A Market Failure Framework for Evaluating Public Sector Undertakings

by Arjun Krishnan.

Commentators and investors often judge companies, including state-owned firms, by their profitability. While profit is a useful metric for private firms focused on generating returns for owners, applying the same standard to state-owned enterprises is problematic. Many lament that India's Public Sector Undertakings (PSUs) incur losses, assuming that losses signal failure and profits signal success. However, this assumption misjudges the real purpose of PSUs. Although some evaluation frameworks expand beyond profit, few explicitly align performance criteria with the specific market failure that the enterprise was established to address. This article argues that assessing PSUs solely on profitability is misguided, and their success should be measured by how well they address the public purpose for which they were created.

This article proposes a two-part framework for evaluating PSUs. The first part poses an ex-ante question about purpose. A PSU is justified only when it aims to correct a market failure that less intrusive instruments cannot correct. The second part poses an ex-post question about performance. Evaluators should then judge a justified PSU on two dimensions: efficiency and effectiveness. Efficiency measures how productively an enterprise converts resources into outputs. Effectiveness captures whether the PSU actually corrects the failure it was created to address. Balance sheets cannot serve as a reliable proxy for either dimension on their own.

Ex-ante: when is a PSU justified?

The justification for any PSU must begin with market failure. When markets function well, they allocate resources efficiently, and the state has no grounds to intervene. Economists identify four situations where markets fail to do so. First, externalities arise when a cost or benefit of an economic activity falls on an unrelated third party. Positive externalities lead to underprovision, and negative externalities to overproduction. Second, public goods are non-excludable and non-rivalrous. Firms cannot easily charge users, and private markets typically underprovide them. Third, information asymmetry occurs when one party to a transaction knows more than the other, distorting decisions and reducing market efficiency. Fourth, market power arises when limited competition allows firms to raise prices or restrict output below socially optimal levels.

A market failure on its own does not justify a PSU. There are three additional tests. First, scale: how many people are affected, and by how much? A localised information asymmetry in a niche market is different from one that excludes millions from credit. Second, persistence: is the failure temporary and self-correcting, or structurally durable? Markets sometimes endogenously mitigate their own failures through competition, reputation, or contracting. Exogenous forces such as technological innovation or institutional adaptation can have the same effect. Non-state mechanisms such as industry associations, cooperatives, or third-party certifiers may emerge to address coordination problems or information asymmetries without government ownership. Even classical public-good cases have been addressed without state ownership. Coase's (1974) account of English lighthouses is a canonical illustration: what was treated in classical economics as a pure public good requiring state provision was, in fact, supplied for centuries by Trinity House, a private body that collected dues from ships at port. The presence of such adaptive mechanisms weakens the case for a PSU. By contrast, failures that persist despite opportunities for institutional adaptation present a stronger case for public intervention.

Even when a market failure is large-scale and persistent, the state has many ways to respond. The third test, then, is instrument choice: Is ownership the right way to address this failure? The state can regulate, tax, subsidise, or contract with private providers. Ownership is one of the most costly options. Ownership exposes the exchequer to operating losses, creates a vehicle vulnerable to political capture, and softens the budget constraint in ways regulation and subsidy do not. The case for ownership has weakened with experience. Publicly owned natural monopolies in many sectors turned out to deliver less output for a given level of inputs than the textbook treatment had suggested. Regulatory practice has grown more sophisticated, with sector-specific knowledge and administrative law tools that did not exist when many PSUs were created. Public-private partnerships have further narrowed the cases for state ownership, with private firms providing goods and services under contracts that set market structure, pricing, and quality. For every PSU, the central question is why the problem could not be addressed through one of these alternatives.

India operates 291 Central Public Sector Enterprises across sectors as varied as petroleum refining, power transmission, hotel management, and defence manufacturing. The policy debate about this universe has been conducted in terms of profitability. How many are loss-making? What do aggregate losses cost the exchequer? These questions are downstream of a prior one: which market failure, if any, justifies each enterprise. Those that address no market failure have no business existing and should be sold off to buyers or wound down, with assets liquidated. Those that aim to correct a market failure face a harder question: how well do they perform in addressing the failure they are expected to correct?

Ex-post: efficiency and effectiveness

Two questions emerge for judging how well a PSU is performing. The first is efficiency. Efficiency is the ability to derive the greatest possible output from a given quantity of financial, physical, and human resources. The second is effectiveness. Since a PSU is justified only for market failures, we need to evaluate whether it, in fact, corrects the failure it was created to address. A PSU can be efficient at producing what a competitive market would produce anyway, or effective at reaching its target population at three times the cost a regulated private operator would charge. Both outcomes are undesirable. In the first case, the PSU adds little social value. In the second, it imposes unnecessary costs to achieve a legitimate public objective.

Experience with direct public provision over the last half-century has weakened the case for PSUs on efficiency grounds. Publicly owned natural monopolies in many sectors exhibited poor x-efficiency, producing less output for a unit of input than private firms. The Ministry of Road Transport and Highways reports that the revenue-to-cost ratio for the 58 reporting undertakings fell to 63.6% in 2021-22, that state cabinets blocked fare revisions, and that the resulting losses reached Rs 30,192 crore in aggregate. The mobility problem the SRTUs were created to address is real, but the case for state ownership of the operator is much weaker than the case for state involvement in the sector through options like subsidies.

The regulatory and contracting alternatives to ownership have grown more capable over the same decades. The regulatory state now possesses sector-specific tariff and quality regulation, administrative law procedures for rule-making, and incentive-compatible contracting techniques (Laffont and Tirole, 1993). Public-Private Partnership (PPP) models have spread across sectors once considered the natural home of direct provision. Iossa and Martimort (2015) show that bundling construction and operation into a PPP can be efficient when build quality materially lowers operating costs. This structure is common in roads, water systems, and many public utilities. Even classical public goods, including urban streets and water supply, are now routinely constructed and operated through PPP agreements that specify quality and pricing. The Government of India's disinvestment policy lists market imperfections and public purpose as criteria for retaining a PSU in public hands. The government excludes profitability as a criterion.

For certain types of goods, state ownership may be the preferable option. When contract terms cannot specify aspects such as quality, the case for ownership over contracting strengthens (Hart, Shleifer, and Vishny, 1997). A private operator paid to deliver an output will cut costs along whatever margins the contract leaves unspecified. Where quality is one of those margins, the cost saving comes at the consumer's expense. A private prison contractor's contract may specify calorie counts and dietary variety, but regulating food quality or taste may prove impossible. These savings flow to the contractor while the welfare loss falls on inmates. Direct public ownership is preferable in such settings precisely because the public manager's weaker incentive to cut costs leaves the unspecified quality dimensions intact.

In addition to efficiency, effectiveness needs to be judged. Effectiveness measures whether the PSU is correcting the market failure it was created to address. To illustrate the difference, consider a state-owned bus operator tasked with providing transport connectivity to remote rural areas. An efficient operator minimises the resources needed to run the service. An effective operator ensures that the targeted rural communities are actually connected. A PSU may succeed on one dimension while failing on the other.

The effectiveness criteria take different forms across failure types because the welfare yardstick differs. The market power row needs some additional explanation. A monopolist with declining average costs cannot price at marginal cost without losses. Ramsey-Boiteux pricing sets the loss-minimising alternative: markups above marginal cost should rise as demand elasticity falls, placing the heaviest charges on users whose consumption is least price-sensitive. A markup on inelastic demand reduces output the least and destroys the least surplus per rupee of revenue. A political cross-subsidy structure follows a different logic, allocating markups across user groups by political weight rather than by elasticity. The effectiveness test for a PSU that disciplines market power, therefore, asks whether its markup structure approximates Ramsey-Boiteux rather than political cross-subsidy.

Table 1 sets out the effectiveness criterion for each market failure, with the less intrusive instrument serving as the comparator.

Table 1: Effectiveness criteria for PSUs by type of market failure

Market failure	Market problem	Role of PSU	Effectiveness criterion	Less intrusive instrument
Externalities (positive)	Producers cannot capture the full social benefit, so the private market undersupplies relative to the social optimum.	Produce at a level that accounts for spillovers private producers ignore, or finance investments whose social returns exceed appropriable private returns.	Is the targeted output being delivered, and is the additional supply above the private optimum sufficient to close the externality gap?	Production subsidies, tax credits, intellectual property protection, advance market commitments.
Externalities (negative)	Private producers impose costs on third parties they do not bear, so the market overproduces relative to the social optimum.	Produce at a level that internalises external costs private producers would otherwise externalise.	Has the targeted reduction in harm been achieved, and are emissions per unit of output below the unregulated counterfactual?	Pigouvian tax, tradable permits, command regulation.
Public goods	Private producers cannot exclude users from a non-rivalrous good, so the market undersupplies or fails to supply.	Provide the good where private cost recovery is impossible or inefficient.	Is the service reaching the target population, and is coverage approaching the welfare-maximising level?	Contracting with private providers under a public service obligation.
Information asymmetry (seller knows more)	Private sellers hold information about quality that buyers cannot observe, so low-quality goods crowd out high-quality ones.	Enter the market and disclose costs, quality, and pricing as a benchmark that private sellers would otherwise suppress.	Has the PSU's presence made quality observable to buyers and sustained transactions that would otherwise have unravelled?	Mandatory disclosure regulation, third-party certification, independent benchmarking authority.
Information asymmetry (buyer knows more)	Buyers hold private information about themselves that sellers cannot verify. Sellers respond by raising prices, rationing, or withdrawing supply.	Offer service to groups private firms avoid because they cannot distinguish high-risk from low-risk customers.	Is the PSU enrolling the high-risk groups private markets exclude, and is the share of high-risk individuals covered higher than under the private counterfactual?	Risk-pooling mandates, mandatory insurance schemes.
Market power	Private firms price above competitive levels or restrict output below the social optimum.	Compete to discipline private pricing. In a natural-monopoly case, price at the welfare-optimal level.	Is the PSU pricing closer to marginal cost than an unregulated monopolist would, and does the markup structure approximate Ramsey-Boiteux rather than political cross-subsidy?	Competition law and antitrust enforcement, sectoral price regulation, separation of monopoly network from competitive services.

A PSU can fail on either dimension or both, and each case calls for a different response. A state-owned bus operator that abandons remote routes for crowded urban corridors is efficiently delivering something the market can deliver. Efficient delivery of a service that the market would have provided is no justification for state ownership. A PSU that effectively corrects a market failure but does so at an unjustified cost may generate more welfare loss through waste than welfare gain from correcting the failure. Reform or contracting out may be the appropriate response.

Soft budget constraints

PSUs operate under what Kornai (1998) called a soft budget constraint. A private firm that runs at a persistent loss is likely to go bankrupt. A PSU does not, because the PSU expects the state to cover the shortfall. The expectation of rescue weakens the discipline that revenues and costs would otherwise impose on managers.

A PSU pursuing a legitimate mandate should not show sustained accounting losses on its own books. Where pricing reflects deliberate policy, including selling output below cost for welfare reasons, the resulting deficit is a transfer from the treasury to the consumer. The right place for that transfer is the government's expenditure account, recorded as an explicit subsidy and matched by income on the PSU's accounts. Accounting separation keeps the cost of social policy visible in the budget, where parliamentarians can scrutinise it, rather than in an enterprise's operating accounts.

The Food Corporation of India illustrates what happens when this discipline breaks down. The Corporation procures grain at minimum support prices set by the Cabinet, stores it, and supplies it to ration shops at prices well below procurement cost. The shortfall is intended to be transferred to FCI as a food subsidy from the union budget. However, for long stretches, the government did not transfer the full subsidy in time, and FCI raised debt, much of it from the National Small Savings Fund, to bridge the gap. This practice was especially prevalent between 2016 and 2021. The losses that appeared on FCI's books reflected the failure to transfer the subsidy on time. The government used FCI's balance sheet to delay recognition of expenditure that should have appeared in the budget.

The existence of PSUs can then soften budget constraints in two ways. First, if a PSU knows it can rely on transfers from the treasury to cover any shortfall, its managers have less incentive to contain costs than managers of a private firm would. As a result, the PSU's budget constraint is softened. Second, PSUs like FCI soften the budget constraint of the government that created them. Since the enterprise absorbs costs that should have appeared in the budget, the state's social spending is understated. Once this practice exists, the headline profit or loss of a PSU carries less information. A loss-making PSU may be one that delivered the mandate but did not receive the subsidy. A loss-making PSU may also be wasteful. Which case applies cannot be understood based on the profit and loss account. Persistent losses on a PSU's books are therefore a useful diagnostic. They suggest either operational inefficiency or off-budget accounting through the PSU's balance sheet.

The framework, so far, treats PSUs as faithfully pursuing their mandates. They often do not. Even an enterprise with a legitimate market failure justification is run by people with their own interests. Governments are themselves made up of self-interested actors, and political objectives can capture an enterprise created to address a market failure. These government failures show up in the performance criteria above: prices far from welfare-optimal levels, investments that do not deliver the promised social benefits, or operations that consume more inputs than the next-best instrument would have required.

Government failure also shapes how the state manages exit from enterprises that have outlived their justification. A framework that identifies when a PSU has no reason to exist is useful only if exit decisions follow honestly from that assessment. Chakrabarty (2023, page 9) finds that around 43% of India's disinvestment proceeds between 1991 and 2022 involved no actual transfer to private hands. Shares were transferred between public entities, and the proceeds were counted towards the disinvestment target without any change in underlying ownership. Even where the case for a PSU has lapsed, political incentives corrupt the exit process and sustain enterprises that should not exist.

Applying the framework

Consider three applications of the framework. First, the electricity transmission network exhibits natural-monopoly characteristics, with high fixed costs and declining average costs over the relevant output range. State intervention to address market power is justified ex-ante, whether through regulated private ownership or direct public ownership of the grid operator. Power Grid Corporation of India is a PSU that runs the inter-state grid. From the standpoint of allocative efficiency, tariffs should be set close to marginal cost. Because the marginal cost of transmission is below the long-run average cost, such pricing would generate a structural revenue deficit. A deficit of this kind would not necessarily signal operational inefficiency. It can reflect a deliberate tariff policy that expands access and maximises network use, and it would be justified where it represents the least-cost route to the social objective when compared with direct transfers or alternative subsidy mechanisms. India does not price transmission at marginal cost. Tariffs are set under the CERC Tariff Regulations, 2024, which use a cost-plus framework. For new transmission projects, Regulation 30(3) provides a base return on equity of 15%, along with recovery of interest costs, depreciation, interest on working capital, and operating and maintenance expenses. The PSU's operational record is strong: the transmission system was available 99.85% of the time in FY24 across 1,77,699 circuit kilometres carrying around half of India's inter-state electricity. Whether the cross-subsidy implicit in cost-plus regulation is the least-cost route to network expansion, or whether a direct transfer would deliver the same access at lower fiscal cost, is a question worth asking. Power Grid no longer builds new lines by default. The regulator auctions each new project to the lowest bidder, and Power Grid competes for these contracts alongside Adani, Sterlite and Tata Power. Private bidders win a growing share. Whether the legacy network would also be cheaper in private hands is a separate question. The framework's verdict on Power Grid therefore turns on an empirical question: whether the cost-plus regulation of the legacy network delivers cheaper transmission than competitive procurement would.

Second, the India Tourism Development Corporation (ITDC) runs the Ashok Group of Hotels. ITDC was established in 1966 to develop tourist infrastructure, including hotels. The Taj, Oberoi, ITC, Lemon Tree and Marriott chains, among others, operate across the segments and price points ITDC serves. Hotels are not a public good. Private operators can charge customers, competition is adequate, and there are no externalities, information failure, or market power problems that require the state to own a hotel chain. The market failure test fails at the first step, so no ex-post analysis is needed.

A third example concerns the post-independence wave of public investment in heavy industry and infrastructure. The standard defence of state ownership in this period rested on the absence of capital markets: long-term finance was scarce, and only the state could mobilise it. Bhagwati and Desai (1970) contested this claim, arguing that private capital existed and that the licensing regime was producing the shortages it purported to remedy. Whatever the merits of the original argument, India's capital markets have since deepened. A second defence rests on positive externalities through learning effects and supply-chain spillovers, where social returns exceed what a private investor can appropriate. Underinvestment results from this appropriability gap, even when capital is available. The defence still has limits. Where production subsidies, intellectual property protection, or advance market commitments can close the gap, ownership is the costlier instrument. A surviving PSU founded on these grounds must show that such alternatives remain inadequate.

India's early integrated steel plants at Rourkela, Bhilai, Durgapur, and Bokaro are concrete cases. The plants were justified on grounds that private firms could not raise the long-term capital required, and that they would generate large downstream spillovers through skilled labour, supplier networks, and engineering capabilities whose full social value private investors could not capture. The appropriability gap was real, and thin capital markets compounded the problem by raising the cost of private investment. Both conditions have since changed. India's capital markets have deepened, project finance has matured, and Tata Steel and JSW Steel have built modern integrated capacity at scale. The spillovers that public investment was meant to generate now flow through the private steel industry instead. SAIL, the operator of the original plants, produces around 15% of Indian steel and is profitable. Profitability does not save it from the framework's test. Where private operators produce the same steels at a comparable scale, the market failure has been resolved, and continued public ownership no longer has a justification.

The way forward

Profit is the wrong measure for judging a PSU. It speaks neither to whether the enterprise should exist nor to whether it is doing what it exists to do. For each of India's 291 central PSUs and more than a thousand at the state level, the question is whether a market failure persists, whether ownership is the cheapest way to address it, and whether the enterprise actually does so. Some profitable PSUs would fail this test. Some loss-making ones would pass.

References

India: Planning for Industrialization: Industrialization and Trade Policies Since 1951 by Bhagwati J and Desai P, 1970, Oxford University Press for OECD Development Centre.

On the Management of Public Monopolies Subject to Budgetary Constraints by Boiteux M, 1971, Journal of Economic Theory, 3(3), 219 to 240.

The Lighthouse in Economics by Coase R H, 1974, Journal of Law and Economics, 17(2), 357 to 376.

The Proper Scope of Government: Theory and an Application to Prisons by Hart O, Shleifer A and Vishny R W, 1997, Quarterly Journal of Economics, 112(4), 1127 to 1161.

The Simple Microeconomics of Public-Private Partnerships by Iossa E and Martimort D, 2015, Journal of Public Economic Theory, 17(1), 4 to 48.

In Service of the Republic: The Art and Science of Economic Policy by Kelkar V and Shah A, 2019, Penguin Allen Lane.

The Place of the Soft Budget Constraint Syndrome in Economic Theory by Kornai J, 1998, Journal of Comparative Economics, 26(1), 11 to 17.

A Theory of Incentives in Procurement and Regulation by Laffont J-J and Tirole J, 1993, MIT Press.

Allocative Efficiency vs. "X-Efficiency" by Leibenstein H, 1966, American Economic Review, 56(3), 392 to 415.

State versus Private Ownership by Shleifer A, 1998, Journal of Economic Perspectives, 12(4), 133 to 150.

Arjun Krishnan is a consultant at the Centre for Civil Society, a Delhi-based think tank. He thanks Sourya Banerjee for the early conversations that inspired this article, Jayana Bedi for her thoughtful feedback during its drafting, and an anonymous referee whose comments considerably sharpened the argument.

History of disinvestment in India

by Sudipto Banerjee, Renuka Sane, Srishti Sharma and Karthik Suresh.

Disinvestment of public sector enterprises has been an important part of Indian economic policy since the 1990s. Research in this field has been constrained by a lack of foundations of facts. There is limited information on policy positions, policy actions, as well controversies around policy actions. For example, Baijal (2008) provides a history of early disinvestment decisions in India; Banerjee Sane and Sharma (2020) provide information on the more recent methods adopted for disinvestment; Banerjee, Moharir and Sane (2020) document disinvestments undertaken to meet the minimum public shareholding rule in India.

In a new working paper, History of disinvestment in India: 1991-2020, we contribute to the literature by documenting the history of disinvestment of Central Public Sector Enterprises (CPSEs) in India between March 1991 to December 2020. The paper is a collection of facts on:

1. The policy position of governments across the years
2. The policy processes adopted by governments on selection of enterprises for disinvestment
3. The difficulties encountered in various transactions on (i) methods of valuation, (ii) legal disputes challenging the transactions, (iii) adverse audit remarks of the CAG, and (iv) labour unrest.
4. Targets for disinvestment and amounts raised
5. The different methods of disinvestment, especially those used in recent years such as compulsory buybacks, Offer for sale through the stock exchange (OFS-SE), CPSE to CPSE sales, Exchange Traded Funds (ETFs), and public offers.

We found it difficult to achieve this level of clarity on the facts, and hope that this helps many others approach the field with better foundations on facts.

References

Baijal, P. (2008), Disinvestment In India: I Lose and You Gain, Pearson; 1st edition.

Banerjee S., Moharir, S., and Sane R. (2020), The problem of minimum public shareholding in public sector enterprises , The Leap Blog, 18 November 2020.

Banerjee S., Sane R. and Sharma, S. (2020), The five paths of disinvestment in India , The Leap Blog, 7 July 2020.

The problem of minimum public shareholding in public sector enterprises

by Sudipto Banerjee, Sarang Moharir, Renuka Sane.

In 2009-10, the government of India increased the minimum public shareholding (MPS) threshold for listed companies from 10% to 25%. The government's rationale for the MPS is that a minimum public float of shares addresses secondary market imperfections like concentration of shares and price manipulation. The Securities and Exchange Board of India (SEBI) has specified several methods that listed firms can use to expedite their MPS compliance. One of the methods is the offer for sale of shares through the stock exchange (OFS-SE). This was introduced in 2012 to facilitate compliance in a broad-based and transparent manner. Prior to the OFS-SE, the government divested shares through OFS by issuing a prospectus. This was a cumbersome and time-consuming process. Since 2012, the government has used the OFS-SE method to undertake disinvestment of CPSEs to meet the MPS threshold.

In 2010, when the Securities Contract (Regulations) Rules were amended [Rule 19A(1)] to increase the MPS threshold from 10% to 25%, listed Central Public Sector Enterprises (CPSEs) were exempted. The government withdrew the exemption in 2014, and set a deadline of August 2017 for compliance with the MPS. This was extended by a year to 2018 and again by two years to 2020. Recently, listed CPSEs got another extension of one year till August 2021. Despite the extensions, 37 CPSEs out of the total 77 listed CPSEs had not met the MPS requirement as on December 31, 2019.

As we approach the August 2021 deadline, we ask if disinvestments through the OFS-SE route have achieved the 25% MPS target. This question is relevant for all disinvestments. We, however, focus on the one's done through OFS-SE as this route was designed to meet the MPS threshold. This study is useful for two reasons. First, it gives us a sense of how much more disinvestment the government has to undertake to meet the MPS. Second, the government's record on meeting the MPS threshold for CPSEs sends a strong signal of its own commitment to the MPS.

Methodology

We sourced transaction data from BSEPSU. We only consider CPSEs where at least 5% stake was divested through the OFS-SE route between 2012 and 2019. This gives us a sample of 22 CPSEs (with 31 transactions) out of the total 77 CPSEs.

Since OFS-SE is a secondary market transaction, details like name of the purchaser, the number of shares purchased and the final sales price are not available in the public domain. Therefore, we studied each annual report issued in the year of the OFS-SE transaction to document the change in the shareholding pattern of the top ten shareholders. Further, we used these changes to identify the possible purchaser of shares. For example, 5% stake of Power Finance Corporation (PFC) was divested in 2015; LIC's shareholding in PFC increased from 4.81% to 9.08% in the same year. We assume that LIC purchased a stake in the OFS-SE transaction of PFC in 2015.

Results: other CPSEs as shareholders

Table 1 shows the shareholding of CPSEs that had undergone OFS-SE as of March 2019. Public shareholding contains CPSE shareholding (column 4) i.e., shares held by other CPSEs in these companies. Since CPSEs are themselves government owned, it is useful to evaluate public shareholding after removing their holdings. As an example, National Fertilizers Ltd. has a public shareholding of 25.29% and meets the MPS requirement of 25%. The following CPSEs are listed under the public shareholding category of National Fertilizers Ltd., i.e. LIC (11.31%), NIA (1.76%), GIC (1.48%), Canara Bank (0.69%), OIC (0.29%). The total share of these firms (15.53%) is deducted from the public share of National Fertilizers (25.29%). Public shareholding of National Fertilizers at 9.76% does not meet the MPS threshold. When the share of CPSEs is excluded from the public shareholding category, 13 out of the 22 CPSEs failed to meet the MPS requirement as of March 2019.

Table 1: Shareholding of CPSEs that have undergone OFS-SE (March 2019)

Company	Promoters’ share-holding	Public share-holding	Shareholding of CPSEs (included within public shareholding)	Whether MPS requirement is met when share of CPSE is not considered?
BHARAT ELECTRONICS LTD.	55.93%	44.07%	LIC (3.61%)	Yes
COAL INDIA LTD.	69.26%	30.74%	LIC (10.94%), LIFE INSURANCE CORPORATION OF INDIA P & GS FUND (2.18%)	No
CONTAINER CORP. OF INDIA LTD.	54.80%	45.20%	LIC (3.08%)	Yes
ENGINEERS INDIA LTD.	52.00%	48.00%	LIC (4%)	Yes
HINDUSTAN COPPER LTD.	76.05%	23.95%	LIC (12.14%)	No
INDIAN OIL CORP. LTD.	51.50%	48.50%	ONGC (14.20%), LIC (6.51%), OIL (5.16%), IOC SHARES TRUST (2.48%)	No
INDIA TOURISM DEVELOPMENT CORP. LTD.	87.03%	12.97%	LIC (3.22%), NIC (0.13%)	No
MMTC LTD.	89.93%	10.07%	LIC (3.39%), UIC (0.24%), GIC (0.18%), NIA (0.11%)	No
MOIL LTD.	65.69%	34.31%	LIC NEW ENDOWMENT PLUS BALANCED FUND (7.12%), UIC (1.05%), NIA (0.35%), OIC (0.46%)	Yes
NATIONAL ALUMINIUM CO. LTD.	52.00%	48.00%	LIC (8.2%), NIC (0.61%)	Yes
NATIONAL FERTILIZERS LTD.	74.71%	25.29%	LIC (11.31%), NIA (1.76%), GIC (1.48%), CANARA BANK (0.69%), OIC (0.29%)	No
NBCC (INDIA) LTD.	65.93%	34.07%	LIFE INSURANCE CORPORATION OF INDIA P & GS FUND (6.55%), SBI(0.48%)	Yes
NHPC LTD.	73.33%	26.67%	LIC (7.31%), PFCL (2.43%), REC (1.75%)	No
NLC INDIA LTD.	80.85%	19.15%	LIC (3.34%), UTI (0.83%), NIA (0.47%)	No
NMDC LTD.	72.28%	27.72%	LIC (12.9%), LIC NEW ENDOWMENT PLUS BALANCED FUND (2.03%), SBI (0.38%), NIA (0.34%)	No
NTPC LTD.	54.50%	45.50%	LIC JEEVAN PLUS NON UNIT FUND (11.51%)	Yes
OIL INDIA LTD.	59.57%	40.43%	LIFE INSURANCE CORPORATION OF INDIA P & GS FUND (12.19%), IOCL (4.71%), HPCL (2.47%), BPCL (2.47%)	No
OIL & NATURAL GAS CORP. LTD.	62.98%	37.02%		Yes
RASHTRIYA CHEMICALS AND FERTILIZERS LTD.	75.00%	25.00%	LIC (2.07%), NIA (0.60%)	No
REC LTD.	52.63%	47.37%	LIC (2.30%), CPSE ETF (3.57%)	Yes
STATE TRADING CORP.OF INDIA LTD.	90.00%	10.00%	LIC (0.91%), NIA (0.89%), OIC (0.07%)	No
STEEL AUTHORITY OF INDIA LTD.	75.00%	25.00%	LIC (9.60%), LIC MARKET PLUS 1 GROWTH FUND (1.24%), LIFE INSURANCE CORPORATION OF INDIA P & GS FUND (0.63%)	No

Source: Company Annual reports

Results: LIC as shareholder

Table 2 indicates an increase in shareholding of LIC (whose 100% shares are held by the government) in the CPSEs post OFS-SE transactions. As an example, Hindustan Copper went through disinvestment in FY16 and FY17. This lead to a decrease in government shareholding from 89.95% in 2016 to 76.05% in 2017, at the end of the two transactions. Shares of LIC increased from 5.27% at the beginning of FY16 to 12.14% in FY18. Similarly, National Fertilizers was disinvested in FY17, where the government's share decreased from 92.5% to 80%. Shares held by LIC in the company had increased from 4.16% to 11.32% in FY18.

Table 2: OFS-SE transactions and purchases by LIC

Name of entity	Year	Stake divested	LIC's share before disinvestment	LIC's share post disinvestment
NMDC	FY12	10%	5%	5.54%
RASHTRIYA CHEMICALS AND FERTILIZERS LTD.	FY13	12.5%	0.87%	6.45%
NTPC	FY13	9.5%	5.91%	7.66%
NALCO	FY13	6.09%	3.25%	6.02%
SAIL	FY14	5%	6.61%	10.11%
COAL INDIA LTD.	FY15	10%	2.10%	7.24%
DREDGING CORP. OF INDIA LTD.	FY15	5%	2.99%	5.86%
POWER FINANCE CORP. LTD.	FY15	5%	4.81%	9.08%
NHPC	FY16	11.36%	3.11%	8.83%
HINDUSTAN COPPER LTD.	FY16	7%	5.27%	10.70%
CONTAINER CORP. OF INDIA LTD.	FY16	5%	1.03%	3.05%
NBCC	FY16	15%	0%	8.11%
HINDUSTAN COPPER LTD.	FY17	6.83%	11.14%	14.25%
NATIONAL FERTILIZERS LTD.	FY17	15%	4.16%	11.32%
MOIL	FY17	10%	3.84%	7.11%
COAL INDIA LTD.	FY18	5.19%	8.97%	10.94%

Source: Annual reports

In the sample of 31 transactions concerning the 22 CPSEs selected for our study, the Life Insurance Corporation (LIC) increased its holding in 16 transactions. For six transactions, the top ten shareholders' names were not disclosed in the annual reports. LIC's equity did not change in the remaining nine transactions.

Conclusion

Out of the total 77 NSE-listed CPSEs, 37 CPSEs had not met the MPS threshold as on December 31, 2019. The government will have to do a lot more to achieve full compliance with the MPS by August 2021. Out of the 22 CPSEs that went through disinvestment by the OFS-SE route, 13 CPSEs do not meet the MPS once we exclude the share of CPSEs. LIC purchased equity in more than 50% of CPSEs in our sample.

One of objectives of disinvestment is to promote public ownership of CPSEs. This also provides an opportunity to citizens to participate in the wealth of CPSEs. The MPS also seeks to widen ownership in listed companies. Under the Securities Contracts (Regulation) Rules and SEBI (Issue of Capital and Listing Disclosure Requirements) Regulations, shareholding of CPSEs and LIC may be considered as public, but their inclusion does not align with the goals of either disinvestment or the MPS. This question also assumes relevance given CAG's recent observation (Para 1.3.2) that disinvestment from one public sector firm to another 'did not change' stake of the government in the disinvested CPSEs. Disinvestment which truly widens CPSE ownership to individuals and institutions outside of the government should be an important goal for policy.

The authors are researchers at the National Institute of Public Finance and Policy. The authors would like to thank Karthik Suresh and Srishti Sharma for useful discussions.

The five paths of disinvestment in India

by Sudipto Banerjee, Renuka Sane and Srishti Sharma.

Privatisation of Central Public Sector Enterprises (CPSEs) in India has typically been done in one of the following ways: in the early years government equity was sold through an auction to financial investors, while since 2004, the popular method has been public offer. Strategic sales, where control of the public sector is transferred to private entities have been very few, concentrated in the 1999-2004 period. As a result, sale of government shareholding in India is referred to as disinvestment and not privatisation.

In recent years the methods used for disinvestment include: a) Public offer, b) Buybacks, c) Sale to employees, d) Exchange traded funds (ETFs), and e) CPSE to CPSE sale. Buybacks and ETFs are new ways of divesting minority stake. As we study the trajectory of disinvestment in India, it is important to understand the relative magnitudes involved in each transaction. There are two metrics that are important - first, the amount of resources raised and second, the change in government equity through these methods. The latter is especially important as disinvestment has great potential to improve economic efficiency by reducing government control. By focusing only on resources raised as an outcome, we end up ignoring the more important economic rationale for undertaking disinvestment.

In this article, we describe the methods adopted for disinvestment of CPSEs since FY2015. We use the BSEPSU disinvestment database and individual annual reports of firms to arrive at the magnitudes of disinvestment. We use two measures:

• Disinvestment proceeds and shares sold. The proceeds are the amount realised through the sale process. Shares sold is the ratio of the number of government shares sold by the total equity of the firm.
• Change in government equity. This is the difference between the share of government in total equity of the firm before and after the disinvestment transaction.

Disinvestment methods

Table 1 provides an overview of disinvestment by the government in the last 6 years. It shows the number of transactions, the number of CPSEs, the disinvestment proceeds, % of total shares sold and the change in government equity post the transaction.

Table 1: Disinvestment from FY15 to FY20

	Methods of disinvestment	Number of transactions	Number of CPSEs	Disinvestment proceeds (INR million)	Average % of shares sold	Average change in % of govt equity post disinvestment
1	PUBLIC OFFER	37	32	984,054	10	10
2	BUYBACK	36	23	403,549	8.34	0.64
3	SALE TO EMPLOYEES	21	15	9,379	0.138	0.138
4	EXCHANGE TRADED FUND*	10	18	989,490	1.09#	1.09#
5	CPSE TO CPSE SALE	8	8	667,119	77.15	77.15
Source: BSEPSU database and authors' calculation based on annual reports

* There were a total of 10 tranches of ETFs in this period. Each tranche contains a basket of firms. If the disinvestment in each firm that was part of an ETF tranche is considered separately then we would have 126 ETF transactions instead of 10. The average change in government equity for ETFs is therefore calculated across these 126 transactions, and not the 10 tranches

The government of India disinvested its stake in 50 CPSEs and raised a total of INR 3,053 billion using five methods: public offer, buy back, CPSE to CPSE sale, exchange traded funds and sale to employees. On an average, the government sold 7.28% of total shares and the average reduction in government equity has been around 5.84%. The sum total of the number of CPSEs in column 2 does not match with the total number of 50 unique CPSEs because some CPSEs adopted multiple methods across years. Public offer was the most used method with 32 firms and 37 transactions. The second most popular method was buyback with 36 transactions. The maximum revenue was raised through ETFs followed by public offer. The maximum share of sales and change in government equity was through CPSE to CPSE transfers. There is some missing data on % shares sold for buyback and ETF transactions as annual reports for FY20 is not published yet (indicated by #).

Figure 1 below shows the yearly distribution of amount raised and % reduction in equity across various methods from FY15 to FY20. The significant increase in proceeds in FY18 and FY19 is driven by ETFs and CPSE to CPSE sales. Besides CPSE to CPSE sales, the average % reduction in government equity remained low and constant across all years. We next study the five methods in detail and understand the extent of disinvestment in each method.

Public offer

Public offer has been the most common method of disinvestment. Since FY 2015, there have been 37 public offer transactions including 21 offer for sale (OFS) transactions. The public offer route is considered as a transparent way of offloading government shares and aims to encourage public participation. In several public offer transactions, the Life Insurance Corporation (LIC), whose shares are fully owned by the central government, has bought majority of the shares. Some of these transactions include:

1. In 2014, LIC bought 5.94% stake in Bharat Heavy Electricals Ltd (BHEL) for INR 26,850 million, increasing its stake in BHEL to 14.99%.
2. In 2015, LIC bought shares worth INR 70,000 million INR in the public offer of Coal India Ltd. This was equivalent to one-third of the public offer.
3. In the same year, it bought nearly 86% of the shares on offer of the Indian Oil Corporation paying over INR 80,000 million.
4. In 2016, LIC bought 59% of shares offered in NTPC stake sale worth $730 million. Thus, LIC spent approximately INR 29,000 million.
5. In 2017, LIC bought shares worth around INR 80,000 million in the disinvestment of General Insurance Corporation of India and again bought shares worth INR 65,000 million in the IPO of New India Assurance Company.
6. In March 2018, LIC subscribed 70% of shares in the IPO of Hindustan Aeronautics Ltd, paying INR 29000 million.
7. Between November 22, 2019 and February 27, 2020, LIC acquired 59.49 lakh shares worth INR 1,770 million, or 2.38 % stake, in RITES though an offer-for-sale (OFS).

LIC spent roughly INR 381,620 million on the transactions listed above. This constitutes 38.7% of the disinvestment proceeds raised through the public offer method in the period of our study.

Buyback

Buyback is a process where a company purchases its shares from its existing shareholders. This helps a company to restructure capital and increase the underlying value of shares. The company is required to extinguish the bought back shares. The government has used buyback in the past as a method of disinvestment. However in 2016, buyback was made compulsory for CPSEs who met the prescribed threshold of net worth and cash reserves.

A company is under an obligation to provide a buyback offer to all existing shareholders. In such a case, reduction in the total equity is higher than the reduction in government shares which may lead to an increase in % of government equity post buyback. However, if a CPSE is wholly owned by the government, total number of shares will be reduced (extinguished) by the same number of shares bought back. Hence, there will be no change in % of equity held by the government post buyback.

Table 2 presents the impact of buyback transactions on government shareholding. Since 2015, 23 CPSEs have bought back shares from the government raising INR 403,549 million. It is important to note that % shares sold for three buyback transactions in FY20 is unavailable since annual report for the year is not published yet (indicated by *). Out of total 36 buyback transactions, 9 transactions led to an increase in government equity. In 11 transactions, where CPSE was wholly owned by the government, there was no change in government holding. The remaining 16 transactions recorded an average reduction of 1.19% in government equity. In column (2) the count of individual number of CPSEs do not match with the total number of CPSEs because same 8 CPSEs recorded increase in equity in one year while decrease in another (indicated by **).

Table 2: Summary of buyback transactions

Transaction type	Number of transactions	No. of CPSEs	Total disinvestment proceeds(INR million)	Average % of shares sold	Average change in % of govt equity post buyback
Reduction in government holding	16	12	244,947	7.63	(1.19)
Increase in government holding	9	9	83590.7	2.31	0.16
No change in government holding	11	7	75,011	15.55*	0
Total	36	23**	40,3549	8.34	(0.64)
Source : Authors' calculation based on annual reports

Sale to employees

As part of its disinvestment strategy, the government has often reserved a certain quantity of its shares for offer to the CPSE employees. Usually these shares are offered at a discount. Such transactions are expected to incentivise the employees and create dispersed shareholding. In the last six years, there have been 21 such transactions across 15 firms from which the government raised a total of INR 9,379 million. On an average, the % of shares sold to the employees is around 0.14%. Almost half of the proceeds from this method comes from two transactions in FY17 by Indian Oil Corporation Ltd. and NTPC Ltd. In May 2016, government sold 0.29% of the total shares of Indian Oil Corporation Ltd. to its employees raising INR 2,624 million. Pursuant to the 5% OFS stake in February 2016, NTPC offered to sell 2.06 crores equity shares of government to the employees at a discount rate of 5%. 85% of the shares were subscribed by around 10,800 eligible employees and government raised approximately INR 2,037 million.

Exchange traded funds (ETFs)

ETF is a pool of stocks that reflects the composition of an index, like S&P BSE SENSEX. This method has been frequently used for disinvestment in the recent past, where the government sells shareholding in select CPSEs to a fund house which owns the ETF. The ETF fund manager first formulates the scheme and offers to the public for subscription by way of a new fund offer (NFO). The subscription proceeds are used to purchase the shares of constituent companies in similar composition and weights based on the underlying index. Shares are usually sold at a discount to the scheme and the fund manager in turn creates and allots units of the scheme, to the investors. Once the NFO closes, the units are listed on the exchanges.

The government has launched two ETFs, namely, CPSE ETF and Bharat-22 ETF. CPSE ETF was launched in 2014. It contains stock of 11 listed CPSEs and follows the NIFTY CPSE index. In 2017, Bharat-22 ETF was created. This comprises of 16 CPSEs, 3 public sector banks and 3 private company stocks held by Specified Undertaking of the Unit Trust of India (SUUTI). The underlying index is the S&P Bharat 22 index. From FY15 to FY20, there were six tranches of CPSE ETF and four tranches of Bharat-22 ETF transactions which raised INR 989,490 million.

Table 3 lists each ETF tranche from FY15 to FY20 and provides details on allotment date, number of constituent CPSEs, amount raised by government and average reduction in % of government equity post each tranche. It is important to note that the average % reduction in government equity for three ETF transactions in FY20 is unavailable since annual report for the year is not published yet (indicated by *NA).

Table 3: Summary of ETF tranches from FY15 to FY20

ETF Name	ETF tranche	No. of constituent CPSEs	Allotment date of ETF units	Average % reduction in government equity	Amount realised (in INR million)
CPSE ETF	FURTHER FUND OFFER 1	10	28/01/2017	0.98	59999.9
CPSE ETF	FURTHER FUND OFFER 2	10	25/03/2017	0.39	24999.9
CPSE ETF	FURTHER FUND OFFER 3	11	07/12/2018	2.88	170000
CPSE ETF	FURTHER FUND OFFER 4	11	29/03/2019	1.22	93500.7
CPSE ETF	FURTHER FUND OFFER 5	10	26/07/2019	NA*	100003.9
CPSE ETF	FURTHER FUND OFFER 6	10	07/02/2020	NA*	165000
BHARAT 22-ETF	NEW FUND OFFER	16	24/11/2017	0.93	145000
BHARAT 22-ETF	FURTHER FUND OFFER 1	16	29/06/2018	0.58	83252.6
BHARAT 22-ETF	TAP OFFER	16	22/02/2019	0.92	104045.9
BHARAT 22-ETF	FURTHER FUND OFFER 2	16	10/10/2019	NA*	43688
Source : Author's calculation based on annual reports

While aggregate proceeds from ETF may have been high, the average reduction in government equity has been low.

CPSE to CPSE sale

Under this method, government transfers its shares in one CPSE to another CPSE. There have been eight such transactions in the last six years which raised a total of approximately INR 667,119 million. The details of each of the transaction is given in table 4. Except REC Limited, the entire government shareholding was transferred to another CPSE. In case of REC Limited, government still holds 0.25% shares. Post these sales, the firms became subsidiaries of the buyer CPSE firms, but continue to remain government companies as defined under section 2(45) of the Companies Act, 2013.

Table 4: CPSE to CPSE sales from FY15 to FY20

CPSE	Date of transaction	Buyer's Name	% of shares sold	Amount realised (in INR million)
HINDUSTAN PETROLEUM CORPN. LTD.	31/01/2018	OIL & NATURAL GAS CORP.LTD.	51.11	369,150
H S C C (INDIA) LTD.	06/11/2018	NBCC (INDIA) LTD.	100	2,850
DREDGING CORPN. OF INDIA LTD.	09/03/2019	CONSORTIUM OF FOUR PORTS	73.47	10,491
R E C LTD.	28/03/2019	POWER FINANCE CORP.LTD.	52.63	145,000
KAMARAJAR PORT LTD.	27/03/2020	CHENNAI PORT TRUST	66.67	23,830
NORTH EASTERN ELECTRIC POWER CORPN. LTD.	27/03/2020	NTPC LTD.	100	40,000
T H D C INDIA LTD.	27/03/2020	NTPC LTD.	74.49	750,00
NATIONAL PROJECTS CONSTRUCTION CORPN. LTD.	26/04/2020	WAPCOS LTD.	98.89	798
Source : BSEPSU disinvestment database

The CPSE to CPSE sale transactions constituted around 22% of total disinvestment proceeds in the last six years. While technically, the government may have divested 77% shareholding in these CPSEs (as shown in Table 1), it did not bring any change in government ownership of these firms.

Conclusion

There has been a huge increase in disinvestment proceeds in the recent years. However, reduction in government equity in the CPSEs has not witnessed much growth. About 5.19% of disinvestment proceeds came from buyback transactions that led to an increase (or no change) in government equity and 21.8% came from CPSE to CPSE sale transactions that led to no change in government ownership. While 32.2% of proceeds came from public offer, almost 39% of these were actually purchased by LIC. Thus, purchases by LIC accounted for 12.49% of the total proceeds which also imply no change in government ownership. Finally, around 32.4% came from ETFs which, on an average reduced government equity by 1.09%. These considerations become central issues for any research on disinvestment and its impact.

The authors are researchers at NIPFP. We thank Karthik Suresh and Sarang Moharir for useful comments.

Applicability of the IBC to public sector enterprises: The case of Hindustan Antibiotics Ltd

by Sudipto Banerjee, Renuka Sane and Karthik Suresh.

Since the enactment of the Insolvency and Bankruptcy Code (IBC) in 2016, the National Companies Law Tribunal (NCLT) has been admitting insolvency cases against public sector enterprises (for example, the Tamil Nadu Generation and Distribution Co. Ltd., the Northern Power Distribution Co. Ltd.). A final resolution order was passed in the case of Burn Standard and Co. Ltd. while liquidation proceedings were ordered in the case of Hindustan Paper Co.Ltd. This suggests that the IBC was being used for resolving defaults by public sector enterprises (PSEs).

The case of Hindustan Antibiotics Ltd. (HAL) has led to uncertainty regarding the applicability of the IBC to PSEs. In this case, the NCLT could not arrive at a decision on the applicability of the IBC to HAL. The dispute was referred to a third member of the NCLT. In the meanwhile, HAL filed a writ petition before the Bombay High Court challenging the constitutional validity of the IBC insofar as it applies to government companies, which was admitted by the Court. This, in effect, has stayed the proceedings before the NCLT. The High Court will now decide on the question of whether the IBC applies to government companies.

This article revisits the dispute and examines the position of PSEs within the ambit of the IBC. It argues that creditors of PSEs (or PSEs themselves) should be able to access the IBC. Removing PSEs from the IBC's purview may lead to delays in resolution, and may close an important route which the government could use for disinvestment.

The dispute

Hindustan Antibiotics Ltd. (HAL) is a central PSE in the business of supplying affordable drugs and antibiotics. The company has been incurring losses since 1993-94. In March 1997, HAL was declared a sick company and placed under the Board for Industrial and Financial Reconstruction (BIFR) which approved a restructuring package in June 2007. However, the company's financial situation continued to deteriorate. In December 2016, the Union Cabinet stated that it will look at options for conducting a strategic sale of HAL, dispose of the surplus land and structure a voluntary retirement scheme (VRS) for its employees. As of January 2020, the strategic sale has not taken place. The company has been unable to pay the salaries of its employees on time.

As a consequence, employees of HAL have filed cases against the company for non payment of salaries and other dues before various courts. Three public sector banks have sent recovery notices to the company under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act). Employees have also filed cases before the Controlling Authority under the Payment of Gratuity Act, 1972 for non payment of dues. Three operational creditors including Mr. Harish Pinge, an employee of HAL, filed cases under the IBC before the NCLT.

The impugned order of the NCLT is concerned with the petition filed by Harish Pinge. The company acknowledged the portion of Mr. Pinge's retirement dues but was unable to pay due to its financial condition. When Mr. Pinge approached the NCLT, the company took the view that IBC does not contemplate handling the insolvency resolution process of PSEs and hence the petition was not maintainable.

The NCLT's order

The judicial member took the view that HAL was a central PSE and thus an 'instrumentality of the state'. He held that even if the company is loss-making and is unable to pay its dues, it cannot be closed. This is because it would be unconstitutional for a tribunal to pass an order to close a PSE which is an instrument of the state itself. The relevant paragraph is extracted as follows:.

In view of the above findings, I am of the considered view that CIRP process cannot be initiated against an instrumentality of the state. To say these words I have made an attempt to lift the corporate veil of the Corporate Debtor to see who is behind the same and I found that it is none other than Govt. of India, in the name of President of India. Initiating CIRP process against the Corporate Debtor practically amounts to initiating CIRP process against the Govt. of India which is impermissible under the Constitution/Law. The law makers while enacting the IBC appears to have not envisaged such a situation otherwise they would have exempted Govt. Companies from the CIRP process as the application of the Code on the said Govt. Companies would create a chaos and defeat the very intent for which IBC is brought into existence. At the same time there is also another way looking at it and that is, there is no reason even to expressly exempt the Govt. Companies because it is an instrumentality of the state and de-horsing the corporate character and independent entity, there is everything to say that the Govt. Companies are an instrumentality of the state or rather we can say that there an alter ego of the state itself and the result of the same is that the IBC cannot interfere with the state owned undertakings. In view of the above the point No. (i) and (ii) are answered against the Petitioner as the Petitioner can have an alternate remedy in a civil court or by way of proceeding under Article 226 or 32 of the Constitution of India in an appropriate forum if so advised. (emphasis added)

The technical member held that all PSEs are liable to be subject to the CIRP as prescribed in the IBC in case of a default. He was of the view that PSEs are instruments of the state but the instrumentality argument cannot be used to negate the statutory right of a reditor. Only financial services providers are explicitly excluded from the definition of 'corporate debtor'. He observed that there are lacunae in the government's own process for restructuring PSEs after the closure of Bureau for Reconstruction of Public Sector Enterprises (BRPSE) in 2015 and suggested that adoption of the IBC process is in the best interest of the corporate debtor.

Since the members had disagreed with each other, the President of the NCLT referred the case to a third member in accordance with the Companies Act, 2013. While the proceedings were pending before the NCLT, the company filed a writ petition before the Bombay High Court.

Proceedings before the Bombay High Court

At the Bombay High Court, the petitioner argued that the provisions regarding the definition of 'corporate debtor', 'person' and the provisions which give financial and operational creditors the right to approach the NCLT in case of default are in direct conflict with a) the statutory provisions of Companies Act, 2013 and b) Article 14 of the Constitution of India as far as 'government companies' are concerned.

The High Court held that the NCLT is not the proper forum for deciding on questions of constitutionality. The court referred to the Supreme Court's decision in Hindustan Construction Co. Ltd. v. Union of India where it has was held that that statutory bodies (like National Highway Authority of India) are not limited in liability and are hence not covered in either the definition of 'corporate person' or 'person' under the IBC. The Bombay High Court said that it would look at whether this decision of the Supreme Court has any bearing on government companies as well. Consequently, it imposed a stay on the proceedings before the NCLT.

In the subsequent paragraphs we discuss why the IBC should be applied to government companies as well.

The IBC does not exclude PSEs

The HAL case seems to depend on the interpretation of 'corporate debtor'. Under the provisions of the IBC, 'corporate debtor' means a corporate person who owes a debt to any person. The definition of 'person' includes a company. Most PSEs are registered as government companies under the Companies Act, 2013 and are generally subject to its provisions and rules.

A similar argument was made by the solicitor general in the context of Hindustan Construction Co. Ltd. v. Union of Indiasupra). He admitted (para 58) that government companies are covered in the definition of 'corporate person' under section 3(7) of the IBC. The court did not make a clear pronouncement on this specific issue since the facts of the case were not primarily concerned with it. But we can presume that the solicitor general, being the statutory lawyer of the Union government, has stated the view of the government on the law.

There are specific provisions in the Companies Act, 2013 which exempt government companies from certain requirements. It is a settled principle of statutory interpretation that legislature speaks its mind by use of correct expression and unless there is ambiguity in law, the law has to be read in its literal sense. The literal reading of the provisions does not indicate exemption of PSEs from IBC.

Inference can also be drawn from the earlier legislation like Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) where it was expressly mentioned that the definition of company did not include a government company. This was removed by an amendment in 1993. Further, the IBC substituted the provisions on revival of sick industrial companies and winding up given under the Companies Act, 2013.

The importance of the IBC to PSEs

There are several reasons that the case before the High Court is extremely important.

The IBC is a time bound process which helps preserves the value of the firm and improves recovery. The World Bank's Ease of Doing Business survey reflects this change --- the recovery rate per dollar has increased from 28.6 cents per dollar to 71.6 cents per dollar since the IBC was brought into force. The exclusion of PSEs from this process will be expensive to its creditors, which are often public sector banks. For instance, the report of the Lok Sabha Committee on Public Undertakings observed that for 2016-17, the losses of the top three loss making central PSEs i.e. Air India, BSNL and MTNL accounted for 55.66% of total losses among central PSEs. The annual reports of BSNL (2015-16), MTNL (2018-19) and Air India (2018-19) show that all of their term loans are from public sector banks, except Air India where there is only one private sector bank. Further, if a PSE defaults on its loan repayment, resolution under IBC can help in the process of disinvestment.

The Public Enterprises Survey (2017-18) showed that 71 central PSEs are loss making, out of which 56 showed negative net worth. It is likely that several PSEs may not have been able to service their debts to their financial or operational creditors. Until 2016, these companies were subject to the restructuring process under the BIFR. However, the process of closure has been far from satisfactory. For example, in 2011, the Comptroller and Auditor General of India (CAG) in its report on closure of PSEs stressed on the need of professional insolvency practitioners to ensure maximum value is obtained either from restructuring or closure of the central PSEs. The Public Enterprises Survey (2015-16) showed that BIFR had listed 18 central PSEs for winding up and closure. But as on July, 2019, only two of those companies were actually closed. In the event of a default by a sick company, the IBC can greatly expedite the process of closure.

Conclusion

Under the older laws governing insolvency, due to multiplicity of processes, the High Court often played the role of being the main forum for settlement of claims. We have already seen that the High Courts, acting as the company court, have demonstrated high rates of pendency. For instance, the Official Liquidator in the Bombay High Court reported that out of 1464 cases pending before the court, 739 have been pending for more than ten years. The IBC has been formulated as a complete code for insolvency laws with specified tribunals and an administrative machinery for its enforcement.

We believe that there is nothing in the IBC that precludes its use by PSEs. Using the IBC to resolve the financially insolvent and bankrupt PSEs in a time-bound manner will facilitate and may even help expedite the process of disinvestment by the government. It can also have implications for the policy concerning restructuring and closure of PSEs.

 

The authors are researchers at NIPFP. We thank an anonymous referee for useful comments.

Using the bankruptcy code for privatisation of state owned firms that have a negative value

by Ajay Shah

In the past, we have seen privatisation as a sale of equity shares. As an example, consider the VSNL privatisation. Everything else about VSNL was held intact; there was just a change in the owner of the equity shares.

This works for a firm like VSNL, where there is positive value after paying off all the liabilities. What about a firm that is so far gone that there is no bidder if we put up the shares for sale? What about the situation where the prospective cashflows from the firm don't pay for the liabilities that are in place.

As an example, consider a firm that has Rs.100 of equity that is all owned by the government, the firm has Rs.200 of debt, and the firm is worth Rs.50 if it is sold as an all-equity firm. If we simply try to sell this firm, buyers will worry about having to take responsibility for Rs.200 of debt.

India has not done a privatisation in such a situation so far. There are two ways out, one that was always possible, and one that is now possible using the Insolvency and Bankruptcy Code of 2016.

One way is to permit negative bids

As an example, in Germany, in 1990 a government agency was created which was put in charge of all the property of the previous German Democratic Republic (GDR). It led the privatisation of 8,500 state owned firms with over 4 million employees. Many of those firms were in deep trouble. A key ingredient which made the privatisation strategy work was that negative bids were permitted.

In our example, the auction will reveal a price of -150. The government will pay the buyer Rs.150, who will augment it with Rs.50 of his own, and pay off the debt of Rs.200. At the end of this, he is holding an all-equity firm which has cashflows worth Rs.50.

In this case, the lenders get Rs.200, and the government gets Rs.-150. The payment of Rs.150 is an ordinary fiscal expenditure for the government.

The other possibility is to utilise the bankruptcy code

1. The firm defaults on one payment.
2. One creditor initiates the Insolvency Resolution Process under the Insolvency and Bankruptcy Code, 2016.
3. The creditors committee is formed.
4. The bidder comes in with a plan which offers Rs.50 for control of the company.
5. The creditors committee agrees to wipe out the debt, take the Rs.50 in the bargain, and walk away.
6. In the end, the bidder gets a clean all-equity firm for the price of Rs.50.

This is a method for privatisation that can now be used in India, when we face firms which have a negative net worth and the creditors will cooperate with the government.

In this case, the lenders  get Rs.50, and the government gets 0.

Conclusion

Financial engineering cannot create value. The fact, in our example, is that the NPV of the cashflows of the company are worth Rs.50. The two solutions address this problem in two different ways. If we do a pure transaction involving equity shares only, then the government has to pay Rs.150, and the lenders are fully protected. If we put the firm into the bankruptcy process, the government (i.e. the equity shareholders) walks away with nothing, and the lenders walk away with Rs.50.

What happens to private airlines when Air India is privatised?

by Ajay Shah.

What's the impact of privatising Air India upon the rest of the domestic airline industry? Some think that the capital stock of Air India will now be put into more capable hands, and that will intensify competition. Instead of a feeble competitor with assets of Rs.546 billion, we'll have a strong competitor wielding those same assets.

As was argued by me in August 2009, the `zombie firms' literature helps us think about this. A zombie firm is one which ought to go out of business, but is artificially kept on life support. Sometimes, the subsidy is explicit, such as the fiscal injections into Air India. Sometimes, the subsidy is less visible, such as banks extending additional capital to bankrupt firms. Regardless of the method adopted, the basic fact stands: A firm that ought to have gone out of business was given a subsidy through which it sold goods at below cost.

To fix intuition, imagine a market price of Rs.100. Imagine a weak firm that, on its own, is only able to produce at Rs.110. This firm ought to rapidly vanish. But instead, it's given a subsidy of Rs.11 (either by the government or by banks) and it manages to sell at Rs.99. This keeps it going. This also harms the healthy firms in the industry, who have to deal with competition from this dead man walking.

Turning to Air India, in 2014-15 the firm produced a profit after tax that was -28.4% of total income. For each Rs.100 of total income, there was a loss of Rs.28.4. The overall industry was at -11.7%, and the industry average was dragged down by Air India which is a substantial player.

The presence of zombie firms harms healthy firms. It's hard for a healthy firm to compete against one that's getting a subsidy. By this logic, the exit of a zombie firm is good news for each firm left standing in the industry.

If one of the incumbent large Indian airlines buys Air India, the combination will have significant market power, which would be a suboptimal outcome. It would be nice, from the viewpoint of competition policy, if a new player buys Air India. In either event, the low and subsidised prices charged by Air India will end. This will improve the profitability of the domestic airline industry. All healthy firms benefit when we address the problem of zombie firms.

Air India's privatisation is an interesting milestone where we may see some of these effects play out. The issue of zombie firms is, of course, present in many parts of the Indian economy. We have a peculiar arrangement where zombie banks keep zombie firms alive. Disrupting these arrangements holds the key for starting India on the next bout of growth.

Bureaucrats in business: The tension between rule of law and commercial considerations

by Anirudh Burman, Shubho Roy, Ajay Shah.

How to achieve high performance in government

In government, the route to performance lies in clarity of objectives and accountability mechanisms, grounded in the rule of law. Every transaction undertaken by a government must be grounded in a written down process, must treat all legal persons equally (Article 14 of the Constitution), must go through due process, must be open to questioning later on. All persons must have full documentation about how the government will behave under various circumstances, must be given documentation about how their transaction was processed, and explained why. Coercive actions of the State must be subject to judicial review. Purchases must be made through General Financial Rules (GFR).

How to achieve high performance in business

These bureaucratic processes have no place in the world of business.

For a firm, counterparties have no Article 14 rights. A manager must choose to give a contract to vendor A or vendor B based on an overall sense of how this will work out. The manager is not obliged to give a reasoned order or even to treat vendors equally.

In finance, private persons choose to buy equity or debt by exercising their own judgment. There is no obligation to have due process or to face audits that question commercial decisions.

This gun-slinging exercise of discretion works because the competitive market sorts it all out. Firms are kept on their toes by the accountability mechanism of the market. Firms get high speed feedback from the market about how they are faring. Good decisions yield improved profits and improved stock prices, and vice versa.

Phase I of India's journey

When Indian socialism was being constructed, the government wanted to be in business. There is a fundamental contradiction between the decision processes that are required in business when compared with the rule of law.

The solution adopted was to sacrifice the rule of law. All across the Indian state, we got politicians and bureaucrats wielding arbitrary power. The construction of Indian socialism damaged India's institutional capital.

Phase II of India's journey

In recent years, the tide has turned decisively. The Constitution of India is asserting itself. We are building the rule of law, we are restoring the institutional capital. You can no longer fudge the process for allocation of spectrum or coal mines. The old clubby ways are being stripped away, all across government.

Some people continue to yearn for the bad old days when a bureaucrat wielded unchecked power, but those days are safely behind us. As an example, see: CAG asks why Air India sold five Boeing 777s at loss to Etihad in 2013 by Mihir Mishra in today's Economic Times.

This great push towards the rule of law has one important implication: the push for the rule of law makes it  harder for the government to do business.

In the olden days, a public sector company could exercise discretion, and participate in the world of business, because the rule of law in India was in tatters. Now that India is pushing back into rebuilding the rule of law, this makes life difficult for the parts of government that are engaged in commercial activities.

On an international scale, we generally see that in countries with strong rule of law, we don't see public sector companies. The intuition that has been offered, in the past, is that there is a deeper thing called `good institutions'; in countries with good institutions, we see the rule of law and we see the absence of public sector companies. Conversely, when there is low institutional quality, we see failures on the rule of law and we see the phenomenon of public sector companies.

The main argument of this article is that there is another causal connection in the picture. A country that sets out to have public sector companies will damage the rule of law, and a country that sets out to strengthen the rule of law will damage public sector companies. Perhaps countries with strong rule of law lack public sector companies as those rule of law strictures have interfered with their functioning.

Implications for public sector companies e.g. public sector banks

In the best of times, it is difficult for bureaucrats to be in business. All over the world, there is ample evidence that government ownership of business hampers productivity. Layered on top of this is this new twist. Earlier, a bank in India could exercise more arbitrary power in trading securities, giving loans, restructuring bad loans, etc. But once public sector banks come under the full strictures of the rule of law, this becomes harder. India's drive towards the rule of law is detrimental to the concept of a public sector company that is owned by the government but engages in commercial activities.

We repeatedly hear public sector bankers complain that it's impossible to do the business of banking when placed under the myriad accountability mechanisms of the government. Their solution is that the rule of law is optional, that banks should be exempted from these requirements even when banks are owned by the government. We suggest that the solution lies in government getting out of banking.

Where is the line drawn, where a public sector company is the State?

Article 12 of the Constitution says: In this part, unless the context otherwise requires, the State includes the Government and Parliament of India and the Government and the Legislature of each of
the States and all local or other authorities within the territory of India or under the control of the Government of India.

This is important because Part III (fundamental rights) can be claimed against the State, such as equal treatment, non-discrimination, etc.

Here the word `includes' implies that this is not an exhaustive definition. The courts have developed tests to determine what `other authorities' means. The key case is Ajay Hasia. These questions turn on the issues of control and financing: (a) the degree of government control over the administration of the authority, (b) the degree of funding/ grants made to the authority, (c) power to appoint/ remove officials, etc. Based on these criteria, various kinds of entities such as public sector companies, educational institutions that receive government money, etc., have been termed state.

When the government owns less than 50% of a commercial enterprise, that organisation is generally not classified as State. However, evidence of pervasive control in such cases may lead to a judicial
determination that the entity is "state" under Article 12. For statutory monopolies or organisations with pervasive State control, even going below 50% ownership does not elude classification as State. In the case of R.D.Shetty v. International Airport Authority of India the Supreme Court stated that an entity such as the International Airports Authority could not act arbitrarily, but was subject to constitutional requirements.

It stated that, ...power or discretion of the government in the matter of grant or largesse including award of jobs, contracts, quotas, licences etc. must be confined and structured by rational, relevant and non-discriminatory standard or norm.... It then went on to say that corporations established by statute, or incorporated under law (including any company under the Companies Act) are "state"
if they satisfy certain tests based on:

1. The source of share capital.
2. Extent of state control over the corporation, and whether it is deep and pervasive.
3. Whether the corporation has monopoly status.
4. Whether the functions of the corporation are of public importance and closely related to governmental functions; and
5. Whether, what belonged to a government department formerly was transferred to the corporation.

For a more detailed answer, see this report of the Law Commission (page 4, paras 2.3 to 2.6).

Three important issues arise related to the 1979 ruling of the Supreme Court:

1. A business entity making a commercial decision does not hand out contracts as a "grant or largesse", but as a competitive player in the market interested in purchasing goods or services that satisfy its own requirements. To constrain it by the rule of law is to fetter its commercial decision making process.
2. The transition of the Indian state is different from the transition of many western democracies such as the USA and UK. These democracies transitioned from laissez faire states to
   regulatory states. The Indian state on the other hand, is transitioning from a pervasive state to a regulatory state. Until not too long ago, the state ran hotels and manufactured bread. As such, most functions sought to be deregulated and/or performed by companies/ corporations are or were of public importance, and closely related to governmental functions.
3. In India, many government functions are being privatised or handed over to government companies. A good example is telecom. Telecommunication services were first transferred to public sector companies owned by the central government, and eventually privatised.

On a related note, GFR has a rule to prevent escaping from GFR through subsidiarisation: Once government provides majority funding to a body, it must accept GFR and CAG.

This results in a situation where though de jure transfers of control, ownership and management have taken place, for government owned/ controlled corporations, there is never a complete de facto escape from the constitutional constraints on the Indian state. Such entities are unable, from the point of inception to act purely on commercial motives. It is therefore questionable whether any government
strategy that aims at greater market discipline and efficiency in a sector can be successful through the route of establishing government owned/ managed entities. Alternatively, the precedent on what constitutes "state" needs to be reviewed. The judgements on what constitutes "state" were made in the era of a pervasive state. A regulatory state must be defined differently.