How Promoters cheat Shareholders - Moneylife article
Source: http://www.moneylife.in/article/71/827.html
Indian promoters manipulate accounts and market prices for two (opposite) reasons. The first is a traditional game, which the majority
of them play – siphoning money from the coffers of a listed company for personal gains. However, in a bull market, a reverse trend starts. Many of them are not interested in suppressing profits. They want to overstate revenues and profits because this boosts their market-cap in a rising market; it helps them to raise ‘free’ money. In the past three years, I have repeatedly expressed doubts about the genuineness of the financial figures of many companies, although foreign institutional investors (FIIs) and many renowned domestic institutional investors (DIIs) were shareholders of precisely such shady companies, even as many brokerage houses, print and electronic media were flashing ‘buy’ recommendations on them.
I mainly track mid-cap and small-cap companies. Large companies are smart enough to camouflage their figures. It is much easier to find flaws in the accounting of small- and mid-cap companies. What is the arsenal of tricks employed by promoters to siphon off money or fudge their accounts? How do they pump up their share prices and dump them on the public?
Here are dozens of examples of how promoters do it. These are actual examples, but we have opted to change their names because the idea is to educate investors about management tricks.
Suppress Income
Consider textile companies. All of us believe that they don’t make money. This is not true. It is only that the promoters are adept at hiding margins. Some listed companies have at least 15-20 private limited companies, two or three proprietary firms, five or six partnership firms in the promoter’s wife’s name, in his in-law’s name, in the married daughter’s name or even in the names of trusted employees who have been working with the promoter for 20-30 years. It sells finished products to private firms that are directly or indirectly owned by the promoters at cost price or even a small loss. Those private firms, in turn, sell the products to the dealer, wholesaler or distributor and make huge profits.
I am a textiles man and know exactly how this works. I can definitely say that listed companies like Ramdiya Mills and Karma Fabrics or Synth Fabrics – have adopted this practice since inception and continue to do so even now. If you look at their cost structure, it will become very clear. Ramdiya Mills and Karma Fabrics have large reputed brands. Since they buy hundreds of crores worth of yarn every year, they get it at the lowest possible price. They get an additional price benefit by making cash payments to suppliers. Since the product they sell is a premium product, these companies ought to have a net profit margin of at least 12%-15% whereas they hardly show a margin of 2%-3%. Text100 Mills is one of the oldest and reputed cotton textile mills with significant exports. But if you look at the segment-wise results, the cotton division always shows losses. Where is the money going? Most promoters either invest it in real estate or benami accounts in India or transfer the money abroad. Of course, each promoter has a different way of looting the company and siphoning off money. The promoter of Ramdiya Mills is a hands-on guy who looks after practically everything. They do not have senior professionals in purchase, marketing or branding. Since the promoter takes all decisions, overheads are also not large. In this category fall companies, like Gofar and other powerloom companies, whose expenses are those of a powerloom, but selling price is akin to the organised sector.
In some cases, shareholders’ money goes to support the promoter’s lifestyle. Look at a famous textile company like Monde Fabrics. It has a higher cost structure – the bigger the brand name, the higher is the number of employees. Monde’s production cost is slightly higher but not high enough to show losses. Also, they should be able to show very decent profits because they have the latest technology, wastage is low and the quality is very good. Their polywool fabric is the most expensive in India but their profit is negligible. Where is the money going? The promoter’s daily expense is in lakhs of rupees which is all debited to Monde’s corporate account. So, although the selling price of Daygod Mills is 20% lower than Monde’s, its margin is higher.
Under-reporting of revenues is also rampant in the steel industry, especially in Kolkata-based companies. Each listed company has at least six or seven unlisted companies through which they do a lot of adjustments, depending on the opportunity. They decide where to show profits and when to disguise them. In this category are companies like Prism Steel and Modern Metals. Look at Modern Metals and compare it with River Electricity, a company with a similar profile. River Electricity did not have captive mines and neither did Modern. But profit margins of Modern have been very low. Their profits are vanishing through their unlisted group companies.
I had met the promoter of Auto Parts some time ago. He had some unlisted group companies with negligible profit margins and plans to merge them. He said: “I will merge all these companies and my profit will be so much higher.” I asked: How? He said: “I am suppressing the profit in these unlisted companies to reduce my tax liability.” I asked: “What is the guarantee that you will pay income tax and will not siphon off funds after merging these companies? If you don’t want to pay the government, what is the guarantee that you will pay shareholders?” Analysts usually don’t know all this; they recommended the stock even at Rs300-Rs350. It is down to just Rs30 now. Business performance has been poor.
Sell in Cash
Dealing in cash is very common in the steel industry. Cash sales take place and are not reflected in the books. That is why you will find that raw material costs rise disproportionately. I knew a person who used to be with a sponge-iron company near Mumbai. He told me that every year they sell Rs500 crore worth of sponge-iron from their plant, in cash. But all purchases and expenses are being fully accounted in the books along with the promoter’s personal expenses.
Take the example of Kanaka Leaf. Why did that company become sick? I know a manager of one of its factories. He tells me that he used to take out 90% of the stock in cash and pay excise duty only on 10% of the goods. That is one reason why this firm got into legal trouble and that factory had to be closed. He was no longer on the payroll; but the owner was still paying him Rs25,000 per month. You always know which companies are selling in cash by sniffing around at the commodity markets. Look at the textile company ABC. If you go to the textile market any time, you can buy ABC products in cash. There used to be a company called Garvi Fils which closed down. It used to sell most of its production in cash. In any textile market, you can get a list of companies which will sell yarn in cash. All of them book expenses fully; sell in cash and claim that costs have gone up. This is how they fool investors.
One major way in which promoters enrich themselves is by selling waste (or passing off even quality material as waste) in cash and pocket the money. This is rampant in the metals and cable industry. Jewel Steel is the king of this. It sells waste as well as fresh material as waste. It even sells zinc which is used for galvanising. You can go to any metal merchant in Delhi and enquire how much zinc Jewel Steel is selling and how much copper Melton Cable is selling in the open market. This is a common feature of the metal traders in Delhi where almost 80% of the business is done in cash. Companies sell to wholesalers; wholesalers sell to small converters and so on. There is an active cash market and promoters are able to sell as much of quality finished goods, raw materials, by-products or waste.
Fake Bills
The most common practice among corporates is to buy fake bills for a small price, make the payment against these bills by cheque and instead of receiving goods, ask for the money back in cash. This is a common practice among the marwari business houses of Kolkata. They buy bills of Rs10 crore or Rs20 crore ostensibly for raw material purchase and pay for it by cheque. The material never comes to the warehouse; instead they get the money back in cash, minus a tiny commission for the fake bill. Naturally, the companies show losses or meagre profits. They are not inefficient companies, neither are the promoters fools. They simply siphon off cash by buying the bills and under-report sales. This leads to losses.
Siphon Windfall Gains
Monde Textiles sold off its unrelated businesses a few years ago but did not pay anything to shareholders. Take Harry & Mala. Around three years ago, it had sold some real estate and had realised around Rs70 crore. No one knows where that money has gone. Another pharma company, Rockhard Life sold its IV-fluids business for about Rs160 crore to a US company. At that time, it was believed that it would use this money to retire debt but what did they actually do with the Rs160 crore?
Well, Rockhard had paid about Rs90 crore to buy a pharma company called Rind Ltd which had a plant near Mumbai. The factory land was sold to a partnership firm belonging to the promoters for just Rs10 crore. So they had a loss of Rs80 crore in the books. This loss was adjusted against the profit from the sale of IV-fluids business. The land on which Rind was located is probably worth Rs500 crore. The same thing happened in Gush Bio which sold all its assets to Darling Biotech. The CFO of Darling had told me that the cash consideration was around Rs60 crore. If Gush cannot survive and the product is not profitable, why doesn’t the promoter sell the whole company? Why is he selling the assets? Did he invite competitive bids? Was the process transparent? So Gush becomes a shell company and shareholders are cheated.
The Indian Spinning Mills closed down due to losses. It had huge land in central Mumbai. The company floated a separate entity and transferred all the surplus land to it for just Rs200 crore. The promoter is now reaping thousands of crores of rupees by developing that land. Why didn’t Indian Spinning Mills develop the land? Primex Textiles is a south-based company with a large land bank. It is developing the land but construction is being done by a partnership firm controlled by the promoters. The deal is such that Primex Textiles will get peanuts.
Real estate companies, big and small, are notorious. When they buy land from villagers or from small landowners, they pay as much as 75% in cash. Where do they generate the cash from? Often, the land is bought in the name of promoter’s firms and then transferred to the listed company at inflated prices.
Fake Exports, Foreign Acquisitions
In a bull market, higher revenues and profits benefit the promoters directly, and instantly, in the form of higher market capitalisation. How do they boost revenues and profits? Often, by transferring illegal money that is stashed abroad by promoters, builders, bureaucrats and politicians to Indian companies through banking channels; it is shown as export proceeds. Many companies suddenly become zero-to-hero, showing a meteoric rise in the topline in just a few quarters. Unknown promoters from unknown companies suddenly do far better than their established competitors.
Over the past three years, major accounting frauds have occurred on the export income front because export income is tax-exempt – companies have to just pay Minimum Alternate Tax (MAT). Such income is not easily traceable and comes in handy to boost market-cap. So, promoters, who could not carve out a respectable niche in India, have become leaders in the international arena, even as global companies want to come to India! Such companies continue to show consistent performance quarter after quarter – until the music stops.
Badami is a big group now, but when I was in textile exports, I often received offers that went something like this: if you have an export turnover of Rs10 crore, you give it to Badami and you will get X% for it. Badami will export the product and claim export benefits, consequently increasing the size of their balance sheet. There is a company called Ecstasy Pharma. They suddenly started showing huge turnover and profit. For nine months ended December 2008, they reported a turnover of Rs110 crore and a net profit of Rs30 crore; yet they have paid income-tax of only Rs38 lakh for those nine months! I do not know how this is possible; even MAT should be higher than that. Maybe they will make a higher provision at the end of the year. But I have a strong suspicion that the exports are cooked up. Drug exports are not a profitable business. The margins are much lower than those in the domestic market; global giants like Dr Reddy’s, Ranbaxy and Cipla – major exporters from India – do not have such profit margins and this company has a pre-tax margin of 33%! Companies that are in formulations have to spend a lot on R&D and employee cost is high. The employee cost of Ecstasy is just 1.7% of the turnover.
Now look at TV Lab. In 2007-08, on a turnover of Rs1,032 crore, it had a net profit of around Rs347 crore. This company is only in bulk drugs, not formulations. It claims to be in contract research and manufacturing, but which other company has margins like TV’s? I know dozens of genuine promoters in the pharma industry very closely who say they can’t see how one can make so much money. The share price of Churchgate Technologies has crashed to Rs40 from a high of Rs2,000. They used to claim they were in the higher-end BPO business. But profits are plummeting and so is the share price. These promoters are essentially laundering money in the garb of export income. Money comes into the company’s books and they show significant profits for three or four quarters. After this, there is an announcement that it is acquiring an overseas company in an all-cash deal. The money that was laundered goes out through official legal channels. It can again be recycled into India as export income.
There is a software company called Dorion. It invested around Rs68 crore in a subsidiary in the US. The company’s total turnover is around Rs200 crore and it made a profit of only Rs53 crore in two years. It took a secured loan of Rs40 crore and promptly gave a loan, which is unsecured, to another company ‘to be recovered in cash or kind’. In effect, it has taken a secured loan to lend the money as an unsecured loan! In such cases, what usually happens is that after five years or so the company will admit that the loan cannot be recovered and write it off against some claimed goodwill or brands or tiny assets whose value is exaggerated. That is how money is siphoned off. Such money laundering cannot be carried on beyond a few years because the main purpose is to dump shares in a bull market. When the share price rises, they sell their benami holdings and extract value out of their listed entity.
False News
Another way of fooling the investing public is by making bogus announcements – such as bagging new orders or signing a memorandum of understanding (MoU). This is easy. Any corporate can get any number of orders or MoUs signed with overseas customers. They have to pay nothing. They just have to tell those customers abroad that they need such orders in hand to get bank limits sanctioned. The foreign party sends a fax or signs the MoU because it has nothing to lose; it is in another country and not accountable to anybody here. There used to be a company called Shree Dhatu. Three years ago, the promoter used to claim he has orders worth Rs800 crore but I don’t ever remember his having reported a quarterly turnover of more than Rs20 crore-Rs30 crore. Karnet Builders has a small piece of land near Mumbai. But they have been making regular announcements about their large land bank, orders received, partnerships, etc, and nothing has happened until now. It is all false.
Pump-and-dump with Operators
Market operators are an essential component of a bull market. Promoters need them to cheat investors through price rigging and profit rigging. The usual route is to show exaggerated profits, loan shares to operators and unload the promoter’s holding. Promoters usually collude with market operators who flaunt the right connections – foreign and Indian institutional investors as clients. It is an open secret in Mumbai that many fund managers receive huge kickbacks for investing in certain companies with an assurance from the promoter/operators that they can exit at a high price through market manipulation.
When Laltane Solutions made its IPO, some Delhi-based operators regularly contacted me to say that the stock would list at Rs500 against an issue price of Rs250. They offered me shares at Rs400 and openly admitted that they belonged to the promoter. That is how they made money in the stock market. When you think of operators, don’t think of shadowy individuals. They could well be institutions with a big name and shining public image.
Empire Clay is a company with an equity of Rs4.47 crore, belonging to an illustrious business family. Its share price started rising from Rs300-Rs400 all the way to Rs3,700, hitting the upper circuit for days together at a stretch. Volumes shot up as well. During that phase, promoters offloaded their holding. When it was around Rs2,500, a broker friend advised me to purchase this scrip. He told me that a relative of his works in a well-known institution called SLIP and he says its price will be Rs10,000. SLIP had made a presentation which was widely circulated among FIIs and high-networth investors to promote the company. Later, my friend told me that SLIP had a mandate from the promoter to implant in its presentation the idea that the share price would hit Rs10,000. It would allow the promoters to sell a part of their holding. Another operator/institution came out with a buy report on Square Tubes when its price was Rs85 with a price target of Rs150 – now the price is Rs11. I think, the institutions have an understanding with the promoters. They officially or unofficially charge a price for circulating such reports.
Remember the hype about the power sector before a major company made its IPO? A grey market had sprung up for the issue quoting a price of Rs800, when the IPO was at Rs450. Operators in Ahmedabad actually ‘bought’ some shares from the public at Rs800 but immediately sold them at Rs790. They created an impression that this grey market was genuine and I could sell my shares at Rs800. The operators lost some money, which was compensated, and the company raised thousands of crores.
In several IPOs, promoters give operators a kickback of as much as 40% to get the issue subscribed. Once it is subscribed, operators who own most of the floating stock are able to ramp up the share price immediately on listing and start exiting. Their risk is minimal because they have already taken a 40% kickback.
Visher Agro buys wheat from the market, converts it into flour and sells it to a food company selling branded atta. It is also into rice milling. It is not selling anything under its own brand name. It is just a converter. The promoter entered into an agreement with an operator and his share price rose to Rs200+ from just Rs15; it has now dropped to Rs49. He claims to have set up an unlisted company which will set up a 20MW co-generation power plant for which he is in talks with Blackstone. He was making up this story but he could not succeed in raising the money as the operator quit the counter. The share price is now languishing at Rs49.
Broken Pacts
Another trick by Indian promoters is to announce a joint venture (JV) for a new project. After a while, there are reports about differences between the JV partners. The money invested in the JV is never recovered. It is written off over five or seven years. All this is well-planned. The JV is floated precisely to siphon off money by taking away money invested in the JV. For instance, Albert Hotels of Bengaluru paid Rs15 crore as its share in a JV with a Pune-based company to set up a five-star hotel in Pune. It later pulled out of the venture due to differences over management control and said it would file a lawsuit to recover its investment. But industry sources told me that the promoter has already taken back the money in cash and written off the investment in its books. This is a popular trick among marwari companies. They lend money to unlisted companies owned by the promoters either directly or indirectly and the money is never recovered.
How can we prevent such abuse? Unfortunately, Indian laws are not stringent enough and existing laws are not being implemented earnestly or swiftly. The auditors do what the promoter tells them to – no matter how big the audit firm. The Satyam saga has, indeed, made many promoters more circumspect and some may even scale down the level of their money laundering.
As all these examples show, Indian promoters are not stupid or less intelligent or don’t know how to run their businesses. They are actually a step ahead of other professionally managed companies. They are much more intelligent, savvy and street smart. They know how to negotiate with suppliers for the lowest possible price, how to cut costs and how to siphon off money. Most of them have trusted people or relatives in key strategic posts to prevent pilferage. Even while selling, they know how to negotiate hard to get the highest price. They work hard and make a lot of money but they don’t want to share it with you.
FEW MORE LEARNINGS COLLATED FROM DIFFERENT SOURCES-
a few simple tricks I use while checking the firm
-is the firm held by the promoter directly or through a holding firm. If it is through a holding firm and that is privately held, it is difficult for us to know about it and it is a minus.
-what are related party transactions - if there are sales subtract the related sales,if costs add the costs then take the adjusted intrinsic value
-has the company given any deposits or taken loans from subsidiaries or holding companies
-does the company pay a very large royalty to parent firm just like that
-is the promoter salary ex of dividend {because this is shared with shareholders} rising faster than profits
-who are the independent directors are they on reputed firms.
-is the promoter a page 3 type, big minus though this is my personal view 
-is the promoter unnecessarily pledging shares and is interested in real estate
-have they been fined for frauds etc in watchoutinvestor database.
-is the company involved in government projects etc especially in states like Bihar, North East etc
-type company and promoter name with words like problem, fraud, default etc type negative adjectives in google
-check equitydesk old threads
-does the management suffer from title inflation. For example does everybody have a title starting with Chief or President. For e.g in Pantaloon they had a Chief Belief Officer who used to tell ACK stories 
-is the company giving dividend even when debt is high (e.g HCC}
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-does the promoter focus more on capital structure timepass rather than improving operations e.g Munna Mobile 
some more promoter / manager check items that might be useful
-what is the salary of the top guys as a % of total manpower expense
-what is the % of total salary in equity at reasonable option prices, higher is better i.e more equity, less cash
-calculate the salary with stock options as an expense, this will change automatically from IFRS next year but even then for the moment it should be added
-unnecessary loans being given by company to promoters/mgmt
-how many of the guys are organically growing with the company, how many of them are fly in fly out types etc
-is the company registered in tax havens like- e.g Jet Airways for some strange reason is listed in Isle of Man. Mauritius can be excluded because we have some specific tax advantages that allows companies from there.
-is the auditor changing every year (from Alok Bholaji's excellent observation on Micro Technologies.
this is of course a list that I use, might not work for everyone so pick choose what you guys think works.
The five metrics that we used to run our check:
Booking Revenues In Advance: Are a company’s Cash Flows from Operations (CFO) growing as fast as its Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA)? The formula: Calculate the percentage rise in CFO and EBITDA from one financial year (FY) to next. Compare the two to see by how much percentage is EBIDTA outgrowing CFO. The higher this result the more the chance of the company booking revenues without corresponding cash flows.
Shoring Up Operating Revenues: This metric asks, “Is a company’s ‘other income’ growing more or less in line with its investment assets?” The formula to apply is: Calculate the proportion of Other Income (OI) to Cash Investments (CI) for a FY. Do the same for previous FY. Compare the two to see whether the former has fallen drastically compared to the latter. The higher the fall the more the chance of a possible diversion of ‘non-core’ revenues to topline revenues.
Disbursement Of Loans To Related Parties: This metric directly looks at the quantum of a company’s loans disbursed to related parties. As a general thumb rule, if more than 1 per cent of loans or advances given out are to such related parties then there is a case to ask the question “Is cash being pulled out of the firm by the promoter?” The formula: look at Loans and Advances figure in the balance sheet. Get the loans to related parties figure from the notes to accounts in the annual report. Find the proportion of the latter to the former.
Shifting Expenses Away From The Current Period: This metric asks “Has a company’s ratio of depreciation to Gross Block of Assets changed significantly in a given FY from the previous one? If so, is the company using depreciation to ‘manage’ earnings?” Calculate the depreciation rate of a FY by dividing the Gross Block of Asset with the Depreciation Charged. Do the same for previous FY. Subtract the former with the latter. If the difference is negative and significant it raises a red flag to dig deeper.
Mis-match Between Quarterly Un-audited Figures and Annual Audited Figures: Do the audited annual FY Sales and Profit After Tax (PAT) reported to the stock exchanges tally with the quarterly sales and PAT reported earlier at the end of each quarter? Except for minor variations or variations due to demergers or other major corporate restructuring they should. Add Q1, Q2, Q3 and Q4 Sales and PAT figures for a given FY. Get the final audited figures for Sales and PAT. Compare the two.
