Supreme Court on Banks’ Obligations Towards Stressed MSMEs: Pro Knits v. Canara Bank

In M/s Pro Knits v. Board of Directors of Canara Bank & Others, decided on 1 August 2024, the Supreme Court of India considered an important question concerning the obligations of banks and financial institutions when dealing with stressed Micro, Small and Medium Enterprises (“MSMEs”).

The decision examines the framework introduced for the identification and rehabilitation of financially stressed MSME accounts and its interaction with recovery measures available to secured creditors, including proceedings under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”).

Background of the Dispute

The proceedings arose from challenges brought by MSME borrowers against measures taken by their respective lenders. A central issue was the applicability of the framework for revival and rehabilitation of MSMEs introduced pursuant to the notification dated 29 May 2015 and the consequential regulatory framework issued by the Reserve Bank of India (“RBI”).

The Bombay High Court had taken the view that the restructuring mechanism was not required to be initiated by the lender in the absence of an application by the MSME borrower.

The matter thereafter reached the Supreme Court, where the MSME borrowers contended that the obligations imposed under the applicable framework could not be avoided merely because the borrower had not independently approached the lender seeking initiation of the restructuring process.

The Question Before the Supreme Court

The principal question was whether the framework for identification, resolution and rehabilitation of stressed MSME accounts imposed obligations upon banks and financial institutions independently of an application being made by the concerned MSME.

In other words, the Court was required to consider whether the process was entirely borrower-driven or whether lenders themselves were required to identify incipient stress and take the steps contemplated under the applicable MSME framework.

What the Supreme Court Held

The Supreme Court disagreed with the approach adopted by the High Court and recognised the binding character of the applicable MSME framework upon regulated lenders.

The judgment emphasises that the framework contemplates identification of financial stress at an early stage. Banks cannot treat the mechanism as being dependent solely upon an MSME borrower approaching the lender and requesting restructuring.

 The precise relationship identified by the Supreme Court between Special Mention Account (SMA) classification, the Committee mechanism, restructuring/revival measures and classification of the account as an NPA should be stated by reference to the relevant paragraphs of the judgment and applicable RBI directions.

Obligations of Banks and Financial Institutions

The decision is significant because it places emphasis on the lender’s role in identifying stress in MSME accounts and following the prescribed institutional mechanism where the applicable conditions are satisfied.

The MSME framework is intended to facilitate identification of incipient stress sufficiently early for corrective measures to be considered. Depending upon the circumstances and the applicable regulatory requirements, such measures may involve rectification, restructuring or recovery.

The judgment therefore has implications for banks and financial institutions contemplating enforcement action against MSME borrowers. Compliance with the applicable MSME framework may become an important consideration when the validity of subsequent recovery measures is challenged.

MSMEs Must Also Establish Their Eligibility

The judgment does not mean that every borrower can claim the protection of the MSME framework merely by describing itself as an MSME.

A borrower seeking the benefit of provisions applicable specifically to MSMEs must establish its status and satisfy the applicable statutory and regulatory requirements. Appropriate registration and supporting documentation can therefore become important when asserting rights arising under the MSME framework.

The Supreme Court’s findings concerning the point in time at which MSME status/registration must exist, and the consequences where the borrower obtains registration after the relevant credit facilities or proceedings, should be verified and incorporated if this article is intended to provide practical guidance.

Impact on SARFAESI Proceedings

The judgment is particularly relevant where a lender proposes to exercise remedies under the SARFAESI Act against an eligible MSME.

Borrowers may rely upon non-compliance with a mandatory MSME stress-resolution framework while challenging consequential measures taken by a secured creditor. At the same time, the decision should not be understood as creating an absolute prohibition against recovery proceedings merely because the borrower is an MSME.

The legal consequences will depend upon the borrower’s MSME status, the chronology of the account, the applicable regulatory framework, the steps actually taken by the lender and the particular recovery measures under challenge.

Why the Judgment Matters

Pro Knits is significant because it reinforces the distinction between ordinary commercial recovery and the regulatory treatment contemplated for eligible MSMEs experiencing financial stress.

For lenders, the decision underscores the importance of documenting compliance with applicable MSME and RBI requirements before and during recovery proceedings. For MSME borrowers, it highlights the importance of maintaining proper evidence of MSME status and raising issues concerning financial stress at the earliest possible stage.

The judgment may therefore have practical consequences not only for restructuring proposals but also for challenges involving classification of accounts, enforcement of security interests and other recovery proceedings.

Conclusion

The Supreme Court’s decision in M/s Pro Knits v. Board of Directors of Canara Bank & Others strengthens the procedural significance of the framework governing stressed MSME accounts. The decision makes clear that obligations imposed upon lenders under the applicable MSME framework cannot necessarily be treated as optional merely because the borrower has not independently sought restructuring.

At the same time, the protection available in an individual case will depend upon the borrower establishing its eligibility and upon the statutory and regulatory framework applicable at the relevant time.

For MSMEs facing financial stress and for lenders considering recovery action, the decision makes early identification of stress, proper documentation and compliance with the applicable regulatory process particularly important.

Disclaimer: This article is intended for general information and legal awareness only. It does not constitute legal advice. The application of the judgment and the MSME regulatory framework will depend upon the facts of each case and the law and regulatory directions applicable at the relevant time.