IBC and Companies Act: Accountability of owners – Will the bells toll now?

By: | Published: September 11, 2018 3:30 AM

Regulations such as IBC and Companies Act have unleashed a sense of discomfort among the Boards and promoters in corporate India who are treading on the thin line of law, but conviction rates are yet to see a major rise

IBC and Companies Act, DCM, Nanda family of Escorts, LIC of India, SFIO, PSU banksA key economic legislation is Section 447 of the Companies Act, 2013

Shuchi Dutta & Kaushik Dutta

The year is 1982. A young Swraj Paul has just attempted a hostile takeover of DCM and Escorts, two leading family businesses of India. At this point, the Bharat Ram family of DCM and the Nanda family of Escorts only held a 10% and 5% share of their company stock, respectively, while still maintaining absolute ownership and management rights. Paul ended up buying a 7.5% stake in Escorts and 13% of DCM, effectively seizing control of the companies from the families.

However, politics and lobbying played a major part in invalidating this transfer of shares. The government stated in Parliament that capital and interests of ‘Indian industrialists’ will be protected. As a result, LIC of India, which held 45% of DCM and 54% of Escorts, went along with the governmental resolve and Paul was made out to be a foreign marauder attempting to overthrow and influence a culture that had been in place for generations—the system of family businesses in India (which enjoyed, in most parts, the rewards of ownership at the expense of public banks and financial institutions without any attendant risk). This corporate action is one of the best-known examples of government protection of the privileged at the cost of developing fair markets and accountability.

Through the 1980s, the Indian economy continued to be governed by a protectionist approach and lack of competitiveness and accountability by local businesses perpetuated through government licences to a favoured few. A default in repaying debts or other obligations scarcely invited a punishment harsher than a rap on the wrist. This resulted in entrenchment of control of the owners, regardless of the percentage of ownership they possessed. This had a two-fold effect: one, the government looked the other way as defaulting companies lost money borrowed from public sources and, two, the Board for Industrial and Financial Reconstruction (BIFR) readily stepped in to bail these businesses out of the financial holes dug by the owners. In effect, the government gave concessions and made excuses for these companies, rather than punish them for financial irresponsibility of public funds entrusted to them, leave alone take control or auction the companies or assets to recover monies owed to banks. The result was a dubious adage: “Businesses become insolvent but owners prosper”.

Equilibrium in a modern society rests on three pillars. (1) Quality and fairness of laws, (2) enforcement of such laws (rule of law) and (3) the citizens’ desire to follow laws. Many studies have rated quality of Indian laws to be amongst the best but on rule of law, the proxy for which is the chance of conviction for white-collared crimes where India ranks amongst the lowest. Bibek Debroy estimated this to be 0.002%, which indicates that financial crime is a profitable engagement. This insidious low level of enforcement tends to make citizens, rich or poor, show total disregard of laws—demonstrated in small and big ways such as flouting traffic rules, evasion of taxes of all kinds, preferring a trail-less cash economy, non-payment of credit card bills of PSU banks, and defaulting on payment of loans.

Today, the status quo has changed. In August 2018, the Serious Fraud Investigation Office (SFIO) made its first arrest and the Supreme Court said banks could enforce personal guarantees of promoters to defray the outstanding loans, signalling a tectonic shift in power equations.

In the recent past, a few landmark events have also challenged the status quo. One of them is enacting new laws and strengthening existing ones, such as the Insolvency and Bankruptcy Code (IBC) in 2016 and Companies Act, 2013.

Earlier, liquidation of assets and restructuring debt were dealt under separate legislations, which took decades to resolve. Debt recovery wasn’t guaranteed while owners never lost control of their companies. The IBC has a time-frame for resolution; further, existing owners or their families cannot participate in the bidding process, which is supervised by an independent professional.
The effect of these laws on our mammoth bad loan problem is evident.

Giants like Essar Steel, Bhushan Steel, Videocon, Jaypee Infratech Ltd, Amtek Auto, etc, are facing turbulent times. The changed operating environment is forcing more responsibility on the promoter and ensuring that defaulting owners who divert funds must suffer a loss similar to the one incurred by the lending bank.

A key economic legislation is Section 447 of the Companies Act, 2013. This section deals with punishment for fraud, which is key in modern economic jurisprudence—it increases the threshold and the magnitude of the punishment ranging from a sentence of six months to ten years, and a fine equivalent to the amount of fraud but may extend to three times.

Further, such offence is non-compoundable, non-bailable and cognisable, with a minimum sentence of three years to those whose frauds are in conflict with public interest. The Act provides clarity to address concerns of large-scale industrial frauds by laying down an inclusive definition which extends to wrongful gains and wrongful losses, including an intention to commit fraud even if no loss is suffered by the victim. Some may argue that these two acts are draconian—be that as it may, these have unleashed a sense of discomfort among the Boards and promoters in corporate India who are treading on the thin line of law.

In terms of enforcement, legal enablement to institutions such as the SFIO have helped in concluding investigations and prosecutions. The number of cases referred to the SFIO in 2017-18 jumped to 209, as against 111 in 2016-17. However, the conviction rate by the SFIO still remains poor, though there has been an uptick—in 2015-16, 39 investigations were completed and 44 prosecutions were filed in the National Company Law Tribunal. The other regulatory agencies like the CBI and state police, too, have significantly more number of financial crimes being investigated by them, although the rates of conviction, a test of quality of investigation and collecting evidence, remain dismal.

The framework of accountability through public scrutiny, Lokayukta, etc, and ‘media trials’ including social media is high especially with the younger population, who tend to be idealistic with low tolerance to bribery, corruption and social crimes, thus making the third pillar robust.

The society is going through rapid changes with technologies such as blockchain integrating disparate people and ideologies. This reduces asymmetry of information and blurs the sharp lines between rural and urban citizens, and the rich and the poor, demanding accountability from custodians of public goods. Hopefully, the current winds of change will blow away the dispensation that works against public interest and justice will be quick, efficient and fair. That is the society we all wish to see and live in.

Shuchi Dutta is with OP Jindal Law College and Kaushik Dutta is founder, Thought Arbitrage Research Institute, a not for profit think tank in areas of governance, public policy and economics

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