27% yield Essar Energy 4.25% 2016 Convertible Bonds-only for the brave

For some context, let me state that when Essar Oil was held ineligible for a sales tax deferment benefit by the Supreme Court, the shares of Essar Oil and its listed UK parent Essar Energy Plc fell by nearly 30%-40%, and the bond yield mentioned above rose by almost 700bps. This was although the promoter entities were seemingly liable for the payment, but investors did not factor it in. This post explains why.

In an earlier post(http://specialsituationsindia.blogspot.com/2012/01/avoid-essar-energy-plcessar-oil-despite.html), I lambasted Essar Oil and its UK listed holding company Essar Energy Inc for withholding legible details of the sales tax dispute. It transpires that perhaps thanks to the UK Regulator FSA Plain English doctrine, they made a much more legible description of the dispute in the $550MM issue size bond prospectus of their 4.25 per cent. Guaranteed Convertible Bonds due 2016. On page 9 of the prospectus(read it here http://www.essarenergy.com/upload/articlepg_attachment/Stamped_prospectus_final_form.pdf), they described their sales tax dispute. I reproduce below the salient features of the dispute

1. Under the Gujarat State investment subsidy scheme titled "Capital Investment Incentive to Premier/Prestigious Unit Scheme, 1995-2000" , if Essar's Vadinar refinery could commence
   commercial production by 15 August 2003, then it would be allowed to retain interest free the proceeds of the sales-tax collected during the exemption period ,on sales of refined petroleum products from the Vadinar refinery. 
2. The exemption limit's sunset clause is earlier of 13 years from fiscal 2008-09(viz till fiscal 2021-22) , or till cumulative sales tax worth 91 billion (presently US$1.8 billion) was collected.  which the company had expected in 2013-14.
3. After the sunset clause was triggered, the tax collected was repayable in six equal annual instalments. Till Dec10, Essar had utilized Rs.42.60 billion (US$950.68 million) detailed below. The amount rose to Rs 63bn by Dec11($1.235bn), and Essar must have booked 80% of that cumulative figure as revenue going by previous years trend
4. Since Essar could retain the revenue and repay it in interest free installments, it recognized nearly 80% of the tax collections as its revenues(viz total collections net of the NPV of tax dues). For example, the revenue recognition impact of that was as below(figures in Rs bn)
   

   Fiscal(all figs Rs bn)	Tax Collected	NPVof tax dues	Net Revenue recognized
   Mar08-Mar09	15.16	3.01	12.15
   Mar09-Mar10	14.74	2.95	11.79
   Mar10-Dec10	12.69	2.78	9.91

5. Essar did not commission the project on time, yet availed the exemption. Driven by opposition clamour, the Gujarat Government reluctantly demanded the tax from Essar, which appealed the matter at the State High Court, where it won in Apr08. The State appealed the matter in the Supreme Court, where it was listed for hearing in Jul11, and order passed in Jan-12, where Essar was held ineligible to claim the benefit.
6. Meanwhile, Essar Energy Plc(Essar Oil's holding company) had launched an IPO in the UK, in Mar-10. Perhaps to reassure investors of the tax liability, Essar Oil  decided to "assign" that liability to its group company Essar House Limited, under a "factoring agreement". It should be noted that under law, Essar Oil remained ultimately liable for the payment of the sales tax liability to the state of Gujarat in the event that Essar House defaulted. 
7. Interestingly, while Essar Oil recognized only 20% of the dues as NPV, it paid Essar House around 28% of the tax dues as consideration for assignment. Even allowing for the passage for time, it implies Essar Oil understated its NPV for inflating revenues, albeit to small extent. This 28% remained constant, as evident by the fact that assigned tax dues were Rs 180bn($353MM)
8. As if Essar House's factoring was not enough, Essar Oil entered into a tripartite agreement with Essar Investment Ltd (“EIL”), another(!) Essar Affiliated Company, whereby EIL would guarantee the payment of the sales tax liability to the state of Gujarat in the event of Essar House being unable to fulfil its commitments under the factoring arrangement. 
9. In essence therefore, investors should not have had to worry about those tax dues payable by Essar Oil, even if it lost the Supreme Court ruling. This is because TWO Essar group companies have guaranteed the payments. However, the guarantee is contractual not statutory, with the onus of immediate payments resting on Essar Oil. 

Perhaps, investors are discounting this(both stock price and bond price) as they fear the promoter entities would find a way to wriggle out of paying the entire amount. After all, the promoter entities would  be suckers to pay 100% for having purchased at 28%. I'm sure high priced lawyers are working overnight on the agreement trying to discover loopholes for the unlisted promoter companies to escape, maybe by invoking a force majure clause etc. And the investor apprehensions seem justified. Compare the contrasting description of the factoring arrangements

1. In May11 bond prospectus:- While, pursuant to a factoring arrangement, the Company has assigned its sales tax liability under the sales incentive scheme of Rs.42.60 billion (US$950.68 million) to Essar House Limited (“Essar House”), an Essar Affiliated Company, at the present value agreed pursuant to the factoring arrangement of Rs.11.83 billion (US$264.0  million) and paid Rs.11.26 billion (US$251.28 million) to Essar House as of 31 December 2010. A plain reading of this arrangement and the meaning of factoring would imply that Essar House took the present upfront, agreeing to pay the tax dues whenever they materialized. Also, it would seem that Rs 42.6bn was assigned. 
2. In Jan12 announcement(http://www.essarenergy.com/upload/articlepg_attachment/120118_Essar_Energy_Gujarat_Supreme_Court.pdf), they said that As per previous disclosure, the sales tax deferment liability has been assigned to a third party. As of  December 31 2011, the amount assigned is Rs1800 crore (US$353 million). This amount is repayable to Essar Oil to meet any payments of the deferred tax benefit in accordance with the terms of the agreement. This implies that (i)The assigned amount was only the present value and (ii)Essar House will only repay the present value and NOT the total gross liability. This goes against all legal conventions and meaning of factoring, and is also contrary to the risk factor in the prospectus, which stated explicitly that the gross value was assigned.

I'm sure that if this matter is litigated, Essar promoters will be sued in UK Courts for misleading disclosures or press releases, IF they do not make full payment of the tax dues. Still, it would  take a long time, and UK investors may have apprehensions of timeframe etc. But for a Carl Icahn or an activist investor, this would be a great opportunity. While the bonds may still seem too risky in relation to the overall debt, I think it is a classic case of market panicking too much, especially if the promoters can be made to cough up their sale proceeds from Hutch Essar stake sale, into honouring their 'factoring'.