Are the proprietor and the sole proprietorship firm the same legal entity?
Kanakprabha Jethani
Financial Services Regulatory Consultant | Published Author | Trainer
A recent ruling by the National Consumer Disputes Redressal Commission, New Delhi (“NCDRC”) has shed light on an issue often faced by borrowers, specifically, in the home loans segment. The issue relates to charging of foreclosure charges or prepayment penalties, and how it is linked to consumer protection.
Here’s a quick analysis of the law:
What are foreclosure charges or prepayment penalties?
Before understanding the law, let us first understand what these charges are.
Borrowers sometimes opt to repay their loans before the due date. Now this repayment can either be in full (which is called foreclosure) or in part (known as pre-payment or part pre-payment). The terms of the loan often have a lock-in, within which the customer cannot opt to pre-pay the loan. In some cases of extremely short-term loans, pre-payments are not allowed. For loans with longer tenures, the customers can choose to prepay, but by paying an additional penalty.
Isn’t it good for the lender to get their repayments earlier? Who doesn’t like quick money right? Well, not really.
Lenders have their internal cash-flow management based on the agreed repayment schedules. By tweaking these schedules, a lender (i) loses out on interest income for the remaining tenure and (ii) must reallocate and manage the funds again, which is a demanding task. This is why, lenders levy these charges- (i) as a client retention tool and (ii) to cover for some bit of the interest loss, if not all.
What does the law say about this?
Generally, there is no bar on charging prepayment penalties or foreclosure charges. However, in 2012 the RBI barred banks from charging foreclosure charges/pre-payment penalties on home loans on a floating interest rate basis. Then in 2014, NHB barred HFCs from charging such penalties on floating-rate term loans sanctioned to individual borrowers. The NHB also clarified that this relief is available only on loans extended to individual borrowers and not to loans where non-individuals are co-borrowers. In 2019, the RBI laid down a similar restriction on NBFCs in case of floating rate term loans availed by individuals for purposes other than business
Intention of the law
The regulators realized that the practice of charging foreclosure charges demotivated customers from prepaying loans even when they had excess funds. This also was restrictive as it deterred borrowers from switching over to cheaper loan alternatives. Of course, killing competition among lenders. This can also be looked at as a measure of customer protection as it allows customers to go debt-free sooner without facing negative cost implications.
Why was there a dispute on such a simple provision of law?
Various reasons. Let us hear the story first.
Ms. Sarita applied to an NBFC for a business loan for her sole proprietorship firm in 2015. Terms of the loan- quite standard, tenure-10 years, floating interest rate, and a pre-agreed prepayment penalty. Now, this being a floating rate, interest rates reduced after a while, and in 2023, she wanted to prepay the loan. The lender, of course, imposed prepayment charges. The borrower, aware of the RBI guidelines on foreclosure and prepayment charges, disputed the validity of the charges. To this, the district forum allowed the borrower’s claim and directed the lender to waive the prepayment charges.
The lender appealed against the order, and the NCDRC held that the prepayment charges were valid due to the following reasons:
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1. The loan is in the nature of a business loan. The RBI has allowed the relaxation for loans extended to individuals for ‘purposes other than business’.
2. The loan was extended to the proprietorship firm and not to the borrower in her individual capacity.
3. The prepayment charges were accepted by the borrower at the time of taking the loan.
4. The RBI guidelines were issued after the loan agreement was executed; hence, the guidelines could not have a retrospective effect.
Interestingly, this is not the only case where this issue has been raised. In 2023, the High Court of Madras held that a loan to a sole proprietorship represented by an individual could not be considered to be a loan extended to the individual for regulatory purposes (S Manoharan v. Reserve Bank of India and others). Similar issues have been raised before the courts several times in the past.
Implications
While the courts have held that a sole proprietorship cannot be considered the same as the individual for the purpose of this regulatory requirement, the same does not override the general principles that a sole proprietorship and the proprietor are treated as the same legal entity for all legal purposes. For instance, for any dishonour of negotiable instruments (like cheques) issued by a sole proprietorship firm, the proprietor is personally liable under the provisions of the Negotiable Instruments Act, 1881; for any legal proceedings against a sole proprietorship firm, the proprietor is automatically considered a party; financial creditors can proceed against the proprietor under the Insolvency and Bankruptcy Code, 2016 and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest, 2002 for any defaults on loans by the sole proprietorship.
There is a clear distinction between the treatment for legal purposes- which is guided by the general principles- and for regulatory purposes – which is guided by the intention of the specific provision. In the given case, the intention of the regulator was to limit the benefit to personal loans (which are not for business purposes). Hence, the definition of individual in this case is strictly limited and cannot be interchanged with the firm.
Things to take care of from a contractual perspective
Learning from this case, a customer must go through the terms of the loan agreement and understand the implications. More so, in the era of digital lending arrangements, where people often skip the terms to get quick loans. Borrowers must understand that most lending agreements are based on a 'take-it-or-leave-it' structure and they may have almost no scope for negotiatons. Hence, the better you understand your terms before signing, the lesser the chances of being stuck in a trap later!
For lenders, it's important to ensure that the terms are transparently disclosed to the customers. Additionally, given the ever-evolving regulatory framework, lenders ought to keep track of the developments- these changes can often be made applicable with an immediate effect (like the guidelines on penal charges). In such cases, the lender ought to issue interim communications and revised KFS (if required) to the customers.
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4 个月Nicely summed up Kanak!