A. INTRODUCTION
A robust debt recovery mechanism is a pivotal element of any developed economy. The importance of establishing an effective legal framework to ensure expeditious and efficient recovery of debt cannot be overlooked in order to achieve sustainable economic and social development. It is the responsibility of the legislature as well as the judiciary to maintain a balanced commercial law structure to encourage lending whilst not discouraging borrowings. Securing such a mechanism is especially conducive for a stable banking sector. Banks are financial intermediaries who owe a special duty to its depositors. If a potent means of recovery of debt is not in place, banks will fail to secure the money entrusted in them by their depositors, which will discourage deposits, which in turn diminishes the lending power of a bank. Consequences thereof are inevitably severe to any emerging economy. Small businesses, especially, will gravely suffer due to lack of capital infusion.
Basic legal procedure governing recovery of debt due to any lender or lending institution including banks in Sri Lanka is governed by the Civil Procedure Code . In addition to the ordinary procedure in filing a civil suit to recover debt , our Civil Procedure Code also provides a summary procedure under which debt or liquidated demand in money arising upon a bill of exchange, promissory note, cheque etc. can be recovered. This special procedure enables a creditor to obtain a judgment expeditiously, as it prevents a debtor from advancing any defence, without the leave of court. Accordingly, the summary procedure eliminates the chances of advancing any spurious defences to deliberately delay court proceedings.
However, more often than not, lenders, especially banks, demand security in order to minimize the risk of default. If the law does not enable lenders to enforce such security expeditiously and effectively upon a default, such security will prove to be no more than a mere piece of paper. The most common and preferred type of security in Sri Lanka is mortgages over property. Statutory provisions relating to recovery of money lent on security of a mortgage is set out in the Mortgage Act .
In reality, recovering debt through the ordinary process of court soon proved to be ineffective due to inordinate delays experienced by banks/creditors. This predicament was exploited by willing defaulters who contributed to the delay and strategically disposed their assets, making recovery of debt costly and futile. Accordingly, there was a growing clamour amongst lending institutions and banks for a more efficacious legal framework for recovery of debt.
In that light, special legislation was enacted by the legislature in the year 1990 to regulate debt recovery procedure and as a result of which, we saw the birth of the Debt Recovery (Special Provisions) Act and Recovery of Loans by Banks (Special Provisions) Act. The Debt Recovery Act provides a procedure to lending institutions, as defined under the said Act, to institute action in the District Court for recovery of money owed. Here a defendant is not allowed to appear and show cause except without the leave of court. The introduction of this procedure no doubt streamlined the debt recovery regime. The process introduced under the Recovery of Loans by Banks Act on the other hand is an extra-judicial means of debt recovery. This Act empowers licensed commercial banks to recover debt by disposing property mortgaged to banks by its borrowers without the need to have any recourse to a court action but in strict compliance with the provisions of the Act.
This article will discuss the practical difficulties faced by banks in exercising this special power conferred upon them by the legislature, especially in a situation where a borrower is sought to be wound-up in terms of the provisions of the Companies Act, by analyzing decided cases and provisions of the relevant statues whilst endeavoring to determine if Sri Lanka has achieved the desired objective in enacting the Recovery of Loans by Banks Act (“Act No. 04 of 1990”).
B. RECOVERING DEBT SECURED BY A MORTGAGE
Prior to discussing the debt recovery regime introduced by the Act No. 04 of 1990, it is imperative to recognize the several options available to a mortgagee in seeking to enforce a mortgage bond so as to realise the debt secured by a mortgage.
i. Mortgage Act No. 06 of 1949 as amended
A mortgagee may institute a hypothecary action in a civil court under and in terms of the Mortgage Act, which reflects principles of Roman Dutch Law. A hypothecary action is instituted to obtain an order declaring the mortgaged property to be bound and executable for the payment of monies due upon the mortgage and to enforce such payment by a judicial sale of the mortgaged property. Provisions of the Act necessitate a finding by a court of law, inter alia, that the borrower is in default of payment and thus the lender is entitled to enforce the mortgage by a judicial sale of the property. Regular procedure of a civil suit set out in the Civil Procedure Code along with additional steps specified under the Mortgage Act are required to be followed in a hypothecary action.
The main advantage of a hypothecary action compared to a regular money recovery action is that from the outset of the case a particular asset belonging to the borrower is identified to be sold and proceeds thereof to be utilized for recovery of debt of the lender. Accordingly, usual dilemma of a judgment-creditor who is prevented from executing a writ obtained in his favour without going on a costly voyage of discovery of assets of a judgment-debtor, does not arise in a hypothecary action. More importantly, requirement to register a lis pendens and provisions which enable the appointment of a receiver to preserve the mortgaged land during the pendency of the court action prevents a willing defaulter from disposing the property fraudulently.
Section 8 of the Mortgage Act No. 06 of 1946 as amended – A lis pendens is a legal notice indicating that a pending court action is attached to a particular land. This notice is registered in the relevant land registry.
ii. Claiming as a secured creditor
When a company executes a mortgage bond in favour of a lender it creates a charge against the assets of such company. Thereby, the lender becomes a secured creditor of the company. A creditor is “secured” when it holds an interest upon an asset that belongs to a debtor. This status is especially beneficial in liquidation process of a company, as a secured creditor takes priority over all other creditors of a company and the property mortgaged to a secured creditor stands outside the common pool of assets.
It must be noted that winding up process set out in the Companies Act is technically not a method of debt recovery. However, the end result of a liquidation process is to realise the assets of a company and discharge its liabilities. Liquidation process concludes upon the dissolution of a company and therefore should be considered as a last resort. However, preferring a winding-up application to court no doubt encourages companies to reach an amicable settlement with lenders in order to avoid drastic consequences of such an application. In any event, a mortgagee is entitled to petition court seeking to wind-up a debtor or participate in winding-up proceedings commenced by another creditor of the company and claim as a secured creditor of the company, in terms of the provisions of the Companies Act.
iii. Recovery of Loans by Banks (Special Provisions) Act No. 04 of 1990
This is a right only available to mortgagees who are licensed commercial banks. Recovery process introduced by this Act is morefully discussed below.
C. PROCESS OF PARATE EXECUTION
Direct translation of the term “parate” means immediate. Therefore, the term “parate execution” connotes an immediate means of recovery. Parate execution process introduced by the said Act effectively allows licensed commercial banks to bypass tedious and often time-consuming court processes and enforce security executed by the borrowers to secure repayment of loans, without any court intervention. Historically, this right was only conferred upon state banks such as the State Mortgage Bank, the People’s Bank, the Bank of Ceylon, Regional Rural Development Bank etc., incorporated under respective Acts. With the enactment of Act No. 04 of 1990, parate rights were extended to all licensed commercial banks within the meaning of the Banking Act.
The Supreme Court of Sri Lanka in determining the constitutionality of the Recovery of Loans by Banks Bill, prior to its enactment, recognized the object of the said Act to be the facilitation of recovery of debts by two categories of institutional lenders “who, in the legislative eye, plays a significant role in the provision of credit for the development of the economy.” The said Act allows a bank to adopt a Board Resolution authorizing the sale of any property mortgaged to the bank as security for any loan in respect of which default has been made in order to recover the whole of the unpaid portion of such loan, together with the money and costs recoverable under the Act. The sale should necessarily be effected through public auction. Notice of every such Resolution passed by a bank should be published in the Government Gazette and in at least three daily newspapers in the Sinhala, Tamil and English languages and copies of such publications shall be served on the borrower. Thereafter, the date, time and place of every sale authorized by Resolution shall be published in the Government Gazette at least fourteen days prior to the date fixed for the sale and notice of such publication shall also be dispatched to the borrower. These provisions are specifically in place to ensure that no property mortgaged to a bank is sold without prior notice to a borrower, but at the same time, these provisions give borrowers time and incentive to take necessary steps to settle the outstanding dues.
Conferring such right to banks have been strenuously argued to amount to a dilution of the judicial power as arguably it allows banks to be their own judge having power over property mortgaged to it, unilaterally. However, a careful scrutiny of the provisions of Act No. 04 of 1990 reveals that the said Act in no way excludes the right of a borrower to available judicial remedies. Exercising the parate rights conferred upon banks in terms of Act No. 04 of 1990 do not empower banks to determine any legal rights and liabilities but merely allows expeditious enforcement of a security upon a default of the borrower. Accordingly, the Supreme Court of Sri Lanka, in its special determination of the Bill held that the provisions of the said Act do not exclude the right of recourse to courts, and “there is therefore no ousting of or interference with judicial power.”
In practice, even though there is a general reluctance of the judiciary to interfere with the process of parate execution, granting of injunctions or interim orders preventing the holding of auctions is not infrequent. This is especially so when borrowers successfully prove to court a prima facie failure on the part of the bank to comply with the provisions of the said Act or in situations where properties mortgaged to the banks belong to third parties.
Pros and cons of parate executing third party mortgages have been the debate for many years. Recently, a fuller bench of the Supreme Court was invited to determine whether a bank can exercise rights under Act No. 04 of 1990 against a property owned by a shareholder of a borrowing company. It is a very pertinent question which affects the entire borrowing system of the country. If court decides that 3rd party mortgages cannot be enforced under the Act No. 04 of 1990, banks will be compelled to demand security over property strictly owned by borrowers, which would place startup businesses in a difficult position. On the other hand, if court decides otherwise, stakeholders of a company will be reluctant to provide their personal property as collateral for company loans. This case is yet to be argued and decided by court and the determination thereof, will undoubtedly be noteworthy.
D. EXERCISING PARATE RIGHTS PENDING LIQUIDATION OF A COMPANY
As per general principles governing liquidation of companies, winding up of a company by court shall be deemed to commence at the time of the presentation of a petition for winding up. However, such commencement per se will only be upon the delivery of a winding up order by court. Therefore, a winding up order has a retrospective effect. One of the main consequences of a winding up order is that upon it being made, all property and things in action to which the company is entitled to, falls within the control and custody of the liquidator appointed by court. Thereupon, powers of directors also cease to exist. Accordingly, assets of a company in liquidation become inaccessible to creditors without the consent of the liquidator or sanction of court. The underlying rationale is to ensure that all creditors of the company in liquidation are treated fairly as a winding up of a company operates in favour of all the creditors of a company as if the application to wind up was made jointly.
The pertinent question in light thereof then is whether a bank is entitled to exercise rights conferred upon it by Act No. 04 of 1990 and proceed with a parate execution of a property mortgaged to it when the borrower is in liquidation.
D.1 THE POSITION UNDER AND IN TERMS OF THE OLD COMPANIES ACT
In the absence of any specific provisions dealing with the above in the said Act as well as in the Companies Act, decided cases on this point will shed some light. DFCC Bank Ltd. vs. Seylan Bank Ltd and Five Others is the main reported case on point which analyzes the provisions of both Acts in an attempt to provide a resolution to the above.
The District Court, by its order held that DFCC bank cannot proceed to parate execute the property mortgaged to it, in terms of Act No. 04 of 1990 when there is an application under the Companies Act to wind up the company which had mortgaged the property in question. Being aggrieved by said order, DFCC bank preferred an appeal. Hearing the appeal of DFCC Bank, the Court of Appeal, inter alia, held as follows;
a) “THE PURPOSE OF ENACTING ACT NO. 04 OF 1990 IS TO HAVE A SPEEDY PROCEDURE TO RECOVER THE MONIES LENT BY BANKS WITHOUT VIOLATING OR ALLOWING TO OVERRIDE THE PROVISIONS OF THE OTHER ENACTMENTS SUCH AS THE COMPANIES ACT.
b) COMPANIES ACT SHOULD PREVAIL OVER THE PROVISIONS CONTAINED IN THE RECOVERY OF LOANS BY BANKS (SPECIAL PROVISIONS) ACT NO. 4 OF 1990”
c) “The property belonging to the company sought to be wound up is not liable to be auctioned in terms of the RECOVERY OF LOANS BY BANKS (SPECIAL PROVISIONS) ACT NO. 4 OF 1990”
Accordingly, the appeal of the DFCC bank was dismissed by the Court of Appeal. An analysis of the reasoning of the Court of Appeal is imperative to better understand the aforesaid conclusion of court. It must be noted that in this case, court arrived at this conclusion by interpreting and giving effect to the provisions of the old Companies Act as the winding up proceedings of the company commenced in terms of the old Companies Act. Accordingly, court relied heavily on sections 260 and 261 of the old Companies Act which provides as follows;
Section 260 – “In a winding up by the court, any disposition of the property of the company, including things in action, and any transfer of shares, or alteration in the status of the members of the company, made after the commencement of the winding up, shall, unless the court otherwise orders, be void.”
Section 261 – “Where any company is being wound up by the court, any attachment, sequestration, distress, or execution put in force against the estate or effects of the company after the commencement of the winding up shall be void to all intents.”
In interpreting and applying the aforesaid sections, Court came to a finding that if one creditor is permitted to dispose the property of a company in liquidation, that would cause grave and irremediable loss and damage to the other creditors of the company, as the object of the above sections is to ensure the equal distribution of assets of a company according to the respective entitlements.
The aforesaid finding of the Court of Appeal arguably is not in consonance with the purpose for which Act No. 04 of 1990 was enacted – the speedy recovery of debts due to a bank without having recourse to adjudication by court. As a result of the decision of this case, a winding up order amounted to an automatic stay of the parate execution process. Consequently, a bank despite having a valid mortgage in favour of the bank and despite being statutorily conferred a special right to enforce such mortgage, was prevented from reaping the benefits thereof to the optimum. In practice, willing defaulters were able to arrange a ‘friendly creditor’ to initiate winding up proceedings upon becoming aware of the steps being initiated by a bank to pass a resolution in terms of Act No. 04 of 1990 and thereby effectively preventing a bank from recovering its debt in terms of Act No. 04 of 1990. Fundamentally, this conclusion diminished the effectiveness of the regime introduced by Act No. 04 of 1990.
A classic example of the colossal impact the aforesaid decision can have on lenders is seen in the matter of Dimo International Limited. Here an application made by the National Development Bank in 1998 seeking permission from the winding up court to have the property owned by the company sought to be wound up and mortgaged to the said bank released so as to enable the bank to proceed with the parate execution process was refused. As a result, the bank was compelled to participate in winding up proceedings which continued for over 20 years, making the recovery process awfully ineffective.
D.2 HAS THE POSITION CHANGED WITH THE ENACTMENT OF THE COMPANIES ACT NO. 07 OF 2007?
Companies Act No. 07 of 2007 came into effect in May 2007 and Act No. 17 of 1982 was repealed thereby. Provisions equivalent to 260 and 261 of the old Companies Act, which were relied upon by the Court of Appeal in arriving at the aforesaid decision of DFCC Bank vs. Seylan Bank are included verbatim in the new Companies Act as well. However, the new section equivalent to the previous section 261 has been included with a very important amendment. Section 276 of the new Companies Act is reproduced below;
Section 276 (1) – “Where any company is being wound up by the court, subject to the provisions of subsection (2) any attachment, sequestration, distress, or execution put in force against the estate or effects of the company after the time of the presentation of the petition for the winding up, shall be void to all intents.”
Section 276 (2) – “Nothing in this section shall apply to an execution process or attachment against any property by or for the benefit of a creditor, who is entitled to a charge in respect of that property.”
Furthermore, in terms of section 279 of the Companies Act a winding up order will effectively act as a stay of all actions and proceedings commenced against the company. However, such stay will not apply to an execution process or attachment against any property for the benefit of a creditor who is entitled to a charge in respect of that property. Accordingly, it can be seen that the legislature has identified a lacuna in the law and has taken necessary steps to remedy same.
It is also interesting to note that, as per section 358 of the new Companies Act, a secured creditor is granted three options out of which he may make an election as to the way in which the secured creditor wishes to deal with the property secured in his favour. Accordingly, the secured creditor may either choose to seize, attach and realise the property; value the property and claim in the liquidation as a secured creditor and as an unsecured creditor for any balance due; or surrender the charge to the liquidator for the benefit of all the creditors of the company and claim as an unsecured creditor.
Accordingly, it can be argued that the Companies Act in unequivocal terms has given a secured creditor the right to realise the property mortgaged to it without having to participate in long drawn liquidation proceedings. This position was established in the above case of Dimo International Limited, where the Court of appeal while questioning the validity of the order of the District Court, held that the said order undoubtedly “denied access to the road to parate execution but it did not take away its right to traverse the silky road in the winding up proceedings to be replenished as a secured creditor if sufficient funds become available.”
Therefore, banks are now in a better position to argue that a winding up order will not prevent a bank from exercising its rights under Act No. 04 of 1990 and to proceed with a parate execution of property to recover its debts expeditiously. However, there are no reported cases in Sri Lanka where this question has been argued and decided pursuant to the enactment of the new Companies Act. In reality though, despite the aforesaid amendments introduced to the Companies Act, there seems to be a general reluctance in the judiciary to allow a bank to proceed with a parate execution when a borrowing company whose property is mortgaged to a bank is in liquidation.
E. CONCLUSION
Debt recovery mechanism introduced by Act No. 04 of 1990 is a major deviation from the Roman Dutch Law principles entrenched in the legal system of Sri Lanka[1]. However, it has more good than bad. It is a process which encourages amicable settlements and thus is beneficial to both lenders and borrowers. The power conferred upon banks is always exercised in strict compliance with the provisions of the Act not only to avoid frivolous objections on procedural irregularities but also because functions of licensed commercial banks are closely scrutinized by the Central Bank of Sri Lanka. Accordingly, banks would not abuse the power conferred upon them as doing so would entail grave consequences and disrupt the smooth functioning of the bank.
Arguments advanced in favour of staying parate execution process against a property of a company in liquidation are often based on the crux of insolvency laws, which is that no one creditor shall gain access to the property of the company to the exclusion of other creditors. Whilst it is essential to uphold the spirit of insolvency laws it is also vital to recognize and give effect to the much needed balance between the competing interests amongst creditors, as denying parate rights of a bank has far-reaching effects on the overall economy.
It is undoubtedly enviable that banks are exclusively granted this privilege to enforce valid security without having any recourse to tedious court procedure, whereas other creditors are compelled to seek relief through court. However, the need for such mechanism was identified by the legislature for the economic development of the country and the Supreme Court of Sri Lanka has also held that the differentiation between banks and other lenders are not arbitrary or unreasonable.Therefore, it is the duty of the bench and the bar to give effect to the intention of the legislature in a holistic manner and use the mechanisms introduced by Act No. 04 of 1990 to achieve its envisioned objectives.
Kasuni Jayaweera
Junior Counsel