Chapter E5
Rule 5 - Employ the Blitz
If you ever went to military school, you would find that they teach a lot of history. It’s clear that in the main, they take lessons from one war and hope to teach you how to fight the next. The practical reality though is that no two wars can ever be alike. It’s not just that the field and conditions of battle change: it’s also that technology moves forward and a great many lessons of the past become obsolete. Nations that are able to adapt their war games to these changes in technology find themselves making great gains when new battles begin. This is the main reason Germany gave its enemies such a drubbing in the opening chapters of the Second World War. Central to this drubbing was a new tactic they called the Blitzkrieg.
Let us recall that the First World War had been reduced quickly to a bloody battle of attrition. The invention of the machine gun gave a huge advantage to the defending side in every battle. Very quickly, any attempt at aggression ground down to a halt under a hail of bullets. Both sides dug themselves into trenches on either side of the battle lines. Anyone showing their head over the trench stopped a bullet. Soldiers were compelled to remain hidden while lobbing cannon shells into the trenches of their enemies. Both sides tried to break the stalemate but suffered horrific casualties. In the end, it was not success in battle that won the day: it was economics. The cost of battle bankrupted Germany faster than the allies, forcing them to sue for peace.
This war convinced war theorists that the state of the art in technology was such that no one could win a modern war. For the next thirty years, every nation focused on building mounds, trenches and machine gun pill boxes along their national frontiers, believing that any subsequent war would suffer the same fate. But the cheese had moved already. Two developments in the First World War pointed to the shape of the future. First, England invented the battle tank. Technology at the time was too rudimentary for tanks to truly shine in the war. With the benefit of hindsight, we can see that bigger better faster machine with heavier amour would run over fixed machine gun posts in no time at all. Then there were the fast-evolving flying machines. Combat aircraft in the first world were truly just kites with a gun attached. Can you imagine flying slowly in a contraption built of wooden spars and covered with leather or cloth as your enemies shoot at you? You have to be mad to think this makes any sense at all. But pilots did it and most died within weeks, if not days, of joining battle. Airplane technology leapt forward in the thirty years between the wars. By the time the Second World War came around, the game had changed. Germany’s contribution to war theory was to invent a tactic that combined fast moving ground amour supported by air power to create an irresistible force capable of overwhelming all opposition.
At the commencement of the Second World War, the German army know the allies were in a numerical majority. But then, the allies were also stretched along a long battle line. The Germans attacked with pin point focus, pulverizing one small strip of the battle line with aerial attacks, followed by an artillery barrage. Once the defense in this small area had been weakened, they then launched a massed infantry attack backed up by armor. In hours, they generally broke through and outflanked allied armies. Central to this blitzkrieg – lightening war – was its narrow focus.
Litigation in India today throws up substantially the same challenges that conventional wars did in the mid-twentieth century. In the main, court actions tend to be fought slowly along defined battle lines, with fixed positions and little attempt to find narrow focus. They become battles of attritions, sapping the strength of both sides, swallowing resources till one or the other party can’t see the economic justification and sues for peace, or just gives up. For sure, this is one way to fight a legal war. Sometimes, there is no other choice but to grind away at an insoluble problem. But if you think there is a way to fight a more decisive fast concluding war, you are going to have the find the tactics to make it happen.
There are two elements to this. First, you need to recognize that the tools you use to win your wars have changed. Laws change as do the players in the Justice Machine. Parliament makes new laws and new Tribunals and Regulators take over old roles that were done by other courts. They have powers and limitations different from those they replaced. These tools can be used in ways that their predecessors could not. To win a legal war, you have to constantly be aware of the true power, and limitation, of these new tools and fight your war accordingly.
The second main element to litigation tactics is the idea of focus. It’s a legal blitzkrieg, hard hitting fast action which overwhelms the enemy. Intelligently applied, the absolute strength of your enemy becomes irrelevant. If you throw enough resources with pin point accuracy at a few carefully selected targets, you will overwhelm your enemy. He will break, and you would have won.
Let us see how this operates in practice.
The Shrimrig case
Shrimrig Industries was the smallest of three major players in the chemical industry at the dawn of the 21st century. Desai, its principal promoter, was generally seen to be a dynamic industry spokesman. He was one of many who found inspiration in the BJP’s ‘India Shining’ campaign of 2004. Even though the feel-good sloganeering didn’t win the elections, Indian entrepreneurs continued to feel good about the economy. Desai developed a business plan to rapidly expand his manufacturing facilities. To fund his ambitions, he engaged with a number of private equity firms.
Soon enough, a consortium of two major private equity funds – HSP and PDP – together bought approximately 40% of Shrimrig’s paid up equity at a hefty premium. Naturally, they extracted a large bouquet of minority protection rights too. Shrimrig rolled out its expansion plans ahead of schedule and generated impressive returns very quickly. In two years, Shrimrig was ready for further expansion. Desai told the Board of Directors as much.
The problem was it was too much money. Shrimrig could not generate this kind of cash and the Funds didn’t want to put in more money. Everyone agreed they should make an IPO. In the ordinary course, you would have expected the two Funds to sell their shares at that point. They didn’t. They saw a rosy future and decided to hold on to about 12% of shares each. Because this was now a listed company, their minority protection disappeared but they retained their right to have a director each on the Board.
This time around, Shrimrig was slow to roll out its new expansion plans. Desai had a readymade story to explain the delay. It all started to fall apart when Desai suddenly told the Board that he had decided to buy a small company called WLP for Rs. 100 crores. Why didn’t he take Board approval? Desai told another story. Before the Funds bought equity, Desai had already taken Board approval to make acquisitions up to Rs. 300 crores. He had the resolution to back it up.
None of this made any sense. Who and what was WPL? The Funds did their homework. It turned out WPL was a Shrimrig Vendor. It had no business except the orders Shrimrig placed on it. Still, Desai had accepted a valuation based on discounted cash flows. How can you buy a company based on its expected cash flow when you are the only one providing the cash flow? This was the most blatant type of siphoning of funds. They confronted Desai and Desai backed down.
The scene was now set for distrust and acrimony between the shareholders. The Funds wanted to have a close look at the affairs of the Company. Desai could not refuse them. They did their diligence and found that Desai had raised Rs. 200 crores of debt even while the company maintained free reserves of 300 crores in an unknown cooperative bank in southern Maharashtra. The Company paid 17% interest to borrow 200 Crores and earned 9 % interest on 300 Crores. It cost the company 17 crores annually to pursue this strategy. Was there a method to this madness?
In the coming months, it got worse. At the next Board meeting, Desai asked the Board to approve an investment of some Rs. 300 crores in a new but related area of business. Directors were asked to approve the investment immediately. The Funds couldn’t understand the business case. As things stood, China had excess capacity in that area. India had little demand for that product. Shrimrig could not sell overseas because China would price it out. Why was Desai in such a tearing hurry? Desai would not back down. It turned ugly. In the end, the majority overruled the two Fund directors and the investment was approved. At the same time, the Company also approved payment of dividend.
A month later, Desai circulated the Quarterly Results of the Company. These revealed that over a three-day period, the Company had recently invested some Rs. 230 crores on the new project. How was it possible to spend that kind of money in three days? Desai was unfazed. These were advances against capex. How blatant can it get? If this was not syphoning of funds, what was?
Two months further down the road, it all came crashing down. Newspapers reported that Shrimrig had failed to pay dividend within the time stipulated by law. What was the problem, the Funds asked? Desai said the lenders had prevented the Company from paying out dividend. Lenders wanted the quarterly installments of loan repayments had been remitted first. Was the Company in default to its lenders? Was the Company in trouble? If it was, then Directors were in deeper trouble because they carried liability for this default, lender or no lender. The poop had hit the fan.
The Funds went into a huddle. Desai refused all information now. He would not allow inspection of Company records either. As a minority shareholder, outvoted in the Boardroom, the Funds saw no way forward but litigation.
Private equity investors generally make very poor litigants. A Fund’s job is to invest at promising targets at a price, grow the business and get out for a profit. Investors don’t put money into a Fund and expect it to blow up the money in litigation. That apart, if you don’t like the way the promoter manages a company, what are your options? You can either manage it yourself, or you can shut up. Do you want to take over management with your combined 24% shareholding? Are you part of the solution, or just the abusive rabble rousers in the stands?
Poor litigant or not, the facts had to be faced. The rate at which Desai was siphoning money out of the company, it would go belly up in months. Was their investment worthless already? The Funds had to stop Desai, or write off their investment. They needed to chuck Desai out of the company, and then either find a third-party buyer or abandon the investment to its fate.
This brought them to the heart of the problem. They were investors only to make money. They could not sustain an expensive lingering litigation. They had a bigger problem: what could they do that would not also drive down company valuation? A public circus about Desai’s shenanigans over the last year would only generate a scandal and erode shareholders value.
The Funds created the frame of a legal case telling a simple story. Desai had one too many skeletons in his cupboard. He had siphoned Rs. 230 Crores in three days. He wanted to buy his own single-customer vendor for Rs. 100 Crores. He was unable to pay his loan installments, leave alone dividends. He had stripped Shrimrig of all the money it had collected at the IPO. He would not allow inspection rights to the Fund’s Directors because he feared its outcome. With a busted public company on his hands, he was obviously planning to flee the country. He had to be stopped and the business had to be saved. They now unveiled their blitzkrieg.
First, the nominee director of both Funds formally wrote to the Securities and Exchange Control Board (SEBI) reporting default in payment of dividend, annexed their letters of protest, roundly criticizing the company’s position and expressing helplessness in remedying the situation. These directors weren’t personally off the legal hook only because they wrote these letters but it would make their story look better in court if they were prosecuted for the dividend payment default. They then followed up with personal meetings with SEBI officials. Meanwhile, the Funds guided several small shareholders and steer them to write letters to SEBI complaining about Shrimrig’s failure to pay dividend. It worked. SEBI reacted and sought Desai’s explanation.
Not long after that, two independent small shareholders filed cases in a small mufassil civil court in Tutticorin (Tamilnadu) and Katwa (West Bengal). They asked the court to restrain Desai from spending money they had paid the Company for its shares. These were strange cases to file but they had the intended effect. Two local papers picked up the news and within the next 24 hours, the national press was onto Desai. Alarm bells immediately started to ring amongst the general body of shareholders.
Next, the Funds persuaded a ‘professional’ shareholder to requisition a general meeting of the company. The national press picked this up as well. Desai immediately became something of a celebrity amongst stock traders who specialized in shorting shares.
Finally, one Fund’s nominee director filed a petition in the Company Law Board[1] (CLB). He said he could not discharge his duties as a director unless he was allowed to inspect company records regarding the two new investments. He also wanted to be protected against the inevitable consequence of Shrimrig’s failure to pay dividends. CLB was sympathetic. It issued notice to the Company and immediately gave him inspection rights.
Desai was in deep trouble. He tried to ‘manage’ the inspection and limit disclosure. It was a tough ask. The inspection revealed that the Company had made a whole new bunch of doubtful investments. It also revealed that the Company paid out large sums of money as fees to persons unknown for no visible service. The bombshell though was the cash. Last year’s Balance sheet showed Rs 300 crores of cash but it wasn’t consistently there. Every month, the promoters brought in cash on the last day of that month and took it out on the first day of the following month. Desai was window dressing his accounts. The fat was now truly in the fire.
One week later, the first Fund filed a very substantial petition in the CLB claiming oppression and mismanagement. They wanted Desai and his nominee directors removed from the Board. They wanted a reconstituted board of external directors approved by SEBI. They wanted Desai’s investments and acquisitions reversed. CLB was sympathetic. While issuing notice to Desai and the Company, it appointed an independent observer to the Board and allowed the Funds to comprehensively inspect the Company’s records.
Desai was now primed for a slaughter. The Funds assigned a large team of auditors to toothcomb the last five years records of the Company. Desai did his best to obfuscate this record. He produced what appeared to be fabricated books of accounts. Amongst other things, these books did not carry the customary stamps of the Company’s auditors. The Rs. 230 crores of pay-outs did not appear genuine. It was made to Indian agents of European industrial machinery manufacturers. Desai paid 100% advance against orders but the orders were unspecific and no delivery dates were agreed. These agents did not appear to have genuine addresses. Many payments were isolated pieces of paper: auditors found no correspondence leading up to the invoices and their corresponding payment.
This was also true of overseas suppliers. A range of substantial payments had been made for materials and machinery to off-shore Mauritius tax haven entities with post box addresses. Other than an invoice and its proof of payment, there was no correspondence to explain the transaction.
The Funds never quite got to understand what had actually gone on in Shrimrig. One body of opinion held the Company had never made a profit. It held that Desai had been “borrowing profit entries” to beautify the balance sheet. He did this to tap the stock market for money from time to time. The stock market crashed of Jan 2008 decimated Desai’s strategy. His “borrow money to show profit to prop up share price to raise public funds” strategy became unfinanceable. A second body of opinion disagreed. They argued that Shrimrig was profitable but Desai systematically juiced the money and spirited it out of India and into his Mauritius based trust companies. The Jan 2008 stock market crash interrupted his plans so he used short term market borrowing to make up the shortfall. When he pulled in more money at the IPO, he had his opportunity to balance the books. His new project represented a golden moment to over invoice his capex imports and come full circle. There was yet a third body of opinion. Based on market rumors, this view argued that Shrimrig always made substantial profits, but Desai siphoned off some of these funds to punt on the stock market. When the stock market crashed in 2008, Desai took a whipping and he tried to pay his stock market debts by milking Shrimrig.
Whatever the story may have been, it was time to deliver the coup de grace. Just a soon as this information came in, the second Fund filed a substantial petition claiming oppression of minority rights and gross mismanagement of the Company. The recently unearthed evidence became the center piece of the case. This fund definitely wanted the company wound up. Through all this excitement, Desai had failed to respond to the general meeting requisitioned by the independent professional shareholder. This shareholder too now filed a petition before CLB demand that a general meeting be convened immediately. In the result, Desai now found himself facing a SEBI instituted investigation, two small town civil litigations, a CLB action at the hands of each of HSP and PDP, a CLB action from a professional shareholder a press running amuck in search of sound bytes. That’s as good as a blitz gets.
To his credit, Desai put up a credible show in his own defense. He told CLB that he had a consistent track record of excellent performance, that he was as bullish as ever. He said that the two Funds were basically disgruntled shareholders with no interest but to sell at a high price and the recent stock market crash had made exit difficult for them. He said he was an achiever while the Funds were just financial academicians who knew all about spread sheets but nothing about business. It was just a shakedown. For good measure he added that he wished he could buy them out he hadn’t the money and besides, this would trigger the takeover code which he couldn’t possibly support.
In the end, it was the street that overwhelmed Desai, not the Justice Machine. The stock market was running way low. Desai knew he was ripe pickings for a hostile take-over. He had to settle. At the same time, the Funds too knew that a third-party acquisition of the Company was everyone’s best option. The Merchant Bankers worked it out. Desai handed over management control to a purchaser and parted with 15% of the equity he held with an option to purchase more in twelve months. Meanwhile, the Funds transferred their shareholding to off shore special purpose vehicles. The purchaser then acquired these vehicles. In this way, without triggering the takeover code, the case was amicably settled between the parties.
The beauty of the Blitz is the speed with which it is unrolled and the intensity with which it is applied. It works well when it overwhelms the enemy and stream rolls over all opposition. The Blitz requires careful planning, a lot of people to run it well and a lot of money. If applied correctly, it produces magical results.
[1] Its successor now is the National Company Law Tribunal