The pledging of shares is one of the methods used by company promoters to get loans to cover working capital requirements and personal needs, as well as to fund other initiatives or acquisitions. To obtain a loan, a promoter’s stock in a company is put up as collateral. Promoters continue to be the owners while making a pledge of shares. However, the value of the collateral also changes as a result of the fluctuating share price. When the value of the shares pledged to a lender falls below a certain threshold, this is called a “margin call,” and the promoters have to make up the difference in the value of the collateral.
Share pledges can sometimes be a problem for businesses since promoters are required to keep the value of the collateral up by giving lenders more shares when their value goes down. If the promoters are unable to make up the deficit, lenders may be able to recoup their money by selling the shares on the open stock market. This could lead to the promoters owning less of the company, the stock losing more value because there is more paper on the market, or even a sudden change in leadership at the company because of a change in how shares are held. In the wake of the Satyam fraud in 2009, India’s securities market regulator, Sebi, has made a number of rules and guidelines about how these loans should be disclosed.
Share pledges are a common way for businesses to raise money, but bad experiences in the past have given the instrument a bad name. This is because it shows bad cash flow patterns, a lack of credit in the business, and the failure of the promoters to cover short-term working capital needs. Promoters often make such pledges for personal needs as well.
Pledging of Shares: An Overview
When determining the best stocks to invest in, the pledge of shares is a crucial issue that most investors either disregard or are unaware of. It’s critical to recognize the considerable investment risk associated with highly pledged shares. The promoters of a company use their shares as collateral to get the money they need. This is called the pledge of shares. Companies with a significant proportion of shares owned by investors frequently pledge their shares. The borrower keeps ownership of the pledged shares and continues to earn interest and capital gains on them.
What Is the Pledging of Shares?
A simple definition of a stock pledge or “share pledge” is the use of shares as collateral to secure a loan. Shares are essentially a shareholder’s or a company’s assets. And pledging is a method by which the promoters of any company take a loan against the held shares to satisfy these personal or professional goals, such as meeting capital requirements, expanding their business, launching a new endeavour, etc.
What Is The Pledging Of Promoters’ Shares?
Many listed Indian companies often use promoter stock as collateral. A promoter is an individual or firm responsible for the incorporation of a company. Generally, most of a company’s shares are held by its promoters when it is still in its early stages. Promoters can also be a group of stockholders who control the majority of the company and run its operations.
A company requires money on a constant basis for both ordinary operations and expansion goals. It can do this by raising equity capital, issuing corporate bonds, applying for a business loan from a bank, etc. The business will need to give the bank some sort of security in exchange for a loan. As financial institutions and banks frequently request companies to submit promoters’ shares as collateral against the loan, this is where a promoter’s promise comes into play. In essence, this is a pledge of promoter shares.
When Do Companies Use Promoter Pledges?
Companies usually use promoter pledges as collateral for loans when no other sources of funding are available. Therefore, a promoter pledge could be a hint that the company is experiencing financial difficulties. Even though SEBI keeps an eye on promoter pledges of shares for companies that are listed, there are no rules for companies that are not listed. A board resolution authorizing the pledge of shares is sufficient for unlisted companies.
Impact Of Promoter Pledge On Stock Prices
As a significant percentage of a promoter’s wealth is often held in the form of shares, the pledging of shares can assist entrepreneurs in raising capital when necessary.
Lenders and promoters typically agree on a minimum contract value for the shares when pledging them in order to create a margin of safety against loans. However, if a sudden incident occurs that causes stock prices to drop significantly, the value of the collateral begins to decline. To preserve the loan-to-collateral value in such circumstances, the lender will urge the promoter to provide additional collateral. An example of this is a margin call. The promoter may choose to reimburse the difference or increase the number of shares pledged as payment.
If the promoter can’t pay the margin call, the bank can use the pledge to get the money back by selling the pledged shares on the stock market. Promoter pledges can cause significant stock price drops when several lenders
When Does a Promoter’s Pledging Become Risky?
In the event of a default, the pledgee, which is the issuer of funds (banks), has the right to recover payments.
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Bull market vs Bear market
In a bull market, investors may not see pledging shares as a cause for concern. However, there may be cause for concern if the promoters are heavily pledging shares during a bear market.
For pledging, promoters use their stake as collateral. Stock prices normally continue to fluctuate. Consequently, the value of the shares pledged as collateral changes as well.
For example, the loan is worth 35 crores of rupees. To raise money, the promoters will commit to buying bank shares worth at least Rs. 35 crore. During a bear market, the value of shares falls from Rs. 35 crores to Rs. 26 crores. In this case, the promoters are required to keep the value of the shares stable. As a result, more shares are pledged to cover
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Fundamentals of the company
According to Warren Buffett, if a company’s fundamentals are sound, external noise shouldn’t be a concern. Promoters pledging shares while maintaining a solid, steady cash position also do not cause concern. However, a company with bad fundamentals, a poor track record, and tight cash flow is a warning indicator of a potential financial threat.
Risk Involved:
The bank has the right to sell the shares in the open market to recover any unpaid debt if a promoter fails to pledge new shares to equal the loan value. This results in two things:
- Decreases in the promotor’s shareholdings
- Additional shares are being infused into the market.
In the end, these occurrences led to a decline in stock value and a modification of the shareholding structure. As a result, companies with good pledges may see abrupt changes in the value of their stock. Investors should therefore closely monitor the holdings of the promoter. Their administrative authority and voting rights are eventually impacted. This is due to the fact that they now have fewer shares required to make important decisions.
When information about an open-market sale becomes public, the stock price drops even further as investors begin to unload their shares. The fact that the company hasn’t paid back the loan or pledged more shares makes it more likely that it isn’t doing well financially.
The Satyam fraud and the current pledge situation: The pledge of shares by the promoter has been linked to many cases of fraud in the past. The Satyam Scam is one such scam. The promoters of Satyam Computer Services Limited gave the lenders a full share promise in 2009 as collateral for loans. Promoters, however, did not pay back the loan amount to the lenders by the due date. The entire Satyam scam gradually became public knowledge. The entire pledged stake was sold on the open market.
Demand and supply were out of balance. This caused the promoters’ ownership of the company to drastically decrease. In the end, promoters of Satyam held barely a few of the company’s shares. As a result, it is crucial that investors always consider the promoter’s actions when assessing a company’s performance.
Conclusion
Share pledging is especially common in companies where promoters hold a large proportion of the stock. It will be problematic for the promoters if the share pledge is greater than 50%, as a general rule. For this reason, you should never take a risk by investing in businesses that have significant share pledges. In short, pledging shares may be a red flag for low credibility, poor cash flow, an inability to satisfy obligations, and significant debt.
However, if you identify a corporation whose pledged shares are decreasing over time, this may be a positive indicator. However, an increase in the number of pledged shares may be extremely risky for both investors and promoters.
Shares being pledged aren’t always a bad thing for companies. Most of the time, pledging shares enables businesses to use the loan amount they have obtained to create outstanding goods, services, and new ventures. Pledges don’t disrupt a company’s financial situation if it is operating profitably and has a healthy cash flow.
Frequently Asked Questions (FAQs)
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What is Pledging of shares?
The term “pledge of shares” refers to the act of obtaining loans against the shares a person owns. Similar to real estate and gold, shares are regarded as assets, and investors can obtain loans by pledging shares as security. In a pledge, a person or a company’s promoters use their share of the company’s stock to get loans to cover a variety of needs. Due to the fact that pledged shares are recognized as collateral, failing to make the promised payment could result in the shares being forfeited, i.e., sold.
While anyone can pledge their holding, the practice is common in businesses when the promoters control a significant portion of the shares or a huge number of them. The benefit of pledging shares is that even if they are pledged shares, the borrower or promoter of the shares retains the ability to use the shares as an asset and can continue to earn interest and capital gains on them. A promoter pledge might be risky for the shareholders, even though it allows people to meet requirements by pledging shares. The price of the shares fluctuates quickly in a constantly shifting market. In the event of a shortfall or if they drop below a predetermined level, the company’s promoters are compelled to make up the value of the pledged shares, which results in a phenomenon known as a “margin call.”
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Is Pledging of Shares Risky for Shareholders?
Promoters of the company use their stock or shares as collateral at the time of the share pledge in order to get loans that meet their needs. During a bull market, there are no problems with pledging shares because the market is going up and investors are generally not worried.
The major issue occurs in a bear market when investors panic and the market is moving downward. Because stock values are always changing, so is the value of the collateral used to secure the loan. Promoters are frequently obligated to preserve the value of the collateral, nonetheless. Additionally, the value of the collateral starts to decline as stock prices continue to decline. Promoters must either pay cash or pledge additional shares to their lender in order to retain this value.
In the worst event, the lender starts selling pledged shares in the market to recover their money if a promoter is unable to make up the deficit. Thus, promoters lose their shares.
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Is Pledging of Shares Risky for Investors?
As you may already be aware, market news and speculation have a significant impact on stock prices. As a result, when investors learn that lenders (banks or other financial institutions) are publicly selling the promoters’ stock pledges, stock values may begin to decline. As a result of the public selling the shares in a panic, the value of the collateral may decline. Additionally, the sale of pledged shares by lenders can alter the shareholding structure of the company. This has an immediate effect on the candidates’ voting rights, as they are left with a small number of shares. It affects their authority in a nutshell.
Additionally, if the share price keeps falling sharply, it could wreak unending mayhem. This is due to the fact that promoters are required to pledge an increasing
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