RBI’s latest crackdown on wilful defaulters: Draft Directions have glaring loopholes

Lack of objective parameters in identification of WDs

In terms of the Draft Directions, a borrower/guarantor may be classified as a WD if inter alia it defaults in making payments despite having the “capacity to honour the obligations”. Interestingly, no objective criteria in the assessment of such inability has been prescribed thus far. This leaves a wide discretion to the lenders to deploy indicators which may result in contradictory outcomes and could potentially be successfully contested by the relevant borrower. Financial indicators such as asset liability ratio, debt/equity ratio, loan to value ratio, current ratios, or project security cover requirements could be alternatively considered  by the RBI, and mandated to objectively determine the financial ability of the borrower in making the repayment obligations based on the nature of the underlying facility and the collateral package, on a case to case basis.

‘Diversion of funds’- Ambiguity

Another parameter for classification as a WD includes ‘diversion of funds’ which inter alia includes any transfer of funds to group companies as well as any shortfall in the deployment of funds vis a vis the amounts disbursed. This may have far reaching consequences especially in project based financing models where monies raised by the project companies may be required to be up-streamed or down-streamed based on the capital structure and  internal requirements. Additionally, borrowers may commercially determine the manner of utilisation of funds where upon such disbursement having been made by the lender, released for the specified end used in a staggered manner.

Debarment on access to institutional finance

A key implication for such classification includes an absolute restriction on the borrower and its subsidiaries, associates and joint ventures from availing credit facilities until 1 year after the WDs name is removed from the list of WDs. Note that a WD includes any director of a company who is established to have knowledge/connivance with respect to such a WD. Whilst such a measure is a strong deterrent in curbing rising cases of wilful defaults, it is fraught with legal issues including:

(a)    A challenge under Article 19 (1) (g) of the Constitution of India as an absolute bar on access to institutional finance could result in infringement on the right of the borrower to carry on their business.

(b)    The principle of ‘lifting the corporate veil’ being successfully contested given that an absolute overarching restriction on the group companies to access institutional finance including subsidiaries and associates of a company for say, any wilful default by the director of the relevant company, could be unnecessary and oppressive.

Implications on equity infusion events

Another parameter for the classification of WDs includes the failure of an entity to wilfully not infuse equity despite having the ability to, especially where the lender has provided loans/concessions based on such commitment. This is extremely tricky in the present volatile markets, where equity valuations have borne a considerable brunt. In fact, the recent ‘funding winter’ has acted as a fillip to the development of domestic bond markets.  This is especially critical since while on one hand, no objective parameters or timelines have been determined by the RBI for the failure to infuse such equity commitments including any timelines for such completion, such classification of a company as WD could, especially from the buy-side could further derail the equity infusion process.

Regulatory over-reach over unregulated entities

The RBI has now prescribed that third-party professionals (which may include chartered accountants, legal counsels, valuers, etc.) within the ambit of the WD regime, and has directed lenders to update information of such third-parties which have played a vital role in the disbursement process and are subsequently found to deficient/negligent in their work, and report to the IBA for disclosure in a caution list. Such an approach could lead to a regulatory interference between the relevant governing bodies including the ICAI, the Bar Council of India, the SEBI (in case such financial indebtedness is availed by way of (unlisted debentures) and further derail the process of ease of doing business. Inter-regulatory coordination and separate regulatory and institutional framework will need to be fleshed out by the relevant governing bodies for more efficacious remedies.

Principles of natural justice

Unlike the previous directives issued by the RBI, the Draft Directions provide an opportunity to the borrower/ guarantor/ promoter/ director/ persons who are in charge and responsible for the management of the affairs of the entity for a dual representation; one before the identification committee and second before the review committee. The identification committee consists of the whole time director (other than the CEO) and two other senior officials of the lender as its members, which is thereafter, required to submit its preliminary findings to the review committee comprising of the whole time director (who is the CEO) and two independent directors. This comes in the backdrop of several rulings from various High Courts and the Supreme Court emphasising on the need to incorporate principles of natural justice for classification of frauds and wilful defaulters. However, given that as per the current framework, it takes 90 days for the determination of NPAs, such further timeline of 270 days from the date of default may be a one-step forward and two steps backward for lenders to take action under the WD framework for recovering their dues especially since no penal provisions have been prescribed under the Draft Directions for any breach of the aforesaid 270 day timeline.

Also read: No major changes in RBI’s draft guidelines on wilful defaulters

Indus Law comments    

Whilst the Draft Directions are a step in the right direction towards consolidation of legal framework governing WDs, few of the suggested changes may have sweeping undesired implications. This becomes crucial in times when WD levels in India have gone up from Rs 0.5 trillion in 2015 to Rs 3.5 trillion in 2023.

Having said that, the proof of pudding is always in the eating, and the suggested changes will have to be analysed in light of the final guidelines issued by the RBI after receipt of stakeholder comments. However, for now, the RBI has demonstrated that where there is a wil(ful defaulter), there is a way!

(Pritha Chatterjee is Partner; Rishabh Bhojwani is Senior Associate and Abhishek Jha is Associate at INDUSLAW)