Inadequate & Fragmented Legal Framework for Recovery: The Case of India’s Small-Value Unsecured Debt

A FEW DECADES BACK economist, banker and Nobel laureate Mohammad Yunus famously stated that access to  credit should also be a human  right. He provided micro credit to vast masses of poor women and 96 per cent of the loan amount was paid back by them. They were truly credit worthy. 

But when we move beyond micro credit and deal with credit in India, which is below INR 20 lakh,  the challenge of recovering the amount confronts the lender in a big way. This is particularly when   our country  has made borrowing easier than it has ever been. Digital banking, credit cards, personal loans and other forms of unsecured credit have brought formal borrowing to a much larger section of the population. A loan can now be sanctioned and disbursed with a speed that would have been difficult to imagine a few decades ago.

But what happens when the borrower does not repay?

For a secured loan, there is a familiar answer: the lender has an asset against which it can proceed. For larger institutional debts, specialised recovery forums are available. But it has been stated  earlier that when the debt is unsecured and below INR 20 lakh, the position is less straightforward.

The lender is not without a remedy. The problem is that the remedies available do not, taken together, provide a coherent recovery mechanism for this class of debt.

The limits of existing routes

The SARFAESI Act is fundamentally a secured recovery statute and offers no remedy where debt is wholly unsecured. The Debts Recovery Tribunals, meanwhile, provide a specialised forum for banks and financial institutions, but their ordinary pecuniary jurisdiction is subject to a statutory threshold of INR 20 lakh.

This leaves a significant category of cases outside both.

An unsecured debt below INR 20 lakh has no security to enforce under SARFAESI and falls outside the ordinary DRT jurisdiction. The lender is consequently pushed towards the civil courts, along with whatever other remedies may be available on the facts.

The Insolvency and Bankruptcy Code does not fill this gap either. While Part III deals with insolvency and bankruptcy of individuals and partnership firms, the provisions brought into force in 2019 concern personal guarantors to corporate debtors. It is not a general insolvency route for an individual who has simply defaulted on a personal loan or credit-card liability.

What remains, therefore, is principally conventional civil litigation supplemented, where applicable, by other statutory remedies.

This is where the distinction between the existence of a remedy and the adequacy of a recovery framework becomes important. It means that the law does not leave the creditor remediless but the available remedies do not necessarily form a coherent mechanism for this particular class of debt. Let's take a close look at how.

Civil courts: a remedy, but not necessarily the solution

A civil suit is, of course, available. A creditor can establish its claim and seek a decree.

But unsecured lending operates on volume. A bank or financial institution may have thousands of accounts in default. Requiring every disputed account to move through ordinary civil litigation and then, potentially, execution proceedings raises a practical question.

Civil courts can decide these disputes. The question is whether conventional litigation is proportionate when such claims arise in very large numbers and individual claims may not justify prolonged litigation.

What happened to arbitration?

Arbitration was another contractual route available to lenders where disputes could be determined outside ordinary court proceedings.

The position became more complicated after the Supreme Court’s decision in Perkins Eastman Architects DPC v HSCC (India) Ltd., which dealt with unilateral appointment of arbitrators by an interested party.

The judgment did not make arbitration unavailable. It remains possible where the agreement and appointment mechanism comply with law. But lender-controlled appointment arrangements could no longer operate in the same manner.

For small-value unsecured claims, this matters. Arbitration carries its own costs and procedures. If the contractual mechanism becomes difficult to operate, arbitration cannot simply be treated as a substitute for a dedicated recovery forum.

Reliance on payment-instruments litigation 

Another part of the problem can be seen in the reliance on payment-instrument dishonour proceedings.

Section 138 of the Negotiable Instruments Act, 1881 provides for penal consequences where a cheque issued towards discharge of a legally enforceable debt or liability is dishonoured. Section 25 of the Payment and Settlement Systems Act, 2007 similarly deals with dishonour of certain electronic fund transfers.

These provisions encourage payment discipline. But the dishonoured instrument and the underlying debt are not always the same thing.

A cheque may represent one instalment even though several remain unpaid. The outstanding loan may also include interest and other contractual amounts. A credit-card account may involve a continuing series of transactions.

A dishonour proceeding, therefore, is not necessarily a complete mechanism for determining all issues relating to the underlying credit relationship.

Lok Adalat is another avenue, particularly in payment-instrument litigation. But its consensual nature is also its limitation. If the parties do not settle, there is no adjudication of the dispute. It cannot substitute for a mechanism capable of determining and enforcing an unresolved debt.

The executive alternative 

There are also State-level public-money and revenue-recovery mechanisms which, depending on the applicable law, can provide a route for recovery of certain debts owed to banks and financial institutions.

But here too, the position varies. Their operation depends upon State law and the administrative machinery implementing it.

Revenue authorities and Executive Magistrates have many responsibilities apart from debt recovery. Its effectiveness can therefore depend upon the workload and capacity of the administration. Therefore certainly not an easy fit for a credit market that increasingly operates at a national scale.

Why does this matter?

Because small-value debt is not necessarily small in aggregate.

Unsecured lending works on volume. One default may not mean much to a large financial institution. Thousands of such defaults do. The cost and time involved in recovery, and the likelihood of eventual recovery, form part of the economics of lending.

Prolonged litigation can add to operational costs, affect provisioning and reduce the expected recovery from distressed accounts. Recovery, therefore, is not merely a problem that arises after a loan goes bad. It is part of the lending equation itself.

The need to acknowledge the inadequacy 

The answer, however, cannot simply be to make recovery easier for creditors. Any recovery mechanism must preserve due process, genuine borrower defences and safeguards against coercive or abusive practices.

At the same time, those safeguards should not mean that genuine defaults have to navigate a fragmented set of remedies, each designed for a different kind of problem.

That is the gap this discussion points to. Civil courts, arbitration, payment-instrument proceedings, Lok Adalat and State-level recovery mechanisms each have a role. But none of them, individually or together, was designed as a dedicated mechanism for resolving the large volume of small-value unsecured debt that exists today.

The question, therefore, is not merely how to recover a debt. It is whether the law has an appropriate mechanism for dealing with this category of debt in the first place.

India has spent considerable effort expanding access to formal credit. The next question is what the law should do when that credit fails.

Shubham Saxena and  Udayan Sharma are In-house Counsel at HDFC Bank & contributors to Bar and Bench.