RBI Can’t Issue Umbrella Directions To Banks To Initiate Insolvency, Says Supreme Court
(Image: Supreme Court website)

RBI Can’t Issue Umbrella Directions To Banks To Initiate Insolvency, Says Supreme Court

The Supreme Court struck down the Reserve Bank of India’s Feb. 12 circular on the grounds that the regulator can give directions to banks on stressed assets only upon the central government’s authorisation and in case of a specific default. The direction has to be only for specific cases of default by specific debtors and not issuance of directions to banking companies generally, the apex court said in its order.

The judgment interprets provisions—sections 35AA and 35AB—under the Banking Regulation Act and section 45L of the RBI Act, which were relied upon by the regulator to issue the Feb. 12 circular. The circular had attempted to lay down a rule-based stressed asset framework which asked banks to resolve stress in large accounts within 180 days or refer them for insolvency proceedings.

First several companies in the power sector and then companies from the sugar, fertiliser and infrastructure sectors objected to the circular’s “one size fits all” approach. They petitioned the Allahabad High Court and subsequently the Supreme Court arguing that their financial stress was on account of government policies and other reasons not connected to the management of these companies. Their case was that the specific powers granted to the RBI, to direct banks to file insolvency proceedings against defaulters, were being wielded in a general fashion.

The Contentious Provisions

Sections 35AA and 35AB were introduced by an amendment to the Banking Regulation Act in May 2017.

Section 35AA - The Central Government may, by order, authorise the Reserve Bank to issue directions to any banking company or banking companies to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.

Pointing to the language of section 35AA, the apex court pointed out that the RBI can issue directions to banks to initiate insolvency against a company only if there’s a central government order authorizing it to do and only in respect of a specific default.

It is clear that the RBI can only direct banking institutions to move under the Insolvency Code if two conditions precedent are specified, namely, (i) that there is a Central Government authorisation to do so; and (ii) that it should be in respect of specific defaults. The Section, therefore, by necessary implication, prohibits this power from being exercised in any manner other than the manner set out in Section 35AA.
Supreme Court Order

The first thing to be noted is that without such authorisation, the RBI would have no such power, the judgment authored by Justice Rohinton Nariman says.

On section 35AB—also relied upon by the RBI to issue the Feb 12 circular—the court noted that it does not grant power to the central bank to direct banks to initiate insolvency proceedings.

Section 35AB - (1) Without prejudice to the provisions of section 35A, the Reserve Bank may, from time to time, issue directions to any banking company or banking companies for resolution of stressed assets

The order noted that section 35AB gives the RBI powers to issue directions to banks to resolve stressed assets without initiating the insolvency process. And so, it explained, when it comes to issuing directions to initiate the insolvency resolution process under the Insolvency Code, section 35AA is the only source of power.

Having dealt with implications of Feb.12 circular for banks, the court then delved into the impact on non-bank financial services companies, which were also impacted by the regulator’s directions. This because the regulator had also relied upon section 45L of the RBI Act to pass the circular. This section gives the regulator power to issue directions to financial institutions.

In issuing any directions under this section, the provision mandates the RBI to have due regard to the conditions in which, and the objects for which, the institution has been established, its statutory responsibilities, and the effect the business of such financial institution is likely to have on trends in the money and capital markets.

The lack of this “due regard” by the regulator in its Feb. 12 circular was another reason for the apex court to have held it ultra vires.

The court noted that RBI circular doesn’t mention that due regard has been given to the issues prescribed under section 45(L)(3). It pointed out that circular applies to NBFCs since they are usually part of the lenders’ forum which jointly lend money to debtors. And since they are inseparable from banks, the 12 circular cannot be applied to them alone.

Such non-banking financial institutions are, therefore, inseparable from banking institutions insofar as the application of the impugned circular is concerned. It is very difficult to segregate the non-banking financial institutions from banks so as to make the circular applicable to them even if it is ultra vires insofar as banks are concerned  
Supreme Court Order

And so, the apex court declared the circular ultra vires as a whole. Consequently, all actions taken under it, including actions by which the Insolvency Code has been triggered must fall along with it, the order concluded.

Watch this discussion with Senior Advocate Sajan Poovayya and Nilang Desai, partner at AZB & Partners.

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