by Shubho Roy and Ajay Shah
Many countries (e.g. New Zealand, Poland, Germany, Norway) have discontinued paper cheques. In other countries (e.g. the U.K., the U.S.), the use of cheques is declining. But in India, the use of paper cheques in India has stabilised in terms of value and number over the last five years. This is despite the extent to which digital and instantaneous payments are now feasible. Why might this be the case?
Prior to 1988, cheques were primarily used as a tool of payment. In that age, there were delays in clearing. Paper cheques had to be transported to the bank branch where the cheque issuer had an account. In that branch, the issuer's signature would be verified against a sample. If the signatures matched, the balance would be cleared (assuming the issuer had adequate funds). This process took seven working days, even when the issuer and recipient had banks in the same city. If the parties were in different cities, the process would take 15 working days, on average.
Today, a cheque issuer can send a secure document showing that the issuer's bank account has adequate funds to honour the cheque. However, in 1988, there was no such system, and the cheque recipient faced the risk that the issuer was writing a cheque that her account could not honour.
Some technical mistakes can always happen, where a person fails to anticipate the date on which funds are required and there are unpredictable delays in the money moving in and out of the account. Alongside this, many unscrupulous people knowingly wrote bad cheques. This made sellers mistrust cheques and prefer cash. While cash as a payment mechanism has the virtues of instantaneity and privacy, it comes with difficulties on physical security.
The 1988 change of the law
In this setting, the Parliament criminalised the bouncing of cheques in 1988. Now, the cheque writer could be sent to jail if the cheque did not clear. The law also stated that every cheque is presumed to be written to clear a debt. This change helped the recipient of cheques because the recipients did not have to prove any underlying transaction. The recipient only had to demonstrate that the cheque was not honoured.
In 2016, the Supreme Court ratified the practice of using cheques as collateral in the case of Sampelly Satyanarayana Rao v Indian Renewable Energy Development Agency Limited. Sampelly Satyanarana Rao (Mr. Rao) had written post-dated cheques as security for a loan from the Indian Renewable Energy Development Agency (IREDA). Mr. Rao did not take the loan personally but wrote the cheques as a director in the company that borrowed the money. The borrower company failed to pay the instalments when they became due. In response, IREDA (the creditor) initiated criminal proceedings against Mr. Rao under the 1988 law. Mr. Rao defended the claim by stating that the cheques were written before the creditor (IRDEA) disbursed the loan amount. IREDA pointed out that the cheques were deposited after the borrower (the company) had failed to pay the instalments, and therefore, the penal provisions of the 1988 Act applied. The Supreme Court agreed with the creditor and allowed for the criminal prosecution of Mr. Rao. This judgement provides legal certainty to the use of post-dated cheques as security. This date, i.e. 2016, is an important milestone in the journey, over and beyond the amendment of the N. I. Act in 1988.
The role of cheques in India today
The threat of imprisonment restored some faith in cheques. Anecdotally, it seems to have worked well in the initial years after the amendment. Cheques became more acceptable in commercial transactions and helped reduce frictions in economic activity. Many a cheque recipient was willing to take the risk of delivering goods without waiting one or two weeks for a cheque to clear.
These considerations do not exist in the present landscape. Instantaneous payment systems are ubiquitous in India, ranging from small value payments to the largest amounts possible. Any problem of trust between buyers and sellers can be readily solved by resorting to NEFT or RTGS. By this reasoning, the number of cheques written in India should have declined sharply. It has not.
People responded to incentives
Alongide this, the rest of the Indian legal system which enforces contracts works poorly. Ordinarily, a loan dispute would be resolved as a contract dispute through civil law, and, in some cases, bankruptcy law may be involved in situations where the debtor is insolvent. In 2020, in enforcing contracts, India ranked 163 out of 190 countries, while its overall rank was 63 (a difference of 100 ranks). India's rank in resolving insolvency was 52. Hence, creditors are unconfident about ordinary credit enforcement mechanisms.
One strand of credit enforcement systems is seizing assets that are pledged as collateral. This tends to work poorly in India. While the SARFAESI Act of 2002 is reasonably effective in getting collateral into the hands of the lender, many assets are hard to sell. Many land titles have encumbrances, and the land market works poorly, which hinders the recovery rate.
These weaknesses of the ordinary (civil) credit enforcement systems made criminal proceedings under S.138 attractive to creditors. Under S.138, a debtor faces up to two years of imprisonment if the debtor is convicted. In reality, the creditor does not even have to wait for the end of the litigation to get the debtor imprisoned. The debtor can be arrested at the beginning of the litigation so that the debtor can be produced before the court. In some cases, the debtor can also be imprisoned for the duration of trial under S.138. In contrast, a civil case proceeds without the debtor, if the debtor chooses not to appear. Most people will pay up to avoid being imprisoned, which gives heart to creditors.
When faced with legal difficulties around land title, it is better for the creditor to threaten imprisonment, and have the borrower solve the problem of selling the land, instead of seizing collateral and then facing legal difficulties in liquidating them.
As a consequence, after the new law was established in 1988, creditors started using cheques as a security. Creditors frequently demand that the debtor provide post-dated cheques for loan amounts. These cheques are payable deep into the future -- sometimes extending to multiple years. In such cases, both parties are aware that the cheque drawer does not have the money in the bank account at the point in time when the cheque was signed. Creditors sometimes demand a separate cheque for each instalment of loan repayment. Consequently, a debtor for a five-year loan may write 60 post-dated cheques. On a similar note, landlords sometimes asked for post-dated cheques for the payment of rent at multiple time points in the future.
Modern economies do not have a debtors prison: the choice of filing for bankruptcy is always there, in which case the creditor gets a low recovery rate. On one hand, in India, there is no legal framework for personal bankruptcy. When threatened with jail time, the borrower may reach into her web of relationships, and borrow from the community. This increases the resources available to the lender.
Weighing the pros and cons
The introduction of S.138 has thus exerted many complex impacts upon the working of the economy.
- An increased level of violence in society
- More people go jail, and more threats of incarceration are bandied about. This is a less civilised society.
- Increased interest in lending
- When lenders are given greater certainty about recoveries, they are likely to be more willing to lend to persons that might otherwise be excluded from the credit market.
- Diminished interest in borrowing
- When borrowers are shown the possibility of jail time, they will be more cautious and avoid borrowing. That has its own welfare consequences.
- Conditions for state failure
- The prospect of jail time is a `high stakes' situation where the policing system gets to make decisions which have a high impact upon the life of a citizen. This increases the incentives for corruption.
- Hindering the emergence of a modern economy
- All advanced economies have moved away from debtor's prison, and evolved civil mechanisms around borrowing, collateral and bankruptcy. These pathways reduce the extent of violence in society and increases user confidence in borrowing.
- The threat versus the cash
- Jail time is indeed a potent threat and creates strong incentives for the borrower to obtain cash, either by borrowing from someone else or by liquidating opaque assets. But once a person goes to jail, all future payments to the lender are stopped. With more civil processes of collatoral and bankruptcy, there is the strategy of keeping the delinquent active in economic life, and obtaining a stream of cashflows to the lender.
- Incentives for policy makers
- Lenders that got comfortable with the use of S.138 were less inclined to persuade policy makers of the need for the institutional apparatus of the credit market.
Conclusion
The introduction of S.138 into the N.I. Act in 1988 was a response to a problem of the time. Some other countries, like Taiwan, had also criminalised cheque bouncing. However, most countries have walked back since then because credit systems have improved and the use of cheques have declined. In those countries, cheques are not used as collateral for loans.
There is a strong argument for repealing this section. The consequences of such a repeal will, however, also be far reaching, particularly in the context where the institutional apparatus for contract enforcement remain weak. It is interesting to look at the list, presented above, of the consequences of criminalising cheque bouncing. We can then ask: Which of these would flip around and arise, in reverse, when cheque bouncing is de-criminalised.
Shubho Roy and Ajay Shah are researchers at XKDR Forum.