High Incidence of NPAs and Positions of Banks And

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High incidence of NPAs and positions of banks

and

financial institutions in insolvency

An analysis of the legal means for debt recovery

with reference to the

SARFESI Act, 2002

Arun Geetesh

©

Introduction

The health of the financial sector is a matter of policy concern, most

especially in

developing countries where failure in financial intermediation can

critically disrupt the

development process. The link between the financial sector and growth

has always been

important and closely watched by both the government, which lays

down the policy and

the various players and the stakeholders in the economy. Today the

quality of the loan



assets is most important factor for the basic viability of the banking

system. The overdue

advances of banks in India are mounting and in consequence the NPAs

in their portfolio

are on the rise, impinging on the banks viability. Avoidance of loan

losses is one of the

pre occupations of management of banks. While complete elimination

of such losses is

not possible, bank managements aim to keep the losses at a low level.In fact, it is the

level of NPAs which to a great extent differentiate between a good and

a bad bank.

Till the enactment of Securitization, Asset Reconstruction and

Enforcement of Financial

Interest Act, 2002, there was no specific legislation or direct effective

measure to deal

with a critical problem facing the financial sector, that of mounting bad

loans or so-called

non-performing assets (NPAs). The extant legal framework governing

the operations of

the financial institutions, it is widely acknowledged, is severely tilted

against lenders who

cannot in practice enforce contracts signed with borrowers because the

legal procedure



©

The author is a student at NUJS, Kolkata and may be contacted [email protected] doing so is impossibly convoluted and

protracted. The lending institutions task of

recovering their loans has been rendered even more difficult by the

steps taken by the

government in the name of reviving sick units through the enactment

of SICA and the

setting up of the Board for Industrial and Financial Reconstruction

(BIFR). The

contribution of SICA and BIFR over the years to the revival of business

enterprises has

been minimal; their more notable role has been to provide a further

avenue for those in

control of companies to renege on their obligations to the financial

institutions.

Borrowers had only to take their units to the BIFR to block efforts by

lenders to recover

their dues as the BIFR went about its notoriously dilatory exercises.

The Indian financial sector has been traditionally dominated by the

government-owned ba nks



and financial institutions. Businessmen have exploited this situation to

build their family

empires with borrowed money even as they kept lenders at bay by

mobilising political

influence to secure government intervention at the central and state

levels against attempts by

lenders to recover loans by enforcing their security. At the same time,

during the long years

of economic control and regulation the real quality of loans to industryand business

remained effectively cloaked by the regime of industria l licensing and

import control and

high tariff walls which ensured that even inefficient enterprises

survived and often flourished.

In any case, given the dominant government ownership and control

banks and financial

institutions did not have to worry overmuch about NPAs. While the

government-owned

banks were periodically capitalised, troubled private sector entities

were bailed out or merged

with government FIs/banks. The fun and games began to lose some of

their flavour with the

economic liberalisation after 1991. Abolition of industrial licensing and

import control meant



competition. Financial sector reforms involving the introduction of

income recognition and

asset classification norms forced banks and FIs to confront the quality

of their loans and

wake up to the reality of huge and rapidly growing NPAs.

The establishment of DRTs was a step in the right direction, since they

considerably

expedited this process of recovery by their speedy recovery

mechanism, not enabling

defaulters to raise pleas of counter-claims and set-off that used to be

reasonablycommonplace in ordinary civil courts. However, this Act did

not really succeed in its end

goal that is to enable bank debt recovery; although its adjudicatory

mechanism did represent

an improvement. Therefore, the shortcomings of this Act, concomitant

with the increasing

proportion of NPAs called for a reorientation of the system. Finally, the

SARFESI Act

presented itself as a solution, although not a complete one as is

becoming evident from its

operation. However, this Act has received its fair share of criticism,

primarily for placing

secured creditors at far too strong a position in comparison to

defaulters.



This paper shall seek to carefully examine the problem of NPAs with

special reference to the

Indian banks and financial institutions, in the process analyzing the

different legal means

available for debt recovery, in the course of which the emphasis shall

be specifically on the

recently passed Securitization, Asset Reconstruction and Enforcement

of Financial Interest

Act, 2002. (SARFESI Act, 2002).

I. THE HIGH INCIDENCE OF NON-PERFORMING ASSETS (NPAS)

AILING THE BANKING SYSTEM: THE ROAD AHEAD AND

CHALLENGES

At this point of time, in banks, no less than 10-20% of the total assets

are in the form of

NPAs. While settling debts and rescheduling repayment has been an

option exercised in the

past, this has failed to fundamentally restructure corporate debt.

1

The problem of NPAs has

secured an important place not only in the realm of regulatory policy

discussion in banking,



but also in general public discussions on the safety and soundness of

banks and financial

institutions. Some of the safeguards against this in the past included

the requirement of the

borrower mandatorily disclosing certain information, this giving rise to

relationship

1

BM Mundhra, SARFESI Act Passes The Test, Chartered Accountant, Vol.

53, No. 2, August 2004, pp.

166-68banking, with the practice of placing an asset as a collateral

being resorted to in cases of the

borrower being reluctant to disclose information.

2

An overview of the Non-performing assets

3

in India:

India has acquired an alarming number of Non-Performing Assets (See

Table 1). As at

31 March 2003, the banks and financial institutions in India held NPAs

worth approximately



Rs. 1 100 000 (around 11 lakh Crores) crore as against an aggregate

gross NPAs of all

scheduled commercial banks amounting to Rs. 63 883 crore at 31

March 2001.

4

[Table 1: Distribution of NPAs percentage to total assets]

Various factors contributing to NPAs:

· The banks functioned in captive capsules under the direct supervision

of the

GOI, finance ministry.

· They were cut off from outside competitions and new vehicles of

lending were

never adopted.

· Major policy decisions were taken by the finance ministry/ RBI.

· Legal remedies were beset with too many formalities and were very

timeconsuming.

· No effective corporate management and credit management.

· Functioning and management inefficiency.

The problem of non-performing assets is more in public sector banks

(PSBs) as compared to

private sector banks and foreign banks. NPAs have a direct impact on a

banks profita bility,



2

Sugata Marjit, Indrajit Mallick, Collateral Monitoring and BankingRegualtion, Economic and Political

Weekly, Vol. XXXIX, No. 12, March 2004, pp. 1259-62

3

In India, an asset is classified as a Non-Performing Asset (NPA) if

interest or instalments of principal due

remain unpaid for more than 180 days. However, with effect from

March 2004, default status would be

given to a borrower if dues are not paid for 90 days. Please refer :

Master Circular- Prudential Norms on

Income recognition, Provisioning pertaining to the Advances Portfolio

issued by the RBI on September1,

2001

4

http://www.geocities.com/kstability/inbank/npa1.html [as on

22/08/07]liquidity and equity. The NPAs of Indian PSBs are considered

relatively high by international

standards. The biggest ever challenge that the banking industry today

faces is management of

the NPAs. The NPAs in PSBs are growing not only due to external

factors like ineffective



recovery tribunals, willful defaults, natural calamities, industrial

sickness, lack of demands,

labour problems, changes in the government policies etc. but also

internal factors like

managerial deficiencies, inappropriate technologies, poor credit

appraisal systems, improper

SWOT analysis, absence of regular industrial visits etc.

This dominance of government securities has only encouraged

colonial banking, since

investing in these securities is free from risk and transactions costs, and

the yields are

reasonably high. Thus, banks do not tend to seek profits, but rather

play safe.

5

This has

caused market distortions, since credit is shifted away from productive

market activities,

in addition to failing to canalize household savings.

6

This is one of the most observable

consequences of NPAs. At the same time, how prudent shall it be to

convert banks that



are not profitable and having large NPAs into banks that do no more

than to invest in

government securities? In other words, should weak banks be

converted into narrow

ones?

7

Public sector banks are supposed to finance priority sectors of the

economy,

including agriculture, small-scale industries, and self-employment

options. At this point

of time, there is a consensus on the need to reduce NPAs, but the

manner in which this

should be done is still not clear. The nature of a business does not

mean that it is likely to

contribute to NPAs, as is often thought about priority sectors.

8

Bank debts should not be

written off so easily, and NPAs should ideally be recovered, as

suggested by some

writers, by the banks themselves, not by an outside agency, and within

a time-bound

schedule.



9

Major Initiatives taken to deal with NPAs:

5

Id. p. 67

6

Id., p. 79

7

Id., 142

8

Instead, different norms should be applicable for different sectors of

the economy. For instance, in the

case of agriculture, the default should be one that has taken place not

by more than two quarters, but by

over two seasons of harvest.

9

Supra note 8, p. 144The Government of India, RBI and other related

agencie s have been hectically engaged

in introducing banking and financial sector reforms. Some of these

salient procedural reforms

are as follows:



· RBI made prudential norms, as conveyed by the Basel Accord of 1988,

applicable to

Indian banks.

· Dismantling of controls and deregulation of working of commercial

banks, permitting

entry of new private sector banks and permission for foreign banks to

open more

branches.

· Banks were permitted to seek infusions of fresh equity from the

public with the

government retaining a 51% share of equity capital.

· RBI has come out with broad guidelines for framing the Fair Practices

Code with

regard to lenders' liability to be followed by commercial banks andfinancial

institutions.

· RBI Guidelines on Fair Practices Code for Lenders are applicable to

SCBs/AIFIs

(excluding RRBs and LABS).

· RBI guidelines on classification of bank advances.

· Circulation of information on defaulters & Recovery action against

large NPAs.



Major Legal Reforms include:

I. The DRT Act & setting up of Debt Recovery Tribunals

The banks and financial institutions can enforce their securities byinitiating recovery

proceedings under the Recovery of Debts Due to Banks and Financial

Institutions Act, 1993

(DRT Act) by filing an application for recovery of their dues before the

Debt Recovery

Tribunal (DRT) constituted under the said act in various states in India.

Once their claim is

adjudicated, a Recovery Certificate for the amount found due and

payable is issued by the DRT. Based on the Recovery Certificate,

execution proceedings are initiated by the Recovery

Officer appointed for facilitating recovery of money under the Recovery

Certificate.

II. Companies Act of 2002 (Second Amendment)

In December 2002, the Indian parliament passed the Companies

Act of 2002 (Second

Amendment) to restructure the Companies Act of 1956 (the 1956 Act)

leading to a new

regime of tackling corporate rescue and insolvency. The provisions of

the Second

Amendment are, however, it is yet to be notified.



III. Securitisation and Reconstruction of Financial Assets and

Enforcement of

Security Interest Act 2002

SARFESI provides for the enforcement of security interests in

movable (tangible

or intangible assets, including accounts receivable) and immovable

property without the

intervention of the court, by way of a simple, expeditious and cost-

effective process.

Where any borrower makes any default in repayment of secured debt

or any installment

thereof, and his account in respect of such debt has been classified by

the secured creditor

as a non-performing asset, then the secured creditor may call upon the

borrower, by way

of a written legal notice, to discharge in full his liabilities within 60 days

from the date of

the notice, failing which the secured creditor would be entitled to

exercise all or any of

the rights set out under SARFESI. The notice must contain details of debt and secured

assets. Any bank or public financial institution or any other institution

or non-banking



financial company as specified by the central government or the

International Finance

Corporation or a consortium thereof can invoke the provisions of

SARFESI relating to

security of interest.

II. THE DEBT RECOVERY TRIBUNALS (DRTS) AND DEBT RECOVERY: A

STEP IN THE RIGHT DIRECTION, AN OBJECTIVE UNFULFILLED

In 1993, the Recovery of Debts due to Banks and Financial Institutions

Act had been

passed, providing for the setting up of Debt Recovery Tribunals (DRTs),

envisaged as quasi- judicial institutions to process suits by banks and FIs

against defaulters. As on 31

st

March 2003, the DRTs had disposed off claims worth Rs. 314 billion, thisamounting to

close to 4% of the total bank credit, with Rs. 79 billion being

successfully recovered. This

has its positive practical consequences, in the form of loan interest

reducing by 1-2%.

This problem of NPAs also ails private banks, which hold no more than

20-25% of the

total assets in the banking sector, but report 10% of their total debt as

an NPA, and this



therefore warranting attention, since at present most of the financial

intermediaries are

private players. Though there are a number of reasons for delayed

judicial intervention in

recovering NPAs, the point that remains is that this is often the

consequence of

procedural norms, which enable a number of applications, counter-

applications and

special leaves, by both sides, in addition to the numerousadjournments. Therefore, the

Tiwari Committee (1981) not only recommended the establishment of

such specialized

tribunals, but also desired that they should not adopt the procedure

prescribed under the

Code of Civil Procedure, and should instead adopt a summary

procedure, wherein they

may pass interim orders, and carry out execution), in accordance with

the principles of

natural justice. This proposal had been endorsed by the Narasimham

Committee. This

Act, by requiring the claim amount to be more than Rs. 1 crore,

targeted large defaults.

10



The legal requirements of a debt are that it should, on the date of the

application before

the DRT, be legally recoverable, and the debt has to arise due to any

business undertaken

by the bank or financial institution. The debt may be secured or

unsecured. More

importantly, it is not necessary that this amount has to be proved to be

due, but this only

has to be alleged.

11

By the operation of Section 31 of this Act, transfer of a suit for bank

debt recovery from the civil courts to the DRTs has been provided for,

12

with the DRT

enjoying exclusive jurisdiction in such suits, this including debt recovery

suits in which

1 0

Sujata Visariay, Legal Reform and Loan Repayment: The

Microeconomic Impact of Debt Recovery

Tribunals in India, Columbia University, January 2005

1 1



United Bank Of India V. Debt Recovery Tribunal And Others, AIR 1999

SC 1381 (Para 2) (DB)

1 2

Id. (Para 3)ancillary or incidental relief has been sought.

13

This ensures that the DRTs are not

relegated to the status of ordinary civil courts, in the process only

frustrating the purpose

of this Act.

14

This Act is clearly an improvement, since it does not enable counter-

claims, that often

used to cause delays.

15

This Act applies only to the debt due to and not by banks and

financial institutions.

16

However, not overriding other laws, this Act does not preclude

other legal remedies from being pursued simultaneously.

17



As per the recommendations

of the Tiwari Committee, the Tribunal shall itself be able to adjudicate

liability and carry

out execution proceedings.

18

This Act had been challenged for depriving a person of legal

remedies in ordinary civil courts. However, the Supreme Court held that

there is no such

right that the dispute should be adjudicated only by a civil court, and

the replacement of

the jurisdiction of civil courts by independent and specialized tribunals

is completely

legal and constitutional.

19

Additionally, this Act had been challenged on the grounds that

the DRTs are not sufficiently independent, there being discrimination

due to the denial of

the right to file a counter-claim, the admission of suits being done on

the basis of their

pecuniary value, and the Constitution not enabling the legislature to set

up separate



tribunals for debt recovery. Under this Act, the different means

available for recovery

include attachment and sale of the immovable or movable property,

arrest of the

defaulter, and even if required the appointment of a receiver.

20

Generally, being desirous

of evading arrest, defaulters pay off their debt.

21

Attachment is only a step that precedes

1 3

Sections 17 and 18 of the Recovery of Debts due to Banks and FinancialInstitutions Act, 1993

1 4

United Bank Of India V. Debt Recovery Tribunal And Others, AIR 1999

SC 1381 (Para 5) (DB) (As

noted, in 1990, no less than 1500000 pending cases had been filed by

public sector banks, for the recovery

of more than Rs. 5500 crores.)

1 5



Bhagbati Prasad Banerjee, Guide to Debt Recovery Law, 1

s t

Edition, Vol. 2, 2004, p. 66

1 6

State Bank of India v. Vijay Kumar Tayal and Others, AIR 1997 Del 170,

as in Bhagbati Prasad

Banerjee, Guide to Debt Recovery Law, 1

s t

Edition, Vol. 2, 2004, p. 69

1 7

Viral Filaments Ltd. v. Industrial Bank Ltd., (2003) 113 Com Cases 85 (at

p. 88) (Bombay HC)

1 8

Allahabad Bank v. Canara Bank , AIR 2000 SC 1535, as in Bhagbati

Prasad Banerjee, Guide to Debt

Recovery Law, 1

s t

Edition, Vol. 2, 2004, p. 77

1 9

Union of India v. Delhi High Court Bar Association, (2002) 4 SCC 275

2 0



Section 25, Recovery of Debts due to Banks and Financial Institutions

Act, 1993

2 1

Bhagbati Prasad Banerjee, Guide to Debt Recovery Law, 1

s t

Edition, Vol. 2, 2004, p. 238 the sale of the said property, and is

provided for under this Act. In the case of immovable

property, an order may be passed prohibiting the defendant from

transferring it.

22

The suits instituted before the DRT should be those involving only

recovery of money,

such suits being filed before the DRT when the company is in

liquidation, or even

otherwise.

23

This Act shall apply not only to loans, but to all forms of debt. This is

evident from the legislative intent in not using the word loan

anywhere in this Act. The

ambit of this Act, however, is not wide enough to include claims for an

amount that has



not been determined previously.

24

For determining the DRTs jurisdiction, the plaint has

to be read as a whole.

25

The ambit of debt is wide enough to include cases in which the

plaintiff contends that a certain amount is legally recoverable, and that

this liability arose

in the course of the defendants business, and is still subsisting.

Therefore, while an

amount misappropriated by an employee is recoverable, this cannot be

done under this

Act.

26

There is no need for the amount to be determined before hand by a

competent

tribunal for the DRT to come into play.

27

However, there is considerable doubt as to

whether the understanding of banking should be limited only to

ordinary lending and



borrowing, since in their present form, banks undertake multifarious

activities.

2 2

He shall have to appear before the RO for taking notice, under Order

21, Rule 54 of the Code of Civil

Procedure.

2 3

Vinod K. Shah, Debt Recovery Tribunals Act, Liquidation Proceedings

and Priorities, Consolidated

Commercial Digest, Vol.4, Part 8, April 2003, p. 4, pp. 4-7

2 4

Vivek Dhamankar and Sandeep Jain, Concept of Debt in the

Recovery of Debts due to Banks and

Financial Institutions Act, 1993, SEBI and Corporate Laws, Vol. 55, 2004,

pp. 59-64

2 5

Union Bank of India v. Debt Recovery Tribunal, AIR 1999 SC 1381

2 6

Bank of India v. VR Kapadia, (1998) 1 Bank LJ 284 (Gujarat HC), as in

Vivek Dhamankar and Sandeep



Jain, Concept of Debt in the Recovery of Debts due to Banks and

Financial Institutions Act, 1993, SEBI

and Corporate Laws, Vol. 55, 2004, p. 61, pp. 59-64

2 7

State Bank of Bikaner and Jaipur v. Ballabh Das and Co., (1999) 7 SCC

539III. THE RIGHTS OF SECURED CREDITORS IN WINDING UP:

ENFORCEMENT OF SECURITY INTEREST OR RECOURSE TO THE

LIQUIDATION PROCEEDINGS

Winding up is not an alternative to the ordinary debt recovery

procedure. At the same

time, it is still an appropriate remedy to be pursued against a company

unable to repay its

debt. However, it needs to be remembered that this is a remedy within

the discretion of

the court, and cannot be claimed as a matter of right.

28

In the case of a secured creditor,

he shall first be required to relinquish his security, only after which can

stand in this

process.

29



The option of standing outside the winding up process, and enforcing

security

interest is available to a secured creditor, in the process taking physical

possession of the

assets, under contract or law, this still being subject to the charge

imposed by the

workmens dues,

30

that shall rank pari passu.

31

In the process of winding up, as is evident

from Sections 529 and 529A, imposing statutory condition, the secured

creditor shall be

able to recover his dues from the assets in the hands of the liquidator,

this being in the

nature of a preferential claim. The statutory requirements are that in

case of a company

winding up, for continuing with previously instituted suit, the lave of

the winding up

cour t is mandatory

32

, this representing the legislative intent that the liquidator does not



have to face protracted and expensive litigation, and in the process the

winding up itself

being delayed.

33

However, this leave is not a condition precedent, but may be sought

2 8

State Trading Corporation of India Ltd. v. Punjab Tanneries, (1989) 66Com Cases 634 (P&H HC). In

this case, a notice had been issued under Section 434 of the Companies

Act against the respondent, but no

reply had been filed thereto. In this case, the ruling in Aluminum

Corporation of India Ltd. v. Lakshmi

Rattan Cotton Mills Ltd., (1970) 40 Com Cases 259 (All HC) had been

relied upon.

2 9

Bharat Overseas Bank Ltd. v. Shree Arcee Steels Pvt. Ltd., (1985) 58

Com Cases 174 (Bom HC) (DB)

3 0

International Coach Builders Ltd. (In Liquidation) v. Karnataka State

Financial Corporation Ltd.,

(1994) Com Cases 19 (at p. 27) (Karnataka HC) (DB)



3 1

Indian Bank v. Perumal Raja and Others, (1993) 76 Com Cases 787

(Madras HC)

3 2

Sudarshan Chits v. G Sukumaran Pillai, AIR 1985 SC 1759, as in

International Coach Builders Ltd. (In

Liquidation) v. Karnataka State Financial Corporation Ltd., (1994) Com

Cases 19 (at pp. 26-27)

(Karnataka HC) (DB)

3 3

Section 446, Indian Companies Act, 1913, Supra note 43 afterwards.

34

At the same time, there is every possibility that this shall only open the

floodgates of litigation.

35

The statutory presumption of the inability to repay the debt shall be

invoked only in cases

in which there is a failure to repay the debt even after the notice has

been served under

Section 434. The creditors may file a collective petition for winding up,

this being



legislatively encouraged, evident from the mandatory requirement of

advertising the

petition. This is more in the nature of class interest litigation, with the

cause of action

being common, commercial insolvency.

36

The liability being acknowledged in the

balance sheet is sufficient to establish that this has been recognized.

37

A company shall not cease to be an industrial concern simply because

it is not

carrying on business, or it is in the process of being wound up.

38

In the process of

passing an order for winding up, the Company Court may direct that

the official

liquidator take possession of all assets.

39

Should a company be in liquidation, it is generally observed that the

secured creditor

stands outside this process, this not requiring the proof of debt.



40

In this process

41

,

ordinarily he should and does not face judicial interference as he is only

realizing his own

security. The failure to realize his security does not result in his

becoming a charge holder

3 4

Reliance placed upon Bansidhar Shankarlal v. Mohd. Ibrahim, (1971)

41 Com Cases 21 (SC), as in

Madhavpura Mercantile Co-operative Bank Ltd. v. Modern Dye Chem.

Pvt. Ltd. and Others, (1997) 88

Com Cases 829 (Guj HC)

3 5

Supra note 46

3 6

AV Krishna and Others v. Karnataka Leasing and Commercial

Corporation Ltd. and Others, (1995) 83

Com Cases 764 (Karn. HC) (DB)



3 7

Shrimati Deepa Anant Bandekar v. Rajaram Bandekar (Sirigao) Mines

Pvt. Ltd., (1992) 74 Com Cases

42 (Bom HC)

3 8

Under Section 2 (c ) of this Act, even those companies that have not

commenced business shall be

included in this definition.

3 9

International Coach Builders Ltd. (In Liquidation) v. Karnataka State

Financial Corporation Ltd.,

(1994) Com Cases 19 (Karnataka HC) (DB)

4 0

Gujarat State Financial Corporation Ltd. v. Official Liquidator and

Others, (1996) 87 Com Cases

658(Guj HC) (DB)

4 1

The rights of a secured creditor to realize his security are recognized by

Section 28 (5) of the Insolvency

Act, as well as Section 529 (1)(c ) of the Companies Act. in the

companys estate. The courts intervention shall not affect him, since

even in the



winding up process, the property is in the courts custody but is not

under its ownership.

42

State financial corporations shall be able to take physical possession of

the assets only

when the defaulter is in charge and control of the same, which is not so

pursuant to a

winding up order being passed.

43

A selection of the procedure to be adopted (Sections 29

and 31) shall be required, this being done bearing in mind the interests

of the Corporation

itself, and that of the general public.

44

Neither is it desirable, nor is it prudent to pursue

both the legal remedies together. They are not under any obligation to

revive and

restructure each and every sick company, or else it may itself run out of

business.

45

The





by the Karnataka State Financial Corporation to sell off the property, it

had been held that

if the property is already in the courts custody, then it shall be a gross

contempt of court

4 2

Supra note 32

4 3

Section 29 (1)

4 4

Srinivas Khandasari Sugar v. Government of Andhra Pradesh, AIR 1976

AP 93, as in Krishnayan Sen,

Exercise of the Right under Section 29 of the State Financial

Corporations Act, 1951 A Review,

Corporate Law Cases, Vol. 2, 2003, p. 376, pp. 375-384

4 5

UP Financial Corporation Ltd. v. Gem Capital (India) Ltd., AIR 1993 SC

1435, as in Supra note 36, p.

377

4 6

Harayana Financial Corporation Ltd. v. Jagdamba Oil Mills, AIR 2002 SC

834, overruling Mahesh



Chandra v. Regional Manager, UP Financial Corporation, AIR 1993 SC

935, as in Supra note 36, p. 378

4 7

KT Sulochana Nair v. Managing Director, Orissa State Financial

Corporation, AIR 1992 Orissa, 157

(DB)if this were to be taken possession of.

48

The liquidator shall be able to sell all the assets to

realize the amount.

49

Sections 442 and 443 mandate that a court may stay or restrain

proceedings against a

company during the presentation of a petition for winding up, and

along with this an

order under Section 443 has to be on a hearing of the winding up

petition itself, this

including orders for dismissing or adjourning the petition. However,

with the leave of the

winding up court, any legal proceeding may be instituted or continuedwith. Winding up

is for the benefit of all the shareholders, creditors and contributories.

Therefore, in this



process, the suit may be stayed, and accordingly the simple act of

instituting a suit shall

not be sufficient to impede this process. Since there is a legal right to

file a suit, its

exercise should not be done in a manner that other legal proceedings

are prejudicially

affected.

50

Generally, if the secured creditors stand outside the process of winding

up, then they shall

seek remedies in the ordinary civil courts, for enforcing their security.

51

In case of

standing outside winding up, then decrees against the company in

liquidation shall have

to be obtained, this involving impleading the official liquidator as a

party, the decree

being enforced against him.

52

This is generally done if the company in question is highly



solvent, in which case it shall be prudent to relinquish the security and

participate in

winding up.

4 8

Karnataka State Financial Corporation Ltd. v. Patil Dyes and Chemicals

(Pvt.) Ltd. and Others, (1991)

70 Com Cases 38 (Karn. HC)

4 9

ICICI v. Srinivas Agencies, (1996) 86 Com Cases 255 (SC)

5 0

Central Bank of India v. Sukhani Mining and Engineering Industries Pvt

Ltd. and Others, (1977) 47 Com

Cases 249 (Patna HC)

5 1

Refer also Section 47 of the Provincial Insolvency Act which says that

he may relinquish his security.

5 2

Karnataka Bank Ltd. v. Craft Tools (Pvt.) Ltd. (In Liquidation), (1986) 60

Com Cases 756 (at p. 758)

(Karn. HC)The judicial approach has been to place government dues

higher than other debts,



including secured debts, but this is not the right approach.

53

It is not clear if this shall

apply only in the case of private unsecured debts.

54

The preferential payment of all

government dues is in such a manner that it stands on the same footing

as workmens

dues and secured debts.

55

However, the settled position as it appears is that government

dues shall be given preference only as compared to unsecured

creditors.

56

IV. SECURITIZATION: WILL CONVERTING RECEIVABLES

INTO MARKETABLE SECURITIES AID IN DEBT

RECOVERY?

Alarmed by an increase in the proportion of NPAs, along with the

unwillingness or

genuine inability of banks to recover their debts, steps had to be taken

to remedy this



situation, in the face of adverse remarks by FFIs.

57

Thus, the SARFESI Act had been

passed, initially promulgated as an Ordinance, with the underlying

legisla tive intent being

to strengthen the rights of banks and financial institutions through

foreclosure and

enforcement of securities, and in the process achieve a concomitant

reduction in NPAs.

58

This process started in the US, in the 1970s, with the issuing of

residential mortgages by

public housing finance corporations, and gained popularity, due to its

being cheaper than

short-term deposits.

59

5 3

In the case of State Bank of Bikaner and Jaipur v. National Iron and

Steel Rolling Corporation Ltd.,

(1995) 2 SCC 19, wherein it had been held that Section 11 AAA of the

Rajasthan Sales Tax Act shall



prevail over an earlier mortgage.

5 4

In the case of Manickan Chettiar v. Income Tax Officer, AIR 1938Madras 360 (FB), in which it had been

held that income tax shall have priority over and above private debts.

5 5

Sections 529 A and 530 of the Companies Act

5 6

Held in Syndicate Bank v. Official Liquidator, Westor Workers and

Engineers Ltd., (1999) 2 Com Cases

211 (Bom HC)

5 7

S Balakrishnan, The Securitization Act, 2002 A Possible Easy RouteFor Recovery Of Huge NPAs Of

Banks And Financial Institutions, Consolidated Commercial Digest, Vol.

8, Part 8, August 2004, p. 643,

pp. 643-48

5 8

For instance, in India, the bulk of NPAs are in industries like iron and

steel and textiles which generally

still continue to use outdated plant and equipment.



5 9

Sarah George T, Securitization: Mechanism and Risk Management,

SEBI and Corporate Laws, Vol. 38,

2002, pp. 10-11, pp. 10-22 The legal remedies available under this Act

include taking over physical possession of

the defaulters assets (this including the lease, assignment or sale of the

same), including

the management that may thereafter be changed.

60

The other options legally available to

the lender include entering into a settlement with the defaulter,

rescheduling the

repayment of the debt, enforcing security interest, not being barred

under this Act. The

securitization and reconstruction companies may act as receivers (in

the case of

liquidation), managers (of the secured assets), or agents (for debt

recovery).

61

Under this

Act, it has been expressly mandated that all disputes concerning

securitization, asset



reconstruction, shall be settled only under arbitration or conciliation.

62

The relevant

provisions enable an appeal to the DRT within a time period of 45 days,

and thereafter to

the DRT Appellate Tribunal, in another 30 days.

63

However, the defaulter is not without a

remedy, since should the possession of assets be adjudged to be

wrongful, then not only

shall the return of the same be directed, but also compensation may be

awarded.

64

However, in the absence of adequate infrastructure for a prompt

takeover, and security

assets sometimes being only on paper, this Act shall not be effective. At

the same time,

the threat of firm legal action, along with the legal remedies being

more easy to pursue,

this shall increase the confidence of lenders, and discipline the

borrowers.

65



In the Mardia Chemicals case, the Supreme Court upheld the

constitutionality of this

Act, while expressing its reservations on Section 17 (2)

66

. In addition, it restricted the

lenders remedy to sell the securitized assets, which at present can be

done only by

waiting for a further period of 45 days, after serving a notice. The

contention that it shall

enable the classification of accounts in an arbitrary fashion had been

negatived.

6 0

Section 13 of the SARFESI Act

6 1

Under Section 13 (4)( c) of the Securitization Act, as in Supra note 69,

p. 645

6 2

Under the Arbitration and Conciliation Act, 2996, as in Supra note 69,

p. 646

6 3



Section 17

6 4

Section 19

6 5

Section 17

6 6

This provision required the deposit of 75% of the claimed amount for

challenging the borrowers actions

before the DRT. Although this did result in conferring the right to

appeal, this provision restricted this right

to an extent that rendered its exercise a practical impossibility. The

understanding of banks under this Act does not include co-operative

banks, this

resulting in a wider conception of banks as compared to the DRT Act.

67

A banking

company shall include one that is engaged in banking, which is

understood to mean the

business of accepting for lending or investing, deposits from the

general public, repayable

on demand, or otherwise.

68



The establishment of a Central Registry as an agency for

registering all transactions involving securitization, asset reconstruction

and creation of

security interest.

69

The failure to repay the principal amount, or interest, or any amount

due for that matter, results in the account to be classified as an NPA in

the books of the

bank or financial institution (in accordance with the guidelines of the

regulator, which at

present is failure to repay for 180 days)

70

, this being the starting point of any action under

this Act.

71

The trading in receivables under securitization shall not amount to a

discharge

of the debt.

72

Any right or interest in a security behind a debt shall be a financial

asset.



73

However, as rightly observed by the Andhyarjuna Committee Report,

there is a need to

comprehensively define financial assets, since in the case of a transfer

of future debt, this

cannot be completed if the originator becomes bankrupt, and this

contract shall then be

terminated by the liquidator. The securitization and reconstruction

companies shall not be

public financial institutions, but being financial institutions under the

DRT Act, may

invoke the legal remedies contained therein.

74

This Act should clarify the procedure

relating to the enforcement of claims in relation to hypothecation,

which is extensively

used by banks and financial institutions.

75

The understanding of an obligor is such so as

6 7



Section 56, Banking Regulation Act MR Umarji, Taxmanns Law and

Practice Relating to Securitization

and Reconstruction of Financial Assets, Enforcement of Security

Interest, 3

rd

Edition, p. 53

6 8

The definition of banking company under Section 2 (1)(d), also refer

to Section 5 (b) of the Banking

Regulations Act. Supra note 83

6 9

Section 2 (1)(g), as in Supra note 83, p. 56tion, p. 56

7 0

Under the Securitization Companies and Reconstruction Companies

(Reserve Bank) Guidelines and

Directions, 2003, the most recent guidelines being issued on 23

rd

April 2003. Supra note 83, p. 58

7 1

For instance, in the case of housing finance companies, this has to be

done by the National Housing



Bank.

7 2

Supra note 83, p. 62

7 3


7 4

By the Security Interest and Recovery of Debt Laws (Amendment) Ord

inance, 2004, which has amended

Section 4 A of the Companies Act, defining public financial

institutions.

7 5

MR Umarji, Taxmanns Law and Practice Relating to Securitization and

Reconstruction of Financial

Assets, Enforcement of Security Interest, 3

rd

Edition, p. 69to include parties liable under a contract or otherwise.

76

The further classification of

NPAs may be done into sub-standard, which shall not continue for a

period of more



than 12 months from the date of being classified as an NPA, doubtful

this being an

account that has already been classified as sub-standard for a period of

more than 12

months, and loss this including all NPAs for more than 36 months, the

threat of failing

to recover being the highest therein.

77

The different instruments in this process include the pass-through

certificates, the paythrough certificates, and the stripped derivative

structures. In the first case, the principal

amount and interest is paid each month, on a pro rata basis as earned

by the originator. In

the second case, the whole cash flow is passed on to the SPV, which

pays the investors at

regular intervals. In the third case, cash flows accruing to the SPV are

classified into the

principal and interest, and are issued against segregated cash flows.

The advantages of

securitization to the originator are cheaper finances, better balancesheet management, no

imbalance between the assets and liabilities and higher liquidity, and

being remote from



bankruptcy. The investor gains out of a reduced risk, collateral provided

may help if the

underlying assets do not perform well. However, this has diminished

the role of banks

and financial institutions, apart from weakening the relationship

between borrowers and

lenders that is otherwise direct and close.

The problem of NPAs affects the profitability of banks, apart from

changing the approach

towards credit delivery, which may result in a liquidity crisis.

78

Securitization is often

thought of as no more than another form of window dressing, since the

NPA is taken off

the balance sheet, there being no corresponding change in the

liabilities

79

At the same

time, while this Act is a step in the right direction, it should not beperceived of as a

legislative sanction for the lenders to just walk in and take physical

possession of the



7 6

Section 2 (1)(q)

7 7


7 8

Shubhrarag Mukeherjee, Vatsal Arya, Curbing the Menace of NPAs in

the Indian Banking Sector Will

the Securitization Act be Effective, SEBI and Corporate Laws, Vol. 55,

2004, p. 40, pp. 39-48

7 9

Id., pp. 43-44secured assets.

80

This Act has erroneously been perceived as a panacea, but actually it

puts defaulters at the receiving end. This approach is not right, and

instead appropriate

preventive action needs to be taken, and if possible this should be

identified and checked

in the middle.

81

The actual reason for NPAs, according to some is not weak lenders



rights, but instead is imprudent lending itself, and often this along with

political

considerations.

82

There are apprehensions that this Act is the POTA of Indian banking,

which shall enable arbitrary seizures of assets. This Act has erred in not

identifying

potential cases of industrial sickness and remedying the same, thereby

proving to be

somewhat short-sighted.

83

This Act however has the consequence of interfering with the

rights and obligations of parties under a contract, placing the lender in

a better position as

compared to the borrower. While the lender has a number of legal

remedies available to

him, in the form of enforcing the security asset, which is now possible

even without

approaching the courts once for this purpose, the borrowers arepractically without legal

remedies.

84



In India, the market for debt is still in its infancy. At the same time, the

experience with

this Act shows that it has been effective only against small defaulters.

The amount

ultimately realized is often as low as 15%. Therefore, a one-sided

approach as adopted by

this Act is wrong. Lenders should be held liable for mala fide lending

decisions, and

regulators for failing to exercise supervision and identify potentialcases.

85

According to

estimates by the CRISIL, 36.4% of the total bad debt shall be outside the

ambit of this

Act. In the absence of restructuring of inefficient industries, and

removal of government

interference, this problem of NPAs shall only worsen.

86

At the same time, bad debt

8 0

Id.



8 1

Akhilesh R. Bhargava, Corporate Debt Restructuring, SCL, Vol. 46, 2003,

p. 5, pp. 5-10

8 2

Id., p. 6

8 3

Id., p. 7

8 4

BM Mundhra, SARFESI Act Passes The Test, Chartered Accountant, Vol.

53, No. 2, August 2004, pp.

166-68

8 5

Shubhrarag Mukherjee, Vatsal Arya, Securitization Act, 2002 AnAssessment of its Pros and Cons,

Company Law Journal, Vol. 3, 2003, p. 25, pp. 25-30

8 6

Id. p. 27 should not simply be taken off the balance sheet, as if this

were to be done, there shall be

no incentive to recover.

87



This Act has a shortcoming since no dispute can be raised and settled in

respect of any

action undertaken in terms of Section 13 of the Act. Only after the

action has been taken,

should it be found that this is illegal, then remedies in the form of

directing repossession

and compensation shall be available. The provisions of appeal are

rather illusory, since

this is only after the physical possession of the property has beentaken. There are certain

questions that are unanswered, including the question of the manner in

which the unit has

to be run after the takeover by the creditors, this including the

employees rights in such

circumstances. The sale of the security should not be in parts, since this

shall only reduce

its value. The sale of a security at a price less than the market value

needs to be checked.

Moreover, a cost-benefit analysis is necessary, so as to determine if it is

better to enforce

the security, or to take recourse to other options, including

rescheduling repayment of

debt.



88

However, one of the biggest shortcomings of this Act is that it enables

only the

expeditious recovery of small debt. As aptly put, Default for Rs.

40000, then you are in

trouble, borrow Rs. 40 crores and default, then the bank is in trouble.

89

The sale of assets at throwaway prices is unchecked. This Act also does

not distinguish

between loans that were NPAs right from the beginning, due to

collusion between the

borrowers and lenders, and loans subsequently declared to be NPAs,

after a time period

of repayment on a regular basis. In case of a wrongful possession of physical assets,

there is no legal remedy under the Code of Civil Procedure.

90

Banks, in the process of

recovering debt do not recover, but while determining the amount,they are adjudicating

but without any regulation. The banks also enjoy discretion in terms of

who should and



who should no t be forced to repay. In the case of a secured debt, there

is already an

agreement in force, valid under both the Indian Contract Act, and the

Transfer of

8 7

Id., p. 28

8 8

Siddhart Sharma, Supreme Courts Judgment on the Securitization Act:

An Analysis in Retrospect,

Company Law Cases, Vol. 6, 2004, pp. 391-92

8 9

Id., p. 75

9 0

This is due to the bar imposed by Section 34. Property Act, which

means a creditor shall be able to sell of the security in accordance

with this, through ordinary bankruptcy proceedings.

91

Bank debt recovery took a turn in the right direction after the SARFESI

Act, which

denied the borrowers an opportunity to challenge debt recovery in

judicial forums. This



Act did simplify the process of foreclosure, but at the same time,

observed instances of

such settlements becoming more common place. This Act, however,

does not intend to

penalize borrowers, but more importantly seeks to ensure that dues

are realized. As far as

the question of innocent and non-willful default is concerned, this can

always be

determined in the course of prosecutions. Banks and financialinstitutions should not sell

off the assets at the earliest possible opportunity, but should ensure

that they obtain the

best price for this. This Act is seen as a means for disciplining habitual

defaulters.

92

CONCLUSION

An effective system of debt recovery is necessary for initiating

insolvency proceedings

when justified, and not initiating such proceedings if not warranted

Insolvency does not

desire or encourage the writing off of debt. The approach of lessening

judicial



intervention is however no substitute for this. Should NPA recovery be

done successfully,

then borrowers shall have a higher incentive to repay, this meaning a

lesser default risk,

lower interest rates, and ultimately higher entrepreneurial activity, and

economic growth.

A solution to the problem of increasing NPAs is observable in the form

of the right credit

assessment and risk management mechanisms, ensuring that there isno adverse selection,

and the quality of assets should not be compromised upon. A separate

legislation on

securitization shall be a step in the right direction. A single institution

that attempts to

restructure a unit or else dispose of the assets shall be more efficient

than different ones.

9 1

Sannjh N. Purohit, Perspectives On The Securitization And

Reconsturuction Of Assets And Enforcement

Of Security Interest Act, 2002, Company La w Journal, Vol. 1, 2004, pp.

24-25, pp. 23-26

9 2



CP Chandrshekhar, Debt Default Strategy, Frontline, Vol. 20, Issue 11,

2003, as in

Documents

High Incidence of NPAs and Positions of Banks And