Legal

Understanding the Comprehensive Framework for Compromise Settlement and Technical Write-Offs

On June 8, 2023, the Reserve Bank of India (RBI) released the Framework for Compromise Settlements and Technical Write-offs (Framework). This framework was issued exactly four years after the release of the Prudential Framework for Resolution of Stressed Assets (PFRSA) and aims to rationalize and harmonize the previously issued instructions.

While the PFRSA was only applicable to banks and systemically important non-banking financial companies (NBFCs), the present Framework applies to all regulated entities (REs), including base-layer NBFCs.

Furthermore, to address any ambiguities that may have arisen after the issuance of the Framework, the RBI has also released a set of Frequently Asked Questions (FAQs) on this topic. These FAQs primarily aim to clarify the intentions behind the release of the Framework and address any questions raised by the regulator.

Applicability

Before delving into the Framework’s specifics, it is imperative to first comprehend the context underpinning this framework. The preface of the Framework declares that the Reserve Bank of India has issued numerous directives to regulated entities (REs) concerning compromise settlements in relation to distressed accounts, including the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019 (“Prudential Framework”), which acknowledges compromise settlements as a legitimate resolution plan.

To provide further momentum to the resolution of distressed assets in the system, as well as to rationalize and harmonize the directives across all REs, as announced in the Statement on Developmental and Regulatory Policies released on June 8, 2023, it has been determined to issue a comprehensive regulatory framework governing compromise settlements and technical write-offs covering all the REs, as detailed in the Annex. Therefore, the Framework endeavours to accomplish more than what the PFRSA could achieve.

However, it is crucial to comprehend that these two are distinct. The Framework neither supplants the PFRSA nor does it need to be read in conjunction with the PFRSA, and this is made abundantly clear in Paragraph 2 of the Framework, which states: The provisions of this framework shall be applicable to all REs to which this circular is addressed and shall be without prejudice to the provisions of the Prudential Framework, or any other guidelines applicable to the REs on resolution of stressed assets.

The RBI has further clarified its position with the following justification provided in the FAQs: The circular is intended to achieve the following objectives:-

• It rationalizes the existing regulatory guidance to banks on compromise settlements, consolidating various instructions issued over the years.
• It also tightens some of the related provisions and ensures greater transparency.
• Establishing a transparent regulatory framework facilitates other regulated entities, particularly co-operative banks, to engage in compromise settlements as part of their standard resolution efforts.
• It offers a clear definition of technical write-offs and provides comprehensive guidance on the procedures that regulated entities should follow when conducting technical write-offs, which is a customary practice in the banking industry.
• To discourage both lenders and borrowers, it introduces the concept of a cooling period for typical compromise settlement cases, during which the lender involved in the settlement is prohibited from extending any new credit to the borrower entity.
• In situations where borrower accounts are classified as wilful defaulters or involved in fraudulent activities, the prohibition on obtaining fresh financing is imposed.

Difference Between PFRSA and Framework

Regarding the applicability of the Framework, it is worth noting that there is a significant difference compared to the PFRSA. While the latter only applies to systemically important NBFCs, the current framework also includes non-systemically important NBFCs.

Consequently, the framework applies to the following entities:-

• Commercial Banks (including Small Finance Banks, Local Area Banks, and Regional Rural Banks)
• Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative Banks
• All-India Financial Institutions
• Non-Banking Financial Companies (including Housing Finance Companies)

Another notable difference between the PFRSA and the Framework is that a substantial portion of the PFRSA is only mandatory for large debt exposures. However, the Framework does not require a specific debt threshold for its applicability.

In other words, the Framework applies regardless of the size of the exposure and whether it is held solely by the RE or shared with other REs. Therefore, all REs must adhere to this framework when undertaking compromise settlements and technical write-offs. Additionally, if the amount of debt involved exceeds the thresholds specified in the PFRSA, compliance with those thresholds is also required.

Compromise Settlement and Technical Write-offs

The first component of the Framework is “compromise settlement.” This expression means a settlement, which involves a compromise. In common parlance, this is referred to as a one-time settlement or OTS. The RBI has defined compromise settlement as any negotiated arrangement with the borrower to fully settle the claims of the RE against the borrower in cash. Such settlement may entail some sacrifice of the amount due from the borrower on the part of the REs with the corresponding waiver of claims of the RE against the borrower to that extent.

The above discussion leads to at least two conclusions:-

• If there is a compromise settlement where the facility due to the RE is not fully settled, this Framework will not cover it. Technically, this may amount to restructuring to the extent there is an economic rationale for a partial waiver of the claim of the RE. Therefore, a partial waiver will have to be covered by the RE’s policy on restructuring.
• A compromise settlement where the facility is converted into another facility, say conversion into equity or another debt instrument or facility, is also not covered by this Framework. The underlying philosophy is that if an RE must enter a compromise with the borrower, the RE should attempt a complete exit from the facility rather than continuing to rely on the borrower for any further promises.

“Technical” write-off: The second part of the framework deals with “technical write-off”. The Framework defines this term as cases where non-performing assets remain outstanding at the borrower’s loan account level but are removed (in whole or in part) by the RE only for accounting purposes, without requiring a waiver by the borrower without impairing its return.

Again, there is a common practice among different categories of lenders where loans are written off or assessed in the accounts. Still, the legal right to recover the amount owed by the borrowers remains. In arithmetic terms, this is a stage 3 defect.

This may be due to applicable regulations, such as IRAC regulations, which require a lender to compulsorily cancel loans after they have been MTA for a certain number of years, or there may be a requirement to estimate expected credit losses based on applicable accounting.

Perhaps the most interesting (and, predictably, widely criticized) provision of this framework is that accounts deemed fraudulent or wilfully negligent can also be settled under the framework, provided the RE board approves proposals for such settlements.

In case of partial technical write-offs, the prudential requirements in respect of residual exposure, including provisioning and asset classification, shall be with reference to the original exposure.

Compromise Settlement and Technical Write-offs Now Allowed for Fraud Accounts or Wilful Defaulters

This provision has generated widespread criticism, but it is noteworthy that such accounts are eligible for compromise settlement under the framework, provided that the Board approves the proposals for such settlements of the relevant entities.

Previously, under the prudential framework, wilful defaulters and debtors classified as fraud were not allowed for restructuring. However, the Reserve Bank of India (RBI) has clarified that this provision enabling banks to enter compromise settlement in respect of such borrowers is not a new regulatory instruction and has been the settled regulatory stance.

The RBI had previously advised the Indian Banks’ Association (IBA) that banks may enter compromise settlements with wilful defaulters/fraudulent borrowers without prejudice to the criminal proceedings underway against such borrowers and that the management committee/board of banks should vet all such cases of compromise settlements.

The Master Circular on Wilful Defaulters, dated July 1, 2015, envisages lenders agreeing to compromise settlement with borrowers classified as wilful defaulters and states that such cases need not be reported to Credit Information Companies provided that the borrower has fully paid the compromised amount.

The Master Directions on Frauds, dated July 1, 2016, provides for compromise settlement with borrowers classified as fraud, subject to the condition that no compromise settlement involving a fraudulent borrower is allowed unless the conditions stipulate that the criminal complaint will be continued. The reason for permitting the same is to enable multiple avenues for lenders to recover the money in default without much delay, as such delays result in the deterioration of asset value, which in turn hampers ultimate recoveries.

Delays of this nature lead to the depreciation of asset value, which subsequently impedes the ultimate recovery process. For this reason, borrowers facing such circumstances were permitted to reach a compromise settlement or undergo a technical write-off.

This was done to prevent lenders from being burdened with unproductive assets on their balance sheets due to ongoing legal proceedings. It is important to note that this provision does not in any way diminish the penalties imposed on this category of borrowers, as outlined in the Master Directions on Frauds dated July 1, 2016, and the Master Circular on Wilful Defaulters dated July 1, 2015.

These penalties will remain unchanged and continue to be enforced. Among these penalties is the restriction on banks and financial institutions from granting additional facilities to borrowers listed as wilful defaulters.

Furthermore, these companies, including their entrepreneurs and promoters, will be barred from receiving institutional finance for new ventures for a period of five years after their removal from the wilful defaulters list.

The compromise framework also allows for compromise settlements or technical write-offs to be undertaken by the relevant entities in relation to these accounts without prejudicing the ongoing criminal proceedings against the debtors.

Cooling Off Time

The framework introduces the concept of a cooling-off period. Borrowers subject to settlement are subject to a mandatory cooling-off period, as determined by each board-approved policy.

Can REs take new risks with such borrowers after such a cooling-off period? RBI has imposed a minimum cooling-off period of 12 months for exposures other than agricultural credit exposure.

However, the Board of RE can decide in favour of a longer consideration. Note that the period is 5 years for fraud/wilful negligence.

Farm Credit Exposures

Farm credit exposures refer to credit facilities that have been extended to agricultural activities as outlined in annexe 2 of the Master Circular – Prudential norms on Income Recognition, Asset Classification, and Provisioning pertaining to Advances.

The duration of the cooling period for these farm credit exposures and exposures that have undergone technical write-offs will be determined by the Relevant Entities (REs) based on the policies that their respective boards have approved.

Can a borrower borrow from other financial institutions during the cooling-off period permissible?

The question arises whether all other financial institutions are also required to adhere to the cooling-off period.

In other words, if a borrower has entered a compromise settlement or had their debt technically written off, are they prohibited from borrowing from the same financial institution for a period of 12 months but allowed to borrow from other financial institutions during this cooling-off period?

The response to this question appears to be affirmative, as the language used in the Framework indicates that the restriction on taking on new loans during the cooling-off period applies only to the financial institution involved in the arrangement and does not imply any prohibition on other lenders from providing new loans during this period.

However, other lenders need to make their own informed credit decisions, taking into consideration the borrower’s impaired credit history.

It has been clarified in the Frequently Asked Questions (FAQs) that the cooling-off period¹ only applies to normal cases of compromise settlements and does not affect the penalties applicable to borrowers classified as fraud or wilful defaulters.

Such borrowers are prohibited from obtaining bank financing for a period of five years from the date of full payment of the defrauded amount.

Should the matter be considered as “restructuring”?

The framework establishes a prudential approach for compromise settlements in cases where the agreed settlement amount is to be paid over a period exceeding three months. In such instances, the settlement shall be treated as restructuring according to the definition provided in the prudential framework.

The prudential framework itself recognizes compromise settlements as restructuring if the payment period exceeds three months. Additionally, compromise settlements and technical write-offs will not affect any mutually agreed contractual provisions between the RE (lender) and the borrower regarding future contingent realizations or recovery by the RE. However, these claims should not be recognized on the RE’s balance sheet at the time of the settlement or subsequently until the receivables are realized. If any such claims are recognized on the RE’s balance sheet, they will be treated as restructuring.

Board-approved Policy

The framework requires REs to have Board-approved policies for conducting compromise settlements with borrowers and technical write-offs.

Furthermore, the Board-approved policy should comprehensively outline the process to be followed for all compromise settlements and technical write-offs, including specific guidance on necessary conditions precedent, such as minimum ageing and deterioration in collateral value.

Moreover, a graded framework for assessing staff accountability in such cases will be implemented with reasonable thresholds and timelines determined by the Board.

Delegation of Power

The policy approved by the Board must include provisions for the delegation of power in order to approve or sanction compromise settlements and technical write-offs.

The REs must ensure that, in the case of compromise settlements, the authority responsible for approving such settlements is at least one level higher in the hierarchy than the authority with the power to sanction the credit or investment exposure.

However, any official involved in sanctioning the loan, either individually or as part of a committee, cannot be involved in approving a compromise settlement for the same loan account in any capacity. Additionally, compromise settlements and technical write-offs approved by a particular authority must be reported to the next higher authority on a quarterly basis.

Reporting Format to Ensure Coverage

The Board of the REs must establish a suitable reporting format to ensure comprehensive coverage of the following aspects, at a minimum: the trend in the number of accounts and amounts subjected to compromise settlements and/or technical write-offs; a separate breakdown of accounts classified as fraud, red-flagged, wilful default, and quick mortality accounts, categorized by amount, sanctioning authority, and business segment/asset class; and the extent of recovery in technically written-off accounts.

Conclusion

The RBI has not only standardized and aligned the instructions across all REs with this framework but has also somewhat liberalized the compromise settlement framework by allowing wilful defaulters and other debtors previously classified as fraud to participate in the compromise process.

However, as mentioned earlier, the cooling period only applies to normal cases of compromise settlements and not to such accounts. Nevertheless, this provision may provide relief for borrowers who were once classified as such from obtaining credit.

Further, for the first time, the framework uses the word “technical write-off”, which is, however, not something new as it was a common practice among lenders to write off NPAs while still trying to recover the same.

1. https://en.wikipedia.org/wiki/Cooling-off_period_(consumer_rights)