Fans of the iconic British serials Yes Minister and Yes Prime Minister, may recall the wily Humphrey Appleby advising the hapless Jim Hacker that major government announcements are usually accompanied by gentle Elgar melodies and conservative dress, while minor changes are boosted by bold Stravinsky tunes and perhaps a flamboyant necktie! Here in India an innocuous-looking amendment by the Reserve Bank of India (RBI) in June, with neither Elgar nor Stravinsky accompaniments, is already turning into an opportunity to allow defaulters to get substantial chunks of their loans written off, while retaining their companies.
Why do non-performing assets (NPAs) arise? Bear in mind that in extending a loan, especially a term loan, a lender is, in effect, making reasoned multi-year projections or forecasts of multiple variables. It assumes that the track record of the enterprise will be maintained, that industrial peace will prevail, that raw material prices will move as per past trends, that the output prices will continue to recoup all costs plus a reasonable profit, that government policies as regards tariffs or quotas on imports and exports will not change drastically, that weather conditions will hover around the mean and so on. Forecasting multiple variables over a year is itself a challenge.
Forecasting multiple variables over several years multiplies the difficulties. If many of these assumptions prove to be somewhat untenable, or even if a few prove massively wrong, the entire business model of the enterprise could fail. For example, the recent ban on the export of non-basmati rice and a floor price for the export of basmati rice have certainly impacted the economics of rice firms. NPAs, oftentimes, arise from such unforeseeable changes in assumptions and variables.
NPAs also arise from deliberate malpractices by promoters in inflating the cost of capital equipment, round tripping of capital infusions, preferential related-party transactions, diversion of funds, falsification of accounts, etc. In some cases (e.g., the infamous Nirav Modi case), such malpractices are aided and abetted by collusion or active wrongdoing on the part of the lender’s staff, the statutory auditors of the borrower, etc.
The above-mentioned distinction matters, since it influences the recovery steps to be taken by the lender. A lender is not only entitled to recover dues, it is in fact duty-bound to do so. In cases where the lender is of the opinion that the NPA was caused primarily by factors beyond the control of the borrower, the lender would try to work with the borrower to devise a restructuring plan that may involve conversion of some part of the debt to equity, waiver of some charges, elongation of maturity, etc, all within the RBI framework, in an attempt to revive the company. However, if the lender suspects malafide activities by the borrower, evidenced by a forensic audit or other relevant tools, the lender would prefer to forthwith take the case under the Insolvency and Bankruptcy Code (IBC) and try to get a fresh promoter to replace the defalcating one.
In this context, what is a one-time settlement or OTS? An OTS is basically a compromise settlement between the lender and borrower, whereby the borrower agrees to pay a certain lump sum (usually in one go but occasionally in defined instalments) that will result in closure of the loan account with no further liability to the borrower. The lender in such cases agrees to sacrifice some of its dues (usually penal interest, interest and other charges, but sometimes a portion of the principal as well). This is, of course, very much in the interest of the borrower whose liability is materially reduced. Why would a lender agree to such a compromise? The lender may be of the view, based on robust evaluation and documents, that the future prospects of the borrower are not encouraging, that the value of the security has deteriorated below the loan value, that the time and cost of the legal recovery process may far outweigh the prospects of recovery.
Such decisions are not taken lightly; lenders have implemented structured systems of committees that examine such cases and recommend courses of actions to empowered higher authorities. Since an OTS would almost always involve the lender absorbing some amount of loss by debit to the profit and loss (P&L) account, there are multiple levels of authority in the lender for such write-offs, with all write-offs above a certain level going right up to the board of directors.
Importantly, a lender would be amenable to an OTS for a loan that has gone NPA for reasons mostly or entirely beyond the control of the borrower, viz., change in market conditions, policy, etc. However, where a loan has gone NPA due to malpractices by the borrower, with or without collusion from auditors or bank staff, it would resist any concession by way of an OTS and for good reason.
Loans extended by a lender to a borrower are governed by legal agreements and contractual documentation. They rank above equity or quasi-equity as far as the borrowers’ obligations are concerned. By its very nature, the information asymmetry favours the borrower; he is the first to see signs of future trouble, much before the lender can. A borrower, who then works with the lender to resolve the situation, is valued and will be assisted. A borrower who deliberately and illegally shirks his obligations, diverts funds, and siphons out money is fundamentally untrustworthy and does not merit any concession.
RBI, as the banking regulator, was, until recently, in full agreement with the above. Vide its circular RBI/2018-19/203, DBR No.BP.BC 45/21.04.048/2018-19 dated 7 June 2019, RBI had made it very clear that (para 34, annex 1) “Borrowers who have committed frauds/ malfeasance/ wilful default will remain ineligible for restructuring. However, in cases where the existing promoters are replaced by new promoters, and the borrower company is totally delinked from such erstwhile promoters/ management, lenders may take a view on restructuring such accounts based on their viability, without prejudice to the continuance of criminal action against the erstwhile promoters/ management.” The logic of this prohibition is faultless. A borrower who has abused the system and engaged in cheating and fraud, cannot possibly be allowed to benefit from his own chicanery. Only in cases where there is a clear change in ownership and/ or management, can this be considered.
In June of this year, RBI issued an apparently innocuous amendment that almost dipped under the radar. Vide its circular RBI/2023-24/40 DOR.STR.REC.20/21.04.048/2023-24 dated 8 June 2023, RBI now said (para 6(ii)), “Proposals for compromise settlements in respect of debtors classified as fraud or wilful defaulter, as permitted in terms of clause 13 of this annex, shall require approval of the Board in all cases.” It hastened, of course, to add (para 13 (annex)) that “Regulated Entities may undertake compromise settlements or technical write-offs in respect of accounts categorised as wilful defaulters or fraud without prejudice to the criminal proceedings underway against such debtors.”
This is a very dramatic and damaging change. And, as always, RBI, from its lofty ivory tower, does not care to explain the reasoning or logic behind the change.
In effect now, as long as the board of directors of the lender were willing to sign off on such a proposal, even a borrower clearly classified as fraud or wilful defaulter, could get the benefit of an OTS and thus profit from their own misdeeds. This is a clear case of moral hazard. Certainly, from the purely logical and economic point of view, a lender will seek to maximise its recovery and minimise its write-offs. It is certainly possible, even likely, that the defalcating borrower, who knows best the condition of the operations and security, would offer the highest OTS amount to the lender; thus, the lender will achieve the economically optimal solution. But what about moral hazard? What then is to prevent a defalcating borrower, who invariably has access to the highest skilled and paid legal and accounting talent, and our snail-paced judicial system, from engaging in fraudulent activities, siphoning off his entire investment, and then buying back into the enterprise for a song? What price ethics and integrity then? The saying goes, When ignorance is bliss, 'tis folly to be wise. We may now change that to When fraud and crime are rewarded, tis folly to be honest.'
Is this what we want?
As a tailpiece, though not directly related, consider the recent news of Yes Bank, JC Flowers and companies of the Subhash Chandra group (Zee Learning, Dish TV, etc). As may be recalled, Yes Bank had been seeking for some time to sell off a portfolio of NPAs of Rs48,000 crore face value to an asset reconstruction company (ARC). Following a well-structured process, in late 2022, JC Flowers ARC emerged as the highest and winning bidder for the NPA portfolio, bidding Rs11,183 crore in a Swiss Challenge auction, after a consortium of Cerberus Capital and Asset Reconstruction Company of India (ARCIL) withdrew its bid. No aspersions are cast here upon Yes Bank which appears to have followed a well-structured process.
In end-August 2023, news emerged that against an outstanding debt of Rs6,500 crore, Subhash Chandra will pay to JC Flowers a sum of Rs1,500 crore and thereby regain control of the family’s stake in assets like Dish TV, and Zee Learning, plus three properties including a bungalow in Dehi. Again, no aspersions are cast here on JC Flowers; doubtless, the value they ascribed to this portion of the Yes Bank NPA portfolio they purchased was less than the price they would now receive. It is, after all, their business model to profit by purchasing distressed assets and realising a higher value from them.
The upshot, however, is that instead of paying Rs6,500 crore to procure the release of the security-charged assets, Subhash Chandra will now pay just over 20% and get back the assets! One does not know if the difference in values will be treated as income and taxed by the revenue. This article does not seek to go into the rights and wrongs of the Subhash Chandra group; that would require a much longer analysis and Moneylife has done so earlier. However, it serves to point out the moral hazard involved whereby a defaulting promoter can game the system and profit while escaping liability. RBI’s June circular seems to legitimise this. In fact, Yes Bank could arguably have maximised its recovery by doing an OTS direct with Subhash Chandra, without the intermediation of JC Flowers!
What message are we sending to honest and sincere borrowers all over – corporate or individual?
(Artha Shastry is a banker who wishes to remain anonymous)
