Pledging shares by promoters increases risks

If they pledge more than 50% of holdings, that's a red flag

Quite a few brokerages maintain a database of pledged promoter holdings, which they update and make available to  clients at frequent intervals. The purpose is to alert investors of the possible dangers and help them in their investments. Many investors choose to ignore the data rendering themselves to high risk, especially when the markets correct.

According to a recent report from Prime Database, the value of pledged shares by promoters in National Stock Exchange (NSE)-listed companies rose to Rs 1.94 lakh crore in 2014-15, up 27 per cent from Rs 1.52 lakh crore a year ago.

Promoters pledge shares to raise capital for the company, financing projects of group companies, inorganic growth or even for personal reasons such as buying a property. Shares are generally pledged with non-banking financial companies, which extend loans up to 50 per cent of the value of shares pledged.

According to investment analyst Arun Kejriwal, pledging can be viewed as positive if the shares are pledged as a collateral to enhance the borrowing limit for short-term requirements or one-time needs. However, investors should be worried if the number of pledged shares rises significantly.

“Pledging can become an issue if more than 50 per cent of promoter holding is pledged or when more than 20 per cent of the company's equity capital is pledged,” says Jimeet Modi, CEO, Samco Ventures.

In situations where the proportion of promoter holding pledged is high, a correction in stock prices can trigger margin calls which could lead to more pledging. If the share prices fall below a threshold limit and the promoter doesn’t have additional shares to offer as margin or funds to repay the loan taken, the lender might invoke the shares, leading to a further fall in stock price. There have been cases in the past wherein lenders have invoked the shares and sold them in the market as promoters were unable to pay up on time.

Promoters also risk losing management control if a significant portion of their holding is pledged. “Lenders are price-agnostic and will dump the shares at any available price as they are only interested in recovering their money,” said Modi of Samco Ventures. For the investor, it means significant losses.

Since these corrections can be sudden, investors might not have enough time to make an exit, say experts. The best way out is to avoid companies where if the promoter pledging has risen to unusually high levels.

According to investment analyst Anand Tandon, one should avoid companies where the promoter has pledged 80-90 per cent of his holding: “Another 10 per cent crash in the company's stock price could mean there are no more shares to put up, which could lead lenders to invoke the shares.”

Tandon suggests a high-risk strategy: “If you are confident about the long-term potential of a company, you can wait for the steep correction and then buy into the stock.”

According to the Prime Database report, promoters in 25 NSE-listed companies had pledged their complete holding as on March 31, 2015. There were 200 companies in which 50 per cent of the promoter’s shareholding was pledged and 77 companies in which more than 90 per cent of the promoter's shareholding was pledged.

Pledge monitors could prove particularly useful now, what with the market going through an uncertain phase and the number of pledges edging higher. Investors into infrastructure and real estate stocks also need to keep an eye on pledging as the need to pledge shares in these capital-intensive businesses is typically higher.

In February 2009, the Securities and Exchange Board of India (Sebi) tightened pledging norms, making it compulsory for firms to give the details of pledged shares every quarter. However, while promoters are required to give a reason for pledging their shares, more often than not, the reason assigned is 'general corporate purposes'. “The reason given by promoters are often vague and not enough to assess the end use of the pledged money,” said Modi. Another reason for investors to be careful.