Legality of charging and claiming interest by Banks/Financial Institutions #indianlaws

Supreme Court in the case namely Central Bank of India vs. Ravindra and Ors., decided On: 18.10.2001 (MANU/SC/0663/2001 = AIR2001SC3095), dealt with the question as to what is the meaning to be assigned to the phrases “the principal sum adjudged” and “such principal sum” as occurring in Section 34 of the Code of Civil Procedure, 1908 [as amended by the Code of Civil Procedure (Amendment) Act (66 of 1956) w.e.f. 1.1.1957] has been the question of frequent recurrence having for reaching implications in suits for recovery of money, especially those filed by banking institutions against their borrowers. The above issue was referred for determination before the larger bench in the present matter.

By the 1956 amendment, in Section 34, for the words “with further interest at such rate as the Court deems reasonable on the aggregate sum so adjudged” the words “with further interest at such rate not exceeding six percent, per annum as the Court deems reasonable on such principal sum” was substituted in sub-section (1). In sub-section (2) the words “on such aggregate sum as aforesaid” were deleted and the words “on such principal sum” were substituted. The phrases “on the principal sum adjudged” and “such principal sum”, as occurring in the opening part of sub-section (1) of Section 34, were not touched by the amendment.

It was held that various English decisions and the decisions of the Courts in India (including the Supreme Court and almost all the High Courts) of the country noticed and approved long established banking practice of charging interest at reasonable rates on periodical rests and capitalising the same on remaining unpaid. Such a practice is prevalent and also recognised in non-banking money lending transactions. Legislature has stepped in from time to time to relieve the debtors from hardship whenever it has found the practice of charging compound interest and its capitalization to be oppressive and hence needing to be curbed. The practice was stated to be permissible, legal and judicially upheld excepting when superseded by legislation and nothing wrong in the parties voluntarily entering into transaction, evidenced by deeds incorporating covenant or stipulation for payment of compound interest at reasonable rates, and authorising the creditor to capitalise the interest on remaining unpaid so as to enable interest being charged at the agreed rate on the interest component of the capitalised sum for the succeeding period.
The term ‘interest’ was explained as amount to which one gets entitled as compensation for the deprivation; the money due to creditor which was not paid, or, in other words, was withheld from him by the debtor after the time when payment should have been made, in breach of his legal rights, and interest was an compensation whether the compensation was liquidated under an agreement or statute. “Interest” in general terms is the return or compensation of that use or retention by one person of a sum of money belonging to or owed to another. The term ‘penal interest’ was distinguished from ‘interest’ as an extraordinary liability incurred by a debtor on account of his being a wrong-doer by having committed the wrong of not making the payment when it should have been made, in favour of the person wronged and it is neither related with nor limited to the damages suffered. Thus, while liability to pay interest is founded on the doctrine of compensation, penal interest is a penalty founded on the doctrine of penal action. Penal interest can be charged only once for one period of default and therefore cannot be permitted to be capitalised.

It was held that the meaning assigned to the expression ‘the principal sum adjudged’ should continue to be assigned to “principal sum” at such other places in ‘Section 34(1) where the expression has been used qualified by the adjective “such”, that is to say, as “such principal sum”. Recognition of the method of capitalization of interest so as to make it a part of the principal consistently with the contract between the parties or established banking practice does not offend the sense of reason justice and equity. Such a system has along established practice and a series of judicial precedents upholding the same. Secondly, when interest is debited to the account of the borrower on periodical rests, it is debited because of its having fallen due on that day. Nothing prevents the borrower from paying the amount of interest on the date it falls due. If the amount of interest is paid there will be no occasion for capitalising the amount of interest and converting it into principal. If the interest is not paid on the date due, from that date the creditor is deprived of such use of the money which it would have made if the debtor had paid the amount of interest on the date due. The creditor needs to be compensated for deprivation. The expression “the principal sum adjudged” may include the amount of interest, charged on periodical rests, and capitalised with the principal sum actually advanced, so as to become an amalgam of principal in such cases where it is permissible or obligatory for the Court to hold so. Where the principal sum (on the date of suit) has been so adjudged, the same shall be treated as “principal sum” for the purpose of “such principal sum” – the expression employed later in Section 34 of C.P.C. The expression “principal sum” cannot be given different meanings at different place in the language of same section, i.e. Section 34 of C.P.C.

It was clarified that the 1956 amendment serves two-fold purpose. Firstly, it prevents award of interest on the amount of interest so adjudged on the date of suit. Secondly, it brings the last clause of Section 34, by narrowing down its ambit, in conformity with the scope of the first clause in so far as the expression “the principal sum adjudged” occurring in the first part of Section 34 is concerned which has been left untouched by amendment.
A creditor can charge interest from his debtor on periodical rests and also capitalise the same so as to make it a part of the principal. Such a course can be justified by stipulation in a contract voluntarily entered into between the parties or by a practice or usage well established in the world to which the parties belong. Such practice is to be found already in vogue in the field of banking business. Such contract or usage or practice can stand abrogated by legislation such as Usury Laws or Debt Relief Laws and so on.

The Court further propounded following few Notes of caution:

1.    Though interest can be capitalised on the analogy that the interest falling due on the accrued date and remaining unpaid, partakes the character of amount advanced on that date, yet penal interest, which is charged by way of penalty for non-payment, cannot be capitalised. Further interest, i.e. interest on interest, whether simple, compound or penal, cannot be claimed on the amount of penal interest. Penal interest cannot be capitalised. It will be opposed to public policy.

2.    Novation, that is, a debtor entering into a fresh agreement with creditor undertaking payment of previously borrowed principal amount coaled with interest by treating the sum total as principal, any contract express or implied and an express acknowledgement of accounts, are best evidence of capitalisation. Acquiescence in the method of accounting adopted by the creditor and brought to the knowledge of the debtor may also enable interest being converted into principal. A mere failure to protest is not acquiescence.

3.    The prevalence of banking practice legitimatize stipulations as to interest on periodical rests and their capitalisation being incorporated in contracts. Such stipulations incorporated in contracts voluntarily entered into and binding on the parties shall govern the substantive rights and obligations of the parties as to recovery and payment of interest.

4.    Capitalisation method is founded on the principle that the borrower failed to make payment though he could have made and thereby rendered himself a defaulter. To hold an amount debited to the account of the borrower capitalised it should appear that the borrower had an opportunity of making the payment on the date of entry or within a reasonable time or period of grace from the date of debit entry or the amount falling due and thereby avoiding capitalisation. Any debit entry in the account of the borrower and claimed to have been capitalised so as to form an amalgam of the principal sum may be excluded on being shown to the satisfaction of the Court that such debit entry was not brought to the notice of the borrower and/or he did not have the opportunity of making payment before capitalisation and thereby excluding its capitalisation.

5.    The power conferred by Section 21 and 35A of the Banking Regulation Act, 1935 is coupled with duty to act. Reserve Bank of India is prime banking institution of the country entrusted with a supervisory role over banking institution of the country entrusted with a supervisory role over banking and conferred with the authority of issuing binding directions, having statutory force, in the interest of public in general and preventing banking affairs from deterioration and prejudice as also to secure the proper management of any banking company generally. Reserve Bank of India is one of the watchdogs of finance and economy of the nation. It is, and it ought to be, aware of all relevant factors, including credit conditions as prevailing, which would invite its policy decisions. RBI has been issuing directions/circulars from time to time which, inter alia, deal with rate of interest which can be charged and the periods at the end of which rests can be struck down, interest calculated thereon and charged and capitalised. It should continue to issue such directives. Its circulars shall bind those who fall within the net of such directives. For such transaction which are not squarely governed by such circulars, the RBI directives may be treated as standards for the purpose of deciding whether the interest charged is excessive, usurious or opposed to public policy.

6.    Agricultural borrowings are to be treated on a pedestal different from others. Charging and capitalisation of interest on agricultural loans cannot be permitted in India except on annual or six monthly rests depending on the rotation of crops in the area to which the agriculturist borrowers belong.

7.    Any interest charged and/or capitalised in violation of RBI directives, as to rate of interest, or as to periods at which rests can be arrived at, shall be dis-allowed and/or excluded from capital sum and be treated only as interest and dealt with accordingly.

8.    Award of interest pendente lite and post-decree is discretionary with the Court as it is essentially governed by Section 34 of the CPC de hors ? the contract between the parties. In a given case if the Court finds that in the principal sum adjudged on the date of the suit the component of interest is disproportionate with the component of the principal sum actually advanced the Court may exercise its discretion in awarding interest pendente lite and post-decree interest at a lower rate or may even decline awarding such interest. The discretion shall be exercised fairly, judiciously and for reasons and not in an arbitrary or fanciful manner.

On the question of reference, the Court held as under:

•    Subject to a binding stipulation contained in a voluntary contract between the parties and/or an established practice or usage interest on loans and advances may be charged on periodical rests and also capitalised on remaining unpaid. The principal sum actually advanced coupled with the interest on periodical rests so capitalised is capable of being adjudged as principal sum on the date of the suit.

•    The principal sum so adjudged is ‘such principal sum’ within the meaning of Section 34 of the Code of Civil Procedure, 1908 on which interest pendente lite and future interest i.e. post-decree interest, at such rate and for such period which the Court may deem fit, may be awarded by the Court.

Law laid down in Corporation Bank vs. H.S. Gowda and Anr. (MANU/SC/0788/1994) and Bank of Baroda vs. Jagannath Pigment & chem was held to be correct.