Prudential Norms for Resolution of Stressed Assets in India - An Analysis of the New Framework

Anand Tripurari and Ayushi Mishra comment on a new framework that has come in place with respect to prudential norms for resolution of Stressed Assets in India.

Background

In April 2018, the authors wrote an article titled ‘Resolution of Stressed Assets in India- An Analysis of the New Framework’ (https://www.indialawjournal.org/resolution-of-stressed-assets-in-india.php) on the February 12, 2018 circular issued by the Reserve Bank of India (‘RBI’) titled ‘Revised Framework for Resolution of Stressed Assets’ (‘Old Framework’). However, pursuant to the decision of the Supreme Court of India (‘Supreme Court’) in Dharani Sugars and Chemicals Ltd. v. Union of India & Ors¹. (‘Dharani Sugars’), the Old Framework has been struck down for being ultra vires to Section 35AA of the Banking Regulation Act, 1949. As a result, all cases filed by financial creditors against corporate debtors under the Insolvency and Bankruptcy Code, 2016 (‘IBC’) pursuant to the Old Framework have been declared non est.

Key points from the judgment

A. The two primary issues before the court in Dharani Sugars were: (a) whether Section 35AA and Section 35AB which were the source of promulgation of Old Framework, constitutionally valid and (b) whether the Old Framework is ultra vires of the Banking Regulation Act, 1949 and the RBI Act, 1934.

B. In relation to the first issue, the Supreme Court upheld the constitutional validity of Section 35AA and Section 35AB which were introduced by the Banking Regulation (Amendment) Ordinance 2017 and the Banking Regulation (Amendment) Act, 2017 by stating that, “They are not excessive in any way nor do they suffer from want of any guiding principle. As a matter of fact, these amendments are in the nature of amendments which confer regulatory powers upon the RBI to carry out its functions under the Banking Regulation Act, and are not different in quality from any of the Sections which have already conferred such power” .² The court further observed that there was no scarcity of guidance as to how RBI must exercise its powers under the newly added provisions and guidance was provided in form of Sections 25, 29, 30 and 31. ³

C. In relation to the second issue, the Supreme Court examined the scheme of Section 35A, Section 35AA and Section 35AB of Banking Regulation Act, 1949 as follows, “Stressed assets can be resolved either through the Insolvency Code or otherwise. When resolution through the Code is to be effected, the specific power granted by Section 35AA can alone be availed by the RBI. When resolution de hors the Code is to be effected, the general powers under Sections 35A and 35AB are to be used. Any other interpretation would make Section 35AA otiose.”. ⁴ Hence, directions under Section 35AA can only be issued with respect to specific defaults by specific debtors. Any directions issued by RBI in respect of debtors generally would be ultra vires of Section 35AA.

D. Further, Section 45L(3) of Reserve Bank of India Act, 1934 gives power to RBI to call for information from financial institutions and give directions. Additionally, it also requires RBI to issue directions to any financial institutions, having due regard to the conditions in which, and the objects for which the institution has been established, and the effect of such financial institutions in the money and capital markets. The court found that there was nothing to show that provisions of Section 45L(3) were satisfied in passing the Old Framework vis-a-vis Non-Banking Financial Companies (‘NBFCs’), which are inseparable from banking institutions and a part of joint lenders’ forum which jointly lend money to debtors. ⁵

Hence, the Old Framework was found ultra vires, having no effect under law.

New Framework

A. Following the decision of the Supreme Court in Dharani Sugars, RBI released the Reserve Bank of India (Prudential Norms for Resolution of Stressed Assets) Directions, 2019 (‘New Framework’) which is applicable not only to scheduled commercial banks and Indian financial institutions as the Old Framework, but also extends to small finance banks and systematically important and deposit taking NBFCs (collectively called ‘Lenders).

B. The primary facets of the New Framework are: (i) early identification and reporting of default in respect of large borrowers by Lenders ⁶ ; (ii) penalty in form of additional provisioning if a viable resolution plan is not implemented with respect to the borrower within strict timelines ⁷ ; (iii) upgradation of standard accounts classified as non-performing assets (‘NPA’) on restructuring when all outstanding loan facilities demonstrate ‘satisfactory performance’ which means if the borrower is not in default at any point during the concerned period ⁸ ; (iv) alignment of meaning of ‘financial difficulty’ to the guidelines issued by Basel Committee on Banking Supervision for the purpose of restructuring ⁹ ; and (v) mandatory signing of inter-creditor agreement to provide a collective and consensual decision making criteria while making a resolution plan. ¹⁰

C. The decision of Supreme Court in Dharani Sugars does not take away the right of RBI to issue directions under Section 35AA of Banking Regulation Act, 1949, for initiation of insolvency proceedings against specific borrowers. ¹¹

D. Further, in addition to classification of accounts as special mention accounts (‘SMA’) 0/1/2 under the Old Framework, the New Framework has introduced SMA sub-categories for revolving credit facilities such as SMA-1 for 31-60 days of default and SMA-2 for 61-90 days of default. ¹²

E. Similar to the Old Framework ¹³ , the New Framework also envisage Lenders to report on classification of accounts as SMA, to Credit Repository of Information on Large Credits (‘CRILC’) for all borrowers having aggregate exposure of INR 50 million or above on a monthly basis in the main report and also on weekly basis by close of business day on every Friday of a week. ¹⁴

F. The New Framework envisage a ‘review period’ within thirty days from default by a borrower during which time, the Lenders may review the borrower’s account and decide on a resolution strategy, including inter alia, the nature of the resolution plan and approach for implementation of resolution plan (‘Review Period’). The New Framework also encourages Lenders to initiate process of implementing a resolution plan even before a default occurs, by identifying financial stress in the borrower entity. ¹⁵ Both these ideas have been introduced in the New Framework and were absent under the Old Framework. This Review Period gives relief to Lenders from making a resolution plan within 180 days, in case of a one-day default, by the borrower.

G. The New Framework mandates Lenders to enter into an inter-creditor agreement (‘ICA’) during the Review Period for finalization and implementation of resolution plans in respect of borrowers, with credit facilities availed from more than one lender. ¹⁶ A decision of Lenders representing 60% strength and 75% value of outstanding facilities would be binding upon all Lenders. ,¹⁷ The Old Framework did not mandate entering into such ICA.

H. For accounts with aggregate exposure above a threshold specified under the New Framework, on or after a ‘reference date’, the resolution plan must be implemented within 180 days from end of the Review Period. The Review Period will commence from the date of first default after the reference date. For example, where the aggregate exposure is above INR 20 billion, the refence date is June 7, 2019; for aggregate exposure above INR 15 billion but less than INR 20 billion, the reference date is January 1, 2020 and for aggregate exposure less than INR 15 billion, the reference date would be announced in due course. ¹⁸

I. Similar to the Old Framework ¹⁹ , the New Framework also requires an independent credit evaluation (‘ICE’) by credit rating agencies where resolution plan involves a restructuring or change in ownership. Where aggregate exposure of lenders is above INR 1 billion, one ICE is required and when the aggregate exposure of lenders exceeds INR 5 billion, two ICEs would be required. ²⁰

J. Under the New Framework, if a resolution plan involves restructuring or change of ownership, it will be deemed implemented only if the borrower is not in default with any Lenders as on the 180^th day of the Review Period. Any subsequent default shall be treated as a fresh default, triggering a fresh review. A resolution plan envisaging change in ownership will be deemed complete when all related documentation is completed and the new capital structure is reflected in the books of the Lenders and borrower and the borrower is not in default with any Lenders. ²¹

K. Additional provisioning can be made if a viable resolution plan is not implemented within the given timelines, such as, 20% provisioning for 180 days from end of Review Period and total of 35% provisioning for 365 days from end of Review Period. ²² Such additional provisioning may be reversed when: (i) resolution plan involves payment of overdues and no default has been made for six months from payment of overdues; (ii) resolution plan involves change of ownership on implementation; (iii) where IBC resolution plan is pursued, half the additional provisions may be reversed on filing and the remaining upon admission of borrower into insolvency resolution process; and (iv) assignment of debt or recovery proceedings are initiated, upon completion of the same. ²³ Such explicit conditions for reversal of additional provisioning was not provided under the Old Framework.

L. Similar to the Old Framework, any attempt by Lenders to conceal the actual status of accounts or evergreen the stressed assets, would invite strict enforcement actions, including higher provisioning and monetary penalties, in addition to directions to Lenders, to file insolvency proceedings under IBC.

M. While the Old Framework made reference to Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning, as amended from time to time to govern prudential norms applicable to any restructuring within or outside IBC, the New Framework under Annexure-1 ²⁴ lays down detailed prudential norms for any restructuring or change in ownership, within or outside IBC.

N. The provisions of the New Framework, except the SMA provisions, would be inapplicable to micro, small and medium enterprises (‘MSMEs’) as they will continue to be governed by Framework for Revival and Rehabilitation of Micro, Small and Medium Enterprises (MSMEs).

O. The New Framework has also withdrawn the extant instructions on resolution of stressed assets, such as, Framework for Revitalising Distressed Assets, Corporate Debt Restructuring Scheme, Flexible Structuring of Existing Long Term Project Loans, Strategic Debt Restructuring Scheme (SDR), Change in Ownership outside SDR, and Scheme for Sustainable Structuring of Stressed Assets (S4A) and Joint Lenders Forum, with immediate effect.

Concluding Remarks

In the case of Dharani Sugars, though the Supreme Court had the option of only declaring reference to IBC under the Old Framework as ultra vires. However, it struck down the Old Framework in entirely, including the requirement to prepare a resolution plan within 180 days, among others. It is important to note that large parts of Old Framework have been introduced unamended, or with a minor tweaking, in the New Framework. Hence, it was advisable for the Supreme Court to only declare parts of the Old Framework as ultra vires.

Having said that, the wide powers of RBI under Banking Regulation Act, 1949 remains unaffected. However, RBI cannot give ‘general directions’ for making reference to IBC, for debtors generally. Going forward, RBI would be required to give special attention to sector specific issues, before referring any particular borrower under the IBC proceedings.

With the Old Framework being declared as ultra vires, the resolution plans implemented under the Old Framework may also be affected. Despite there being no clarity on this issue, it cannot be the intent of the Supreme Court to unwind resolution plans entered on a consensual basis among various parties. The primary objective of the judgment was to prohibit RBI from mandatorily referring matters under IBC, in relation to debtors ‘generally’. Hence, resolution plans under IBC, drafted pursuant to the Old Framework, would not be affected by the judgment in Dharani Sugars.