This article is written by Prathamesh More pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution. This article has been edited by Zigishu (Associate, Lawsikho).

This article has been published by Sneha Mahawar.

Introduction

Pledging of shares is one of the most important factors to consider before investing in a company. A corporation having a large number of pledged shares is a source of anxiety for investors.

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According to a recent news report, the value of shares pledged by promoters in BSE 500 businesses fell to 1.95 percent in June 2020, down from 2.34 percent the previous quarter. According to the story, promoters pledged shares worth 1.3 trillion at the end of the June quarter, accounting for less than 1% of India’s overall market capitalization.

Let us try to grasp what pledging of shares is and how it affects investors in the company through this post.

What is pledging of shares 

The pledge of shares is one of the methods used by company promoters to get loans for working capital, personal needs, and to support other initiatives or acquisitions. To obtain a loan, a promoter’s interest in a company is utilized as collateral. Promoters keep their ownership when pledging shares. However, as the value of the stock fluctuates, so does the value of the collateral. A ‘margin call’ occurs when the value of shares pledged to a lender falls below a certain threshold, forcing the promoters to make up the shortfall in the collateral’s value.

The promoters are expected to preserve the value of the collateral at all times by delivering additional shares to lenders when the value of the collateral erodes. This can be problematic for businesses at times. If the promoters are unable to make up the shortfall, lenders may sell the shares on the open market to recoup their losses. This can result in the promoters’ shareholding in the firm being reduced, the stock’s value being eroded further due to the infusion of fresh paper into the market, and even a rapid change of guard in the company due to the change in shareholding pattern.

In the aftermath of the Satyam scam in 2009, India’s securities market regulator, Sebi, developed several rules and regulations on adequate disclosure of such borrowings. Fears of a margin call spurred selling in numerous midcap and small-cap stocks in the Indian market in February 2013.

How does pledging of shares work

The process of pledging shares is similar to that of pledging a property, except that instead of a house, shares of a publicly-traded firm are promised. Anyone who holds stock in a public corporation can use it to secure a loan. When the company’s promoters pledge their ownership, however, investors should be aware of this.

Assume that the promoters of XYZ Ltd own 60% of the company. If there are 1 crore shares outstanding, a 60% holding indicates the promoters own 60 lakhs of them. Each share has a market value of $500. As a result, the promoters’ stake is worth Rs. 300 crore (60,00,000 * 500).

Assume the promoters need to raise Rs.100 crore to enhance the company’s manufacturing capacity and are looking for a bank loan.

When lending based on a stock promise, RBI regulations require that a loan to value (LTV) ratio of 50% be maintained at all times. The entrepreneurs will have to commit at least 200 crores worth of shares with the bank, which translates to 40 lakh shares because the proposed loan amount is 100 crores. It’s also worth noting that any gap in maintaining the 50% LTV that occurs as a result of share price movement should be paid up within seven working days.

Assume that XYZ Ltd.’s stock price drops to 450 as a result of poor financial performance. Because the collateral is now only worth (40 * 450) 180 crores, the LTV has increased to 55 percent (100/180). The promoters will now be asked to pledge additional shares in order to maintain a 50 percent LTV. The value of the collateral might be increased to 200 crores by pledging an additional 4.44 lakh shares. If the price falls to 350, the promoters will be required to promise another 17.14 lakh shares. When the price falls to 333, 60 lakh shares must be pledged to ensure that the collateral value is around 200 crores, which is the promoter entity’s whole shareholding.

If the promoters are unable to raise the collateral by pledging new shares or paying cash to lower the loan liability at any stage, the financial institution will sell the shares in the open market, realizing the proceeds and reducing the loan liability.

Let’s say the share price of XYZ Ltd declines from 500 to 250 in a matter of days owing to unforeseen events. Even if the promoters guarantee their whole 60 lakh shareholding, the collateral will only be worth 150 crores, and the LTV will be 66.67 percent (100 / 150). Only by selling the shares, realizing the cash, and reducing the loan amount can the LTV be reduced to 50%. A total of 50 crores can be raised if 20 lakh shares are sold.

The loan outstanding will then be 50 crores (100 – 50), and the pledged value will be 100 crores (150 – 50), resulting in a 50 percent (50/100) LTV. However, dumping 20% of the company’s outstanding shares into the market will put downward pressure on the stock price, causing it to fall further.

How to pledge shares

  1. The promoter must use the trading terminal to submit a request for pledging shares.
  2. After receiving the request, the trading terminal sends it to NSDL/CDSL for confirmation.
  3. For PAN/BOID authentication, NSDL/CDSL uses email/mobile authentication.
  4. The promoters can trade the collateral margin once it has been granted.

Promoters can also submit a Margin Pledge Request Form to Angel One, which must be signed by all holders.

How to draft a share pledge agreement

When you make a share pledge or a stock pledge agreement, you’re pledging your stock as collateral for a loan. Although you can pledge your stocks informally, a formal pledge agreement is safer since it makes it easier to determine the facts if someone becomes confused or forgets the terms.

Terms

Your share pledge agreement should identify you as the pledgor as well as the pledgee with whom you’re working. It specifies the stocks you’re referring to and that you’re using them as collateral. A proper pledge agreement also spells out what happens if the stock is reclassified or changed, as well as the pledgee’s options if the pledge is declared void. Once you and the pledgee are both satisfied with the terms, both of you sign.

Requirements

You can’t put up shares that have already been pledged to another lender or that have any form of lien or encumbrance on them when you sign a pledge arrangement. They must not be in debt. Similarly, you cannot sign the agreement and then pledge your shares to someone else. Unless you actually default and have to give up the shares, signing the commitment has no effect on whatever voting rights the stock grants you.

Consequences

You’re done if you pay off your debt: The pledgee relinquishes all rights to the shares you promised, and the arrangement is nullified. If you don’t pay, the lender has the authority to sell your stock to recoup the money you owe. He has the option of selling it directly or holding an auction. If the note compels you to pay off any residual debt after the sale, demand that the pledgee auction them off to raise the most money. If they must be sold, they must be sold at full market value.

Considerations

Before you sign the contract, read it well. If you and the lender end up in court, it doesn’t matter what you thought the agreement meant; what matters is what the printed word states. Some share pledge agreements allow the pledgee to accelerate the loan, meaning you’ll have to pay the full amount straight away. This can happen if you miss even one payment, or if certain other conditions occur, such as filing for bankruptcy to eliminate your obligations.

Points to remember for the pledgee

  1. For pledging of shares, necessary board resolutions and corporate permissions have been secured.
  2. At the time of pledging, the pledged shares are completely paid up.
  3. On the pledged shares, there are no other charges or encumbrances.
  4. The company’s articles of incorporation allow for stock pledges.
  5. The underlying corporation is listed on the NSE, and the pledged shares are freely tradeable on the exchange.
  6. The lenders have the right to attend any meeting of the firm or any gathering of creditors, as well as exercise voting rights over the pledged shares.
  7. Except for the lender’s pledge, the borrower will not create any additional rights, pledges, encumbrances, or transfers of the pledged shares.
  8. The pledger of shares is not or will not become a party to any agreement that restricts the transfer of shares pledged. 
  9. The Pledgor shall cause the charge created on the Pledged Shares to be recorded in its register of charges upon the creation of the pledge of the Pledged Shares in favor of the Security Trustee. The Pledgor shall also ensure that the Underlying Company files the necessary documentation evidencing the charge with the appropriate Registrar of Companies, as required by the Companies Act, 1956.
  10. In the event that the pledger defaults, the lender has the option to sell or acquire the pledged shares for whatever price the lender deems appropriate.
  11. The security provided under the share pledge agreement will continue if the Pledgor is wound up (voluntary or otherwise), or if the Pledgor is merged, amalgamated, rebuilt, or otherwise restructured, or if the Pledgor is taken over, managed, or nationalized.

Points to remember for pledgor

  1. The share pledge agreement, pledges, and security interests will be cancelled once all secured obligations have been fully satisfied to the satisfaction of the lender.
  2. The lender shall return the pledged shares and deposits to the credit of the borrower’s designated account upon termination of the arrangement, and redeliver the power of attorney obtained in favor of the lender marked “cancelled.”
  3. Without the approval of both parties, no addition or modification to this agreement will be permitted.

Conclusion

Share pledging is a common approach for businesses to raise funds, but bad experiences in the past have left an unfavorable perception of the instrument since it indicates poor cash flow patterns, a company’s credit crisis, and promoters’ failure to satisfy short-term working capital requirements. Share pledges are frequently made by promoters for personal reasons as well. Increased share pledges are risky not only for promoters but also for shareholders. The bottom line is that investing in companies with 5-10% pledged shares is not an issue, but beyond that, the investor should use caution.

References

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