Pledging of shares -A must check.


Hi there,
In our last article we talked about analysing the shareholding pattern of the company and its significance. In this article, we look at one more aspect connected to it-Pledging of shares by promoters. For example, the promoters of the company may hold 60% of the shares, but what if all those shares are pledged with a financier as collateral for getting additional loan funds? That’s a dangerous situation.

WHY ?

  • Promoters, in order to raise funds for either personal or company needs, pledge their holding shares to any financial institution.
  • Non-banking financial institutions are more active than banks in providing such loans.  Sometimes, promoters collateralize their shares for converting warrants into shares. Also, they might find share prices in the secondary market quite lucrative for fresh purchase and adopt this route for garnering funds for the consideration to be paid for open market purchase. So there are lots of reasons why promoters pledge their shares. Generally, pledging shares is not a good sign.


As a general rule, if promoters raise the money for the betterment of the business, investors should take it positively but if the money is raised for any personal needs, it imparts negative signal. Even if the funds are raised for improving the business it indicates a liquidity problem.

WHAT DOES PLEDGING INDICATE?

Low credit-worthiness of the company

Businesses need money to grow and invest in resources. The most preferred ways to do this is to go for debt or equities. Going for equities is not a frequent event and hence most of the companies need debt to finance their business expenses. However, some companies do not have enough credit worthiness to secure required debt for their needs. Hence pledging shares is the only way to get loan.

High debt in the company

Companies do not get further debt if they already have high debt in their balance sheet. This could be a reason for companies to pledge the share against loan. A high debt in the balance sheet will increase the interest expenses of the company. Hence major part of the profit will go towards paying the debt holders, leaving very little for shareholders. This will hurt investors in two ways. First, it may eliminate the option of dividends completely. Second, because of low earnings per share, the stock price appreciation is also less.

Its even more dangerous in a falling market.

Bankers or financiers give loan taking the shares as collateral. When the market is in bull phase, pledging doesn’t create issue because promoters can count on rising value of their stake. Banks too do not mind lending against shares because of rising value of shares as collateral. The problem occurs when the market enters in a bear phase. whenever the prices of shares come down to a certain level in the secondary market, the promoter is required to either make some payment or pledge more shares. If the promoter cannot do either, the lender keeps the right to sell pledged shares in the market. Apart from this, promoters always have the risk of a hostile takeover.

NBFC`s -The preferred lenders:

Under Section 19(2) of the Banking Regulation Act 1949, it is provided that no banking company shall hold shares in any company whether as pledgee, mortgagee or absolute owner of an amount exceeding 30% of the paid-up capital of that company or 30% of its own paid-up capital and reserves, whichever is less.So, NBFC`s or other lenders are preferred by promoters as lenders as such loans will give them greater flexibility.

WHERE TO GET THE INFORMATION?

Before the Satyam debacle, there were no disclosure norms made by SEBI (Securities and Exchange Board of India) for promoters to disclose their pledged shares. But post satyam, disclosure regarding Pledging of shares by their promoters has been made mandatory by the Securities exchange board of India. Sebi has asked promoters to disclose details of pledged shares if the same exceeds 25,000 shares in a quarter or 1 per cent of the total shareholding or voting rights of the company, whichever is lower.

WAYS TO HIDE THE INFORMATION.

Many promoters are uncomfortable with their share-pledge details put in the public domain due to the stigma attached to such information and the attention it draws from short sellers.

  • In order to keep such borrowings away from the market glare, a promoter often parks a slice of his holding — which is to be used to borrow — into a separate demat account and creates a ‘negative lien’ on it. It’s a mechanism to ensure the shares cannot be pledged or sold to anyone else. Non-banking finance companies (NBFCs) and finance arms of brokerages lend against such an arrangement.
  • Another transaction to circumvent the rule is to transfer some of the shares to a special purpose vehicle (SPV) controlled by the promoters or members of the promoter group, and raise money by pledging shares of the SPV.
  • It’s also common to give lenders power of attorney that can be exercised to sell shares if borrowers default or certain triggers are breached. Often these are arrangements entered into between the borrower, the brokerage and the NBFC arm of the same brokerage.

CONCLUSION

Pledging shares by promoters is generally not good for investors. However, investors should be careful about the rumours. There could be vested interests in the market that spread rumours about companies and their promoters pledging shares. This happens when the market is already beating down a company because of this. Investors should use the sources available to know about companies and promoters pledging their shares. NSE website is good source of information.

You may like these posts:

  1. Shareholding pattern – it tells you a lot.
  2. Benefits of owning shares
  3. Principle 16. Avoid financial litigations

5 Responses to “Pledging of shares -A must check.”

RITESH

August 2, 2012 at 12:20 pm

very good article victor

J Victor

August 2, 2012 at 1:00 pm

thanks:)

Venkat

November 23, 2012 at 8:19 pm

Thank you Victor for a well written article.

I just want to clarify below real time situation which seems related to article.

Zylog Systems Promoters who pledged there shares with few finanical companies for past few years. Recently those financial companies sold there pledged shares in open market once margin call was triggered. Because of huge shares in open market, Zylog Systems Shares plummeted from 300 levels to 70 currently.
Do you see,

1) As a contrarian investment philosophy, as good chance for long term investor to mop up the shares at dead-cheap valuations
or,
2) This situation, wherein pledged shares in open market, which may displace the promoters holding in company, a dangerous signs for investor in long term

Please help to clarify above situations

Thanks
Venkat

Sukh

November 25, 2012 at 7:55 pm

Not good article. ordinary stuff

J Victor

November 26, 2012 at 2:45 pm

Dear venkat.

as far as zylog system’s case is concerned, this is an excellent opportunity to buy. as you said it’s at dead cheap valuations and the share price may move down further from the present position. it may not be possible to predict how far it can go.

Generally, such liqiudation of promoter’s holding is definitely a waning sign. In Zylog’s case, the promoters have started looking for option to increase their stake.In our opinion, It qualifies as a good investment at cheap valuation on all other parameters.

Another risk factor that may be considered is that it get’s 77% of it’s business from US and Canada. 54% is from US. so it’s solely depended on that market for major chunk of it’s revenues.

Logically , it’s also exposed to foreign currency risk.

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