A test case

DHFL resolution will strain IBC, but is systemically vital

The Reserve Bank of India (RBI), which serves as the banking regulator, has superseded the board of the troubled non-banking financial company Dewan Housing Finance Corporation (DHFL) and appointed an ex-banker as the company’s administrator. This is in order to prepare DHLF to enter the process under the Insolvency and Bankruptcy Code (IBC); the National Company Law Tribunal will have to appoint the administrator as the appropriate resolution professional for this case. DHFL will be an important test case, because it is the first such systemically important financial company to be entrusted to the insolvency and bankruptcy process under new rules, which have been recently drawn up for non-banking financial companies (NBFCs) that have an asset size of at least Rs 500 crore. The precedents set in this case might have to be relatively widely applied to an NBFC sector that has shown many signs of stress over the past year, since the collapse of Infrastructure Leasing & Financial Services (IL&FS). DHFL, while less systemically intertwined than IL&FS, nevertheless has debts of around Rs 90,000 crore on its books and an outsize impact on the vital housing and real estate sector. Almost Rs 40,000 crore of that is owed to banks. Under 10 per cent is to public deposit holders. 

Although DHFL has been troubled since June, there have been multiple delays in getting to this point. The first reason is that, as a financial institution, there is no separate law to deal with its unwinding. The rules under the existing IBC are one way of going about it, but their robustness will have to be examined. The second problem was, that, again as a financial company, it has multiple different creditors — not just banks, but mutual funds, bond holders, and retail fixed depositors — with varying interests involved, so creating an inter-creditor agreement was not straightforward. The question now will be whether the IBC process will manage to balance these priorities. The final problem was that there is also a fraud investigation underway. The progress of this investigation impacts how lenders wish to treat their loans to DHFL. An audit report had suggested fund diversion, perhaps into accounts linked to DHFL’s promoters, and lenders naturally wanted to know first if that was recoverable. Finally, there have been various revival plans floated, most of which seemed unlikely to achieve a consensus or success. 

The IBC will thus have to manage these multiple problems while keeping in mind the precedents that are being set, the systemic importance of the sector, and the possibility that many projects linked to DHFL might be viable on their own. What will be particularly important is to keep in mind the fact that the Supreme Court has recently underlined the necessity for the IBC to honour the variable importance of various creditors — secured get priority over unsecured. Thus, while the banking regulator might like to see deposit holders paid off, the fact is that the IBC process will have to prioritise the secured creditors. If the DHFL test case runs into problems, then the government will have to act swiftly and re-introduce a modified version of its Bill to deal with insolvent financial institutions, which it withdrew last year after public concern about deposit safety.