You might have come across the term pledging of shares if you are an intraday trader or a long-term investor. Shares can be pledged by individual investors as well as promotors of a company. But what is the meaning of pledging of shares? How does it work?
watch our video to learn about pledging of shares
Let us explore the following in this article:
- What is Pledging of Shares? Who can pledge shares?
- Why do investors pledge their shares? How can one pledge shares?
- Why do promotors pledge shares? Why is pledging shares risky?
- When does promoter pledging become risky?
- Solution to your problems.
And more followed with real examples.
What is Pledging of Shares? Who can pledge shares?
Pledging simply means taking loans against the shares that one holds. Shares are considered a type of asset. They act as a collateral against loans. Any individual or institution that holds shares can pledge them.
Individuals pledge their shares for two main reasons:
- To obtain a bank loan
- To fund their trading activities.
Promoters of a company can pledge shares to raise funds for various purposes. Companies can raise funds by applying for loans, issuing debt or fresh equity. By pledging shares, companies borrow
loans to meet their operational requirements.
It is used to meet different needs like funding other ventures, working capital requirements, paying debts, etc. If a significant portion of the shares held by promotors is pledged, it can adversely affect shareholder’s value. It usually is regarded as a risky investment.
Why? Let’s find out.
Why do investors pledge shares? How can one pledge shares?
Pledging of shares allows an investor to trade higher volumes.
Investor’s savings there are locked in their trading account in the form of shares when they buy them. Even though they hold an asset in the form of shares, their funds are locked and cannot be used for a new trade.
Hence, investors pledge their shares in their Demat account. This is also known as Margin Against Shares. With Samco’s StockPlus, you can make the best of this opportunity with many unique features. You can use your Samco account virtually as a Zero Balance Trading Account.
With StockPlus, traders can avail margin against their shares and never miss out on a trading opportunity. The best part is, you can sell the pledged shares without having to unpledge them first.
Related Read: How to subscribe to StockPlus?
How to pledge and unpledged holdings with Samco under StockPlus via CDSL.
Why do promotors pledge shares? Why is pledging shares risky?
Promoters pledge shares to meet various operational requirements. Generally, pledging of shares is considered as the last resort for the promoters to raise funds. Raising funds by issuing debt or equity is comparatively safer than pledging shares held by promoters. If they are planning to pledge shares, it means that all the other options to raise capital have been closed.
Companies consider this option when they are in immediate requirement of funds. If a company’s shares are not performing well in the market due to uncertainty or poor past performance, then pledging shares is the best available option for the promoters.
When does promoter pledging become risky?
Once shares are pledged, they act as aliens. The pledgee, that is the issuer of funds (banks), has the right to recover dues in case of a default.
- Bull market vs Bear market
Pledging of shares may not be a red flag for investors during a bull market. However, if the promoters are pledging shares heavily during a bear market, it is a sign of concern.
For pledging, promoters use their stake as a collateral. Prices of stocks keep fluctuating. As a result, the value of the shares pledged as a collateral also fluctuates.
For example, value of loan is Rs. 35 crores. Promoters will pledge their shares worth Rs. 35 crores or more with the bank to raise capital. During a bear market, the value of shares plunges from Rs. 35 crores to Rs. 26 crores. In such a case, the promoters are required to maintain the value of the shares. Hence, additional shares are pledged to meet the loan value.
Keep reading to know more about the risks involved …
2. Fundamentals of the company
As Warren Buffett says, you don’t have to worry about external noise if the fundamentals of the company are strong. Similarly, promotors pledging shares with a strong stable cash position is not a red flag. But a company with poor fundamentals, weak past performance, and cash flow crunch is a sign of a financial threat.
For example, one will put their home on lien only if they are in a financial crunch. Similarly, when a company pledges the promoter’s shares, it signals financial trouble in the company.
The risk involved:
If a promoter fails to pledge additional shares to match the loan value, the bank has the right to sell them in the open market to recover the balance. This leads to two events –
- Decreases in the promotor’s shareholdings
- Additional shares being infused into the market.
These events eventually result in a decrease in stock value and a change in the shareholding pattern.
Thus, companies with high pledging can experience sharp fluctuations in their stock price. Hence, investors must keep a close watch on promoter’s holdings. It eventually affects their voting rights and managerial power. This is because they now hold fewer shares to make crucial decisions.
When news of such open-market sale surfaces, the stock prices fall further as the investors start selling their shares. It suggests that the company is not in a good financial position as they failed to repay their loan value, or pledge more shares.
The Satyam Fraud and the current pledging situation:
There have been many fraudulent cases in the past linked to promoter’s pledging of shares. One such cash is the Satyam Scam.
In 2009, promoters of Satyam Computer Services Limited pledged their entire shares with the lenders as security for loans. But on due date, promotors failed to repay the loan amount to the lenders. Gradually, the entire Satyam Scam unfolded in public eyes. The entire pledged stake was sold in the open market.
The demand and supply was mismatched. This led to a massive decline in the shareholding of the promoters in the company. In the end, Satyam promoters owned just 3.6% of the shareholding of the company.
Hence, it is very important for the investors to always check the promoter’s actions while analysing a company.
For example, Future Consumer’s Kishore Biyani and family pledged 92.5% of their shareholding in June 2020. The value of pledged shares stood at Rs. 1,320 crore.
Shares of Future Consumer plunged over 50% within a month in June 2020. The Covid-19 lockdown has hit various manufacturers. Despite having the upper hand, few manufacturers were hit badly leading to losses and operation shut down.
In May 2021, pledging of shares by promoters rose to an all-time high of Rs. 3.35 lakh crore despite the stock markets trading close to their lifetime highs. You can check each company’s share pledging data on bseindia.com.
Click this link to check share pledging related information of any company.
Investor invests in a company because they trust their promoters. Management is the backbone of every company. As Warren Buffett says, quality of the management is equally important as much as a strong fundamental records.
Avoid companies with a large portion of pledged shares. This will help you avoid unnecessary troubles later. It could be a sign of poor cash flow or high-debt. Analyse the cash flow statement to understand the cash inflows and outflows. Analyse how much debt the company owes to outsider by checking their balance sheet.
If the records are poor in the financial statement along with heavy promotor pledging, it is a red flag. If the operating cash flow is increasing, that means that the company is able to manage its day-to-day expenses. This might not be as threatening as the previous case. However, thoroughly analyse before you invest in such companies.
5% to 10% of shares pledged can be efficiently managed. The problem occurs when the pledging increases too much. A decrease in pledged shares over time is a positive sign. Whereas an increase in pledged shares is dangerous for promoters and shareholders. Even quality companies can become a victim if the pledging of shares is not reduced over time.
You can check a company’s pledged holdings data on nseindia.com too. Click on this link to check pledging data of any company.
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Nice article about the pledging of shares. I didnt realise they were risky but your article explains it perfectly.