After suffering a major setback in the case of Dharani Sugars and Chemicals Ltd. v. Union of India (“Dharani”) where its Feb 12 Circular was struck down, RBI has come back with a more prudent and humble framework under the “Reserve Bank of India (Prudential Framework for Resolution of Stressed Assets) Directions 2019” (“2019 Directions”), inter alia, choosing to abandon mandatory insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 (“IBC”).
This article seeks to make a thorough analysis of the new resolution framework under the 2019 Directions, comment on it and test it on the touchstone of Dharani.
[We have analysed the Dharani Judgement at length, here. Furthermore, a thorough analysis of the Feb 12 Circular can be found here.]
In 2018, to tackle the growing problem of NPAs in the Indian economy, RBI came up with a Circular titled ‘Resolution of Stressed Assets – Revised Framework’ (“Feb 12 Circular”). By this new framework, the RBI had mandated a timeline of 180 days from default for the lenders to implement a ‘Resolution Plan’ (“RP”) aimed at resolving said default. However, beyond these 180 days, the banks were bound to refer the defaulting company to go under the insolvency resolution process under the IBC where the aggregate exposure stood at Rs. 2000 Crores and more. Among various other highlights, this outgone framework evolved the concept of an RP (outside of the IBC) that is a potentially assimilated exercise of all of its outgoing instructions, enforced generically, scrapping the tools for resolution that it proceeded like the Joint Lenders Forum (“JLF”), Strategic Debt Restructuring (“SDR”), Corporate Debt Restructuring (“CDR”), etc. The Feb 12 Circular was struck down by the Apex Court in Dharani for being ultra vires the Banking Regulation Act, 1949 (“BR Act”) and the RBI Act, 1934.
2. Analysis of the Framework
While the new 2019 Directions follow generally in the direction of the erstwhile Feb 12 Circular, there are certain substantial changes that have been made to this framework in view of the Dharani judgment and with the benefit of hindsight, that should help in its successful implementation. The 2019 Directions set out the following:
RBI has expanded the applicability of the 2019 Directions by bringing Small Finance Banks along with Non-Banking Finance Corporations (“NBFC”) within the ambit of the resolution framework. This is in addition to the Schedule Commercial Banks and All India Term Financial Institutions that had already been covered under the Feb 12 Circular.
The revival and rehabilitation of Micro, Small and Medium Enterprises shall be in terms of RBI’s 17.03.2016 Circular on the subject, along with lesser exceptions carved out for the applicability of prudential norms to MSMEs as provided under the 2019 Directions.
2.2. RBI’s Power to Direct for Insolvency Resolution
The 2019 Directions have not been issued in prejudice of the power of the RBI to direct banks to initiate insolvency proceedings against specific borrowers under the IBC. However, the use of such power has limitations as pointed out in Dharani and discussed below. The overall discretion to this effect, unless power under Section 35AA of the BR Act is exercised, remains with the lenders.
2.3. What Constitutes a Default?
Under the 2019 Directions, a ‘Default’ means non-payment of debt (as defined under the IBC) when whole or part or instalment of the debt has become due and payable but is not paid by the debtor. Furthermore, for revolving facilities like cash credit, default would also mean, without prejudice to the above, the outstanding balance remaining continuously in excess of the sanctioned limit or drawing power (whichever is lower) for more than 30 days.
2.4. Resolution Framework
2.4.1. Early Identification and Reporting of Stress
Lenders are obligated to recognize the incipient stress in the loan account immediately upon default and must categorize these accounts as Special Mention Accounts (“SMA”) on the basis of the following criteria:
|SMA Sub-categories||Basis for classification – Principal or interest payment or any other amount wholly or partly overdue between|
A separate criterion for SMA classification has been provided in case of revolving credit facilities like cash credit. This is as follows:
Basis for classification – Outstanding balance remains continuously in excess of the sanctioned limit or drawing power, whichever is lower, for a period of:
The present circular also provides for the reporting of the SMA classifications to the Central Repository for Information on Large Credits (“CRILC”) by borrowers for accounts with aggregate exposure of Rs. 5 Crores and above, on a monthly and a weekly basis.
2.4.2. Resolution Plans and their Implementation
The 2019 Directions expects lenders to initiate the process of implementation of a Resolution Plan with regard to a defaulting borrower, even before a default takes place, since “a default with any lender is a lagging indicator of financial stress faced by the borrower”. Nevertheless, where default occurs with any of the stipulated lenders other than NBFCs, all lenders are mandated to take a prima facie review of the default and the defaulting account within 30 days of the default. During this Review Period, lenders may decide on the resolution strategy, including the nature of the RP, the approach for implementation of the RP, etc. The lenders may also choose to initiate legal proceedings for insolvency or recovery in the review period. Therefore, the discretion to pursue statutory processes under IBC or SARFAESI, for example, are completely vested with the lenders.
This 30-day Review Period represents a necessary discretion in the hands of the lenders that would enable them to undertake a sound analysis to determine the best course of action with regard to the defaulting account rather than hastily targeting resolution within 180 days. As Benjamin Franklin rightly said, “great haste makes great waste”. It seems that the RBI has finally heeded to this wisdom.
After the review period, in case the lenders choose to implement an RP, the lender must implement a Board approved Resolution Plan to resolve the default to be implemented within 180-days. In this direction, where there is more than one lender, this consortium must enter into an Inter-Creditor Agreement (“ICA”) to provide for ground rules for finalisation and implementation of the RP.
Under the ICA, a decision of the consortium would be affected by a vote of lenders holding 75% share of the outstanding loans and 60% of lenders by number, binding upon the whole of the consortium. Importantly, the ICA shall also set out the rights and duties of the majority lenders, treatment of lenders with cash flow priority or secured interests, etc. The present circular mandates that the ICA must provide for not less than the liquidation value due to the dissenting lenders in order to ensure their rights aren’t lost at the whims of the majority.
2.4.3. Staged Application of the Circular
The 2019 Directions are to be rolled out in stages based on the aggregate exposure of borrowers, as follows:
|Aggregate Exposure to Lenders (In Rs.)||Reference Date|
|20 billion and above||June 7, 2019 (Date of 2019 Circular)|
|15 billion and above, but less than ` 20 billion||January 1, 2020|
|Less than ` 15 billion||To be announced in due course|
2.4.4. The Generic Resolution Plan Prevails
The Feb 12 Circular marked a substantial change in the approach of the RBI towards stressed asset resolution. One of these was to overhaul in the form of a generic “Resolution Plan” for default resolution in place of its (overly) many pronged series of instructions for a resolution that presented their own functional challenges like JLF, CDR, SDR, etc. The generic RP, now also under the 2019 Directions, may involve any action/plan/ reorganization including, but not limited to, regularisation of the account by payment of all over dues by the borrower entity, sale of the exposures to other entities/investors, change in ownership and restructuring. This generic resolution plan is very much the sum of all the outgoing tool in RBI’s arsenal, not beholden to the procedural lapses of its constituents, by its very nature.
2.5. Conditions for Implementation of an RP
Like before, the 2019 Directions mandate that an Independent Credit Valuation (“ICE”) for accounts with aggregate exposure of Rs. 100 Crores and more and 2 such ICE’s for accounts with aggregate exposure of Rs. 500 Crores and more, by a credit rating agency, must be undertaken. Only those RPs that are awarded an RP4 rating (having a moderate degree of safety regarding timely servicing its financial obligations/ having moderate credit risk) or more on the residual debt would be considered for resolution. An RP is deemed to be implemented when only where the following conditions are met:
|Type of RP||Condition|
|RP involving restructuring/change in ownership||Where the lender is not in default up to the 180th day from the|
|RP not involving restructuring/change in ownership||
i. Where all related documentation/creation of security charge/perfection of securities are completed;
ii. The new capital structure and/or changes get reflected in the books of all the lenders of the borrower; and,
iii. The borrower is not in default with any of the lenders.
Where the RP comprehends of change in ownership, it has to be affected in a manner consistent with Section 29A of the IBC which lays out the persons who are not eligible to submit a resolution plan for its own offences/lapses or relation to the corporate debtor. It has even been provided that the new promoter of the corporate debtor should not be a person or entity from the existing promoter group.
2.6. Tackling Delays with Provisioning
RBI has chosen to pursue a more stringent route to ensure effective and efficient resolution by mandating heavy additional provisions in cases of deviation from the 180-day timeline, for the implementation of an RP. After the 30 + 180 days, additional provision of 20% of the total outstanding of the debt would have to be made by the lenders. Further, if the RP is not implemented within a period of 365 days from the commencement of the review period, an extra 15% of the outstanding debt would have to be provisioned for by the lenders, totalling additional provisioning of 35%. These provisions would be over and above the provisions already held or the provisions required to be made as per the asset classification status of the borrower account, subject to an upper limit of a provision of 100% of the total outstanding. The additional provisions shall be made by all the lenders with exposure to such borrower.
Additional provisions shall also be made in cases where the lenders have initiated recovery proceedings unless the recovery proceedings are fully completed. These provisions are then to be reversed in the following cases:
[i] Where the RP involves only payment of overdue by the borrower and it is not in default for a period of 6 months from the date of clearing of the overdue with all the lenders;
[ii] Where RP involves restructuring/change in ownership outside IBC – the additional provisions may be reversed upon implementation of the RP;
[iii] Where resolution is pursued under IBC – half of the additional provisions made may be reversed on the filing of insolvency application and the remaining may be reversed upon admission of the insolvency application by the NCLT; or,
[iv] Where an assignment of debt/recovery proceedings is initiated – the additional provisions may be reversed upon completion of the assignment of debt/recovery.
2.7. Mandatory Insolvency Proceedings, No More
One of the biggest flaws and the defining attribute of the Feb 12 Circular was the mandatory direction to banks to initiation of insolvency resolution process under the IBC against the corporate debtor where the implementation of an RP had failed. This is no longer a condition under the 2019 Circular and the discretion to pursue a debtor under the IBC is now vested with the lenders subject to the power of the RBI to direct bank(s) to this effect under Section 35AA of the BR Act. However, this power is to be exercised with regard to specific defaults and with due authorization from the Central Government.
RBI has carved out an exception for cases in which it has already directed for the initiation of insolvency proceedings. The provisions of this Circular are not to apply in such cases. This includes RBI’s Press Release dated 13.06.2017 where it had directed banks to send the 12 Mega Defaulters for insolvency resolution under the IBC.
2.8. When to Upgrade the Accounts?
The 2019 Directions stipulate that an upgrade of asset classification would only be allowed where there is no default in the period after the implementation of the RP and the repayment of 10% of the outstanding principal debt. If there is a default in this period, the RBI has imposed a condition for the creation of an additional provision of 15% by the lenders.
2.9. Cases of Fraudsters and Willful Defaulters
Borrowers who have committed frauds/ malfeasance/ wilful default will remain ineligible for restructuring. However, in cases where the existing promoters are replaced by new promoters, and the borrower company is totally delinked from such erstwhile promoters/management, lenders may take a view on restructuring such accounts based on their viability, without prejudice to the continuance of criminal action against the erstwhile promoters/management. This is in line with the Government’s multi-faceted attack against such offenders.
2.10. Role of the NBFCs
The role of the NBFCs, under the 2019 Directions, seems more like that of a tag along in the resolution process. First, where a default is reported with an NBFC, the same would not lead to the initiation of a review period. Second, the reference date provided under the Directions would be in respect of all of the lenders except NBFCs. Therefore, default with an NBFC would not trigger the process under the 2019 Directions but where a default is reported with other banks, it would be tagged along in the Inter-Creditor Agreement for resolution, as provided under these Directions.
3. Testing the 2019 Directions on the Touchstone of Dharani
In the course of its decision in Dharani, the Supreme Court had laid down certain principles with regard to the mandate and power of the RBI in terms of the BR Act and the RBI Act that are relevant even in the case of the 2019 Directions, these are:
3.1. Section 35AA of the BR Act
The Apex Court had held that RBI’s power to direct for insolvency under the IBC is only to be exercised within the four walls of Section 35AA of the BR Act. RBI can only direct banks to initiate insolvency proceedings where, first, the central government has authorized the RBI to this effect and second, such authorization must be with regard to specific defaults and not in generality. Going forward, RBI must take note of this where it hopes to direct banks to initiate insolvency resolution proceedings under the IBC.
3.2. Section 35AB of the BR Act
The Apex Court had in Dharani, delineated between Sections 35AA and 35AB of the BR Act to the effect that when it comes to issuing directions to initiate the insolvency resolution process under the IBC, Section 35AA is the only source of power. However, when it comes to issuing directions in respect of stressed assets, which directions are directions other than resolving this problem under the IBC, such power falls within Section 35A read with Section 35AB of the BR Act. This means that RBI cannot purport to give directions for the initiation of the insolvency resolution process in the garb of these directions or Section 35A/35AB for that matter.
3.3. Section 45-L of the RBI Act
The 2018ited the power contained in Section 45L of the RBI Act insofar as directing non-banking financial institutions is concerned. Section 45L(1)(b) of the RBI Act empowers the RBI to give to such institutions either generally or to any such institution in particular, directions relating to the conduct of business by them or by it as financial institutions or institution if the Bank is satisfied for the purpose of enabling it to regulate the credit system of the country to its advantage it is necessary so to do. However, Section 45L(3) of the RBI Act provides that in issuing these directions, the RBI shall have due regard to the conditions in which, and the objects for which, the institution has been established, its statutory responsibilities, if any, and the effect the business of such financial institution is likely to have on trends in the money and capital markets. The Apex Court had in Dharani, held that there is nothing to show that the provisions of Section 45L(3) had been satisfied in issuing the Feb 12 circular and therefore, it falls foul of the same requirement under the RBI Act. It remains to be seen what considerations were made to this effect, under the 2019 Directions.
The 2019 Directions are a re-do for the RBI. After over-stepping its mandate under the Feb 12 Circular, it has sought to come back with a better framework and in this process, hindsight has served them well. While these new Directions are not perfect, what regulatory endeavour in this wide/wild world ever is? Nevertheless, the Author seeks to bring out the following facets of the 2019 Directions:
- Moving from the requirement of unanimity, the RBI has stipulated that in terms of the Resolution Plan, the will of 75% of the lenders by the value of the total outstanding and 60 % of lenders by number will prevail. This is an effective measure to bring balance to the decision making of the lenders’ consortium.
- The Inter-Creditor Agreement serves as a platform that enables the consortium of lenders to set the ground rules of the resolution process. This gives an air of certainty to the whole resolution process altogether. For example, the lenders can agree under the ICA that during the resolution process, none of the lenders would take action under the IBC.
- The generic scheme of an RP allows for an effective mechanism of resolution leaving behind the shortcomings of the respective outgone tools like JLF and others.
- Under the 2019 Directions, where default occurs with one lender, and not with any other lenders, the resolution process under the 2019 Directions would have to be pursued with all of them.
- The requirement of high provisioning is likely to hit the banks hard with regard to their profitability and force banks to have to choose the IBC route even where resolution can be successful outside of it. Illustratively, the 2019 Directions provide, as means of reversing the strict additional provisions, filing an insolvency application against the Debtor, half upon application and half upon admission.
- Unlike the last time, in the 2019 Circular, RBI has refrained from mentioning the source of statutory authority in formulating the 2019 Directions. This may just be out of abundant caution, seeing how in Dharani, such a clause in the Feb 12 Circular was used as a legend to establish its ultra vires.
4.3. The Bittersweets
- The strict provisioning requirement, though would land a blow to the profitability of the banks, would serve to benefit the timelines for resolution of the stressed assets.
- While the 75&60% requirement for the approval of the Resolution Plan would help in ensuring success in the approval of a Resolution Plan and detract deadlocks, the claims of smaller banks or banks having smaller exposure like NBFCs would be more prone to be lost in the struggle to get a Resolution Plan approved by the 75 & 60 per cents.
- While the addition of the 30-day Review Period is a much-needed relief to the lenders, a new level of stringency has been introduced in the resolution process by way of heavy provisions that are to be created by the lenders. Furthermore, an incentive has been built into the framework which allows the reversal of the provisions created, when the lender ‘chooses’ resolution under the IBC.
The Reserve Bank of India’s Revised Framework for the Resolution of Stressed Assets has got a new lease on life. While it is essentially the Feb 12 Circular sans the mandatory insolvency provision, RBI has not failed to introduce some important provisions to the resolution framework to effectively implement it. As the Greyjoy House’s saying goes, “what is dead may never die, but rises again harder and stronger” so did the 2019 Directions rise harder (in provisioning) and stronger (in vires). This framework has shed a lot of weight by getting rid of the direction for mandatory IBC resolution and so it has lost s0me of its fangs. Nevertheless, the RBI has not failed to put in place, honey traps and pressure points to game the lenders towards “choosing” to go with the insolvency resolution process, if not for the sake of IBC resolution but simply to get the weight of high provisioning off their chests, especially after the implementation of the RP has been delayed.
The 2019 Direction ought not to be looked at in isolation. These Directions, along with the IBC are the future for the resolution of defaults in financial credit. Furthermore, measures of resolution without the invocation of the Code through means like pre-packaged and mediated insolvency along with other non-IBC means would very well strengthen this holistic exercise in the resolution of stressed assets. Nonetheless, time will tell what awaits the 2019 Directions and how the RBI, the lenders and the borrowers would execute their roles therein.