Diverting funds borrowed from banks and financial institutions to uses other than what the money was lent for may soon be a criminal offence punishable under the Indian Penal Code.

The law and the home ministries have been pushing for this for some time, but the Reserve Bank of India is not inclined towards the move.

However, a working group set up by the central bank under the chairmanship of D T Pai, banking ombudsman of Uttar Pradesh, has endorsed the ministries' views.

The next stage is likely to be an amendment to the penal code to make breach of trust while using lenders' funds a punishable offence.

The RBI set up the working group on January 28 to suggest appropriate measures, including penalties and criminal action, against borrowers who diverted funds with malafide intent.

The group, which submitted its report early in May, was in favour of making funds diversion a punishable offence under the code.

The law and the home ministries are of the view that diverting funds is a breach of trust, and hence, a punishable offence.

But they could not go ahead with this idea because the RBI felt borrowers were not trustees and diversion of funds was a breach of contract but not a breach of trust since there was no entrustment involved. This was essentially a civil offence and not a criminal one, the RBI argued.

However, with the working group approving it, the government might go ahead with the move.

"Setting up the working group was part of the action taken against the backdrop of the joint parliamentary committee's observations on the 2001 stock market scam. No one knows whether the government will seriously look into the recommendations and amend the Indian Penal Code or whether the report will gather dust," a government official pointed out.

Even though banks may use the power sparingly and after due diligence and caution, companies may argue that the power is draconian. Moreover, establishing a case of funds diversion will not be easy.

"In cases of project loans, banks normally monitor the end use of funds. But it is difficult to establish funds diversion in the case of working capital loans," said a lawyer familiar with banking activities.

Diversion of funds is not a culpable offence now, either under the Banking Regulation Act or the penal code.

The RBI had earlier appointed another working group under Punjab National Bank Chairman and Former Indian Banks' Association CEO S S Kohli to look into the issue.

The report recommended banning defaulters from accessing finance from banks and financial institutions for five years.

The group also recommended that banks and institutions should be empowered to attach the assets (of wilful defaulters) charged to them as security directly without the intervention of the courts.

However, the group did not deal with setting criminal liability against companies that divert funds.

Based on the recommendations of the group, the government passed the Securitisation Act to enable borrowers to attach assets of wilful defaulters.

The objective of setting up the Pai panel was to define "breach of trust" and give banks and institutions a handle to initiate criminal action against borrowers who diverted funds with malafide intent.

Strict measures

• The next stage is likely to be an amendment to the penal code to make breach of trust while using lenders' funds a punishable offence.
• Even though banks may use the power sparingly and after due diligence and caution, companies may argue that the power is draconian.