How India is successfully using insolvency code to resolve NBFCs in trouble

RBI superseded boards of Srei Infra Finance and Srei Equipment Finance, and their insolvency process is expected to be IBC-like, as it was in DHFL’s case.

Illustration by Manisha Yadav | ThePrint

Earlier this week, the Reserve Bank of India superseded the boards of Srei Infrastructure Finance and Srei Equipment Finance, owing to “governance concerns” and the failure of these companies to meet their loan repayment obligations. The RBI now plans to initiate their insolvency proceedings through the IBC.

The RBI invoked its powers under Section 45-IE of the RBI Act. The section gives RBI the power to supersede the board of directors of NBFCs and appoint an administrator. The RBI Act was amended through the Finance Act of 2019 to give the RBI a bigger role in the management of NBFCs in adverse situations. The insolvency is expected to proceed through an IBC-like process, as was done with DHFL.

How is an NBFC different to a bank and a non-financial company, and how is the NBFC resolution framework different to banks and non-financial firms?

Banks make high-intensity promises to unsophisticated households, to pay back their money with interest. NBFCs are like non-financial firms in that they generally borrow from professionals who are expected to be able to think, take risks, and suffer losses when business plans do not pan out as expected.

The framework for bank resolution is different from that of NBFCs. In the case of banks, there is a deposit insurance mechanism which protects unsophisticated households. The law gives RBI the power to take control of a bank when default is imminent, and sell it to a buyer.

An NBFC is different not just from banks but also from non-financial firms that produce goods and services, in terms of the Indian legal system. The bankruptcy framework of NBFCs is different from that of non-financial firms whose bankruptcy is governed by the IBC. The resolution process under the IBC is driven by a committee of creditors. After a company defaults, IBC pushes aside the shareholders and their board of directors, and hands over the control of the company to the committee of Creditors. The creditors coordinate and decide the fate of the firm, and obey the sequence defined in the IBC through which claims of different classes of creditors are settled.

In the NBFC framework, RBI does not have to wait for an actual default to take place. In this respect, the process is similar to the resolution process for banks. And once RBI steps in, there are expansive powers, and the lack of legal predictability on the resolution strategy that will be used by RBI.

Evolution of the framework

After the global financial crisis of 2008, countries across the world realised the need for a separate framework for resolution of banks, insurance companies and systemically important firms. It was understood that normal insolvency proceedings are not viable for a bank. While a default in payment could trigger a normal insolvency proceeding, in case of banks, the regulator cannot wait till banks default on their payment obligations to depositors or a systemically important financial institution has actually failed and had ripples across the country.

Recognising that the failure of banks and insurance companies can be highly disruptive for consumers and could pose systemic risk concerns for the economy as a whole, in India the Financial Sector Legislative Reforms Commission (FSLRC, 2011-2015) recommended a specialised resolution mechanism and establishment of a ‘Resolution Corporation’ that will have powers of prompt resolution that make highly intense promises to consumers, such as banks, insurance companies and systemically important financial firms. In the concepts of the FSLRC, back in 2015, there was a distinction between this specialised resolution framework for some financial firms, versus the normal bankruptcy code for all other firms.

This normal bankruptcy code was built by the Bankruptcy Legislative Reforms Commission (BLRC, 2014-15) which also respected this separation: For some financial resolution problems to be solved using the FSLRC Resolution Corporation, and all others that go through the IBC.

Cost of coordination

Banks and insurance companies raise funds from retail sources such as depositors or policy holders and their liabilities are spread across a large number of depositors. The collective action through a committee of creditors is not an optimal mechanism as the cost of coordination is likely to be very high.

With NBFCs, the creditors are generally a small set of professionals. This is much like the creditors of a large corporation — for example, Tata Steel. The IBC strategy, of shifting the powers of the board of directors to the committee of creditors after default, is feasible here.

Default vs concern of default

In the case of a non-financial firm, there needs to be a default before the company can be taken through the IBC, while in the case of a financial firm, in the present framework, the regulator under its new powers can take control of the NBFC and decide to put it through the IBC.

From a situation when the RBI and government tried to take over an NBFC that was going to default (eg IL&FS) themselves, the bankruptcy process has improved. Under the amended legal and regulatory framework, NBFCs can also go through the IBC process.

An interim framework

The IBC initially excluded Financial Service Providers from its scope. However, Section 227 of the IBC empowered the government, in consultation with the financial sector regulator, to bring financial service providers or some categories of financial service providers under the purview of the IBC. The rules framed in 2019 provide the procedure for insolvency of financial service providers. In November 2019, the central government notified the applicability of the rules to non-banking finance companies (which include housing finance companies) with asset size of Rs 500 crore or more.

Pursuant to the amendment under the RBI Act and the IBC Rules, in 2019, the RBI launched insolvency proceedings against DHFL. It was the first finance company to be referred to the National Company Law Tribunal by the RBI using the special powers under IBC.

Thus, under the new NBFC resolution framework, the insolvency resolution process is initiated on the application of the appropriate regulator. The NCLT appoints an administrator proposed by the regulator for financial service providers admitted into insolvency proceedings. The administrator takes on the management of the company, accept or reject claims of creditors and handle liquidation proceedings. Upon accepting a resolution plan, the administrator is required to seek a no-objection from the regulator regarding the persons who will take over the management of the financial service provider.

The amendments under the IBC and the RBI Act were made as an interim arrangement to deal with the insolvency of certain financial service providers until a full-fledged framework is enacted for this.

Looking ahead

Two changes may be expected going forward.

One, setting up of a Resolution Authority that will resolve banks, insurance companies and systemically important financial firms. The Resolution Authority will have little role in resolving non-systemically important NBFCs.

Two, as the IBC processes and NCLT courts stabilise, NBFC creditors should directly be able to take the company to IBC. This will require amendments to the IBC and the RBI Act so that creditors can directly approach NCLT after a default without the intervention of the RBI.

Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.

Radhika Pandey is a consultant at NIPFP.

Views are personal.