The RBI, in September, released the Draft Master Direction on the Treatment of Wilful Defaulters expanding the very definition of wilful defaulters, and mandating lenders to complete identification process within six months of loan being classified as non-performing. The Draft has significant implications for both, Indian financial institutions and the business fraternity. It is designed to address issues related to wilful/large defaulters, aiming to strengthen the credit discipline among borrowers while safeguarding the interests of banks and financial institutions. It applies to banks, non-banking financial companies (NBFCs) and other all-India financial institutions.

India’s banking sector faced a significant challenge in the form of rising NPAs (non-performing assets) in the last decade. The mounting stress on banks’ balance sheets posed a threat to financial stability and necessitated regulatory intervention. In February 2016, the RBI introduced a framework (Master Directions on Frauds) for dealing with wilful defaulters which essentially provided guidelines for identifying and reporting wilful defaulters and further laid down punitive measures for such borrowers and their promoters.

The exclusion of right of the borrowers to be heard under the RBI framework, 2016 was challenged before the Telangana High Court which stressed the importance of a “prior hearing” for classifying borrowers as wilful defaulters, recognising the severe implications of such classifications. It ruled that the “right to be heard (audi alteram partem)” should be integrated into the RBI framework, ensuring transparent and reasoned decisions to prevent arbitrary actions.

As a result, the court overturned the decisions of the Joint Lenders Forum (JLF) and the Fraud Identification Committee (FRIC), deeming them arbitrary and contrary to the principles of natural justice and the matter then went to the Supreme Court, which finally ruled that such actions taken by banks such as classifying a borrower’s accounts as fraudulent, have criminal and severe civil implications, effectively blacklisting borrowers.

Therefore, the principles of natural justice, specifically “the right to be heard” as ruled in State Bank of India & Ors. v. Rajesh Agarwal & Ors was factored in by the RBI in the present Draft along with stricter measures for dealing with wilful defaulters and there is emphasis on prompt action.

Revised credit facility

The revised framework represents a departure from previous practices in several ways. Firstly, it extends the prohibition on additional credit facilities for wilful defaulters up to one year after their removal from the List of Wilful Defaulters (LWD), whereas the previous practice didn’t indicate such a specific timeline.

Secondly, the introduction of a five-year bar on extending credit for new ventures is a notable change, implying a longer-lasting impact on borrowers. It also denies wilful defaulters opportunity for credit facility restructuring. Lastly, lenders can initiate legal and criminal proceedings and impose penal charges thereby adding a more punitive dimension.

When a resolution plan is successfully implemented, firstly the wilful defaulter’s name is removed from the LWD and, secondly, the penal measures shall not apply to the entities/business enterprises after the said implementation under IBC or the prudential framework. However, it is crucial to highlight that these criminal measures continue to apply to the former promoter(s), director(s), guarantor(s), or people formerly responsible for managing the corporation or commercial venture.

This method varies from prior practises in that it distinguishes between the enterprise and its management, ensuring that sanctions are levied on persons responsible for the default while providing the entity a new start following successful resolution under the IBC or the prudential framework. This is another strong and good message to the industry that mere resolution of distress of a company does not absolve the management from criminal proceedings and is in line with Section 32A of the IBC, 2016.

The Draft strengthens borrowers’ accountability, requires banks to disclose information about large defaulters on their websites and in annual reports enhancing transparency and additionally, aligning with the objectives of the IBC, providing a legal framework for timely resolution of defaults. The Draft encourages banks to adopt preventive measures such as robust credit risk assessment and early warning systems. This proactive approach may help in identifying potential defaulters before they become a significant risk.

The argument against a strong initiative like this would be that the definition of default in the draft may be too stringent, potentially burdening borrowers who are facing temporary financial difficulties but have the capacity to recover. This may discourage lending and hinder economic growth. Some believe that the Draft’s provisions for restricting promoter access to capital markets and directorship positions could be overly punitive and have unintended consequences, such as deterring entrepreneurship and stifling corporate growth.

Stringent actions such as these could be momentarily seen as being against the spirit of entrepreneurship, etc., but it’s better to ensure that “financial discipline” and “accountability” to stakeholders become a part of entrepreneurship in India and it will certainly have long-term benefits.

The writer is a practising Advocate in the Madras High Court