo Padoan ruled out the recourse of bail-in tool, in spite of the Directive, for the rescue of its two ailing regional banks. This is to safeguard citizens’ confidence in other banks which are already suffering from bad loans caused during recession.[8] Implementation and Procedural Transparency The stark contrast in the above headings display a major difference in the nature of implementation of bail-in clause. Denmark implemented the bail-in clause within the framework of a bank-package wherein the cap of insured amount deposited in banks was increased and a safety net was set up.[9] In Cyprus, the bank holiday was declared and ATMs were shut down, cutting complete access of money to the citizens.[10] Even with the Directive, it is difficult to ensure that the hierarchy of deposits defined is upheld by countries during use of bail-in tool. The International Monetary Fund, which has endorsed the bail-in tool, has also pointed out the need to implement it in an orderly and clear manner-[11] “The legal framework needs to be designed to establish an appropriate balance between the rights of private stakeholders and the public policy interest in preserving financial stability. Debt restructuring ideally would not be subject to creditor consent, but a “no creditor worse off” test may be introduced to safeguard creditors’ and shareholders’ interests.” The RBI in its Report of the Working Group on Resolution Regime for Financial Institutions has suggested that the bail-in tool be used with due care, only as an interim measure which works along with a plan for permanent resolution like sale, merger, etc.[12] Therefore, it is reiterated that if the bail-in clause is to be used, its implementation must be clarified by a fixed set of rules and regulations which would include a system of hierarchy defining the order of volatility of deposits. Another concern is with respect to the insurance cover for the deposits that has remained at Rs. 1 lakh for over two decades. A revision and increase in insurance cover for deposits could help deter financial failure of weaker banks, as once the health of banks becomes well-defined and public, existing depositors may be induced to make bank-runs to protect their savings and pensions in safer banks. The All India Reserve