Failing financial firms: Need for legislative intervention

In 2016, India enacted the Insolvency and Bankruptcy Code, 2016 (IBC) to provide a dedicated and streamlined legal regime for resolving distressed companies. This marked a substantial shift from the previously fragmented and multi-layered legal framework.

The implementation of the IBC was motivated by the view that appropriate resolution of a defaulter was a commercial decision which would be best made by its creditors. However, the IBC excluded financial service providers (FSPs) from the definition of ‘corporate person’ and, consequently, from the definition of ‘corporate debtor.’ This ensured that FSPs could not be resolved under the IBC. This decision, however, has introduced a legal lacuna within the country’s financial crisis management framework.  

Certain distinguishing features of FSPs had justified their exclusion from the IBC. First, FSPs deal with public money and any faltering on their part may impact the economy as a whole. Second, FSPs operate with high levels of inter-connectedness. Hence, the failure of a FSP may also negatively affect other FSPs in business with it. Third, standard resolution arrangements may not be suitable for FSPs due to their time-consuming nature and disregard for broader systemic stability considerations. However, this created a legal vacuum regarding the resolution of FSPs in India.

To fill this regulatory gap, the Financial Resolution and Deposit Insurance Bill, 2017 (FRDI Bill) was introduced in the Parliament, to create a dedicated resolution corporation to resolve certain FSPs in distress. However, the FRDI Bill was withdrawn in 2018 in the face of political backlash and concerns regarding the conversion of retail deposits to equity under the ‘bail-in’ clause.

Around the same time, two major FSPs in India - Infrastructure Leasing & Financial Services Limited and Dewan Housing Finance Corporation Limited - collapsed. This triggered a liquidity crisis and highlighted the need for a targeted resolution mechanism for FSPs. Accordingly, the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019 (FSP Rules) were notified.

The FSP Rules were aimed at constituting a special interim mechanism for corporate insolvency resolution process (CIRP) of systematically important FSPs till a focused legislation could be enacted. However, due to their transitional and temporary nature, the FSP Rules focus on only certain classes of FSPs that meet an array of qualifications or are notified by the Government of India. In addition to this, a CIRP against any FSP can only be initiated upon an application being made by the appropriate regulator. This further precludes creditors from initiating CIRP and may allow regulatory discretion and procedural inertia to delay the process. As a result, several key FSPs remain outside the ambit of the FSP Rules and continue to be dealt with through a fractured legal framework and sectoral regulatory mechanisms.

This leads to the very uncertainty and opacity that the IBC was designed to alleviate. For instance, recently, the financial creditors of Karvy Comtrade Limited, a stock-broker, attempted to initiate a CIRP, but their petition was dismissed. The creditors could not initiate proceedings under the IBC as Karvy was considered an FSP engaged in stock-broking. However, they could also not proceed under the FSP Rules as only a financial sector regulator can initiate CIRP under the FSP Rules.

A similar situation arose in the matter of Centbank Financial Services Limited wherein it was found that the debtor was an FSP and, hence, the provisions of the IBC would not be applicable to it. It was additionally noted that since the Securities and Exchange Board of India (SEBI) had not been notified as a financial regulator under Section 227 of the IBC, a CIRP could not be initiated against an FSP registered with SEBI. Such a situation leaves the financial creditors with no recourse under the IBC or FSP Rules alike. 

It is, therefore, argued that a comprehensive law offering a resolution process for FSPs must be devised and enforced in India. Such a law must focus on balancing creditor interests with the broader aim of ensuring systemic stability. Further, this law must account for creating an independent regulatory authority, composed of representatives from different financial regulators, for strategising and conducting the resolution process.

A tiered approach may also be beneficial, where FSPs may be divided into categories based on their inter-connectedness and risk profile, with each category having pre-decided timelines and mechanisms that may trigger resolution. This will ensure that FSPs are subject to monitoring and resolution processes in proportion to the level of risk they pose to systemic stability. The law must also account for the specifics of the process such as determining the priority order for re-payments across claims. The establishment of such a legal regime will lead to increased inter-agency coordination, harmonisation of business considerations and enhanced creditor safeguards. This will, in turn, lead to greater regulatory, procedural and legal certainty in the financial ecosystem of India.

Shuchi Agrawal is a Legal Consultant at the National Institute of Public Finance and Policy.