The Supreme Court recently (K. K. Baskaran v. State rep. by its Secretary, Tamil Nadu & Ors., C.A. 2341 of 2011) upheld a fairly drastic, even if wellintended, State law for protection of depositors. This law was held to be unconstitutional by a Full Bench of the Bombay High Court and this decision has now been overturned by the Supreme Court. The importance of this decision for this column is particularly due to the fact that it applies to raising funds from the public in almost any form and not just in the form of ‘deposits’ as conventionally understood.
It is worth recounting briefly the background of this law, the circumstances of those times to understand the implications better.
The last few years of the preceding millennium saw a lot of companies and other entities raising monies in various forms at very ‘attractive’ rate of return and then defaulting. The monies were raised in innovative forms and not merely in the conventional form of raising of deposits, though of course, huge amounts were raised as deposits too. The series of defaults that followed revealed several things. Firstly, the promised ‘returns’ were high enough to be impossible to maintain at all times. Secondly, the businesses in which they were invested were risky, partly because the rate of return promised was high. Of course, some monies were straightaway siphoned off and huge commissions/ incentives were paid to agents. Thirdly, many of the schemes were purely ‘Ponzi’ schemes where fresh monies raised were the source of payment of ‘returns’ to earlier deposits, apart from return of principal.
The series of defaults and the resulting uproar resulted in several drastic laws being passed. The Reserve Bank of India Act was amended with strict provisions being inserted to regulate non-banking financial companies. SEBI notified its Regulations relating to Collective Investment Schemes which, ensured the closure of most of such schemes. However, at the State level, various States, over the following few years, passed laws for protection of depositors. Maharashtra, Tamil Nadu, Bihar, Gujarat, etc. were amongst such States [in Maharashtra, it was “the Maharashtra Protection of Interests of Depositors (in Financial Establishments) Act, 1999]. The broad model and most of the details of the laws of each of such States were more or less the same.
The basic scheme of the State Law was to give relief to the depositors where the monies were raised from them with a fraudulent intent. In case there was default due to this, the law provided for wide-ranging reliefs and punishment. The assets could be traced and attached, even if in other entities or in the names of the promoters/employees, etc. of the company. The definition of fraudulent intent was made artificially wide by including two situations. If monies were raised at returns that were commercially unviable, then the law deems that there was a fraudulent intent. Further, if the monies so raised were invested in businesses that were inherently risky, then, too, the law deems that the there was a fraudulent intent. The law covered corporate as well as several non-corporate entities such as individuals, firms, etc. Importantly, it covered even — corporates governed u/s. 58A of the Companies Act, 1956, and non-banking financial companies governed by regulations of the Reserve Bank of India.
The term ‘deposit’ is widely defined and would include monies in any form and not merely ‘public deposits’ or loans. However, there were certain exceptions provided for, but still, the definition was far wider than the word may normally convey. The law provided for appointment of an authority to take charge of the assets to ensure their disposal for meeting the liabilities to the depositors.
Stringent punishment was also provided. The State laws typically provide that in absence of special and adequate reasons, the punishment shall not be less than imprisonment of three years. The promoter, partner, director, manager or any other person or an employee responsible for the management or conducting the business of such entity is liable to be punished.
In case of default, not only the assets of the entity are to be attached, but if they are not sufficient, the properties of the director, partner or member of such entity can also be attached, if the State Government deems fit.
This law was challenged, inter alia, in the Bombay High Court. The Bombay High Court, by a Full Bench decision, held the law in Maharashtra to be unconstitutional (Shri Vijay C. Puljal v. State of Maharashtra, WP No. 5186 of 2001). However, a Full Bench decision of the Madras High Court upheld the constitutionality of the law in Tamil Nadu.
The decision of the Madras High Court was appealed against and the decision of the Bombay High Court was cited. The Supreme Court upheld the decision of the Madras High Court and held that of the Bombay High Court as not correct.
Various grounds were raised for holding the law to be unconstitutional including that the State had no power to enact such a law and that the other laws relating to deposits such as section 58A of the Companies Act, 1956, the Reserve Bank of India Act, etc. covered this field.
The Court gave the background in which the law by various States was enacted and particularly highlighted that the object of the Act and the reliefs provided thereunder were different from those under the RBI Act.
First, it described the background of the circumstances which necessitated such a law in the following words:
“The present case illustrates what has been going on in India for quite some time. Non-banking financial companies have duped thousands of innocent and gullible depositors of their hardearned money by promising high rates of interest on these deposits, and then done the moonlight flit, often disappearing into another State or even foreign countries leaving the depositors as well as the State police high and dry.”
The next contention was that: “the said Act is beyond the legislative competence of the State Legislature as it falls within Entries 43, 44 and 45 of List I of the Seventh Schedule to the Constitution. It was also submitted that the impugned Act is liable to be struck down as the field of legislation is already occupied by legislation of the Parliament, being the Reserve Bank of India Act, 1934, Banking Regulation Act, 1949, the Indian Companies Act, 1956 and the Criminal Law Amendment Ordinance, 1944 as made applicable by Criminal Law (Tamil Nadu Amendment) Act, 1977.”
It was also contended that the Tamil Nadu Act was arbitrary, unreasonable and violative of Articles 14, 19(1)(g) and 21 of the Constitution.
The Court, applying the doctrine of pith and substance to consider under whose powers the field belonged, held that the State did have power to enact laws covering the field.
“12. As noted in the impugned judgment, the Tamil Nadu Act was not focussed on the transaction of banking or acceptance of deposits, but it is designed to protect the public from fraudulent financial establishments who defraud the public by offering lucrative returns on deposits and then disappear with the depositors’ money or refuse to return the same with interest. In our opinion, the impugned Tamil Nadu Act is in pith and substance relatable to Entries 1, 30 and 32 of the State List (List II) of The Seventh Schedule.”
“20. It may be noted that though there are some differences between the Tamil Nadu Act and the Maharashtra Act, they are minor differences, and hence the view we are taking herein will also apply in relation to the Maharashtra Act.”
“26. The doctrine of pith and substance means that an enactment which substantially falls within the powers expressly conferred by the Constitution upon a Legislature which enacted it cannot be held to be invalid merely because it incidentally encroaches on matters assigned to another Legislature.”
The Court then highlighted the objective of the State Law and also its different scope to distinguish this law from the other laws. It observed,:
“30. The Tamil Nadu Act was enacted to find out a solution for the problem of the depositors who were deceived on a large scale by the fraudulent activities of certain financial establishments. There was a disastrous consequence both in the economic as well as social life of such depositors who were exploited by false promise of high return of interest.
31. By the impugned Act the State not only proposed to attach the properties of such fraudulent establishments and the mala fide transferees, but also provided for the sale of such properties and for distribution of the sale proceeds amongst the innocent depositors. Hence, in our opinion, the doctrine of occupied field or repugnancy, has no application in the present case.”
The Court even more specifically said that the other statutes that also provided for certain matters relating to depositors had different scope even if overlapping. However, since the State Law had a different angle and purpose, it had to be upheld.
“35. The Reserve Bank of India Act, the Banking Regulation Act and the Companies Act do not occupy the field which the impugned Tamil Nadu Act occupies, though the latter may incidentally trench upon the former. The main object of the Tamil Nadu Act is to provide a solution to wipe out the tears of several lakhs of depositors to realize their dues effectively and speedily from the fraudulent financial establishments which duped them or their vendees, without dragging them in a legal battle from pillar to post.”
Thus, the Supreme Court upheld the constitutionality of the Tamil Nadu and the Maharashtra State laws for protection of depositors. Implicitly, this should mean that the corresponding laws in other States, being pari materia, may also be held to be constitutional.
The implications are quite far reaching because of the wide scope of the State Laws and the powers granted and also the deeming provisions contained therein. While the other laws restricting deposits provide for quantitative restrictions in the form of maximum interest rates, maximum deposits, etc., this law considers qualitative aspects. It considers the intent of the entity raising deposits including the unreasonableness of the returns promised and the nature of investments made. Further, the law can be invoked not just when there is a default, but even earlier if the conditions specified by the law are met.
In conclusion, an old, harsh and wide-ranging law is brought alive again and any entity raising monies in any form need to consider this law, though apparently it is intended to cover entities with fraudulent intent.
