Pledging shares & the mirage of prosperity

Pledging shares has become an easy option to raise funds, even for many well-known business families. Unfortunately, they do not seem to visualise scenarios where the optimistic assumptions about future performance may not always materialise. As of May 2019, 62 per cent of all listed companies in India had pledged at least some (in a few cases all) of their promoters holding. As many as 193 companies’ promoters had pledged 75 per cent or more of their shares and 327 companies’ promoters had pledged at least 50 per cent of their stake. The scenario of lenders liquidating the pledged shares of defaulted borrower is very scary.
 
Pledging of shares where promoters use their shares as collateral to raise money is not a new phenomenon but has become popular amongst promoters in recent years. It was after the scam involving Satyam Computers in 2009 that the Securities and Exchange Board of India (Sebi) made it mandatory for promoters to disclose to the stock exchanges of any pledging of shares. It is often understood as pawning the “family jewel” as a last resort to tide over difficult times. Stock market sees it as a sign of weak financial position of the promoter. Promoters often pledge shares for personal use like investment in another venture or buying more shares of the company. Pledging shares in a “cash cow” company to fund a risky untested startup or a fledging business may spook the investors.
 
Similarly, when the promoters pledge their shares to buy more shares of their own company, it signifies that the promoters think the share is undervalued and/or have confidence in the prospects of the company. It therefore should send a positive signal to the market. However, promoters are not only putting more of their eggs in the same basket but also taking on leverage to do so. Adding to this, the increase in control in the company is based on information asymmetry that exists between the promoters and the minority shareholders. This gives rise to insider trading and governance concerns. In a recent amendment to insider trading regulations, to promote fair market conduct, the Sebi has plugged this gap by closing the trading and pledging of shares window for the promoters starting from the end of a quarter to 48 hours after the declaration of quarterly results by the company.
 
Trouble begins when the value of the pledged shares falls below the agreed level with the lenders. Many promoters get into the trap of pledging more shares to fill the drop in value in the hope that they will soon be able to revoke the shares by repaying the amount to the lenders.
 

When stock prices fall or go in a downward spiral and the promoters are no longer able to either pay the money or pledge more shares, the lenders invoke the shares, and sell them in the open market. The promoters may even end up losing control, as has happened with a few companies recently. The implications for business families are grave, particularly with a lot of their family wealth blocked up in the business. Family splits, loss of reputation and bleak career possibilities for the next generation do happen in such cases, resulting in formation of entirely new trajectories of life for everyone.
 
In a rapidly growing economy, entrepreneurial promoters naturally tend to assume that the rising graph of growth and prosperity will never fall. This is a myth. Pledging beyond small quantities is very dangerous, like over leveraging. Shares are virtual collaterals with very high potential for volatility, due to known as well as many unknowns, including news or events that are totally not related to the company, its performance or management. There is a huge possibility of share prices falling anytime.
 
Most bankers and lenders fail to learn from history that in a crisis, most assets become illiquid. Most of the risk models do not account for illiquidity. They assume that markets are perfectly liquid. However, that is not the case. Lenders often invoke the pledge and dump shares in the market at very low prices, translating the already downward spiral into a shock. Financial Institutions need to have built-in mechanisms and standards to ensure that investments are made in assets that can be liquidated at the lowest possible cost.
 
The Sebi must also put in place a limitation to the percentage of shares that can be pledged, including the cumulative pledged shares after margin calls. Having pledged most of the shares and yet maintaining the voting rights may seem like a good situation to the promoters when in reality their fate is hanging by a day’s movement on the stock exchange. Or, pledging should also suspend voting rights till the pledge is not revoked. If the promoters need to raise more money, they should take a conscious decision to sell their stake in a phased manner or through a strategic sale.
 
The board of directors must also assert and prevent promoters from taking this treacherous road to the mirage of prosperity. As the custodian of the wealth of all stake holders, the board has a vantage view of the things to happen. It has to exercise its rights instead of being a rubber stamp.

Bang is associate director and Ramachandran professor and executive director at the Thomas Schmidheiny Centre for Family Enterprise at the Indian School of Business