A comprehensive framework for compromise settlement and technical write offs

Dayita Kanodia | Executive finserv@vinodkothari.com

The first bad bank loan was, no doubt, made around the time as the opening of the first bank.

James Grant^[1]

Background

RBI  released the Framework for Compromise Settlements and Technical Write-offs^[2] (Framework) on June 8 2023. This framework, issued exactly four years after the release of the Prudential Framework for Resolution of Stressed Assets^[3] (PFRSA), aims to rationalize and harmonize the instructions earlier issued. Additionally, while PFRSA was applicable only to banks and systemically important NBFCs (among others), the present Framework is applicable across all REs, including base layer NBFCs.

Subsequently, to clear the ambiguities that may have arisen after the issuance of the Framework, the RBI also released a set of Frequently Asked Questions^[4] on the topic: of these, these FAQs were largely intended to respond to certain questions of intent that were being thrown at the regulator in releasing the Framework.

This article discusses the Framework along with its applicability, as also it intends to help REs to make a calculated decision on choosing between compromise settlements, writedowns, restructuring, or doing nothing at all. For either of the options, the article also discusses  the other requirements which need to be ensured while pursuing the option. 

Applicability

Before we delve into specifics of the Framework, it is essential to first understand the context behind this. The preamble of the Framework states:

The Reserve Bank of India has issued various instructions to regulated entities (REs) regarding compromise settlements in respect of stressed accounts from time to time, including the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019 (“Prudential Framework”), which recognises compromise settlements as a valid resolution plan. With a view to provide further impetus to resolution of stressed assets in the system as well as to rationalise and harmonise the instructions across all REs, as announced in the Statement on Developmental and Regulatory Policies released on June 8, 2023, it has been decided to issue a comprehensive regulatory framework governing compromise settlements and technical write-offs covering all the REs, as detailed in the Annex.

Therefore, the Framework attempts to achieve more than what PFRSA could achieve. However, it is important to understand these two are independent. The Framework neither replaces the PFRSA, nor does it have to be read along with the PFRSA, and this comes out very clearly from para 2 of the Framework which states:

The provisions of this framework shall be applicable to all REs to which this circular is addressed and shall be without prejudice to the provisions of the Prudential Framework, or any other guidelines applicable to the REs on resolution of stressed assets.

The RBI has made its position even clearer with the following justification it provided in the FAQs:

The circular is intended to achieve the following objectives:

1. It rationalises the existing regulatory guidance to banks on compromise settlements, consolidating various instructions issued over the years. It also tightens some of the related provisions and ensures greater transparency.
2. By providing a clear regulatory framework, it enables other regulated entities, particularly cooperative banks, to undertake compromise settlements as part of the normal resolution efforts.
3. It provides clarity on definition of technical write-off and provides a broad guidance on the process to be followed by the regulated entities for technical write-offs, which is a normal banking practice.
4. As a disincentive to both the lenders and the borrowers, it introduces the concept of cooling period for normal cases of compromise settlement during which the lender undertaking settlement shall not take any fresh exposure on the borrower entity. In case of borrower accounts classified as wilful defaulter or fraud, the debarment to obtain fresh finance, as explained at (2) above, will apply.

With respect to the applicability of the Framework, one notable difference with the PFRSA is that while the latter is only applicable to systemically important NBFCs, the one released now has drawn non-systemically important NBFCs within its purview. Accordingly, the framework is applicable to-

• Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks)
• Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative Banks
• All-India Financial Institutions
• Non-Banking Financial Companies (including Housing Finance Companies)

Another notable difference between the PFRSA and the Framework is that a major part of the PFRSA becomes mandatorily applicable only in case of large debt exposures, the Framework, however, does not provide for any debt threshold for it to become applicable. That is to say, the Framework is applicable irrespective of the size of the exposure, and whether the exposure is held singly by the RE or shared with other REs.

Therefore, all REs shall have to adhere to this framework while undertaking compromise settlements and technical write offs, and where the amount of debt involved exceeds the thresholds provided in the PFRSA, the same shall also have to be complied with.

Compromise settlement and technical write-offs

The first component of the Framework is “compromise settlement” The expression means a settlement, which involves a compromise. In common parlance, this is referred to as one-time settlement or OTS. The RBI has defined compromise settlement as any negotiated arrangement with the borrower to fully settle the claims of the RE against the borrower in cash. Such settlement may entail some sacrifice of the amount due from the borrower on the part of the REs with corresponding waiver of claims of the RE against the borrower to that extent.

The above discussion leads to at least 2 conclusions:

• If there is a compromise settlement where the facility due to the RE is not fully settled, it will not be covered by this Framework. Technically, this may amount to restructuring, to the extent there is an economic rationale to a partial waiver of the claim of the RE. Therefore, a partial waiver will have to be covered by the RE’s policy on restructuring.
• A compromise settlement where the facility is converted into another facility, say conversion into equity or another debt instrument or facility, is also not covered by this Framework. The underlying philosophy is that if an RE has to enter into a compromise with the borrower, the RE should attempt a complete exit from the facility, rather than continuing to rely on the borrower for any further promises.

“Technical” write off

The second part of the Framework deals with “technical write-off”. The Framework defines the term as the cases where the non-performing assets remain outstanding at borrowers’ loan account level, but are written-off (fully or partially) by the RE only for accounting purposes, without involving any waiver of claims against the borrower, and without prejudice to the recovery of the same.

Once again, it is commonplace practice across different classes of lenders, where they write-off  or write-down the loans in the books of accounts, yet retain the legal right to recover the amount due from the borrowers. In accounting parlance, this is a case of impairment at stage 3. This can arise either from the applicable regulations, for instance, the IRAC norms require the lenders to mandatorily write-off loans after it has remained NPA for a certain number of years, or could be the requirement of estimation of expected credit losses under applicable accounting standards, or may be based on the judgment of the management.

Compromise Settlements vs Technical write off vs Restructuring

	Compromise settlement	Technical write off	Restructuring
Economic rationale	Recognition of practical impossibility or loss of value in recovery of the full amount; maximization of time value of recovery.	Recognition that part of the carrying value of the claim, net of provisions, is difficult to recover.Hence, an accounting impairment.	Recognition that the current schedule of repayment is difficult for the borrower to honor; hence rescheduling by giving terms/payment schedule that may lead to better adherence.
Legal right of recovery	No legal right of recovery to the extent of sacrifice. Compromise amounts to a partial waiver of the claim.	The legal right to the claim remains unimpacted by the write off.	The legal claim is redefined by the restructured terms – may go up or come down.
Contractual engagement with the borrower	Borrower is a party to the compromise	Borrower is not a party at all. Borrower does not and should not have anything to do with the write off.	Borrower is a party to the restructuring
Derecognition	Compromise settlement is always for the whole of the outstanding, and therefore, on completion, will result into full derecognition	Write off may be full or partial, and therefore, the loan to the extent not written off may continue.	Loan continues.
Accounting treatment	Sacrifice amount should be immediately written off. The settlement amount should be taken as paid only on actual realization.	The write off is immediately expensed, after netting off any provisions already existing	Restructuring results into the asset being taken as NPA. If the asset was already an NPA,then an impairment on a/c of restructuring should be recognised by considering lifetime losses
Possibility of complete write down	Does not exist	Exists	Does not exist
Bureau reporting	Lender should report a/c as being closed on compromise settlement	Bureau reporting will continue	Bureau reporting gets modified based on restructured terms
Reporting by borrower	Borrower may credit the waiver of liability in his books of account	No question of borrower accounting for the write off	Borrower will account the liability as per restructured terms
Possibility to take fresh exposures on the borrowers	Only after the completion of the cooling period	Only after the completion of the cooling period	There is no bar.

Compromise settlement and technical write offs now allowed for fraud accounts or wilful defaulters

Perhaps the most interesting (and, as expected, it did create widespread critique) provision of this framework is that accounts declared as fraud or as wilful defaulters^[5] are also eligible for compromise settlement under the Framework, provided the proposals for such settlements are approved by the board of the REs.

Under the prudential framework, wilful defaulters and debtors classified as fraud were not allowed for restructuring.

However, as stated by RBI in the FAQs in this regard, this provision enabling banks to enter into compromise settlement in respect of such borrowers is not a new regulatory instruction and has been the settled regulatory stance. The following circulars contain similar provisions-

1. RBI had advised IBA vide letter dated May 10, 2007 that, “(i) banks may enter into compromise settlement with wilful defaulters/ fraudulent borrowers without prejudice to the criminal proceeding underway against such borrowers; (ii) All such cases of compromise settlements should be vetted by Management Committee/ Board of banks.”
2. Master Circular on Wilful Defaulters dated July 1, 2015 envisages lenders agreeing to compromise settlement with borrowers classified as wilful defaulters and states that such cases need not be reported to Credit Information Companies provided inter alia that, “the borrower has fully paid the compromised amount.”
3. Master Directions on Frauds dated July 1, 2016 provides for compromise settlement with borrowers classified as fraud, subject to the condition that, “No compromise settlement involving a fraudulent borrower is allowed unless the conditions stipulate that the criminal complaint will be continued.

The reason for permitting the same is to enable multiple avenues to lenders to recover the money in default without much delay. Such delays result in the deterioration of asset value which in turn hampers ultimate recoveries. It is because of this that compromise settlement and technical write off was allowed for such borrowers as continuing with such exposures on the balance sheet of the lenders without any resolution due to undergoing legal proceedings would lock lenders funds in an unproductive asset.

Further, this provision does not in any way affect the penal measures on such a category of borrowers and the penalty prescribed under the Master Directions on Frauds dated July 1, 2016 and the Master Circular on Wilful Defaulters dated July 1, 2015 shall remain unchanged and continue to apply. Such penal measures entail inter alia that no additional facilities should be granted by any bank/ FI to borrowers listed as wilful defaulters, and that such companies (including their entrepreneurs/ promoters) get debarred from institutional finance for floating new ventures for a period of five years from the date of removal of their name from the list of wilful defaulters.

The compromise framework further  provides that REs may undertake compromise settlements or technical write-offs in respect of such accounts without prejudice to the criminal proceeding underway against such debtors.

Cooling off period

The Framework introduces the concept of cooling period. The borrowers who are subject to compromise settlement shall be subject to a mandatory cooling period which shall be determined by the respective board approved policies. It is only after such a cooling period that the REs may assume fresh exposures on such borrowers.

RBI has stipulated a minimum cooling period of 12 months in respect of exposures other than farm credit exposures. The board of the REs may however decide on a higher cooling period.

Note that in case of frauds/wilful defaulters, the cooling off period will be 5 years (see also below).

Farm credit exposures

Farm credit exposures mean credit facilities extended to agricultural activities as listed in annex 2 of  Master Circular – Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances.^[6]

The cooling period on such farm credit exposures and in respect of exposures subjected to technical write-offs shall be decided by the REs through their board approved policies.

Can a borrower borrow from other REs during this cooling period ?

However, the question which arises is, if the cooling off period is required to be followed by all other REs? In other words,  in case a borrower has gone for compromise settlement or technical write off he cannot borrow from the same RE for a period of 12 months, but can he borrow from other RE during this cooling off period?. The response to this seems affirmative, as the language of the Framework suggests that bar on taking fresh exposure during the cooling off period is on the RE involved in the arrangement, however, it does not suggest any prohibition on other lenders to take fresh exposure during this period. Of course, other lenders will have to take their own informed credit call, in view of the impaired credit history of the borrower.

Situation in case of wilful defaulters and borrowers classified as fraud

It has been clarified in the FAQs that the cooling period is only for normal cases of compromise settlements and shall in no way affect the penal measures applicable in respect of borrowers classified as fraud or wilful defaulters. Such borrowers are debarred from availing bank finance for a period of five years from the date of full payment of the defrauded amount.

Whether to be treated as “restructuring”?

The framework provides for a prudential treatment for compromise settlement where the time for payment of the agreed settlement amount exceeds three months. In such cases the same shall be treated as restructuring as defined in the prudential framework.

The prudential framework itself considers compromise settlements as restructuring if the time for payment of settlement amount exceeds three months.

Further, the compromise settlements and technical write-offs shall be without prejudice to any mutually agreed contractual provisions between the RE and the borrower relating to future contingent realizations or recovery by the RE, subject to such claims not being recognised in any manner on the balance sheet of REs at the time of the settlement or subsequently till actual realization of such receivables.

And if any such claims are recognised on the balance sheet of the RE then the same shall be treated as restructuring.

Partial technical write offs

In case of partial technical write-offs, the prudential requirements in respect of residual exposure, including provisioning and asset classification, shall be with reference to the original exposure.

However, the amount of provision including the amount representing partial technical write-off is required to meet the extant provisioning requirements, as computed on the gross value of the asset.

Board-approved policy

The framework casts an obligation on the REs to have in place Board-approved policies for undertaking compromise settlements with the borrowers as well as for technical write-offs.

It has also been provided that this Board approved policy shall comprehensively lay down the process to be followed for all compromise settlements and technical write-offs, with specific guidance on the necessary conditions precedent such as minimum ageing, deterioration in collateral value etc. Further, a graded framework for examination of staff accountability in such cases with reasonable thresholds and timelines as may be decided by the Board shall be put in place.

Various categories of exposures

The framework has further specified that in case of compromise settlement the policy shall inter alia contain provisions relating to permissible sacrifice for various categories of exposures while arriving at the settlement amount, after prudently reckoning the current realizable value of security/collateral, where available. The methodology for arriving at the realizable value of the security shall also form part of the policy.

The objective of the RE here should be to maximize the possible recovery from a distressed borrower at minimum expense, in its best interest.

Delegation of power

The board approved policy is further required to contain provisions for the delegation of power for the purpose of approval/sanction of compromise settlements and technical write-offs.

The REs are further required to ensure that in case of compromise settlements the delegation of power for such approvals rests with an authority (may be either individual or committee) which is at least one level higher in hierarchy than the authority vested with power to sanction the credit or the investment exposure.

However, any official who was part of sanctioning the loan (as individual or part of a committee) shall not be part of approving the proposal for compromise settlement of the same loan account, in any capacity.

There is a further requirement of reporting compromise settlements and technical write offs approved by a particular authority to the next higher authority at least on a quarterly basis.

Reporting format to ensure coverage

The Board of the REs is required to ensure a suitable reporting format is in place so as to ensure adequate coverage of the following aspects at the minimum:

• trend in number of accounts and amounts subjected to compromise settlement and/or technical write-off;
• out of (i) above, separate breakup of accounts classified as fraud, red-Flagged, wilful default and quick mortality accounts;
• amount-wise,  sanctioning authority-wise, and business segment / asset-class wise grouping of such accounts;
• extent of recovery in technically written-off accounts.

Concluding remarks

The RBI by coming up with this framework has not only rationalized and harmonized the instructions across all REs but has also sort of liberalized the compromise settlement framework by allowing wilful defaulters and other debtors who were once classified as fraud to participate in the compromise process. However, as already mentioned above the cooling period is only for normal cases of compromise settlements and not for such accounts.

Nevertheless this provision may act as a relief for the borrowers who were once classified as such from obtaining credit.

Further, the framework for the first time uses the word “technical write-off” which is however not something new as it was a common practice among lenders to write off NPAs while still trying to recover the same.

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^[1] Author of Money of the Mind:Borrowing and Lending in America from the Civil War to Michael Milken.

^[2] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12513&Mode=0

^[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11580&Mode=0

^[4] https://www.rbi.org.in/Scripts/FAQView.aspx?Id=160

^[5] Wilful defaulters are borrowers who refuse to repay the loans despite having the capacity to pay.

^[6] https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=12472

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Our Resources on the topic:-

1. Modes of Restructuring of Stressed Accounts
2. Prudential Framework for Resolution of Stressed Assets: New Dispensation for dealing with NPAs
3. https://vinodkothari.com/wp-content/uploads/2020/10/Restructuring-Framework-PPT.pdf