Upgradation of NPA Account – Whether Permissible After Issuance of Demand Notice under Section 13(2) of the Sarfaesi Act

Introduction

The Master Circular¹ issued by the Reserve Bank of India (RBI) defines non-performing assets (NPA) as an asset that ceases to generate income for the bank and states that an account that remains overdue/out of order for more than 90 days can be classified as NPA. Once a borrower’s account has been classified as NPA, a bank/financial institution (also, referred to as the “secured creditor”) becomes entitled to invoke the provisions of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act)² by issuing a demand notice under Section 13(2)³ of the Act calling upon such a borrower to discharge in full his liabilities (i.e. to pay the entire outstanding amount) within 60 days failing which the secured creditor gets a right to take recourse to any of the measures provided under Section 13(4) of the Act for the enforcement of security interest. Contrary to the mandate of Section 13(2), Clause 4.2.5 of the Master Circular provides for the upgradation of loan accounts classified as NPA to “standard” assets merely on payment by the borrower of the “entire arrears of interest and principal” (i.e. overdue amount only). This apparent conflict between Section 13(2) and Clause 4.2.5 can be understood by the illustration below:

“X” (a borrower) avails of a loan/financial assistance of Rs 100 from “Y” (a bank/financial institution) by creating a mortgage/security interest on one of his properties (secured asset). After repaying for a few months, “X” starts committing defaults leading to the classification of his account as NPA. As of the date of NPA, the overdue amount was Rs 10 whereas the outstanding amount was Rs 80. “Y” issues a demand notice under Section 13(2) of the Act calling upon “X” to discharge in full his liabilities by paying the outstanding amount of Rs 80 within 60 days. Despite receipt of the demand notice, “X” decides not to pay the outstanding amount of Rs 80 and instead seeks the upgradation of his account from NPA to “standard” in terms of Clause 4.2.5 of the Master Circular by paying Rs 10.

As far as the position before the issuance of the demand notice under Section 13(2) is concerned, there can be no dispute regarding the applicability of Clause 4.2.5, and loan accounts classified as NPA can be regularised or standardised on payment of entire arrears of interest and principal by the borrower. However, once the demand notice under Section 13(2) is issued and the borrower is put under a statutory mandate to discharge his liabilities in full within 60 days of the receipt of the said notice, a question arises on the applicability of Clause 4.2.5.

Main issue for consideration

Whether regularisation/upgradation of an NPA account in terms of Clause 4.2.5 of the Master Circular is permissible after the issuance of demand notice under Section 13(2) of the SARFAESI Act.

Analysis

The conflict between Clause 4.2.5 of the Master Circular and Section 13(2) of the SARFAESI Act regarding the upgradation of NPA accounts after the issuance of a demand notice necessitates a comprehensive review of statutory, regulatory, and judicial perspectives to determine the appropriate course of action.

Statutory and regulatory analysis

The SARFAESI Act was enacted to speed up the recovery of defaulting loans and mounting levels of non-performing assets of banks and financial institutions. This Act empowers banks and financial institutions to take possession of the securities and sell them without the intervention of the court/tribunal. Service of the demand notice under Section 13(2) upon the borrower calling upon him to discharge in full his liabilities within 60 days marks the commencement of the enforcement proceedings. However, before doing so, the secured creditor is under a statutory duty to classify the borrower’s account as NPA. Unless the borrower’s account is classified as NPA, the demand notice cannot be issued. When we delve into the provisions of the SARFAESI Act, we find that the provisions of the Act do not expressly provide for the manner or mechanism of classification of account as NPA, however, in terms of Section 2(1)(o)⁴, a bank or financial institution is required to classify the account as NPA per the directions or guidelines relating to assets classifications issued by the Reserve Bank or any other authority by which such institution is administered or regulated.

The Master Circular issued by the Reserve Bank of India defines NPA and provides the mechanism for classifying an account as NPA. As per Clause 2.1, an asset becomes non-performing when it ceases to generate income for the bank. Clause 2.1.2 states that an NPA is a loan or an advance where interest and/or instalment of principal remains overdue for more than 90 days in respect of a term loan; the account remains “out of order” in respect of an overdraft/cash credit (OD/CC); the bill remains overdue for more than 90 days in the case of bills purchased and discounted, etc. As per Clause 2.3, any amount due to the bank under any credit facility is “overdue” if it is not paid on the due date fixed by the bank.

Clause 4.1 provides for the categories of NPAs. As per this clause, banks are required to classify NPAs further into the following three categories based on the period for which the asset has remained non-performing and the realisability of the dues: (i) substandard assets; (ii) doubtful assets; and (iii) loss assets. A substandard asset is one which remains NPA for a period less than or equal to 12 months. An asset is classified as doubtful if it remains in the substandard category for 12 months. A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection, but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.

Clause 4.2 lays down the guidelines for the classification of assets. In terms of these guidelines, the classification of assets into the above categories should be done considering the degree of well-defined credit weaknesses. The classification of an asset as NPA should be based on the record of recovery. Banks should not classify an advance account as NPA merely due to the existence of some deficiencies which are temporary in nature such as the non-availability of adequate drawing power based on the latest available stock statement, balance outstanding exceeding the limit temporarily, non-submission of stock statements and non-renewal of the limits on the due date, etc. Thus, a bank or financial institution covered by this Master Circular is bound to adhere to these guidelines and the borrower’s account is required to be classified as NPA in strict compliance with these guidelines. Any unjustified deviation from these guidelines makes the action of such bank or financial institution liable to be set aside.

Once the account of the borrower has been classified as NPA in terms of the relevant guidelines/circulars and in case the secured creditor decides to enforce the security interest created in its favour, it has to take recourse to Section 13(2) and issue a demand notice calling upon the borrower to discharge in full its liabilities within 60 days from the receipt of the said notice. After the receipt of the demand notice, the borrower can make representation or raise objections against the demand notice. In such a situation, the secured creditor is bound to consider the said objections/representation and take a reasoned decision accepting or rejecting said objections/representation. The secured creditor is liable to communicate its decision along with reasons to the borrower. In case the entire amount demanded by the secured creditor is not paid by the borrower within 60 days and the objections/representation, if any raised by the borrower is considered and rejected by the secured creditor, it is entitled to take recourse any of the measures provided under Section 13(4) for recovery of its dues.

A bare reading of Section 13(2) read with Section 13(4) makes it amply clear that after receipt of the demand notice issued by the secured creditor, the borrower has no option but to discharge in full its liabilities within 60 days of its receipt failing which a legal right accrues in favour of the secured creditor to recover its dues by enforcing security interest. Part payments, or say, payment by the borrower of the entire overdue amount i.e. the arrears of interest and principal cannot have any effect on the recovery proceedings and the account of the borrower cannot be regularised/standardised.

However, Clause 4.2.5, as mentioned above, provides for the upgradation of loan accounts classified as NPAs. This clause states that the loan accounts classified as NPAs may be upgraded as “standard” assets only if the entire arrears of interest and principal are paid by the borrower. In case of borrowers having more than one credit facility from a bank, loan accounts shall be upgraded from NPA to standard asset category only upon repayment of entire arrears of interest and principal pertaining to all the credit facilities. This clause, in general parlance, has been understood to mean that an NPA account can be regularised on payment of the overdue amount i.e. the unpaid instalments along with charges, etc. that fell due as of date.

Pertinently, Clause 4.2.5, while providing for the upgradation of NPA account does not take note of the mandate of Section 13(2) of the SARFAESI Act. The impact of issuance of the demand notice under Section 13(2) on NPA accounts has nowhere been discussed in the Master Circular. This has created ambiguity on the applicability of Clause 4.2.5 once demand notice under Section 13(2) is issued by the secured creditor and served upon the borrower. A few High Courts have dealt with this issue and have delivered contradictory judgments. There is no unanimity on this issue.

Judicial precedents

In Anu Stone Crusher v. Bank of India⁵, the borrowers after receipt of the demand notice paid a few instalments which were accepted by the bank after the expiry of 60 days. As the borrowers failed to discharge their full liabilities pursuant to the demand notice, the bank issued notices under Section 13(4) for taking possession of the secured assets. The borrowers assailed the actions of the bank by filing a writ petition before the Madhya Pradesh High Court. It was submitted by them that once the bank accepted the part payment after the expiry of the period specified in the notice issued under Section 13(2) of the Act, the accounts of the borrowers no longer stood classified as NPA and, therefore, action under Section 13(4) was impermissible unless a fresh notice was issued under Section 13(2). While dismissing the said writ petition, the Court observed that the use of the word “full” in Section 13(4) has an important significance and it denotes that in case the borrower fails to discharge his liabilities in full within the period specified in Section 13(2) the bank becomes entitled to take recourse of the measures provided in the sub-section to recover its secured debt. Thus, for the borrower to avoid an action under Section 13(4) by the bank, he must discharge his full liabilities within the period specified in the notice and he cannot escape the action by making part payments.

In Sravan Dall Mill (P) Ltd. v. Central Bank of India⁶, the borrower questioned the notice under Section 13(2) of the Act, assailing the classification of its account as NPA and the initiation of proceedings under the provisions of the Act. It was held by the Court that the subsequent payments by the borrower entitled him to upgrade the said account and come out of NPA. The Court observed that it was incorrect to presume that once an NPA is always an NPA and it was precisely for the said reason that Clause 4.2.4 (now 4.2.5) of the prudential norms specifically states that if interest and principal are paid by the borrower in case of loans classified as NPA, the said account should no longer be treated as NPA and may be classified as substandard account.

The most useful and relevant judgment in this line is Chembeti Brahmaiah Chowdary v. State of Hyderabad⁷. In this case, the borrowers after availing of the loan from the bank committed defaults in repayment due to which their loan account was classified as NPA. Thereafter, a demand notice under Section 13(2) was issued by the bank. The borrowers failed to discharge their liabilities in full within 60 days. Consequently, measures under Section 13(4) were initiated by the bank. The actions of the bank were challenged before DRT, however, upon failure to comply with the condition imposed by the DRT for granting interim relief, the securitisation application was dismissed. Thereafter, various rounds of litigation took place. Before the High Court, the borrower contended that the payment of Rs 1 lakh made by him in terms of the court’s order which has been reckoned and adjusted towards the dues of the borrower would have the effect of bringing his account out of NPA. In this regard, the borrower relied upon Sravan Dall Mill case⁸. The Court observed that the observations in Sravan Dall Mill case⁹ cannot fairly be understood as laying down a principle that payments made after the account had been validly classified as NPA and the proceedings initiated by issuing notice under Section 13(2) of the Act would have effect of upgrading the account and bringing out of the contours of NPA. It was further observed that where an account is classified as NPA and there is a time-lag between such classification and initiation of proceedings under the provisions of the Act, if any payments are made and those payments have the effect of upgrading the account and bringing it out of the contours of NPA under the applicable prudential norms of the RBI (relating to assets classification), then and in such an event alone initiation of the proceedings under the provisions of the Act would be unsustainable as devoid of the jurisdictional factual basis for initiation of proceedings. The contention of the borrower that NPA classification is a dynamic event to be computed every time a payment is made into an account and even after a valid initiation of proceedings would frustrate the legislative philosophy underlying the provisions of the Act, which is intended to provide a speedy remedy to a secured creditor to realise its debts by enforcement of the security interest without the intervention of a court or tribunal, in respect of a secured asset.

On the same lines is the judgment of the High Court of Calcutta in Nik-Nish Retail (P) Ltd. v. Union Bank¹⁰, wherein the borrowers contended that their account was entitled to be standardised after they made part deposits after receipt of the demand notice under Section 13(2). The borrowers relied upon Clause 4.2.4 (now 4.2.5) and the judgment in Sravan Dall Mill case¹¹. Repelling such contentions, the Court observed that the borrowers were not entitled to upgrade the NPA account. The Court went on to observe that the scheme of the Act envisages a grant of 60 days to the defaulter for clearance of the liability or to object. Even if the defaulting party falls short of paying Rs 1 of the amount specified in the demand notice within the permitted period, its account would still be a “non-performing asset” and continue to be treated as such and the secured creditor is, in the circumstances, entitled to initiate further action in terms of provisions of the Act including taking measures to take possession of the secured assets after the period of 60 days has expired if no objection is received in the meantime or the objection to the demand notice has been overruled. The period of 60 days is the time-limit for clearing the liability and if the liability is not cleared, notwithstanding part payment the secured creditor is well within its right to exercise power conferred by Section 13(4) of the Act.

Thereafter, the question of whether payment of the entire overdue amount would result in the upgradation of the account from NPA to standard was considered by the Punjab & Haryana High Court in Oswal Spg. & Wvg. Mills Ltd. v. RBI¹². While referring to Clause 4.2.5 and agreeing with the judgment in Sravan Dall Mill case¹³, the Division Bench observed that to have an account upgraded from an NPA to a standard account, it is not necessary that the entire amount due from the borrower to a creditor is paid in full. It is sufficient if the amounts due at the material time towards principal and interest are paid.

In Rakesh Sharma v. Central Bank of India¹⁴, the Allahabad High Court observed that if the borrower corrects the deficiency, then the substandard asset would be upgraded to a standard account as per Clause 4.2.5, which provides that if arrears of interest and principal is paid by the borrower, the account would no longer be treated as non-performing and would be classified as a standard account. In this regard, the Court further observed that from a reading of Clause 4.2.4, the classification of an account as NPA must be done by the bank based on the record of recovery and that the bank could not classify an account as NPA merely due to the existence of some deficiencies which are temporary in nature such as balance outstanding exceeding the limit temporarily.

Various other High Courts while dealing with this issue have relied upon either Sravan Dall Mill case¹⁵ or Oswal Spg. case¹⁶ to allow the upgradation of the NPA account on payment of the entire arrears of interest and principal even after issuance of demand notice under Section 13(2). It is, however, relevant to note that judgment in Chembeti case¹⁷ or Nik-Nish case¹⁸ which, after considering Sravan Dall Mill case¹⁹, disagreed with it and held otherwise were not brought to the notice of the Court dealing with Oswal Spg. case²⁰. Another crucial point is that the impact of Section 13(2) vis-à-vis Clause 4.2.4 has not been discussed anywhere in Sravan Dall Mill case²¹ or Oswal Spg. case²².

Sub-issues

The conflicting judgments and the lack of statutory/regulatory clarity on this issue necessitates us to ponder upon the issue of whether Clause 4.2.5 is inconsistent to the mandate of Section 13(2). If the answer to this question is in affirmative, what further needs to be examined is whether Section 13(2) of the Act will override Clause 4.2.5 of the Master Circular to the extent of the inconsistency between them and is there any way by which Clause 4.2.5 can be harmonised with Section 13(2).

(i) Whether Clause 4.2.5 is inconsistent to the mandate of Section 13(2).

As apparent from a bare reading of Section 13(2) r/w Section 13(4) makes it clear that once a demand notice under Section 13(2) is issued by the secured creditor the borrower has no other option but to discharge in full his liabilities within 60 days from the receipt of the demand notice. Contrary to this statutory mandate and intent of speedy recovery, Clause 4.2.5 allows a defaulting borrower to claim upgradation of the NPA account merely on payment of overdue amount (i.e. arears of interest and principal due). In case an NPA account is permitted to be regularised after issuance of the demand notice, the secured creditor would be forced to withdraw/hold on its recovery measures. This practice will allow defaulting borrowers to delay the recovery proceedings by making repayment of overdue amounts as and when the secured creditor issues demand notice. This situation becomes worse where the secured creditor reaches an advanced stage of recovery, say, the secured creditor has taken possession of the mortgaged properties and is in the process of initiating proceedings for sale of the said properties. In such circumstances, this practice will be licence to the defaulting borrowers to clear the overdue amounts and force the bank to reinitiate the entire exercise from the inception. In our humble opinion, Clause 4.2.5, thus, is inconsistent to the mandate of Section 13(2) to the extent it permits regularisation/upgradation of NPA account after the issuance of demand notice under Section 13(2).

(ii) Whether Section 13(2) of the Act will override Clause 4.2.5 of the Master Circular to the extent of the inconsistency between them

Section 35²³ of the Act states that the provisions of this Act shall have effect, notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law. In terms of Article 13(3)²⁴ of the Constitution of India, “law” includes any ordinance, order, bye-law, rule, regulation, notification, custom or usage having in the territory of India the force of law. The Master Circular has been issued by the RBI in the exercise of the powers conferred and mandated under Sections 21²⁵ and 35-A²⁶ of the Banking Regulation Act, 1949. There is no dispute that these Master Circulars have got statutory flavour as held by the Supreme Court in ICICI Bank Ltd. v. APS Star Industries Ltd. (Official Liquidator)²⁷. Thus, viewed from different angles, the Master Circular will be a “law” and therefore, by operation of Section 35 of the Act, Section 13(2) will prevail over Clause 4.2.5 of the Master Circular. Hence, the Clause 4.2.5 cannot be given effect to the extent it runs contrary to the mandate of Section 13(2).

(iii) Ways in which Clause 4.2.5 can be harmonised with Section 13(2)

We have already noted the inconsistency between Clause 4.2.5 and Section 13(2) and the overriding effect of Section 13(2) over Clause 4.2.5. The question on the validity of the Master Circular is no more res integra in view of the judgment passed by a Division Bench of the High Court of Madras in Deccan Chronicles Holdings Ltd. v. Union of India²⁸, which upheld the validity of the Master Circular and recognised the statutory force of the Master Circular. In such circumstances, the only issue that remains to be examined is the way in which Clause 4.2.5 can be harmonised with Section 13(2). In our opinion, Clause 4.2.5 can be harmonised with Section 13(2) by limiting its application to the stage prior to the issuance of the demand notice under Section 13(2). In other words, it can be harmonised by stating that an NPA account can be regularised/upgraded prior to the issuance of the demand notice under Section 13(2) as held by the Court in Chembeti case²⁹. This way Clause 4.2.5 will survive and coexist with Section 13(2) without contravening its statutory mandate. However, a practical problem that may arise for the borrowers is when there is no time-gap between the classification of the account as NPA and the issuance of demand notice. To overcome this situation, we are of the opinion that the secured creditors may, after classifying an account as NPA, give to the borrower(s) a bit of time to regularise their account in terms of Clause 4.2.5 before issuing a demand notice under Section 13(2). This, in our opinion, would not only enable the borrower(s) to claim the benefit of Clause 4.2.5 but would also safeguard the secured creditors from unwarranted litigations.

Subsequent upgradation of NPA account insignificant

As discussed above, the issuance of the demand notice under Section 13(2) marks the commencement of the proceedings under the provisions of the Act. In terms of Section 13(2), the borrower’s account must have been classified as NPA prior to the issuance of the demand notice. Thus, for the purpose of the application of the provisions of the Act, what needs to be seen is whether on the date of the issuance of the demand notice, the account of the borrower was classified as NPA or not. Once there has been a valid invocation of the provisions of the Act, the compelling inference is that the secured creditor is entitled to pursue the enforcement provisions to the logical conclusion by taking recourse to one or more of the measures enumerated in Section 13(4) to recover the secured debt, in full. Part payments after the issuance of the demand notice, even if having the effect of upgrading the account as standard, shall not impede the enforcement of security interest validly initiated by the secured creditor.

This can be examined in light of Section 13(8) also which provides that if the dues of the secured creditor together with all costs, charges and expenses incurred by him are tendered to the secured creditor at any time before the date of publication of notice for public auction or inviting quotations or tender from public or private treaty for transfer by way of lease, assignment or sale of secured assets, the secured asset shall not be sold or transferred by the secured creditor, and no further steps shall be taken by him for transfer or sale of that secured asset. This provision considered in the context of Sections 13(2) and (4), signals the legislative intent that the sale or transfer of the secured asset by the secured creditor is prohibited only where its dues (the liability in full) together with all costs, charges and expenses incurred are tendered at any time before the date of publication of notice for public auction or inviting quotations or tender from public or private treaty for transfer by way of lease, assignment or sale of secured assets. If there is no tender of the whole of the liability, the sale or transfer of the secured asset may proceed.

A comparative analysis of the issue involved herein can also be done with the mandate of Section 31(j)³⁰ of the Act which states that the provisions of the Act do not apply in case the amount due is less than twenty per cent of the principal amount and interest thereon. In other words, as per Section 31(j), the provisions of the Act do not apply where eighty per cent of the loan amount has been repaid by the borrower. Thus, as on the date of invocation of the provisions of the Act, the recoverable amount should be more than twenty per cent of the principal amount and interest thereon. Once that is the case, subsequent reduction of the recoverable amount below twenty per cent cannot have any effect on the recovery measures initiated the secured creditor. Though Section 31(j) has no relation with the classification of account as NPA, yet this comparative analysis is being done to show that the relevant date, for the purpose of invocation of the provision of the Act, is the date of the issuance of the demand notice and therefore, the position of the loan account of the borrower as of the date of the issuance of the demand notice is to be seen and subsequent change in the position of the loan account is insignificant and can have no bearing on the measures lawfully initiated by a secured creditor.

In Azam Foods Products (P) Ltd. v. Debts Recovery Appellate Tribunal³¹ the borrower contended that if the payments made after the Section 13(2) notice are taken into account, the liability of the borrower would fall below twenty per cent of the principal amount and the interest due thereon and therefore proceedings under the Act cannot be pursued in view of the provisions of Section 31(j) of the said Act. Repelling such contention, the High Court of Andhra Pradesh held that in the context of Section 31(j), any payment made by a borrower to a secured creditor after issuance of the notice under Section 13(2) would not affect or invalidate pursuit of the remedies available to a secured creditor under Section 13(4), even where on giving credit to such subsequent payments made, the amount due would fall below twenty per cent of the principal amount and interest thereon. It was held that the provisions of Section 31(j) are threshold conditions for valid initiation of processes under the Act for enforcement of the security interest.

In R. Krishnamoorthy v. UCO Bank³² the borrower contended that since the amount due was less than twenty per cent, the proceedings initiated under the SARFAESI Act was liable to be set aside. Rejecting the said contention, Division Bench of the High Court of Madras held that since the outstanding amount payable by the borrower was more than twenty-five per cent on the date of issuance of demand notice under Section 13(2), there was no impediment for the secured creditor to initiate the proceedings under the Act.

In Shycy Santhosh v. HDFC Housing Finance³³, the High Court of Kerala observed that a bare reading of Section 31(j) makes it indubitable that it is designed to offer protection to a borrower who repays the loan amounts honestly and in time, thus keeping the amounts recoverable from him, at every point of time, below twenty per cent of the principal amount and interest thereon. This provision certainly cannot apply to persons who commit persistent default but cleverly manage to keep the overdue instalments below twenty percent of the principal amount and interest on it and if this is how Section 31(j) of the SARFAESI Act is to be interpreted, then it would be a total travesty of justice, offering a premium to dishonesty.

These judgments make it amply clear that once the provisions of the Act have been validly invoked, subsequent payments by the borrower slashing down their liabilities below twenty per cent will not affect the enforcement proceedings initiated by the secured creditor. Similarly, once a demand notice under Section 13(2) is issued, the payment by the borrowers of the overdue amount shall not affect the enforcement proceedings.

Conclusion

In light of the analysis above, we believe that regularisation/upgradation of an NPA account in terms of Clause 4.2.5 of the Master Circular is impermissible after the issuance of demand notice under Section 13(2) of the SARFAESI Act. We are of the view that Clause 4.2.5 of the Master Circular being partly inconsistent with the mandate of Section 13(2) r/w Sections 13(4) and (8) of the Act cannot be given effect after the issuance of the demand notice and the application of Clause 4.2.5 deserves to be restricted to a stage prior to the issuance of the demand notice under Section 13(2). As a sequitur, once a demand notice under Section 13(2) is issued, the borrower becomes statutorily liable to discharge his full liabilities i.e. pay the outstanding amount within 60 days. Payment by the borrower of the overdue amount i.e. entire arrears of the interest and principal will not result in the regularisation/upgradation of the NPA account after demand notice under Section 13(2) is issued.