Mumbai: The legal battle between Indian microlenders and the Andhra Pradesh government on regulating microfinance institutions (MFIs) is approaching a critical juncture, with the Gujarat high court saying non-banking finance companies (NBFCs) will not fall under the purview of a state moneylending law.

Legal experts said this will have a “persuasive value" on the Andhra Pradesh high court, which is deciding the fate of a similar case challenging the controversial Andhra Pradesh Microfinance Institutions (Regulation of Moneylending) Act, 2010, a law that pushed the sector into a major crisis in late 2010.

“The Gujarat high court order can have a persuasive value on the case, though it is not binding on the Andhra Pradesh high court," said Bomi Daruwala, a partner at legal firm Vaish Associates Advocates. “The central Reserve Bank of India Act will prevail over the state law on regulation of NBFCs, as ruled by the Gujarat high court."

The Gujarat high court earlier this month ruled that Gujarat Money Lenders Act (GMLA), 2011, was not applicable to NBFCs operating in the state and registered under the section III(B) of the Reserve Bank of India Act. The two-year-old case in the Andhra high court—filed separately by SKS Microfinance Ltd, Spandana Sphoorty Finance Ltd and industry lobby Microfinance Institutions Network (Mfin) challenging the state law—is likely to be heard by the Andhra high court in the next few weeks.

In their petition, MFIs have argued that since NBFCs are regulated by the Reserve Bank of India (RBI) under a central law, the state law doesn’t apply to them. The state government has been maintaining that even those MFIs that are incorporated as NBFCs will fall under the state moneylending law, hence under the control of state government.

In May, the Supreme Court had ruled that a central law will prevail over a state law on the same subject, while annulling the Kerala Chit Funds Act of 1975. The top court had said only the Central Chit Funds Act, 1982, will be applicable to all chit fund firms operating in the country.

This too may influence the Andhra high court, experts said. “When a central act is already in place on a subject, it will prevail over any state act," Daruwala said.

In July, RBI had submitted an affidavit in the Andhra Pradesh high court, saying the state law has no jurisdiction on MFIs which are NBFCs registered with it.

In the aftermath of the crisis, the RBI had framed regulations to regulate NBFCs engaged in microlending based on the recommendations of Y. H. Malegam panel. The RBI created a separate category of such NBFCs and asked them to register with it. Such NBFCs have to maintain a margin cap of 10% if they have a loan portfolio above 100 crore.

The high court’s ruling is critical for the sector as loans worth about 6,500 crore by MFIs are stuck in the state as an existing state law has put severe restrictions on MFIs disrupting their operations in the southern state, which was their biggest market till the crisis. MFIs give small loans to low-income borrowers at 24-36% interest rates.

The new law made MFIs take government approval to give every second loan. They are also barred them from doing doorstep business, which is the basic business model of MFIs.

This, coupled with a state-wide campaign by a political party asking borrowers not to repay MFI loans, were followed by a wave of defaults in Andhra Pradesh. Banks, too, significantly reduced funding to MFIs.

Any chance of survival for the industry exists only if the microlenders are freed from the restrictions put by the state law, industry officials said.

“It is very clear that Andhra Pradesh Act is unconstitutional as NBFCs are regulated by RBI. There cannot be dual regulation. Borrowers are in dire need of microfinance loans. MFIs will be able to serve them only if we are freed from the influence of the Act," Kishore Kumar Puli, managing director and chief executive officer of Trident Microfin Pvt. Ltd and head of the Andhra Pradesh chapter of Mfin.

Dilli Raj, chief financial officer of SKS, said his firm has filed an interlocutory petition in the Andhra court to expedite the hearing of the case.

SKS might also consider moving the Supreme Court after Andhra Pradesh failed to meet an apex court direction to dispose the case “as early as possible but preferably by 31 January, 2012," Dilli Raj said.

“We have filed an interlocutory petition last week itself in the Andhra Pradesh court requesting to speed up the proceedings. The company might also consider approaching the apex court in this regard. The Gujarat high court order and similar judgements in other courts have established that state law cannot dominate over central Acts," Dilli Raj said.

According to Dilli Raj, a favourable court ruling will have immediate positive impact on the microfinance sector in the state. “Once this happens (state withdraws the law), we can go back to the field and begin fresh incremental lending."

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