IL&FS' systemic structural flaw

The beleaguered IL&FS group has been in the eye of the storm since September last year for defaults in payment obligations of bank loans by group companies. What has also come under the scanner is the group’s complex corporate structure with 346 sub-companies under its ambit. This includes over two-dozen direct subsidiaries, 135 indirect subsidiaries, six joint ventures, four associate companies, among others.

Although most companies in the infrastructure business claim operating a multi-layered corporate structure is regular business practice, it may be worthwhile to check out how this hydra-headed organisation structure created opaqueness in group’s operations and its financials.

Soon after taking charge, the new government-appointed board at IL&FS in October appointed an external agency to suggest ways to consolidate the current structure with multiple layers. Whatever shape the trimmed down multi-layered structure takes, however, experts say it has to be backed by enhanced regulatory monitoring mechanisms, both from within the company and from outside.

Legal experts feel that the regulatory oversight over IL&FS group was the result of the group structure, with a non-banking finance company (NBFC) sitting at the top. IL&FS Ltd, the holding company, is a specialised NBFC that has been categorised by the Reserve Bank of India (RBI) as Systemically Important Core Investment Company (CIC). CICs are allowed to invest in group companies or give guarantees to issues on behalf of group companies. They enjoy several exemptions that a typical Companies Act-regulated corporation would not enjoy.

There are no specific provisions in the Companies Act that deal with the structuring of infrastructure lending companies. The relevant guidelines on borrowing and lending norms are provided under the RBI guidelines, say experts. Interestingly, the Companies Act allows up to two levels of step-down subsidiaries. There are some grandfather clauses permitting companies with layers of subsidiaries in excess of the prescribed limit to merely report the structure to the Registrar of Companies.  “The Rules also provide blanket exemption from applicability of restrictive layers to systematically important ‘Non-Bank Financial Institutions’ and ‘Non-Bank Financial Companies’,” says Nischal Arora, director, regulatory at Nangia Advisors.

While the two-layer restrictive structure is essentially meant to weed out rampant use of Special Purpose Vehicle (SPV) structures, use of SPVs is a common business practice in infrastructure projects business, say experts.

Many experts feel the exemptions given at the NBFC level did not allow the regulators — the RBI and Securities and Exchange Board of India (Sebi, for listed entities) — to get a full view of group’s wide maze of associate companies and multiple layers and the attendant financial stress that they were going through. As a result, regulatory monitoring and supervision over a diverse group like IL&FS fell through the cracks. The slips may continue for any large, diverse group like IL&FS without consolidated view of group’s financials and appropriate group-level corporate governance practices. 

The absence of group-level reporting created an opaque structure for lenders. “In most cases the lenders would assess any proposal looking at standalone figures, without much visibility over group level stress,” says a banker who has dealt with the group. The new board reportedly found that there were no central repository of bank accounts and that the data was stored in different formats and in different systems across the group.


The government in its court filing said IL&FS was “indiscriminately” borrowing money, and “has been presenting a rosy picture and camouflaging its financial statements by hiding severe mismatch between its cash flows and payment obligations, total lack of liquidity and glaring adverse financial ratios”.

One of the recommendations by the Sebi Corporate Governance Committee, headed by Uday Kotak, on the enhanced monitoring of group entities was to constitute a dedicated group governance unit to monitor subsidiaries. The recommendation was accepted by Sebi in May last year. The presence of such a unit at IL&FS would have given holding company directors, regulators, investors a better view of group’s corporate governance practices. 

However, another recommendation by the Committee that is still to find acceptance is to make auditors of listed companies in holding companies responsible for the audit opinion of all material unlisted subsidiaries. Audit experts say this would have given holding company auditors a better view of the financials across the group. The current practice is that the holding-level auditors accepts the views presented by the entity-level auditors and qualify their reports accordingly. 

The government has now moved courts to scrutinise IL&FS accounts for the past five years. The new board has instituted a forensic audit while the RBI has initiated a special audit. This may be a case of vigilance after the problem has developed into a full-blown crisis. Given IL&FS’s systemic risks, the time to tackle the “subsidiary” problem of the NBFC industry has become urgent.

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