a fundamental flaw in the banking companies (recovery of loans, advances, credits and finances) act, 1997

A FUNDAMENTAL FLAW IN THE BANKING COMPANIES (RECOVERY OF LOANS, ADVANCES, CREDITS AND FINANCES) ACT, 1997 A FUNDAMENTAL FLAW IN THE BANKING COMPANIES (RECOVERY OF LOANS, ADVANCES, CREDITS AND FINANCES) ACT, 1997 By Sohaib Khalid Ishaque, Advocate, Sindh High Court The Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act, 1997 was legislated by the Parliament to consolidate and re enact, with some modifications, the Banking Companies (Recovery of Loans) Ordinance, 1979 and the Banking Tribunals Ordinance, 1984. Whereas the Special Banking Courts set up under the 1979 Ordinance had jurisdiction to deal with cases involving both interest and non‑interest based finance provided by banking companies, the 1984 Ordinance was promulgated to establish special banking tribunals to exclusively try cases involving non‑interest based finance. Under section 5(3) of the 1984 Ordinance, the jurisdiction of other Courts was barred with respect to any matter to which the jurisdiction of banking tribunals extended under the Ordinance. The 1979 and 1984 Ordinances were enacted for the specific purpose of facilitating recovery of loans, credits and finance provided by banking companies as it was felt that the ordinary remedy of filing recovery suits before Civil Courts was not efficacious for such purpose. Both these Ordinances, obviously in view of the intention behind their promulgation, were heavily inclined in favour of the lenders, and contained drastic provisions in an attempt to provide effective and expeditious means of recovery for banking companies and financial institutions. The 1979 law followed the summary procedure laid down under Order XXXVII of the Civil Procedure Code which requires the defendant to seek leave from the Court in order to defend the suit filed against him. The 1984 law went further and allowed the defendant only 10 days time to show cause why a decree as prayed in the plaint should not be passed against him. Both laws allowed notice of the proceedings filed thereunder to be served on a defendant by mere publication in any newspaper. As a result of this method of serving notice and the short period of time in which a defendant was required to file his reply to the suit, a number of defendants found themselves debarred from defending the recovery proceedings filed against them. While, the 1979 Ordinance allowed banking companies a two‑year extension in the limitation period for filing their recovery actions, the 1984 Ordinance completely barred the application of the Limitation Act on any suit, application or other proceedings filed thereunder by a banking company. In sharp contrast to the 1979 Ordinance, the 1984 law only allowed the lenders to institute proceedings under it‑‑the 1979 Ordinance permitted both the banking companies as well the borrowers/customers to file proceedings thereunder. The 1984 law also contained a number of draconian measures against the defendants. Its section 6(6) provided that in case the recovery proceedings continued beyond a period of 90 days from the tiling of the plaint, the defendant would be asked to furnish a bank guarantee acceptable to the banking tribunal to the extent of the claim in the suit, and that upon failure of the defendant to so furnish a bank guarantee within a period of 15 toys, the tribunal shall pass a decree in favour of the banking company as prayed in the suit. The Ordinance also went on to provide that m case the proceedings continued beyond a further period of 120 days, the defendant shall deposit with the banking tribunal in cash the amount claimed in the plaint, and that on failure of the defendant to make such a deposit within 15 days, the tribunal shall pass a decree in favour of the banking company as prayed for in the plaint. Section 9, containing the appeal provisions of the Ordinance, also required the defendant to deposit the amount claimed in the suit, or the decretal amount, in order to have his appeal entertained by the High Court. Despite the presence of such extreme provisions, the workability of these Ordinances proved to be fairly unsatisfactory. Contrary to the contemplation behind their enactment, they failed to ensure the swift disposal of recovery cases. The constitutionality of certain provisions of the 1984 Ordinance also came to be challenged before the Lahore High Court in the case of Ramzan Sugar Mills Ltd. v. Habib Bank Limited (PLD 1996 Lah. 672). The Lahore High Court declared that sections 6(6) and 9 of the 1984 Ordinance were unconstitutional. It was held by the Court that the provisions of section 6(6) to the effect that delay for any reason whatsoever must result in allowing the claim of the banking company, and in the passing of a decree, were not only unreasonable, unjust, unfair, despotic, and also amounted to legislative judgment, and were thus liable to be struck down. The Court also held that the right of appeal having been made subject to the condition of deposit amounted to negation of the right of appeal itself. The Court expressed the need for enacting a provision similar in nature to that of section 12 of the 1979 Ordinance which vested the discretion of the Court to dispense with the condition of deposit of decretal amount and to instead order the furnishing of security so that public dues, especially those advanced under the Islamic mode of financing, were not stuck up Later, in the case of Abdul Rahim and others v. United Bank Limited (PLD 1997 Kar. 62) the Sindh High Court also declared that the provisions of section 6(6) and section 9 of the 1984 Ordinance could only be looked upon as being directory and not mandatory. However, in the case of Tank Steel and Re Rolling Mills (Pvt.) Ltd. and others v. Federation of Pakistan and others (PLD 1996 SC 77) the Supreme Court of Pakistan declined to examine the question whether the provisions of section 6 of the Banking Tribunals Ordinance violated the Injunctions of Islam on the ground that the power to review legislation on the touchstone of Islamic Injunctions vested solely with the Federal Shariat Court. The main object behind the enactment of the two Ordinances was to provide an effective machinery for the expeditious disposal of recovery cases filed by banking companies and other financial institutions so that the considerable difficulties faced by them in recovering their outstanding dues were removed. However, despite such well‑intentioned purposes, the functionality and effectiveness of the Ordinances proved to be wholly inadequate. The 1984 Ordinance contemplated disposal of recovery suits within a maximum period 210 days, however, even the cases filed thereunder remained pending for several years. Furthermore, even the superior Courts found it unconscionable and unreasonable to give effect to the very provisions which has been specifically designed to facilitate the early disposal of recovery cases filed by banking companies. As such, it came as no surprise when it was decided to consolidate the two Ordinances, and to re‑enact the recovery law, with improvements and modifications, in line with the observations of the superior Courts in various judgments, and to meet with the impediments encountered in the enforcement of the two laws. Hence the enactment of the Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act, 1997. Having been enacted recently, it may be a bit early to gauge the effectiveness of the 1997 Act and to judge whether it will operate as smoothly as desired. However, at least in theory, the Act attempts to make a number of improvements over the old laws. It also endeavours to strike a balance between the interests of the banking companies and those of the borrowers/customers by tempering the provisions of the old laws and by introducing some new provisions which were badly needed to curb certain improper practices that had developed in relation to banking transactions. Some of the significant measures put into effect by the Act are‑‑ (i) not only the banking companies but also their borrowers/customers may file proceedings before the Banking Court constituted under the Act. It may be recalled that, while under the 1979 Ordinance, banking companies as well as their borrowers could institute proceedings, the 1984 Ordinance permitted only banking companies to file proceedings under' its provisions. The Act has now allowed all aggrieved bank borrowers/customers to bring their proceedings, whether in relation to interest or non‑interest based finance, to the banking Courts; (ii) a banking company may, within 3 years of the coming into force of the Act, file a suit for recovery of any amount written‑off, released or adjusted on any day on or after 1‑1‑1990 and before the coming into force of the Act, if it can establish that the amount was written‑off, released or adjusted for political reasons or for considerations other than bona fide business considerations. Although the cut‑off date of 1‑1‑1990 in the above provisions may be questioned on the ground of discrimination, yet it is difficult to disagree with the intention behind this provision, viz., that influential borrowers/customers should not be allowed to get away with the illegal and improper write‑off, release or adjustment of the finance availed by them; (iii) a procedure for leave to defend has been adopted under the Act with a power to the banking Court to pass an interim decree to the extent that the plaintiff's claim is undisputed. A 21 days' time has also been given to the defendant to seek leave to defend the suit filed against him, and it has further been provided that where service has been effected only through publication in the newspapers, the Banking Court may extend the time for filing an application for leave to defend, if satisfied that the defendant did not have knowledge of such publication; (iv) in line with the observations of the superior Courts, the Banking courts have also been given a discretion to require the defendant to furnish a security in such amount as the Court thinks fit, if the suit filed under the Act is not disposed of within 90 days leave to defend being granted. It has further been provided that the requirement of furnishing security shall be dispensed with if, in the opinion of the Banking Court, the delay is not attributable to the conduct of the defendant; (v) the expeditious trial of cases under the Act has been attempted to be ensured by providing that only in exceptional circumstances and only upon reasons to be recorded will the Banking Court allow adjournments for more than 7 days in any case; (vi) the requirement to pass a preliminary decree in mortgage suits has been dispensed with, and the Banking Court has been empowered to directly pass a final decree of foreclosure; (vii) banks have been prohibited from obtaining signatures of a borrower or customer on banking documents which contain blanks in respect of important particulars, including the date, the amount or the period of time in question. This provision is quite praiseworthy as it will hopefully put an end to a most reprehensible practice that has developed among bankers which is to obtain signatures of their borrowers/customers on blank documents, and later to fill them in as they desire. By placing such a prohibition on banks, the provision takes into account the critical observations of the Hon'ble Sindh High Court on this practice in the above‑cited judgment reported at PLD 1997 Kar, 62; (viii) in similar vein, and to reinforce the above prohibition, the Act also requires, for removal of doubt, all banking agreements executed between bank and a customer/borrower to be attested in the manner laid down in Article 17 of the Qanun‑e‑Shahadat, 1984. The said Article requires attestation of all instruments relating to financial or future obligations by at least 2 witnesses; (ix) the appeal provision in the Act, unlike the appeal provision in the 1984 Ordinance, does not make the deposit in the appellate Court of the amount claimed in the suit, or the decretal amount, a pre‑condition, for the entertainment of the appeal. The said provision, however, rather innovatively, states that the admission of the appeal would not per see operate as a stay of the decree passed, and that no stay shall be granted in the appeal unless the appellant deposits in cash with the high Court (the appellate Court) an amount equal to the amount due, or, at the discretion of the High Court, furnishes security equal in value to such amount. This provision thus attempts to mitigate the rather onerous provisions of appeal as contained in the 1984 Ordinance; (x) the Act also makes the provisions of the Limitation Act applicable to all cases filed or instituted in a banking Court after the coming into force of the Act. In this connection, the Act also evolves a novel concept by providing that in relation to past transactions a fresh cause of action will be deemed to arise, for the purpose of limitation only, on the date on which the Act comes into force. The balancing Act of the 1997 legislation in relation to the interests of banking companies and those of the borrowers/customers is thus quite perceptible from the above provisions. There is, however, one area in which the 1997 Act appears to have fallen prey to a common misconception. Section 15(1) of the Act provides that: 15. Decree.‑‑(1) The decree shall provide for interest or mark‑up, as the case may be, on the judgment debt from the date institution of the suit to payment‑‑ (a) in the case of a loan, for interest at the contacted rate or at the rate of tw6 per cent. above the State Bank Repo rate, whichever is higher; and (b) in the case finance under a system not based on interest, for mark‑up at the contracted rate or at the latest rate of the banking company for similar finance whichever is higher. The provision is quite similar to section 8 of the 1979 Ordinance which provided that the decree of a special Court "shall provide for interest or return, as the case may be, on the judgment‑debt from the date of institution of suit till payment‑‑ (a) in the case of interest‑bearing loans, for interest at the contracted rate or at the rate of two per cent. above the bank rate whichever is the higher; (b) in the case of loans given on the basis of mark‑up in price, lease, hire purchase or service charges, for the contracted rate of mark‑up, rental, hire or service charges, as the case may be, or at the latest rate of the banking company for similar loans, whichever is the higher; or (c) in the case of loans given on the basis of participation in profit and loss, for return at such rate, not being less than the rate of annual profit for the preceding six months paid by the banking company on term deposits of six months accepted by it on the basis or participation in profits and loss, as the Special Court may consider just and reasonable in the circumstances of the case, keeping in view the profit‑sharing agreement entered into between the banking company and the judgment -debtor when the loan was contracted." There was a conceptual flaw in the above provision of the 1979 Ordinance with respect to the loans given on mark‑up basis. Under mark‑up based financing, the lender and the borrower enter into a mark‑up agreement under which the banking company advances a certain sum of money to the borrower as the sale price of certain goods sold by the borrower to the lender. There is a simultaneous buy‑back of the goods by the borrower from the lender at a purchase price which is marked‑up from the sale price. This purchase price; which is the marked‑up price, is payable by the borrower to the lender at a specified date or dates (if the repayment of finance is to be in Instalments) and constitutes the liability of the borrower towards the lender. An example may perhaps make the concept a bit clearer. Suppose a customer wants to obtain a loan of Rs.100 from a bank, and the bank is agreeable to provide such a loan to him. A mark‑up agreement would then be entered into between the bank and the customer whereby the customer would sell certain goods (specified in the mark‑up agreement) to the bank for a sale price of Rs.100. The bank would advance this sum of Rs.100 to the customer who would simultaneously agree, under the terms of the mark‑up agreement, to buy‑back the goods from the bank at a marked‑up purchase price of say Rs.120. This purchase price of Rs.120 thus becomes the liability of the customer and contains the mark‑up amount of Rs.20. The crucial difference between interest‑based finance and mark‑up based finance is that while under the former banks could continue to levy and charge at the agreed rate a return on the amount lended, even after the expiry of the due date of repayment, in the latter mode of finance the banks cannot charge any such return after the expiry of the due date of repayment. In other words, the underlying simultaneous sale purchase transaction in mark‑up based lending prevents any increase in the fixed marked‑up price even if such price is not paid by the borrower to the lender on the agreed date. It is essentially this fixation of the return on the amount lended that distinguishes mark‑up based finance from interest based finance. Instead of allowing the mark‑up to increase or to continue to run (as in the case of interest) after the due date of repayment, the mark‑up agreements used by banks invariably provided for liquidated damages to be payable by the customer in the event of his failure to pay the marked‑up buy back price on time. Despite the above concept of finance based on mark‑up, banking companies treated mark‑up based financing as just another name for interest based financing, and charged mark‑up calculated at a daily rate from their borrowers, just as interest was charges on a daily basis in interest‑based transactions. As such, despite the fundamental difference between mark‑up based and interest based financing, mark‑up agreements continued to be entered into between banks and their customers where under the bank provided finance ostensibly under the mark‑up bases system, but instead continued to levy and charge interest on such finance under the garb of mark‑up. One could attempt to speculate the reason behind the banks treating mark‑up based transactions as essentially interest based ones, albeit with a different name. The reason may perhaps be that even the introduction of Islamic banking in Pakistan made no difference whatever as far as the banks' obligations towards their depositors were concerned. The banks felt obliged to give their depositors a fixed and guaranteed rate of return even under the profit and loss sharing deposit scheme, for the simple reason that no bank could afford to declare a loss in its deposits, and thus cause a run on itself. The banks, therefore, understandably felt constrained to keep accumulating their return in non‑interest based transaction, just as they accumulated interest in transactions based on interest. This the banks felt compelled to do in order to recover enough' revenue to keep paying profit to their depositors. They found themselves in a situation where, in order to survive commercially, they could not afford to transfer to, or share with, their depositors the risk of loss in banking transactions and, at the same time, felt constrained to bear such risk themselves. It was perhaps because of such considerations that section 8(2)(c) of the 1979 Ordinance provided that in a recovery case involving a loan given on the basis of participation in profit and loss, the decree passed by the Special Court shall provide a return on the judgment debt at a rate not less than the rate of the annual profit for the preceding six months paid by the banking company on term deposits of six months accepted by it on the basis of participation in profits and loss. The banks however not only started piling‑up mark‑up in all non interest based transactions, whether or not such transactions were based on mark‑up, but even charged mark‑up on mark‑up from their defaulting customers by compounding it just like they compounded interest in interest‑based transactions. This the banks did despite the fact that conceptually such action on their part negated the very principle of non‑interest based finance. Confusion was also created as to how mark‑up based finance was to be implemented in practice. It was not entirely clear how certain banking transactions, such as running finance, for instance, could be harmonised with the mark‑up based system. No clear‑cut and effective directions or guidelines were also issued by the State Bank to clarify matters in this regard. The entire concept of mark‑up based financing thus came to be viewed as just a new and Islamized name for the old interest based lending. A fundamental error therefore crept into section 8 of the 1979 Ordinance seemingly because of the way the concept of mark‑up based finance was being understood and applied in banking circles. The said section 8 required that the decree passed by the Court shall provide for mark‑up on the judgment debt from the date of institution of the suit till payment. Such a requirement completely ignored the fact that mark‑up based financing was essentially based on a sale‑purchase transaction, and that the moment any mark‑up amount over and above that provided in the mark‑up agreement was allowed to be recovered from the customer, the basic difference between mark‑up based financing and interest‑based financing was completely obliterated. This error was perhaps realized while promulgating the 1984 Ordinance for that legislation contained no such provisions allowing for mark‑up to be granted from the date of institution of the suit till payment. Instead, the said Ordinance recognized the conceptual impossibility of granting such mark‑up and, as such, allowed for liquidated damages to be paid over to the plaintiff in the event of the defendant's failure to satisfy the decree within 30 days. See section 11(4) of the 1984 Ordinance. Thus, in so far as section 15 of the 1997 Act provides for the grant of mark‑up from the date of institution of the suit till payment, the same mistake that was made in the 1979 Ordinance has unfortunately been repeated. The provisions of section 15 not only allows, but in fact requires, mark-up to be accumulated during the pendency of a recovery suit filed under the Act. The Court has no discretion but to allow mark‑up on the decretal amount from the date of institution of the suit till actual payment. The basic difference between mark‑up based and interest‑based finance has thus been completely nullified. It may be relevant to reproduce here the following observations of the Hon'ble Sindh High Court in the case of Habib Bank Limited v. Farooq Compost Fertilizer Corporation (1993 MLD 1571): "Word 'finance' within the meanings of section 2(e) of the Banking Tribunals Ordinance, 1984, does not involve any equivalent of interest and by its own force does not carry returns beyond the stipulated period unless emanating in due course of law of expressly covenanted, again within the framework of law. In the relevant agreement, envisaging sale and purchase of goods, no such term (finance) nor perhaps a term to that effect could be improvised, the reason being that such an improvisation may have exposed itself as a degenerative, relegating the transaction to one carrying interest. Patently, a provision of sale and repurchase of the goods within periods specified (Bai Mujjal), culminating in repurchase, is calculated to advance the concept of trade and to forestall the extension of interest." In the said case, the Hon'ble High Court upheld the decision of he banking tribunal which disallowed any mark‑up to the banking company beyond the period of the mark‑up agreement, and extended it only for the cushion period of 210 days contemplated under the Ordinance for the institution and conclusion of recovery proceedings tiled thereunder. It is respectfully submitted that the above judgment in so far as it allowed mark‑up to be recovered for the cushion period of 210 days, beyond the period of the mark‑up agreement, also failed to properly deal with the concept of mark‑up. After itself observing that no return beyond the stipulated period (i.e., stipulated under the finance agreement) could be recovered under finance as defined by section 2(e) of the 1984 Ordinance, the High Court should have refrained from allowing any mark‑up beyond such period. It is submitted that extending the recovery of mark‑up to even the so‑called cushion period of 210 days also introduced an element of 'interest' in a mark‑up based transaction, the entire point whereof is to fix beforehand the return on that transaction, and thereby to distinguish it from a transaction‑based on interest. The misunderstanding of the concept of mark‑up has also resulted in another serious flaw in section 15 of the 1997 Act. While section 8 of the 1979 Ordinance recognised that non‑interest based loans could be given on the basis of mark‑up in price, and also on the basis of lease, hire purchase or even service charges, section 15 of the 1997 Act completely ignores this aspect of the matter. Instead, it simply presumes that all systems of finance not based on interest have an element of mark‑up. As pointed out above, for finance to be based on mark up, there has to be an underlying sale purchase transaction which would lead to a marked‑up price being paid to the lender. Mark‑up means mark‑up, or an increase, or an increment, in, price. Without an underlying sale purchase transaction requiring a marked‑up buy‑back price to be paid to the lender there can be no financing on the basis of mark‑up. However, this is not to say that all modes of non‑interest based financing have to contain an underlying sale purchase transaction or have to be mark‑up based. As recognised in the Act itself, interest‑free finance does not have been founded only on mark‑up. In this regard it may be said that the provisions of section 15 are also somewhat inconsistent with those of section 2(e) of the Act which define "finance" as under: (e) "finance" includes an accommodation or facility under a system which is not based on interest but provided on the basis of participation in profit and loss, mark‑up or mark‑down in price, hire purchase, equity support, lease, rent‑sharing, licensing, charge or fee of any kind, purchase and sale of any property, including commodities, patents, designs, trade marks and copyrights, bills of exchange, promissory notes or other instruments with or without buy‑back arrangement by a seller, participation term certificate Musharika certificate, Modarba certificate, term finance certificate or any other mode other than an accommodation or facility based on interest and also includes credit or charge cards, guarantees, indemnities, letters of credit and any other obligation, whether fund‑based or non‑fund‑based, and any accommodation or facility the real beneficiary whereof is a person other than the persons to whom or in whose name it was provided." It is amply clear from the above provisions, which is virtually the same as that of section 2(e) of the 1984 Ordinance, that non‑interest based accommodation or facilities can be provided by banking companies in a number of modes other than mark‑up. All such modes, on the face of it, do not contain an element of mark‑up. The above reproduced provision lists 'mark‑up in price' as just one way of providing non‑interest finance, among many others. In fact the provision even recognises that non‑interest based financial facilities can be granted on the basis of a mark‑down in price'. It is submitted that by providing for the grant of mark‑up from the date of institution of the suit till actual payment in proceedings filed in respect of all modes of interest‑free finance, section 15 of the Act attempts, not only to allow interest to be recovered in the form of mark‑up, but also artificially interpolates an element of mark‑up in a transaction where :nark‑up has no place. It is reiterated that without the presence of an underlying sale purchase transaction there can be no basis for allowing mark‑up to be recovered in a financial or other transaction. A fortiori, there cannot be any basis for providing mark‑up on the decretal amount allowed by the Banking Court. Granting mark‑up on the decretal amount in all cases involving interest free finance would mean that the law would presume the existence of an inherent sale purchase of goods, and of a marked‑up price, under all modes on non -interest based financial transactions, even when there would be clearly no such elements present in all these transactions. Even more absurdly, the law would also presume the existence of a sale purchase of goods, and a mark‑up in price, underlying every decree passed by the banking Court. In view of the above discussion, it is submitted that the provisions of section 15 of the 1997 Act need to be immediately reviewed.