IL And FS Financial Scandal
Author: LawSphereX
Category: Banking & Finance
Published:
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IL AND FS FINANCIAL SCANDAL
Rimjhim, Symbiosis Law School, Nagpur
ABSTRACT
IL&FS scam, is one of the most famous and biggest financial scandals of India, exposed the = deficiencies deep-rooted in corporate governance, financial regulation, and regulatory frameworks in the non-banking finance industry. IL&FS, a well famous infrastructure development and financing company, at the stage of going into bankruptcy, due to defective business model of funding long-term infra projects through short-term borrowings. The Infrastructure Leasing & Financial Services, Financial crisis began in
2018 when it had defaulted on its massive debt liabilities, plunging financial
markets into turmoil and exposing weaknesses in India's shadow banking system. With the help of this case study will try to understand the history and organizational intricacies of IL&FS, why it collapsed, and the consequential effect on the finance industry. It also analyses the regime of regulation that applies to NBFCs in India, such as the Insolvency and Bankruptcy Code, RBI regulation, the Companies Act and SEBI regulation. Lastly, the paper discusses the possibilities to improve corporate governance, enhance the regulatory firewall, and foster resilience.
INTRODUCTION
The IL&FS Scandal is India’s one of most shocking financial scandals , revealing well established weaknesses in corporate governance, financial mismanagement. IL&FS, was a business having pre-eminent infrastructure development and finance, had been keen in funding India's large-scale projects. But beneath the curtain of success, a complex network of financial malpractices and reckless actions that was ruining inside the company. IL&FS crisis emerged in September 2018 when the firm defaulted on ₹450 crore of intercorporate deposits and commercial papers, leading to panic in India's financial markets. The root cause was a faulty business model, where short-term borrowings financed long-term projects, compounded by poor regulation and poor financial disclosure. This resulted in credit rating downgrades, investor confidence shaken, and liquidity shortages in the NBFC sector.
The crisis revealed fault lines in India's shadow banking system, whose lax regulation allowed governance lapses. The government responded by ousting the IL&FS board and introducing regulatory reforms. This case study examines the crisis, existing NBFC regulations, comparisons with financial laws in the United States, and proposes reforms to make India's financial system more robust. Shadow banks in India, these are Non-Banking Financial Companies (NBFCs) that perform activities identical to banks, such as extending loans or credit, but without being regulated as tightly as regular banks. Due to this relaxed regulation, they can lend more easily, but it also exposes them to more financial risks — as witnessed in the IL&FS crisis.
(NBFCs): A Non-Banking Financial Company, are the companies listed under The Companies Act of1956, and whose main business is revolving around financial activities like granting loans and advances, purchase of stocks, shares, bonds, debentures, government securities, leasing, hire-purchase, and insurance business etc. The entities whose primary business is agriculture, industrial activities, buying and selling of goods (except securities), providing services, or dealing in immovable properties are not covered under this. Also, an organization whose main business is to receive deposits under any scheme or arrangement in lump or instalment form is referred to as a residuary non-banking company and also comes under the category of NBFC.
A firm's activity is deemed financial in nature when: Its financial assets exceed 50 percent of total asset, and its revenues from financial assets are greater than 50 percent of gross revenues. Only companies meeting this test are registered as NBFCs by the Reserve Bank of India . This test ensures that companies whose core activities are not financial, such as agriculture, industrial activities, or property dealings, are not mistakenly brought under RBI’s regulatory framework1.
BACKGROUND
Infrastructure Leasing & Financial Services Ltd. was a company that was formed in 1987 as a Investment Company of the Reserve Bank of India. IL&FS was formed to be a private-public partnership to build up big-scale infrastructural projects and to perform funding for it in India. The Prominent financial institutions like the Central Bank of India, Housing Development Finance Corporation Ltd (HDFC), and the Unit Trust of India (UTI) were the initial promoters of IL&FS. Primarily it operated in infrastructure, finance, social, and environmental services and had a corporate structure of complex nature consisting of 256 subsidiaries which consists of including direct subsidiaries, indirect subsidiaries, joint ventures, and associate companies2. Key institutional shareholders included3: • LIC: (25.34%)
Orix Corporation (Japan): (23.5%) • Abu Dhabi Investment Authority: (12.5%) • Employees Welfare Trust: (12%) •
SBI: (6.42%)
Central Bank of India: (7.67%) 1 Ayush Agrahari, NBFCs and other Financial Service Providers within the scope of IBC, 2016, VEDHAS, (Dec. 15, 2024,), https://vedhaslawjournal.com/2024/12/15/nbfcs-and-other-financial-service-providers-within-thescope-of-ibc-2016/. 2 Baranidharan Subburayan, Unraveling the Mirage: The IL&FS Accounting and Financial Fraud Case Study, Vol.14, No.2, 2-3 (2023).
3 IL&FS Scandal, VRD NATION, https://www.vrdnation.com/il-and-fs-scandal.
During its existence IL&FS was a key contributor in the overall growth India's infrastructure. Had started various funding projects worth about ₹1. 8 lakh crore in different sectors such as transport, power, urban infrastructure, and e-governance, etc. IL&FS, being an NBFC, collected funds by raising long-term bank loans and short-term debt instruments like bonds, commercial papers and non-convertible debentures. Specifically, the transportation business of IL&FS, undertook mega projects, including constructing 14,000 lane kilometres on 30 projects and financing the Chenani-Nashri Tunnel in the Jammu & Kashmir state. During the year 2018, the company had an outstanding debt of total ₹91,000 crore, of which ₹57,000 crore was from public sector banks.
Governance failures, financial mismanagement, and fraudulent financial reporting practices led to a severe liquidity crisis, leading to defaults on debt repayment and loss of market confidence4. IL&FS CRISIS FACTS: IL&FS in the year August 2018, had defaulted on its debt, giving rise to a sudden liquidity crisis in the financial service sector. The firm and group entities default on payment obligation on long-term bank loans and interest, long term and short-term deposit, inter corporate payments, and commercial paper redemption. Its humongous consolidated debt of ₹99,354 crores having already caused it to default on inter-corporate deposits to the value of around ₹450 crores with the Small Industries Development Bank of India, further defaults were anticipated5. IL&FS also received a number of notices of delay and default in payment of intercorporate deposits during this period.
Consequently, credit rating agencies ICRA and CARE downgraded its long-term and short-term borrowing proposals, severely damaging its reputation. The downgrade shook the entire financial system with mutual funds, corporates, and insurance companies that had lent to IL&FS's debt instruments being badly hit. This liquidity crisis hit the equity market as well when investors were fearful of their funds getting stuck in IL&FS debt instruments further destabilizing the market6. Having been one of the major financers of various megaprojects, IL&FS has financed highvalued infrastructure projects which was delayed due to land acquisition, regulatory approvals, and cost overruns, its cash flows remained stressed.
IL&FS was exposed to the risks inherent in the business, which included regulatory delays, cost overruns, natural calamities, unforeseen contingencies, and shifts in the business environment. The projects of the company tended to get delayed, thus, payments were delayed. While this was happening, IL&FS had mobilized large amounts of funds via short-term papers like commercial papers (CPs) and non-convertible debentures (NCDs). It defaulted on repayments as it wrestled to create liquidity, triggering a domino effect within the financial industry. The crisis had a cascading effect, touching banks, non-banking financial institutions (NBFCs), and investors. The share market saw a sharp fall, and mutual funds with IL&FS exposure attempted to withdraw their funds. Banks also stood at the risk of heavy losses since IL&FS did not have the liquidity to repay its creditors.
The crisis threatened to exacerbate the financial instability in the Indian economy. Both the Reserve Bank of India and the Indian government, realizing the gravity of the crisis, acted promptly to prevent a full-fledged market liquidity crisis. Through their prompt action, they were able to contain the spillovers and restore stability to some degree to the financial system. LEGAL FRAMEWORK7:
1 Insolvency and Bankruptcy Code 2016
Previously, NBFCs and other Financial Service Providers (FSPs) were exempted from the Insolvency and Bankruptcy code(IBC) in order to avoid economic destabilization. Nevertheless, post-DHFL's liquidity crisis, the government, on 15 November 2019, permitted IBC proceedings against NBFCs having assets in excess of ₹5 billion. The proceedings are unlike typical insolvency cases since they can be instituted by the RBI alone before the NCLT. The RBI also nominates an administrator to monitor the process, maintaining regulatory oversight. In furtherance of it, the committee of creditors has to obtain no-objection from the RBI before accepting a resolution plan.
The Insolvency & Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers) Rules, 2019, are aligned with the Corporate Insolvency Resolution Process (CIRP) but includes exceptions for maintaining financial stability and protect 7 Tanya Rathod, Harsha Tiwari, Analysis of Indian Laws in the Wake of IL&FS Crisis, 3. 2 JCLG 218, 226-22 (2020). financial system. Sec. 227 of the IBC authorizes the government to serve notice of such proceedings after taking advise financial regulators8.
2 Banking Regulation Act, 1949
Banks that are in India are governed by the provision of the Banking Regulation Act,
1949 Sec. 36, 36AA, 36AE, 36AF, 36AG, 37, 38. NBFCs, being of different types (asset
finance, loan companies, microfinance, etc.), are governed by the RBI to manage sector-specific risks while ensuring operational flexibility.
3 RBI Regulations
According to Section 45-IA of the Reserve Bank of India Act, 1934, a non-banking company which is engaged in business related to finances, e.g., loan extension, advances, or investments, falls under the ambit of Non-Banking Financial Company (NBFC).
Although NBFCs cannot engage in all the regulations of a bank, their own activities are regulated by the (RBI). The RBI sets guidelines for NBFCs periodically regarding the disclosure of financial information in the form of quarterly, half-yearly, and annual returns.
4 Companies Act 2013
As NBFCs is considered as a company under Company Act hence the provisions off Company Act is applied here on the NBFCs. Also, as NBFCs are company registered under the Companies Act, 1956, they have to meet all the legal and regulatory obligations of the Act. Sec. 270 of the Companies Act, 2013: This section deals with the winding up of the NBFCs either voluntarily or on the order of (NCLT). Allowing public depositors (creditors) to initiate insolvency proceedings against banks would conflict with RBI’s objective of financial stability. 8 Anisha Shroff ,,&” Sharanya Kundu, NBFCs brought under purview of insolvency code, Law.asia (Jan. 20, 2020), https://law.asia/NBFCs-purview-insolvency-code/.
5 SEBI Regulations
NBFCs (Non-Banking Financial Companies) deals in financial instruments including share, stock, bond, debenture, and government, local body, or other marketable securities. Since many NBFCs are listed companies (listed in the stock exchange), they need to comply with all the provisions and regulations declared by the SEBI in order to protect the interest of the investor
ANALYSIS
v REASONS FOR THE CRISIS: The crisis was created mainly due to an excessive burden of debt, financial inefficiency, and a mismatch in assets and liabilities. IL&FS crisis made us realize severe corporate governance deficiencies once again after Satyam and Sahara scams and stricter legislations. A comprehensive description of causes that led IL&FS into collapse:
1 Structural Defaults
IL&FS possessed a complicated, interconnected structure of subsidiaries, where the holding company raised funds, which were channelled to the project financing of its subsidiaries. The holding company, however, was under financial strain because of payment arrear and delayed cash flows, impacting the entire group.
2 Layered Debt Accumulation
With a low equity capital of Rs. 9.83 crores, IL&FS gathered a humongous debt of Rs. 91,000 crores. The parent company took loans and invested them as equity in subsidiaries, who in turn invested this equity to take more loans, building a debt structure that was unsustainable.
3 Asset-Liability Mismatch
IL&FS took short-term borrowing (e.g., commercial papers and debentures) but invested in long-term infrastructure development projects with gestation periods of more than a decade. This mismatch resulted in acute liquidity deficiencies and failure to repay.
4 Unviable Projects
Several IL&FS projects, particularly roads, power, and water projects, were bogged down due to land acquisition, regulatory clearances, and cost overruns. Project delays and rising costs made some projects economically unviable.
5 Weak Governance and Risk Management
IL&FS lent to poorly creditworthy businesses and invested in non-performing assets with a lack of proper due diligence. Weak risk management practice resulted in excessive accumulation of bad loans.
6 Complex Corporate Structure and Financial Misreporting
IL&FS intricate structure, including many subsidiaries and Special Purpose Vehicles (SPVs), made its financial health unascertainable. IL&FS also pursued fraudulent financial disclosure, hiding its increasing debt burden and liquidity issues, deceiving lenders and investors. Regulatory Failures and Credit Rating Failures: IL&FS was able to obtain good credit ratings, despite its increasing financial distress, owing to laxity in the regulatory environment. This falsification deceived investors and enabled the company to carry on borrowing funds even when financially frail.
7 Governance Failures
IL&FS board and management were accused of favouritism, conflict of interest, and transparency deficiency in awarding loans and contracts. Weak governance mechanisms enabled fraud to be executed.
8 Financial Market Liquidity Crisis
IL&FS The crisis developed in the backdrop of an environment of liquidity crisis in the Indian financial system. When IL&FS failed to meet its debt obligations, investor confidence plummeted, and there was dislocation in the debt and equity markets, further escalating the crisis. v AUDITORS ROLE: IL&FS evaded scrutiny by presenting itself as a government-backed organization and a reliable partner for large public projects. Deloitte Haskins & Sells LLP, the group's auditor for 10 years, did not notice any discrepancies and issued clean reports all along. But the SFIO probe found gigantic frauds:
1 Round Tripping of Loans (₹2,270 crore)
Funds were lent to firms and then these funds were routed back to IL&FS group companies to display exaggerated financial health.
2 Tenure Mismatch (₹541 crore)
Short-term borrowings were utilised for long-term uses, which is a deviation from lending practices. 3. Fudging Credit Documents (₹411 crore): discrepancies were traced between systembased and manual records of credit approvals.
4 Lending at a Loss (₹2,400 crore)
Loans were extended at low or even negative interest rates, suspecting political influence.
5 Loans to Defaulters (₹1,922 crore)
Money was advanced to companies that already had risk indicators.
6 No Collateral Charge (₹1,819 crore)
Loans were released without charging collateral.
7 Evergreening (₹145 crore)
New loans were utilized to repay outstanding defaults, hiding financial difficulties.
8 Funding Directors (₹94 crore)
Indirect Loans favoured IL&FS directors, showing clear conflict of interest.
9. This showed significant lapses in the auditors and governance shortfalls.
v WHAT HAPPENED NEXT: Following a month-long report by Grant Thornton that revealed fraud at IL&FS, the Serious Fraud Investigation Office and Enforcement Directorate acted fast. Important executives such as Vibhav Kapoor and K. Ramchandra resigned ahead of the filing of a resolution plan. The K. Ramchandra and ED arrested Arun Shah, under the PMLA, and SFIO arrested former CEO R. C. Bawa and director Hari Sankaran. Founder Ravi Parthasarathy was not arrested because of health problems. Investigations showed massive fraud, misreporting, and loan evergreening. Auditors Deloitte and BSR were taken action against for negligence. Even after attempts to stabilize the situation, there are doubts regarding regulatory failures. LIC promised it would prevent IL&FS's collapse. • The role Central Government: Sensing the gravity of the situation, the central government intervened.
With the sanction of (NCLT), the government invoked its SeC. 241 and 242 of the Companies Act 2013, to oust the 12 current board members. These were replaced by a new board comprising dignified names such as Uday Kotak, Vineet Nayyar, GN Bajpai, and GC Chaturvedi, Malini Shankar, and Nanda Kishor as six newly elected members. This was for restoring stability and safeguarding the overall financial system. Uday Kotak, being as the Managing Director of Kotak Mahindra Bank, who was made the chairman of the new board. It was the first time since the Satyam Computers scam that the government itself intervened in corporate governance to safeguard the financial system and public interest. • The role of MCA and RBI: The MCA brought NBFCs under the Insolvency and Bankruptcy Code, 2016, providing them with moratorium period for protection against legal action. The IL&FS default in
2018 during the financial crisis put NBFCs and credit rating agencies in the limelight,
enhancing transparency. Timely intervention by the RBI and the replacement of the old IL&FS board enabled recovery of more than 90% of debts. As NBFCs are in close connection with banks and infrastructure sectors, a crisis in NBFCs is impacting the broader economy, as evidenced by the deceleration of shadow banking and infrastructure projects during
2018 CONCLUSION
IL&FS financial Scandal is a typical instance of the risks involved in poor corporate governance, faulty business models, and lack of stringent regulation which threaten even major financial institutions and affect more than to the remaining economy. The crisis sets the risk of financing the long-term infrastructure through short-term borrowing in the absence of proper fiscal caution. It has also foregrounded the need for greater surveillance and strong regulatory mechanisms for NBFCs. The government intervention, the reforms at the regulatory level, and the Insolvency and Bankruptcy Code reforms have been going in the correct direction. But the scam reflects the need for vigilant surveillance, openness, budget discipline, and accountability at large-ticket financial establishments.
In the years to come, building better corporate governance, building a stronger regulatory firewall, and taking risk management in a timely fashion are essential to ensuring financial stability and investor confidence in India's financial system.
BIBLIOGRAPHY:
1. https://www.rbi.org.in/Scripts/FAQView.aspx?Id=92.
2. https://www.vrdnation.com/il-and-fs-scandal.
3. https://groww.in/blog/how-ilfs-crisis-led-to-panic-indian-economy.
4. https://journals.iium.edu.my/ijcsm/index.php/jcsm/article/download/208/90/1001.
5. http://www.scconline.com/DocumentLink/RV7yVBOt.
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