Issue XV | December 2013
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
Disclaimer – This bulletin is for information purposes and should not be construed as legal advice.
© PSA
Issue XV | December 2013
1.1
Stand of the Companies
(i)
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 Act 1.
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.
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
1
2
Commissioner of Sales Tax, M.P v Jaswant Singh Charan Singh, 1967 (2) SCR 720
ICICI Bank Ltd v Official Liquidator of APS Star Industries Ltd, (2010) 10SCC 1
2
Disclaimer – This bulletin is for information purposes and should not be construed as legal advice.
© PSA
Issue XV | December 2013
1.2
Stand of the Banks
(i)
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.
(ii)
(iii)
(iv)
1.3
The stand of RBI in the three civil appeals
(i)
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
(ii)
(iii)
(iv)
(v)
3
Peerless General Finance and Investment Co. Ltd and Anr v Reserve Bank of India, (1992) 2 SCC 343
3
Disclaimer – This bulletin is for information purposes and should not be construed as legal advice.
© PSA
Issue XV | December 2013
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
4
Disclaimer – This bulletin is for information purposes and should not be construed as legal advice.
© PSA