Abstract
This case study investigates multiple issues related to corporate governance, regulations, auditing and financial reporting of Infrastructure Leasing and Financial Services Limited (IL&FS). Combinations of these issues resulted in default in payment obligations by IL&FS in August 2018 originated from the agency problem. It posed a substantial systematic risk to the whole financial system of India. This case study highlights the severe drawback of concentration of decision-making and unprofessional work ethics at the senior management level. Further, the case study also provides the opportunity to discuss the inappropriate regulations and governance practices which cause a severe problem in long-standing and prominent organizations like IL&FS.
Research Questions:
(a) Discuss the vital role of corporate governance in major corporations and the reasons behind governance failures. (b) How did asset–liability mismatch create liquidity problems in a company which deals with long-term projects? (c) How does lack of a proper and unified regulatory framework for Non-Banking Financial Corporation (NBFC) harm investors’ interest?
Link to Theory:
This case study provides an opportunity to learn the role of corporate governance in NBFC. This case demonstrates the problems arisen because of agency problem and conflict of interest among real-world stakeholders. The case study also highlights the importance of assets–liabilities management in a strategically important organization like IL&FS.
Phenomenon Studied:
This case study attempts to understand the potential problems that occurred in IL&FS from the failure of good governance, lack of unified regulations for NBFCs and non-adherence of professional responsibilities by the external auditors.
Case Context:
The case study explores the vital role of the infrastructure development and financing companies in developing economies like India and how it may affect other vital entities of the financial system. Further, it demonstrates how unethical practices at senior management and lack of unified regulations can harm the organization.
Findings:
The research study found senior management’s potential involvement in unethical practices while managing the company. The financial statements did not reflect the true and fair picture of the entity, which misled investors and other stakeholders. It created chaos in the stock market, resulting in a loss to shareholders. The government set up a new board to restore the confidence of the stock market. Further, the government started to address the problems that arose.
Discussions:
The case of IL&FS by default, at first glance, looks like a case of asset–liability mismatch due to the lack of supervisory roles of the board and senior management’s massive regulatory failure. It is shocking how under the nose of regulators like Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and Ministry of Corporate Affairs (MCA) a default of this scale could take place. How could IL&FS group grow unchecked into a massive 348 entity. It appeared that regulators, marquee shareholders (banks and institutions), and the board of directors failed in their fiduciary obligation to regulate and supervise IL&FS.
Introduction
The trouble in Infrastructure Leasing & Financial Services Limited (IL&FS) started when IL&FS, a group company, defaulted payment obligations of bank loans (including interest), long-term and short-term deposits and the commercial paper due on 14 September 2018. On 15 September, the company reported that it had received notices for delays and defaults in servicing some of the inter-corporate deposits (Table 1). Consequent to defaults, rating agencies such as Investment Information and Credit Rating Agency (ICRA) and other agencies downgraded the ratings of its short-term and long-term borrowing instruments to BB from AA+. The defaults jeopardized hundreds of investors, banks, pension funds and mutual funds associated with IL&FS, along with other non-banking financial companies (NBFCs) for their investment safety and collectability. It resulted in a massive sell-off in shares of NBFCs and their prices nosedived, resulting in redemption (repayment) pressure in mutual funds holding such financial instruments and adversely impacted sentiments in the stock, money and debt markets. It also created a considerable systematic risk, leading to good-quality debt papers being sold at steep discounts to meet redemption demand.
IL&FS Timeline: When and What Happened from June 2018 till December 2019
The failure of corporate governance at IL&FS was the leading cause of the problem as per the published available resources discussed in the following sections.
In response to such a crisis, the Government of India suspended the then board and reconstituted a new board with eminent professionals to restore confidence among the market players. The government asked various government departments to release funds to IL&FS to ease the liquidity problem of IL&FS. Further, the government told National Company Law Tribunal (NCLT) that the collapse of IL&FS may lead to a collapse of many mutual fund companies and pension funds and might adversely impact the market players, stock market and economy.
Overview of Infrastructure Leasing & Financial Services Limited and Its Capital Structure
IL&FS is one of India’s leading infrastructure development and finance companies. Its central mandate was to catalyse the development of innovative world-class infrastructure in the country. It is a Systemically Important Non-Deposit Accepting Core Investment Company registered with Reserve Bank of India (RBI) (Banking Regulator of India). IL&FS was initially promoted by India’s institutional investors such as the Central Bank of India, Housing Development Finance Corporation Limited and Unit Trust of India. Over the last 30 years, IL&FS has broadened its shareholding and inducted other institutional investors such as the State Bank of India, Life Insurance Corporation of India, ORIX Corporation Japan and Abu Dhabi Investment Authority (Table 2).
IL&FS Ltd. Equity Shareholding Pattern as on 31 March 2017
The sheer size of IL&FS can be gauged from the fact that it has 186 subsidiaries, 146 jointly controlled entities, including 111 jointly controlled operations outside India and 20 associate entities as per its annual report of 2017–2018. Its international presence includes offices in Singapore, Spain, London and Dubai, and robust network partners in the USA, Tokyo, Philippines and Abu Dhabi. As per the audited financials of the company as on 31 March 2018, the size of the total assets and borrowings was US$16.5 billion and US$13.6 billion, respectively.
The IL&FS group has two NBFCs, namely IL&FS and IL&FS Financial Services (IFIN); these two firms held over 35% of the group debt. The business model is distinctive; it was both a financier and developer and the group transactions are also intricate. IL&FS, the holding company, had equity investments in its subsidiaries, and its financial arm IFIN lent money, apart from having an equity stake in these subsidiaries. IL&FS depended heavily on external borrowings to fund its projects resulting in a high debt–equity ratio (Table 3), and it became increasingly difficult for IL&FS to service its borrowing obligations. Apart from high debt–equity ratio, the company had duration mismatch, and the duration gap was widening. IL&FS carried a debt which was always at the higher end of the range of debt–equity ratio carried by other companies in the same industry. However, in the year 2017–2018, IL&FS debt–equity ratio suddenly spiked, demonstrating severe stress on the financial position of the company. High debt–equity ratio placed severe pressure on IL&FS to generate that many revenues to continue to service its debt (Figure 1).
Debt Equity Ratio of IL&FS and Its Competitors
It can be noticed from Figure 2 that short-term borrowings in proportion to long-term borrowings have been showing a rising trend, particularly over the last 3 years. Over the last 5 years, both kinds of borrowing have been rising steadily. The fundamental nature of the financial services business is about managing asset–liability mismatch. An asset–liability mismatch is inherent, but it needs to be monitored and controlled by the top management.
Corporate Governance Practices
The Organisation for Economic Cooperation and Development (OECD) published its Principles of Corporate Governance in the year 1999, which defined corporate governance, as follows:
A set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders, and should facilitate effective monitoring, thereby encouraging firms to use recourses more efficiently.
The theoretical foundations for corporate governance come from Berle and Means (1932) classic work, which described the agency problem arising from the separation of ownership and control. Companies incur high agency costs as agents (managers) are driven by self-interest (Jensen & Meckling, 1976); the governance discussions stress that managers must act in the interests of external stakeholders (Fama, 1980). Effective corporate governance mechanism is considered as a powerful approach in reducing agency costs (Vishnani & Bhatia, 2019)
Top Management at Infrastructure Leasing & Financial Services Limited
IL&FS was led by one man, Ravi Parthasarathy, and his chosen cabal, for 30 years. The Serious Fraud Investigation Office (SFIO) has charged the erstwhile top management members of the group’s financial services subsidiary IFIN of forming a ‘coterie’ with its auditors and independent directors. SFIO has gathered enough evidence to show gross failure in corporate governance, several conflicts of interest, and even undue personal enrichment of some key personnel who were running IL&FS (Business Standard, 2019b). The charges against some of the former directors include masking the actual state of the group’s financial stress, suppression, misrepresentation of critical facts, siphoning off funds via excessive executive package and gross financial mismanagement.
The new board appointed by the Government of India ordered an extensive special audit of crisis-hit IL&FS group which was conducted by Grant Thornton (GT). The audit identified numerous financial irregularities in deals with financial implications of over US$1.9 billion. The audit firm noted 10 anomalies, including conflict of interest, inadequate risk assessment, deviations from banking norms and loans sanctioned at a negative spread. More than 50% of these transactions studied by the audit firm relate to IFIN, a 100% subsidiary of IL&FS. The audit report has identified at least 29 instances where loans disbursed to borrowers appeared to have been used by their group companies to repay the existing debt obligations with IFIN. IL&FS, and its direct subsidiaries—IL&FS Financial Services and IL&FS Transport Networks—borrowed short-term funds from the market and banks, based on window-dressed financials and high credit ratings. They lent the money for the long term at high interest rates to its project subsidiaries and group companies, which in turn used these funds to pay interest on loans taken in the past from the same set of lenders. That made the parent, and its key subsidiaries, look financially healthy to borrow more. The cycle continued till it became impossible to sustain, ending in multiple defaults and spooking the credit market (Business Standard, 2019a).
Further, Grant Thornton’s IL&FS audit found that former IFIN directors have been accused of sanctioning loans worth thousands of crores (1 crore = 10 million) to certain entities by ‘overlooking negative assessment by the credit risk assessment group’ and without recording any cogent justification, despite having full knowledge that the assets of the borrower entities were stressed. A scrutiny of the loan books has revealed that around US$171 million loans are without any security, and another US$286 million are without adequate security. Advances of close to US$429 million have been made without proper risk assessment, and another US$429 million have been routed to other entities that were not eligible to borrow. The auditors have also discovered that US$357 million was used for ever-greening earlier loans.
Besides, loans given to several entities were written off. Former directors of IFIN have been accused of being ‘prima facie responsible for causing financial stress and losses to the company by acting in a mala-fide manner’. According to an estimate of IFIN’s outstanding loan book of over US$2.1 billion as of March 2018, nearly US$1.0 billion of advances, availed of by 50 entities, have turned non-performing. Bad loans surged after borrowers stopped repaying, taking advantage of distress in the group (Business Standard, 2019a).
The GT report pinpoints responsibility on the Committee of Directors of four persons, including its founder Chairman Ravi Parthasarthy. The Enforcement Directorate (ED) has charged the former top officials, including its chairman Ravi Parthasarathy, Ramesh C. Bawa, Hari Sankaran and K. Ramchandaran, under the Prevention of Money Laundering Act (PMLA), and conducted searches across several of its offices. A first information report (FIR) was filed by the Economic Offences Wing of the Delhi Police in December 2018. Later after the investigation by ED, it has been revealed that the IL&FS siphoned out roughly US$43 million over several years through fake work orders issued as part of the construction of the Gurgaon Rapid Metro. Further, FIR revealed that the IL&FS’ subsidiary, IL&FS Rail Infra issued work orders to a string of companies for non-existent work, namely Silverpoint Infratech, Suryamukhi Projects, NKG Infrastructure, Divyanshi Infra Project and Ethical Construction, among others. ‘The task assigned to these bogus companies was to generate cash and hand over the same to the persons accepting those bogus invoices as genuine’, as stated in FIR. The Income Tax Department had noticed the discrepancy first time in May 2018 and had issued a demand notice to IL&FS Rail, seeking clarity on unexplained expenditure (Business Today, 2019).
Independent Directors in Infrastructure Leasing & Financial Services Limited Board
Independent directors of the erstwhile board were all well-known personalities, namely R. C. Bhargava, Chairman Maruti, Michael Pinto, former Secretary for shipping, Sunil B Mathur, Former LIC Chairman, Jaithirth Rao, Banker Citibank and Rina Kamath, a legal practitioner. The board is effective only if it has independent directors who have expertise in the industry in which the company operates. The independent directors of IL&FS lacked experience in managing complex NBFC. The then board did not recognize the importance of risk management function. That is why the risk management committee, comprising mostly of independent directors, never met after July 2015, even as the company’s finances kept tumbling. Also, the nominees of IL&FS shareholders on the board and the bankers never questioned the Chairman and Managing Director (CMD).
External Auditors
An initial investigation by GT suggested that auditors did not fulfil their professional duties. The Institute of Chartered Accountants of India (ICAI) is self-regulating professional bodies to take disciplinary actions against its members in India (Business Standard, 2019a). The National Financial Reporting Authority (NFRA) indicted Deloitte Haskins and Sells LLP for its significant failure in conducting audit of IFIN and in its Audit Quality Review (AQR) report of the statutory audit for the year 2017–2018, has concluded that ‘the failure to comply with the Standards on Auditing are of such significance that Deloitte did not have adequate justification for issuing the audit report’. ‘NFRA has concluded that the quality control system and processes of Deloitte Haskins and Sells are severely inadequate and ineffective…,’ NFRA is examining whether disciplinary proceedings against the auditor need to be initiated (Money Life, 2019).
The Institute of Chartered Accountants of India has held certain statutory auditors of the beleaguered IL&FS group, including its parent IL&FS Ltd. and two of its subsidiaries ITNL and IFIN, ‘prima facie guilty’ of professional misconduct (Saxena, 2018). ICAI interim report alleged that the auditors failed to report:
That IL&FS did not meet RBI’s regulatory framework for core investment companies. Whether the required approvals were being taken to provide high managerial remuneration. Direct and indirect investments made by the parent IL&FS in its group subsidiaries. The ‘serious mismatch’ between assets and liabilities which indicated liquidity concern. Key balance sheet indicators of the beleaguered financier, such as its over-reliance on short-terms borrowings for financing its long-term assets, adverse key financial ratios and deterioration in the value of the assets used to generate cash flows. ‘In fact, the SA (statutory auditors) have mentioned that in view of its (IL&FS) positive net worth, positive cash flows, credit ratings and boards proposals, there is no doubt on the ability of the entity to continue as a going concern.’ The report also found irregularities in the books of IL&FS Financial Services. Even though RBI pointed out that the net owned funds of the non-banking lender had turned negative and its balance sheet was over-leveraged, in its 2014–2015 annual inspection report, and made similar observations later, the auditors failed to state the material facts in their report. Auditors understated the lender’s bad loans and did not point out the inadequate provisioning made against such loans, violating RBI’s circular on ‘Disclosure in the Notes to Accounts to the Financial Statements – Divergence in Asset Classification and Provisioning’. No reasons were given for increasing liabilities/loans and increasing borrowing costs of the financial services arm, leading to non-disclosure of the consequential impact of insufficient provisioning for debts. Auditors failed to show the diversion of the lender’s funds through its subsidiaries, due to fraud or error. They failed to report that the lender indulged in non-viable financial transactions with its own subsidiaries and did not indicate the risk involved in such transactions.
In the special audit conducted by Grant Thornton following the following points were reported (Business Standard, 2019a):
The credit rating rationale which is supposed to be drafted by the rating agencies was materially modified, or significant suggestions from the former key employees of IL&FS were incorporated, to provide and support good ratings given by the Credit Rating Agencies (CRAs); If the then key employees of IL&FS became aware that ratings are not going to be favourable, they then either delayed the process of rating surveillance or delayed the publication. Intentionally incorrect or incomplete information was being provided to CRAs to avoid rating downgrade. If the then key employees of IL&FS did not receive the desired rating from the CRA, they used to potentially pressurize rating agencies to either withdraw the credit ratings or credit rating request or approach other rating agencies that would provide the desired ratings. If the ratings were not favourable, the then key employees of IL&FS tended to keep the ratings in the private domain. After meeting with the then key employees of IL&FS, CRA would not downgrade the ratings that it initially decided.
Regulatory Framework
IL&FS is an NBFC regulated by RBI. However, RBI does not have all the information needed to understand other financial firms’ risks arising from its debt. Notably, pension funds, provident funds, mutual funds and insurance companies hold the debt of IL&FS subsidiaries. However, RBI does not regulate these and hence will not have the full picture.
IL&FS’s case is a loud wake-up call to the lawmakers and regulators to take cognizance of such systemically important institutions. There is an urgent need to develop a risk-sensitive oversight regime for financial conglomerates (FC) like IL&FS where the intrusiveness of oversight of FCs is proportionate to a combination of the entity’s size, and the likelihood of an adverse event, so that remedial measures are taken in a timelier manner.
Post financial crisis of 2008, one of the supervisory tools applied by the central banks is banks’ stress testing. All systemically important financial institutions should be covered by the stress testing exercise at periodic intervals.
Discussion
IL&FS is an organization needed for a developing country like India. These institutions need to be governed and monitored by a team of professionals with high repute. There were many red flags ignored by the external auditors as per ICAI and GT report. Over-relying on very key senior management raises the failure of good governance. The lack of effective governance was noted as RBI, Ministry of Finance, Ministry of Corporate Affairs and Securities and Exchanges Board of India were partly sharing monitoring responsibility. There was no single regularity body to regularize it. ICAI and NFRA observed lack of professionalism by the external auditors, and there is a need to reform the audit profession in India.
RBI must credibly step up its supervisory abilities, or even be willing to hand this over to a new agency created for this purpose. Appointment of auditors is another critical area that needs the attention of regulators. Mandatory rotation of audit firms and joint auditors’ appointment can mitigate the risk of audit negligence significantly. It is time to establish an inspection mechanism for such systemically important companies similar to RBI’s inspection of banking institutions.
The government may consider forming an emergency fund wherein a certain percentage of profits from NBFC’s is transferred to tide over any systemic crisis like IL&FS. It is similar in line with reserve requirements for banks.
Remedial Measures Taken So Far
The Government of India has taken over the Board of IL&FS and appointed a six-member team which includes Uday Kotak of the Kotak Mahindra Bank, retired IAS officer Vineet Nayyar, former Securities & Exchange Board of India (SEBI) chairperson G. N Bajpai, ICICI’s non-executive chairperson G. C. Chaturvedi, IAS officer Malini Shankar and senior bureaucrat from C. A. G. Nand Kishore. NCLT had asked the new board to submit a report on its findings and a roadmap before the NCLT bench. The new board ordered an extensive special audit of crisis-hit IL&FS group which was conducted by Grant Thornton (Vyas, 2018).
The Reserve Bank of India is in a dialogue with market regulator SEBI to flesh out new regulations that would impact the way credit rating agencies function (The Siasat Daily, 2019).
The Institute of Chartered Accountants of India is investigating the role of statutory auditors in multiple IL&FS group entities (Srivats, 2018). Banks’ request to RBI, seeking relaxation in classification NPA norms in respect of dues from IL&FS, has been turned down by RBI. However, NCLT has passed an order stating that the debt of all IL&FS group firms should not be declared as NPAs (The Economic Times, 2019).
Under the Financial Stability and Development Council (FSDC), an Inter Regulatory Forum for monitoring Financial Conglomerates (IRF-FC) is carrying out the oversight of Financial Conglomerates (FCs).
In its half-yearly Financial Stability Report, RBI acknowledged that while the present system is exhaustive, it is backward looking and may not adequately capture emerging risks and vulnerabilities. A risk-sensitive FC oversight regime where the intrusiveness of oversight of FCs is proportionate to a combination of the size of the entity, and the likelihood of an adverse event may help make remedial measures in a timelier manner (The Economic Times, 2018).
Days after Grant Thornton (GT) India LLP submitted its interim report detailing out irregularities in IL&FS, the new government-appointed board of IL&FS has sent show-cause notices to the erstwhile Board of IL&FS Financial Service Ltd (IFIN) asking why criminal action should not be initiated against them.
The new Board of IL&FS is taking a series of measures to improve the liquidity position of the group, which includes taking workforce cost optimization measures and selling stakes in subsidiaries.
Conclusion and Recommendations
IL&FS is a serious case of corporate mismanagement and massive regulatory failure. It is shocking how under the nose of regulators such as RBI, SEBI and Ministry of Corporate Affairs, Ravi Parthasarathy and his chosen cabal IL&FS could grow unchecked into a massive 348-entity empire masquerading as the favourite partner of state and central governments. It is apparent that regulators, marquee shareholders (banks and institutions) and the board of directors failed in their fiduciary obligation to regulate and supervise the actions of Ravi Parthasarathy and his chosen coterie.
IL&FS’s case is a loud wake-up call to the lawmakers and regulators to take cognizance of such systemically important institutions. There is an urgent need to develop a risk-sensitive oversight regime for FCs like IL&FS where the intrusiveness of oversight of FCs is proportionate to a combination of the entity’s size and the likelihood of an adverse event so that remedial measures are taken in a timelier manner. RBI has acknowledged the need for such a risk-sensitive oversight mechanism in its half-yearly Financial Stability Report (The Economic Times, 2018). BI must credibly step up its supervisory abilities, or even be willing to hand this over to a new agency created for this purpose.
Post financial crisis of 2008, one of the supervisory tools applied by the central banks is banks’ stress testing (Bernanke, 2013). All systemically important financial institutions should be covered by the stress testing exercise at periodic intervals.
Appointment of auditors is another critical area that needs the attention of regulators. Mandatory rotation of audit firms and joint auditors’ appointment can mitigate the risk of audit negligence significantly.
It is time to establish an inspection mechanism for such systemically important companies similar to RBI’s inspection of banking institutions.
The government may consider forming an emergency fund wherein a certain percentage of profits from NBFC’s is transferred to tide over any systemic crisis like IL&FS. It is similar in line with reserve requirements for banks.
Limitations of the Study
This case study is solely based on publicly available information. None of the authors has access to confidential primary information on IL&FS and other parties and entities under investigation. Authors have not interviewed IL&FS management, people involved in the audit of IL&FS, or any party or the investigator charged with fraud. The evolution and unfolding of the IL&FS story are covered only until December 2019. Any significant developments after December 2019 must be considered for case discussion.
Footnotes
Declaration of Conflicting Interests
The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
Funding
The authors received no financial support for the research, authorship and/or publication of this article.