The promoter pledge: Regulators must join hands to check misuse

Tighter oversight and regulation, along with better disclosure norms, will help improve a method of raising funds that often leads to over-leverage and increases the risk of contagion across sectors

India’s financial and equity-market regulators are reportedly working in concert to review and tighten the framework for pledging shares. Tighter oversight and regulation of this common practice, along with better disclosure norms, would help improve a method of raising funds, which often leads to over-leverage and increases the risk of contagion across sectors because of linkages between financial entities.

The practice of promoters pledging equity as collateral to raise money has many downsides. It can cause steep losses in market value in the company concerned, which means loss of wealth for minority shareholders. If there is a default on the debt, the money is often unrecoverable by selling the pledged shares because the share price plummets. The loss to creditors can lead to broader contagion, which affects the entire market. This risk is heightened when the pledged shares are those of promoters in private banks and non-banking financial companies (NBFCs). NBFCs often have opaque holding structures, making it difficult to assess the cumulative exposure of the group. Banks are deposit-taking entities where a drop in the market value of the equity affects their ability to borrow or extend credit. This practice has certainly contributed to the issues plaguing the financial sector, including banks, debt mutual funds, and NBFCs.

There is also the question why promoters pledge shares. This is often to raise funds for personal purposes and it is usually a red flag about a company. A healthy listed business should not need to pledge shares to raise funds. A promoter who pledges shares is often looking to route the money back through a series of shell companies or use it to manipulate stock prices. Moreover, as the track record shows, there is little hesitation among promoters in defaulting to lenders. Disclosure norms are also often bypassed by using shell companies to avoid apprising investors about the existence of pledged positions.

The implications are wide-ranging enough to necessitate consultations between the Securities and Exchange Board of India (Sebi), Reserve Bank of India (RBI), Insurance Regulatory and Development Authority, and Pension Fund Regulatory and Development Authority to cover all the possible angles in terms of default and malpractice. There is a need to ensure that the debt exposure is adequately collateralised. This means that there should be a review that takes the outstanding debt of the group as well as individual promoters into consideration, rather than simply looking at single transactions. The RBI norm that the market value of shares should be at least twice the borrowed amount has often been flouted in practice and promoters routinely use complicated structures to understate the debt exposure. Moreover, the RBI norms apply only to banks and NBFCs and such deals often involve mutual funds as well. 

Sebi has reportedly proposed that the collateral should be raised to four times the exposure and this is worth serious consideration. It is also necessary to examine the end uses of borrowed funds. Mutual funds should also have ceilings on their exposures to such transactions. In general terms, the pledging of company stock as collateral for a loan is not considered a responsible use of equity. Since this is common practice, it behoves regulators to tighten the framework governing such transactions.