* India took rare step of saving IL&FS as it feared contagion
* Nearly two-thirds of IL&FS debt was from public sector banks
* Gov't says it feared damage to economy and financial markets
* Gov't accuses IL&FS's previous board of mismanagement
* IL&FS collapse could have sparked debt market selloff-gov't
By Aditi Shah and Aditya Kalra
NEW DELHI, Oct 5 (Reuters) - The Indian government said it was forced to take control of ailing shadow banking firm Infrastructure Leasing & Financial Services (IL&FS) as it feared its collapse would cause "catastrophic" damage to the financial markets and the economy, a court filing shows.
In the largest intervention of its kind, India this week replaced the board at IL&FS, a construction and infrastructure firm that had defaulted on a series of repayments to creditors as it struggled under a debt pile of more than $12 billion.
The company's downfall has undermined confidence in India's shadow banking sector, triggered declines in the nation's stock and bond markets, and stoked fears of outflows from the mutual fund industry which has a large exposure to such financing companies.
In a 36-page petition filed by India's Corporate Affairs Ministry at the company law tribunal, the government does not pull its punches, referring to IL&FS as a "titanic ship" and accusing its board of mismanagement.
The petition, which sought permission for the board takeover and the right to replace executives and was approved by the tribunal, has not been made public, though some media outlets have quoted from parts of it in recent days. Reuters was able to review the entire petition.
Saving IL&FS was critical as nearly two-thirds of the firm's accumulated debt of 910 billion rupees ($12.36 billion) was from public sector banks. Moreover, IL&FS accounts for 16 percent of the total exposure of banks to India's non-banking financial companies (NBFCs), the government said in the petition.
"The future impact of more defaults in the group may be catastrophic for the (country's) financial stability," it said.
"Any impairment in its ability to finance and support the infrastructure projects would be quite damaging to the overall infrastructure sector, financial markets and the economy," the government added.
IL&FS, whose top shareholders are state-run Life Insurance Corporation, the State Bank of India, Japan's Orix Corp and the Abu Dhabi Investment Authority, is one of the largest of thousands of NBFCs which have mushroomed in India in recent years.
The NBFCs, that currently manage an aggregate loan book of nearly $300 billion, have played a key role in lending growth in India as the main banking sector struggled to tackle a bad-debt burden of $150 billion.
It is rare for the Indian government to take control of a private company. In 2009, it took over Satyam Computer Services following an accounting scandal at the firm.
But the rescue was critical for Prime Minister Narendra Modi who can ill afford a financial crisis months before he faces voters at the next election, due by May 2019. His administration is already facing public ire over high fuel prices, a falling rupee currency and farmer protests due to low crop prices.
In a "critical lapse", IL&FS' risk management committee, which was tasked to keep tabs on liquidity, credit and market risks, met just once between 2015 and 2018, the government said.
IL&FS' proposed restructuring plan, announced just days before the government take over, was a "sham" and a "disguised way" to further dupe the stakeholders and misguide the general public, the government said.
The board was "responsible for negligence, incompetencies and putting veil on the misleading intent by presenting rosy financial statements," the petition said.
The "unscrupulous" manner in which public money has been managed and is stuck in projects indicates that the management not only failed but was involved in "operation cover up" till the end and willfully created a financial mess, the government alleged.
IL&FS' former managing director and board member, Hari Sankaran, did not respond to a request for comment. Reuters could not immediately contact the other former board members of IL&FS, who have not commented publicly on the matter.
IL&FS has 348 entities and has over the years developed marquee road, township and water-treatment projects in India and abroad. The group's debt levels rose to more than $12 billion this year, from $6.6 billion in 2014.
The government said IL&FS was not making enough profits to take care of its interest expenses, leading to defaults and rating downgrades. The over exposure to loans had been without "prudent commercial practices", it said.
The government has ordered its Serious Fraud Investigation Office to probe the IL&FS matter, and the finance ministry on Sept. 30 drafted an internal note on possible ramifications of an IL&FS collapse.
The ministry warned that mutual funds had an exposure of 28 billion rupees ($381 million) to IL&FS bonds and were likely to face redemption pressure from their corporate clients following the IL&FS episode, according to the petition.
That, the government feared, could trigger an Indian debt market sell-off if mutual funds resorted to selling government securities because of an illiquid corporate debt market.
The collapse of IL&FS could have also sparked a liquidity crunch, hit market sentiment and impacted profitability at NBFCs, the government warned in its petition.
IL&FS' new board is exploring all possible options to revive the company and does not underestimate the size of the challenge, its new non-executive Chairman Uday Kotak said on Thursday.
India on Friday asked the tribunal to allow the new board to act fearlessly and independently as it looks to revive the firm, government lawyer Sanjay Shorey told Reuters. (Additional reporting by Promit Mukherjee Editing by Martin Howell & Simon Cameron-Moore)