Should Master Circular cover derivative transaction?

Introduction

Derivative is a financial contract that derives its value from a specific market reference, such as a common stock, index, interest rate, commodity, or currency. Derivatives are one of the three main categories of financial instruments; the other two includes equities and debt. Derivative transactions include a variety of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof. Derivative contracts are entered either for risk management or for speculation and, therefore either of the contractual parties can be obligated to make payment to the other depending on the value of the underlying asset. The most crucial legal question that arises in such derivative transactions is whether the relationship of the parties can be construed as that of a lender and borrower and, consequently whether the Master Circular issued by RBI dated July 1, 2008 on “wilful default” (“Master Circular”) becomes applicable. In the recent past, Supreme Court was confronted with the said question of law in a three separate appeals namely, (i) Kotak Mahindra Bank vs. Hindustan National Glass and Ind Ltd and Ors (“Calcutta case”), (ii) Emcure Pharmaceuticals Ltd and Anr vs. ICICI Bank Ltd and Ors and (iii) Finolex Industries Ltd and Anr vs. Reserve Bank of India and Ors (“Bombay cases”), wherein the Supreme Court has interpreted to decide whether a wilful default in meeting payment obligation to a bank under derivative transaction will be covered under the Master Circular. The present bulletin discusses the highlights of the appeal.

1. Facts of the Cases

The facts of all the three cases, Calcutta case and Bombay cases are similar, wherein the companies have entered into foreign exchange derivative transaction with respective banks and, accordingly credit facility of huge amount has been sanctioned to the companies for hedging foreign currency fluctuation. In the course of the transactions, huge sums have become due and payable by companies to their respective banks. Despite repeated requests, companies failed to pay the due amounts. Meantime, RBI issued the Master Circular requesting the banks and financial institutions to provide information on wilful defaulters. Consequently, the banks issued notices to the respective companies to show cause why they should not be classified as “wilful defaulter” as per the Master Circular. The companies contended that the Master Circular will be applicable only to the transactions constituting lender-borrower relationship and, therefore no action can be taken against the companies under the Master Circular. The issue was placed before the Grievance Redressal Committee and it was held that the Master Circular will also cover derivative transactions. Aggrieved, the companies filed writ petitions before Calcutta High Court (“CHC”) and Bombay High Court (“BHC”). While CHC held that the Master Circular will not cover derivative transactions, BHC held that the Master Circular covers derivative transactions. Aggrieved parties of all the three cases filed Special Leave Petitions before the Supreme Court which were then heard and decided jointly.

1.1   Stand of the Companies

• Wilful default can arise only out of a lender – borrower relationship between the bank and its constituents and, therefore, unless the bank has given a loan or an advance to its constituent, the question of wilful default under the Master Circular does not arise.
• The fundamental difference between a loan/ advance and a derivative transaction is that in the case of a derivative transaction, either party could be required to effect payment depending on the change in value of the underlying asset, whereas in the case of a loan or advance, it is the borrower alone who has to effect the payment.
• The relationship that exists between the parties in a loan transaction is that of lender and borrower, but in a derivative transaction, the relationship existing between the parties is that of creditor and debtor.
• BHC erroneously recorded a finding that wilful default covers default in payment obligations under derivative transactions by relying on the circulars issued by RBI which do not relate to wilful defaults, but relate to prudential norms, assets classification as non –performing assets etc.. It is a settled principle of statutory interpretation that a definition of one Act should not be imported to another Act¹. The Master Circular should be construed on its own terms and language and if so construed, it does not contemplate or cover a creditor and debtor relationship.
• The functions of the banks are categorized under two broad heads namely a) core banking functions of accepting deposits and lending, and b) miscellaneous functions and services². The Master Circular will apply only to core banking functions constituting lender- borrower relationship. Derivatives are part of the miscellaneous functions and services and hence do not create a lender-borrower relationship.
• The Master Circular covers the dues under the borrower –lender relationship between the customer and the bank. Derivative transactions do not involve a borrower –lender relationship at all. So, it could not create a borrower-lender relationship subsequently on default of payment under the derivative transaction.
• Categorizing the companies as wilful defaulters as per the Master Circular will have severe consequences such as criminal liability and restrictions in obtaining further loans and/ or credit facilities, which in turn affects the rights of the company/person to carry on any trade, business or occupation. Hence, the Master Circular will have to be strictly and/or narrowly interpreted and should not be applicable to derivative transactions. The information relating to derivative transactions should be treated as confidential and should not be disclosed either to RBI or any other banks. There is an implied contract between customer and bank that the bank will not disclose any information pertaining to its customer to third parties.
  

1.2 Stand of the Banks

• As per clause (c) of section 2 of the Credit Information Companies (Regulation) Act, 2005, the term “client” includes a person who not only obtains or seeks financial assistance from credit institution, but also obtains assistance in any other form or manner so that the person who has defaulted payment in derivative transactions would also fall under the ambit of a wilful defaulter.
• Derivative transaction is a facility provided by banks to its customers for the management of risks arising from foreign exchange and interest rate fluctuations. It is a non- funded credit facility and, therefore the person who defaults payment in such transactions would also be covered under the Master Circular.
• RBI is an expert body regulating the economy of the country and, therefore courts should not interfere with the decisions of RBI without concrete reasons as it would impact the credit system of the financial institutions and that of the country³as a whole.
• As per section 45A(b) and 45A(c) of the RBI Act, banks and/ or financial institutions have authority to disclose information with respect to derivative transaction dues to RBI.

1.2   The stand of RBI in the three civil appeals

• Clause 2.1 of the Master Circular defines the term “wilful default” as „a default by a unit in meeting its payment/ repayment obligations to the lender‟, but the word lender has not been defined in the Master Circular.
• The intention of RBI while issuing the Master Circular was to cover all eventualities where payment/ repayment obligations exist and, therefore the Master Circular would cover all banking transactions including foreign exchange derivative transactions.
• The purpose of the Master Circular is to ensure that the clients of the banks who had defaulted in their payment/ repayment obligations are not provided additional finance and, therefore a client who had defaulted under foreign exchange derivative transaction would also be covered under the Master Circular.
• Clause 2.1 of the Master Circular makes it clear in sub clause (a) that a wilful default will cover also a case where a unit has defaulted in meeting its payment obligations to the lender if it had the capacity to honour the said obligation. In a lender-borrower relationship there may be a repayment obligation to the borrower but no payment obligation, whereas in non-funded facility such as derivative transaction, there is no re-payment obligation but only a payment obligation. Thus, the Master Circular covers derivative transactions.
• The definition of “wilful default” under the Master Circular is wide enough to cover derivative transactions and it is the legislature which should keep in pace with the changing needs of business transactions. The Master Circular was issued to cover all kinds of dues to the bank and, therefore as and when validity of new products such as derivative transactions are questioned, the Courts should interpret widely to cover such new products under the Master Circular.

2. Court’s Judgment

The Supreme Court rejected the narrow approach adopted by CHC in deciding that the relationship of parties in derivative transactions should be construed as that of a lender and borrower just by relying on the definition of “wilful default” mentioned in the Master Circular which contains the word lender. The Supreme Court opined that CHC construed the meaning of the word “wilful default” literally and hence it must be interpreted in the context and subject matter in which it is actually used. In the present case, the Master Circular was issued at the instance of Central Vigilance Commission‟s (“CVC”) letter dated November 27, 1988, intended for putting in place a system for disseminating credit information pertaining to wilful defaulters to all financial institutions, thereby to safeguard their interests and also to restrict such wilful defaulters from obtaining further finance. CVC‟s letter intends that all cases of wilful defaults of INR 2.5 million and above should be reported to RBI irrespective of whether the transactions involve lender – borrower relationship or not. Similarly, while deciding the issue, Supreme Court rejected the viewpoint of BHC related to payment obligations under derivative transactions by relying on the language of not only the Master Circular but also other circulars on prudential norms, assets classification as non performing assets etc, issued by RBI. The meaning of any word mentioned in the statute or and Act should be construed according to its purpose and, hence the Master Circular will cover dues payable under derivative transactions. The ratio of the Supreme Court was that the Master Circular itself does not have penal consequences and, therefore need not be strictly construed. Further, the Supreme Court has rejected the contention of the companies that banks and/or financial institutions act of sharing its customer information with RBI will amount to breach of confidentiality. It was further held that RBI Act includes provisions for confidentiality, as well as exceptions to the same and, therefore sharing of information by banks with RBI with respect to wilful defaulters under the Master Circular will not amount to breach of the confidentiality provisions.

Conclusion

In the present matter, Supreme Court has set an approach that language of the RBI circular should be construed according to its purpose and, accordingly held that derivative transactions will come under the aegis of the Master Circular and perhaps, a similar approach can be followed by the courts while interpreting other government regulators‟ notifications. The Supreme Court held that wilful defaults by parties of dues payable under derivative transaction are covered by the Master Circular and this ratio was given not because RBI wants the Supreme Court to take this view, but it is the judicial interpretation of the Master Circular. The Supreme Court has, in its judgment, only dealt with the question whether derivative transactions will be covered under the Master Circular and has not opined on the other individual transactions between banks and the companies.

Authored by:
Krishnakanth

1 Commissioner of Sales Tax, M.P v Jaswant Singh Charan Singh, 1967 (2) SCR 720
2 ICICI Bank Ltd v Official Liquidator of APS Star Industries Ltd, (2010) 10SCC 1
3 Peerless General Finance and Investment Co. Ltd and Anr v Reserve Bank of India, (1992) 2 SCC 343