Wilful Defaulter Framework in India, Challenges and Legal Implications

Context

The Bombay High Court recently invalidated a section of a central government memorandum, which allowed public sector banks to seek the issuance of lookout circulars (LoCs) for wilful defaulters.

• The court ruled in the case of Viraj Chetan Shah v Union of India, stating that this provision violated fundamental rights to life (Article 21) and equality (Article 14). 

About Wilful Defaulter

Definition: A wilful default occurs when a borrower deliberately fails to repay a loan despite possessing the means to do so.

• Large defaulter: it is a borrower with the balance of Rs. 1 crore or more. Whose account has been marked as doubtful or a loss. 
• Misuse of Funds: Another scenario of wilful default arises when the borrower diverts the borrowed funds for purposes other than the intended use.
• Asset Disposal: Wilful default also includes all situations where the borrower sells or disposes of the asset pledged as collateral for the loan.
• Penalty Threshold: Any borrower classified as a wilful defaulter with an outstanding balance of Rs 25 lakh or more is subject to penal provisions.
• Threshold Application:  The Rs 25 lakh limit also applies when funds are misused.

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Prohibitions and Rules for Wilful Defaulters in India

The concept of a wilful defaulter in India carries significant weight, essentially blacklisting borrowers from financial opportunities. Here’s a breakdown of the key points:

• Designation Authority: Commercial lenders like banks and NBFCs have the power to designate borrowers as wilful defaulters.
• Consequences: This designation comes with severe consequences, prohibiting access to:
  • Additional credit facilities from the designating lender.
  • Any credit for new ventures.
  • Issuing equity shares (listed companies).
  • Launching an Initial Public Offering (IPO).
  • Submitting a resolution plan under the Insolvency and Bankruptcy Code.
• Evolution of Institutional Arrangements for Wilful Defaulters
  • The designation of wilful defaulters by commercial lenders has undergone significant institutional changes over time. 
    • Central Vigilance Commission Directive (1998): It initiated the first layer of institutional design in 1998.
      • It instructed the Reserve Bank of India (RBI) to gather information on wilful defaults exceeding Rs 25 lakh. 
    • Parliamentary Standing Committee Recommendations (2000): This committee has recommended blacklisting wilful defaulters from institutional finance and equity markets. 
      • However, it didn’t propose adequate procedural safeguards
    • Penal measures: The RBI circular in 2002 introduced penal measures, which were updated over time due to judicial intervention.
      • RBI kept on updating these through circulars, primarily on account of judicial intervention
    • The Insolvency and Bankruptcy Code (IBC) of 2016: it allowed  creditors to take over a defaulted company regardless of the default being wilful or not.
    • Procedural Safeguards: These safeguards were prioritized  in 2019 when the supreme court rulings emphasize the need for proper procedures before designating a wilful 
      • Natural Justice: Borrowers must be granted access to relevant investigation material before being labelled a wilful defaulter.
      • Right to Respond: This aligns with the concept of allowing inspection of documents in securities law enforcement proceedings.
        • The rights of wilful defaulters: In September 2023, the RBI provided an initial guideline proposing changes to the procedures aimed at better protecting the rights of wilful defaulters and those with significant defaults.

Reasons for Criticism with Lenders Classifying Wilful Defaulters

The current system of wilful defaulter designation in India faces criticism due to potential conflicts of interest:

• Lender as Judge: Banks and NBFCs, who are parties to the loan agreement, are responsible for classifying borrowers as wilful defaulters. This raises concerns about impartiality.
• Shifting Blame: A lender’s poor initial credit assessment could lead to a default. 
  • However, the system incentivizes the lender to classify the borrower as wilful, deflecting blame.
• No Impact on Lender: Wilful defaulter designation doesn’t affect the lender’s financial obligations, further raising questions about their objectivity.
  • This structure violates the principle of natural justice: “nemo judex in causa sua” (no one can be a judge of their own cause).

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