Legality of Sale of NPAs Between Banks

Last week, the Supreme Court issued its ruling on whether non-performing assets/loans (NPAs) can be transferred between banks without the concurrence of the borrowers.

The case involved a transfer of NPAs (relating to the borrower, APS Star Industries Ltd.) from ICICI Bank to Kotak Mahindra Bank. The borrower was in liquidation. When the assignee Kotak Mahindra Bank sought before the Company Court to substitute its name as lender, the borrower objected on several grounds (including improper payment of stamp duty). The Company Court refused to recognize the assignee on account of improper presentation of the document of transfer. On appeal, a Division Bench of the Gujarat High Court upheld the Company Court’s decision, but on a different ground, i.e. that the assignment of debts by banks is not an activity permissible under the Banking Regulation Act, 1949 (BR Act).

On further appeal, the Supreme Court considered two issues:

1. Whether inter se transfer of debts between banks is an activity permissible under the BR Act?

2. Whether the assignee bank (Kotak Mahindra) is entitled to substitution in place of the original lender / assignor (ICICI Bank) in proceedings relating to liquidation of the borrower company?

On the first issue, the Court examined in detail the scheme and provisions of the BR Act and concluded that assignment of NPAs is within the purview of a bank’s permitted business activity:

– The Reserve Bank of India (RBI) can lay down parameters enabling banking companies to expand its business;

– Apart from accepting deposits and lending, the BR Act leaves ample scope for banks to venture into new businesses being subject to the control of RBI;

– Section 6(1)(n) of the BR Act “enables a banking company to do all things that are incidental or conducive to promotion or advancement of the business of the company”;

– The Guidelines on Purchase / Sale of Non Performing Financial Assets dated 13 July 2005 issued by the RBI allow banks to deal inter se in NPAs, which makes the activity a bona fide business. After going into the rationale for declaring a loan as an NPA, the court goes on to hold that the Guidelines “have been issued as a “restructuring measure” in order to avoid setbacks in the banking system”.

On the second issue, the Court distinguished between the transfer of (i) mere rights, which can be effected without concurrence of the borrower, and (ii) obligations, which requires a novation of the contract (thereby necessitating concurrence of the borrower):

– In the present case, it was found that the assignor is only transferring the rights under contract (which represent its assets);

– There is no transfer of obligations of the assignor towards the assignee, as they continue to be borne by the assignor;

– Hence the deed of assignment transferring the NPAs from ICICI Bank to Kotak Mahindra Bank is not unsustainable in law.

In addition, the court also ruled that the provisions of the SARFAESI Act, 2002 are not applicable to the case because that relates to a transfer of financial assets from banks to specific types of financial vehicles (such as securitization companies and asset reconstruction companies).

With its ruling on the limited questions before it, the Supreme Court remitted the matter to the Gujarat High Court for consideration of the other issues.

Ajay Shah’s Blog has a nice summary and analysis of the judgment, while this discussion on CNBC-TV18 also examines the impact of the decision on the securitization markets. As these demonstrate, in view of the Supreme Court’s limited mandate, it can be said to have merely covered the tip of the iceberg when it comes to the plethora of issues that arise from securitization of financial assets. More issues can be expected to be addressed through the future course the matter is likely to take.

Although securitization has acquired popularity in the Indian markets for over a decade now, the legal regime has been founded on age-old principles of law laid down in legislation such as the Transfer of Property Act, 1882, and the law relating to stamp duty and registration. While these laws do provide solid fundamentals in terms of legal concepts within which modern financial practices such as securitization can be worked, the judiciary has been presented with limited circumstances to interpret these legislation in the modern context. The opportunity that the current batch of cases presents the judiciary may well help clear the air on some of the issues.

Finally, when the SARFAESI Act was enacted in 2002, there was great expectation that such a law would create a modern framework to carry out securitization transactions. However, with its limited application (recognized by the Supreme Court in this latest decision), one cannot afford to turn a blind eye towards pre-existing law on transfer of financial assets.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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