Banks await final judgment on loan portfolio trading

While banks are still reeling from the the recent collapse of the financial system, a recent decision from the Gujarat High Court serves an additional blow that has the potential of creating far-reaching implications for the overall banking industry in India.

In its judgment, arising from an appeal in Kotak Mahindra Bank and Others v M/S APS Star Ind Ltd, the Gujarat High Court held that the trading of debt through the buying and selling of loan portfolios was “illegal” and did not qualify as a permitted banking activity under the Banking Regulation Act, 1949.

Case background

The APS Star litigation stems from an inter-bank transfer of a pool of non-performing loans (NPAs) together with their underlying security. The transfer was contested in connection with the liquidation proceedings undertaken with respect to APS Star Industries – a borrower whose loan account formed part of the transferrred portfolio of loans.

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In the resultant appeal, the Gujarat High Court held that the transfer was illegal, being speculative in nature and contrary to what a bank is permitted to undertake under the Banking Regulation Act. The court held that the act did not envisage the right to deal with secured assets in the manner desired by such a transfer.

The court further stated that the right to deal with the secured assets was limited to ensure the recovery of the outstanding amounts under the loans, and trading in the loans together with the underlying assets could not be termed as a means of recovery. Furthermore, the court clarified that only securitization or asset reconstruction companies would be permitted to undertake the trading of NPAs.

Wide ramifications

What is significant is the potentially far-reaching import of the judgment. Although the APS Star litigation arose in the context of the trading of NPAs, the scope of the judgment by Gujarat High Court arguably extends to NPAs as well as the trading of good assets, since the basic underlying rationale for the judgment would apply equally across all categories of debt. This in itself serves a massive blow to the securitization market in India, a critical tool used by many banks and financial institutions in managing their balance sheets.

Unanswered questions

The judgment also leaves several important questions unanswered. For instance, what happens to the numerous securitization transactions that have already been concluded in over the past several years? Should the decision have retrospective effect and should all such transactions be unfolded? How should the Reserve Bank of India (RBI) assess the balance sheets of various banks on the basis of debt that has been acquired or transferred through securitization or bilateral assignments? If such transactions are disregarded, the impact on the balance sheets of transacting banks could be quite damaging.

To illustrate, many institutions may not meet their basic priority sector lending requirements, which were partly satisfied through acquired loan assets originated by other banks, using securitization transactions as the necessary tool.

Doubts have been cast over the validity of previous transactions and defaulting borrowers may attempt to seek shelter under this judgment where the recovering lender is a subsequent assignee. Extensive litigation can be expected on this ground, particularly if the borrower or its underlying assets are situated in Gujarat, where, save for the temporary stay imposed by the apex court, this judgment would have a binding effect on all lower courts. Existing restructurings that are being negotiated could also suffer adversely wherever such restructurings also involve an element of transfer of all or part of the existing exposures.

Awaiting a final verdict

The setback that the judgment poses for the banking industry is evident. The banks involved have already filed an appeal to the Supreme Court. The Supreme Court, by its interim order on 16 February stayed the operation of the order of the high court pending final resolution of the dispute.

The RBI was also impleaded as a party to the appeal and the matter has been posted for hearing on 14 April. At the time of writing, a final decision in the matter is pending.

Needless to say, the financial sector will closely follow any developments since the final judgment of the Supreme Court will have a bearing on transactions undertaken in any part of the country.

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Karan Singh is a partner and Ameya Khandge is a counsel at Trilegal in Mumbai. Trilegal is a full-service law firm that advises on corporate and commercial law in India and provides commercially oriented legal advice in relation to all sectors of the economy. The firm has offices in Delhi, Mumbai, Bangalore and Hyderabad and has over 100 lawyers, some with experience at law firms in the US, the UK and Japan.