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Financial Institutions and Markets The ITC Classic Story

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. Answer: ITCs Classic was a non-banking finance company engaged in hire purchase and leasing operations. It also undertook investment operations, capital market operations and merchant banking. The company did very well in the initial years and developed a strong network to mobilize retail deposits. But, due to various internal issues at ITC, crashing of stock market, Classics negative cash flows, its huge asset liability mismatch and huge losses at Classic let to its downfall. Following are in detail the reasons for Classics failure:

In the year 1996, many of the Board Executives were jailed on charges of FERA and excise violations. The scandals in ITC had a major impact on Classic as deposit holders wanted to withdraw their funds and there was no fund flow into Classic. 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.' 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. In 1995-96 stock market downturn took a toll on its performance. 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. This was due Classics 25% investment in the stock market. Classic 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
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quick' by stock market deals, besides to spread the risk associated with asset financing. A majority of Classic's problems stemmed from the structural anomalies like cross holdings in other group companies. There were certain financial services companies in which it was not needed that Classic should hold any equity. Some of its investments in group companies like Greenline 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. Classic's real estate forays did not prove to be beneficial for the company. Analysts remarked 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. 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.

I agree that Classics demise was largely due to ITCs poor handling. There are various instances which suggest that it was a lag on part of ITC to handle Classic which are as follows:

The scandals in ITC had a massive damaging effect on Classic as it was inundated with desperate fixed deposit holders wanting to withdraw their funds. 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. The parent company i.e ITC should have ensured that the 25% is invested in the right proportion. Classic emerged as a full-scale financial services company in early 1990s, no efforts were made to mature it from its original status as an asset financing subsidiary. 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. 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. The reports from the consultants should have been reviewed by ITC.
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The consultants recommended various measures like Classic should reduce its investment banking exposure, concentrate more on asset financing and re-enter niche segments like automobile finance. But none of the recommendations were considered by ITC or by Classic. ITCs poor handling can be judged from the fact that 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." Last but not the least ITC also ignored the credit rating by Credit Rating Information Serviced Ltd. (CRISIL) who 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.

ITC did infuse money- Rs 75 crore credit line to maintain cash flow, Rs. 60 crore in Classic during the 1995-96 stock market downturn and bought back Rs. 69 crore worth of shares, but these were all monetary transactions. What Classic needed was a right path, right direction and focus on its crucial problems and a way out of them. 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? Answer: During the year 1996, the scandals in ITC has a massive damaging effect on Classic, which along with Classics negative cash flows, its huge asset liability mismatch and the slow process of divestment of stakes held by Classic lead to ITC think that it would be better off without Classic. ITCs decision to hunt for a buyer was justified as its brand image was at stake and ITC Classic finance was facing a crisis of trust from its stakeholders. The financial industries runs on trust, trust that the money will be safe with the company will earn revenue. In these circumstances, search for the suitors and not closing down the company was a better option, as it would ensure the ITC brands remain intact and investors and depositors of the companys are taken care of. The merger was more of Classic agreeing to all terms and conditions of ICICI and ICICI was at an advantage in the merger. Following are the reasons behind ICICI agreeing to merge with the loss-making Classic:

The deal was struck with ICICI at a swap ratio of 1 ICICI share for 15 shares of Classic. It was a Risk-free takeover. The merger was a step for ICICI to achieve its goal to move towards universal banking with a spectrum of financial solutions. Thus it capitalized the opportunity to move closer to the goal.
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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. ICICI had maintained right from the beginning that they would consider the deal as long as it did not involve any cash outgo. 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 was not a true win-win situation for Classic and ICICI, as ICICI was a clear winner in the proposition. Along with the reasons mentioned above following were the advantages for ICICI:

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. The retail network of Classic helped ICICI save two to three years. The MD of ICICI suggested that on an average the estimate of opening 15-20 branches to reach a million people at the retail level is at least 2-3 years and Classics retail network was 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. Classic offered high interest rates and ICICI was forced to give this promised interest while the going rates were much lower. However, ICICI tried to average out the interest outgo by asking the depositor coming in for renewals to switch over to ICICI books thus increasing its customer base.

The advantages that Classic got with this merger were:

ITC Classic Finance would get an opportunity to grow under a different brand and image. It would also have a chance to succeed as its current image had taken a beating and there was a clear erosion of trust among the customers. Even though 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.

But as compared to the advantages following are the disadvantages that Classic had to face because of the merger and which suggest that it was not a win for Classic:

ICICI accepted to absorb the Classic personnel as per its requirements and the rest had to be redeployed by the ITC group. This situation must have created a feeling of resentment among the employees. Classic offered high interest rates and ICICI was forced to give this promised interest while the going rates were much lower. However, ICICI tried to average out the interest outgo by asking the depositor coming in for renewals to switch over to ICICI books thus increasing its customer base. This was easy to do as the depositors got the security of an AAA-rated institution, thus leading to Classic loosing its customer base. ICICI used Classic's retail network comprising eight offices, 26 outlets, 700 brokers and a depositor-base of 7 lakh investors to strengthen its hold for its Credit- a consumer finance subsidiary. Since ICICI had maintained right from the beginning that they would consider the deal as long as it did not involve any cash outgo, so ITC assumed the liabilities and obligations in relation to all guarantees and indemnities issued by Classic.

3. 'Classic should have stuck to its leasing and asset financing business rather than entering secondary market operations.' Critically comment on the above statement. Answer: Classic did very well in the initial years and developed a strong network to mobilize retail deposits. It was predominantly engaged in hire purchase and leasing operations. Its fund-based activities such as corporate leasing, bill discounting and equities trading also grew substantially over the years. 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. Classic entered the secondary market operations to get rich quickly by stock market deals, thus eventually shifting its focus from its primary business. It is said that only 55% of Classics business was in hire purchase and leasing, while the rest was in stock market operations. If Classic
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would have concentrated on its primary operations it would have done fairly well as it had a strong retail network and a large customer base. Since ITC was facing large-scale investigations against ITC top brass in connection with various issues of unethical practices, on charges of FERA and excise violations, it decided to merge Classic with some other financial institution due to Classic's negative cash flows, its huge asset liability mismatch and the slow process of divestment of stakes held by Classic. This lead to the merger of ICICI and Classic. With the merger, Classic expected that its share prices will rise, it will get an increased customer base and it hoped for a better future with ICICI, but nothing of that sort happened. Some highlights of the merger are as follows:

ICICI accepted to absorb the Classic personnel as per its requirements and the rest had to be redeployed by the ITC group. This tarnished Classics image in the market. Classic offered high interest rates and ICICI was forced to give this promised interest while the going rates were much lower. However, ICICI tried to average out the interest outgo by asking the depositor coming in for renewals to switch over to ICICI books thus increasing its customer base. This was easy to do as the depositors got the security of an AAA-rated institution, thus leading to Classic loosing its customer base at the same time creating an impression that Classic could not keep up with its promises to its customers. ICICI used Classic's retail network comprising eight offices, 26 outlets, 700 brokers and a depositor-base of 7 lakh investors to strengthen its hold for its Credit- a consumer finance subsidiary. Classic could have used this base to strengthen its operations in its primary business of leasing and asset financing business. Since ICICI had maintained right from the beginning that they would consider the deal as long as it did not involve any cash outgo, so ITC assumed the liabilities and obligations in relation to all guarantees and indemnities issued by Classic. ITC infused funds in Classic at regular intervals- the funds should have been utilised by Classic wisely to stabilize its primary operations. There was a fall in profits of Classic as it had to cope up with Rs 800 crore excise duty claims.

The consequences of merger were more in favour of ICICI and Classic did not receive anything much, rather if it would have focussed on its primary business of hire purchase and leasing and not made a tactical error to shift its focus to secondary market operations to get rich quickly would have been better for Classic. Classic should have tried to cope up with its own liabilities and problems and tried to emerge as a winner, this would have lead to an increase of faith of its customers, potential investors and foreign partners and eventually leading to better business and increase in profits.