Asian Journal of Management and Commerce 2020; 1(1): 43-45

E-ISSN: 2708-4523
P-ISSN: 2708-4515
AJMC 2020; 1(1): 43-45 Corporate governance failure at IL&FS: The role of
© 2020 AJMC
www.allcommercejournal.com internal and external mechanisms
Received: 07-11-2019
Accepted: 17-12-2019
Dr. Anjali Arora
Dr. Anjali Arora
Associate Professor,
Department of Commerce, Sri
DOI: https://doi.org/10.22271/27084515.2020.v1.i1a.63
Aurobindo College University
of Delhi, Delhi, India Abstract
This paper explores the origins of the Infrastructure Leasing & Financial Services (IL&FS) crisis which
threatened to become a domestic credit crisis by its mere size and extent had it not been for the timely
intervention by the government. In most of the scams post liberalisation, the most high profile being
Satyam, there was a failure of both internal and external mechanisms of corporate governance, that is
there was a failure on the part of the board of directors (internal) and failure on the part of auditors and
credit rating agencies (external). This paper argues that in most cases, and especially in case of a non-
banking finance company like IL&FS the external mechanisms are as important if not more so, than the
internal ones and if they function properly they can play a pivotal role in regulating and supervising the
management thus making overall corporate governance effective.

Keywords: Crisis, corporate governance, board, auditors, credit rating agencies

Introduction
Infrastructure Leasing & Financial Services Limited (IL&FS) was brought into existence in
1987 with a view to looking after the funding needs of the prime infrastructure projects all
over India. While HDFC, Central Bank of India and UTI initiated it, ORIX, LIC and Abu
Dhabi Investment Authority also joined in later as major stakeholders. IL&FS had in its fold
a large number of subsidiaries to dispense financial, infrastructure, and, technology services
to sectors such as roads and transportation, power, education, sports, tourism and the like.

Crisis at IL& FS
Trouble surfaced for IL&FS in July 2018 when two of its subsidiaries (out of the 250 odd
ones) defaulted on payment of loans to banks and inter corporate deposits to their lenders.
Come September, it was being reported that IL&FS was having problems repaying huge
amounts (to the tune of Rs. 1,000 crores) to Small Industries Development Bank of India
(SIDBI). A similar story was unfolding with Il&FS Financial Services Limited (IFIN), the
nonbanking financial company (NBFC) arm of II&FS, that they had been backtracking on
commercial paper (CP) payment. The month of September proved disastrous for IL&FS in
meeting their commitments and the Reserve Bank of India (RBI) stepped in to take stock of
the situation and look at the effectiveness of management.
Soon it blew up into a contingency situation with default one after the other, so the
government intervened and took quick action. They dismissed the senior management and
replaced them with a new board with Uday Kotak at its helm. The very grim situation where
it would have become a Lehman moment (Lehman Brothers was the leading global financial
services firm in USA which became the largest bankruptcy due to its erroneous policies of
excessively high debt equity ratio and exposure to high risk subprime clients) was prevented
from getting out of control. Nevertheless, some damage in terms of liquidity crunch did take
place and took a toll on the mutual funds which relied on commercial paper (CP) of large
corporations.
The paper is organised as follows: First, some facts which were unveiled during
Corresponding Author:
Dr. Anjali Arora investigations following the crisis are discussed. An analytical review is then made,
Associate Professor, classifying the mechanisms of corporate governance (CG) into internal and external and how
Department of Commerce, Sri these mechanisms failed at IL&FS. Some conclusions and recommendations follow.
Aurobindo College University
of Delhi, Delhi, India

~ 43 ~
Asian Journal of Management and Commerce https://www.allcommercejournal.com

Some Facts and Observations 8. Grant Thornton was commissioned to undertake special
1. The newly setup board declared the existence of 348 audit by the name of project ‘Icarus’ and pointed out in
entities, much higher than the disclosure made his report submitted in February 2019, on several
previously. The amount of debt was stated to be irregularities. Some of these were ‘ever-greening’(a
₹91,000 crores at the end of the financial year 2017-18. practice where loans are used to repay previous loans,
Such an enormous amount of debt could not have piled which is prohibited by RBI), ‘round-tripping’( by first
up in a year unless there was serious misgovernance borrowing and then lending to own subsidiaries either
and an attempt to cover up the messy financial position. directly or through third parties even after being fully
2. There was a huge asset-liability mismatch due to short aware of their financial status), loans being advanced to
term funds being used for long term projects. With less ‘stressed companies’ not approved by the ‘risk
procurement of funds from banks, than its ever management team’, lending at abysmally low cost, even
burgeoning needs considering it’s huge spread & ‘less than the borrowing rate’, loans granted ‘without
voluminous size (complex and multi layered), it started collaterals’, ‘loans transferred to promoters’ etc.(
relying excessively on CP for long term requirements source- Grant Thornton forensic analysis)
also (CPs are promissory notes having a short maturity
period, not more than 270 days). Analytical Review
3. The rating agency ICRA, gave the highest rating AAA Corporate governance mechanisms consist of both internal
rating to non-convertible debentures which continued and external sources. Mechanisms which originate from
till August 2018, just a month before it downgraded it within the firm, namely ‘board of directors, ownership and
by several notches, due to a series of defaults in not managerial incentives’ have been given an exceeding
meeting commitments. amount of importance in research on corporate governance.
4. The RBI with which IL&FS was registered also had no Examples of external CG mechanisms which exercise
clue of the impending catastrophe till as late as control from outside are the legal system, external auditors,
September 2018, so there was a supervisory failure on and rating agencies to name a few (Aguilera, R.V, et al.
the part of RBI and the mismanaged state of affairs at 2015) [1].
IL&FS continued, unabated. In the IL&FS case there was a failure of internal
5. The auditors also did not report anything untoward mechanisms and the ‘agency problem’ did take place in that
which would warrant immediate attention. In the case the directors acted in their own self interest which was to
of IL&FS, there was a major neglect of duty by the receive high amounts of compensation. They neglected their
auditors which was put by ministry of corporate affairs fiduciary duty to act in the interest of the corporation.
(MCA) secretary Injeti Srinivas in the following words: Agency costs are reflected in:
“We are not expecting an auditor to detect a needle in a The account statements of IL&FS showing profits from
haystack, but if an elephant is in a room, they ought to 2015-2018 whereas if consolidated group accounts were to
find it." be seen, they were showing continuous losses; the directors
6. The remuneration of the chairman (managing director), carrying away huge amount of remuneration by showing
vice-chairman and CEO increased significantly during good performance whereas there was a huge asset- liability
2015-2018, the period when the company was in mismatch, short term funds like CPs were used to finance
doldrums and earnings were depleting. The nomination long term projects and ever greening of loans took place.
& remuneration committee (NRC) consisting of The risk management committee which is of primary
nominee and independent directors, instead of replacing importance in finance and investment businesses and to
them for their poor performance, rewarded them by ascertain which clients were creditworthy enough, did not
paying high amounts as compensation. meet after 2015 till the time the crisis surfaced. Even where
7. IL&FS had on its board five independent directors the risk management committee identified a borrower as
(IDs) of repute namely R C Bhargava (chairman of subprime, loans were given which would then be paid back
Maruti), Michael Pinto, (a former secretary for by group companies to whom money was advanced for this
Shipping), another was a former LIC chairman and the purpose.
other two also were well known professionals. But at The external mechanisms at IL&FS which could have saved
the end of the day, they were all bureaucrats dealing the situation like the supervisory role of the RBI (with
with the government, who did not have the competency whom IL&FS was registered), the external auditors, Deloitte
and creativity to deal with fraud and mismanagement. and KPMG and the credit rating agencies ICRA also did not
Even though they possessed a high stature they were do much.
not suitable for IL&FS since none of them had the Though RBI had in 2015 raised red flags in connection with
experience in infrastructure financing. Though there is a IFIN lending to group companies for ever greening and
data pool of independent directors prepared by agencies wrong calculations of ‘net owned funds’ it did not take any
authorised by the ministry of Corporate Affairs (MCA) action when IFIN did not conform and take steps in
yet, which of them will be suitable for their particular accordance with RBIs inspection report. Had RBI
industry has to be decided by the Board. The intervened on time the situation would not have assumed
independent directors in case of IL&FS did not have the such alarming proportions.
requisite experience and hence not appropriate to the The company’s auditors Deloitte Haskins & Sells LLP
business of finance and lending which was apparent in should have highlighted the observation of RBI in its
their being unable to handle the crisis. (Independent inspection report about IFIN being over-leveraged. They
directors were kept more to meet the mandatory legal also failed to disclose in their report ‘negative cash flows’
requirement than to really be vigilant towards improper and ‘unfavourable key financial ratios’. IFIN provided loans
situations). to businesses who were not in a position to pay their debt.

~ 44 ~
Asian Journal of Management and Commerce https://www.allcommercejournal.com

Further, it granted loans to the defaulters’ group companies and rating agencies i.e., the external mechanisms of
in order to repay the previous loans, so as to not classify corporate governance instead of placing too much reliance
them as bad loans. The auditors also did not disclose the end on the internal mechanisms. These outside channels will
use of funds that were raised by debentures of IFIN, which strengthen the effectiveness of internal channels and hence
they are supposed to according to norms. They did not use improve overall corporate governance.
analytical tools which auditors typically use during their
audit and no attention was given to the statements made by References
RBI during inspection. 1. Aguilera RV. Desender K, Bednar MK, Lee JH.
The rating agency ICRA, gave A+ and AAA rating to its Connecting the dots: Bringing external corporate
commercial paper and non- convertible debentures in as late governance into the corporate governance puzzle.
as March 2018, just about a few months before it reached an Academy of Management Annals 2015;9(1):483-573.
impasse, caused by a series of non- payments and not 2. Hazari H. Behind IL&FS Default, A Board that Didn’t
meeting commitments at a stretch. The share of IL&FS in Bark When It Was Supposed To. The Wire 2018.
the funds disbursed by banks to the total NBFC sector was https://thewire.in/business/behind-ilfs-default-a-board-
quite high. The rating agencies should have considered this that-didnt-bark-when-it-was-supposed-to
huge ‘public interest’ involved while going so casual in their 3. IL&FS crisis a repeat of Satyam. (2018, October 7).
ratings. The rating agencies are expected to make an Nagaland Post. http://www.nagalandpost.com/il-fs-
independent professional assessment on the expertise they crisis-a-repeat-of-satyam/182985.html
possess. They failed to fulfil their duty and relied instead on 4. IL&FS crisis: ED files first charge sheet in the case;
their impressive ‘institutional parentage’. attaches assets worth Rs 570Crore. 2019. Business
Along with this, it was a well known fact that the risk Today.
management committee of ILFS did not meet after 2015, https://www.businesstoday.in/latest/corporate/story/ilfs-
risk management committee being a crucial committee in a crisis-ed-enforcement-directorate-files-first-
business involving lending funds. The rating agency chose chargesheet-in-the-case-attaches-assets-worth-rs-570-
to show a blind eye to all these facts and kept on rewarding crore-221848-2019-08-17
them with high ratings. 5. IL&FS scam: Here is the list of key players and
allegations they are facing. 2019. Business Standard.
Conclusions and Recommendations https://www.business-
For regulation of NBFCs which are now of formidable size standard.com/article/companies/il-fs-scam-here-is-the-
and have a huge amount of business, a separate specialised list-of-key-players-and-allegations-they-are-facing-
department or agency can be created working under RBI. 119060401390_1.html
RBIs hands are too full, and it needs to delegate so that 6. Press Trust of India. 2019. Grant Thornton’s IL&FS
proper monitoring of NBFCs can be done. audit finds irregularities in deals worth Rs 13K cr.
The suitability of independent directors for the company Business Standard. https://www.business-
should be assessed and the board while recommending their standard.com/article/pti-stories/grant-thornton-report-
names should justify their relevance to the business of the on-il-fs-points-to-several-irregularities-in-deals-worth-
company so that the IDs can give their best contribution to rs-13-000-cr-119030400503_1.html
the affairs of the company and not just be ceremonial 7. Reuters. (2019, June 13). IL&FS scam: Govt alleges 22
showpieces simply to fulfil mandatory obligations. auditing standards violations by Deloitte, KPMG arm;
The auditors and rating agencies have a major role to play as companies deny wrongdoing. First post.
far as investors are concerned. An audit gives reasonable https://www.firstpost.com/business/il-and-fs-scam-
assurance though not absolute that the financial statements govt-alleges-22-auditing-standards-violations-by-
do not contain any material misstatement due to error or deloitte-kpmg-arm-companies-deny-wrongdoing-
fraud. Thus, audit of great importance to the owners and 6809501.html
other users of financial statements be it creditors, regulators 8. Subodh Varma, 2018. IL&FS: Not Satyam, Not
or analysts. An auditor needs to work with professional Lehman, Maybe it’s Both! News Click.
skepticism in the performance of his duties. Where auditors https://www.newsclick.in/ilfs-not-satyam-not-lehman-
fail in their duties, they should be subject to stringent maybe-its-both
supervision and penalties so that they perform their audits in 9. Upadhyay JP. 2019. Inside the audit lapses that led to
a trustworthy manner which can be relied upon. Similarly, IL&FS crisis. Mint.
the rating agencies failed the investors who relied on their https://www.livemint.com/companies/news/inside-the-
ratings while putting in their hard earned money in IL&FS. audit-lapses-that-led-to-il-fs-crisis-
A rating by an independent agency which is a specialised 1558456079750.html
opinion about the corporation’s ability to meet its financial
obligations as and when they become due guides the
investors and creditors about their creditworthiness. Severe
penalties should be imposed for such lapses so that the
innocent investors do not suffer.
The paper supports the view, ‘Internal governance
mechanisms such as the board of directors do not operate in
isolation, and external factors play an essential role in
determining directly and indirectly the effectiveness of a
firm’s governance’ (Aguilera, R. V. et al, 2015) [1]. Hence,
an enhanced role should be assigned to the external auditors

~ 45 ~