All you wanted to know about promoter pledging

In recent weeks, stock market investors have been hit by sharp swings in prices after news of high promoter pledging, sale of pledged shares by lending institutions and agreements between the lenders and promoters to go slow on such sales have hogged the headlines. Shares of the Essel/Zee group, Reliance ADAG group and Apollo Hospitals have dipped 15-30 per cent on such incidents.

Ever approached a bank for a temporary loan because your household budget was tight? The bank is likely to have asked you to provide some collateral on the basis of which it gave you the loan. Banks usually accept assets such as property, gold jewellery, shares or investments held by you as collateral. Company promoters are no different. In India, many large companies still have a chunk of their shareholding controlled by their original founders or promoters.

The promoters, when in need of money, pledge their equity shares in the company with banks, NBFCs or others to get loans against them. Promoters may then use this money to fund new ventures, add to their capital in existing ventures, carry out acquisitions or even meet personal requirements. Pledging of shares is common in those companies where the promoter holding is high.

Given that a large proportion of a promoter’s wealth is likely to be held in the form of shares, share pledging agreements help entrepreneurs raise quick money when they need it. But there are risks to investors when promoters pledge a very large proportion of their holdings with lenders, especially in volatile markets.

At the time of pledging shares, lenders and promoters usually agree on a minimum contract value for the shares, so that the lenders can build a margin of safety into their loans. But if a sudden adverse event or bear attack on a stock prompts it to fall sharply, the value of this collateral shrinks. The lender in such cases will ask the promoter to bring in more collateral to maintain the loan-to-collateral value. This is known as a margin call. This shortfall is either covered by the promoter paying up the difference or pledging additional shares. If the promoter fails to meet the margin call, the lender usually ‘invokes’ the pledge, sells the pledged shares in the market and realises his money. If multiple lenders invoke promoter pledges at the same time, it can trigger big stock price falls.

Theoretically, promoters pledging their personal holdings with lenders should not affect the operations of a company which has good cash flows or sound fundamentals. But companies with a high proportion of promoter pledging are viewed as risky by the market because it raises questions about promoters being cash-strapped in their personal capacity or facing debt problems in other group ventures. In a bull market, promoter pledging may not create too many issues as higher stock prices boost the value of the collateral against the loans advanced by lenders. But in bear markets, steep stock price declines can trigger margin calls that set off a downward spiral in a stock.

Investors therefore need to keep a close eye on promoter pledging, as companies with high pledging can witness high volatility in their stock prices.

As an investor, you can find the information on pledged shares on the websites of the stock exchanges. SEBI has mandated that publicly listed companies need disclose information on their pledged shares along with the shareholding pattern every quarter to NSE and BSE.

Count high or rising promoter pledges as an extra risk factor when choosing stocks for your portfolio.

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