Promoters' Pledged Shares: The Pros And Cons Of Investing In Such Stocks

Dalal Street, the financial hub of Mumbai, is the ideal indicator to gauge investor sentiments. Till a few weeks ago, Dalal Street was agog with the hustle and bustle of investors strutting from one place to another, commending the milestone level of 10,000 on Nifty. Today, the investors dread to take a glimpse at the stock prices as the broader markets have felt the squeeze as though there is some kind of a surgical strike by the bears. The Mid-cap and Small-cap indices had witnessed a steep crash in a short span of time and investors shudder as there is no stopping this bloodbath on the streets. It is clear that the savage selling of the past few weeks has taken a heavy toll on investors’ confidence and the feeling of covetousness has given way to the feeling of dread. 

The dreadful turmoil in the markets, particularly in the boarder markets, suggests that going ahead the stock picking will have to be selective and investors need to keep their eyes and ears open and stay alert while picking stocks for investment purpose. The turmoil in the markets prompted us to explore and evaluate the risks associated with the stocks where the proportion of shares pledged by the promoters is high. 

The concept of pledging of shares by promoters is not new to India. However, thanks to Ramalinga Raju of Satyam Computers; it caught the attention of the investors. Before the Satyam disaster happened, there were no disclosure standards laid down by the Securities and Exchange Board of India (SEBI) for promoters to reveal the proportion of their pledged shares. Be that as it may, post the Satyam fiasco, disclosure regarding pledging of shares by promoters of the company was made mandatory by SEBI. Promoters, in order to raise funds either for personal or company's needs, pledge part of their shareholding with the lender. Nonbanking financial institutions are more active than banks in providing such loans. 

WHAT IS PLEDGING OF SHARES? 

Pledging of shares implies the proprietors/promoters of the company pledge their shareholding in the listed company as collateral for obtaining loan. This liability of a loan is taken either for personal use or for funding the company’s business—be it for expanding the business or for everyday activities, i.e. meeting working capital needs. The shares are pledged with banks or non-banking finance institutions who offer the loan to promoters. NBFCs have been major lenders for these sort of debts.

WHY DO PROMOTERS GO FOR PLEDGING OF SHARES?

More often than not, the promoters go for pledging part of their shares only after exploring alternate sources for raising funds. Share pledging is the last resort–akin to a person mortgaging his house or personal assets for money. 

1. Low credit-value of the organisation: Every now and then, businesses require funds for expansion and to meet their working capital requirements. The most preferred way for an organisation to fulfil this requirement is to go for debt. But all the companies do not have enough creditworthiness to secure required debt for their needs. Consequently, they resort to pledging of shares to secure funds. 

2. Loaded with high debt: The companies that already have high debt on their balance sheet do not get further debt easily. Therefore, the company’s promoter go for pledging of shares to get further debt. A high debt on the balance sheet will result in high interest expenses for the company as a major part of the profit will be utilised for paying the lenders, leaving very little on the table for the shareholders. This will be a doubleedged sword for the investors. First, it may eradicate the option of receiving dividends completely. Second, because of low earnings per share, the stock price appreciation would be also less.

CAN LENDERS SELL THE PLEDGED SHARES OF PROMOTERS? 

Yes, the lenders can sell the pledged shares. When the price of pledged shares come down to a certain level in the secondary market; there is a shortfall in the margin amount that these lenders retain as security. In this case, the promoter is required to either make some payment or pledge some more shares as collateral. However, if the promoters are not able to top-up the collateral, the lenders can sell the shares to maintain this margin. An example stands out where a bank sold the pledged shares.In the year 2013, the country’s largest lender State Bank of India sold shares of United Spirits and Mangalore Chemicals and Fertilisers that were pledged with SBI by Vijay Mallya against money lent to Kingfisher Airlines. The bank took this action after the airline failed to repay its debt. 

RISK OF INVESTING IN STOCKS WHERE PROMOTERS PLEDGED SHARES ARE HIGH:

1. Valuation Trap: It is often seen that retail investors select stocks for investment where they see price has eroded a lot in quick time and they view this as a perfect value buy. For example, let us say if a stock was trading last year at Rs 500 and presently it has been quoting at the level of Rs 150, they term it as a good value buy. However, they fail to understand this is a valuation trap when it comes to these companies. A number of such companies are trading at lower valuation as a result of a decline in their share prices, but these companies may not be adding much value to their equity shareholders. 

2. Panic selling occurs when institution starts offloading: Under pledging, the bank or financial institution gives loan taking the promoter shares as collateral. In a bull phase, pledging does not create any issue because promoters can count on the rising value of their shares. Institutions too do not mind lending against shares as collateral because of the rising value of shares. The issue crops up when the market enters into a bear phase. At any point of time, if 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 fails to do either, the lender can exercise the right to sell the pledged shares in the market. The sudden supply of shares in the market by the lender can trigger further fall in the price of the share, which is a hazard for retail investors and traders alike, who may have to sell their shares for a significant loss as there is panic selling in the stock. There have been cases in the past where banks have solicited offers for shares and sold them in the market as promoters were unable to pay up on time.

3. Management may lose control: Promoters pledge their holding as collateral with banks and financial institutions to raise funds. But when the stock price heads southwards, the value of the pledged shares also plummets. In this situation, the bank or the financial institution asks for repayment of loan, margin money or other assets as collateral. If the promoter fails to provide any of these three options, the shares pledged by the unscrupulous promoters could go down in value and the promoters may not mind losing control of the company as there is a possibility that the promoters have already siphoned off funds before the share price collapses. Great Offshore, a company once owned by Vijay Sheth and his associates, saw a management restructuring, resulting in his eventually losing control after he failed to redeem the pledge. 

4. Relatively higher volatile stocks: Investors who invest in stocks where the promoters' pledging is high need to be a bit cautious as these stocks are highly volatile. In case there is correction in the stock market, the prices of such stocks tend to witness a steep fall, resulting in erosion of wealth of the investor at a faster pace.

WHICH STOCKS TO AVOID? 

Check intention or purpose of raising funds: Remember that a promoter pledging his shares with an institution is not always unscrupulous.  Promoters of some fundamentally sound companies pledge shares to raise funds for day-to-day needs and are generally able to pay off their debts and release their pledges shares. Hence, if a promoter of a fundamentally sound company raises funds for the betterment of the business, investors should take it positively. But if the fund is raised for any personal needs, there comes a red flag. Hence, it’s important to know the intention or the purpose for which the funds are raised.  

The line of 50 per cent suggests caution: Stocks where the promoters' pledged shares are more than 50 per cent are viewed as risky investment bet.   

Past track record: If a promoter has been heedless in the past when it  came to raising assets for careless development, there is no motivation to trust that he will not be foolhardy this time around. Just avoid such stocks. 

Warren Buffet, the legendary investor, has said “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. “Since markets have entered into a correction phase as of now, it is important as an investor to be cautious with stocks where promoters have pledged their shareholding. Investors who have a low appetite for risk should certainly stay away from such stocks. 

Dyaneshwar Padwal, AVP – Technical Analysis, KIFS Trade Capital

❝Although promoters may have pledged their shares to raise funds which is in the long-term interest of the company, it increases risk for other investors, especially retail investors. Retail investors may lose value if promoters end up pledging a significant portion of their holdings. 

While extending funds against pledged shares, lenders agree with promoters on threshold levels for liquidation in case of fall in the stock price. The general concern that the lender may sell shares at some point may prevent new investors from buying the stock in the secondary market, keeping the stock price low due to lower demand. 

The situation may get further complicated if the sentiment turns bearish due to some unexpected reason (which may or may not have any impact on the fundamentals of the company) and the value of its stock may fall purely due to the negative market sentiment. If the stock price falls below a threshold limit and the promoter does not have additional shares to offer as margin or any other collateral, then the lender might be forced to liquidate the pledged shares – often even without any notice to the borrower. In the market parlance, this is known as triggering of the margin call. This sudden and large supply of shares pulls down the stock price further. 

Often, unscrupulous promoters tend to pledge shares of their companies to profit from unrealistically high levels of the stock prices. In certain circumstances, promoters are unambiguous and find it difficult to assess the profitable application of the funds raised by pledging shares. It is important for investors– especially the long-term retail investors–to keep track of the promoters’ activities with their holdings. The SEBI rules mandate promoters to keep investors updated on shares pledged by them. Pledging of shares must raise red flag in two scenarios: Investors should consider exiting the stock if more than 50% of promoter holding is pledged or more than 20% of the company's equity capital is pledged.❞ 

Vaibhav Agrawal, Head of Research & ARQ, Angel Broking Pvt Ltd. 

Why do prompters pledge their shares?
Promoters pledge their shares as a collateral when they are having tight liquidity conditions and want to quickly raise funds. 

What are the risks associated with investing in highpledged companies?
The companies where there is a high proportion of pledged shares, the risk is higher than other companies. In case promoters are not able to repay the loan, lenders may choose to sell the shares partially/fully in the market in order to recover their dues. This can lead to a drop in the share price of that particular company. It may also reduce the confidence of investors/lenders in the management. 

Is high-pledging by promoters a warning sign?
Yes, it is a warning sign and the same should be scrutinised carefully. It should also be seen whether the promoters have been constantly pledging their shares and have gradually increased their pledged shares. 

What should investors do with such stocks?
It is best to avoid the companies if a high proportion of promoter's shares are pledged, especially those companies which are not well-managed. If any large cap, well-known name happens to be in the list of such companies, one need to look at percent of pledged share to the total outstanding shares. If this number is minuscule, one can still go ahead and invest based on the fundamentals. In the case of high debt, stretched working capital, poorly governed companies, it is best to fully avoid such shares. 

What is the difference between pledging of shares by general shareholders and promoters?
One should look at the proportion of total pledged shares to the total outstanding shares. Nevertheless, promoters pledging their shares is always a concern as any sell-off by lenders can reduce promoter's stake in the company and, in some cases, it may lead to loss of control for the management. In the case of general shareholders, the shares change hands, but in most cases, the shareholding pattern remains the same.