• Supreme Court holds that RBI’s Master Circular on wilful defaulters applies to non-funded transactions such as derivative contracts.
• Supreme Court holds that credit information of a defaulter on non-funded obligations to banks is information which the RBI can request from such banks. There is no right of confidentiality/privacy in respect of such information.
• Supreme Court applies principle of literal interpretation and holds that other RBI circulars cannot be relied on to interpret the Master Circular on wilful defaulters.

In Kotak Mahindra Bank Limited v. Hindustan National Glass & Industries Limited & Ors.¹ (“Ruling”), the Supreme Court of India (“Supreme Court”) considered whether the RBI Master Circular dated July 1, 2008, on Wilful Defaulters² (“Master Circular”) would be applicable to defaults on derivative transactions.³ This issue arose in appeals in three separate cases presenting an interesting scenario with the Calcutta High Court ruling that that the Master Circular was not applicable to derivative transactions (“Calcutta Case”)⁴ and the Bombay High Court ruling that the Master Circular applied to derivative transactions (“Bombay Case”).⁵ Analyzing the provisions of the Reserve Bank of India Act, 1934 (“RBI Act”) and the powers of the Reserve Bank of India (“RBI”) set out in the RBI Act and the Banking Regulation Act, 1949 (“Banking Act”), the Supreme Court held that the Master Circular applied to derivative transactions and that the Master Circular would also apply to non-funded obligations, such as a guarantee. The Supreme Court noted that the Master Circular was an initiative taken at the instance of the Central Vigilance Commission (“CVC”) to ensure that there was greater coordination among banks regarding willful defaulters. Consequently, the Master Circular would have to be interpreted in the context of the purpose it sought to achieve, namely, sharing of credit information relating to defaulters and preventing access of finance to such defaulters.

In three separate and distinct transactions, three different entities⁶ (the “Company”) entered into a foreign currency derivative transaction and executed a Swaps and Derivatives Association Master Agreement (“Derivatives Agreement”) with three different banks⁷ (the “Bank”). The Company was sanctioned limits under the Derivatives Agreement and when the Derivative Agreements lapsed, the Company failed to pay the Bank as per the Derivatives Agreement. The Bank issued a notice to the Company classifying it as a willful defaulter under the Master Circular. The Company challenged the classification before the Bank’s Grievance Redressal Committee which upheld the classification. The Company challenged the classification before the jurisdictional High Court in a writ petition. In the Calcutta Case, the High Court held that default on the Derivatives Agreement would not be covered by the Master Circular. The Calcutta High Court reasoned that the Master Circular applied only to lending transactions (since the Master Circular used the expression ‘lender’) and hence was not applicable to derivative transactions.

In contrast, in the Bombay Case after an analysis of RBI Act, Banking Act and circulars on prudential norms, asset classification, non-performing assets etc.⁸, the court concluded that the Master Circular applied to derivative transactions.

The Supreme Court had to reconcile two conflicting judgments and the relevant laws. In the Ruling, the Supreme Court did not examine whether Company was in fact a willful defaulter – the scope of examination was restricted exclusively to whether the Master Circular would apply to derivative contracts and consequently, the Supreme Court did not consider facts specific to the Calcutta Case or the Bombay Case.

The Supreme Court held that the Master Circular applied to derivative transactions. More importantly the court held that although RBI had articulated its interpretation, ultimately, it was incumbent on the court to interpret the Master Circular. The Supreme Court rejected the narrow approach in the Calcutta Case and the wide approach in the Bombay Case and held that the Master Circular had to be read in the ’context of the subject matter’¹¹, namely, Banking Act and the RBI Act. The Ruling noted that the purpose of the Master Circular was to have a system to disseminate credit information pertaining to willful defaulters among banks and financial institutions so that no further finance is available to such entities. The Supreme Court relied on a CVC letter, dated November 27, 1998, on the subject ’improving vigilance administration in banks’ to ensure that RBI had all information relating to willful defaults and not just defaults by borrowers. The Master Circular was to ’put in place a system to disseminate credit information pertaining to willful defaulters..’ and hence the purpose of the Master Circular was to share information and ensure that no credit was provided to defaulters. The Ruling noted that clause of 2.6 of the Master Circular covered even guarantee transactions and thus, non-funded transactions were also covered by the Master Circular. In conclusion, the Ruling also rejected the contention of violation of privacy and sets out the power of RBI to call for information for the purpose of regulating credit and monetary policy. In this regard, the Ruling has held that the Master Circular does not have the effect of blacklisting a client.

The Ruling highlights the approach to be followed by RBI in interpreting notifications released by RBI – a notification should be applied in the context of the subject of the relevant notification and the relevant parent laws. Although this interpretation has been given in the context of RBI, it is arguable that a similar approach is to be followed in the context of other regulators such as the Telecom Regulatory Authority of India, Securities and Exchange Board of India etc. Therefore, the exercise of powers must be in relation to the subject notification and cannot extend beyond that.

From the perspective of the law on derivative transactions, the Ruling examined FEMA Derivative Regulations but did not examine derivative transactions either from an accounting perspective or with reference to the underlying transaction. It is possible that a closer examination of the underlying transaction or the derivative transaction could have led the court to a different conclusion based on the funding principle. The Supreme Court has instead proceeded on the basis of an overarching principle that a derivative transaction creates a payment obligation¹² and the object of the Master Circular. Interestingly, the International Monetary Fund has explained derivative transactions to be instruments unlike debt instruments in respect of which no principal is to be repaid.¹³

Companies must therefore take into account the above principle of interpretation of statutory notifications while engaging in transactions. Specifically, companies should be aware of the considerations that weigh with the RBI while evaluating whether a non-funded transaction would be covered by the Master Circular.