Inter-se Ranking of Creditors – Not Equal, but Equitable

-Megha Mittal, Associate and Prachi Bhatia, Legal Intern 

(resolution@vinodkothari.com)

Insolvency laws, globally, have propagated the principle of equitable distribution as the very essence of liquidation/ bankruptcy processes; and while, “equitable distribution” is often colloquially read as “equal distribution” the two terms hold significantly different connotations, more so in liquidation processes – an ‘equitable distribution’ simply means applying similar principles of distribution for similarly placed creditors.

Closer home in India, the preamble of the Insolvency and Bankruptcy Code, 2016 (‘Code’/ ‘IBC’) also upholds the principles of equitable distribution – thus balancing interests of all stakeholders under the insolvency framework. Judicial developments have also had a significant role in holding such equity upright[1]. However, in the recent order of the Hon’ble National Company Law Appellate Tribunal, in Technology Development Board v. Mr. Anil Goel[2], the Hon’ble NCLAT has refused to acknowledge the validity of inter-se rights of secured creditors once such security interest in relinquished in terms of section 52 of the Code.

In what may potentially jeopardize interests of a larger body of secured creditors, the Appellate Authority held that inter-se arrangements between the secured creditors, for instance, first charge and second charge over the same asset(s), would not hold relevance if such secured creditors choose to be a part of the liquidation process under the Code – thus placing all secured creditors at an equal footing. The authors humbly present that the instant order may not be in consonance with the established and time-tested principles of ‘equitable’ treatment of creditors. The authors opine that contractual priorities form the very basis of a creditor’s comfort in distress situations – as such, a law which tampers with such contractual priorities (which of course, are not otherwise hit by avoidance provisions) in those very times, will go on to defeat the commercial basis of such contracts and demotivate the parties. This, as obvious, cannot be a desired outcome of a law which otherwise delves on the objective of ‘promotion of entrepreneurship and availability of credit’. The authors have tried putting their perspective in this article.

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Failed Redemption of Preference Shares: Whether a Contractual Debt?

– Sikha Bansal, Partner and Megha Mittal, Associate (resolution@vinodkothari.com)

Preference shares, as the nomenclature suggests, represent that part of a Company’s capital which carries ‘preference´ vis-à-vis equity shares, with respect to payment of dividend and repayment of capital in case of winding up. However, the real position of preference shares may be quite baffling, given that the instrument, by its very nature, is sandwiched between equity capital and debt instruments.  Although envisaged as a superior class of shares, preference shareholders enjoy neither the voting powers vested with the equity shareholders (true shareholders) nor the advantages vested with debenture-holders (true creditors). As such, the preference shareholders find themselves suspended midway between true creditors and true shareholders – hence facing the worst of both worlds[1].

The ambivalence associated with preference shares is adequately reflected in the manner various laws deal with such shares – a preference share is a part of ‘share-capital’ by legal classification[2], but can be a ‘debt’ as per accounting classification[3]; similarly, while a compulsorily convertible preference share is classified as an ‘equity instrument’[4], any other preference share constitutes external commercial borrowing[5] under foreign exchange laws. Needless to say, the divergent treatment is owed to the objective which each legislation assumes.

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Acknowledgement in Balance Sheet – A Fresh Limitation: The Final Word of Law

-Prachi Bhatia 

Legal Intern at Vinod Kothari & Company 

(resolution@vinodkothari.com)

The three-judge bench of the Hon’ble Supreme Court vide its order dated 14th April, 2021, in Asset Reconstruction Limited v. Bishal Jaiswal & Anr[1] (‘ARCIL v. Bishal) has settled the dust around acknowledgment of liability in books of corporate debtor for the purpose of section 18 of the Limitation Act; corollary to the applicability of the section to the Insolvency and Bankruptcy Code, 2016 (‘Code’). This comes in tandem with another recent order of the Hon’ble SC in LaxmiPat Surana v. Union Bank of India & Anr[2], wherein too the Apex Court upheld that acknowledgement of debt in the balance sheet would render initiation of the limitation period afresh for the purpose of filing an application under the Code.

In what seems to be the final word of law, the, vide the instant order, the Hon’ble SC further set aside the judgment set aside the Full Bench judgment of the Hon’ble NCLAT in V.Padmakumar v. Stressed Assets Stabilisation Fund[3], (‘V. Padmakumar’), wherein the Appellate Tribunal dismissed the benefit of extension of limitation to the creditors by virtue of the debt’s presentation in the books of the corporate debtor.

In this article, author humbly analyses the order of the Apex Court in ARCIL v. Bishal in light of the catena of preceding judgements both in favour and against the ratio-decidendi in ARCIL v. Bishal.

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Prepack for MSMEs – A Vaccine that doesn’t Work?

– Megha Mittal

(resolution@vinodkothari.com)

The Insolvency and Bankruptcy (Amendment) Ordinance, 2021 (‘Ordinance’)[1] was promulgated on 5th April, 2021 to bring into force the prepackaged insolvency resolution framework for Micro, Small, Medium Enterprises (MSMEs). While the Ordinance put forth the structure of the prepack regime, a great deal was dependent upon the relevant rules and regulations. On 9th April, 2021, the Insolvency and Bankruptcy (Pre-packaged Insolvency Resolution Process) Regulations, 2021 (“Regulations”)[2] as well as the Insolvency and Bankruptcy (Pre-Packaged Insolvency Resolution Process) Rules, 2021 (“Rules”)[3] have been notified with immediate effect.

As one delves into the whole scheme of things, including the complicated provisions of the Ordinance and the even complication regulations, one gets to feel that the prepack framework will act only as a consolation for the MSMEs – while efforts aimed to increase the efficacy of insolvency resolution, the proposed Framework seems to do a little towards this end. In the author’s humble opinion, key elements of prepacks – cost and time efficiency and a Debtor-in-Possession approach, have been diluted amidst the micromanaged Rules and Regulations. In this article, we discuss how[4].

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Understanding regulatory intricacies of Payment Aggregator business

-Siddarth Goel (finserv@vinodkothari.com)

Abstract

The penetration of electronic retail payments has witnessed a steep surge in the overall payment volumes during the latter half of the last decade. One of the reasons accorded to this sharp rise in electronic payments is the exponential growth in online merchant acquisition space. An online merchant is involved in marketing and selling its goods and/or services through a web-based platform. The front-end transaction might seem like a simple buying-selling transaction of goods or services between a buyer (customer) and a seller (merchant). However, the essence of this buying-selling transaction lies in the payment mode or methodology of making/accepting payments adopted between the customer and the merchant. One of the most common ways of payment acceptance is that the merchant establishes its own payment integration mechanism with a bank such that customers are enabled to make payments through different payment instruments. In such cases, the banks are providing payment aggregator services, but the market is limited usually to the large merchants only. Alternatively, merchants can rely upon third-party service providers (intermediary) that facilitate payment collection from customers on behalf of the merchant and thereafter remittance services to the merchant at the subsequent stage – this is regarded as a payment aggregation business.

The first guidelines issued by the RBI governing the merchant and payment intermediary relationship was in the year 2009[1]. Over the years, the retail payment ecosystem has transformed and these intermediaries, participating in collection and remittance of payments have acquired the market-used terminology ‘Payment Aggregators’. In order to regulate the operations of such payment intermediaries, the RBI had issued detailed Guidelines on Regulation of Payment Aggregators and Payment Gateways, on March 17, 2020. (‘PA Guidelines’)

The payment aggregator business has become a forthcoming model in the online retail payments ecosystem. During an online retail payment by a customer, at the time of checkout vis-à-vis a payment aggregator, there are multiple parties involved. The contractual parties in one single payment transaction are buyer, payment aggregator, payment gateway, merchant’s bank, customer’s bank, and such other parties, depending on the payment mechanism in place. The rights and obligations amongst these parties are determined ex-ante, owing to the sensitivity of the payment transaction. Further, the participants forming part of the payment system chain are regulated owing to their systemic interconnectedness along with an element of consumer protection.

This write-up aims to discuss the intricacies of the regulatory framework under PA Guidelines adopted by the RBI to govern payment aggregators and payment gateways operating in India. The first part herein attempts to depict growth in electronic payments in India along with the turnover data by volumes of the basis of payment instruments used. The second part establishes a contrast between payment aggregator and payment gateway and gives a broad overview of a payment transaction flow vis-à-vis payment aggregator. The third part highlights the provisions of the PA Guidelines and establishes the underlying internationally accepted best principles forming the basis of the regulation. The principles are imperative to understand the scope of regulation under PA Guidelines and the contractual relationship between parties forming part of the payment chain.

Market Dynamics

The RBI in its report stated that the leverage of technology through the use of mobile/internet electronic retail payment space constituted around 61% share in terms of volume and around 75% in share in terms of value during FY 19-20.[2] The innovative payment instruments in the retail payment space, have led to this surge in electronic payments. Out of all the payment instruments, the UPI is the most innovative payment instrument and is the spine for growth in electronic payments systems in India. Chart 1 below compares some of the prominent payment instruments in terms of their volumes and overall compounded annual growth rate (CAGR) over the period of three years.

The payment system data alone does not show the complete picture. In conformity with the rise in electronic payment volumes, as per the Government estimates the overall online retail market is set to cross the $ 200 bn figure by 2026 from $ 30 bn in 2019, at an expected CAGR of 30 %.[4] India ranks No. 2 in the Global Retail Development Index (GRDI) in 2019. It would not be wrong to say, the penetration of electronic payments could be due to the presence of more innovative products, or the growth of online retail has led to this surge in electronic payments.

What are Payment Aggregators and Payment Gateways?

The terms Payment Aggregator (‘PA’) and Payment Gateways (‘PG’) are at times used interchangeably, but there are differences on the basis of the function being performed. Payment Aggregator performs merchant on-boarding process and receives/collects funds from the customers on behalf of the merchant in an escrow account. While the payment gateways are the entities that provide technology infrastructure to route and/or facilitate the processing of online payment transactions. There is no actual handling of funds by the payment gateway, unlike payment aggregators. The payment aggregator is a front-end service, while the payment gateway is the back-end technology support. These front-end and back-end services are not mutually exclusive, as some payment aggregators offer both. But in cases where the payment aggregator engages a third-party service provider, the payment gateways are the ‘outsourcing partners’ of payment aggregators. Thereby such payments are subject to RBI’s outsourcing guidelines.

PA Transaction Flow

One of the most sought-after electronic payments in the online buying-selling marketplace is the payment systems supported by PAs. The PAs are payment intermediaries that facilitate e-commerce sites and merchants in accepting various payment instruments from their customers. A payment instrument is nothing but a means through which a payment order or an instruction is sent by a payer, instructing to pay the payee (payee’s bank). The familiar payment instruments through which a payment aggregator accepts payment orders could be credit cards, debit cards/PPIs, UPI, wallets, etc.

Payment aggregators are intermediaries that act as a bridge between the payer (customer) and the payee (merchant). The PAs enable a customer to pay directly to the merchant’s bank through various payment instruments. The process flow of each payment transaction between a customer and the merchant is dependent on the instrument used for making such payment order. Figure 1 below depicts the payment transaction flow of an end-to-end non-bank PA model, by way of Unified Payment Interface (UPI) as a payment instrument.

In an end-to-end model, the PA uses the clearing and settlement network of its partner bank. The clearing and settlement of the transaction are dependent on the payment instrument being used. The UPI is the product of the National Payments Corporation of India (NPCI), therefore the payment system established by NPCI is also quintessential in the transaction. The NPCI provides a clearing and settlement facility to the partner bank and payer’s bank through the deferred settlement process. Clearing of a payment order is transaction authorisation i.e., fund verification in the customer’s bank account with the payer’s bank. The customer/payer bank debits the customer’s account instantaneously, and PA’s bank transfers the funds to the PA’s account after receiving authorisation from NPCI. The PA intimates the merchant on receipt of payment and the merchant ships the goods to the customer. The inter-bank settlement (payer’s bank and PA’s partner bank) happens at a later stage via deferred net-settlement basis facility provided by the NPCI.

The first leg of the payment transaction is settled between the customer and PA once the PA receives the confirmation as to the availability of funds in the customer’s bank account. The partner bank of PA transfers the funds by debiting the account of PA maintained with it. The PA holds the exposure from its partner bank, and the merchant holds the exposure from the PA. This explains the logic of PA Guidelines, stressing on PAs to put in place an escrow mechanism and maintenance of ‘Core Portion’ with escrow bank. It is to safeguard the interest of the merchants onboarded by the PA. Nevertheless, in the second leg of the transaction, the merchant has its right to receive funds against the PA as per the pre-defined settlement cycle.

Regulatory approach towards PAs and PGs

The international standards and best practices on regulating Financial Market Infrastructure (FMI) are set out in CPSS-IOSCO principles of FMI (PFMI).[5] A Financial Market Infrastructure (FMI) is a multilateral system among participating institutions, including the operator of the system. The consumer protection aspects emerging from the payment aggregation business model, are regulated by these principles. Based on CPSS-IOSCO principles of (PFMI), the RBI has described designated FMIs, and released a policy document on regulation and supervision of FMIs in India under its regulation on FMIs in 2013.[6] The PFMI stipulates public policy objectives, scope, and key risks in financial market infrastructures such as systemic risk, legal risk, credit risk, general business risks, and operational risk. The Important Retail Payment Systems (IRPS) are identified on the basis of the respective share of the participants in the payment landscape.  The RBI has further sub-categorised retail payments FMIs into Other Retail Payment Systems (ORPS). The IRPS are subjected to 12 PFMI while the ORPS have to comply with 7 PFMIs. The PAs and PGs fall into the category of ORPS, regulatory principles governing them are classified as follows:

These principles of regulation are neither exclusive nor can said to be having a clear distinction amongst them, rather they are integrated and interconnected with one another. The next part discusses the broad intention of the principles above and the supporting regulatory clauses in PA Guidelines covering the same.

Legal Basis and Governance framework

The legal basis principle lays the foundation for relevant parties, to define the rights and obligations of the financial market institutions, their participants, and other relevant parties such as customers, custodians, settlement banks, and service providers. Clause 3 of PA Guidelines provides that authorisation criteria are based primarily on the role of the intermediary in the handling of funds. PA shall be a company incorporated in India under the Companies Act, 1956 / 2013, and the Memorandum of Association (MoA) of the applicant entity must cover the proposed activity of operating as a PA forms the legal basis. Henceforth, it is quintessential that agreements between PA, merchants, acquiring banks (PA’s Partners Bank), and all other stakeholders to the payment chain, clearly delineate the roles and responsibilities of the parties involved. The agreement should define the rights and obligations of the parties involved, (especially the nodal/escrow agreement between partner bank and payment aggregator). Additionally, the agreements between the merchant and payment aggregator as discussed later herein are fundamental to payment aggregator business. The PA’s business rests on clear articulation of the legal basis of the activities being performed by the payment aggregator with respect to other participants in the payment system, such as a merchant, escrow banks, in a clear and understandable way.

Comprehensive Management of Risk

The framework for the comprehensive management of risks provides for integrated and comprehensive view of risks. Therefore, this principle broadly entails comprehensive risk policies, procedures/controls, and participants to have robust information and control systems. Another connecting aspect of this principle is operational risk, arising from internal processes, information systems and disruption caused due to IT systems failure. Thus there is a need for payment aggregator to have robust systems, policies to identify, monitor and manage operational risks. Further to ensure efficiency and effectiveness, the principle entails to maintain appropriate standards of safety and security while meeting the requirements of participants involved in the payment chain. Efficiency is resources required by such payment system participants (PAs/PGs herein) to perform its functions. The efficiency includes designs to meet needs of participants with respect to choice of clearing and settlement transactions and establishing mechanisms to review efficiency and effectiveness. The operational risk are comprehensively covered under Annex 2 (Baseline Technology-related Recommendation) of the PA Guidelines. The Annex 2, inter alia includes, security standards, cyber security audit reports security controls during merchant on-boarding. These recommendations and compliances under the PA Guidelines stipulates standard norms and compliances for managing operational risk, that an entity is exposed to while performing functions linked to financial markets.

KYC and Merchant On-boarding Process

An important aspect of payment aggregator business covers merchant on-boarding policies and anti-money laundering (AML) and counter-terrorist financing (CFT) compliance. The BIS-CPSS principles do not govern within its ambits certain aspects like AML/CFT, customer data privacy. However, this has a direct impact on the businesses of the merchants, and customer protection. Additionally, other areas of regulation being data privacy, promotion of competition policy, and specific types of investor and consumer protections, can also play important roles while designing the payment aggregator business model. Nevertheless, the PA Guidelines provide for PAs to undertake KYC / AML / CFT compliance issued by RBI, as per the “Master Direction – Know Your Customer (KYC) Directions” and compliance with provisions of PML Act and Rules. The archetypal procedure of document verification while customer on-boarding process could include:

  • PA’s to have Board approved policy for merchant on-boarding process that shall, inter-alia, provide for collection of incorporation certificates, constitutional document (MoA/AoA), PAN and financial statements, tax returns and other KYC documents from the merchant.
  • PA’s should take background and antecedent checks of the merchants, to ensure that such merchants do not have any malafide intention of duping customers, do not sell fake/counterfeit/prohibited products, etc.

PAs shall ensure that the merchant’s site shall not save customer’s sensitive personal data, like card data and such related data. Agreement with merchant shall have provision for security/privacy of customer data.

Settlement and Escrow

The other critical facet of PA business is the settlement cycle of the PA with the merchants and the escrow mechanism of the PA with its partner bank. Para 8 of PA Guidelines provide for non-bank PAs to have an escrow mechanism with a scheduled bank and also to have settlement finality. Before understanding the settlement finality, it is important to understand the relevance of such escrow mechanisms in the payment aggregator business.

Escrow Account

Surely there is a bankruptcy risk faced by the merchants owing to the default by the PA service provider. This default risk arises post completion of the first leg of the payment transaction. That is, after the receipt of funds by the PA from the customer into its bank account. There is an ultimate risk of default by PA till the time there is final settlement of amount with the merchant. Hence, there is a requirement to maintain the amount collected by PA in an escrow account with any scheduled commercial bank. All the amounts received from customers in partner bank’s account, are to be remitted to escrow account on the same day or within one day, from the date amount is debited from the customer’s account (Tp+0/Tp+1). Here Tp is the date on which funds are debited from the customer’s bank account.  At end of the day, the amount in escrow of the PA shall not be less than the amount already collected from customer as per date of debit/charge to the customer’s account and/ or the amount due to the merchant. The same rules shall apply to the non-bank entities where wallets are used as a payment instrument.[7] This essentially means that PA entities should remit the funds from the PPIs and wallets service provider within same day or within one day in their respective escrow accounts. The escrow banks have obligation to ensure that payments are made only to eligible merchants / purposes and not to allow loans on such escrow amounts. This ensures ring fencing of funds collected by the PAs, and act as a deterrent for PAs from syphoning/diverting the funds collected on behalf of merchants. The escrow agreement function is essentially to provide bankruptcy remoteness to the funds collected by PA’s on behalf of merchants.

Settlement Finality

Settlement finality is the end-goal of every payment transaction. Settlement in general terms, is a discharge of an obligation with reference of the underlying obligation (whatever parties agrees to pay, in PA business it is usually INR). The first leg of the transaction involves collection of funds by the PA from the customer’s bank (originating bank) to the PA escrow account. Settlement of the payment transaction between the PA and merchant, is the second leg of the same payment transaction and commences once funds are received in escrow account set up by the PA (second leg of the transaction).

Settlement finality is the final settlement of payment instruction, i.e. from the customer via PA to the merchant. Final settlement is where a transfer is irrevocable and unconditional. It is a legally defined moment, hence there shall be clear rules and procedures defining the point of settlement between the merchant and PA.

For the second leg of the transaction, the PA Guidelines provide for different settlement cycles:

  1. Payment Aggregator is responsible for the delivery of goods/service– The settlement cycle with the merchant shall not be later than one day from the date of intimation to PA of shipment of goods by the merchant.
  2. Merchant is responsible for delivery– The settlement cycle shall not be later than 1 day from the date of confirmation by the merchant to PA about delivery of goods to the customer.
  3. Keeping the amount by the PA till the expiry of refund period– The settlement cycle shall not be later than 1 day from the date of expiry of the refund period.

These settlement cycles are mutually exclusive and the PA business models and settlement structure cycle with the merchants could be developed by PAs on the basis of market dynamics in online selling space. Since the end-transaction between merchant and PA is settled on a contractually determined date, there is a deferred settlement, between PA and the merchant.  Owing to the rules and nature of the relationship (deferred settlement) is the primary differentiator from the merchants proving the Delivery vs. Payment (DvP) settlement process for goods and services.

Market Concerns

Banks operating as PAs do not need any authorisation, as they are already part of the the payment eco-system, and are also heavily regulated by RBI. However, owing to the sensitivity of payment business and consumer protection aspect non-bank PA’s have to seek RBI’s authorisation. This explains the logic of minimum net-worth requirement, and separation of payment aggregator business from e-commerce business, i.e. ring-fencing of assets, in cases where e-commerce players are also performing PA function. Non-bank entities are the ones that are involved in retail payment services and whose main business is not related to taking deposits from the public and using these deposits to make loans (See. Fn. 7 above).

However, one could always question the prudence of the short timelines given by the regulator to existing as well as new payment intermediaries in achieving the required capital limits for PA business. There might be a trade-off between innovations that fintech could bring to the table in PA space over the stringent absolute capital requirements. While for the completely new non-bank entity the higher capital requirement (irrespective of the size of business operations of PA entity) might itself pose a challenge. Whereas, for the other non-bank entities with existing business activities such as NBFCs, e-commerce platforms, and others, achieving ring-fencing of assets in itself would be cumbersome and could be in confrontation with the regulatory intention. It is unclear whether financial institutions carrying financial activities as defined under section 45 of the RBI Act, would be permitted by the regulator to carry out payment aggregator activities. However, in doing so, certain additional measures could be applicable to such financial entities.

Conclusion

The payment aggregator business models in India are typically based on front-end services, i.e. the non-bank entitles are aggressively entering into retail payment businesses by way of providing direct services to merchants. The ability of non-bank entitles to penetrate into merchant onboarding processes, has far overreaching growth potential than merchant on-boarding processes of traditional banks. While the market is at the developmental stage, nevertheless there has to be a clear definitive ex-ante system in place that shall provide certainty to the payment transactions. The CPSS-IOSCO, governing principles for FMIs lays down a good principle-based governing framework for lawyers/regulators and system participants to understand the regulatory landscape and objective behind the regulation of payment systems. PA Guidelines establishes a clear, definitive framework of rights between the participants in the payment system, and relies strongly on board policies and contractual arrangements amongst payment aggregators and other participants. Therefore, adequate care is necessitated while drafting escrow agreements, merchant-on boarding policies, and customer grievance redressal policies to abide by the global best practices and meet the objective of underlying regulation. In hindsight, it will be discovered only in time to come whether the one-size-fits-all approach in terms of capital requirement would prove to be beneficial for the overall growth of PA business or will cause a detrimental effect to the business space itself.

 

[1] RBI, Directions for opening and operation of Accounts and settlement of payments for electronic payment transactions involving intermediaries, November 24, 2009. https://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=5379

[2] Payment Systems in India – Booklet (rbi.org.in)

[3] https://m.rbi.org.in/Scripts/AnnualReportPublications.aspx?Id=1293

[4] https://www.investindia.gov.in/sector/retail-e-commerce

[5] The Bank for International Settlements (BIS), Committee on Payment and Settlement Systems (CPSS) and International Organisation of Securities Commissions (IOSCO) published 24 principles for financial market infrastructures and  and responsibilities of central banks, market regulators and other authorities. April 2012 <https://www.bis.org/cpmi/publ/d101a.pdf>

[6]Regulation and Supervision of Financial Market Infrastructures, June 26, 2013 https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2705

[7] CPMI defines non-banks as “any entity involved in the provision of retail payment services whose main business is not related to taking deposits from the public and using these deposits to make loans”  See, CPMI, ‘Non-banks in retail Payments’, September 2014, available at <https://www.bis.org/cpmi/publ/d118.pdf>

 

Our other related articles:

Overview of Regulatory Framework of Payment and Settlement Systems in India by Anita Baid – Vinod Kothari Consultants

RBI to regulate operation of payment intermediaries – Vinod Kothari Consultants

Major recommendations of the Committee on Payment Systems on Payment and Settlement System Bill, 2018 – Vinod Kothari Consultants

No compound interest during moratorium: RBI directs lenders pursuant to SC order

Anita Baid | Vice President, Financial Services (anita@vinodkothari.com)

Overview

The Supreme Court of India (‘SC’ or ‘Court’) had given its judgement in the matter of Small Scale Industrial Manufacturers Association vs UOI & Ors. and other connected matters on March 23, 2021. The said order of SC put an end to an almost ten months-long legal scuffle that started with the plea for complete waiver of interest, but edged towards waiver of interest on interest, that is, compound interest, charged by lenders during Covid moratorium. From the miseries suffered by people due to the pandemic, to the economic strangulation of trade and activity – the unfinished battle with the pandemic continues. Nevertheless, the SC realised the economic limitation of any Government, even in a welfare state. The SC acknowledged that the economic and fiscal regulatory measures are fields where judges should encroach upon very warily as judges are not experts in these matters. What is best for the economy, and in what manner and to what extent the financial reliefs/ packages be formulated, offered and implemented is ultimately to be decided by the Government and RBI on the aid and advice of the experts.

Compound interest continues to elude judicial acceptance – there are several rulings against compound interest pertaining to arbitral awards, and a lot more for civil awards. In the present ruling as well, observations of the Apex court seem to be indicating that compound interest is penal in nature. This may be surprising to a person of finance, as in the financial world, compound interest is ubiquitous and unquestionable.

In the concluding part of the judgment while dismissing all the petitions, the Court lifted the interim relief granted earlier, pertaining to the NPA status of the borrowers. However, the last tranche of relief in the judgement came for the large borrowers that had loans outstanding/ sanctioned as on February 29, 2020 greater than Rs. 2 crores, and other borrowers who were not eligible to avail compound interest relief as per the Scheme for grant of ex-gratia payment of difference between compound interest and simple interest for six months to borrowers in specified loan accounts (1.3.2020 to 31.8.2020) dated October 23, 2020 (“Ex-Gratia Scheme”). The Court did not find any basis for the limit of Rs 2 crores while granting relief of interest-on-interest (under ex-gratia scheme) to the borrowers. Thus, the Court directed that there shall not be any charge of interest on interest/ penal interest for the period during moratorium for any borrower, irrespective of the quantum of loan, or the category of the borrowers.  The lenders should give credit/ adjustment in the next instalment of the loan account or in case the account has been closed, return any amount already recovered, to the concerned borrowers.

Given that the timelines for filing claims under the ex-gratia scheme have expired, it was expected that the Government would be releasing extended/ updated operational guidelines in this regard for adjustment/ refund of the interest on interest charged by the lenders from the borrowers. Further, it seemed that the said directions of the Court would be applicable only to the loan accounts that were eligible and have availed moratorium under the COVID 19 package.

However, as a consequence of the aforesaid ruling, the Reserve Bank of India (‘RBI’) has issued a circular on April 7, 2021 (‘RBI Circular’) instructing the financial institutions to take steps for refund/ adjustment of the interest on interest. While the SC order clearly pertains to the Ex-Gratia Scheme of MoF, the RBI does not talk anywhere about the burden being passed to the GoI.

The RBI Circular is applicable on all lending institutions, that is to say, (a) Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), (b) Primary (Urban) Co-operative Banks/State Co-operative Banks/ District Central, Co-operative Banks, (c) All All-India Financial Institutions, (d) Non-Banking Financial Companies (including Housing Finance Companies).

Interest on Interest

More than 20 writ petitions were filed with the Supreme Court and the relief sought by them can broadly be classified in four parts – waiver of compound interest/ interest on interest during the moratorium period; waiver of total interest during the moratorium period; extension of moratorium period; and that the economic packages/ reliefs should sector specific. Our write on the issue can be read here.

The contention of the petitioners was that even charging interest on interest/compound interest can be said to be in the form of penal interest. Further, it was argued that the penal interest can be charged only in case of wilful default.  In view of the effect of pandemic due to Covid­19 and even otherwise, there was a deferment of payment of loan during the moratorium period as per RBI circulars, hence, it cannot be said that there is any wilful default which warrants interest on interest/penal interest/compound interest. The appeal was that there should not be any interest on interest/penal interest/compound interest charged for and during the moratorium period.

The Central Government and RBI had already provided the following reliefs to mitigate the burden of debt servicing brought about by disruptions on account of Covid­19 pandemic:

The nature of moratorium was to provide a temporary standstill on payment of both, principal and interest thereby providing relief to the borrowers in two ways, namely, the   account   does   not become NPA despite nonpayment of dues; and since there was no reporting to the Credit Information Companies, the moratorium did not adversely impact the credit history of the borrowers.

It is important to understand the concept of “moratorium”- the word “moratorium” is categorically defined by the RBI, while issuing various circulars. The relevant circulars of RBI show that “moratorium” was never intended to be “waiver of interest”, but “deferment of interest”. In other words, if a borrower takes the moratorium benefit, his liability to make payment of contractual interest (both normal interest and interest on interest) gets deferred for a period of three months and subsequently three months thereafter. After a very careful and major consideration of several fiscal and financial criteria, it’s inevitable effects and keeping the uncertainty of the existing situation in mind, the payment of interest and interest on interest was merely deferred and was never waived.

Further, it is to be noticed that while the standstill applicable to bank loans results in the bank not getting its funds back during the period of moratorium, the bank continues to incur cost on bank’s deposits and borrowings. Since a moratorium offers certain advantages to borrowers, there are costs associated with obtaining the benefit of a moratorium and placing the burden of the same on lenders might just shift the burden on the financial sector of the country. If the lenders were to bear this burden, it would necessarily wipe out a substantial and a major part of their net worth, rendering most of the banks unviable and raising a very serious question over their very survival. Even on the occurrence of other calamities like cyclone, earthquake, drought or flood,  lenders do not waive interest but provide necessary relief packages to the borrowers. A waiver   can only be granted by the Government out of the exchequer. It cannot come out of a system from banks, where credit is created out of the depositor’s funds alone. Any waiver will create a shortfall and a mismatch between the Bank’s assets and liabilities.

Considering the same, the Government had granted the relief of waiver of compound interest during the moratorium period, limited to the most vulnerable categories of borrowers, that is, MSME loans and personal loans up to Rs. 2 crores. Our write up on the same can be viewed here.

However, the SC felt that there is no justification to restrict the relief of not charging interest on interest with respect to the loans up to Rs. 2 crores only and that too restricted to certain categories. Accordingly, the SC had directed that directed that there shall not be any charge of interest on interest/compound interest/penal interest for the period during the moratorium and any amount already recovered under the same head, namely, interest on interest/penal interest/compound interest shall be refunded to the concerned borrowers and to be given credit/adjusted in the next instalment of the loan account.

The ruling however, did not clarify as to who shall bear the burden of the waiver of such interest on interest. Further, the RBI Circular seems to place the burden on the lenders and not wait for the Government to come up with a relief scheme or extend the existing ex-gratia scheme.

RBI Circular

Coverage of Lenders

All lending institutions are covered under the ambit of the RBI Circular. The coverage includes all HFCs and NBFCs, irrespective of the asset size. Clearly, non-banking non-financial entities, or unincorporated bodies are not covered by the Circular.

Coverage of Borrowers

The borrowers eligible as per March 27 Circular (COVID-19 – Regulatory Package) were those who have availed term loans (including agricultural term loans, retail and crop loans) and working capital financing in the form of cash credit/ overdraft. Certain categories of borrowers were ineligible under the March 27 Circular such as those which were not standard assets as on 1st March 2020. Hence, loans already classified as NPA  continued with further asset classification deterioration during the moratorium period in case of non-payment.

The question that arises is whether the benefit under the RBI Circular is limited to any particular type of facility? The benefit of the RBI Circular is to be provided to all borrowers, including those who had availed of working capital facilities during the moratorium period. Further, the benefit is irrespective of the amount sanctioned or outstanding and irrespective of whether moratorium had been fully or partially availed, or not availed. However, this should include only those loans that were originally eligible to claim the moratorium but did not claim it or claimed partially or fully.

Thus, all corporate borrowers, including NBFCs who may have borrowed from banks, are apparently eligible for the relief.

Another crucial aspect is whether the benefit is applicable to facilities which have been repaid, prepaid during the moratorium period? If so, upto what date? The benefit must be provided to all eligible loans existing at the time of moratorium but has been repaid as on date.

Coverage of facilities

Both term loans as well as working capital facilities are covered. Facilities which are not in the nature of loans do not seem to be covered.  Further, facilities for which the Covid moratorium was not applicable also do not seem to be covered. Examples are: unfunded facilities, loans against shares, invoice financing, factoring, financial leases, etc. In addition, borrowing by way of capital market instruments such as bonds, debentures, CP, etc are not covered by the RBI Circular.

Questions will also arise as to whether lenders will be liable to provide the relief in case of those loans which are securitised, assigned under DA transactions or transacted under co-lending arrangement? We have covered these questions in our detailed FAQs on the moratorium 1.0  and 2.0.

Since the moratorium benefit was to be extended only to such installments that were falling due during the said moratorium period. Hence, only those borrowers were eligible for availing moratorium who were standard as on February 29, 2020 and whose installments fell due during the moratorium period. Accordingly, there can be the following situations:

 

Burden of interest on interest

The SC order was with reference to the Central Govt decision vide Ex-Gratia Scheme. Among other things, the petitioners had challenged that there was no basis for limiting the amount of eligible facilities to Rs 2 crores, or limiting the facility only to categories of borrowers specified in the Ex-Gratia Scheme. As per the GoI decision, the benefit was to be granted by lending institutions to the borrowers, and correspondingly, there was a provision for making a claim against SBI, acting as the banker for the GoI.

The SC order is an order upon the UoI. Neither were individual banks/NBFCs parties to the writ petition, nor does it seem logical that the order of the Court may require parties to refund or adjust interest which they charged as per their lending contracts. The UoI may be required to extend a benefit by way of Covid relief, but it does not seem logical that the burden may be imposed on each of the lending institutions, who, incidentally, did not even have the chance to take part in the proceedings before the apex court.

Hence, it seems that the impact of the SC order is only to extend the benefit of the Ex-Gratia Scheme to all borrowers, but the mechanics of the original circular, viz., lending institutions to file a counterclaim against the UoI through SBI, should apply here too.

Accounting disclosure for FY 20-21

The RBI Circular talks about a disclosure for the adjustment or refund to be reflected in the financial statements for FY 20-21.

In terms of accounting standards, the question whether the liability for refund or adjustment of the compound interest is a liability or a provision will be answered with reference to Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets. Since the RBI Circular may be seen as creating a liability as on 31st March, 2021, the lending institution may simply adjust the differential amount [that is, compound interest – simple interest on the Base Amount] into the ongoing account of the customer. If such a liability has been booked, there is no question of any provision.

The computation of the differential amount will have to be done for each borrower. Hence, any form of macro computation does not seem feasible. Therefore, there will not be much of a difference between a provision and a liability.

Accounting for the refund in FY 20-21 by the borrowers

If the lending institution makes a provision, can the borrower book a receivable by crediting interest paid or provided? The answer seems affirmative.

Mechanism of extending the benefit

Methodology for calculation is to be provided by IBA. In this regard, representation has been made to the Government to bear the burden.

Base amount: If the mode of computation as provided in the RBI Circular is to be followed [IBA’s methodology will be awaited], then the computation will be based on the amount outstanding as on 1st March 2020.

Computation: On the Base amount, the differential amount will be CI- SI.

If the facility has been fully repaid during the moratorium period, the Differential Amount will run upto the date of the repayment.

Actionables

A board approved policy is to be put in place immediately. In this regard, the concern is whether the lenders can modify existing moratorium policy or adopt a new policy altogether? In our opinion, the existing policy itself may be amended to give effect to the RBI Circular or alternatively a new policy may be adopted.

Also, there is no timeline prescribed as to by when are these actionables required. However, since there are certain disclosure requirements in the financials for the FY 2020-21, the policy must be in place before the financials are approved by the Board of the respective lenders.

The lender may await the instructions to be issued by the Government and the methodology to be prescribed by IBA. Logically, the same method as was provided under the Ex-Gratia Scheme should be applicable. Accordingly, lenders may create provisions for the refund of the excess interest charged and whether corresponding receivable will be shown would depend on whether the same is granted by the Government.

Asset Classification

The RBI moratorium notifications freezed the delinquency status of the loan accounts, which availed moratorium benefit under the scheme. It essentially meant that asset classification standstill was imposed for accounts where the benefit of moratorium was extended. A counter obligation on Credit Information Companies (CIC) was also imposed to ensure credit history of the borrowers is not impacted negatively, which are availing benefits under the scheme.

Various writ petitions were filed with the SC seeking an extended relief in terms of relaxation in reporting the NPA status to the credit bureaus. Hence, while hearing the petition of Gajendra Sharma Vs Union of India & Anr. and other writ petitions, the SC granted stay on NPA classification in its order dated September 03, 2020. The said order stated that:

“In view of the above, the accounts which were not declared NPA till 31.08.2020 shall not be declared NPA till further orders.”

The intent of granting such a stay was to provide interim relief to the borrowers who have been adversely affected by the pandemic, by not classifying and reporting their accounts as NA and thereby impacting their credit score.

In its latest judgment, the SC has directed that the interim relief granted earlier not to declare the accounts of respective borrowers as NPA stands vacated. We have also covered the same in our write up.

As a consequence of the SC order, the RBI Circular has clarified the asset classification as follows:

This would mean that after September 1, 2020 though there was a freeze on NPA classification, the same cannot be construed as a freeze on DPD counting. The DPD counting has to be in continuation from the due date of the EMI. The accounts classified as standard, but in default of more than 90 DPD may now be classified NPA, since the freeze on NPA classification is lifted by the SC and directed by the RBI as well.

SC gives purposive interpretation to section 238A of IBC:

Time lost in SARAFESI proceedings can be excluded from limitation period for IBC initiation

-By Sikha Bansal and Urmil Shah [resolution@vinodkothari.com]

The recent ruling of Supreme Court (SC) in Sesh Nath Singh v. Baidyabati Sheoraphuli Co-Operative Bank Ltd., Civil Appeal No. 9198 of 2019 (Ruling) partially addresses the persistent debate on the interplay between the Limitation Act, 1963 (‘Limitation Act’) and the Insolvency and Bankruptcy Code, 2016 (‘IBC’).

The central issue involved in the case was – the financial creditor had initiated SARFAESI proceedings against the corporate debtor years back when the default occurred.  Later, while the SARFAESI proceedings were still pending before the High Court (which prima facie viewed that the financial creditor, being a co-operative bank, could not invoke the provisions of SARFAESI), the financial creditor filed for insolvency proceedings under section 7 of IBC against the corporate debtor. Such application was filed after a lapse of 3 years from the default. Hence, the corporate debtor objected the initiation of insolvency on grounds of the application being barred by limitation.

SC, however, read the expression “as far as maybe” as used in section 238A of IBC as a conscious choice of words by the legislature. As such, the words are to be understood in the sense in which they best harmonise with the subject matter and object to the legislation. These words permit a wider, more liberal, contextual, and purposive interpretation by necessary modification.  Therefore, section 5, 14, and even section 18 of the Limitation Act would apply to proceedings under IBC.

The article below notes the important observations of SC, along with the authors’ insights.

Read more

An Odd Scheme: Case for exclusion of schemes of arrangement from scheme of liquidation

Sikha Bansal, Partner

[resolution@vinodkothari.com]

The Article below has also been published on the IndiaCorplaw Blog, see here 

The concerns around section 230 schemes in the background of insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 (IBC) have been partly addressed with the ruling of Supreme Court (SC) in Arun Kumar Jagatramka v. Jindal Steel and Power Ltd. The SC has held that the prohibition contained in section 29A should also attach itself to a scheme of compromise or arrangement under section 230 of the Companies Act, when the company is undergoing liquidation under the auspices of IBC. Reason being: proposing a scheme of compromise or arrangement under section 230 of the Companies Act, while the company is undergoing liquidation under the provisions of the IBC, lies in a similar continuum.

Earlier, there were several rulings of NCLAT which allowed schemes of arrangement during liquidation – for instance, see S.C. Sekaran, Y. Shivram Prasad, etc. After such rulings, the IBBI (Liquidation Process) Regulations were amended to include Regulation 2B, which also state that “a person, who is not eligible under the Code to submit a resolution plan for insolvency resolution of the corporate debtor, shall not be a party in any manner to such compromise or arrangement.” Read more

Fragmented framework for perfection of security interest

Introduction An interesting question of law came up for consideration by way of appeal before National Company Law Appellate Tribunal (NCLAT) in Volkswagen Finance Private Limited v. Shree Balaji Printopack Pvt. Ltd.[1]  The brief facts of the case involved a car financing company, which extended a car loan to the corporate debtor. The car financier […]