IL&FS case reveals what India’s resolution mechanism is lacking

The infra-major going belly up cracked open some major flaws in the system — the most evident being weak corporate governance and how layers of corporate structures could be formed adding to the opaqueness of the group.

Hamsini Karthik reports.

Scars of September 21, 2018, or India’s financial services sector’s Black Friday cannot fade easily.

Two major housing financiers — Dewan Housing Corporation and India­bulls Housing — saw over 55 per cent single-day crashes in their stock prices caused by fears of redemption in the debt market.

That brought to fore that India’s then largest non-banking fin­a­nce company (NBFCs) — Infra­structure Leasing and Financial Services (IL&FS) — was neck-deep in crisis calling for a swift government intervention.

With over Rs 1 trillion of loan due to mainly banks and mutual funds, preventing a systemic contagion was top priority.

Nearly three years later, banker Uday Kotak, chairman of IL&FS’s reconstituted board, is relieved that the aftermath was largely contained.

Appointed on October 1, 2018, Kotak and his seven-member team was inducted to resolve the defunct lender’s mammoth loan burden.

On April 15, the board ann­ounced that Rs 43,100 crore of debt had been resolved. Resolution in this case implies a combination of resolution, restructuring and recovery as outlined by the board — that is, finding a new suitor for operational assets, court-led resolution and, in case of a stalemate, liquidating assets to recover as much as possible.

For now, nearly 40 per cent of the problem has been addressed.

Yet, Shailesh Haribhakti, a renowned chartered accountant and a board member of several listed companies, says IL&FS’s resolution “has moved rather slowly and nobody anticipated that even after three years it’s still only where it is”.

Many industry observers agree.

With the earlier government-led resolution for Satyam Computers in 2009 finding closure in less than four months, the pace of progress with IL&FS is indeed slow.

But the complexities in­volved in this case are far bigger.

IL&FS is the holding company of IL&FS group, incorporated as a non-banking finance company registered with Reserve Bank of India as a core investment company (CIC).

Under it are multiple layers of subsidiaries, mostly special purpose vehicles (SPVs) created for various infrastructure projects.

As Anand Shah, senior partner, banking and finance practice, AZB, put it, four levels of companies below the main CIC — 347 sub-companies under its ambit, which includes over two dozen direct subsidiaries, 135 indirect subsidiaries, six joint ventures, and four associate companies — have posed a key challenge for its resolution.

Initially, 156 subsidiaries were identified for resolution and graded as green (50 companies), amber (18) and red (80), and eight in different stages of resolution.

On April 15, the board announced that resolution was reached for 186 out of 347 subsidiaries, and it targets to resolve another Rs 8,000 crore loans by September and eventually reduce the number of subsidiaries to double digits.

For SPVs in roads, highways, water and other infra projects, there’s been some progress with respect to finding a buyer, though at heavily discounted valuations.

For the 18 entities marked amber, initiating resolution through the Insolvency and Bankruptcy Code (IBC) could be an option.

On March 12, 2020, the National Company Law Appellate Tribunal (NCLAT) approved the resolution and distribution framework for the IL&FS Group.

The problem is with 80 entities marked red where resolution even through the IBC process may be unsuccessful; eventually the businesses may have to be wound up and their investment values written off.

This is the plan but the prolonged impact of the Covid-19 pandemic may be a party spoiler.

Even now, with state governments holding back their annuity payments to SPVs because of pandemic-induced constraints, some are knocking at banks for help to recast their dues.

Ultimately how many “green” companies will remain operational is anyone’s guess and seen in this context, even achieving 62 per cent closure or resolution as laid down by the board seems to be an ambitious target.

“No framework exists under Indian law that pertains to or could in its entirety apply in a ‘group insolvency’ scenario,” Shah pointed out.

Therefore, “proposals have to be obtained for each of these assets and treated independently for resolution.

“What was applied in one case for resolution cannot be applied for another because each entity has its own unique proposition”, he explained.

The other difficulty is that banks are classifying their exposure to IL&FS entities as fraud.

“Any buyer wanting to acquire such assets would want immunity from legal proceedings, which is not being granted now,” said a person privy to the resolu­tion process.

What helped Sat­yam Computers find a new buyer was the grant of immunity.

For now, a net sum of Rs 26,800 crore has been recovered from the resolution process.

The challenge remains on how this money can be repatriated to the holding company for distribution to lenders in a compliant and tax-efficient manner.

For India Inc how the IL&FS mess is cleaned up will be an important lesson.

The infra-major going belly up cracked open some major flaws in the system — the most evident being weak corporate governance and how layers of corporate structures could be formed adding to the opaqueness of the group.

“Money was flowing like water,” said Kotak in the recent press briefing.

Questions were also raised on how it was possible to create a combination of NBFC and several SPVs and create so many umbrellas under it.

“This is the fundamental issue — how such an entity was allowed to be created and function.

“There should have been enough laws to curb such complexities,” he pointed out.

The IL&FS crisis was a surprise even to regulators.

“Back then, CICs were only required to file annual returns with the RBI.

“There was no supervision or audit conducted on CICs,” said N S Vishwanathan, former RBI deputy governor.

Therefore, to have identified the problem and nip it at the bud would have been difficult.

Three years later, however, experts feel that reasonable learning has gone into the system especially around cracking down complex corporate structures and increasing transparency.

“With the Tapan Ray committee recommending a stringent regulatory and supervision framework, many of the loopholes have been plugged,” Vishwanathan explained.

Tapan Ray is a former secretary of the corporate affairs ministry who headed a working committee set up in November 2019 to review guidelines for CICs.

Also, Shah pointed out that the Companies Act 2013 has beefed up the requirements on inter-corporate loans.

“The Companies Act 2013 provides a framework to regulate the loans and investments made between companies — by adding the requirement for a special resolution to lend for principal business activities of the group borrowing entity, payment of interest for intra-group borrowing and restricting investment to two layers in order to check the misuse of multiple layers of subsidiaries for diversion of funds,” he explained.

Haribhakti is confident that it’s almost impossible to create another IL&FS-like entity now.

That said, Kotak remains sceptical.

“India continues to have intermingling of business groups and that creates a challenge.

“IL&FS highlights the challenges in India’s financial services,” he said at the press briefing.

Ultimately, the impact of the pandemic, investor interest in buying distressed infrastructure projects and some government support are essential to decide which way the resolution efforts would swing.

Disclosure: Entities controlled by the Kotak family have a significant holding in Business Standard Pvt Ltd

Photograph: Danish Siddiqui/Reuters

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