In a move that may change the very basics of the India’s bankruptcy regime, the Supreme Court today declared RBI’s momentous circular on defaulting companies as unconstitutional.

The circular in question sought to deal with resolution of stressed assets by way of a revised framework. Commonly referred to as the February 12 circular, it had forced seriously stressed companies to come clean and declare bankruptcy.

The circular had taken away lenders’ discretion to not act tough on soured loans, forcing defaulting businesses to either opt for resolution, or file for insolvency.

Since the beginning, the circular created a huge amount of hue and cry in various quarters. Banks, corporates and even the government were staunchly opposed to it from the very outset. On many occasions, these power centres had pushed RBI to roll back or at least water down some of the most stringent clauses.

The RBI refused to budge, insisting that the new rules will change India’s credit culture for the better — it will force banks to deal with NPAs more proactively, leading to a reduction in NPA accumulation in future.

The RBI under Urjit Patel stuck to its line till the end, causing much heartburn in government circles, which eventually led to the governor abruptly putting in his papers.

Corporates and banks were particularly riled about two specific provisions — (a) abolition of traditional restructuring processes, and (b) the one-day default rule. The circular stipulated that lenders had to mandatorily send all accounts with over Rs 2,000 crore loans to the NCLT if they failed to resolve the problem within 180 days of default. More importantly, banks were forced to classify a loan account as stressed if there was even one single day of default.

Why RBI brought in the one-day rule
There were a host of reasons — (a) to force banks to identify stress in loan account without delay; (b) to bring about a change in the country’s credit culture by way of timely repayment of loans and cutting out deliberate delays; and (c) the RBI wanted the system to penalise the defaulter via rating downgrades, which would raise borrowing costs for offending businesses.

Why borrowers & lenders opposed it
Various companies — in power, sugar and fertiliser sectors — had challenged RBI’s directive as unconstitutional on the ground that it wrongly classified them as wilful defaulters. Their argument was that they were stressed because of external reasons beyond their control.

Some genuine cases where customer payment is overdue was because of slow processing by government departments, a number of defaulters had argued. They said they didn’t want to be labelled defaulters for other’s mistakes. The RBI, however, held that many delay payments wilfully and earn income by investing the money that belongs to banks.

The traditional methods
There were quite a few — Corporate Debt Restructuring, Strategic Debt Restructuring, Flexible Structuring of Project Loans and the Scheme for Sustainable Structuring of Stressed Assets (S4A). Under the earlier processes, lenders could change the tenor and rates for easier payments by the borrower.

These methods failed to reduce the problem, leading to a spike in bad loans over time. The situation became so bad that over 10% of total bank loans turned into NPAs at one point. Both borrowers and lenders misused these schemes because it helped them conceal the true state of affairs. Many companies tried to avoid the NPAs tag by sidestepping the rules. And in that effort, they had lenders by their side.

The February 12 circular ended all this by bringing big businesses under its ambit — barring MSMEs that had loans of Rs 25 crore or less. All accounts where any of the past schemes like SDR and S4A have been invoked but not implemented, were brought under the revised framework.

What happens now
Since the circular has been quashed, all cases referred to IBC will now be likely reversed. Every consequential proceeding, including insolvency proceedings, initiated under Section 7 of IBC also stand to be quashed now.

The court also held that reference under IBC has to be on case-specific basis and with authorisation of central government.