The Dos and Don’ts of Penal Charges

RBI to release guidelines on penal charges 

– Tejasvi Thakkar, Executive | finserv@vinodkothari.com

Introduction 

The Reserve Bank of India (‘RBI’) announced various policy measures in its Statement on Developmental and Regulatory Policies dated February 08, 2023, which includes introduction of guidelines for regulating the penal charges levied by financial institutions in case of delay or default in repayment of loans or where there is a non-compliance of ‘material’ terms and conditions. RBI observed that some of the financial institutions were levying unreasonable penal charges. It has time and again been RBI’s concern that financial institutions levy excessive charges under the garb of different names such as penal charges, penal interests, legal charges, notice charges, levy charges etc. A large number of customer grievances with respect to excessive penal charges and divergent practices have influenced the regulator to think on these lines.  

Existing regulatory structure and practice

It is said that ‘where there is no law, but every man does what is right in his own eyes, there is the least of liberty’. Presently, RBI provides discretion to NBFCs for determination of the rates of interest on advances as well as other charges levied by them in lieu of the services provided to the borrowers. However, these charges are subject to the board-approved policy formulated in this regard as well as the specific terms and conditions mentioned in the loan agreement.

It was observed by RBI that some lenders were charging high penal charges, and instead of using ‘penalty’ as a tool to build a sense of credit discipline, it was being used as a revenue enhancement tactic by lenders. As also provided in the Digital Lending Report of the RBI, the core rationale for deregulating rate of interest lies as much in wide variation in cost of funds, business models, and margins, etc. as in promoting an open market for credit. Further, a rate cap or margin is likely to result in crowding of interest rates at the upper threshold, which will be disadvantageous to the general borrower.

Given the above context, let us first understand the current practices with respect to imposition of penal interests/ charges. 

What are penal charges?

In respect of loans or credit facility availed, penal charges are levied on the borrowers in cases of delay/default/non-adherence to the repayment schedule as agreed or breach/non-compliance with the agreed terms and conditions. In general, regulated entities or lenders impose penal charges on prepayment of advances, non-compliance with terms of the loan contract, breach of repayment timelines etc. 

The rate of penal charges is intimated upfront and may either be standardized across all loans and borrowers or may depend upon the type of loan, level of credit risk, and the terms and conditions as mutually agreed by the borrower and the lender. However, such charges come under general fetters of the RBI to not be ‘excessive’ or ‘exorbitant’ and to be fair and transparent, with the additional requirement to mention such penal interest in bold. 

Generally, there are two categories of debt default:

1. Financial defaults: A late or a missed payment of an installment is the most common example of a financial default.
2. Technical defaults, which may include: 
   • Covenant breaches, such as late financial reporting (e.g., income tax filings for personal borrowers or accountant-prepared financial statements for corporate/commercial borrowers).
   • Breaches to important or material “representations and warranties,” meaning that a loan contract may have been entered into under certain circumstances or assumptions that were thought to be true on the contract date but that were later found to be no longer be true.

Further, non-compliance of any other ‘material’ terms and conditions may also warrant penal charges. However, the determination of materiality would be subjective. Usually, it is determined by the lender as to what would constitute material.

In certain instances, a grace period may also be offered. Therefore, what will constitute default shall be governed by the terms of the specific loan contract.       

Levy of Charges and Penalties

It is also important to understand the mechanics of charges and penalties levied by the regulated entities. 

First of all, “Penal interest” has to be distinguished from “interest” where the latter is based on the doctrine of compensation for time value of money and the former on the doctrine of penal action. Also, the concept of penal interest varies from that of penal charges. Penal interest is an interest on the interest already levied whereas penal charges are the charge, which shall be separately levied and collected at a specified rate only on the amount of the default.

Penal charges may be levied either on ad-hoc basis, wherein the charges are levied separately upon the  event of default as for example each event of default/delay  by the borrower shall attract a penal charge of ‘x’ amount, or on interest overdue basis wherein the default in the payment of interest or the instalment attracts further interest in addition to the existing interest rate, as for example the delay in payment shall attract an additional interest of 1% on the overdue amount.

In some cases, financial institutions levy ‘penal interest’ over and above the rate of interest on loans in case of defaults i.e., if the loan carries an interest of 10%, additional penal interest of 2% is being charged on the EMI amounts (which already had factored in the rate of interest portion). This practice leads to ‘compounding of interest’.

RBI Proposals

Considering the present practices and the grievances faced by the borrowers, the RBI has proposed to issue guidelines to regulate the levy of penal charges by lenders. The propositions are discussed below:

• Penal charges shall be ‘reasonable’ and transparent. 

What shall be reasonable is always subjective in nature and based on surrounding circumstances. This may still mean that lenders will be allowed to charge penal charges as per their discretion as long as they are ‘reasonable’ in nature. 

• Penalty has to be in the form of a charge and not interest

Penal interest as stated above is an interest on the interest already levied whereas penal charges are the charge which shall be separately levied and collected at a specified rate only on the amount of the default.

Does this mean that the various charges levied by lenders under the nomenclature of ‘charges’ for so and so default would not be allowed henceforth? It seems that the intent is to permit penal charges only in case of delay or default in repayment/servicing of the loan or breach of material terms and conditions of the loan. Not other penal charges or interest could be recovered from the borrowers. Further,  it is expected that the proposed RBI guidelines might prescribe the methodology for determination of ‘material’ terms and conditions

• No capitalization of penal charges

Capitalization of penal charges refers to the penal charge amount getting aggregated with the principal amount and interest being charged upon such aggregated amount. It can be illustrated as follows : 

Suppose Mr. A avails a loan of Rs.10000 from NBFC B at a rate of interest of 2% per month. Thus the interest amount for Month 1 shall be Rs. 2000, on capitalization, the compounded amount of Rs. 12000 shall be considered for the purpose of calculating interest for Month 2 i.e Rs. 2400 and so on. This leads to capitalization of interest or the concept of interest over interest.

The said capitalization would not be allowed henceforth. A similar relaxation was provided by the RBI through its circular dated April 7,2021 at the time of granting of Moratorium due to COVID 19 pandemic.

In the case of Punjab & Sind Bank vs M/S Allied Beverages Company it was held by the Apex Court, ‘…penal interest can be charged only once for one period of default and therefore cannot be permitted to be capitalized. Though interest can be capitalized on the analogy that the interest falling due on the accrued date and remaining unpaid, partakes the character of amount advanced on that date, yet penal interest, which is charged by way of penalty for non-payment, cannot be capitalized. Further interest, i.e. interest on interest, cannot be claimed on the amount of penal interest. Penal interest cannot be capitalized. It shall be opposed to public policy.’

However, RBI realizes that a lender bears the risk of defaults while extending loans to a borrower and should be adequately compensated for assuming such risks. The initial interest rates are determined based on the credit worthiness of the borrower and the likelihood of defaults at the time of origination of the loan. However, where the creditworthiness of the borrower deteriorates during the tenure of the loan, financial institutions should be permitted to accordingly modify the credit risk premium. Of course, the same shall be backed by sufficient cause and intimations to the borrower.  

Applicability timelines

As per the propositions put forth by RBI, the intent of these guidelines seems to be beneficial for the borrowers bringing about uniformity in the practices followed by various regulated entities, and it shall relieve the borrowers from the burden of penal interest over and above the existing interest rate. Moreover, the detailed guidelines will have to bring more clarity and transparency with regard to the quantum and the extent of the penal charges to be levied in order to ensure minimization of default as well as protection of the interest of the borrower.

Our resources on financial sector: https://vinodkothari.com/category/financial-services/