Securitisation Act ? Lender's right and liability   Dharmalingam Venugopal The Business Line Published on May 7, 2004

 

THE recent judgment of the Supreme Court in the Mardia Chemicals case upholding the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (Sarfaesi) Act, 2002, seems to have received more brickbats than bouquets from bankers and analysts. The ruling, some feel, has put the clock back to the pre-Sarfaesi days. Others say there is more smoke than fire in the judgment. However, a careful reading shows that the judgment is well-reasoned and pragmatic, striking a balance between a lender's right and his liability.

 

Lender's right

 

The main contention of the defaulters was that the Sarfaesi Act was one-sided and had vested the banks and the financial institutions with arbitrary powers in dealing with defaulters; that the Act did not take into account lender's liability and provide safeguards against irresponsible action by the lenders; and that the conditions under which an appeal was allowed were too stiff and unfair.

 

Nevertheless, while giving due consideration to the defaulters' objections, the Supreme Court upheld the validity of the Sarfaesi Act based on the broader national objective being sought to be served by it.

Having accepted the path of globalisation and liberalisation to spur economic growth, the country had to first bring its economic policies, rules, laws, practices and institutions in line with global standards. The balance of payments crisis of the early 1990s came as a blessing in disguise as it provided a major fillip to push through such reforms.

The thrust of the reforms focussed on the financial sector, in general, and banks, in particular, as these were fundamental to any reforms in the economy.

 

After many high-level committees and much deliberations, the Narasimham Committee laid down a roadmap for reforms in the banking and financial sectors. It stands to the credit of the financial system that it adapted itself to the changes in a remarkable manner in quick time.  However, while the banking industry was progressively complying with the international prudential norms and accounting practices, it was lagging in certain crucial areas. There was, in particular, no effective way to deal with bad debts or non-performing assets which were already at much higher than globally accepted levels.

 

As the court observed, the existing legal framework relating to commercial transactions had not kept pace with the changing commercial practices and financial sector reforms.  Debt Recovery Tribunals were set up under the Recovery of Debts Due to Banks and Financial Institutions Act 1993 but were plagued by their own problems so much so that they could hardly cut down on legal delays. There was, therefore, an imperative need for a faster procedure empowering the banks to recover their dues. More specifically, as in the case of international banks, Indian banks needed to be vested with the power to take possession of the securities given by the defaulters and sell them to realise their dues. This practice of securitisation of debts is in vogue all over the world.

 

It was in these circumstances that the Sarfaesi Act was enacted, duly recommended by the Narasimham Committee and then the Andhyarujina Committee. Explaining that the intention of the Act was not to interfere with an individual's right, the Supreme court held that "wherever public interest to such a large extent is involved, individual rights may have to give way... Even if a few borrowers are affected here and there, that would not impinge upon the validity of the Act which otherwise serves the larger interest".

 

Lender's liability

 

At the same time, while upholding the Sarfaesi Act, the court held that the process of implementing the law must be fair and reasonable. The apex court underlined the need for action under the Act to be in keeping with the concept of right to know and lender's liability, which are part of international best practices in banking. In fact, there was a move to introduce a Bill to legislate on lender's liability but it was deferred as it was later felt that the provisions of the Act might be more misused than used. Nevertheless, a Fair Practices Code with regard to lender's liability has since been introduced.

 

Stressing further the case for upholding the principles of lender's liability, the court felt that the Act cannot be a one-sided affair shutting out all possible and reasonable remedies to the borrowers. It has, therefore, struck down the contentious condition of the Act which required the defaulters to deposit 75 per cent of the disputed amount before going on appeal. The court described the condition as "one example of hitting below the belt''. The Supreme Court has also empowered the DRT to grant stays on sale of assets in deserving cases.

 

Guidelines

 

The apex court summed up its judgment by laying down certain general guidelines to be followed by banks and financial institutions while taking recourse to the Sarfaesi Act.  First, it is incumbent upon the banks to serve 60 days notice before proceeding to take any of the measures as provided in the Act. After service of notice, if the borrower raises any objection or places facts for consideration of the banks, such reply to the notice must be considered with due application of mind and the reasons for not accepting the objections, howsoever brief they may be, must be communicated to the borrower. An internal mechanism must be particularly evolved to consider such objections raised in the reply to the notice.

 

However, the reasons so communicated shall only be for the purposes of the information/knowledge of the borrower without giving rise to any right to approach the Debt Recovery Tribunal under Section 17 of the Act, at that stage.

Second, after taking possession of the securities it would be open for the defaulter, before the date of sale/auction of the property, to file an appeal before the Debt Recovery Tribunal.

 

The Tribunal can stay the sale or auction or pass an interim order subject to conditions it may deem fit and proper to impose. The defaulter need not deposit any amount before preferring the appeal. In addition, the aggrieved party can, under certain limited grounds, take recourse to a civil suit if the matter relates to an English mortgage enforceable without intervention of the court.

 

Impact

 

What will be the net impact of the judgment on banks' NPA levels is the big question now. In the last two years of its existence, Sarfaesi has had a salutary effect on NPA management in banks. Banks have issued over 15,000 legal notices on defaulting companies to recover bad loans worth about Rs 20,000 crore. Besides, the Act has paved the way for several out-of-court settlements. It has also generally helped inculcate a repayment discipline among borrowers.

The judgment does not appear to have diluted the power of "seize and sell'' originally vested with the banks under the Act. There is also not much scope for defaulters to misuse the relaxations allowed by the recent judgment and flood the courts with such cases.

 

The appeal allowed under the Act is at best only an indemnity on the part of the banks in case they act wrongly. Besides, stay of the sale or auction of assets cannot be expected as a matter of routine.

According to estimates, the judgment is expected to reduce the gross non-performing assets (NPAs) of banks and FIs by about 20 per cent from the present level of around Rs 1,00,000 crore within a year.

 

The net impact of the Act must be viewed in the context of the progress of the overall banking reforms. Indian banking is in the second phase of reforms when more stringent prudential norms are likely to be introduced.

India has also agreed to adopt the Basle-II norms in stages. The loan impairment period has been reduced from 180 days to 90 days, meaning a loan will be declared non-performing at the end of the third month itself if the dues are not paid. This together with the stricter inspection and auditing practices, which have been introduced as part of the reforms, would keep the potential defaulters under scrutiny from the beginning.

 

In the circumstances, it will be in the interest of the banks as well as the borrowers to avoid defaults and take timely remedial action in the first place. Where defaults are unavoidable, the banks will be left with no option but to resort to Sarfaesi. The defaulters will have little to gain by challenging the action unless they have a definite case of malafide action by the banks.

 

At the same time, it may not be in the interest of banks to use the Sarfaesi Act as a matter of routine. There is severe competition among banks and the avenues of credit deployment by banks have narrowed down significantly.

In such a situation, banks cannot afford to scare away potential borrowers with Acts like Sarfaesi. It is for the bankers to determine where to draw the line.

 

(The author is an economist with Indian Overseas Bank and can be contacted at dvenu@xxxxxxxx)