Has RBI Lost All Power To Direct A Debtor To Insolvency?

The full implications of the Supreme Court decision to strike down the RBI’s debt restructuring circular.

A security guard stands by a Reserve Bank of India logo in the RBI building in Mumbai, India. (Photographer: Karen Dias/Bloomberg)
A security guard stands by a Reserve Bank of India logo in the RBI building in Mumbai, India. (Photographer: Karen Dias/Bloomberg)

Ironically, the very section added to the Banking Regulation Act, 1949 to enhance the Reserve Bank of India’s powers has now served to cut them down.

The central bank and regulator has already had wide powers under Section 35A which permit it to issue directions to banking companies to protect public interest or in the interest of banking policy. In 2017, first via the promulgation of an ordinance and then an amendment to the Banking Regulation Act, the RBI was granted two new, specific powers to resolve stressed or non performing assets.

May 4, 2017 Ordinance

Section 35AA: Power of the central government to authorise the RBI for issuing directions to banking companies to initiate insolvency resolution process.

Section 35AB: Power of the RBI to issue directions in respect of stressed assets.

A day after the ordinance was promulgated, the government issued an order authorising RBI to use the power under Section 35AA.

In exercise of the powers conferred by Section 35AA of the Banking Regulation Act, 1949 (10 of 1949), the Central Government hereby authorises the Reserve Bank of India to issue such directions to any banking company or banking companies which may be considered necessary to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.
Ministry of Finance Order - May 5, 2017

Using these powers the RBI took three separate actions...

In June 2017, it issued a list of 12 corporate debtors to be referred to insolvency proceedings. It arrived at this list using certain size parameters and via selection by an Internal Advisory Committee.

In August 2017, the IAC identified another 29 companies and directed banks to file insolvency proceedings against them if debt resolution was not achieved.

In February 2018, the RBI issued a circular laying down the framework for resolution of stressed assets across the financial system.

The contentious feature of the circular is that it directed banks to file insolvency proceedings in the event they failed to achieve a debt restructuring plan within 180 days. First several power companies, then sugar, textile and infrastructure companies objected to the circular arguing that the RBI had exceeded its remit in pushing banks to file insolvencies. On April 2, 2019, the Supreme Court agreed with that argument.

Section 35AA - The Central Government may, by order, authorise the Reserve Bank to issue directions to any banking company or banking companies to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.

According to the apex court’s judgment, Section 35AA permitted the RBI to direct banks to file insolvency petitions against debtors only on directions of the central government and only in the case of specific default.

This judgment raises two important issues...

The circumscription of the RBI’s powers to direct banks to file insolvency proceedings against defaulters.

The impact on the over 40 other loans accounts that banks sought to file insolvency proceedings against in 2017.

In this discussion, Senior Advocate Sajan Poovayya, counsel for power companies, and Nilang Desai, partner at law firm AZB & Partners, examine the implications of the judgment.

The Fault Lies Not In Section 35AA...

Menaka Doshi: The flaws lie not in Section 35AA but in RBI’s reading and use of it?

Sajan Poovayya: We should remember that the entire dispute began contextually on the power sector and it raised the issue last year in Allahabad High Court. And it has been a long journey from Allahabad to the Supreme Court. But what the Supreme Court has actually said is and, let’s be very clear, it does not find fault with Section 35AA as such. It does not say that the section is unconstitutional and thus that must be struck down. It has indicated that there is nothing wrong with the section per se. But what it finds faults with is the exercise of the power of the RBI under that section. Because it indicates that for the RBI, to exercise power under section 35AA, pursuant to a direction or notification from the government of India, it has to be specific and for a default. It (RBI) must thus have a rational indicator for what intends to do.

When such is the contour of power, the limited power that is given, the RBI could not have gone ahead and issued one circular (Feb. 12 circular) to indicate that irrespective of sector, industry or the position that you (debtor) are in, you will necessarily go through an insolvency proceeding come 180 days from February.

Doshi: It’s ironical - section 35AA was inserted into the Banking Regulation Act in 2017 to enhance RBI’s powers. Because there were concerns about the existing section 35A not being specific enough to allow RBI to direct banks to take corporate debtors to insolvency. This same section has now come to circumscribe RBI’s powers.

Poovayya: Not really, if you look at it from a larger perspective. Look at how the Supreme Court has dealt with economic legislation over a period of time. Look at the IBC. The Supreme Court has championed the legislation and put a legal matrix which is very sound today, and one of the most sound legal matrices in the world on insolvency, There was the Swiss Ribbons judgment in which the Supreme Court upheld the validity of the act (IBC) and indicated that it is in the interest of resolution rather than liquidation that the act has been brought in. The general tendency of the courts is to not interfere in economic legislation very easily.

The Supreme Court is very clear. It is not indicating that the RBI does not have powers as a regulator of the financial sector; it has all powers to regulate. But what was the RBI doing? Under the garb of regulating the financial sector, it was actually insisting that the banks who have a relationship with the debtor will necessarily take the debtor to the IBC process. The law was amended to not give additional powers to the RBI over and above the discretion vested in the banks to take or not take a particular entity through the IBC process. The power was only given to the RBI through a notification of the central government to say that in specific cases, say for instance I have a large debt going on, and my company is in doldrums and there is no way for me to make sure that a rectification methodology is brought in. But, the bank, the board of the bank and the chairman of the bank are my best friends and will thus never take me through the IBC process. This means that as a sector issue, as a sector regulator—the RBI had no power to mandate the banks that in this case it is egregious and they must take the person to IBC. However, that vacuum is filled where despite all egregiousness existing, the banks don’t take a particular action in a particular case for whatever reasons—whether genuine or extraneous— then the RBI can step in to say that in that specific case one will take action.

Don’t look at the section as a section giving extraordinary powers to the RBI. At the same time, don’t look at the judgment of the Supreme Court as the scuttling the powers of the RBI. The RBI had its powers as a banking regulator, no doubt, but it did not have the overarching powers it thought it did under the BR Act. Therefore, the circular, which is actually overarching, being struck down is bringing everything back to focus.

Should Government, RBI Be Exercising Discretion In Individual Cases?

Doshi: So here on unless the government explicitly asks the RBI to direct a bank to send a debtor to insolvency, the RBI will not be able to do so?

Poovayya: Yes, and no. What the judgment now entails is the following: If you really, irrespective of the sector, want to force the banks and compulsorily mandate the banks to take a particular company through the resolution process under the IBC, that exercise of power must be specific in the sense that it must be rationally oriented to a default, which is a case. The central government may notify, indicating that in the case of ‘A’, ‘B’, C’ defaults, it is authorising the RBI to undertake certain actions. The RBI must by a circular, indicate to the bank, that it is directing a bank or consortium of banks to necessarily take case ‘A’ to the process under the IBC.

It can’t be a scenario where the RBI says that it is now directing the banks, irrespective of who and where you are, for all debts above a particular value in 180/130/90 days, you will necessarily take them through an insolvency process. That discretion or over-arching power does not exist and is no longer available with the RBI. It never had it, and exercised it under the guise that it had it. The Supreme Court has now said that the RBI never had it.

Nilang Desai: I don’t think that is how things will play out. The court has said very clearly to use those particular sections (35AA) there needs to be specific default and it has to be with the instructions of the central government. But this can’t be about the RBI walking about saying that here’s ‘X’ company and put it into IBC. That is not what the RBI does. It is not what it would do.

Like you said, it is ironic how this played out, that this very technical interpretation has been taken of section 35AA and 35AB because the Supreme Court admits that under 35A, which is the old section, it thinks the RBI did have the power to push a generic circular requiring that a whole bunch of companies meeting objectives goes into IBC. As you said, when 35AA and 35AB came in, the government thinking was that, “listen, we think it (RBI) has the power, but just so that there is no constitutional challenge against its power to do so, let’s be more specific.” My understanding then was that these sections came in to be a little clearer about the RBI’s ability to go forth and exercise this power. I agree that it is ironic 35A has been read in such a way, which actually circumscribes the RBI’s power. I think we have come to a position that might not strictly have been intended, in my personal view.

Doshi: Mr. Poovaya, if it has to be on specific direction of the central government, to the RBI, in a specific case, then we are now asking both to exercise discretion in individual cases to decide whether insolvency proceedings should be brought against a debtor? If the RBI chooses not to pick individual cases then from here on it has effectively no power to tell a bank to send a company/defaulter to insolvency?

Poovayya: We should step and look at it in the context of how various legislation operate. Don’t look at the Banking Regulation Act just separately as an artificial island of regulation when it comes to a debtor-creditor relationship, and the whether section 35AA says ‘X’ or whether section 35AB says ‘Y’ or whether section 35A in its original form covered it, etc. Let’s look at in terms of its practical implication to the scenario today. We have a multitude of stressed assets. Let’s take power as an example. Of the Rs 2.5 lakh crore assets stressed in the country, how are the stressed assets to be dealt with? We have an IBC, and it is possibly one of the best legislations we have got in the recent times. The IBC provides a methodology by which these stressed assets can be resolved and nobody is really finding fault with that. But, it also rests on the discretion for the banks/lenders to actually take a particular debtor through the insolvency process. It is for the banks to take that determination because they are closely dealing with the debtor and they know what indications or what reason have gone behind the particular episode for the debt to actually become stressed, etc. That discretion is always with the banks.

Now, in addition to that you bring in an amendment to the Banking Regulation Act where you take away the discretion from the banks and give it to the RBI under section 35AA. As the RBI, I am not the bank but the regulator for the bank, but I will now ensure that you will do a particular act although you may, in your discretion, choose not to do it. Therefore, there is some sort of a dichotomy here. You should leave it to the banks. The banks are actually taking the process. If you as a regulator of the RBI believe that the bank is not doing a particular action in a particular case, then go ahead and exercise the power. Now, that power is not given to you under the Banking Regulation Act automatically. That is given under section 35AA with another safeguard which says that the central government will first notify and based on that notification, you as a regulator will exercise your powers. That is the law. I don’t think we can go behind the legislation.

Desai: I do think that the RBI circular has helped in speeding up NPA resolution than otherwise would have been seen. I do think that has caused the activity in the industry, the influx of foreign capital. All of the things the RBI has done so far has had good effects. Has it also had some bad effects? Possibly. But in a country like ours it is practically impossible to do something which only has good effects.

For instance, Mr Sajan Poovayya’s point, that there will be borrowers who will be caught in a bad cycle in a bad time with bad supply, etc and who may have justifiably needed more time and frankly giving them more time may have gotten better results for the banks.

The problem is the RBI can’t say that of these 20 cases, I am going to say seven go into IBC and 13 don’t. It is inevitable for any law which does good to do a little bit of bad or a little bit of unexpected bad.

The Fate Of The Dirty Dozen And Thirty Others

Prior to the Feb. 12 circular RBI had similarly issued directions to banks in the case of first 12 and then 30 companies—asking for insolvency proceedings to be filed against them. This was pursuant to a rather general government authorisation that didn’t name specific companies. If the Supreme Court order indicates that there should be central government authorisation before RBI acts against a specific default, then the 2017 directions too could come under scrutiny. Will the Supreme Court decision give the promoters of those 42 companies a new reason to litigate?

Let me give you an example of the dirty dozen, that’s the 12 cases brought in prior to the circular. There is nothing wrong with that because our case was “please do exactly what you did in 2017 and 2018”. The February circular said that if you have a debt more than Rs 2,000 crore and it is not resolved in 180 days, you necessarily shall go under the guillotine of the insolvency and bankruptcy code. That was under 35AA. The same RBI in 2017 under the same 35AA, when it looked at larger debts, that is Rs 5,000 crore plus debt which are stressed assets, they did not say that everybody who has more Rs 5,000 crore of debt and are stressed, and if they don’t de-stress, you will necessarily go to IBC. They appointed an advisory committee which looked at all cases and out of the multitude of cases, 12 were chosen by specificity and name to say that these are companies which must go to IBC. You didn’t make a one-size-fits-all approach in 2017. You took the pain to identify the bad apples and separate the bad apples from the cart. Why didn’t you do that in 2018? Because you found it more difficult so you pushed the entire apple cart into the resolution process. What happens to the good apples simply because they are stuck with the bad apples?

The present judgment which said that the exercise of power in February is bad does not strike down 35AA. It does not say that 35AA is bad. Therefore, the exercise of power, pursuant to the notification of the central government, by the RBI in 2017 for the dirty dozen 12 cases according to me is perfectly valid in law.

Doshi: Nilang, do you think the promoters of those 40 companies now have a defence to move the supreme court?

Desai: A lot of people will be thinking about this.

Poovayya: Unfortunately, litigation or contempt of litigation in this country is not regulated. I think you are entitled to raise every argument available to you by the law and fight it in court. But when a judgment is rendered by a Supreme Court in terms of a particular circular, will that have ramifications and manifestations and litigation as a by product? Obviously yes. When the privacy judgment was rendered, the world celebrated it. But then everyone started litigating saying don’t ask me for ‘y’ or don’t ask me for ‘x’ because I have a fundamental right to privacy.

Doshi: But can those promoters hope to stand a chance in court ? Especially for insolvency cases that haven’t yet reached fruition?

Poovayya: Hope is a matter of heart but law is a matter of reality. Somebody will find hope when nobody else does and a writ petition will come to be. But it won’t lead to a scenario like the present where the circular has been struck down. Why is it that only the February circular under 35AA was challenged? That is because there was rationality brought to bear by the RBI in the previous exercise of power. That rationality was missing in the present exercise of power and that is why it was challenged in various courts.

Doshi: Will this Supreme Court decision mean fewer cases going to insolvency?

Desai: I think there will be market players who will argue that fewer may not be necessarily bad. It will reduce pressure on the system and give banks more time to process their bad assets, provide diligence and discuss with players to buy those debts. The hope is that despite there not being a guillotine by the RBI, that just cases are taken to insolvency in a sensible amount of time. We need to see if that happens or not. If not, that’s a tragedy.