Laws for sick industrial companies still need to be harmonized

Laws for sick industrial companies still need to be harmonized

Non-performing assets (NPAs) have been a perennial problem for banks and financial institutions (FIs). It is to counter the extent and negative impact of NPAs on FIs that Parliament enacted the Recovery of Debts due to Banks and Financial Institutions Act, 1993 (RDBFI Act), followed by the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (Sarfaesi Act), to establish a separate mechanism for debt recovery to enable FIs to recover their NPAs and enforce security without the intervention of the courts.

Under the provisions of the Sarfaesi Act, a secured creditor has the right to enforce security interests if the loan is classified as an NPA in accordance with guidelines issued by the Reserve Bank of India. In the case of financing by more than one secured lender, the rights under Sarfaesi can be exercised only after it is agreed upon by secured creditors representing not less than three-fourths in value of the amount outstanding, and such action is binding on all secured creditors.

A precondition to initiating action under the Sarfaesi Act is that an NPA must be backed by securities charged to FIs by way of hypothecation, mortgage or assignment— whether by the borrower or a third party.

Under the provisions of the Sarfaesi Act, if a borrower fails to discharge its dues in full within a notice period of 60 days, then the FI may take recourse by taking possession of the security, and selling, leasing or assigning the right over the security and/or managing the same or appointing any person to manage the same.

The Sarfaesi Act, while welcomed by FIs, was challenged by defaulting borrowers. With the Supreme Court upholding the Constitutional validity of the Sarfaesi Act in the Mardia Chemicals case, the next legal challenge for FIs was whether they could simultaneously proceed against a borrower under the RDBFI and Sarfaesi Acts. The Supreme Court, in the Transcore judgement, held that FIs are not required to elect one of the two remedies, but could simultaneously proceed under both RDBFI and Sarfaesi.

However, an area of conflict that persists is the interplay between the Sick Industrial Companies (Special Provisions) Act, 1985 (Sica), and the Sarfaesi Act. Though the Sick Industrial Companies (Special Provisions) Repeal Act, 2003, repealing Sica, has been passed by Parliament, it is yet to be notified and Sica continues to be the applicable law in relation to industrial sickness.

Section 22 of Sica provides that legal proceedings against an industrial company—that is, a company that owns a factory wherein it carries on any of the industries specified in the schedule to the Industries (Development and Regulation) Act, 1951—shall remain suspended if an inquiry to determine whether the industrial company is sick is pending before the Board for Industrial and Financial Reconstruction (BIFR), if a scheme for its rehabilitation is being prepared or is under consideration of BIFR, or if an appeal against BIFR’s order is pending.

Parliament, through the Sarfaesi Act, has amended Sica and has inserted a provision whereby a “reference pending" before BIFR shall abate if secured creditors representing three-fourths in value of the amount outstanding against the financial assistance disbursed to the borrower have taken measures to recover their secured debt under section 13(4) of the Sarfaesi Act (as per the process described above).

On a plain reading, it seems the amendment to Sica ensured that there remains no conflict between Sica and the Sarfaesi Act. However, the words “reference is pending", as used in the amendment to Sica, are being utilized by defaulting corporate borrowers to avoid enforcement of security by FIs. The borrowers argue that for FIs to be able to initiate action under the Sarfaesi Act, it is necessary that the reference filed by such borrowers should be pending before BIFR and that such reference does not remain pending once the borrower has been declared a sick industrial company by BIFR.

In its recent judgement in Noble Aqua Pvt. Ltd v State Bank of India, AIR 2008 Ori. 103, the Orissa high court upheld the borrower’s argument and opined that once an industrial company has been determined to be a sick industrial company by BIFR, the reference made under section 15 of Sica shall not remain pending and, hence, the respondent bank would not be able to enforce its security interest.

In this context, it is relevant to examine the purposes for which a “reference" is made to BIFR. Under the provisions of section 15 of Sica, the board of directors of an industrial company, which has become a sick industrial company (as per the criteria laid down in Sica), is required to make a reference to BIFR for determination of measures which shall be adopted regarding the company, including the implementation of rehabilitation schemes. Thus, the reference under section 15 of Sica is for determining measures regarding the company and not for determining whether the company is a sick industrial company since a reference under section 15 of Sica presupposes industrial sickness.

The Calcutta and Madras high courts, in Imperial Tubes (P) Ltd v BIFR and Golden Weaving Mills Pvt. Ltd v Tamil Nadu Industrial Investment Corporation Ltd, respectively, have held that a reference under section 15 of Sica will continue to remain pending even though a company has been declared to be a sick industrial company by BIFR, and FIs can initiate measures under the Sarfaesi Act. The Imperial Tubes and Golden Weaving judgements give rise to another question: Can FIs initiate measures under the Sarfaesi Act even when a scheme for rehabilitation is under way?

While such measures under the Sarfaesi Act, if permitted, may enable FIs to recover public money, it could have disastrous consequences for companies currently being rehabilitated under such schemes, especially if the secured creditors of such companies have differing opinions. If such measures are allowed under the Sarfaesi Act, the very spirit of Sica—the revival and rehabilitation of sick industrial companies—may be defeated.

With an appeal against the Orissa high court’s judgement in the Noble Aqua case currently pending before the Supreme Court, it is hoped that the provisions of the two statutes would be given harmonious construction in such a manner that the objectives of both legislations are achieved and the interests of sick industrial firms as well as FIs are protected.

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This column is contributed by Kartikeya Singh of AZB & Partners, Advocates & Solicitors.