No Borrower, No Lender, Yet Willful Defaulter?

Source: Money-control ; Sat, Sep 17, 2011

Who is a Willful Defaulter?

 The answer to that question lies in one judgment covering two cases and setting a precedent for all derivatives transactions. Payaswini Upadhyay has the details.

In 2009, India’s leading pipemaker Finolex Industries refused to pay Deutsche Bank dues arising from a derivatives transaction. Deutsche Bank approached the Debt Recovery Tribunal alleging that Finolex was a Willful Defaulter. Last year, ICICI Bank termed Emcure Pharmaceuticals a Willful Defaulter as well, for not paying up on a derivatives deal.

Shishir Mehta
Partner, Khaitan

“Being a Willful Defaulter, there are grave implications for a borrower- the main one being that all lines of credit would be cut off. They would be blacklisted in the financial community. That means you would not have access to bank finance, getting access to capital markets would be a problem, the Directors of a Willful Defaulting company will have to step down from their directorships in other companies. So it’s basically a mechanism to blacklist a borrower and get them to, therefore, come on the negotiating table.”

That didn’t go down well with the companies who appealed to the High Court! The question facing the 2 judge bench was- Whether default under a derivatives transaction can be termed as ‘Willful Default’?

Now, the who, what, how of Willful Defaulting is governed by the RBI. Its Master Circular defines Willful Default to include ‘default by a unit in meeting payment or repayment obligations to the lender even when it has the capacity to do so’. The banks claimed their clients were Willful Defaulters as they had not honored the derivatives contracts even though they had the means to do so. But the companies argued that ‘Willful Default’ is based on the existence of a relationship of a lender and borrower and a derivatives transaction does not involve lending of money. Emcure’s Counsel Hitesh Jain says dues arising under a derivatives contract do not come under RBI’s Willful Default circular.

Hitesh Jain 
ALMT Legal
Counsel for Emcure Pharmaceuticals 

“This is a standalone circular, lender and borrower has been clearly defined. The meaning of lender and borrower is clear. So therefore, the dues arising under the derivative contracts cannot come under the circular.

Take for an illustration- suppose if a bank has taken a premises on a leave and license basis and it ahs paid a security deposit to the landlord and after the termination of the agreement, if the landlord is not paying the security deposit, can you say that since the landlord is liable to pay the money to the bank, therefore that transaction can also be termed as a lender and borrower.”

 But the banks argued that the RBI circular on Willful Defaults should not be looked at in a standalone manner. Deutsche Bank Counsel Fraser Alexander refers to other RBI circulars on NPA norms, exposure norms and prudential norms to make his case.

Fraser Alexander
Partner, Juris Corp
Counsel for Deutsche Bank

“When you refer to other circulars of RBI, it clearly shows for all purposes, derivative dues were to be considered as an exposure on the bank and of the borrower. Therefore, it would be a non-fund based facility. That is the reason why these circulars were referred to.”

The Bombay High Court agreed that the two companies were Willful Defaulters!

The Bombay High Court’s decision is in stark contrast to that of the Kolkata High Court. In 2009, a single judge bench of the Kolkata High Court, when hearing a similar case, ruled that RBI’s Willful Default circular did not cover derivatives transactions. So why did the Bombay High Court think otherwise?

Because it believed all the circulars must be seen in tandem. Also RBI filed an affidavit in court saying derivative dues are included under Willful Default.

So the banks were proven right and yet they lost the case!

 On a technicality! Finolex and Emcure both argued that the banks had not provided them with all the case papers before tagging them as Willful Defaulters.

Hitesh Jain
ALMT Legal
Counsel for Emcure Pharmaceuticals 

“No procedure has been followed and arbitrarily the banks classified the company- because they wanted to recover the money- as Willful Defaulters.”

The Court saw merit in that. It ruled that an incomplete Grievance Redressal Process was a violation of the principles of natural justice. 

Fraser Alexander
Partner, Juris Corp 
Counsel for Deutsche Bank

“Due to a technical reason, the court quashed this order on the basis of a technicality that the minutes of the meeting of the Willful Defaulter Committee was not provided to the corporate even though the reasoning was mentioned in the notice issued to them.”

Shishir Mehta
Partner, Khaitan

“I think this is a clear signal. As the derivative saga unfolds in the country, on one hand the banks need to make sure that the borrowers are the right entities – they have the right qualifications to enter into a trade. But once that checklist has been ticked off, I think it’s a very clear signal that borrowers can’t just walk away from a debt on derivative trade. Of course, in the present case, there were issues with regard to natural justice, but that is something which can be remedied. It’s just at the Grievance Redressal Committee stage. But what we can extract from this judgment is that banks would be very pleased with it and rightly so.”

It’s a near miss for banks in this round. The question is how will the Supreme Court view the same matter? All 3 cases - the two from the Bombay High Court and the one from the Kolkata High Court one will be heard together at the Apex Court starting October 18th.