Banking Law

Invocation of Bank Guarantees: Conflicting Opinions Adding to the Uncertainty

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[By Talin Bhardwaj] The author is a student at Rajiv Gandhi National Univerisity of Law, Patiala. Introduction: Bank guarantee is a type of guarantee under section 126 of the Indian Contract Act, 1872 (“ICA”) in which the bank becomes a guarantor to reduce the risk in a commercial transaction between parties. The Supreme Court in various cases while considering the judgments given by the Courts of the United Kingdom (“UK”), has held that the invocation of bank guarantees ideally should not be restrained as it may act as a detriment to trust in internal and international commerce. However, the Supreme Court, at the same time, through various judgments has also held that the invocation of bank guarantees may be restrained in two cases: Firstly, in cases of egregious fraud which vitiates the entire transaction and secondly, in cases where there is a risk of an irreparable harm/injustice to one of the parties. These grounds were in furtherance to the judgments given by the courts of the UK and the USA.  Additionally, the High Court of Calcutta in the case of Texmaco Ltd. v. State Bank of India & Ors. added a condition of “special equities” for restraining the invocation of bank guarantees. The condition of “special equities” was to be considered as a measure for providing relief to the parties due to the harm suffered in exceptional circumstances and was also accepted by the Supreme Court recently in the case of Standard Chartered Bank v. Heavy Engineering Corporation Ltd. These conditions have become particularly pertinent in light of the catastrophic financial distress brought about by the COVID-19 pandemic. The Delhi and the Bombay High Courts have presented conflicting opinions on whether COVID-19 can act as ground under “special equities” to restrain the invocation of bank guarantee in recent times. The author through this article seeks to analyze the conundrum posed by the recent judgments and provide some clarity on the question of whether COVID-19 constitutes a valid ground for restraining the invocation of bank guarantees. The saga of conflicting judgments: As mentioned earlier, both the Delhi and the Bombay High Court have presented diverging opinions on whether COVID-19 could act as a ground for the court to restrain the invocation of bank guarantee. The Bombay High Court in the case of Standard Retail Pvt. Ltd. v. GS Global Corp. & Ors., denied granting an injunction to restrain a party from invoking the bank guarantee. On account of the financial impact of the pandemic, the petitioners contended that the commercial contracts that were entered between the parties were frustrated, and thereby, the encashment of the bank guarantees should be prohibited. The Bombay High Court, however, refused to restrain the respondents from encashing the letters of credit and the bank guarantees even in the circumstances emanating from COVID-19, majorly due to the nature of the contract. On the contrary, the Delhi High Court in the case of M/S Halliburton Offshore Services Inc. v. Vedanta Limited & Anr. restrained the encashment of eight bank guarantees due to the pandemic. The parties entered into a contract for the construction of walls. On account of certain differences arising between the parties pertaining to the completion of the project, the petitioner moved to the Delhi High Court pursuant to section 9 of the Arbitration & Conciliation Act, 1996. The petitioner claimed that COVID-19 had adversely affected the completion of the project as a nation-wide lockdown was announced by the government to tackle the transmission of the virus, which consequently led to a shortage of labor due to their migration. The Delhi High Court, in consonance with the Standard Charted Bank judgment, upheld that special equities and irretrievable harm are two separate grounds on which the court can interfere with the encashment of a bank guarantee. The court, while reviewing the facts and circumstances of the case, finally came to the conclusion that the unprecedented circumstances brought about by the pandemic would validly constitute “special equities”, which thereby, entitles a party to seek interim relief for restraining the invocation of bank guarantees. Increasing complications to an already persisting conundrum: The verdict of the Delhi High Court in the case of Indirajt Power Private Ltd. v. Union of India & Ors. has added fuel to the already persisting conundrum. In the present case, the petitioner was assigned the responsibility for the completion of a thermal project. The petitioner thereby, contended that due to the adverse circumstances brought by the pandemic, the court should stay the invocation of the bank guarantees, in furtherance to the judgment given by the court in the M/S Halliburton Offshore Services Inc. v. Vedanta Limited & Anr. case. The Delhi High Court in this case noticed that the project was to be completed in April-May 2018 and was repeatedly delayed by the petitioner. On these grounds, the court held that the petitioner cannot be entitled to an interim relief on the ground of “special equities”. Further, the court while relying on the judgment of Umaxe Projects Private Limited v Air Force Naval Housing Board & Anr., held that the court shall not interfere in the case of encashment of bank guarantees even if a party would suffer damages unless these damages are irreparable. Recently, the opinion of the Delhi High Court again oscillated in the case of Technimont Pvt. Ltd. & Ors. v ONGC Petro Additions Ltd., whereby, it restrained the respondent from encashing the bank guarantees because of the pandemic and due to the fact that these guarantees remain valid for a period till December 2020 which shall balance the interests of both the petitioner as well as the respondent. Understanding the juxtaposing Delhi High Court judgments: A closer look at the initial two juxtaposing judgments of the Delhi High Court has clearly made the applicability of the “special equities” more complex to understand. Both the cases involved the completion of a project in which the deadline for completing the project was much before the outbreak of the pandemic and thereby, time

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Right of Subrogation Under IBC: Impact on Market

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[By Gopal Gour] The author is a student at Maharashtra National Law University Mumbai. Introduction Guarantees play a pivotal role in any commercial transaction because the parties prefer to be secured if the other party fails to perform its obligation. For example, in a loan transaction between A & B; C stands as a guarantor of B, ensuring the repayment of the loan if B defaults. Guarantee is purely a contractual arrangement between/among the parties, and it can be drafted according to the transaction and needs of the parties. However, there are certain principles enshrined under the Indian Contract Act, 1872 (‘Contract Act’) that protect the rights of both, the parties, and the guarantor. Anything done, or promised to be done, in favour of the party is a sufficient consideration for the guarantor.[1] Further, the surety/guarantor is subrogated to all the rights of the creditor against the principal debtor viz. the guarantor steps into the shoes of the creditor, and is entitled to enforce all the securities that the creditor has against the borrower, on whose behalf the payment is made.[2] Recently, the issue of subrogation came to be discussed in the cases of Insolvency and Bankruptcy Code, 2016 (‘IBC’), wherein the right of subrogation was denied to the guarantor. In the very celebrated case of Essar Steel, followed by many, the Apex Court approved the resolution plan which denied the rights of subrogation to the guarantors. Subrogation is a right of equity and natural justice. Even though the Courts have been justifying the denial of right of subrogation citing cogent reasons, it is unjust on the part of the guarantor; besides, the principle borrower gets unjustly enriched in this set-up. This article discusses the concept of ‘Equitable Subrogation’ with the help of foreign jurisprudence, and analyses the impact of such denial of the right of subrogation of the guarantor on the Indian credit market. Right of subrogation under IBC It is established that the approval of the resolution plan and consequent extinguishment of the liabilities of the Corporate Debtor does not absolve the guarantor of its liability under the Contract Act.[3] The primary reason for this is that the discharge of Corporate Debtor’s liability is through the operation of law as the same is stemming from the proceeding under the Insolvency and Bankruptcy Code.[4] Now, once it is established that the guarantor is still liable to pay the principle creditor even though the Principle Borrower (Corporate Debtor) is absolved, the question of the right of subrogation surfaces naturally. The right of subrogation is an equitable and natural right of the guarantor against the Corporate Debtor on whose behalf he has paid the money. In the Essar Steel[5] case, the creditors of the corporate debtor sought to invoke the guarantees given for the remainder amount, after receiving the haircut amount through the Resolution Plan.[6] In the said case, the Supreme Court relied upon SBI v. V. Ramakrishnan[7] and held that the guarantor’s liability remains intact even after the approval of the resolution plan.[8] Further, the Court approved the resolution plan that rest the guarantors devoid of their right of subrogation and did not hold anything substantial, backed by reasoning in this regard. In the case of Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors.[9], the NCLAT discussed the issue of subrogation when the promoters, who were also the personal guarantors, sought to claim the right of subrogation under section 133 and 140 of the Contract Act. The NCLAT held that the resolution under IBC is not a recovery suit, and it was not the intention of the legislature to benefit the ‘Personal Guarantors’ by excluding the exercise of legal remedies available in law by the creditors, to recover legitimate dues by enforcing the personal guarantees, which are independent contracts. Further, NCLT Mumbai in the case of State Bank of India v. Calyx Chemicals & Pharmaceuticals Limited[10] and IDBI Bank Ltd. v. EPC Constructions India Limited[11] again approved a resolution plan that had not given the right of subrogation to the guarantors of the Corporate Debtor on whose behalf the payment was made. Subrogation: An Equitable Right The surety paying off a debt shall stand in the place of the creditor and have all the rights which he has, for the purpose of obtaining reimbursement. This rule here is undoubted, and it is founded upon the plainest principles of natural reason and justice.[12] Subrogation rests upon the doctrine of equity and is a settled common law principle.[13] In the case of Kundanmal Dabriwala v. Haryana Financial Corporation and Ors.[14] the High Court of Punjab & Haryana discussed the liability of the surety where the liability of the Principle Borrower stands extinguished through a sanctioned scheme of arrangement under section 391 of the Companies Act, 1956. The Court absolved the surety of the liability on the ground inter alia that the surety cannot be placed in the shoes of the creditor i.e. cannot have the right of subrogation. This case becomes significant as it stresses the importance of subrogation right, in absence of which, the liability of the surety stands pointless. The foreign jurisprudence considers the right of subrogation as one of the ways to cure the ‘unjust enrichment’ under the law of restitution.[15] In the case of Swynson Ltd. v. Lowick Rose LLP[16] the UK Court discussed the equitable subrogation and unjust enrichment in the following words, Equitable subrogation as a remedy for unjust enrichment …It belongs to an established category of cases in which the claimant discharges the defendant’s debt on the basis of some agreement or expectation of benefit which fails.[17] … …The cases on the use of equitable subrogation to prevent or reverse unjust enrichment are all cases of defective transactions. They were defective in the sense that the claimant paid money on the basis of an expectation which failed.[18] … …What this suggests is that the real basis of the rule is the defeat of an expectation of benefit which was the basis of

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The Interface Between IBC and Foreign Investment Instruments

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[By Palak Mohta] The author is a student at ILS Law College, Pune. One of the key determining factors of economic growth for a country is the inflow of foreign investments. Although, there are specialized boards and tranches to handle the intricacies of such foreign investments, the Insolvency and Bankruptcy Code, 2016 (IBC or the Code) inevitably forms part of the play. This write-up discusses a recent order of NCLT which categorized compulsorily convertible debentures as ‘debt’. Additionally, it discusses the recently developed borrowing route for foreign investment- External Commercial Borrowings (ECBs) and analyses how IBC and ECB complement each other. The Case of Compulsorily Convertible Debentures A pertinent question that arises while taking into account whether a particular investment falls under the purview of IBC, is, whether such an investment is debt or equity. The air on whether foreign investments via FDI route are to be treated as debt or equity has been cleared by the NCLT. The NCLT, vide order dated, 31st January, 2020 has held the view that Fully and Compulsorily Convertible Debentures (FCCD) are to be construed as ‘debt’ if, at the time of application of Corporate Insolvency, such instrument is yet to reach maturity date. The order was passed while considering the application made by Financial Creditor, Ziasess Ventures Limited (Ziasess) in a principal matter of SGM Webtech Pvt. Ltd. v Boulevard Projects Pvt. Ltd. Initially, the Resolution Professional (RP) rejected Financial creditor’s claim on grounds that, as per provisions of FEMA, 1999 and allied regulations, the aforementioned instrument in question, falls under the ambit of ‘equity’ and not ‘debt’, thereby not affording Ziasess the status of a financial creditor. The decision of RP was challenged by Ziasess and appeal was filed before the NCLT (Principal Bench). The tribunal quashed the decision of RP on several grounds, inter alia, unconverted debentures to be considered as a debt instrument, there is no ambiguity as to the inclusion of debentures as ‘financial debt’ under section 5(8) definition and overriding effect of IBC over other laws and regulations such as the FEMA.[i] Overriding Effect of the IBC:  Section 238, IBC clearly states that the Code shall have an overriding effect on all other laws for the time being in force. This provision has stirred up many conflicting views on part of NCLT and Securities Exchange Board of India (SEBI). It has time and again, come up for consideration, and been held that the Code shall have an overriding effect on SEBI Rules and Regulations as well.[ii] The Hon’ble Supreme Court has upheld the overriding effect of IBC, over the Income Tax Act,[iii] Tea Act, 1953[iv], etc. The rationale behind the same is certainly to ensure the smooth functioning of the IBC without any hindrances that may be caused due to inconsistencies between two laws. It must, therefore, be borne in mind that such an overriding effect only pertains to situations when there is any inconsistency between two applicable laws. At this juncture, it is also pertinent to observe the legal maxim, ‘leges posteriores priores contraries abrogant’ which implies that when the non-obstante clause forms part of both the special laws, such law which was enacted later, chronologically, shall override the former.[v] The Hon’ble Supreme Court’s final decision in the matter of SEBI v. Rohit Sehgal & Ors. is awaited, wherein the SEBI has preferred an appeal against NCLT and NCLAT order, authorizing overriding effect of IBC over SEBI.[vi] This decision might settle the tussle between IBC and SEBI. External Commercial Borrowings Foreign investment can be in various forms such as Foreign Direct Investment (FDI), Foreign Portfolio Investment (FPI), commercial loans, official flows, etc. One other such route of international investment is via External Commercial Borrowings (ECB). It is governed by RBI under the Master Directions- External Commercial Borrowings, Trade Credits and Structured Obligations[vii] (Master Directions). While the key intricacies of such foreign investment inclines towards investment activities, this write-up aims to highlight its interplay with the IBC regime. Stressed Assets: A key aspect of the resolution process under the IBC is to secure a revival of the Corporate Debtor (CD). A resolution plan is laid out by resolution applicants and approved by the Committee of Creditors (CoC) as it suits their interests. In 2019, the RBI has afforded a new avenue for resolution applicants and the CoC. The RBI has rationalized ECB norms and permitted borrowing via approval route from approved foreign entities/lenders for repayment domestically availed rupee loans. On the precondition that if such borrowing is permitted by the Resolution Plan, an eligible corporate borrower can avail loan to repay and revive itself. Therefore, such debt instruments can not only be used to raise capital and finances by eligible Indian companies, but can also aid the process of bidding on stressed assets. The liberal approach of RBI in structuring regulations for ECBs provides a wide window for investment via the ECB route. It is noteworthy to mention that the eligible borrower has to comply with all the conditions of raising funds via the ECB framework i.e. Minimum Average Maturity Period (MAMP), all-in cost, end-uses, exchange rate, and other such provisions while raising funds as a CD as well. Additionally, oversea branches or subsidiaries of Indian banks do not constitute to be approved lenders for the purposes of this scheme. Investor as Financial Creditor: ECBs are loans sanctioned by approved lenders to eligible resident borrower entities. Such loans can be in the form of debentures, bonds, floating/fixed-rate notes, etc. and FCY or INR denominated. Section 5(8) of the Code, categorically recognizes loans and the aforementioned credit availing instruments as ‘financial debt’. Such classification secures the foreign entity, the right to file insolvency petition under section 7 as a financial creditor against the defaulting borrower. Moreover, the robust IBC regime has facilitated, to a great extent, ease of doing business in India.[viii] The time-bound resolution mechanism enables the disbursement of dues in a prompt manner, thereby ensuring a secured position to the creditors. It is pertinent to mention

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The NPA Conundrum: Evaluating the Bad Bank Approach

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[By Shubham Nahata]   The author is a student at Hidayatullah National Law University, Raipur Introduction One of the most drastic and disastrous impacts of the economic slowdown induced on account of COVID-19 will be seen on the balance sheets(“B/S”) of banking and financial institutions. As the availability of easy credit will become the norm in the post COVID-19 society, banking institutions will need to deal with the herculean task of resolving stressed assets on their B/S. According to the Financial Stability Report, published by the Reserve Bank of India, scheduled commercial banks (“SCBs”) account for almost 9.3% of Gross Non-Performing Assets (“NPAs”) in the economy. Almost 85% of these stressed assets can be traced to the B/S of Public Sector Banking institutions (“PSBs”). One of the prospective solutions on cards for resolving the banking crisis is the creation of a ‘Bad Bank’ that would take over NPAs from banking and financial institutions. Unlike traditional banking institutions, it does not engage in credit lending functions, however, it assists in the recovery of stressed assets in the financial sector. The soundness of the credit infrastructure of an economy is largely dependent on the recovery and resolutions mechanism in place for dealing with stressed assets. This blog post maps the growth of different regulatory practices adopted overtime to deal with NPAs and analyses the viability of a Bad Bank structure based on the experiences of different jurisdictions. Mapping the Trajectory Different strategies have been adopted over time in order to deal with stressed assets in the banking infrastructure. It includes measures like corporate debt restructuring, recapitalisation of banks etc. in order to improve the capital adequacy and keep NPAs in control. However, the overtime rise of NPAs in an economy is a signal for the need for a robust and effective resolution and recovery infrastructure. Neo-liberal banking reforms introduced in the first decade of the 21st century although increased the credit flow in the economy but it also led to a steep rise in bad loans as well. In order to portray the sound health of the banking industry, drastic measures like Corporate Debt Restructuring (“CDR”) were taken. It involved complete overhaul strategies like conversion of debt into equity, reducing interest, or extending the maturity to maintain the soundness of B/S.  One of the benefits that restructuring offered was that it exempted banks from creating provisioning for stressed assets. However, the Reserve Bank of India (“RBI”) prescribed stricter norms for classifying and recognition of stressed assets in the economy after the Asset Quality Review of 2015. This led to a steep increase in the ratio of NPAs in the banking sector. In order to deal with the ‘twin balance sheet problem’, the Insolvency & Bankruptcy Code (“IBC”) was enacted in the year 2016 which provided an effective avenue for financial lenders to undertake the resolution of stressed assets. The Banking Regulation (Amendment) Act, 2017 also empowered the RBI to issue directions to the banks to undertake resolution process against defaulters under the IBC. Similarly, under the framework of Joint Lenders Forum, the Reserve Bank empowered the banks to undertake measures like Corporate Debt Restructuring, Strategic Debt Restructuring and, the Scheme for Sustainable Restructuring of Stressed Assets (“S4A”). S4A offered an opportunity to the lenders to identify the sustainable level of debt for the borrowers and convert the unsustainable part of debt into equity instruments. However, these policies were discontinued after the RBI notified Prior Framework in March 2018. The prior framework was struck down by the Supreme Court in Dharani Sugars and Chemicals Limited v. Union of India, for being violative of Section 35AA of the Banking Regulation Act, 1949. Hence, on June 7, 2019, the RBI notified Prudential Framework for Resolution of Stressed Assets (Prudential Framework) which prescribes an incentive-based approach for resolution of stressed assets to improve the resilience of the credit infrastructure of the economy. Bad Bank Economics Asset quality, capital adequacy, liquidity and, responsiveness to the market are considered to be the key indicators of the financial health of a banking enterprise. Overtime rise in the ratio of NPAs not only affects the asset quality of banking institutions but also affects its capital to asset ratio, in turn, fracturing its ability to lend swiftly in the market. Bad Bank is a special purpose vehicle constituted as an Asset Reconstruction Company (“ARC”) tasked with the objective of acquiring and managing stressed assets of banking and financial institutions. It acquires discounted stressed assets from banks by upfront payment of a certain proportion in cash and issuing security receipts for the rest of the amount. Bad Banks are tasked with the responsibility to uniformly carry out resolution and recovery steps in respect of stressed assets and increase the return on such assets. Generally, such a form of entity is funded by the government and banking institutions in order to carry out its activities. Bad Bank structure for resolution of NPA can be effective as compared to the recapitalisation of banks, as the latter increases the burden on the taxpayers to provide for weak recovery infrastructure for banking institutions.  Global Experience Different jurisdictions around the globe have found recourse in a Bad Bank framework in order to deal with the problem of mounting stressed assets in the banking industry. Sweden during the financial crisis of 1992, formed a state-owned company (‘Securum’) tasked with the objective of acquiring stressed assets from its banking institutions. Securum was successful in resolving banking crisis in the economy and was able to return a substantial amount of government funding. Similarly, the Korean Asset Management Corporation of South Korea was formed in order to deal with stressed assets lying with banking and financial institutions. It was successful in reducing the ratio of NPAs in the economy from 17% in 1998 to 2.2% in 2002. It also introduced and developed the market for asset-based securities which attracted investments from both domestic and foreign investors. After the global financial crisis of 2008, the United States of America also formulated

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Sensing Fears, Shifting Gears: Did the RBI Steer in the Wrong Way?

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[By Ujjwal Jain] The author is a third year student of Tamil Nadu National Law University. One of the most important functions of any central bank is to formulate and execute monetary policy. In our case, the Reserve Bank of India (“RBI/Bank”), the banking regulator and India’s central bank, is statutorily entrusted with this responsibility.[i] Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to primarily achieve the goals of price stability, which is a precondition for sustainable growth. Some of the monetary instruments include repo rate and reverse repo rate[ii] and they influence the cost and availability of money in the economy.[iii] The RBI had recently (in April 2020) reduced the reverse Repo Rate without convening and consulting the Monetary Policy Committee. The author analyses the statutory prescriptions which the RBI has violated in doing so and contemplates for a possible solution. Legal Background The preamble of the RBI Act, 1934 (“RBI Act”) enunciates that the rationale for constituting the central bank is to secure monetary stability in India, secured by way of monetary policy.  As macroeconomic conditions change, a central bank may change the rates of the instruments in its monetary policy. Until 2016, a Technical Advisory Committee consisting of the Governor, Deputy Governor, and advised by external advisors would decide on the rates of various instruments. Notably, the decision(s) of the advisors were not binding on the RBI and the Governor’s decision was final. In 2016, Chapter III-F was inserted[iv] in the RBI Act by way of an amendment and a Monetary Policy Committee (“MPC”) was constituted (“2016 Amendment”).[v] The 6-member Committee was entrusted with the responsibility to determine the policy rate[vi] and its decision(s) were made binding upon the RBI.[vii] The reason for coming up with MPC can be traced to the Report of an Expert Committee[viii] which took cognizance of the ‘monopoly power’ in deciding the monetary policy and batted for communication and transparency in the monetary policy framework. It is believed that democratic societies require public institutions to be accountable.[ix] The Financial Sector Legislative Reform Commission in its Report submitted to the Ministry of Finance in March, 2013, had also echoed the same tone. It had flagged concerns of autonomy and independence and posited that achieving independence of a central bank requires appropriate institutional design and thus, recommended constituting MPC.[x] Notably, in the time before the constitution of the MPC, the Governor of the RBI was vested with enormous powers and the 2016 Amendment strived to overcome this shortcoming; thus, ensuring no abuse of power. It is noteworthy that the MPC framework is structured in such a manner that autonomy and independence of the Committee are vouchsafed. For instance, though the Central Government can “convey its views” to the MPC[xi], but the same has not been made binding upon the MPC’s or the RBI’s decision. The modus operandi of management of the RBI is enshrined in Section 7(2) of the RBI Act, which states that: “..the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which may be exercised or done by the Bank.” Clearly, only with the exception to the monetary policy, the Central Board of the RBI is entrusted with over-arching powers. Do lofty ideals justify faux measures? The RBI (as prescribed[xii] in Chapter III-F, 1934 Act) convenes MPC meeting and decides upon the rates of various monetary policy instruments. The Secretary of the MPC releases the policy resolution & statement and the minutes of the MPC meeting in the manner prescribed. The RBI is then, under Section 45 –ZJ of the RBI Act, mandated to take steps to implement the decision of the MPC. Surprisingly, in April 2020, the RBI had suo moto reduced the reverse repo rate under the Liquidity Adjustment Facility (LAF) without convening & consulting the MPC. Due to the Covid-19 pandemic, which is having a cascading effect on liquidity in the market, though the above move seems to be a much-needed one, it raises eyebrows as the RBI has patently transgressed the statutory prescription by not consulting MPC. Furthermore, Regulation 5(b) of the MPC Regulations, 2016 prescribe ‘ordinarily’, 15 days’ notice should be given to the members of the MPC to convene a meeting, the Regulations also allow flexibility to convene an “emergency meeting” by giving “a 24 hours’ notice” to every member “to enable him/her to attend, with technology-enabled arrangements.”[xiii] Despite a framework which gives such great latitude that it can convene an ‘emergency meeting’, if the exigency of a situation so demands, the RBI has gone ahead and tinkered with the rates without taking MPC into confidence, thus disregarding the mandate of the RBI Act. The April 17th Notification declares the reduction of reverse repo rate in the following words:  “it has been decided to reduce the fixed-rate reverse repo rate under the LAF by 25 basis points from 4.0% to 3.75% with immediate effect. It is unclear from the statement of the RBI Governor on how the decision was reached. Ironically, the Governor concludes his statement with the following words: “…without infringing in any way on the mandate of the MPC”, but by what it has done it has committed a “regulatory overreach” and the same is ex facie contra legem, therefore, takes us back to the pre-MPC times. Can the RBI’s move be justified? At this juncture one might argue that the RBI, by virtue of the Banking Regulation Act, 1949, has been vested with the powers to issue directions to banking companies “in the public interest and in the interest of banking policy” and is also empowered to “control advances by banking companies” and every banking company shall be bound to comply with such direction(s).[xiv] This read with Section 17(15-A)[xv] of the RBI Act [which provides for the RBI to perform its duties enshrined under the RBI Act

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RBI’S Prudential Framework for Resolution of Stressed Assets – Modus Operandi, Analysis and Implications

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[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

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NBFCs – Unravelling the Indian Shadow Banks

Leave a Comment / Banking Law /

[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

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Depositing A Post-Dated Cheque During Moratorium

1 Comment / Banking Law, Insolvency Law /

[ Vatsal Patel ]   The author is a 3rd year student of Nirma University. Introduction The Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as“Act”) augmented by its 2018 Amendment Act[1](hereinafter referred to as“Amended Act”) has received wide-spread positive response from different sides of corporate sector.[2]The bringing in of the Act resulted in immediate shifting form a debtor-in-control regime to a creditor-in-control regime and is buttressed by a stipulated time period of 180/270 days for the completion process which is adhered to strictly by the National Company Law Tribunals (hereinafter referred to as“NCLTs”) all across the country. The moratorium period stipulated under Sec. 14 is one of the prominent feature of this act which restricts the continuation of the mentioned proceedings against the corporate debtor in case of an admission and subsequently, commencement of the Corporate Insolvency Resolution Process (hereinafter referred to as“CIRP”). Moreover, it has already been established that the moratorium does not apply to all proceedings in light of the NCLAT judgement in the case of Canara Bankv. Decan Chronicle Holding,[3]which noted the absence of the word “all” in Section 14 of the Act. The moratorium as prescribed for by Sec. 14, inter-alia, provides for prohibiting: “…(1)(c). any action to foreclose, recover or enforce any security interest created by the corporate debtor in respect of its propertyincluding any action under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002” It would be pertinent to note that by virtue of Section 3(31) of the Act, a “security interest” would include a claim to property. Moreover, the term “property” as defined under Sec. 3(27) would include money. Therefore, the question that arises for consideration in this article is whether a cheque, more specifically, a post-dated cheque, the date of beginning of which falls within the stipulated moratorium period could be deposited during the moratorium period or would it be against the moratorium? In terms of an Example – Consider that A (Operational Creditor) contracted with  B (Corporate Debtor) on 01.01.2019 for the supply of goods/services. For the same, cheques were issued by B to A dated 02.07.19 (first cheque), 02.07.20, 02.07.21 and 02.07.22. All these cheques were delivered on 01.01.2019 to the Operational Creditor. Subsequently, CIRP was initiated against the Corporate Debtor and moratorium was granted between 01.07.19 to 01.10.19. Therefore, the question that arises is whether A can encash the first cheque in the instant case? The answer to the aforementioned question could be related to the proposition of law which governs the date of payment of a cheque i.e. if the date of payment by cheque is the date on which the cheque is delivered then the payment has already happened and therefore, there is no bar to encashment via cheque and vice-versa. Supreme Court On Delivery Of Cheque The First Casethat comes for consideration is CIT, Bombayv. Ogale Glass Works Ltd.,[4] wherein the Supreme Court while dealing with a cheque which was not subsequently dishonoured held that the cheque would be considered to be payed on the date of its delivery. However, had the cheque been dishonoured, the same would not be the case. In the words of Supreme Court: “…The position, therefore, is that in one view of the matter there was, in the circumstances of this case, an implied agreement under which the cheques were accepted unconditionally as payment and on another view, even if the cheques were taken conditionally, the cheques not having been dishonoured but having been cashed, the payment related back to the dates of the receipt of the cheques and in law the dates of payments were the dates of the delivery of the cheques.”[5] The same position of law was supported by a three-judge bench of the Supreme Court in the case of K. Saraswathyv. P.S.S. Somasundaram Chettiar.[6] The Second Casethat comes for consideration is the case of Jiwanlal Achariyav. Rameshwarlal Agarwalla,[7]wherein themajority of the three-judge bench of the Supreme Court distinguished between a conditional and an unconditional payment while dealing with Section 20 of the Limitation Act, 1908. It was held that an ordinary cheque amounted to an unconditional payment if the cheque was subsequently honoured.[8]However, the court also considered a post-dated cheque to be a conditional payment for which the date of payment would not be the date of delivery but the date on which it was dated to begin. The case also distinguished from Ogale’sCase,[9]by stating that the issue before that court was not specifically in relation to a post-dated cheque and as such the court was not bound by that case. However, it is pertinent to note that the minority opinion by Justice R. S. Bachawat did not distinguish Ogale’scase from the instant case and as such held that Ogale’scase applied even to a post-dated cheque.[10]Thus, according to the minority opinion, even payment by a post-dated cheque related back to the date of delivery of the cheque in terms of payment. One would expect that the courts would rely on the aforementioned two cases for the payment in terms of delivery all types of cheque i.e. ante-dated, date of the delivery and post-dated. However, the Supreme Court has deviated from its established position of law. The Third Casethat arises for our consideration is the recent case of Director of Income Tax, New Delhiv. Raunaq Education Foundation,[11]wherein the Supreme Court dealt with an issue pertaining to a cheque which was delivered on 31.03.2002 and dated 22.04.2002. The court herein again relied on Ogale’s Case.[12]However, in doing so it did not distinguish between an ordinary cheque and a post-dated cheque and the payment of a post-dated cheque was also considered to be completed on the date of the delivery of the cheque. Conclusion Thus, on perusal of the aforementioned judgements it can be distinctly observed that the position of law in terms of the ordinary cheques is clear i.e. the date of delivery of cheque is the date of payment via cheque if the cheque is subsequently honoured. However, as far as post-dated cheques are concerned,

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The Law of Bank Guarantees: Important Tools of Modern Day Commercial Transactions

Banking Law /

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.

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