Ordinance puts depositors ahead of secured creditors

By Devyani Dhawan and Jyotika Bajaj, SNG & Partners

The last three decades have seen an unprecedented rise in dubious deposit-taking schemes run by unscrupulous operators in various parts of India such as the Saradha Realty scam, the MPS Greenery scheme and the Rose Valley scheme. The Reserve Bank of India reported that 978 unregulated deposit schemes were passed to regulators and law enforcement agencies for action between July 2014 and May 2018.

In spite of having laws such as the Prize Chits and Money Circulation Schemes (Banning) Act, 1978, and the Chit Funds Act, 1982, the absence of a general prohibition on unauthorized deposit-taking and a large number of unregulated activities and unregistered companies result in a lot of small investors being deprived of their life savings.

Devyani Dhawan
Principal associate
SNG & Partners

There was an urgent need to have a framework to deter unauthorized deposit-taking in the country, which led to the Banning of Unregulated Deposit Schemes Ordinance, 2019 (ordinance).

The ordinance bans all deposits, except those that are specifically regulated under other statutes, and those that are stated as such in the ordinance, such as deposits regulated by the Securities and Exchange Board of India, the Ministry of Corporate Affairs and other regulators.

Further, the term deposits itself excludes from its ambit certain transactions so that genuine dealings are not impacted – these include loans from banks or financial institutions, amounts paid under foreign exchange regulations and amounts genuinely received in the course of business.

However, one aspect of the ordinance could be detrimental to secured creditors of an entity. Section 12 of the ordinance requires that where a person makes deposits under a Ponzi scheme or any other scheme that is banned by the ordinance, repayment of the amounts due to the depositors takes priority over the payments of all other debts of the deposit takers.

Jyotika Bajaj
Senior associate
SNG & Partners

The ordinance is silent as to what constitutes “all other debts” and is open to a wide interpretation, which can be construed to include all secured and unsecured debts.

However, this priority status accorded to depositors has been made subject to the priority order set out under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI), and the Insolvency and Bankruptcy Code, 2016 (IBC).

According to SARFAESI, the secured creditor is placed over other creditors for payment of proceeds from the enforcement of the particular assets charged for securing the creditor’s interest in case of enforcement of security. Under the IBC, in the case of distribution of liquidation proceeds, the secured creditor is placed over unsecured creditors.

A reading of the above implies that while in case of enforcement of security interest under SARFAESI or liquidation proceedings under IBC, the secured creditors would be given priority over such depositors, however, in the ordinary course of repayment, the depositors are likely to get paid before all other creditors, including secured creditors. This interpretation is also supported by the ordinance’s objective of protecting the interests of depositors.

This may not be a happy scenario for the secured creditors if in case a borrower has in fact taken illegal deposits, repayment of dues to the secured creditors, in the ordinary course, would become subservient to the repayment of dues of the depositors.

This could have the effect of possibly pushing a loan account towards a default, and it could also impact the escrow mechanism devised by creditors to tap receivables of a borrower for repayment of dues.

Therefore, it is crucial for the creditors to conduct a thorough due diligence on proposed borrowers to ascertain whether such illegal deposits have been or are being accepted. Further regular financial checks at periodic intervals will also be needed. While the priority of repayments under SARFAESI and the IBC has been protected under the ordinance, the standing committee on finance, in its January 2019 report, recommended the removal of even this priority on the rationale that it would be contrary to the legislative intent of the ordinance as it will effectively place depositors at the bottom rung of the ladder.

This, however, is only an interpretation of the possible consequences of section 12 of the ordinance and unless a clarification is issued by the regulator this could throw up significant concerns for secured creditors.

SNG & Partners has offices in New Delhi, Mumbai and Singapore. Devyani Dhawan is a principal associate and Jyotika Bajaj is a senior associate.


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