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Going Belly Up: How Conglomerates can be Prevented from causing Economic Crises - An Analysis of IF&LS Case

October 11, 2018

[ Ananya Sharma and Zaara Zia are fourth-year students of Amity Law School, Noida.]

 

The credit business of banks is on the rise, in proportion to the increased borrowing capacities of companies. As debt-financing is increasingly becoming a major financing approach for the companies, the influence of corporate governance mechanism on debt-financing has become pivotal in today’s modern world. The mighty conglomerate Infrastructure Leasing & Financial Services Limited (IL&FS) has created a furore in the country. IL&FS managed to acquire loans up to approximately 18 times more than that of its own equity, which is being held as the prime cause of its fall into the rabbit hole worth INR 91,000 crore, out of which, INR 57,000 crore belongs to public sector banks already reeling in the current scenario.

 

While the Central Government is forced to bail-out yet another corporate entity and apprehend the select individuals behind this mammoth debt crisis, experts continue to cite lack of strong corporate governance norms for such corporate entities to be compulsorily followed. This is also not the first time since India, post-delicensing and deregulation reforms, has witnessed and suffered due to such a colossal economic setback. Other such incidents include the allegations of conflict of interest against the erstwhile ICICI CEO, Axis Bank, as well as the National Stock Exchange. These incidents are not unforeseeable accidents; they are the result of lack of steadfast corporate governance, opacity in the running of such institutions, and lack of accountability on the part of those at the helm of affairs in such institutions. Regulators are forced to take stringent action only when it is too late, usually by reprimanding the CEOs of such defaulting institutions. However, this has never helped the shareholders, who face an unprecedented financial risk in such times. Most importantly, the economy, as a whole, is negatively affected by routine economic disasters such as that of IL&FS. Unremitting defaults will continue to plague the Indian economy until both the corporate sector and the Central Government cooperate to create holistic solutions and ensure that such transgressions do not become customary for such institutions.

 

The conglomerate of IF&LS group could not have escaped the radar of multiple regulators for unconscionable regulatory lapses, financial disclosure and incongruous corporate governance. The group, which was once exemplary of public-private partnership, saw crediting agencies downgrading it from AAA to DD within a span of just 60 days. The sickness of one financial system engulfs the others as was seen when the banks’ shares fell due to lack of clarity regarding IF&LS crisis and tightening of money-market. The IF&LS case is not similar to the famous fraud case of Satyam Computer Service, except for the Central Government’s intervention in both cases for resolution by changing boards of the companies, but while the Satyam case pointed out the grim reality of lack of enforceable and strict corporate governance structure and welfare of employees, the IF&LS crisis is a consequence of ugly defaults resulting from humungous loans without a smooth cash flow.

 

IL&FS, founded in 1987 with equity from Central Bank of India to fund infrastructure projects, is an Indian infrastructure development and finance company. Its projects include some of the largest infrastructure projects in India, and it currently has 256 group companies, subsidiaries, joint venture companies and associate entities. The group has a widespread system of services relating to environment, infrastructure, finance and social service.

 

IF&LS has Japan’s ORIX Corporation, Abu Dhabi Investment Authority, SBI and LIC as institutional stakeholders, with LIC and ORIX holding great volume of shares at 25.34% and 23.54% respectively. From July to September 2018, two out of IL&FS’s 256 subsidiaries reported having trouble paying back loans and inter corporate deposits to other banks and lenders, resulting in the Reserve Bank of India requesting its major shareholders to rescue it. These were not mere blips, as defaults culminated into failure of the IL&FS to repay a Rs. 1,000 crore short term loan taken from SIDBI. As officers of the company were being removed by SIDBI, the debt hole was discovered by various entities. The company had not only failed to meet the commercial paper redemption obligations, but also defaulted on bank loans and short-term and long-term deposits. The default has not only proven as a set-back for the company, but has jeopardised hundreds of investors, banks and mutual funds setting a panic among the investors in the light of default scare. In its move to lap numerous infrastructure projects, the group ended up building a debt to equity ratio of 18:7. Lack of timely action, hurdles in land acquisition and cost escalations aggravated the malady. Many loopholes have been found as of date due to lack of proper governance in place, one of them being opacity of IF&LS in mobilizing funds for their project of special purposes vehicles for construction and building, which was prima facie a conflict of interest as they ended up lending to their SPVs. Another significant issue that arose due to this fiasco was that private executives played a proxy role in public institutions. Since the essence of corporate governance is greater transparency and accountability, the IF&LS fiasco draws attention to the fact that even though infrastructure projects are far more complex, the financial onus has to be made out clearly so as to increase accountability. Delineating the role of state and private companies with regards to public-private partnership does not only ensure perspicuity but safeguard the ethos of corporate governance like accountability and transparency.

 

The case of IF&LS has shown that independent directors are used as mere ornaments. As the risks started to build up on the balance sheet, the opacity was increased with little to no oversight from the board-members and shareholders. Integrity issues, subservient boards and flaws in governance show that the models to achieve economic goals are not efficient.

 

Ultimately, to prevent further economic damage, the National Company Law Tribunal (NCLT) allowed the government to constitute a new board for the lender, asking it to devise a plan for the group and file a response by October 15. As the government scrambles to bail this entity out by appointing a board led by Mahindra CEO Uday Kotak, it has sorely failed to learn from past reports dating back to at least two decades by committees which have dealt with similar catastrophes before. The Central Government is sure that failure to contain the IL&FS disaster will cause irreparable damage to mutual funds companies.

 

Reports and extensive studies have shown that legislation is not the only solution, especially when institutions with diversified shareholding have no dominant shareholders. Worryingly, these institutions are mostly state-run or are backed by government(s) to a great extent. One of the most paradoxical aspects of the great public-private partnership is that the  lines between the public and private entities are either blurred or crossed beyond redemption. This mainly takes place on account of the fact that entities such as IL&FS are allowed to misuse public resources, rendering them worthless upon use or depleting them entirely. Even when IL&FS assets exceed its INR 91,000 crore debt, it must be realized that the assets in question are not private in nature; they form the core of public infrastructure. The government in these instances is forced to do damage control and left grasping at straws while those who are liable for such routine yet colossal downfalls of mammoth institutions manage to evade the law. In the absolute din caused by bleeding conglomerates, the government fails to study the enduring effects and possible causes of loan default and dynamically change its own outlook towards prevention of large-scale defaults. This calls for a stricter regime which does not cast a shadow on the operational aspects, management responsibility, and most importantly the financial assets and liabilities of conglomerates that are simply too big to fail since they will continue to have an indelible effect on the economic stability of the country, even when they are forced to shut down. Accountability by way of collateral remains an abstract concept still not followed in the market. Audits are only conducted and scrutinized microscopically after disaster strikes and the damage has already been done. Civil society organizations and numerous activists have played a pivotal role in bringing unethical practices of conglomerates under the judicial scanner, but it is the government which has to ensure that the need for arduous litigation does not arise. Failure to pay back loans cannot be reduced to a cyclical event for institutions especially when such failure can wreak havoc on the economy on a long-term basis, as taxpayers’ money continues to cushion the blow.  Panic and paranoia can be avoided only when the assets and liabilities of conglomerates are accounted for, which shall bring in an era of economic transparency which continues to elude Indian markets.

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