Bolstering The Regulatory Framework for Insolvency Resolution of NBFCS

BOLSTERING THE REGULATORY FRAMEWORK FOR INSOLVENCY RESOLUTION OF NBFCS

A more rare and unexplored form of triggering insolvency resolution, lies hidden under the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudication Authority) Rules, 2019 ("FSP Rules")

Introducing the Insolvency and Bankruptcy Code

Credit flow amongst enterprises is one of the most important indicators of the health of an economy. Put reasonably, no business can sustain itself without credit. With each non-performing asset ("NPA") that is introduced in the economy, some part of the credit is taken out of circulation. As the number of NPAs kept ballooning over the years in the Indian economic ecosystem, it was felt that the debt recovery laws were failing miserably in plugging the hole causing credit drain.

It was in these circumstances that the Insolvency and Bankruptcy Code, 2016 ("IBC"/ "Code") was introduced on 28 May, 2016. The predominant goal of the IBC, as envisaged by the lawmakers, was to pull companies out of insolvency and give them a new lease of life through insolvency resolution. The Indian insolvency regime took a firm shape only in the year 2016, when the Code was enacted.

Insolvency resolution of financial service providers: an unexplored phenomenon

Typically, the insolvency resolution for a corporate person can be initiated by either the financial creditor or the operational creditor or by the corporate debtor itself, under Sections 7, 9 or 10 of the Code, respectively. A more rare and unexplored form of triggering insolvency resolution, lies hidden under the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudication Authority) Rules, 2019 ("FSP Rules").

The FSP Rules find their roots in Section 227 read with Section 239 of the IBC which enable the Central Government to formulate special provisions for the insolvency resolution of financial service providers ("FSP"). The FSP Rules envisage that the provisions of the IBC relating to the corporate insolvency resolution process ("CIRP") of the corporate debtor would, mutatis mutandis apply, to the insolvency resolution process of an FSP¹ except that:

(i) the CIRP for FSPs shall only be initiated upon an application made by an appropriate financial sector regulator²;

(ii) an interim moratorium shall commence from the date of filing of application, till its admission or rejection³;

(iii) the adjudicating authority shall appoint an administrator to exercise the powers and functions of the insolvency professional for the purpose of insolvency and liquidation proceedings of an FSP⁴;

(iv) the appropriate regulator may constitute an advisory committee, consisting of three or more members to advise the administrator in the operations of the FSP during the CIRP⁵.

Another peculiar feature of the FSP Rules is that these rules do not apply to all FSPs as defined under Section 3(17) of the Code, but only to those which the Central Government notifies under Section 227 of IBC.

The DHFL case: first ever insolvency resolution matter under the FSP Rules

In 2019, DHFL, one of the biggest housing finance company in India, was brought under the realm of insolvency under the 2019 FSP Rules. It was the very first case of insolvency resolution initiated against an FSP under the FSP Rules.⁶ The Reserve Bank of India ("RBI") initiated insolvency proceedings against DHFL after replacing the board of directors of the company citing governance concerns and defaults by DHFL in meeting various payment obligations.⁷

The resolution plan submitted by Piramal Capital & Housing Finance Limited ("Piramal Capital") was approved by the Committee of Creditors on 15 January 2021 by a significant majority of 93.65% of the voting share. On 16 February 2021, the RBI provided its assent for change in DHFL management and the resolution plan of Piramal Capital was approved by the Adjudicating Authority (National Company Law Tribunal) ("NCLT"), Mumbai Bench on 7 June 2021.⁸

The SREI case

The RBI from November 2020 to January 2021 had conducted a special audit of two SREI Group companies, SREI Infrastructure Finance Ltd. ("SREI Infrastructure") and SREI Equipment Finance Ltd. ("SREI Equipment"). The audit brought to light various related-party transactions, which the companies in their own books of accounts had failed to report, as mandated by the applicable law.⁹

The two SREI Companies had reportedly¹⁰ lent over ₹ 6,000 crore to 22 companies where the Kanoria Foundation, the ultimate beneficial owner of the SREI Group, had a direct interest. Further, the two Companies were reportedly¹¹ routing about ₹ 2900 crore by advancing loans, on generous terms to at least 9 other companies, which are either wholly owned by or where a majority stake in ownership is held by public trusts, which have strong links with the SREI Group Companies. The borrowing of the two SREI Companies at present is estimated to be around ₹ 30,000 crore, which includes borrowings from commercial banks including the UCO Bank, other institutions such as NABARD and a huge chunk of public money.

Taking into consideration, the financial position of both SREI Infrastructure and SREI Equipment, the RBI on 4 October 2021, superseded the board of directors of both the companies, owing to governance concerns and defaults in meeting their various payment obligations.¹² The SREI Group promoters filed a writ petition before the Hon'ble Bombay High Court on 6 October 2021, against the supersession which was dismissed by the Hon'ble Court on 7 October 2021.¹³ On 8 October 2021, the NCLT, Kolkata Bench, through two separate orders admitted the petition filed by the RBI to initiate CIRP for SREI Infrastructure¹⁴ and SREI Equipment.¹⁵

The Reliance Capital Case

On 29 November 2021, the RBI superseded the board of Reliance Capital Ltd.¹⁶ ("Reliance Capital") citing loan defaults and serious governance concerns which the non-banking financial company ("NBFC") was unable to address and appointed Mr. Nageswar Rao Y (Ex-Executive Director, Bank of Maharashtra) as the administrator of the Company. RBI has also constituted a three-member advisory committee to assist the administrator in the proceedings.¹⁷ Subsequently, on 2 December 2021, RBI had also filed an application before the NCLT, Mumbai Bench for the initiation of CIRP against Reliance Capital.¹⁸ On 6 December 2021, the NCLT, Mumbai Bench taking into consideration the existence of debt and default to meet the requirements of Section 7 of the Code, admitted the petition filed by RBI to initiate CIRP for Reliance Capital.¹⁹

Non-banking Financial Companies: A sinkhole for creditors' money?

The recent debacles involving financial frauds and irregularities in matters such as the IL&FS case, DHFL case and the ongoing matter in SREI case and the Reliance Capital matter have certainly raised concerns over the regulatory framework surrounding the NBFCs. The RBI has recently introduced a new regulatory structure by the way of guidelines. The regulatory structure is pegged to have a four-layered scrutiny based on parameters such as size, activity, and perceived risk of operations of an NBFC. The new guidelines namely Scale Based Regulations would be brought to effect from 01 October 2022.²⁰ The increased scrutiny and regulation from RBI is a much-needed move and should inspire some confidence in the stakeholders.

Conclusion

The rising number of NPAs still poses a serious challenge in the economic ecosystem of India. Insolvency of enterprises is a common phenomenon and equated with the end of the life cycle of a company. The object of the IBC is to prevent such corporate death of a company and to maintain the flow of credit in the system.

But what if the creditor to many enterprises such as an NBFC itself becomes insolvent? This reflects an undesirable state of affairs as the insolvency of an NBFC would mean many loans accounts being declared as NPAs.

Therefore, in order to avoid such a state, the RBI must continue to make stricter norms for better regulation of NBFCs. The aim should be to foresee catastrophes as witnessed in the DHFL case, IL&FS case etc. and flag issues at the right stage, going forward.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.