SC order on insolvency circular is a blow but war on bad loans to continue

The starting point of the conflict between former RBI governor and the government was this circular; it turned acrimonious in due course and finally led to the exit of Patel

At the risk of being in contempt of court, I would love to say that Tuesday’s Supreme Court judgment in military parlance is akin to a “surgical strike” on the Indian central bank. The judgment is a big blow to the Reserve Bank of India’s (RBI) war against rising bad loans in Asia’s third largest and the world’s fastest growing major economy.

The apex court has set aside the February 12, 2018, circular of the RBI, which among other things directed banks to take the defaulting power, sugar, shipping companies to the insolvency court.

A bunch of power companies, as well as industry bodies such as the Association of Power Producers and Independent Power Producers Association of India, had in August 2018 moved the Supreme Court, challenging the constitutional validity of the circular.

On what grounds has the court squashed the RBI directive? Typically, the courts, even in developed markets, do not interfere with policy decisions of the government and the regulatory bodies in “deference” to their expertise. (Remember the landmark case of Chevron USA., Inc. Vs Natural Resources Defense Council, Inc, in 1984 that led to the coinage of the term “Chevron Deference”?) However, a court can always look into the procedural violation in the implementation of a regulation. And, it can also take a call if it finds that a particular regulation is violating any constitutional provision. 

In this case, the two-judge Bench of Justice Rohinton Fali Nariman and Justic Vineet Saran has found that the circular has violated the spirit of Section 35AA of the Banking Act, amended in May 2017. Under this Section, directions can be issued for “a default” but the regulator, in this case, has bunched up many default cases. 
 

The power companies had, in fact, alleged that the RBI has adopted a “one-size-fits-all” approach without taking into consideration why the power companies could not pay up their debt. They have also based their arguments on the issues of supply side (shortage of coal) and demand (inability to raise the tariff). The RBI, on its part, has maintained that those companies were given ample time to resolve issues but they failed.

The RBI won the first round of the court battle when in August 2018, the Allahabad High Court denied any relief to the power companies, represented by the two industry associations. It, however, suggested that the government could use Section 7 of the Reserve Bank of India Act and “direct” it to modify the order – something which the government threatened to do. 

Following the Allahabad High Court judgment, some three-dozen companies moved the Supreme Court that transferred all the cases being fought at different high courts (in Chennai and Delhi) to itself and also stayed insolvency proceedings against these companies. 

The final order sealed the fate of the RBI’s circular that was put up on the Indian central bank’s website close to midnight of February 12. Why was it so? The next day, February 13, was a holiday for the markets and the banking sector on account of Maha Shivaratri. By releasing it ahead of a holiday, the RBI wanted to avoid any knee-jerk reaction from the market.

To be sure, the government has all along had a soft corner for these companies; it had tried hard to convince the central bank to go soft on the circular and even threatened to “direct” it using a clause of the RBI Act but without success. Despite the government’s nudge, the central bank did not dilute its stand on taking the power sector defaulters to the National Company Law Tribunal (NCLT).

Many say the starting point of the conflict between former RBI governor Urjit Patel and the government was this circular that turned acrimonious in due course and finally led to the exit of Patel in December. The circular had asked banks and other lenders to either execute a resolution plan for big stressed accounts (of Rs 2,000 crore or more) or file insolvency petitions against them in the insolvency court. For resolution, 180 days were given, failing which the asset was to be taken to the NCLT for insolvency.

This was only one part of the circular. It had many other directions. For instance, all existing frameworks for addressing stressed assets – such as corporate debt restructuring (CDR), strategic debt restructuring (SDR) and the scheme for sustainable structuring of stressed assets (S4A), among others — were withdrawn and the joint lenders’ forum, an institutional mechanism that was overseeing them, was dismantled. I guess these won’t be revived following this judgment. 

By saying that all bad loans should be resolved within 180 days, failing which the account must be referred to the Insolvency and Bankruptcy Code (IBC) court, the RBI wanted to say that when a borrower fails to pay a bank loan in time, it becomes a defaulter. It also wanted to remove the term “stressed” account from its lexicon that was often an excuse for the banks to postpone the inevitable.
 

Indeed, the postponement was done, in many cases, by giving fresh loans (evergreening in banking parlance) to help the borrowers service an old loan. The banks were typically reluctant to take a hit on its balance sheet; besides, many also enjoyed a cosy relationship with their borrowers.

Introduced in June 2015, SDR gave banks the power to convert a part of their debt in stressed companies into majority equity; it didn’t work because promoters delayed the restructuring, dangling the promise of bringing in new investors. Before that, in February 2014, the RBI had allowed a change in management of stressed companies. The idea was to force the shareholders (not the lenders) to bear the first loss and ensure the promoters have more skin in the game. This was done as the CDR mechanism, put in place in August 2001, failed to alleviate the pain of the lenders. The S4A scheme allowed the banks to convert up to half the loans of stressed companies into equity or equity-like securities. Not much has, however, got resolved under this scheme either.

The RBI’s war against bad loans started with the so-called asset quality review, or AQR, in the second half of 2015 under which the central bank’s inspectors swooped on the books of all banks and identified bad assets. The bankers were directed to come clean and provide for all bad assets by March 2017. On top of that, the central bank started forcing banks to disclose the divergence between the RBI’s assessment of loan books and the banks’ recognition of bad assets in the notes to accounts of their annual financial statements to depict “a true and fair view of the financial position” of each bank.

An ordinance was promulgated in 2017, amending the Banking Regulation Act, 1949, giving powers to the central bank to push the banks hard to deal with bad assets. It authorised the RBI to direct the banks to invoke the IBC against the loan defaulters. It was necessary to demonstrate to the corporate world that the government was backing the move. Armed with this, the RBI forced banks to push 39 bad accounts into IBC in two phases in 2017 that collectively accounted for at least 40 per cent of the industry’s bad assets then. And, the 12 February circular was backed by it which the Supreme Court doesn’t approve of. (The 39 cases of 2017 were outside this circular and hence should not be affected.)

Indeed, the judgment will deal a blow to the RBI’s war against bad loans and the cleanup drive will lose its steam but it’s a temporary setback. The resolution process of these cases will get delayed and those banks that had already provided more than what they were expecting to get following resolution of cases will be disappointed as they won’t be able to write back some money and add to their profits. But will they be too happy to give fresh debt to those borrowers that rush to court and stymie any move to recover money lent to them? 

Does the RBI need to go back to drawing board and redraft the rules of tackling the defaulters? Not exactly. It was empowered to direct the banks to do things even before the amendment of the Act. All it probably needs is to tell individual banks to act to recover bad loans. 

And, every default doesn’t necessarily have to be dealt with at the insolvency court. They can be done outside and the trend is catching up.

Following the cleanup drive, the body language of both the bankers and corporate honchos has changed. The promoters are not taking their empire for granted anymore and the banks are no longer giving them kid-glove treatment. Will this judgment reverse that? I don’t think so. A strong banking system is a must as otherwise India will not be able to support its growth story.

The columnist, a consulting editor with Business Standard, is an author and an senior advisor to Jana Finance Bank Ltd. Twitter: @tamalbandyo