Recently, the Bombay High Court in Milind Patel v Union Bank of India added to the evolving jurisprudence on this subject. It held that a lender must follow natural justice and allow a borrower access to all relevant investigation material before designating him as a “wilful defaulter”. The court imported the jurisprudence on the law of inspection from securities law as laid down by the Supreme Court in T. Takano v SEBI. This convergence in regulatory jurisprudence is indeed welcome.

Yet, it is hard to overlook the fundamental difference between a SEBI enforcement proceeding and a wilful defaulter designation proceeding. While the former is carried out by a statutory regulator which is expected to comply with natural justice and has the institutional capacity to do so, the wilful defaulter designation under RBI regulations is done by commercial lenders themselves.

This regulatory construct is legally problematic. A lender is a party to the credit contract and may not be an impartial arbiter in a wilful defaulter designation proceeding. For instance, the default could be the result of poor credit appraisal by the lender itself. A lender may, therefore, have strong incentives to push the blame for default onto the borrower by classifying it as a wilful defaulter. Such a wilful default classification does not affect the lender’s provisioning obligations either. Therefore, by making the lender the sole judge of wilful default, the regulations compromise a cardinal principle of natural justice — nemo judex in causa sua, that is, no one can be a judge of his own cause.

This peculiar institutional arrangement is the outcome of a multi-layered process of institutional change over time. The first layer of institutional design was initiated by the Central Vigilance Commission in 1998. It instructed RBI to collect information on wilful defaults of Rs 25 lakh and above, and disseminate the same to reporting banks and financial institutions. The RBI issued a scheme in February 1999 mandating banks and financial institutions to report quarterly details of wilful defaults which had occurred or were detected after March 31, 1999. Since this scheme involved only information sharing, there was no pressing need for procedural safeguards while designating a wilful defaulter.

The second layer of institutional design was initiated by the Parliamentary Standing Committee on Finance in December 2000. It recommended blacklisting of wilful defaulters from institutional finance as well as equity markets but did not suggest any commensurate procedural safeguards. The RBI circular on wilful default in 2002 introduced these penal measures for the first time. RBI kept on updating these through circulars, primarily on account of judicial intervention. Procedural safeguards, however, did not receive their fair share of regulatory attention till the Supreme Court decision in Jah Developers in 2019. In September 2023, RBI released a draft master direction on the treatment of wilful defaulters and large defaulters proposing to update the procedural safeguards.

It is important to recognise here that the basic institutional arrangement of commercial lenders designating wilful defaulters was originally intended for information sharing among banks and financial institutions. It was not intended for blacklisting borrowers from financial markets. Yet, this arrangement continues unquestioned when the ultimate purpose of the wilful defaulter designation has changed from information sharing to blacklisting.

The Bombay High Court decision in Milind Patel is a timely reminder that the current institutional arrangement for wilful defaulter designation is deeply problematic. While the court has provided a working solution by mandating commercial banks to follow natural justice principles, the larger question for policymakers is whether the wilful defaulter concept itself has outlived its utility.

In 2002, it probably made sense when India did not have a modern corporate insolvency law. In 2024, when a company defaults, financial creditors like banks and NBFCs can simply trigger the Insolvency and Bankruptcy Code and take over the company’s business irrespective of whether such default is wilful or not. In this contemporary institutional setting, is there any practical utility in continuing with the convoluted wilful defaulter framework to blacklist borrowers, their promoters and directors from financial markets and issue LoCs against these individuals?

This article was originally published in The Indian Express on 9 May 2024 Written by: Pratik Datta, Associate Director. Click here for original article

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