A pandemic from China to India: Can Indian Financial System keep up?
– Abhishek Tripathi & Narayan Gupta
Covid 19 poses a novel challenge for the financial service sector which has no parallel. Of the four key stakeholders of the financial system, i.e. the regulator(s), the lenders (including banking and non-banking institutions), the depositors, and the borrowers, Covid 19 has affected all them. The buck stops at the Government and the Reserve Bank of India (“RBI”) to rescue the financial system.
RBI derives its regulatory powers over financial institutions from the Reserve Bank of India Act, 1934; and the Banking Regulation Act, 1949 (“BRA”). Section 21 (Power to control advances by banking company) and Section 35A (Power to issue directions in public interest) of the BRA confer significant powers on the RBI to regulate the banking system. Exercising these powers, RBI has issued various directions to the banks to manage the impact of COVID – 19. The key highlights of such directions can be accessed in our corporate newsletter for the month of March 2020. The directions issued by the RBI to banking institutions, were in the form of enablers to the banking institutions to alleviate the stress on the consumers (including commercial borrowers). RBI has permitted the lenders registered with it to defer the payment obligation of all term loan holders (including principal, interest, bullet repayments, EMIs, and credit card dues) that were due from March 1, 2020 to May 31, 2020, amongst other reliefs. Since then, most banking institutions have passed on the benefit to the consumers making them eligible to claim deferment of their monthly instalments. This direction of RBI potentially offers short term benefits to the consumers, with the following riders:
- Deferment of payment obligation is applicable on borrowers only when their lender chooses to do so through a board approved policy. Most banking institutions have initiated processes for deferment of repayments and have reached out to their consumers. Consumers are well advised to check the fine print of the terms of deferment before making a decision.
- Interest has not been waived and will continue running during the moratorium period. While the loan tenures are expected to be increased by three (3) months, accumulated interest for the three (3) months period is recoverable immediately at the end of the moratorium which has the potential to significantly increase the payout at the end of the moratorium. With financial situation unlikely to improve dramatically at the end of the three (3) months period, borrowers may be expecting more relief.
Impact on the borrowers under Financing Agreements
The relationship between the lender and the borrower is principally governed through the loan agreement, and security documentation (“Financing Agreements”). While borrowers may expect relief from the RBI as a regulator, the lenders, (unless otherwise prodded by the regulator) are likely to rely on the terms set out in the Financing Agreements. Unlike many other contracting documents (discussed in our earlier posts here, here and here), Financing Agreements usually insulate the lenders contractually from the effects of force majeure such as pandemic, and repayment obligations of the borrowers remain unaffected even during the continuation of force majeure events.
Further, it is fairly common for prepayments to get triggered under Financing Agreements upon a material adverse effect/ change in the borrower’s position, or fall in the value of the collateral. Such events may also entitle the lender to withhold any undisbursed portion of the loans and withdraw any sanctioned facility. A typical material adverse effect or change is defined as an event or consequence of event(s)/ circumstances that adversely affect the ability of the borrower to service its obligations, or which adversely affects the business or financial condition of the borrower. The impact of Covid-19 on businesses in most cases may qualify as material adverse effect. Also, the general economic slowdown may result in fall in the value of collaterals, whether consisting of securities, or other moveable or immoveable assets. Unless borrowers are able to furnish additional collateral, the borrowers may be running the risk of recall of the loan. The Financing Agreement must also be reviewed to verify if these events are classified as events of default or as standalone prepayment events. Classification of the event as an event of default as opposed to a mere prepayment event may trigger cross-default clauses under other loan agreements.
The concept of frustration of contract under Section 56 of the Indian Contract Act, discussed in our earlier post, may be difficult to apply to borrowings in the context of Covid-19. Frustration is typically applicable in cases of impossibility or illegality, and not merely commercial difficulty. In certain situations where loans have been disbursed for specific purposes/ businesses, and such purposes/businesses may have become impossible or illegal due to certain government orders, it may be possible to build a case for frustration. However, by invoking frustration of contract, the borrowers may be subjecting themselves to the obligation to repay the outstanding loan. Frustration of a contract makes the contract void, and under a void contract the party that has received a benefit must restore such benefit that it has received or provide compensation for such benefit.
What should borrowers do now?
The borrowers must review the terms of their Financial Agreements before making any decision. While borrowers must make commercially prudent decisions regarding their right to exercise the moratorium offered by the banks pursuant to RBI’s directions, they may be well advised to consider discussing restructuring of their loans with their lender based on their anticipated cash flows. The borrowers must also discuss with the banks to seek reduction in interest rates, pursuant to the reduction in rates by the RBI.
Conclusion: Need of the pecking order
While we wait for the return of normalcy, in exceptional times like these, borrowers alone may not be able to avoid the risks of default. The measures taken by RBI so far may not be sufficient, and RBI and the Government will have to announce further steps that carefully balance the needs of the businesses and retail borrowers with the need to prevent the banking and the financial sector from systemic failure. Perhaps, new laws may also be required. In the end, the solution will lie with the RBI, government, lenders and the borrowers working collectively, with those having deeper pockets sharing a higher burden.