Case Details:

Case Code : FINC020

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Themes : Corporate scams / Controversies

Case Length : 16 Pages

Period : 1998 - 2001

Pub. Date : 2002

Teaching Note : Not Available

Organization : Essar Steel

Industry : Steel, Financial Services

Countries : India

Abstract:

The case examines the financial crisis faced by Essar Steel (Essar), the leading Indian sponge iron
manufacturer and the flagship company of the Essar Group, during the late-1990s and the early 21st
century.

It discusses how the company issued floating rate notes (FRNs) in the mid-1990s to finance its Hazira
HRC plant and examines in detail the reasons why it defaulted in repaying the FRN-holders on the
maturity date.

The case critically analyzes the measures taken by the company to come out of its financial
problems, the role of the FIs and the promoters.

Issues:

» The suitability of FRNs in the capital structure of a long-term project

"The fault did not lie in the instruments itself but in the financial planning that went behind it. It may
be relevant to quote the safety motto of the National Rifle Association - 'Guns do not kill people.
People kill people."

- A December 2002 article on www.indiainfoline.com, commenting on the Essar FRN default issue.

The Default

In July 1999, Essar Steel (Essar), the leading Indian sponge iron manufacturer and the flagship
company of the well-known business house, the Essar Group was facing a severe financial crisis.
Essar earned the dubious distinction of becoming the first Indian company to default in honoring its
international debt repayment obligations.

The company failed to repay its Floating Rate Notes (FRNs) worth $ 250 million issued to foreign
investors. These had matured on 20th July, 1999. Analysts claimed that this development could
seriously hamper the credibility of Indian companies and Indian paper in the international debt
markets. Expressing its inability to make arrangements for repayment, Essar announced that it
would come up with a concrete solution by the end of October 1999.

The company sent notices to its FRN-holders assuring them that within 90 days (starting from the
date of default), it would announce its plans of rollover payment or refinancing through external
sources.

The notice required FRN-holders to choose between the two options (rollover or refinance). Essar
sources said that the future course depended on the response of the FRN-holders.

According to financial institutions1 (FIs), if the FRN-holders sought immediate payment, the issue
could even go to international courts, and the company would have to face demands for liquidation
of its assets towards repayment of the amount. FI sources felt that refinancing would be difficult as
the default had cast doubts on Essar's credibility as a borrower. Moreover, they expressed fears that
this default could become a major crisis, if other creditors of the company sought to recall their
loans. The default did not come as a surprise for company observers and many of them had
predicted this eventuality much earlier. They considered the poor asset liability management
practices followed at Essar responsible for all these problems.

Background Note
Essar's parent organization, the Essar Group was engaged in various businesses including power,
telecom, shipping, oil and iron and steel. Essar was the second largest private sector steel
manufacturer in India (TISCO is the largest).

The history of the Essar Group dates back to 1956, when its founder, Nand Kishore Ruia (NKR) began
undertaking independent contract works (mostly in the construction and shipping businesses) under
the name of Essar Construction and Carriers Ltd.

In 1969, after NKR's demise, his brothers Shashi Ruia and Ravi Ruia took over the business
responsibilities. During the 1970s and 1980s, the company diversified its operations by entering into
the power, steel and oil businesses. Over the years, the Essar group continued to grow in related
fields i.e. offshore construction, pipeline laying, contract drilling and marine transport.

The liberalization of the Indian economy in the early-1990s opened up many opportunities for the
Essar group. The Ruias tried to diversify further and emerged as a conglomerate of companies (Refer
Table I).

ESSAR STEEL

Essar was incorporated in 1976 as Essar Steel Ltd. According to analysts, the Ruia family played a
significant role in the development of the industry. Essar was the first private sector company, which
was permitted by the government to set up a 2-million tonne steel plant. During that period (1989),
the group found out that it was difficult to acquire long-term funds for financing capital-intensive
projects such as steel in India. Moreover, foreign investors were also not permitted to extend funds
for more than five years. Due to this, Essar had to borrow funds from Indian FIs, for the construction
of the Hazira (Gujarat) hot rolled coil (HRC) plant (with a repayment period of seven years).

Detailing the Problems

By the late-1990s, the profits of the entire Essar group had started declining. Analysts attributed this
to the various unrelated diversification moves undertaken by the group during the early and mid
1990s.
In 1998, the group incurred a loss of Rs 4.13 billion (it had earned a profit of Rs 1 billion in 1997).
Some of the major reasons for this were: ineffective project planning, delay in the completion of
projects, dumping , wrong choice of financial instruments, and reduced returns on investments.

Moreover, many of these diversification moves failed to deliver the desired results and the group's
image took a beating. The simultaneous launch of various projects during the mid-1990s pushed the
group towards a liquidity crunch. As a result of these diversification efforts, Essar Steel got entangled
in a complex mesh of cross holdings in other Essar companies, which created serious problems...

End of Problems?

In late-1999, the global steel industry began recovering and prices reached a high of $450 per tonne
by 2000. In the light of this development, analysts were quick to comment that Essar's cash flows
would improve and it would be able to pay back its debts in due course.

This view was also strengthened by the massive restructuring exercise undertaken by the company
in 2000. This exercise mainly focused on financial restructuring. The objective of the financial
restructuring was to avoid constant liquidity crunches, enhance debt service and interest coverage
ratios and frame repayment terms to ensure a smooth flow of operations.

The request for extension to the FRN-holders was one of the first moves in this direction. Not only
did the FRN-holders agree for an extension, the FIs also agreed to extend the maturity period by
eight years. Partly secured creditors also extended their maturity period by 5-6 years, in line with the
other creditors