Compounding of interest where contract does not contain specific provisions thereof

An important question arises before Hon’ble High Court in Syndicate Bank Vs. Mahalaxmi Gining Factory- [2005] 58 SCL 3(KAR) (CLP) as to whether in the absence of contractual provisions providing for compounding of interest, the bank can charge compound interest.?

Brief facts: The Bank sanctioned a loan of Rs. 6.37 to the defendant, a SSI unit. The Borrower executed a term loan-cum-hypothecation agreement in favour of the Bank agreeing to repay the loan in agreed installments with interest at the rate of 2.5 per cent above the RBI rate of interest subject to minimum of 12.5 per cent per annum on 31st March, 30th June, 30th September and 31st December. But there was no express provision as regards compounding of interest. It was also agreed that in default of payment of any installment or interest, the entire loan amount shall become due without reference to further installment; that they would pay the overdue interest at the rate stipulated by the Bank and varied from time to time in accordance with RBI direction. They also waived the requirement of notice on account of change in rate of interest.  On default by the parties a suit was filed by the Bank for recovery of its dues with interest at the rate of 21.5 per cent per annum compounded quarterly. The suit was resisted, inter alia, on the ground that there was no agreement to pay compound interest and that whenever there was revision in the RBI rate the bank neither informed the borrower nor obtained their consent for the revision. Trial court, inter alia, allowed the contention and allowed interest at simple rate of interest at 12.5 per cent per annum and disallowed overdue interest of 2 per cent as claimed by the Bank. The trial court also held that the Bank was not entitled to revise the rate of interest as per RBI directive as increase was not notified to the Borrower.

Held : On appeal the High Court held as follows:

a] Revision of interest without notice to the Borrower: - The Court held that the Trial Court failed to notice that the borrower had specifically waived the need for any notice whenever there were variations in the rate of interest and had agreed that the Bank would be entitled to revise the rates of interest as per RBI rate from time to time without notice. The Court relied upon the Supreme Court judgment in the case of State Bank of India Vs. Ganjam District Tractor Owners’ Association [1994]5SCC 238, where it was held that where there is contract between the Bank and the borrower providing for and governing the interest payable and such contract does not provide for ‘compound interest’ or ‘interest with periodical rests’ then the bank will not be entitled to compound interest.

b] Compounding of interest at quarterly intervals: - The Court held that clause 3 of the term loan agreement did not authorize charging of compound interest. Nor did it state that the bank was entitled to charge the interest with quarterly rests or yearly rests or monthly rests, which in banking parlance, mean charging of compound interest, by capitalizing the interest at the end of quarter or year or month. All that clause 3 stated was that the borrower had agreed to pay the interest on 31st March, 30th June, 30th September and 31st December of each year. A provision in the agreement that interest should be paid at the end of each quarter does not mean that the borrower has agreed to pay the compound interest. It was contended by the Bank that even though there was no specific contract for payment of interest with quarterly rests, it was entitled to charge interest with quarterly rests for three reasons, namely, the RBI circulars permit charging of interest with quarterly rests, the universal custom of bankers to charge compound interest and the borrower did not protest, but acquiesced to the debiting of interest with quarterly rests. As regards the first contention the court held that “there are several types of loans in respect of which the bank may not or should not charge compound interest. Therefore, the RBI circular permitting levy of compound interest, cannot be construed as direction to levy compound interest, even where the contract does not provide for compound interest”.

As regards universal custom to charge compound interest, usage or practice the court held, such custom, usage or practice can be relied upon only when there is no express contract, as in the case of temporary overdraft. The question of pleading a custom or practice does not arise when the matter is covered by express contract, as in the instant case.

As regard the argument of acquiescence, the court held that mere failure to protest by the borrower is not acquiescence. It was not the case of the Bank that the terms of the contract in writing were altered by any fresh contract and such novation was acquiesced by the borrower.

Implications/views:-  The case pertain to period when the rate of interest was regulated by RBI circulars. However, the principal discussed in the case are relevant from the point of view of terms of agreement regarding charging of interest.