Disequilibrium: Long Shadow Over Shadow Bank

Ravi Parthasarthy, Hari Sankaran & Co blissfully sailed on the Titanic wilfully crashing it on the iceberg, looting from a dizzying maze of subsidiaries and other entities. In an election year, it was imperative for the Govt to move in and cauterise the open sore, which was thrown into the arc lights by a vigilant media including FC

Disequilibrium: Long Shadow Over Shadow Bank
Disequilibrium: Long Shadow Over Shadow Bank

What happens when the unequivocal recitation of truth birthed by avarice, human fragility and error becomes a festering sore. In the cathedral of greed, also an echo chamber, a compelling story is laminated with half truths and sold to one and all. The management chants a mantra that all is well, even as the blood begins to coagulate. At IL&FS, this became the norm. A closed user group enjoyed the fruits of a poisoned tree for 30 years as all oversight mechanisms failed to nail the malfeasance. Finally, when the government woke up to the rot courtesy an alert media realising that a grave contagion could take the burning house down with it, it is now imperative that a few fingerlings are not caught while the blue whale gets away. Each and every member of this CUG which ran IL&FS into the ground has to be brought to book. The happy cabal went about its merry ways spending public money at will. For years we heard rumours of excesses, but the improprieties stayed under the radar. Actually, it is only after the new land acquisition bill was notified on January 1, 2014 that the cracks appeared and then widened into fissures. As concessions went awry, the government woke up to the ticking time bomb and liquidity crunch facing the company, it was obvious that the imminent defaults would have a cascading effect on the entire banking system and larger financial markets not limited to the mutual fund industry and money markets. Finance minister Arun Jaitley personally supervised operation take over knowing fully well what the doom of such an institution would mean for the economy. That is why after the take over, he said on Thursday — Since IL&FS is an “internal factor to India, it should be contained so no adverse impact is felt.” In an election year an entity called the Titanic in the Union government petition to the NCLT capsizing would have meant calamity. Jaitley had come under pressure to act after receiving formal letters, including one from opposition lawmaker KV Thomas, raising concerns about operations at IL&FS. Jaitley’s team last Sunday sent a confidential note to the Ministry of Corporate Affairs recommending that the NCLT be approached for the “reconstitution and supersession” of the over geared IL&FS board.

The sheer negligence and incompetence of the board of directors bringing the company to ruin. The holding company IL&FS alone has a mountain of debt staring in its face, in the vicinity of Rs 57,000 crore out of the total group debt of Rs 91,091 crore. This Rs 57,000 crore debt is from public sector banks and institutions. And if nothing had been done, this would turn into NPAs. Even now, one doesn’t know how much of it will turn into bad loans. Moreover, the majority of the capital invested in the holding company is by public financial institutions like LIC, SBI, CBI, besides UTI AMC. Which means it has linkages across the Indian economic vector and perhaps that is why that it was too big to fail and the government stepped in to avert a catastrophic situation. The current management had to be superseded because it was completely unforgiving in showing its incompetence while managing the affairs of the holding company even as group companies were a party to major infrastructure and financial projects  and as such accountable for their misdeeds. The net worth of the company — a core investment company — was down to Rs 6950.19 crore. Since April 1, 2016 till September 21 2018, IL&FS had provided financial assistance by way of shareholder loans or share capital amounting to Rs 22,989 crore to its vast swathe of subsidiaries. Its outstanding financial assistance and investment across all group companies including the identified group companies aggregated to Rs 22,929 crore.

A list of all the entities of the holdco IL&FS is nothing short of surreal. There are as many 334 entities which includes domestic and foreign entities. The losses of the key subsidiaries are a tale of woe (see box for top debtors on next page). The group debt shot up to Rs 91,091 crore in 2018 from Rs 48,671 crore in 2014 virtually doubling itself. The worst part was that interest outgo rose to Rs 7,922 crore from Rs 3,907 crore during the same period. Then came the ultimate denouement — by 2018, it was unable to meet its debt servicing obligations. In this cosy club of silence, a code not dissimilar to Omerta — the management, auditors, rating agencies, independent directors — the whole eco system was complicit. This collusion at the highest level carried on till as recently 1.8.2018 when IL&FS in its private placement prospectus announced that it would be declaring a dividend of Rs 6 per share to its equity shareholders and the company is CURRENT on all its debt obligations. This way IL&FS was able to raise Rs 50 crore from its debt investors with a green shoe option of Rs 25 crore. The said issue closed on 27.8.2018 with IL&FS relying on good ratings from CARE and ICRA to market the issue that took on record the standalone financial numbers for  the financial year 2018, which showed a profit of Rs 584 crore, but gave no hint of the consolidated losses of Rs 2,400 crore. The blind, deaf and dumb show continued unhindered till 30.8.2018 after the issue closed, when IL&FS declared that it had slashed dividend payout to Rs 1 per share and by 27.9.2018, two days before the AGM, the company actually went ahead and scrapped the entire dividend payout. Lies and more lies had been nailed. This too after the debenture trustee Centbank Financial Services not granting permission to the company to offer dividend to its shareholders.

Domino one had fallen. These acts of misrepresentation and falsehoods about the financial state of affairs at IL&FS jeopardized and imperiled the nation’s fiscal health. The unscrupulous manner in which public money was frittered away with utter and complete disdain came to such a sorry pass that that it was no longer in a position to service its debt, no assets left to raise funds, no credibility with banks, no takers for its promises and nothing to offer to its stakeholders and the public at large to assure its continuation. A debt obligation storm had hit the front door. The sheer enormity of the situation can be best summed up in this manner —On a consolidated basis, the borrowing of IL&FS from banks and financial institutions (debentures, loans, cash credit and commercial paper) comes to about Rs 63,000 crore as per 2017-18 balance sheet. If the exposure on banks is assumed to be Rs 57,000, then considering that the exposure of the entire banking sector to all NBFCs is about Rs 3.3 lakh crore, IL&FS is not inconsequential, but critical to the financial stability as its share in the total exposure of the banks to the NBFCs is about 16 per cent.  The gravity of public interest is ensuring financial solvency and good governance and prudent management of this Group was vital. The IL&FS Group has shown a loss of Rs 2,670 crore for 2017-18 in the consolidated balance sheet, which is a leverage of about 13 times as the borrowing of approximately Rs 91,000 crore is on the base of equity capital and reserves of about Rs 6,950 crore. The indebtedness  of IL&FS was approximately Rs 16,468 crore, with the debt market drying up for this company. Any future debt assimilation would be impossible as leverage levels were already extremely elevated.

The IL&FS Group, especially its subsidiary companies, IL&FS Engineering and Construction Company Limited (IL&FS Engineering) and IL&FS Transportation Networks Ltd. had got into major problems beginning 2012. This led to massive delays in execution of projects and a number of projects had become stalled infrastructure projects even before 2014. This affected their financial performance and significantly increased the leveraging as delayed projects were kept afloat by more and more debt financing. IL&FS Engineering had a series of losses beginning 2011-12 and minimal profit started after 2015-16. IL&FS Transportation Network Ltd. witnessed significant erosion of profit starting from 2012-13 and the net debt also increased more than two times from Rs 13,939 crore to Rs 29,961 crore in 2017-18.

Deterioration in the financial performance and substantial leveraging of the IL&FS Group started many years ago on account of stalled projects in infrastructure sector largely owing to wrong decisions and policy paralysis before 2014.

The Finmin statement provided more pointers to the impending disaster:

# The consolidated financial statement of IL&FS holding company and its subsidiaries, associates and joint ventures projected a picture through highly exaggerated depiction of non-current assets in the form of intangible assets amounting to over Rs 20,000 crore.

# The bulk of revenue was in the form of receivables, around 50 per cent, which was locked up in litigation and arbitration.

# There was a sharp increase in bank deposits held in lien, which rose by Rs 1,681.59 crore in the year ended March 2018.

# Overall, the company has negative cash flows from operations.

# The net outflow was Rs 7,020 crore in 2017-18.

# It had a deep-rooted mismatch in the debt-equity ratio because of excessive leveraging, which put a question mark on its ability to continue as a going concern if allowed to continue in the hands of the present management.

# The high debt stress was clearly visible in the company and its main subsidiaries for the last so many years, but was camouflaged by misrepresentation of facts.

# The company misled one and all by continuing to pay dividends and huge managerial pay-outs regardless of looming liquidity crisis which threw into stark relief that the management had lost total credibility.

On viewing the NCLT order properly what emerged is a litany of afflictions — The government maintained that IL&FS’ auditor, SRBC & Company, an EY network firm, had in its limited review report pointed to “the existence of material uncertainty on the company’s ability to continue as a going concern”. While the order didn’t clarify, this most likely refers to the going concern status of key subsidiary IL&FS Transportation Networks Ltd., which was highlighted by auditor SRBC & Company (also auditor for ITNL) in its limited review at the end of the June quarter. IL&FS, being an unlisted company does not publish quarterly earnings reports. The government also expressed doubts about the “correctness” of the company’s financial statements, according to the NCLT order. Incidentally, the lawyer representing IL&FS in the NCLT neither opposed nor supported the government’s petition. It is clear as daylight that the management of IL&FS was being run in a manner prejudicial to public interest. Eight directors—Hari Sankaran, Arun Saha, SB Mathur, RC Bhargava, Michael Pinto, Jaithirth Rao, Rina Kamat and erstwhile whole time director Ravi Parthasarathy have been named in the Union of India petition. Moreover, Chief Financial Officer MM Wagle and Company Secretary Varsha Sawant, have also been named as respondents in the petition.

As the process of untangling the knots begins, it will be long and arduous. The independent directors who were party to this carnage and should have been the first to red flag the murky goings on in this secret society are equally culpable. On Wednesday, they dashed off a missive to the government appointed non exceutive chairman Uday Kotak trying to distance themselves from this mess. The letter stated — “Despite several attempts during our tenure, IL&FS was unable to raise additional equity directly or at the level of its subsidiaries. It was also unable to complete a merger with a strategic party which failed to consummate in the final stretch. With its mounting counter-party receivables and the need to continue with existing projects and the absence of long-term financial support in the markets, the asset-liability mismatch continued to aggravate almost inexorably... we believe that this structural conundrum needs to be addressed for all infrastructure financing in the country.” This explanation simply doesn’t wash. The government had argued earlier — “The financial mismanagement of the IL&FS is apparent from its rapid debt built up and misrepresentation of true state of financial fragility, which is being reflected in unprecedented rating downgrade from highly rated to a default category,” What were these pre-eminent worthies doing all this while? Did they raise Cain over the gross mismanagement? No, instead th?ey chose to follow the code of silence.

The onerous task before the board and government gets bigger by the day — The new board will meet before Oct. 8, the National Company Law Tribunal said on Monday. It must devise a plan and file a response to NCLT by Oct. 15. The tribunal will next hear the matter on Oct. 31. The contagion may have been halted at the shadow bank, but there is still a large degree of uncertainty especially as the government is starting a corruption probe into IL&FS. Skeletons will tumble out. It may be difficult to save IL&FS as we know it unless the lenders agree to take substantial haircuts. India’s parliamentary panel on finance has decided to investigate the IL&FS matter and its members will visit Mumbai this month to meet the new board. Worse hit seem to be mutual funds which were providing key liquidity infusion in a year where FPIs have been pulling out, acting as a counterweight — Fears of a liquidity crunch following the IL&FS crisis hit the mutual fund industry in September. Cash plans or liquid funds were the worst hit. According to data from CAMS, a mutual fund registrar which covers 85 per cent of the industry flows, cash plans or liquid funds saw outflows worth a whopping Rs 69,694 crore. Ultra liquid schemes also suffered from net outflows of Rs 19,479 crore last month. Not only cash plans all categories in the debt segment also registered outflows, barring fixed maturity plans.

The government statement showed intent — Restoration of confidence of the financial market and to ensure solvency and orderly sale of the assets of the IL&FS Group would, inter alia, require time-bound sale of assets and realisation of receivables, fresh capital infusion, restructuring of business and ensuring continued access of the IL&FS Group to the financial market to meet its present and future financing needs. The government is committed to ensuring the financial solvency of the IL&FS Group with a view to maintaining the financial stability in the country. Towards this end, the government is committed to ensure that ILFS Group receive much needed temporary liquidity support. It is hoped that financial institutions would be supportive for providing urgent liquidity.

Tough love as game on.