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Thursday, October 07, 2010

Transactions between banks in bad assets: An interesting legal drama

by Pratik Datta and Shubho Roy.

The much awaited decision of the Supreme Court in the matter of ICICI v. Official Liquidator of A.P.S. Star Industries is now available. The case had come as an appeal against a decision of the Gujarat High Court which invalidated transfer of Non-Performing Assets between banks. The decisions of the High Court and the Supreme Court are important in illuminating the legal foundations of Indian finance.


Various borrowers owed a total of Rs. 52.45 crores to ICICI (Amongst which one of the borrowers was M/s A.P.S. Industries). These loans were classified as Non-Performing Assets (NPAs) by ICICI. ICICI transferred these NPAs to Kotak Mahindra on "as is where is" basis by way of a Deed of Assignment. Consequently, the Kotak Mahindra became the full and absolute owner of the debts and as such the entity legally entitled to receive the repayments of debts.

M/s A.P.S. Star Industries subsequently went into liquidation. Kotak Mahindra filed a Company Application in the winding up proceedings of A.P.S. Star, praying for being substituted in the place of ICICI (As it was now the owner of the debt). Though the transfer document between ICICI and Kotak was held to be valid the company court held that such transfers of NPAs was not allowed under the Banking Regulation Act of 1949 (BR Act).

The High Court ruling

On appeal a Division Bench of the Gujarat High Court upheld the observation of the Company Court on the following main grounds:
  • Section 6 of BR Act gives and exhaustive list of activities a bank is allowed to carry out and sale of NPAs is not present in the list.
  • Since banks prohibited from trading activities (See section 8 of the BR Act) and the sale of NPAs is essentially trading, such transfer was invalid.
  • Such trading of NPAs would mean transfer of NPA from one banks balance sheet to another without any resolution and therefore against the health of the banking industry.
  • Since individual loans were lumped together and bought there was no way to ascertain the value of individual loans and the amount recovered from them. This made such loans essentially speculative trading.
  • Since the customer is forced to transact with another bank now and also he is being lumped with other loans, this amounts to violation of the relationship between the bank and the customer.
  • By legislating s.5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), the Parliament has made it clear that only securitisation companies can buy NPAs and not banks.

The Supreme Court ruling

To much relief of the banks, the Apex Court has set aside the impugned judgment and order, laying down the following important legal propositions:
  • Section 6(1) of the BR Act is a general provision and enumerates topics as fields in which banks can carry on their business. This is the core banking business. However, RBI, being the regulator, under Section 21 and 35A can issue directions having statutory force, laying down parameters enabling banks to expand their business. Such parameters will define `banking business'. (¶ 13)
  • RBI, by issuing guidelines authorized banks to deal in NPAs and such guidelines cannot be held ultra vires of the Act. Such guidelines have statutory force and hence inter se transfer of NPAs between banks is permissible. (¶ 14)
  • The 2005 guidelines of RBI are not to eliminate NPAs but to restructure the same. Such restructuring cannot be treated as trading. (¶ 15)
  • The SARFAESI Act was enacted enabling specified SPVs to buy the NPAs from the banks. However, from that it does not follow that banks cannot transfer their own assets. (¶ 21)

Deeper issues

While the judgment seems to set law in the correct direction, it raises other questions. The borrowers had argued that the only legal way of transferring financial assets is under Section 5 of the SARFAESI Act which reads:

``Notwithstanding anything contained in any agreement or any other law for the time being in force, any securitisation company or reconstruction company may acquire financial assets of any bank/FI..''

However, Chief Justice Kapadia, while writing the judgment observed in ¶ 21 that `the SARFESI Act 2002 was enacted enabling specified SPVs to buy the NPAs from the banks'. As discussed, this statement seems to be missing out that even good debts which are not NPAs can be bought by those SPVs under s. 5 of the SARFESI Act. May be this is an inadvertent omission, but it is interesting to observe that Justice Kapadia previously also in Transcore v. Union of India (2008) 1 SCC 125 observed (in ¶ 20) that `it is only when these assets in the hands of the bank/FI becomes sub-standard, doubtful or loss then the account or asset becomes classifiable as a NPA and it is only then that the NPA Act comes into operation'. The same is reiterated in ¶ 30. Clearly, these observations do not quite fit with the literal interpretation of s. 5. Probably the pedantic have got another question lingering in their minds: `Can a bank/financial institution sell off a debt, which is not a NPA, to a securitisation/assets reconstruction company?'

One also asks what remains of Section 6 of the BR Act which describes what activities banks can take part in. Justice Kapadia states `In other words, the 1949 Act allows banking companies to undertake activities and businesses as long as they do not attract prohibitions and restrictions like those contained in Sections 8 and 9'. This would mean that while the legislature drafted Section 6, this is irrelevant today. He also goes on to state `Thus, RBI is empowered to enact a policy which would enable banking companies to engage in activities in addition to core banking process it defines as to what constitutes ``banking business''.'

This implies that there is unfettered power with RBI to define what business banks can take part in. This is unusual as it seems that there are no parliamentary control over what banking business can imply. Unlike `securities' which is defined under the Securities Contract Regulation Act by Parliament and only the central government may modify it by notification, (and therefore no regulator is free to define any instrument as a security and regulate it) `banking' seems to be under a Henry VII clause for RBI. There seems to be no provision under the BR Act allowing the central government (let alone the RBI) to change the definition of `banking'. The judgment however empowers RBI to do so without and rider or guidelines. This also goes against the principles of interpreting laws as it makes all provisions in Section 6(a) to (o) irrelevant.


The judgment reveals the state of financial laws in the country which are unable to guide the judiciary unambiguously. The judicial interpretations also seem to alter the nature of the laws and the drift between the letter of the law and its meaning continues to increase.


  1. I agree with the conclusion....the big daddy of Indian banking know how to control a teenage banking sector and doesn't have idea what is the need of a mature adult...and law maker doesn't even understand both.

  2. Whoa! I didn't know this could be done in India. Now I'm not even sure how I can spot this while reading banks' financial statements.

    I agree financial laws in India leaves a lot to be desired, especially if we are to attract foreign capital and investments.

  3. well i am a student.
    So if anybody could please help me to understand that why wwould somebody buy NPA's. I mean whats the profit in doing so, as done in this case where kotak has purchased NPA's from icici..


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