Pratik Datta, Riddhi Vyas, and Ulka Bhattacharyya *

Peculiar political economy factors nudged Indian policymakers to legally classify certain loan defaulters as ‘wilful’ defaulters. The full might of the regulatory state has been used to empower regulated lenders (such as banks and NBFCs) to blacklist wilful defaulters from vast swathes of financial markets. The need for procedural safeguards did not receive its fair share of policy attention. This changed with the Supreme Court’s decision in State Bank of India v. Jah Developers (2019).Regulatory attention has now shifted to the procedure for identifying and classifying wilful defaulters. The RBI’s draft Master Direction of September 2023 promises to make this procedure relatively fairer, reducing the scope for arbitrariness. Yet, as this article explains, fundamental concerns persist. Policymakers should seriously engage with these concerns. For if the procedure for identifying and classifying wilful defaulters is itself faulty, the entire regulatory edifice around wilful default becomes questionable.

“If the proposed law be unique – be utterly without analogy in civilised communities of modern times – suspect its soundness.”

– Raja Sir Tanjore Madhava Rao

Introduction

India is probably the only country in the world that legally classifies certain loan defaulters as ‘wilful’ defaulters. The wilful defaulter tag has severe legal consequences for a borrower. For example, the Reserve Bank of India (RBI) prohibits lenders from extending additional facilities as well as any credit facility for floating new ventures to a wilful defaulter. Similarly, the Securities and Exchange Board of India (SEBI) prohibits a company from launching an Initial Public Offer if such company or any of its promoters or directors is a wilful defaulter. SEBI also prohibits listed companies from issuing equity shares, convertible as well as non-convertible securities, if any of its promoters or directors is classified as a wilful defaulter. A wilful defaulter is also prohibited from submitting a resolution plan under the Insolvency and Bankruptcy Code, 2016 (IBC). The wilful defaulter classification is therefore akin to “blacklisting” of the borrower from credit and equity markets. Not only does it severely hamper the borrower’s business, it also tarnishes the reputation of the borrower, its promoters, and directors. These implications make it critical that appropriate procedural safeguards are in place while designating a person as a wilful defaulter.

The Supreme Court (SC) dealt with this issue in Jah Developers[1] where it laid down some fundamental procedural safeguards while classifying a person as wilful defaulter. In September 2023, the RBI released a draft Master Direction on treatment of Wilful Defaulters and Large Defaulters (draft MD) updating the procedural safeguards in keeping with Jah Developers. Against this backdrop, this article traces the evolution of the regulations around wilful default in India and highlights some challenges and concerns that continue to persist.

Evolution of Wilful Default

The balance of payments crisis in early 1990s nudged major structural reforms in the Indian economy. In the banking sector, a major concern was the erosion in profitability of banks. Income generation was hurt due to deterioration in the quality of loan portfolios. Banks experienced considerable difficulties in recovery of loans and enforcement of securities.[2] To address these concerns, the Narasimham Committee (1991) recommended enactment of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, which established the Debt Recovery Tribunals. In parallel, the Harshad Mehta scam broke out in 1992. Policymakers became conscious that inter-bank transactions in government securities were manipulated by brokers to siphon money out of the banking system, for speculation in the stock market.[3] This incident went on to shape several reforms that were to follow.

It was in this context that the Budget speech of February 1994 focussed on two measures to encourage discipline among borrowers. First, RBI would circulate names of defaulting borrowers (above a threshold limit) among banks and financial institutions (FIs) to alert them and put them on guard against borrowers who have defaulted in their dues to other lending institutions. Second, RBI would publish a list of defaulting borrowers where suits had been filed by banks and financial institutions. This was followed by RBI’s Scheme of Disclosure of Information on Defaulting Borrowers of Banks and Financial Institutions of April 1994.[4]

In 1998, the Central Vigilance Commission (CVC) issued guidelines to improve vigilance administration in banks. It instructed RBI to collect of information on wilful defaults of Rs. 25 lakhs and above, and disseminate the same to reporting banks and FIs.[5] Accordingly, the RBI issued a Scheme in February 1999 mandating banks and FIs to report on quarterly basis details of wilful defaults which had occurred or were detected after 31st March 1999.[6] The term ‘wilful default’ was explicitly defined for the first time to broadly cover the following:

• Deliberate non-payment of the dues despite adequate cash flow and good net worth.
• Siphoning off-of funds to the detriment of the defaulting unit.
• Assets financed have either not been purchased or have been sold and proceeds have been mis-utilised.
• Misrepresentation/falsification of records.
• Disposal/removal of securities without bank’s knowledge.
• Fraudulent transactions by the borrower.

The Scheme made it clear that identification of wilful default should be made keeping in view the track record of the borrowers and not merely on isolated transactions/incidents. Most importantly, for a default to be categorised as wilful, it had to be intentional, deliberate, and calculated.

In December 2000, the Parliamentary Standing Committee on Finance in its 8^th Report highlighted ‘wilful default’ as one of the major reasons behind growing NPAs. It brushed aside the Finance Ministry’s concern that ‘wilful default’ is difficult to define exhaustively, citing the above six categories of default clearly specified by the RBI. The committee recommended that the government should incorporate the definition of ‘wilful default’ either under Chapter III-B of RBI Act, 1934, or Public Financial Institutions (Obligations as to Fidelity and Secrecy) Act, 1983. It further suggested that discretion should be given to financial institutions to publicly disclose the names of wilful defaulters. The committee was in favour of stringent actions such as filing criminal cases against wilful defaulters. It recommended that promoters of such companies should not be allowed to avail institutional finance from public sector commercial banks, Development Financial Institutions, government owned Non-Banking Financial Corporations, investment institutions etc for floating new ventures for a period of 15 years. Moreover, SEBI should ensure that companies on whose board wilful defaulters were present, are mandated to disclose the same in the prospectus and offer documents when accessing primary markets for raising debt or equity so that investors could take an informed decision. These measures were expected to have deterrence effect on wilful defaulters.

This Report of the Parliamentary Standing Committee on Finance prompted the RBI, in consultation with the government, to constitute a Working Group on Wilful Defaulters in May 2001. This Working Group submitted its report in November 2001, which formed the basis for RBI’s circular on wilful defaulters issued in May 2002.[7] This circular amended the definition of ‘wilful default’ to cover default by the borrower in payment obligations to the lender when – first, it had the capacity to do so; or second, the finance was not utilised for the specific purpose that it was availed but was diverted for other purposes; or third, the borrower siphoned off the funds so availed from the lender. Most importantly, the requirement of intent for establishing ‘wilful default’ under the 1999 Scheme was replaced by a deeming fiction in the 2002 Circular. Consequently, if the lender noted any of the above three types of default, the law automatically presumed it as a ‘wilful default’.[8] Additionally, certain penal measures, as suggested by the Parliamentary Standing Committee, were also introduced through this circular.

Subsequent to the 2002 circular, RBI issued several circulars to banks and FIs containing instructions on matters relating to wilful defaults. The RBI Master Circular on Wilful Defaulters 2013 (2013 Master Circular) added another category of wilful default. Wilful default would have also occurred if the unit had disposed of or removed the movable fixed assets or immovable property given by the lender for the purpose of securing a term loan without the knowledge of the bank/lender. It entrusted the decision to classify the borrower as wilful defaulter to a committee of higher functionaries headed by the Executive Director and consisting of two GMs/DGMs as decided by the Board of the concerned bank or FI. Before classifying a borrower as a wilful defaulter, the bank or FI was required to, first, advise the borrower about the proposal to classify him as wilful defaulter along with the reasons for the same; second, give the borrower fifteen days for making representation against the proposed decision; and third, constitute a Grievance Redressal Committee (GRC) headed by the Chairman and Managing Director along with two other senior officials to hear the defaulting borrower and thereafter arrive at its decision.

The 2013 Master Circular was updated by a 2014 Circular. It amended the Grievance Redressal Mechanism and introduced a clear two-tier structure. First, the Identification Committee (IC) would examine the evidence on wilful default and if satisfied, issue a show cause notice to the concerned borrower. After considering submissions of the borrower and its promoter/whole-time director, the IC would issue a reasoned order recording the wilful default. An opportunity of personal hearing could be given at the discretion of the IC. Second, the order of the IC would be reviewed by a Review Committee (RC) comprising the Chairman/CEO, MD, and two independent directors of the bank. The order would become final only after it has been confirmed by the RC.

The 2014 Circular was further revised by a 2015 Circular. It clarified that the RC was not needed to be set up if the IC did not pass an Order declaring a borrower as a wilful defaulter.

Evidently, the definition of ‘wilful default’ as well as the process for designating a wilful defaulter has gradually evolved over time. In parallel, legal challenges against several instances of wilful defaulter designations led to conflicting decisions among various High Courts.[9] The Delhi High Court noted that the wilful defaulter designation involves far-reaching civil and criminal consequences. It held that the two-tier mechanism constituted a tribunal vested with the State’s judicial powers. Accordingly, it held that natural justice required that borrowers be heard and given the right of legal representation.[10] This reasoning did not find favour with the SC in Jah Developers, which settled the law on the subject.

The legal principle that has now emerged is that borrowers do not have an unconditional right to legal representation in the wilful defaulter designation process. The key reason for this is that the committees set up under the two-tier mechanism have been held to be administrative bodies, which cannot adjudicate, inquire into disputes, or collect evidence, absent statutory judicial powers. Hence, natural justice is not violated by disallowing borrowers from obtaining legal representation.[11]

The SC decision in Jah Developers has helped institutionalise some procedural safeguards within the ambit of the wilful default regime. The draft MD has now proposed a non-discriminatory and a transparent procedure which is relatively better compliant with the principles of natural justice for classifying borrowers as wilful defaulters. However, certain challenges and concerns persist.

Challenges and Concerns

• Going beyond the parent legislation

The draft MD is proposed to be issued under Chapter III-A of RBI Act, 1934, sections 21, 35A and 56 of the Banking Regulation Act, 1949 and section 11 of Credit Information Companies (Regulation) Act 2005. These provisions give wide powers to RBI to issue general directions to its regulated entities (such as banking companies, credit information companies, credit institutions or specified users) in the interest of banking policy and depositors. None of these provisions specifically empowers the RBI to blacklist any borrower from the credit markets. Yet, clause 5(3) of the draft MD explicitly provides for ‘penal and other measures against wilful defaulters’, which specifically include ‘debarment from institutional finance’. The SC has itself held such debarment to be akin to blacklisting a borrower from availing credit.[12]

The idea of blacklisting wilful defaulters from institutional finance as well as equity markets was originally recommended by the Parliamentary Standing Committee on Finance in its Eighth Report (December 2000). This report also categorically recommended that the definition of ‘wilful defaulters’ be incorporated into the relevant statute through necessary amendments. However, no such amendment was carried out. Instead, RBI gradually developed an entire regulatory framework for classifying and blacklisting wilful defaulters on the basis of its general statutory powers.

The only other financial sector regulator which relies on blacklisting as a regulatory tool is SEBI. It uses this tool to debar persons from capital markets. Although this regulatory tool has been criticised for being too wide,[13] it stems from specific statutory provisions.[14] For instance, section 11(4)(b) of the SEBI Act 1992 explicitly empowers SEBI to pass reasoned orders to ‘restrain persons from accessing the securities market and prohibit any person associated with the securities market to buy, sell or deal in securities’.

There is no comparable statutory provision that explicitly empowers the RBI to blacklist a defaulting borrower from the credit market or worse to delegate such blacklisting powers to regulated lenders. Consequently, the draft MD may well be beyond the scope of the parent statutes and may not stand the test of a stringent judicial scrutiny.

• Blacklisting without natural justice

The SC has consistently held that natural justice must be followed before a person is put on a blacklist.[15] Natural justice comprises two fundamental principles – (a) audi alterem partem, that is, a person affected by administrative, judicial or quasi-judicial action must be heard before a decision is taken; and (b) nemo judex in causa sua, that is, no one should be a judge of his own cause.[16] While the draft MD provides for audi alterem partem through the two-tier mechanism, it violates the cardinal principle of nemo judex in causa sua. Just like the earlier circulars, the draft MD empowers the lender to decide whether the defaulting borrower is a wilful defaulter or not. However, the lender may not be an impartial arbiter in this context. It is after all a party to the credit contract. For instance, the default could be the result of poor credit appraisal by the lender itself. A lender may have strong incentives to push the blame for the default on to the borrower by classifying it as a wilful defaulter. Such a wilful default classification does not affect the lender’s provisioning obligations either. Therefore, by making the lender the sole judge of wilful default, the draft MD makes the lender a judge of its own cause. This regulatory construct compromises a cardinal principle of natural justice. 

• Blacklisting as a disproportionate restriction

Article 19(1)(g) of the Constitution provides all Indian citizens (including wilful defaulters) the fundamental right to carry out any trade, business, or profession subject only to reasonable restrictions.[17] Proportionality requires the least restrictive measure be adopted in order to achieve the statutory objects.[18]

An avowed objective of the draft MD is to disseminate credit information about wilful defaulters for cautioning lenders, so that further institutional finance is not made available to them. This objective could be achieved by regulatory measures which are much less restrictive than blacklisting. For instance, it may be adequate to apply the wilful defaulter tag to such defaulting borrowers for a prescribed period. This will let lenders take an informed credit decision on whether to lend to such a wilful defaulter depending on the merits and circumstances of each case. That would effectively increase the cost of capital (borrowing rates) for wilful defaulters, automatically rationing the institutional credit available to them. By not even considering such less restrictive regulatory responses short of blacklisting, the draft MD imposes a disproportionate restriction on the fundamental rights of defaulting borrowers under Article 19(1)(g).

Conclusion

Peculiar political economy factors nudged Indian policymakers to distinguish wilful defaulters from the rest who default due to genuine business failures. The full might of the regulatory state has been used to enable lenders to blacklist wilful defaulters from vast swathes of financial markets. However, the need for procedural safeguards did not receive its fair share of attention from policymakers. This changed with the Supreme Court’s decision in Jah Developers.The attention has shifted to the procedure for identifying and classifying wilful defaulters. The draft MD now promises to make the procedure relatively fairer, reducing the scope of arbitrariness. Yet, fundamental concerns persist.

First, the statutory basis for blacklisting wilful defaulters from institutional financing remains doubtful. The draft MD could potentially be challenged as ultra vires the parent statutes. Second, the draft MD has unwittingly violated a cardinal principle of natural justice by making the lender the sole judge of wilful default. Third, the draft MD imposes a disproportionate restriction on the fundamental rights under Article 19(1)(g) by not resorting to less restrictive regulatory responses short of blacklisting.

The broader policy discourse on wilful defaulters need to seriously engage with these fundamental procedural concerns. For if the procedure for identifying and classifying wilful defaulters is itself faulty, the entire regulatory edifice around wilful default becomes questionable.  

[1] State Bank of India v. Jah Developers Pvt. Ltd. and Ors. [(2019) 6 SCC 787]

[2] Reserve Bank of India, Report of the Committee on Financial System, November 1991, paras 3 and 16.

[3] Ahluwalia, M.S., Backstage – The story behind India’s high growth years, Rupa Publications, 2020, p. 156.

[4] RBI Circular DBOD.No.BC/CIS/47/20.16.002/94 dated 23 April 1994

[5] Central Vigilance Commission Annual Report [01.01.1998 to 31.12.1998] dated 29.04.1999, Paragraph 1.3.7, p. 8; also see Jayadev M and Padma N, Wilful defaulters of Indian Banks: A first cut analysis, IIMB Management Review (2020), 32, 129-142.

[6] RBI Scheme for Collection and Dissemination of Information on cases of WD of Rs. 25 lakhs and above [DBOD.No.BC.DL.(W)12/20.16.002(1)98-99]datedFebruary 20, 1999

[7] RBI Guidelines ‘Wilful defaulters and action thereagainst’ [DBOD. No..DL(W).BC ./110 /20.16.003(1)/2001-02], dated May 30, 2002

[8] Clause 3, ibid.

[9] See, Kingfisher Airlines Limited v. Union Of India & Others [2015 1 Comp LJ 151] (Calcutta High Court); Kingfisher Airlines Limited v. Union Of India & Others [2016(2)Mh.L.J 838] (Bombay High Court); Dynametic Overseas Pvt Ltd. and Anr. v. State Bank of India & Anr. [AIR 2016 Cal 303] (Calcutta High Court).

[10]Punjab National Bank v. Kingfisher Airlines and Ors [2016(154) DRJ164]

[11] See, State Bank of India v. Jah Developers Pvt. Ltd. (2019) 6 SCC 787, paras 12, 21.

[12] State Bank of India v. Rajesh Agarwal, (2023) 6 SCC 1, para 56.

[13] Sundaresan, S., How constitutional are SEBI’s directions?, Business Standard, March 29, 2015, available at < https://www.business-standard.com/article/opinion/how-constitutional-are-sebi-directions-115032900678_1.html>.

[14] See, Sections 11(4), 11B of the SEBI Act, 1992.

[15] State Bank of India v. Rajesh Agarwal, (2023) 6 SCC 1, paras 58-62.

[16] State Bank of India v. Rajesh Agarwal, (2023) 6 SCC 1, para 36.

[17] See, Article 19(6) of the Constitution of India, 1950.

[18] See, Internet and Mobile Association of India (IAMAI) v RBI, AIR 2021 SC 2720, Paras 6.143 to 6.147; Om Kumar v. Union of India, (2001) 2 SCC 386 as discussed in Akshay N Patel v RBI¸ 2022 (3) SCC 694 at Para 16.

* The authors are part of a Policy Research Group at Shardul Amarchand Mangaldas & Co., New Delhi. Pratik Datta is an Associate Director – Research, Ulka Bhattacharyya is a Research Fellow, and Riddhi Paritosh Vyas is a Research Fellow as well.

The authors would like to thank Ms. Veena Sivaramakrishnan, Mr. Prashant Saran, and Mr. Gopalkrishna Hegde for their valuable inputs.

Picture Credits- Binay Sinha (Business Standard)