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The Supreme Court has annulled the RBI’s February 12 circular on ‘Resolving bad debts’ and said the banking regulator had acted beyond its legal powers while issuing the directive.

The broad contours of the judgment are as follows:

l The February 12 circular had asked lenders to institute a board-approved policy for the resolution of stressed assets.

l Banks were told to start the resolution process as soon as a borrower defaulted on a term loan even by one day.

l Lenders were given 180 days to cure it, failing which the account would have to be referred to the National Company

l Several companies in power, sugar and fertiliser sectors had challenged the circular as ultra vires on the grounds that it wrongly classified them as wilful defaulters. They argued that they were stressed because of extraneous reasons beyond their control and could not be treated as wilful defaulters.

A two-judge Bench of Justice Rohinton Fali Nariman and Justice Vineet Saran have now observed that the banking regulator did not consult the government before issuing the circular. The bone of contention was Section 35AA of the Banking Regulation Act, which says the government can authorise the RBI for issuing directions to banks to initiate the insolvency process but only in respect of a default and not for a group of defaulters. The top court, however, held that the regulator was well within its rights to exercise powers under Section 35 AA and that the Section, along with Section 35 AB (which gives power to the RBI to issue directions on stressed assets), was not manifestly arbitrary.

The Banking Regulation Act was amended after the introduction of the IBC in 2016. Under the erstwhile Section 21 of the RBI Act, the central bank had broader powers but Section 35AA narrowed them down, limiting the scope for the central bank.

The Supreme Court order has now restored the free hand available to banks to explore steps to either rescue such companies outside the court or refer to NCLT depending upon their perception of factors like chances of revival, management quality and track record.

The Supreme Court decision is the correction of a flaw and will provide flexibility for Lenders to restructure stressed assets either through IBC mechanism or restructuring of Assets, wherever they have confidence in the existing promoters.

Correction of institutionalised disincentives

The leverage available to the lenders is notwithstanding of the fact that, repayment culture is among the most critical inception points for an efficient credit delivery mechanism. Impediments include delayed/disputed payments, litigation on payment issues, poor enforcement of government contracts – to cite a few.

However, credit flow delays at the end of the borrowers result in defaults across the board. Often cash flow delays result due to delays in government programmes. Both union and state governments more often than not delay their disbursements to the private sector.

Even the IT sector is not spared the travails of other well-known affected sectors like power, sugar and fertilisers. Nasscom has estimated recently - Government dues to the IT industry could be more than Rs. 5,000 crore. This problem is far worse in core sectors such as infrastructure and power. In the long run, private investment in big projects remains muted.

Delayed cash flows particularly from government sector remains the bane of industrial distress. This seems contextually most relevant to the scenario of India’s power sector, which has the highest sectoral ratio of NPAs. Firms in steel and power are stymied due to cancellation of their iron and coal blocks.

Most power projects still remain stalled or unproductive due to severe cash-flow concerns –related to availability of fuel, allocation of coal from govt. agencies and effective power purchase agreements. Even though the SC has ruled in favour of these companies, offering a longer-time available to restructure their debt, the core issues connected with the culture of delayed payments and resultant cash-flow problems need structural reforms. Electricity boards owe private power plants large amounts. In the case of roadways, the NHAI has pending arbitration cases running into tens of thousands of crore rupees. RBI and adjudicating authorities may consider entertaining petitions to impose financial penalties on these government units. A 4-5 % penalty per month on a delayed payment may improve the situation. All over the world, lenders function on the two most essential currencies of confidence and trust. When there is a fragile trust-relationship with a borrower, lenders, over a period of time, remain reluctant to lend, particularly in areas where credit demand is higher (say, infrastructure and core areas like power and steel) and repayment mechanism borrowers remain weak.

Taking a step back, it is important to view the current SC order and NPA (non-performing asset) debate in the context of a far more structural concern. That is, India’s NPA culture, created by a fragile lender-borrower dynamic and delayed payment process which the IBC mechanism has proven to have corrected to a great extent.

Role of IBC and delay in admission of IBC cases

RBI and government arms have repeatedly acknowledged the role of the insolvency law as a game-changer. After the implementation of the IBC code, India has the opportunity to consolidate, increase competitive advantage for industrial enterprises. IBC code based restructuring of these distressed assets is driving the structural transformation of the industry.

A healthier banking industry, with unlocked flow of capital, will be in a position to fund large investments required to build new capacities for meeting future demand for the country. With the lower and optimum burden of debt, the balance-sheet problem shall stand resolved. Finance Minister Arun Jaitley had in a Facebook post titled ‘Two years of Insolvency and Bankruptcy Code’, acknowledged the role of IBC and said NCLT has become a trusted forum of high credibility. He had also stated that the increase in conversion of NPAs into standard accounts and decline in new accounts falling in NPA category show a definite improvement in the lending and borrowing behaviour.

Inference

With the automatic referral gone, the ball is back in the banks’ court. While IBC does give them enough teeth to act against defaulters, the judgment will have no impact on the cases referred to the NCLT voluntarily by the banks whether prior or after the date of the circular, and affects only those insolvency cases that were specifically referred under the circular. If banks continue to voluntarily invoke the bankruptcy code, there will be minimal practical impact of the court’s decision.

At a time when unemployment levels are rising with aggregate private investment levels being dismally low across sectors, building growth capacities across the economy is critical for sustained job creation and requires a credible, fluid and flexible credit delivery and collection culture.

Building of confidence and trust to ensure due payments is key to ensuring that industries with higher-growth capacity in sectors like (infrastructure, manufacturing, mining, etc.), are given access to credit from banks/ NBFCs so that they have access to credit at reasonable rates of interest and simultaneously build on penal measures like IBC to deter the delayed payment culture.

IBC is rightly heralded as the biggest reform in the Indian banking sector. Just the threat of being yanked to the bankruptcy code should result in better recovery for Indian banks. In countries such as China and Brazil, where bankruptcy laws were introduced in 2005 and 2007 respectively, recovery rates have increased considerably from 18.80% to 33.4% in China and 12.6% to 26.3% in Brazil, and there is no reason why India should not follow suit.

In due course, the IBC code is expected to become the most water-tight code with every clause being tested. In every country where bankruptcy laws were introduced, it has taken time to stabilise. In India, the process will be faster with precedents and judgments coming sown expediently from the judiciary.

—  The author is a CA is insolvency professional and Founder Director of 'Fair Resolution Professionals Pvt.Ltd.' The opinions expressed are of his own.