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How not to draft regulation

RBI rules on wilful default are a throwback to the age of khap panchayats.

Written by Ajay Shah |
September 16, 2014 2:14:34 am
Giving any one bank the power to inflict a boycott by all banks is a throwback to the age of khap panchayats. (Source: Reuters photo) Giving any one bank the power to inflict a boycott by all banks is a throwback to the age of khap panchayats. (Source: Reuters photo)

The September 9 ruling of the Gujarat High Court has raised questions about RBI regulations on “wilful default”. While India needs to do much more to strengthen 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 warrant losing sight of constitutional principles.

Say there are two persons, P and Q. You have a contractual dispute with P. When P becomes unhappy with you, the law requires Q to 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 or balances. Such an arrangement would raise many questions.

The RBI’s approach to wilful default is similar. If a bank, P, determines that your default is wilful, all other banks are forced to punish you. P gives you a bad name, and then all other banks, Q, are forced — by RBI regulations — to hang you. The formal processes of enforcement are missing. Non-state actors don’t have the appropriate skills or incentives when it comes to justice. There is no mechanism for judicial review either. The RBI’s regulations on wilful defaulters violate principles of the rule of law.

A khap panchayat engineering a village-wide boycott against someone it deems to be an offender is not the rule of law. If a law has been broken, the case should go through the due process of a chargesheet and a judge, and then the state should punish the guilty. Giving any one bank the power to inflict a boycott by all banks is a throwback to the age of khap panchayats. The September 9 Gujarat High Court ruling expressed some of these problems. But the trouble with the RBI’s regulation on wilful default runs much deeper. India does have a problem with promoters who borrow and then fail to repay.

But our outrage with their behaviour does not justify abandoning the foundations of liberal democracy. We must not indulge in knee-jerk responses. The way forward involves solving the deeper problems of corporate bankruptcy while being anchored in sound legal philosophy.

We must question the tag, “wilful”. Debt is a contract, and default is a violation of the contract. The intent of the person who violates the contract is impossible to assess and irrelevant for the purpose of enforcement. What we need is a 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 bankruptcy code must be grounded in the rule of law and avoid superficial responses such as the RBI’s approach to wilful default. The process design used by the Financial Sector Legislative Reforms Commission led by Justice B.N. Srikrishna was quite effective and has resulted in a high-quality draft Indian Financial Code. Many elements of this process design could be utilised for drafting the Indian bankruptcy code.

RBI Governor Raghuram Rajan has criticised the FSLRC on the question of judicial review of the central bank’s regulatory decisions. RBI regulation on wilful default and actions taken in its pursuance are a good test case for this debate. Rajan would like the RBI to have the power to write subordinated legislation of this nature without checks or balances. He argues for “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” is often a euphemism for unchecked executive discretion.

Nobody should be allowed 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 — the Gujarat High Court ruling is one such example. The proposed Financial Sector Appellate Tribunal would do better, on speed and domain knowledge, than 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. Draft regulation must be made public for comment, and approval of the relevant regulatory agency’s board must be obtained. Public feedback and board scrutiny would most likely catch some errors and improve the regulation. Adopting such a procedure might have blocked the wilful-defaulters regulation before it reached the courts. At present, a large number of regulations are issued by financial agencies without any discussion or oversight of the board, and without soliciting public comment.

For all financial regulators, building the intellectual capital to understand law and economics and the rule of law is a complex objective that will take time to achieve. In contrast, rolling out better processes for regulation-making is a concrete and actionable initiative that can be achieved in the short run. The ministry of finance would do well to take this up with the boards of all regulators and pass a resolution that clearly lays out the regulation-making process.

The writer is professor, NIPFP, Delhi

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