A banker’s bosom friend


The Sarfaesi Act aimed at strengthening the banks and lending institutions has triggered a large number of disputes that are clogging up the Indian court system say Neerav Merchant and Melvyn Fernandes at Majmudar & Partners

The collapse of Lehman Brothers in 2008 rocked the banking system to its core. It showed that the exit of a significant player in the banking sector can have a disastrous effect on the economy of a nation.

In India, the banking industry has been progressively complying with international prudential norms and accounting practices. However, the country’s banking industry has some catching up to do in the area of management of non-performing assets (NPAs) – an unhealthy build up of which can trigger chaos.

Neerav Merchant
Neerav Merchant

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, (Sarfaesi Act) was put in place to ensure that Indian banks have a system in place to check the mounting levels of NPAs. However, the Sarfaesi Act is often misused and many industry players argue that its provisions are draconian in nature. The Sarfaesi Act has created many instances where borrowers have been pressurized to settle at terms that may not be to their advantage, but which benefit the lenders.

This article looks at two key instances, where banks exercise discretion: (i) in the classification of an asset as a NPA, and (ii) in the regularization of a debt owing to a long-standing relationship with its borrowers.

Classification of a non-performing asset

The classification of a borrower’s account as a NPA is the trigger for a bank to initiate proceedings under the Sarfaesi Act. To this end, banks are mandated to adhere to the Reserve Bank of India (RBI) guidelines for classification of an asset as a NPA. However, there is no statutory format (either express or implied) that requires a bank to follow a particular or formal procedure, or a formal declaration, as a condition precedent to classifying a customer’s account as a NPA. Under the Sarfaesi Act, the banks have a wide margin of discretion to assess and classify a debt as a NPA.

In M/S Sri Srinivasa Rice and Flour Mill v State Bank of India, the court held that “a court is not constituted an appellate authority over the bank’s exercise of discretion in this area”. Further, in M/S Signal Apparels Pvt Ltd & Another v Canara Bank, the court held that the discretion granted to a bank while declaring a debt as a NPA should be exercised judicially and should be in consonance with the guidelines issued by the RBI.

Regularization of debt

Most often, when a bank takes action under the provisions of the Sarfaesi Act, the borrower requests the bank to settle the account by taking a hairline cut on the total monies that may be recoverable. Depending on the relationship with the borrower, the officials at the bank are at times willing to accept the borrower’s request.

However, banks have been accused of at times changing their stand even after the borrower has paid a substantial amount. This is despite guidelines from the RBI to settle such accounts under terms of the one-time settlement. While backtracking on the settlement reached with the borrower, the banks continue to take recourse under the Sarfaesi Act for recovering the entire sum of monies as may be due.

Often the bank and the borrower reach the settlement orally and the banks take undue advantage of the lack of any written record of it. Thus, it is advisable that borrowers ensure the settlement terms are recorded in a document, which can hold some evidentiary value if the bank tries to wriggle out from the settlement. Further, the onus should be on the banks to take care while accepting the settlement.


Action taken by Indian courts to curtail the discretionary powers granted to the banks under the Sarfaesi Act and the resultant hardships faced by borrowers have prompted amendments to the act.

While considering the constitutional validity of the Sarfaesi Act, including the provisions of section 13(2) and section 17(2) in Mardia Chemicals Ltd and another v Union of India and others, the Supreme Court held that “it is necessary to communicate the reasons for not accepting the objections raised by the borrower in reply to the notice issued to him under subsection (2) of section 13 of the Act”.

This prompted the introduction of section 13(3A) in the Sarfaesi Act whereby banks are now mandated to reply to the borrower’s objections after a securitization notice is issued. This has reduced the discretion granted to banks to proceed with the securitization of the asset.

In addition, the Security Interest (Enforcement) Rules, 2002, limit the discretion granted to banks to abort the planned sale – most often by auction – of a NPA if bids are expected to be lower than the anticipated price.

In spite of these amendments, the Sarfaesi Act is still considered to have tilted the balance of power in favour of the banks and as a result, courts continue to step in to regulate their discretionary powers. There is a continuing need for sufficient checks and balances to be built into the act, to ensure it can fulfil the purpose for which it was enacted and not be misused by the banks.

Neerav Merchant is a partner in the disputes practice of Majmudar & Partners where Melvyn Fernandes is a senior associate.