India: Banking Circles Welcome Circular On Wilful Defaults

The master circular on wilful defaulters issued by the Reserve Bank of India (RBI) defines a "wilful default" as occurring when: a "unit" defaults in its payment/repayment obligations to a lender even though it has the capacity to make such payments; a unit defaults in its payment/repayment obligations to a lender, and has not used the finance raised from the lender for the specific purposes for which it was sanctioned and has diverted the funds for other purposes; a unit defaults in its payment/repayment obligations to a lender and the funds raised have been siphoned off and are not available with the unit in the form of other assets; or a unit defaults in its payment/repayment obligations to a lender and has also disposed of or removed the movable fixed assets or immovable property given by it as security for the purpose of securing the financing without the knowledge of the lender.

Notably, while the term "unit" appears ubiquitously in the master circular, its scope was clarified only recently.

Being classified as a "wilful defaulter" has significant consequences. The master circular provides that banks and financial institutions cannot sanction additional facilities to wilful defaulters. Further, where the cause of the wilful default is identified as siphoning/diversion of funds, misrepresentation, falsification of accounts or fraudulent transactions, promoters of companies identified as wilful defaulters are debarred from raising financing for new ventures from scheduled commercial banks, development financial institutions, government-owned non-banking financial companies, and investment institutions, for five years from the date of publication of the name of the wilful defaulter by the RBI.

Banks and financial institutions are also required to include a covenant in loan agreements with borrowers in which they have "significant stake", that the borrower cannot induct a promoter or director of a company that has been identified as a wilful defaulter as a director on the borrower's board. At a practical level, this covenant is included in all loan agreements entered into by banks, whether with fresh or repeat borrowers.

The master circular further provides that group companies which do not honour invoked guarantees provided on behalf of a defaulting entity will also be classified as wilful defaulters.

The clarification

On 9 September the RBI issued a clarification to the master circular stating that the term "lender" would include all banks and financial institutions to which any amount arising out of a "banking transaction" is due. While neither this clarification nor the master circular defines the ambit of the term "banking transaction", the clarification states that this would also include off balance sheet items such as derivatives, guarantees and letters of credit facilities.

The clarification also states that the term "unit" would include individuals, all juristic persons, and all forms of business enterprises (whether incorporated or unincorporated). The clarification further states that where a wilful default is committed by an entity other than a company, the names of the persons responsible for the management of the entity will be reported.

Guarantors

The RBI also clarified that individuals (that are not directors of the defaulting unit) and non-group entities that fail to make payments under guarantees provided for a defaulting unit, "despite having sufficient means to make payment", would also be classified as wilful defaulters. In marked contrast, group entities that fail to make payment after invocation of a guarantee are classified as wilful defaulters without taking into account their ability to make payment.

The rationale for this differentiation may be gleaned from the definition of "wilful default", which contemplates a two-level failure by a defaulting unit – default in payment/repayment obligations coupled with factors like capacity to make such payments, siphoning of funds, diversion of funds, or disposal of secured assets without lenders' consent. Therefore, a group company of a wilful defaulter that does not make payments on an invoked guarantee could be reckoned to be complicit with a defaulting unit. This presumption may not apply to a non-group guarantor of a defaulting unit or an individual guarantor that is not a director of the defaulting unit. In view of the above, the addition of the rider of the ability to make payment under an invoked guarantee is reasonable.

Conclusion

Identifying a borrower as a wilful defaulter is a powerful weapon for lenders, and has been used effectively by lenders to bring defaulting borrowers (and their group concerns) to the negotiating table. Banks' ability to identify delinquent borrowers as wilful defaulters is particularly important in the context of denying access to public funds to such borrowers. While the master circular and the clarification of 9 September could be worded more clearly, the overall intent of the clarification to strengthen the wilful defaulter mechanism has been welcomed in banking circles.

This article was originally published in the November 2014 issue of the India Business Law Journal.

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