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Veritas-Indiabulls Fight: The Employee Welfare Trust


Veritas, the Canada based research company that dug out dangerous details about DLF and RCOM, has targeted IndiaBulls now, stating that Indiabulls has created structures to bilk institutional investors by profiting promoters instead.

I’ll write more about the case later (I haven’t even seen the full report yet). But the allegations have received counter allegations and then further counter allegations. One part regards the Employee Welfare Trust (EWT) of Indiabulls, which has received loans of more than Rs. 900 cr. at 12% p.a. to buy Indiabulls shares. These loans are repaid when employees exercise their options, at which point shares are sold in the market, and the purchase price (plus interest) is then recovered by EWT and paid back to Indiabulls.

Monga from Veritas noted, and correctly in my opinion, that this doesn’t make sense. The EWT has no other income other than dividends, and that pays them about 2-3% dividend yield. Assume the stock price remains where it is – then, the EWT is toast, because the only money it can earn is through dividends, which was Rs. 10 per share in 2011 and Rs. 13 per share in 2012, which is about 5-7% of the current share price.

If the share price goes up,then presumably employees will exercise the options and pay the interest costs, which is okay. But obviously the share price needs to go up by 12% per year for that to happen.

If the share price goes down, the EWT is in a hole because employees won’t exercise, and the interest gap simply can’t be filled. In effect the loan is a bet on the stock price going up, and in this case, it’s IndiaBulls presuming that will happen. Note that this is common practice, so it’s not just IndiaBulls that lends an "EWT" money to buy shares (I’ve noted something like this in Network 18 too). But it remains very shady in principle.

Secondly, Indiabulls added more than 100 cr. as interest income from the EWT into their financials. This is strange, because it’s not money they have got at all, it is money they are owed, and is contingent upon the stock price going up (as described above). Indiabulls states the money isn’t so much – their cost of funds is 9%, so they make only Rs. 18 cr. But I’m not sure that means much; if the company is issuing fresh shares (at market prices) to the EWT, there is no "cost of funds" – since the money they give as a loan comes right back as shareholder equity. Of course it could be that the EWT is buying shares from the market, which creates another issue – it amounts to a company buying its own shares and is just a bet on the stock price that can go sour (and doesn’t really meet the spirit of option compensation). If it’s the latter, the size of the EWT is much bigger than presumably required.

Third, the quantum of the loan is out of whack. The 900 cr. could buy, at the current price of Rs. 210, 4.5 cr. (45 million) shares. That is about 15% of their capital (of about 32 cr. shares).

Out of this, the total outstanding options in the three plans till 2011 (as per their 2011 report) are:

ESOP 1 2006: 847,946 at avg price of Rs. 64 per share.

ESOP 2 2006: 442,824 at Rs. 100.

ESOP 2008: 5,277,516 at Rs. 102.

Effectively, only 65 lakh (6.5 million) shares are outstanding in earlier plans. These plans are mostly "in the money" – i.e. the stock is trading at higher than the grant price, and for the earliest tranches granted at Rs. 95 per share or so, the interest cost can be recovered through dividends today (of Rs. 13 per share). But this is a tiny quantity -at the weighted average price of issue, these shares would have cost only Rs. 65 cr. or so to buy.

They have "allocated" another 3 cr. (30 million) shares in a 2010 plan in which NO shares have been granted to any employee as of March 2011. This was March 2011, when the stock price hovered between Rs. 150 and 200. Even at Rs. 200, the maximum loan needed to buy shares in the open market was 600 cr. So I’m not sure how this Rs. 900 cr. loan – 50% higher than required – was granted to the EWT.

The EWT structure is shady, in the sense that the loan given to it seems to be much higher than required, and it thus seems that the company might have used the trust to "prop up" the value of the shares. Now this is not uncommon in India – every company does it. (The only thing we can do to avoid this is to disallow ESOP trusts from buying shares directly from the market. They should only get fresh shares issues from the company at a certain price, and that also only on exercise.)

Also, there is little or no chance that the EWT can pay back Mr. Indiabulls if the stock price remains stagnant or go down. This means the loan given to the EWT can at best be considered "sub standard" and interest revenue only recognized in case of options that are "in the money" (the rest should not be considered as income at all). But further, they will have to recognize that the loan itself is "impaired" in some manner where options are out of the money. That will hurt both profitability and solvency ratios for IndiaBulls.

I must state that I’m disappointed by the lack of proper disclosure about the EWT’s holdings. It doesn’t seem to figure in the shareholding pattern (holders of more than 1% of capital, or in promoter holdings). Which means we don’t really know how much this EWT actually owns – what if, in reality, it owns nothing and the loan/interest are really funny money? If anything, Indiabulls needs to come clean with

a) How much money has the EWT been given, with tranches of loan amounts and interest actually received vs. booked.

b) How much has the EWT spent, per ESOP tranche, and how many shares it now owns.

c) How much has the EWT received on exercise of options, and how much principal has it paid back.

While IndiaBulls has a large press release talking about various allegations that Veritas has raised, the answers to the EWT piece are less than satisfactory. The share price has now fallen to less than Rs. 200 (from Rs. 270 before the Veritas report), and if their next annual report throws up more surprises, I wouldn’t be shocked if the share price falls much more.


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