ITC Classic Story

"ITC is ready to hawk ITC Classic to anyone, for even a rupee."

- An ITC Classic manager in 1997.

"There is no value in ITC Classic. I wonder how ICICI will benefit from the merger!"
- A stockbroker in 1997.

Troubled Times
In late 1996, almost half of the executives on board of the tobacco to hotels major

ITC Ltd. were in jail on charges of FERA and excise violations. It was at this point

that the downfall of ITC Classic Finance (Classic), ITC's flagship financial services

49% subsidiary, began.

The scandals in ITC had a massive damaging effect on the ITC brand and corporate

image. The impact got reflected on Classic too and it was inundated with desperate

fixed deposit holders wanting to withdraw their funds. Funds worth over Rs 50 crore

were withdrawn within a few days after the crisis broke out. The continuing

uncertainty on fund flows into the company and the eroded value of its portfolios

began scaring off potential investors and foreign partners as well. International

Finance Corporation (IFC), which was to provide a credit of $ 45 million to Classic,

also held back the offer till 'things cleared up.'

Analysts were quick to raise fingers at Classic's negative cash flows, its huge asset

liability mismatch and the slow process of divestment of stakes held by Classic in the

ITC group companies. Like the proverbial 'final nail in the coffin,' Classic declared a

Rs 285 crore loss in June 1997, which almost wiped out its entire net worth.

Meanwhile, troubles mounted as redemptions kept increasing - from Rs 750 crore in

mid 1996, deposits came down to Rs 550 crore in May 1997. From a peak level of

one million depositors, Classic was left with just six lakh. ITC gave Classic a Rs 75

crore credit line to maintain cash flow to meet the redemption pressure. There were

even reports that Classic had to take inter-corporate deposits 1 to fund the outflow.

The sustained downturn in the capital markets during 1995-96 added to the

company's woes and soon, key personnel began leaving the company. Already neck-
deep in legal troubles, ITC realized that it would be better off without Classic to add

to its problems. ITC then initiated discussions with Daiwa Securities of Japan and a

few Korean, British and American investment banks for a possible tie-up. A Business

Today report2 claimed that ITC was desperate not to let Classic go for liquidation, as

that would have reflected badly on its brand power. ITC announced that it was even

willing to infuse more funds to keep Classic afloat.

Both GE Capital and the Hinduja Group evinced interest in Classic. Since they laid

down very stiff terms for the buy-out and valued Classic much below ITC's

expectations, talks did not proceed further. Nothing seemed to be working out in

favor of Classic as there were no takers for a company with non-performing assets of

over Rs 350 crore and an investment portfolio that was by any standards an

extremely poorly executed one. At this juncture, ICICI Ltd. stepped in as the 'knight

in the shining armor' to rescue Classic, taking the corporate world and the media by

surprise. All those involved in the issue kept asking themselves - What did ICICI see

in Classic that so many other companies could not?

Classic: The ITC Fostered Baby

Named after ITC's premium cigarette brand 'Classic,' Classic was incorporated in

1986. Classic was a non-banking finance company (NBFC) predominantly engaged in

hire purchase and leasing operations. Besides, the company undertook investment

operations on a substantial scale. The company did very well in the initial years and

developed a strong network to mobilize retail deposits. Its fund-based activities such

as corporate leasing, bill discounting and equities trading also grew substantially

over the years. At a compounded annual growth rate of 78% during 1991-96,

Classic's annual turnover increased from Rs 17.3 crore to over Rs 310 crore and net

profits from Rs 2.3 crore to Rs 31 crore in the same period. By June 1996, the

company had a deposit portfolio of Rs 800 crore consisting mainly of retail deposits.

The capital market boom of the early 1990s was responsible to a large extent for

Classic's impressive financials. Around 50% of Classic's assets had to be kept in

financing and a further 25% was to be held in liquid funds or cash to handle cash

outflows. However, Classic was free to invest the remaining 25% as it deemed fit -
which happened to be in the 'boom stocks.' When the markets crashed in 1992,

Classic had to face heavy losses.

Like most other finance companies, Classic too saw the 1995-96 stock market

downturn taking a toll on its performance. A sharp increase in cost of funds, weak

capital market conditions and the general liquidity crunch marked the beginning of

the company's poor financials. Almost all the 145 scrips in the stock-in-trade list in

the company's balance sheet had lost nearly half their value during 1995-96. While

Classic's quoted investments stood at Rs 231.06 crore as on March 31, 1996, the

market value as on that day was just Rs 57.40 core. In 1996, ITC had to infuse Rs

60 crore in Classic by buying up group company shares held by it.

Soon after this, troubles began at ITC's headquarters with the Enforcement

Directorate (ED) initiating large-scale investigations against ITC top brass in

connection with various issues of unethical practices. Almost half of the ITC board

was arrested and the intensive negative media coverage significantly harmed the ITC

brand equity. Amidst all this, it seemed as if ITC had given up all hopes of ever being

able to find a suitable partner for Classic.

The Classic Post-Mortem

Many management consultants remarked that though Classic emerged as a full-scale

financial services company in early 1990s, it never matured from its original status

as an asset financing subsidiary. A majority of Classic's problems stemmed from the

structural anomalies like cross holdings in other group companies. Although

consultants McKinsey & Co and Arthur Andersen (who had been mandated to go into

the details of restructuring Classic in the mid 1990s), had emphasized the need for

untangling Classic from the corporate maze of cross holdings in the group

companies, no action was taken to do so. A Classic source3 remarked, "McKinsey

could not even figure out why some of the financial services companies existed and

why Classic should hold equity in such companies." McKinsey wanted to form Classic

into a single financial services company by merging various group companies

involved in financial services such as Classic Infrastructure Development Ltd.,

International Travel House Summit, Sage, Pinnacle, ITC Agrotech Finance and a host

of other small companies. McKinsey further recommended that Classic should reduce
its investment banking exposure, concentrate more on asset financing and re-enter

niche segments like automobile finance.

The Arthur Andersen study talked about the need for a leaner organization with

strong management. The consultants identified a complete lack of focus as the most

crucial problem faced by Classic. However, ITC sources brushed aside the

recommendations stating that, "Reorganizing the business is very much on our

agenda but our immediate concern is to keep the company liquid."

After the Rs 285 crore loss was recorded, Classic sold its heavily eroded investments

in Morgan Stanley and Jaiprakash Industries, which helped in covering the losses to

a certain extent. However, its portfolio still comprised shares that had seen heavy

erosion in their values. Classic had to hold large amounts of shares of other ITC

group companies like ITC Bhadrachalam and International Travel House, whose

share prices had also taken a beating. The company could not even sell these shares

because of their low prices. Though ITC bought back Rs 69 crore worth of

Bhadrachalam shares, financial analysts remained skeptical of Classic's portfolio.

Some of its investments in group companies like Green line Construction, Minota

Aquatech and ITC Agrotech Finance etc. were illiquid for all practical purposes and

only artificially inflated the company's net worth and the asset values.

The Classic Post-Mortem Contd...

Classic also had a huge asset-liability mismatch. Its asset-financing portfolio was

functioning fine till September 1995, when due to a liquidity crunch it had to miss on

installment repayments. Eventually, the volume of overdue payments reached as

high as Rs 300 crore. A Classic executive said, "Most of our assets are wholesale in

nature while our liabilities are retail. When the market got gripped by a panic, all

wanted their funds, but we cannot make our assets liquid at such short notice."

In 1995, Classic had entered into a lease and buy-back deal of used electricity

meters with the Rajasthan State Electricity Board (RSEB). Later, RSEB defaulted on

lease rentals worth Rs 40 crore, forcing Classic to make provisions to repossess the

meters and settle the losses. Classic's real estate forays also did not prove to be
beneficial for the company. Analysts also remarked that the fact that over the years,

Classic had become increasingly dependent on public deposits. Public deposits,

deemed to be a rather volatile source of fund, had to be resorted to by Classic

mainly due to the reluctance of banks to fund NBFC operations during that period.

This later resulted in the heavy redemption rush putting a strain on the company's

cash reserves.

The credit rating agency, Credit Rating Information Serviced Ltd. (CRISIL)

downgraded Classic's rating for its fixed deposit scheme and non-convertible

debentures from AA to A+ and from FAA+ to FAA-, respectively in June 1996 and

further to A- and FA, respectively in December 1996. An internal CRISIL note

revealed some other important issues that had led to Classic's demise. The note

stated: "Although the company's asset portfolio remained fairly well-diversified in

terms of the client base/industry spread, the high growth rate, and the inherent risk

in corporate plant and machinery financing had an adverse impact on the company's

asset quality, resulting in difficulty in timely recovery of dues from a number of

clients." The note further criticized Classic's exposure to the corporate asset

financing business in general, and to the machinery segment in particular, which was

inherently deemed to be risky.

Classic was also reported to have made a tactical error by shifting its focus from its
primary business of hire purchase and leasing to secondary market operations. The
company was blamed to have entered the latter arena to 'get rich quick' by stock
market deals, besides to spread the risk associated with asset financing. In 1995-96,
a former Classic director said, "Only about 55% of Classic's business was in hire
purchase and leasing, while the rest was in stock market operations."

The Merger
ITC soon realized that only one of the country's three mega-financial institutions -
Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India
(IFCI), or ICICI would be in a position to absorb Classic's losses and bad loans. ITC
approached IDBI and ICICI and held extensive discussions with both the FIs.
Eventually, a deal was struck with ICICI at a swap ratio of 1 ICICI share for 15
shares of Classic4.

In January 1998, shareholders of Classic approved the company's amalgamation with

ICICI with 99.93% of the votes in favor of the resolution. Justifying the merger from
ICICI's perspective, Kamath said, "Our goal is to move towards universal banking
with a spectrum of financial solutions. Any opportunity to move closer to the goal will
be capitalized." However, a section of ICICI shareholders, holding shares of both
ICICI and ITC Classic, opposed the merger resolution claiming that the merger ratio
was unfair and was 'leaked' to the market. They said that the price dropped and
adjusted to the merger ratio much before the announcement of the ratio by the
company. They also alleged that if the market price of the share was one of the
considerations, then the fall in the price of the share just before the merger was a
clear indication that the swap ratio was already in the market before the
announcement. Voices were also raised against ICICI's decision to retain only those
Classic employees whom it found capable after internal evaluations. However, since
the dissenting shareholders were in minority, the resolution was successfully tabled.

ITC and its affiliate companies subscribed to a preferential share issue of Rs 350

crore of ICICI as part of the merger proposal. The preferential share capital carried a

nominal interest of Re 1 for every Rs 1 crore of share capital issued for a period of

20 years. The infusion of funds in ICICI by ITC was to take care of any future

liabilities arising out of the merger. One-fourth of Classic's asset base of Rs 1,000

crore accounted for investments in subsidiaries that operated in the stockbroking and

mutual funds business. As ICICI was not interested in them, ITC provided Rs 272

crore to repay secured creditors, and to make up for the losses due to the decline in

the investments made by these subsidiaries

It was decided to prepay Classic's creditors to reduce its interest burden. ITC also
assumed the liabilities and obligations in relation to all guarantees and indemnities
issued by Classic. ICICI accepted to absorb the Classic personnel as per its
requirements and the rest were redeployed by the ITC group.

The Merger Post-Mortem

Media reports claimed that pressure from FIs coupled with desperation drove ITC to

hand Classic on a platter to ICICI. K.V. Kamat, managing director, ICICI had

maintained right from the beginning that he would consider the deal as long as it did

not involve any cash outgo. The issues of ITC bringing in substantial funds, providing

cushion against bad debts and loans and accepting an 'unfair' swap ratio kept

surfacing in the media. The only silver lining for the unhappy Classic shareholders'

seemed to be the fact that they could hope for a better future with ICICI.
 Table I

Gainers and Losers

 ICICI  Classic  Investors

Selling off
Risk-free
a business Acquiring, for
takeover of
it was not every 15
a retail
keen on, shares in a
network
which sick
The since ITC
enabled company, 1
Upsides would pay
BAT to ICICI share
Rs 622
enter whose value
crore for
financial was bound to
ITC Classic's
services rise.
NPA.
on its own.

A fall in

profits in
ITC Classic's An ICICI
1997-98,
NPAs might share would
since it
be larger have to rise
would also
The than by 400% if
have to
Downside projected, the pre-
cope with
s and its merger ITC
the Rs 800
depositors Classic share
crore
might cash price was to
excise
out. be realized.
duty

claims.

Source: Business Today, December 22, 1997.

As far as ICICI was concerned, it seemed to be a clear 'win' proposition. The biggest

benefit for ICICI was Classic's retail network comprising eight offices, 26 outlets, 700

brokers and a depositor-base of 7 lakh investors. ICICI planned to use this to

strengthen the operations of ICICI Credit (I-Credit), a consumer finance subsidiary

that ICICI had floated in April 1997. Kamath said, "The retail network will help us

save two to three years. Our estimate of opening 15-20 branches to reach a million

people at the retail level required at least 2-3 years. This offer came our way, which

had the retail network already in place." An additional benefit for ICICI was in the

form of the Rs 110 crore tax-break because of Classic's losses and the provisions for

bad loans. This was something ICICI badly needed since its net profits of Rs 572

crore during the first half of 1997-98 had increased by 71.77% per cent.

While ICICI was happy over getting a large deposit base of about seven lakh, it

seemed to have ignored the fact that the base was built on high interest rates

offered by Classic - about 16%. ICICI was forced to give this promised interest while

the going rates were much lower. Also, deposits aggregating Rs 550 crore were to

mature by 1999, threatening to be a cash outflow burden on ICICI. However, ICICI

tried to average out the interest outgo by asking the depositor coming in for

renewals to switch over to ICICI books.

This was easy to do as the depositors got the security of an AAA-rated institution.

ICICI soon began the 'clean-up operation' of Classic's balance sheet by substituting

high-interest liabilities. As 75% of Classic's clients were ICICI clients as well, ICICI

was confident of recovering 8-16% of the outstanding amounts from various parties.

ICICI sources claimed that the Classic merger would not affect the dividend or the

non-performing assets of ICICI. This was supported by his justification that Classic

was a company with an asset base of just Rs 1000 crore, while ICICI's asset base

was as large as Rs 41,000 crore.

Questions for Discussion

1. Analyze the reasons behind Classic's failure. Do you agree that the company's

demise was largely due to ITC's poor handling of the company? Support your answer

with reasons.

2. Explain the reasons behind ICICI agreeing to merge with the loss-making Classic.

Was the merger truly a win-win situation for both the parties involved?

3. 'Classic should have stuck to its leasing and asset financing business rather than

entering secondary market operations.' Critically comment on the above statement.