RBI's `wilful default' framework vs. the rule of law

Indian Express, 16 September 2014

The ruling of the Gujarat High Court on 9 September has raised questions about RBI regulations on `wilful default'. While India needs to do much more on strengthening the rights of creditors, this should be grounded in the foundations of liberal democracy. Our well justified outrage about the misbehaviour of some borrowers does not justify losing sight of constitutional principles.

There are two persons P and Q. You have a contractual dispute with person P. When P becomes unhappy with you, the law requires that Q must punish you. That is, the coercive power of the State, which forces Q to punish you, is being placed at the disposal of a non-State actor, P, without checks and balances. Such an arrangement would raise many questions.

RBI's approach to `wilful default' involves a bank P which determines that your default is `wilful'. Once this is done, subordinated legislation issued by RBI forces all banks to punish you. P gives you a bad name and then all banks Q are forced (by RBI regulations) to hang you. The formal processes of enforcement are missing: non-State actors lack appropriate skills and incentives when it comes to justice. There is no mechanism for judicial review. RBI's regulation on wilful defaulters gives non-State actors the ability to wield the coercive power of the State, without adequate checks and balances. This violates the rule of law.

A khap panchayat sets up a boycott by everyone in a village, against someone who is deemed an offender. This is not rule of law. If there is a violation of law, this should go through the due process of a chargesheet and a judge, and then the State inflicts punishment. Giving any one bank the power to inflict a boycott by all banks is a throwback to the age of khap panchayats.

On 9 September, the Gujarat High Court came out with a ruling which expresses a small part of this problem. However, the problems with RBI's regulation on wilful default run much deeper.

India does have a problem with promoters who borrow and then fail to repay. Our outrage about their behaviour does not justify abandoning our foundations of liberal democracy. When we get outraged about the Delhi rape, we should not engage in knee jerk responses. The way forward involves solving the deeper problems of corporate bankruptcy in India, while being imbued with sound legal philosophy.

We must question the tag `wilful'. Debt is a contract, and default is a violation of the contract. The intent in the mind of the person who violates a contract is impossible to assess and is irrelevant for the purpose of contract enforcement.

We must build an `Indian Bankruptcy Code', which kicks in when firms default. The establishment of the T. K. Viswanathan Committee, by the Ministry of Finance, is a key initiative in economic policy reform. This Indian Bankrutpcy Code must be fully grounded in the rule of law. It should avoid superficial responses, such as the RBI approach to wilful default. The process design used by the Financial Sector Legislative Reforms Commission (FSLRC), led by Justice Srikrishna, was quite effective, and has given us a high quality draft Indian Financial Code. Many elements of this process design can be utilised for drafting the Indian Bankruptcy Code.

Raghuram Rajan has criticised FSLRC on the question of judicial review of RBI regulatory actions. The RBI regulation on wilful default, and actions taken in pursuance to these regulations, is a good test case for this debate. Rajan would like for RBI to have the power to write subordinated legislation of this nature without checks and balances. He argues in favour of `healthy respect for the regulator'. However, the essence of the rule of law is protecting private persons from excessive executive discretion and the abuse of discretion. `Respect' might often be a euphemism for unchecked executive discretion.

Nobody should have the power to violate the Constitution, and unelected officials should not have the power to write subordinated legislation that is incompatible with Parliamentary law. The Constitution of India establishes mechanisms for judicial review, e.g. the Gujarat High Court ruling. The proposed Financial Sector Appellate Tribunal would do better, on speed and domain knowledge, when compared with the high courts.

In the FSLRC approach, writing law is a sacred power of Parliament, and when this is delegated to officials, there is a need for thorough processes. This requires putting draft regulations out for public comment, and obtaining approval from the board. Feedback from public comments will catch some errors. The scrutiny of the board of the draft regulation and of the public comments will improve the work. This procedure might have blocked the wilful defaulters regulation, before it reached the Gujarat High Court and the Supreme Court. At present, a large number of regulations are issued by financial agencies without any discussion or oversight by the board, and without public comment.

For all financial regulators, achieving the intellectual capital of understanding law and economics, and becoming imbued with the rule of law, is a complex objective that will take time. In contrast, rolling out better processes for regulation making is a concrete and actionable initiative which can be achieved in the short run. The Ministry of Finance would do well to take this up at the boards of all regulators, and pass a board resolution that defines the regulation-making process.

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