On November 17, the Central Government imposed restrictions on the withdrawal of funds from the Lakshmi Vilas Bank (LVB) till December 16, (except for a maximum Rs 25,000 per account as relief to small depositors) on the advice of the Reserve Bank of India (RBI). Plus, the LVB’s Committee of Directors was superseded. The RBI invited suggestions and objections “within three days” on a draft scheme of amalgamation of LVB with DBS Bank India. On November 25, the Central Government approved the scheme proposed by the RBI. The LVB-DBS merger came into force on November 27 and the moratorium imposed on withdrawals was lifted. Foreign banks may operate in India either by having their branches in the country directly owned/operated by them or by creating a wholly-owned subsidiary (WOS) registered here. The Singapore-based DBS Group Holdings Limited has been operating in branch mode since 1994 but switched to WOS model in March 2019.

All the assets and liabilities of LVB now stand transferred to DBS India. By June, DBS India had a sizeable customer deposit base of Rs 24,700 crore, including Rs 5,700 crore as low-cost deposits. It is now busy rebranding LVB branches and ATMs with its logo. The parent foreign bank is expected to bring an additional investment of Rs 2,500 crore. DBS India, with just over 30 branches in the country (most of its business is in the branchless mode) now gets ownership of the LVB’s fixed assets (historical, depreciated cost of Rs 463 crore on March 31, mainly comprising 560 branches and 970 ATMs); cash and investments with the RBI (Rs 1,048 crore on March 31) and other investments (Rs 5,384 crore on March 31). The LVB gets access to deposits of Rs 21,443 crore, including about Rs 6,000 crore low-cost CASA (current and savings accounts) deposits. On the flip side, DBS has to service LVB’s borrowings (Rs 756 crore on March 31). Out of the total advances (Rs 13,828 crore outstanding on March 31), about one-fourth were Non Performing Assets (NPAs). The gross NPA ratio had deteriorated from 15.3 per cent on March 31, 2019 to 25.39 per cent on March 31 this year and remained high at 24.45 per cent on September 30.

While the LVB’s 20 lakh depositors and 4,000 employees can heave a sigh of relief, its over 97,000 investors have been hit hard. Forced mergers of banks are nothing new but in an unprecedented action in the LVB’s case, the shareholders have been divested of their equity shareholding, reserves and surpluses. Since the value of equity shares is officially decreed to be zero, the erstwhile owners of the LVB will not get any share in the LVB+DBS banking entity. Also hurt are bondholders as all of LVB’s  Basel-III compliant Tier-2 bonds worth Rs 318 crore were written down. Bond-holders will not get back their invested money, nor interest on them. Significantly, srapping Tier-2 bonds is an unprecedented action. The move was thus both, swift and uncommon, but the problem had been brewing for some time. The LVB had been incurring losses for the past 10 quarters and the RBI initiated Prompt Corrective Action (PCA) in September 2019, which asked the bank to bring in additional capital, restrict further lending to corporates, reduce NPAs and improve the Provision Coverage Ratio to 70 per cent.

These actions/decisions of the Central Government and the RBI have been challenged by the LVB’s shareholders in Mumbai and Madras High Courts (HCs). The Mumbai HC declined to stay the amalgamation but kept the plea filed before it for monetary compensation pending. The Madras HC, too, declined to stay the amalgamation but passed some interim orders giving some relief to the LVB’s shareholders on a petition filed by AUM Capital Market Private Limited, a retail investor holding shares in LVB.

Shareholders contend that they have been deprived of the LVB’s ownership without any monetary compensation. This amounts to unjust enrichment of a foreign bank. The manner of selection of DBS India as the transferee company has also been questioned. What has frustrated the LVB shareholders is the fact that the same DBS that has now acquired the bank with zero compensation to shareholders had offered to buy 50 per cent of the LVB’s shares for at least Rs 100 per share in 2018. Since then, the LVB’s value deterioration has been fast. The share price of the LVB lost 58 per cent this year and went to less than Rs 10 a share. The LVB’s total business shrank from Rs 47,115 crore at the end of September 2019 to Rs 37,595 crore at the end of September this year.

By then, the LVB’s Tier-1 Capital Ratio and overall Capital Adequacy Ratio (CAR) as per Basel-III norms had turned negative. With a large gross NPA ratio of 24.45 per cent, the LVB had a negative net worth of Rs 699 crore. Therefore, scrapping the shares and Tier-2 bonds of the LVB means that the bank has been practically wound up, with core investors asked to bear the accumulated losses. And the junked entity has been handed over to a white knight investor to take over in the interest of the LVB’s 20 lakh depositors. Aggrieved shareholders contend that even if the authorities have the power to reduce the share value during an amalgamation, reducing share value to zero cannot be done without very compelling reasons. And these reasons (if any) have not been disclosed.

Instances of commercial banks failing are rare. As the Government and the RBI are empowered to order consolidation, compulsory amalgamation and liquidation of small banks, no commercial bank has failed. Forced mergers of weak banks with stronger ones are a normal practice to safeguard depositors’ interest.

The LVB is one of the oldest private banks. It was founded in 1926 with a fairly distributed ownership. At the end of March 2012, the LVB had 12.92 per cent non-resident shareholding, which increased to 43.1 per cent by March 2019. During the period, resident individual shareholding came down from 56.73 per cent to 27.7 per cent. Resident financial institutions increased their stake from 8.47 per cent to 20.9 per cent.

The 20.9 per cent Indian Financial Institutions and 38.4 per cent foreign companies, together commanding majority control of the LVB, failed to exercise due diligence and control the management even as the bank’s lending portfolio became problematic. The LVB is a banking company registered under the Companies Act, 1956. Banking companies are governed differently from other companies in India. They are regulated by both the Companies Act and the Banking Regulation Act, 1949. And the Banking Regulation Act, being a specialised law, takes precedence over the conflicting provisions of  the Companies Act. Section 45 of the Banking Regulation Act, 1949 empowers the RBI to apply to the Central Government “for suspension of business by a banking company and to prepare a scheme of reconstitution of amalgamation.” So the triggers, processes, control mechanism and so on for mergers and acquisitions are different than those for non-banking companies.

Just like the Companies Act, the Insolvency and Bankruptcy Code applies to banking companies, too, but the Banking Regulation Act prevails over the other two Acts. The one month “moratorium” imposed on the LVB on November 17 was akin to anaesthesia that is given before a surgery. Keeping the LVB under a moratorium for too long would have affected 20 lakh depositors. The RBI had to find an able and willing investor ready to take over. For the last two years, the LVB and its promoters have been trying to lure investors to infuse additional capital to meet regulatory norms.

For the takeover of financially-distressed non-banking companies, resolution professionals are appointed by the National Company Law Tribunal (NCLT). This invites tenders from potential investors and the company is handed over to the highest bidder. In the case of  weak banks that are in need of rescue, there is no such practice of inviting tenders. The transferee banking company is selected based on the professional judgment of the RBI. Whether the selection of DBS India was based on rational considerations and whether the LVB’s pre-amalgamation valuation justified shareholders/bondholders being denied any monetary compensation are now sub-judice. Judicial review of regulatory wisdom is not unprecedented.

 (The writer is former Special Secretary, Ministry of Commerce and Industry)

Although capital is a scarce resource for any business, it is even more scant for small and medium enterprises (SMEs). Therefore, cash flow and working capital management are the most crucial challenges of organisations in general and SMEs in particular. Working capital is short-term in nature and refers to the funds required for the daily functioning of a firm. In business parlance it consists of accounts receivables (debtors and any pre-payments, stock or inventory) and accounts payable (creditors and short-term provisions). The lifeline of any enterprise is the flow of cash and other liquid assets through a business cycle — a journey of collecting receivables from the debtors to pay off the creditors. This is also known as the cash conversion cycle. The efficiency and, therefore, the success of a business depends upon how fast the goods are converted into cash.

SMEs differ in many ways from large firms in terms of their financial behaviour and decision-making, mainly because of their characteristics and ownership. This ultimately reflects in their financial habits. So, what are the factors that affect the availability of capital to small enterprises? One of the most important issues is the size. According to researchers, during the start-up phase, the owner’s personal savings are an important source of funds. Young and small firms do not have an established track record and may be characterised by informational opacity, making banks and other financial institutions reluctant to lend to them. In general, firms which are less than four years old, rely more on informal sources of funding.

However, when the SMEs increase in size and become larger, they have a greater network of banks willing to fund their business. The firm’s ability to deal with multiple banks and other credit agencies generally grows with size, too. So, they rely more on long-term debt and external financing, including bank loans.

Second, the type of ownership is another important determinant for the source of funding. Any SME with a concentrated ownership, like in a proprietorship, should be more prepared to use bootstrap financing, as it would have greater difficulty in accessing a formal source of credit. From the lender’s perspective, in such SMEs, there is no clear distinction between the owner and the firm, information asymmetry is prevalent and an ability to provide collateral is missing. On the other hand, a private limited SME may be viewed by financing agencies as more structured and credible. As a result, formal financing options are freely available to it. Third, the location of the start-up makes a huge impact. A firm’s proximity to the banks has an influence on its ability to gain external funding. Research also suggests that one of the reasons for a company’s failure is poor location that prevents customers and suppliers from reaching it. Therefore, despite high rentals, SMEs prefer to move to urban areas for the sake of better infrastructure and the ease of raising external finance.

Fourth, several researchers have provided evidence that the sector where the SME is operating has an impact on the short and long-term debt available to it. For example, short-term credit is used more in wholesale and retail trade as compared to manufacturing SMEs. Whereas the construction sector, hotel, hospitality and mining industries appear to depend more on long-term finance. And finally, availability of assets plays an important role in raising funds. From a lender’s point of view, collateral, which is also known as the lender’s second line of defence, is highly relevant while approving loans. Researchers Ono and Uesugi studied the Japanese SME loan market and found a positive relationship between the use of collateral and the ease of access to bank loans and external financing. It can also be understood that firms with lower tangible assets would face difficulties in accessing funds.

Additionally, the characteristics and gender of the owner too influence a firm’s capability to raise external funding. According to several researchers in different countries, men and women differ in the way they raise cash for their businesses. There is empirical evidence that women entrepreneurs start their business with a smaller start-up capital, in fact less than half of the amount used by men. In addition, women also face discrimination from banks and other financial institutions. This is evident from the higher rates of interest charged from women entrepreneurs, the requirement of additional collateral, higher loan denial rate and so on. The age of the owner, too, impacts the personal financing preference. Older SME owners are less likely to take additional finance into their firms. Younger owners tend to use a variety of external cash sources like loans, overdrafts, credit cards and personal savings.

SMEs are the backbone of any growing economy. Therefore, it is crucial to understand their financial behaviour and practices which are very different from the financial management of large corporations. This would help policymakers come up with ways to improve the external financing scenario for such firms, as stronger SMEs make a stronger economy.

(The writer is Associate Professor, Amity University, Noida)

While Raghuram Rajan often sounds like he is yet to come to terms with his effective removal from the Governorship of the Reserve Bank of India (RBI), he and his successor Viral Acharya do have a point when they panned the idea mooted by the central bank to allow the corporate sector to enter banking. In a piece, they argued that this would be devastating and would lead to “connected banking” and it isn’t hard to see their point of view. We have seen what happens with “connected banking” and the dramatic collapse of Yes Bank and the more recent rescue of Laxmi Vilas Bank by the RBI are cases in point. As Rajan and Acharya asked, “How can a bank make good loans when it is owned by the borrower?”

The central bank would be stupid to ignore the advice of their own former honchos as well as India’s top legal eagles that were consulted on this. India has had far too many banking disasters in the recent past for another one to be made through bad policy making. Even if the RBI promises to continue through regulatory oversight, the scandals involving Vijay Mallya and Nirav Modi highlight that promoters can bend the rules and cover their tracks (for a while at least) if they want to. Even if corporate-owned banks are prevented from giving loans to non-financial entities of the corporate, what will stop them from giving loans to relatives of bureaucrats and politicians in order to curry favour? Even in the best-run banks, allegations of underhand dealings and impropriety exist as we are learning in the case of ICICI Bank and their disgraced former chief executive against whom there are damning allegations. Instead, it would be more prudent for the RBI and the Ministry of Finance to explore possibilities of privatising India’s burdensome public-sector banks. Are the rule changes being made to assist one or two particular corporate groups in India and make them even stronger? Until the RBI and the government cannot answer this one question, one will assume it to be true. Ergo, this bad idea should be dispensed with forthwith. As for private lenders failing, just remember the lasting impact of the IL&FS fiasco.

Issuing of post-dated cheques or signing of irrevocable mandates to banks to debit the agreed  Equated Monthly Installment (EMI) on a fixed date every month is a common practice when loans or goods purchased on credit are repaid on a regular basis. If the cheque or automatic electronic debit is dishonoured by the bank for want of funds/mandate and the debtor fails to clear the dues within 15 days of a written notice by the bank (to be given within 30 days of dishonour), the creditor can file a criminal complaint. This is because  the debtor commits an offence punishable with up to two years in jail or fine up to two times the amount of the cheque issued or both. The criminal case can be dropped in case of a compromise or settlement. This is provided under Section 138 of the Negotiable Instruments Act, 1881. The objective of all this is to promote the efficiency of banking operations and to ensure credibility in transacting business through cheques. The 1881 Act was amended in 1989 to introduce a one-year jail term that was enhanced to two years in 2003. But the offence was made “compoundable”, meaning that the criminal proceedings can now be dropped if some compromise is reached between the two parties.

India, with its huge population, has problems that are unique to it and the overburdening of resources or institutions is one of them. So, it is not surprising then, that a total of 346 lakh court cases were pending in the country on October 29 this year. Out of this, there were over 251 lakh criminal and over 95 lakh civil cases, of which over 199 lakh criminal cases were more than a year old.  A Public Interest Litigation (PIL) filed by the Indian Banks’ Association (IBA) in 2013 had highlighted that out of the pending 270 lakh court cases, about 40 lakh were cheque bounce cases, involving about Rs 1,200 crore. These cases, estimated to be about 20 per cent of the total caseload (2018), are clogging the already overburdened criminal courts. Do we have enough jails and judges to convict every offender? Shouldn’t we have a hierarchy or priority list of offences to be targetted by the prosecution and adjudicating systems? Should the debtors, who have already mortgaged movable and immovable properties, be further subjected to criminal liability?

The Government is considering decriminalising cheque bounce cases and some other “civil wrongs.”  On June 8, the Finance Ministry sought stakeholder comments on its proposal to decriminalise 39 “minor economic offences” created under 19 Acts, including non-repayment of loans and dishonour of a cheque or automatic electronic debit for “improving the ease of doing business and helping unclog the court system and prisons.” However, the decriminalisation proposal has been opposed by the IBA, the Confederation of All-India Traders, the Finance Industry Development Council, the Federation of Industrial and Commercial Organisation and some Bar Councils.

The Bar Council of Delhi has highlighted the effect of the pandemic on lawyers in the country and how every advocate is facing a financial crisis.  The Bar Councils of Maharashtra and Goa, too, have opposed the proposal to decriminalise Section 138 of the Negotiable Instruments Act. They contended that the offence of cheque bounce should not be termed as a “minor” infraction by the Government in its bid to decriminalise the same. For lawyers, decriminalisation clearly means an adverse impact on their livelihoods. For traders selling on credit, there is a genuine problem of having no security against customer default. Instalment purchase of goods on EMI is supported by post-dated cheques, and no one will accept cheques if their bouncing is decriminalised. Trade will be left at the mercy of civil litigation that takes several years for justice to be delivered. Even after the current stringent Section 138, more than 20 per cent of all pendency of cases across the country is only pertaining to cheque bounce.

The bankers’ opposition to decriminalisation can also be understood for cheque bounce against unsecured loans. However, there is absolutely no justification for continuing with this additional protection in case of secured loans. While sanctioning EMI-based loans, banks insist on mortgage of immovable property or shares, debentures, fixed deposits and so on. Or they obtain guarantees from employers for deduction from the borrowers’ salary. In such cases, cheque bounce should be considered for decriminalisation to begin with. Borrowers — distressed by the Coronavirus pandemic — have been provided some relief by way of moratorium and deferral of fresh applications for insolvency proceedings but the criminal liability under the Negotiable Instruments Act, 1881, as amended in 1989, 2003 and 2018, remains. Normally, for criminal liability to be pinned to a person, presence of mens rea, malafide intention is a must. However, in cheque bounce cases, malafide intention may or may not be there and need not be proved. A strict liability has been created without going into a cheque issuer’s intentions as a measure to build trust and credibility in cheque transactions.

The objective of amending Section 138 of the Negotiable Instruments Act in 1989 was to add credibility in transacting business through cheques. Current realities are so very different from 1989 when cheque bounce was first criminalised.

Provision of criminal liability — prosecution and imprisonment — on strict liability basis, without the need to prove malafide intention, is an identified deterrent for attracting new investment. It is in larger public interest to declog our criminal courts and jails.

In Kaushalya Devi Massand vs Roopkishore Khore case, the Supreme Court held that the offence committed under Section 138 of the Negotiable Instruments  Act cloaks a civil wrong as a criminal act and the gravity of offence under Section 138 of the Act cannot be equated with a crime under the provisions of the Indian Penal Code or other criminal offences.

In Makwana Mangaldas Tulsidas vs. State of Gujarat and others case, the Supreme Court recently favoured decriminalisation of dishonour of small value cheques. The court suggested various ways to deal with the situation of overflowing cheque bounce cases pending adjudication across the country. The apex court suggested developing a mechanism for pre-litigation settlement in these cases.

The Centre, while decriminalising some defaults, has to balance the interests of lawyers, the business community and the welfare of the public at large, especially those who are not wilful defaulters. In cheque bounce cases, we need to find a balance so that malafide intent is punished while other, less serious offences are compounded. As the working of the SARFESAI Act (The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act) and the Insolvency and Bankruptcy Code (IBC) have shown, the cases of wilful defaults are very few and such offenders continue to dodge the law while a large number of non-wilful defaulters continue to suffer harassment in courts. Public policy is all about balancing conflicting requirements and expectations. Creditors would want to have as many solutions as possible and pursue all those remedies simultaneously. However, such an approach has a deleterious effect on business sentiment. It may end up having a chilling effect on potential borrowers and consumer demand. If fear of imprisonment and litigation charges along with a fine truly had a deterrent effect and resulted in  timely payment of cheques, the courts would not have such a big pending caseload. And it is this huge backlog of cheque bounce cases that delays the trial of more serious crimes and at the same time erodes public faith in the judicial system.

Hence, decriminalisation of bounced cheques should be seriously pursued. Secured creditors have remedies available under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 and the IBC, 2016. Cases involving secured lenders should be decriminalised except for borrowers declared “wilful defaulters” or “fugitive economic offenders.” Even in cases involving unsecured creditors, the criminal cases should be continued against repeat offenders and a more lenient view may be taken of first-time defaults and offenders. There should be very clear articulation of legislative intent as to its retrospective or prospective operation. To eliminate a large pendency of court cases, retrospective application based on a differentiating criterion like secured/unsecured creditor and wilful/non-wilful defaulters would be necessary and desirable.

(The writer is former Special Secretary, Ministry of Commerce and Industry)