The final word on secured lending

In a judgment delivered on February 27, the Supreme Court held that the Debt Recovery Tribunal (DRT) Act and Securitisation Act do not create first charge in favour of banks, financial institutions and other secured creditors and the provisions contained in Section 38C of the Bombay Sales Tax Act and Section 26B of the Kerala Sales Tax Act are not inconsistent with the provisions of the DRT and Securitisation Acts so as to attract non-obstante clauses (overriding provisions) contained in Section 34(1) of the DRT Act or Section 35 of the Securitisation Act.

The Supreme Court also held that the principle of interpretation that a later law prevails over the earlier one by itself will not render the state legislation void to the extent of inconsistency with the central legislation. The Supreme Court also held that if Parliament intended to give priority to the banks, financial institutions and other secured creditors over the first charge created under the state legislation, then Parliament should have enacted provisions similar to Section 529A of the Companies Act under the DRT Act and the Securitisation Act.

The effect of the Supreme Court judgment is that claims of the state government for arrears of sales tax and other taxes, if given a statutory first charge over the properties of the assessee, will have priority over the claims of secured creditors. This further means that banks and financial institutions will have to continuously monitor and ensure that borrowers regularly pay their taxes.

It may be possible for banks to obtain periodical declarations from borrowers to confirm that they have paid all the taxes. But taxation laws, whether state or central, do not contain any provision for issue of any certificates by the tax authorities confirming that the assessee has paid all the tax dues. In the absence of such a provision in the taxation laws, any declaration obtained from the borrower will not be binding on the tax authorities.

The judgment dilutes the rights of banks under the DRT and Securitisation Acts.The lending activity of banks will have to be on the basis of the strength of the balance sheet of the borrower and for short-term purposes. Term lending for capital expenditure and project financing will be rendered difficult and in the process while the big corporates may continue to have access to bank finance, the small and medium sector will face difficulties in obtaining finance from the banks.

It is well-established that credit is the driving force of the economy and higher growth rates can be achieved if the legal system recognises utilisation of full value inherent in assets to obtain credit and extend priority to secured creditors over all other claimants including the revenue. In other words, if the lender has the comfort that in the event of default he will have the right to sell the assets created by using his funds, he will be willing to lend but if such assets are subject to some statutory first charge, he would be reluctant to lend.

The state and central governments need to appreciate that high levels of revenue collection can be achieved by recognising secured lending in the economy and by conceding priority to secured creditors over tax arrears. The government has to realise that it is not a prudent policy to assert priority of the government claims (crown debts) over sale proceeds of assets of insignificant number of failed business enterprises.

It is to be seen whether the RBI, central and the state governments appreciate the need to recognise secured lending and make specific provisions in the relevant laws to trigger further growth in the economy by using intrinsic value of assets for extending credit.

Chief Adviser (Legal), IBA (Views expressed are personal)