Ousted IL&FS chief arrested for fraud: Why it spells crisis for India’s financial markets

The Serious Fraud Investigation Office (SFIO) on Monday arrested Hari Sankaran, former managing director and vice-chairman of Infrastructure Leasing and Financial Services (IL&FS) for abuse of power through fraudulent conduct.

Sankaran will be remanded in custody till April 4 as SFIO probes his connection to an ongoing investigation into the infrastructure lender’s defaults, government officials told Reuters on condition of anonymity.

The company, which sits atop 169 subsidiaries, is believed to have run out of money—defaulting on payments worth Rs 17,000 crore recently. This spells trouble not only for the firm but also its investors, which include banks, insurance companies, and mutual funds. Such a massive default could, in turn, result in a massive crisis for India’s financial market.

Sankaran’s is the first big arrest in the still-unfolding case, which is being probed under provisions of the Companies Act, by the investigative wing of the ministry of corporate affairs.

What does IL&FS do?

IL&FS, a major infrastructure financing and construction company established over thirty years ago, is also a “shadow bank” performing transactional operations and services similar to traditional commercial banks.

It has a whopping 169 subsidiaries, associates, and joint ventures, with majority stakes (25.34%) held by state-owned Life Insurance Corporation of India (LIC), followed by Japan’s Orix Corporation (23.54%).

Other key shareholders are the Abu Dhabi Investment Authority (12.56%), Housing Development Finance Corporation (9.02%), Central Bank of India (7.67%), and State Bank of India (6.42%).

What went wrong and how is its financial services entity responsible?

For a long time, the company has been trying to sell its assets to repay debt following a government-forced overhaul of its management after several defaults. Simply put, the infrastructure lending giant has run out of funds, rendering it unable to fulfill its obligations.

A third of the total outstanding loans by a unit of IL&FS to borrowers, were either unsecured or had inadequate collateral, as per a Grant Thornton India audit of the firm.

Last year, IL&FS Financial Services came under scrutiny for delayed payments on inter-corporate deposits and commercial papers.

“It may be worth noting that IL&FS Financial Services Ltd had borrowings of more than Rs 17,000 crore from debt instruments and bank loans,” the SFIO said this week. “Provident funds, pension funds, gratuity funds, mutual funds, public and private sector banks, are among those who have invested in these debt instruments.”

Since August 27, 2018, IL&FS Financial Services has defaulted on around Rs 450 crore of inter-corporate deposits to the Small Industries Development Bank of India (SIDBI). According to reports, it had about $500 million in repayments due in the second half of FY18-19, but only managed to raise about $27 million when the creditors came knocking for their dues.

The entity has borrowings of more than 170 billion rupees ($2.46 billion) from debt instruments, bank loans, other investment firms, according to latest reports.

Sankaran’s involvement and response

The SFIO had filed two reports at the National Company Law Tribunal (NCLT), alleging that the practices followed by IL&FS flouted banking and lending norms. The office also claimed complacency in the subsidiaries’ auditors when it comes to detecting financial irregularities.

Sankaran allegedly granted loans to IL&FS subsidiaries, which were not or later turned non-performing assets. His transactions resulted in losses for the company and its creditors, the SFIO said in a statement.

Also read: Sacked and stripped of bonuses: Srikrishna report finds Chanda Kochhar guilty of bank code violations

In an earlier submission to the NCLT, Sankaran denied all allegations. Appearing before the tribunal in October last year, he said, “All material acts of IL&FS were performed with the sanction and knowledge of the board and key shareholders of IL&FS, and as per approved processes and procedures.”

Sankaran was forced to resign from the IL&FS board of directors on October 2, 2018. He was produced before a special sessions court in Mumbai on Monday, April 1, that has asked for him to be kept in custody till April 4.

Market meltdown on the cards?

The crisis had already shaved off Rs 8.48 lakh crore ($116.33 billion) in investor wealth last September, making IL&FS central to the crisis confronting India’s financial market. The situation is so dire, it is being compared to the 2008 Lehman Brothers crisis that triggered a global financial meltdown.

Investors and traders are mainly apprehensive about the domino effect of IL&FS’s defaults, which due to the presence of so many subsidiaries is even more worrisome and complex.

In September itself, the benchmark index, Sensex, shed over 2,000 points till now. Credit rating agencies ICRA and Care Ratings further downgraded IL&FS and its subsidiaries from investment grade to junk last year, causing the bond’s price to go down and affecting debt funds in turn.

IL&FS’ defaults stand to majorly impact India’s domestic corporate debt and credit markets as lenders already ride a sea of bad loans. With Rs 57,000 crore in borrowings from banks, the infrastructure firm’s debt accounts for some 0.7% of the banking system’s loans disbursed, 1% of total outstanding debentures, and 2% of commercial papers.

What truly killed IL&FS’ prospects of turnaround was the fact that most of the group’s assets cannot be liquidated as they include financial claims on infrastructure projects such as roads, tunnels, water treatment plants, and power stations.

Why it matters and what’s next

The IL&FS has been responsible for some arterial and state-of-the-art infrastructure projects across the country including India’s first multi-service SEZ, named Gujarat International Finance Tec-City (GIFT); the Tripura power project, -Nashri tunnel, Sports Hub in Trivandrum, and Kharagpur-Baleshwar highway were also developed by the company.

The health of India’s construction sector has been deteriorating for quite some time, but the recent slowdown in infrastructure projects has worsened its situation.

Also read: Mumbai railway bridge collapse: Why is public infrastructure not a poll issue?

As an indirect impact of this crisis, individual investors and the value of mutual funds, unit-based insurance, pension schemes will be hit. According to Quartz, several infrastructure projects like the Bengaluru Metro construction plans are likely to be delayed as well.

To allay the crisis, IL&FS has already put up its Rs 1300 crore-worth corporate headquarters for sale, besides identifying 25 other projects to sell. Although this can reduce debt by a large margin—roughly one-third of its total—the divestment process can take over a year.

Meanwhile, regulatory intervention may be on the cards, with RBI reportedly conducting a forensic audit into IL&FS’s books, and SEBI pacifying anxious investors.

Prarthana Mitra is a Staff Writer at Qrius

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