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Why IL&FS Picked This Route To Solvency

Insolvent infrastructure finance firm IL&FS Ltd. has sought to reorganise its financial affairs under a scheme of arrangement involving itself and 40 group companies. The company has filed an application for such a scheme with the National Company Law Tribunal, it said in a statement today.

The resolution of IL&FS presents a complex challenge. Not only because it involves the need for additional capital as well as debt restructuring. But also because unfortunately there is no specific legal framework to work with. Yet.

IL&FS is a core investment company as per classification of the Reserve Bank of India. That is, a non-banking financial company whose core business is to make investments. In RBI parlance, it is better described as a CIC - SI - ND or a Sytemically Important Non-Deposit Accepting CIC.

This classification is important as it determines what route IL&FS can take to resolve its insolvency.

Besides the complex nomenclature, that IL&FS has 24 direct subsidiaries, 132 indirect subsidiaries and six joint ventures adds layers to the resolution problem.

No Specific Insolvency Framework For Financial Firms, Yet

Had the Financial Resolution and Deposit Insurance Bill been passed, a specific framework for resolution of financial firms would have been available.

Because standard insolvency processes are not suited to financial firms of systemic importance, the bill sought to create “a credible resolution regime under an expert statutory institution that is able to ensure efficient, orderly and fair resolution of financial firms,” according to the committee that worked on its draft.

That expert statutory institution was conceived as a Resolution Corporation that would count among its members representatives of the finance ministry and key economic regulators —RBI, SEBI, IRDAI and PFRDA— along with independent members.

The Resolution Corporation would have powers to takeover any financial firm classified as having “critical” risk of failure, administer a resolution process within two years or a liquidation process if required.

This special mechanism brought to bear the force of the government and the combined expertise of regulators when resolving a financial firm of systemic importance.

But the FRDI Bill ran into other trouble and hence, unlike several other countries, no such special route is yet available for resolution of insolvent financial firms.

Even if it were operational, a Resolution Corporation-led solution would have to kick in before a firm reached crisis point, said Bhargavi Zaveri, researcher at Indira Gandhi Institute of Development Research. “(FRDI) is meant to be a speedy resolution. For example, in the U.S. it would happen over a weekend. They step in to the bank on Friday and on Monday your bank is a different bank with no discontinuity of services to consumers, etc. It is very difficult to replicate that now for IL&FS.”

Could IL&FS Have Taken The IBC Route?

The Insolvency and Bankruptcy Code, 2016 does not cover a “financial service provider”.

One way into the IBC though for a company like IL&FS is by special notification of the government, under Section 2 of the code. This route has not been used so far, but then the IBC itself is just under two years in implementation.

Even if the IBC were to apply in such a case, the layered complexity of IL&FS could have made for a tough, protracted resolution, experts say.

Maybe it could have worked if each insolvent subsidiary went through a separate resolution process, said MR Umarji, former legal adviser to the Indian Banks’ Association.

Zaveri disagreed. Several subsidiaries are interconnected, she pointed out, adding that it would be more effective to pursue the resolution of the holding company.

“For instance, you may find that triggering the IBC for one specific operating subsidy may end up triggering the insolvency of the connected entities because there are inter corporate deposits and they are intrinsically linked. It may be not an efficient route.”

Company Law Solution

The Companies Act, 2013 does provide for an immediate solution, even if not an ideal one.

Section 230 of the law provides for a scheme of compromise or arrangement between a company and its creditor or shareholders. In simple terms, a scheme to reorganise the company’s financial structure.

Any debt restructuring under such a scheme would need approval of at least 75 percent of the secured creditors in value. Or else, such a scheme would need similar approval from shareholders. And approval from the National Company Law Tribunal.

This route bears two obvious advantages—that equity rights are maintained, important in the IL&FS context as major shareholders are expected to bring in fresh funds. In an insolvent firm equity is worth nothing.

And, that the scheme structure offers considerable flexibility in crafting a multi-faceted solution.

But the lack of certain provisions may make the implementation of a scheme unwieldy.

1. For instance there is no explicit provision of a moratorium or standstill. But earlier judgments, under the 1956 Act, indicate that the courts can grant moratorium, the lawyer pointed out.

2. Unlike IBC, there are no fixed timelines in a scheme.

3. Also, a resolution plan approved by the NCLT under the IBC has an overriding effect over all other laws, such as Income Tax Act. However, schemes approved by the NCLT under Section 230 of the Companies Act, 2013 do not have any such benefit. They are subject to all other applicable laws and to that extent it may reduce the effectiveness of the scheme.

Besides, the scheme route is vulnerable to more court interventions than IBC, Zaveri pointed out.

The court has the discretion to make provision for dissenting creditors and shareholders.That leaves scope for anybody who is dissenting from the scheme to apply to court. We have seen that happening in past.
Bhargavi Zaveri, Researcher, IGIDR

Other difficulties may include the lack of a comprehensive framework covering all classes of creditors, like the Committee of Creditors in an insolvency resolution proceeding under IBC.

But it’s the lack of many of these features that provide the necessary flexibility an IL&FS type situation needs, said Umarji.

In a scheme of arrangement under company law, the regulators who are regulating this particular entity can come together, set up some committee or authority to look at the overall working of the holding company and all subsidiaries and formulate a scheme which is applicable to all. Since no time limits are applicable, it could be done in a phased manner, sector wise.
MR Umarji, Former Legal Adviser, IBA

Though as one senior corporate lawyer pointed out, on condition of anonymity, schemes have not been tested in a group insolvency situation.

Zaveri agreed that resolving IL&FS under company law would be as much of an experiment as under IBC.

Schemes of arrangement and compromise in India are not typically used for corporate debt restructuring, especially financial services firms. We see them used for mergers, demergers but not so much for corporate debt restructuring, although the Companies Act of 2013 specifically mentions that it can be used for corporate debt restructuring. That is more like a clarified provision. It is anybody guess that this is better than the other as it is a first time event.
Bhargavi Zaveri, Researcher, IGIDR

But given the lack of immediate other options, IL&FS has picked this route to nurse itself back to health.

Details of the scheme have not been disclosed so far except that it will involve IL&FS and 40 other group companies. These include IL&FS Transportation Networks Ltd., IL&FS Engineering & Construction Company Ltd., IL&FS Energy Development Company Ltd., IL&FS Maritime Infrastructure Company Ltd., IL&FS Environmental Infrastructure & Service Ltd., IL&FS Township & Urban Assets Ltd., Hill Country Properties Ltd. and many of their subsidiaries.

The first step towards returning to solvency has been taken.

Shortly before IL&FS announced the filing of a scheme, BloombergQuint discussed the pros and cons of IBC vs Companies Act with MR Umarji, former legal adviser to the Indian Banks’ Association, and Bhargavi Zaveri, researcher at IGIDR.

Watch that discussion here.