PSEs' Insolvency Shield Debate Puts Creditors in Jeopardy

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AuthorIshaan Verma|Published at:
PSEs' Insolvency Shield Debate Puts Creditors in Jeopardy
Overview

Public Sector Enterprises (PSEs) are seeking to avoid insolvency by claiming 'sovereign character,' sparking a legal debate. This issue is compounded by widespread financial weakness in PSEs, as reported by the 16th Finance Commission. The situation leaves contractors, vendors, and lenders facing significant uncertainty and financial risk.

The 'Sovereign Shield' Debate

Insolvency proceedings against Cauvery Neeravari Nigam Limited (CNNL), even though currently paused, have revived important discussions about the financial health and legal status of Public Sector Enterprises (PSEs) under India's Insolvency and Bankruptcy Code (IBC). This legal action raises key questions about whether state-owned companies can use their 'sovereign character' to avoid legal duties, which could put the financial interests of their creditors and stakeholders at risk.

The Legal Impasse

Public sector firms have repeatedly tried to protect themselves from the IBC by claiming they perform 'sovereign functions.' This argument received significant attention when the Supreme Court noted that an organization like the National Highways Authority of India (NHAI), acting as an extension of the government, might not be subject to insolvency proceedings or liquidation. The reasoning was that the IBC is for resolving issues, not just recovering debt, and that non-payment related to essential public services should not lead to insolvency. However, the IBC itself does not distinguish between private and government companies when admitting cases. It also doesn't give tribunals broad powers to exempt companies based on ownership or their function. This legal uncertainty creates a risky situation for anyone dealing with or lending to PSEs.

Widespread Financial Weakness in Public Sector Firms

The 16th Finance Commission's report for 2026-31 reveals a grim outlook for PSE financial health. Roughly half of state public sector enterprises (SPSEs)—around 541 out of 1,107—are losing money or making no profit, and many are not operating at all. In the 2022-23 financial year, total losses for SPSEs reached ₹1.14 lakh crore. Central Public Sector Enterprises (CPSEs) alone reported annual losses of ₹51,419 crore. The electricity distribution sector is particularly burdened, with ₹7.08 lakh crore in outstanding debt as of 2023-24. The report suggests that companies consistently losing money might need to close or be privatized, and using the IBC to wind down loss-making or inactive entities is a practical option.

Infrastructure Debt and Funding Challenges

As PSEs struggle with widespread problems, the broader infrastructure sector has found different ways to get funding since the 'House of Debt' period. Investment has moved towards options like Infrastructure Investment Trusts (InvITs), which now manage about ₹6.28 lakh crore in assets as of fiscal year 2025. Despite this, problems remain. Infrastructure debt funds have not been widely used, suggesting funding shortages and possible struggles to pay off debt for some companies. Firms like Supreme Infrastructure India Ltd. show clear financial stress, with high debt relative to equity and pledged promoter shares, highlighting the sector's risks. While the government's large spending on infrastructure helps, it doesn't fix the deep financial weaknesses within state-owned companies.

Why Creditors Are at Risk

The way PSEs use 'sovereign character' to avoid IBC duties reveals a deep conflict between business sense and public service goals. This tactic risks getting caught in lengthy legal battles, leaving creditors like banks, vendors, and contractors facing long periods of uncertainty and possible losses. The huge losses reported by PSEs, as shown by the 16th Finance Commission, along with large debts in sectors like electricity distribution, point to a widespread problem that can't be solved with simple legal arguments. Earlier attempts to fix troubled companies, like the Board for Industrial and Financial Reconstruction (BIFR), were largely unsuccessful, making the IBC's goal of faster resolutions important but difficult to achieve. The Supreme Court has indicated that overturning sovereign immunity requires very clear intent, setting a high standard. This implies that business dealings might be outside its protection. However, exactly where this line is drawn is still debated and leads to more lawsuits and delays. The Supreme Court has also stated that while creditors' committees have the main say in business decisions, courts can still review these decisions if they are illegal or outside their authority.

Moving Forward

Clear rules are needed for applying the IBC to PSEs. The current legal uncertainty over 'sovereign functions' requires a careful approach that supports the IBC's goal of timely resolutions while recognizing the special public service roles of some state-owned firms. Policymakers must decide whether to demand better financial discipline and contract adherence from PSEs, or to pursue options like privatization or managed closure, as recommended by the 16th Finance Commission. If this issue isn't resolved, it could lead to ongoing financial burdens for the government and erode trust among private companies essential for public infrastructure and services.

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