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Opinion - Non-Performing Assets


Securitisation Ordinance — How long will the party last?

Jayanthi Iyengar

THE last few months have been far too good for Indian lenders. Armed with the new Securitisation Ordinance, lenders have been going around, flexing their muscles, warning recalcitrant borrowers that they would not hesitate to take them to the cleaners if they failed to remit their dues.

The borrowers, too, have been bowing to the lender's fiat and have been coughing up the cash with greater alacrity than what has been exhibited thus far. Yet, things may not remain thus for long, if one goes by the global experience.

In the late 1980s and the early 1990s, American lenders suffered from similar afflictions and were inclined towards quick foreclosure of loans to resolve their NPA problems. The net result was a spate of lender liability litigations, which peaked at all-time high settlement of $70 million plus $18 million in post-judgment interest. The sum was paid in 1994 by the lender in the Anuhco Inc v. Westinghouse Credit Corporation case. Many such multi-million dollar litigations later, the lenders and borrowers have now come to their senses. The 1990s thus, has seen the lenders and the borrowers working together in the US to turn bad loans into paying ones.

Briefly, the "fair practices code", which is at the core of the lender liability, says that lenders must treat their borrowers fairly, and when they do not, they can be subject to litigation by the borrower for a variety of reasons. During the decade gone by, lender liability litigations in the US have broadly evolved into two broad categories — breach of contract and fraudulent claims. Simultaneously, the US case law has gone beyond exploring lender liability towards large borrowers. It now encompasses such new areas as lender liability in environmental clean-ups. Here, the US courts have actually extended protection to lenders from environmental damage claims. The courts have recently taken the view that unless the nominee director, representing the interest of the lender, was directly and wilfully involved in the decision-making that led to the environmental degradation, he will not be liable for damages.

India, it may be recalled recently extended similar protection to nominee directors from disqualification under the company law. Under the new disqualification of director norms, a director cannot be appointed to the board of another company for five years, if any of the companies on whose board he sits on has defaulted on deposit payments.

A decade-long evolution of the lender liability claims in the US has now made it a substantive segment of law. The US courts over the years have gone into innumerable areas of lender liability claims arising out of as diverse a cause as breach of contract, breach of commitment to fund or renew loans, oral commitments, bad faith, breach of fiduciary duty, fraud and misrepresentation, negligent loan processing and administration, interference with contractual affairs, interference with corporate governance, fraudulent and preferential transfers.

Further, lender liability claims have been examined and settled under such other laws as the Fair Labour Standards Act, Equal the Credit Opportunity Act, anti-trust laws, environmental laws, including the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), the Resource Conservation and Recovery Act, trustee and fiduciary liability, state super-lien laws, securities laws, Bank Secrecy Act and director and officer liability to state and federal regulators.

Though India is looking at lender liability only in the context of large borrowers, particularly from banks and financial institutions, it is only a matter of time before a widow or a retiree extends the scope of the "fair practices code" by slapping a lender liability claim on a housing company or a credit card firm for misrepresentation, disinformation and misguidance — all of which are a common enough occurrence. The mindset to litigate every issue is nowhere as pronounced in India as in the US, but it is clear from a perusal of RBI's draft "fair practices code" that the apex bank, on its part is trying to weave in the international experience.

Thus, the single important thing the RBI draft code does is that it tries to standardise loan agreements by trying to put everything into the written word. The underlying assumption here is that since loan agreements are contracts like any other, standardisation reduces scope for litigations.

Besides the US code draws heavily upon what is known as the "parole evidence rule". This rule prevents admission of evidence in court of certain oral agreements that would contradict a later signed agreement. The rationale behind this rule is that written evidence is more accurate than human memory, and hence it removes scope for claims of fraud at a later date.

But, as is typical with the history of litigation in the US, despite the thought and good intent behind this rule, it still has opened doors to lender's misconduct. Here, borrowers have been able to successfully prove that lenders intentionally misguided them, failed to render their fiduciary duty, or failed to follow an arms length principle while advising them, despite the latter being backed by tight contracts and the "parole evidence rule", Besides, cases have also been filed and won for inappropriate collateral sales in US courts.

Of these, the US case laws of lender's misconduct and improper collateralised sales of assets are of particular interest to India. With liberalisation, banks and financial institutions have been venturing into the untested waters of fee based activities, including advisory services and distribution and promotion of a range of allied and unrelated products from mutual funds to insurance policies from their premises.

A pointer to what awaits lenders possibly lies in the famous US case law, Scott v. Dime Savings Bank, which dates back to the late 1980s. Scott approached his bank for a $5000 loan on his and his mother's behalf. Scott's banker prevailed upon him to borrow $1,00,000 and invest it in "Invest", an investment firm affiliated to the bank and operating out of its premises.

Scott mortgaged his mother Evelyn's house and raised $1,00,000. Of this, he invested $52,000 in "Invest". As luck would have it, the sum was wiped out in the stock market crash of 1987. Evelyn Scott defaulted on her mortgage. The Scotts sued the bank and "Invest" for breach of fiduciary duty and negligence. The loan was foreclosed, but Scott's lender liability claim went to jury trial. The bank took the plea that a debtor-creditor alone did not create a fiduciary responsibility on them. Hence, it was liable for not taking safeguarding the interest of the borrower. The jury however took the view that it did.

The trial court subsequently upheld the jury verdict. It took the view that the manner in which employees of the bank and investment company advised and oversaw Scott's investments, went beyond debtor-creditor relationship and created fiduciary responsibility. Evelyn Scott earned $36,000 in monetary damages. Besides, the bank was forced to establish life tenancy in her favour, so that she could stay in her house for her lifetime, in spite of the fact that the loan had been foreclosed. In subsequent court cases, lenders were able to limit liability arising out of the fiduciary nature (that is, the lender owes special duties to the borrower and must look out for that other person's interests with special care) of debtor-creditor relationship, but that was millions of dollars worth of lawsuits later. In India, where unsolicited, uninformed and at times fraudulent advice is available aplenty, the scope for such lender liability litigations is immense.

Besides, another pitfall awaits lenders on account of the weakness in the securitisation law, which the Government or the RBI is yet to address. This stems from the failure to specify that lenders must set a minimum reserve price before trying to dispose off the assets recovered. The Ordinance also fails to specify the mode of valuation of the asset recovered, though it does specify the procedures for sale such as giving due notice and placing an advertisement in the newspaper to widely publicise the sale.

One need not go far to under the importance of specifying the mode of valuation. India's disinvestment programme has seen several charges being levelled on this account. But if one were to draw parallels from the US, lenders have run into trouble by inappropriately selling the mortgaged assets after a loan default. The US Uniform Commercial Code requires that the method, manner, time, place and terms of the sale be "commercially reasonable". This concept has been worked into the law to protect borrowers as well as guarantors.

The US courts have upheld lender liability claim when sales of the recovered assets have been found to be "commercially unreasonable". Such unreasonable sales can occur where the lenders relied on an appraisal they knew, or should have known, was too low. A sale can also be considered commercially unreasonable if insufficient publicity for the sale resulted in attracting few bidders for the assets shortlisted for disposal. Similarly wrongful repossession or disposal of the recovered assets has also resulted in lenders not only losing their claims, but also leaving themselves open to damages.

(The author is Consulting Editor, Business Content, Jain Television.)

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