Widening the Ambit of IBC To Include Financial Service Providers: How far is it Credible?

This blog is inscribed by Khyati Mehrotra.

Background

The Central government on 15th November 2019 notified the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2011[1] (“FSP rules”) under Section 227 read with Section 239(2)(zk) of Insolvency and Bankruptcy Code, 2016 (“IBC”), which empowers the government to initiate insolvency proceedings in consultation with the appropriate financial regulator (as prescribed by law) against financial service providers (“FSPs”) which were earlier outside the purview of  IBC. This major step of the government was driven by the liquidity crisis faced by the financial service providers in recent past, such as collapse of IL&FS and failure of one of the biggest NBFC, Dewan Housing Finance Corporation to discharge its immediate debt obligation.

The FSP rules in line with Section 227 of the Code prescribe that these rules shall apply to only those financial service providers or categories of FSPs which are notified by the central government from time to time. Owing to the same, by a notification on 18th November 2019[2], Government has only extended the applicability of the FSP rules to Non-Banking Financial Companies (“NBFCs”) including housing finance companies, having an asset size of over INR 500 crores and appointed Reserve Bank of India as an appropriate regulator for the notified FSP.

FSPs were excluded from IBC Regime

As per Section 3(17) of IBC, financial service provider is a person engaged in the business of providing financial services in terms of authorisation granted by, or registration with, a financial sector regulator who is an entity constituted under any law in force to regulate services or transactions in the financial sector.[3] Earlier FSPs were kept outside the purview of IBC as the definition of ‘corporate person’ under IBC explicitly excluded any financial service provider which meant that FSPs could not undergo corporate insolvency resolution process under IBC.

FSPs were kept outside the ambit of IBC because these institutions are “systematically critical” financial institutions, also known as “too big to fail” which if fail will cause a financial crisis leading to domino effect in the economy. FSPs such as banks and insurance companies grant huge loans and make large investments in financial instruments such as bonds and shares which mostly comprise their assets. This makes them highly interconnected with the financial system and real economy. Using such a standard resolution process for such financial institutions which monetize these assets in a short period will lead to larger implications for the financial system. For instance, recovering cash form the bank’s asset “loans” will include premature recalling of loan, which will create stress for the borrowers who are financially constrained. These borrowers may resort to taking another loan may be at unfavourable terms to repay the original one which will trap them in further indebtedness. This may also set off a chain of insolvency of such borrowers.

Keeping in mind the critical nature of FSPs and their specific requirements in case of insolvency the government introduced in the parliament in August 2017, Financial Resolution and Deposit Bill 2017[4] (FRDI) which sought to lay down a framework for resolution of financial firms such as banks and insurance companies etc. in case of insolvency.  But it was withdrawn in 2018 due to the concerns raised by stakeholders with respect to certain provisions in the bill such as use of ‘bail-in’ instrument to resolve insolvency of a bank[5].

So, these financial entities are then left with only the option of liquidation. Recently, in 2019, RBI issued Reserve Bank of India (Prudential Framework for Stressed Assets) Directions, 2019[6] which provided a framework for early recognition, reporting and time bound resolution of stressed assets. These regulations apply to banks, NBFCs and All India Term Financial Institutions.

Recent rules issued by the government to bring the notified FSPs under the purview of IBC is a step to provide faster and efficient resolution process for the FSPs and this recourse is in addition to all the already existing gateways available to financial institutions in case of insolvency.

Main Features of FSP Rules, 2019

  • Under the FSP rules, 2019, the resolution process of a financial service provider can be only initiated by the appropriate regulator appointed by government. Even if the FSP wants to go for voluntary liquidation, the particular FSP has to seek prior permission of the appropriate Regulator.
  • The adjudicating authority (National Company Law Tribunal) will appoint an ‘Administrator’ suggested by the regulator who will exercise the powers and functions of an insolvency professional or a liquidator for carrying out insolvency and liquidation proceedings of FSPs.
  • If the regulator considers it necessary, it may form an Advisory Committee to advise the administrator on conduct of operations of FSP during CIRP.
  • In the case of FSP, interim moratorium will commence on and from the date of filing of the application until the admission/rejection of the application. Also, during the interim moratorium, the license or registration of FSP will not be suspended.
  • Once the resolution plan is approved by the committee of creditors, the regulator will seek ‘no-objection’ certificate from the Regulator declaring that it has no objection to the persons who will be controlling the management of the FSP after resolution plan is approved by the NCLT. The requirements for getting a no-objection certificate are specific to the business of FSP.
  • During the liquidation process, the Adjudicating Authority will provide to the regulator and the FSP equal opportunity to be heard before passing an order.

NBFC – The only category of FSPs brought under IBC yet

By the notification of 18th November 2019, Government made Non-Banking Financial Companies, the only category under FSPs to which the IBC will apply and insolvency and liquidation of which will be carried in accordance with newly notified FSP rules, 2019.

Earlier there was a long-standing debate about the nature of NBFCs that whether NBFCs are categorized as financial Service Provider or not? In the case of Randhiraj Thakur v. Jindal Saxena Financial Services[7] and HDFC Bank Ltd. v. RHC Holding Private Limited[8] NCLAT dealt with this question and refused to initiate CIRP under IBC against NBFCs. This debate was also set to rest by the November 18 notification as it clearly suggested the legislature’s understanding of NBFC as a FSP.

Now the question comes that how suitable is the IBC mechanism for NBFCs?

IBC mechanism is not suited for the firms where the cost of coordinating the collective action process of creditors is huge. Collective action process is followed during the CIRP of conventional firms where all the creditors coordinate and decide how the value of the assets is to be realized and how the claims of different classes of creditors will be settled. The financial firms such as banks and insurance companies raise funds from retail sources such as depositors or insurance customers and their bulk liabilities are spread across a large number of depositors including some large institutional lenders. Therefore, there are inescapable structural differences in their liabilities which make cost of collective action process go up.  However, unlike banks and insurance companies, NBFCs including housing finance companies fund themselves through wholesale sources and creditors of such firms can be represented through agent or trustee which make collective action process easy. Hence, IBC mechanism could work well with NBFCs.

On 30th November 2019, RBI filed an application before NCLT for initiating CIRP against Dewan Housing Finance Corporation Ltd. (DHFL).[9] Thus, after the November 15 notification, DHFL has become the first FSP to be dragged to bankruptcy tribunal.

Conclusion

The issuance of FSP rules and November 18 notification is a commendable step by Central government to effectively deal with the liquidity crisis being faced by FSPs such as NBFCs. Owing to the “systematically critical” nature and complex structure of FSPs, there was a requirement of a special legal framework in case of insolvency. However, bringing these institutions under IBC by introducing a slightly different procedure under FSP rules must serve the purpose. The provision of only empowering the appropriate regulator to initiate CIRP gives discretionary powers to the regulator and makes sure that such critical financial institutions go for insolvency only after due analysis of the case by the regulator. This also prevents the financial system from suffering due to abrupt decisions of creditors of such firms.

The government also rightly notified NBFCs including Housing Finance Companies under 18th November notification. These are better suited for IBC regime for there is a possibility of easier coordination of collective action process in such entities. Creditors of such firms are now much relieved and empowered to have a faster resolution process in case of default. In future, companies like brokerages or mutual funds which perform merely advisory, custodianship or broking functions may also be brought under FSP rules as these are also amenable to the resolution process under IBC. However, FSPs such as insurance companies or banks demand for a very specific procedure of resolution suited to their exclusive structure.


[1] The Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019.

[2] Ministry of Corporate Affairs, Notification under Section 227 of the Insolvency and Bankruptcy Code, 2016 (Nov. 18, 2019).

[3] The Insolvency and Bankruptcy Code, 2016, §3(17).

[4] The Financial Resolution and Deposit Insurance Bill, 2017.

[5] Gayatri Mann and Vatsal Khullar, The FRDI Bill: Bail-In provisions explained, PRS Legislative Research (Dec. 7, 2017), https://www.prsindia.org/theprsblog/frdi-bill-bail-provisions-explained (Last Accessed Apr. 8, 2020, 10:10 AM).

[6] Reserve Bank of India (Prudential Framework for Stressed Assets) Directions, 2019.

[7] Randhiraj Thakur v. Jindal Saxena Financial Services, 2018 SCC OnLine NCLAT 508.

[8] HDFC Bank Ltd. v. RHC Holding Private Limited, 2019 SCC OnLine NCLAT 398.

[9] Reserve Bank sends DHFL to NCLT for debt resolution, The Economic Times (Nov. 30, 2019), https://economictimes.indiatimes.com/markets/stocks/news/reserve-bank-sends-dhfl-to-nclt-for-debt-resolution/articleshow/72302934.cms?from=mdr (Last Accessed Apr. 8, 2020, 10:30 AM).

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