This blog post written by Saanvi Singla, a student of University Institute of Legal Studies, Panjab University, explains the concept of pledging of shares.

Introduction

Pledging of shares is just a refined form of the familiar term of “girvi rakhna”. Banks and many Financial Institutions in the market provide loans against the shares, and they call them “collateral.” Pledging of shares to obtain a loan is not a new concept in the market. In short, when a promoter wants to raise funds for the development and well-being of his company or personal needs, he pledges his shares with a financial or a non-financial institution better known as NBFC’s.

Legal Understanding of Pledging of Shares

Before understanding the concept of pledging of shares we have to understand it legally. It is mainly covered under three laws, i.e., the Indian Contract Act, 1872, the Banking Regulation Act, 1949 and External Commercial Borrowing Guidelines.

Indian Contracts Act, 1872

Section 172 of the Indian Contract Act, 1872 gives us the definition of a Pledge. It states that the bailment of goods as security for payment of a debt or performance of a promise is called ‘pledge.’ The bailor is in this case called the ‘pawnor.’ The bailee is called ‘pawnee.’[1]”

According to this definition, a pledge creates only the right of possession while the pawnor has the title of the property.

The Companies Act, 2012 does not place any restriction on amount or manner of pledging of shares. The Act has not prescribed any minimum percentage of share to be held by the directors. But the Article of Association of a company can prescribe the qualification shares of a director. It is a very nominal figure which is immaterial to the movement of the share price.

Regulation 36 of the SEBI Regulations, 2009 provides that when a company is making a public issue, the promoters or directors should be holding at least 20% of the shares with a lock in period of minimum three years. After the lock-in period of 3 years, the promoters or directors are free to sell their shares. So if the holding of promoters is below 20% after the lock-in period, it will not violate the norms of SEBI.

Banking Regulations Act, 1949

Section 19(2) of the Banking Regulations Act, 1949 provides that no banking company should hold the shares of any other company whether in the form of pledge, mortgagee or absolute ownership that is more than 30% of the paid up capital of the respective company or 30% of the company’s paid-up capital and reserves, whichever happens, to be less. The shares of a company are taken by a bank or any other financial institution as security in the following cases:

• Overdraft facility against recorded and affirmed shares of any open restricted organization.
• Overdraft of shares of a listed company against recorded and affirmed shares of any open restricted organization.

Nowadays most of the shares are held in the form of Demat. There are two main depositories in India – NSDL and CDSL and both have equally competent software’s to create a pledge and its invocation that are listed in the statement as two columns named “Free” and “Pledged.”

For many years now, lending against shares was a common practice amongst promoters. As prices were rising, there was no or rather a little risk. NBFC’s and banks were comfortable in lending such type of loans. These types of loans were lent for one to three years and carried a margin of two to three times, which means that the value of shares pledged was 2-3 times the amount of the loan. For banks and NBFC’s, it is a low-risk business as they can charge a mark –up of 3-4 % over the Prime Lending Rate (Prime Lending is the interest rate at which banks lend to favored customers—i.e., those with good credit—but this is not always the case). Hence, the lender has to ensure that his market risk is covered as the shares being pledged should be liquid enough to ensure the timely recovery from the borrower.

Before the Satyam debacle, there were no disclosure norms made by SEBI (Securities Exchange Board of India) for the promoters to disclose their pledged shares. In developed countries like USA, directors as well as promoters are required to disclose their pledged shares. There the pledging of shares by promoters, or insiders, as collateral for a loan is equivalent to a sale of the stock to the pledge. In the UK this is covered under Insider Trading Regulations.

As banks or NBFC’s give loan taking the shares as collateral, the promoters are required to make some payment or pledge some more shares whenever the price of the share comes down to a certain level in the secondary market. (A secondary market is a market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The national exchanges – such as the NSE and BSE are secondary markets in India.)

The lender of the loan keeps the right to sell pledged shares in the market. As a result of this, promoters always have the risk of hostile takeover. Hence, certain disclosures were necessary regarding the pledging of shares by promoters as pledging of shares could result in a change of ownership if the promoter is unable to redeem those shares by repaying the shares. This is critical, as many investors consider promoter holding and management structure of the company as a critical aspect of their investment decision. When promoters of big companies raise money by pledging their shares, they pledge away their voting right, and hence it becomes a risk factor. This reduction in shareholding deteriorates the company’s valuation. Beside this, in the event of promoters not being able to repay the loan on time, the lenders dump the shares in the market in huge quantities to recover their dues which have a cascading effect on the price of shares.

Pledging of Shares by General Shareholders

Whenever an investor or a shareholder needs a loan from a bank or financial institution, he/she can pledge the shares to the lender for availing the loan. Unlike a promoter, a small investor is not required to disclose that he has pledged his shares. For taking a loan against shares, the investors have to collateralize the shares (in DEMAT FORM) to the bank.

Guidelines for Pledging of Shares under the Banking Regulation Act, 1949

Under Section 19 (2) of the Banking Regulation Act 1949, it is provided that no banking company shall hold shares in any company whether as pledge, mortgage, or absolute ownership of an amount exceeding 30% of the paid up capital of that company or 30 % of its own paid-up capital and reserves, whichever is less . The shares of any company are taken as security by the banks and financial institutions in following cases:

1. Overdraft facility against listed and approved shares of any public limited company.
2. Pledge of shares of listed companies as an additional or collateral security for a loan or overdraft given against other prime security.

Availment of Loans by NRIs through Pledging of Shares

NRIs can take a loan by pledging shares, though they have to take the permission of the RBI. The application has to be made through the same bank in which the NRO/NRI account is opened[2] or being held.

Conclusion

Consequences relating to the pledging of shares may appear to be routine paperwork, but it is beyond filling of forms since a better understanding of practical fundamentals helps the person to avoid risks, ensures better compliance and makes the task easier. A promoter is a person who is in ultimate control of the company and formulates its operating plans, and he is the first to be aware of its good or bad future. The SEBI guidelines prescribe restrictions on the increase in promoters holding after a certain limit but contain no prescription of minimum promoters holding. This leaves the promoter with the scope to sell or pledge even 100% of his shares with an ordinary disclosure. Such companies are always at risk of a sudden crash which leaves the investors awed3.

Footnotes:

[1]‘ https://indiankanoon.org/doc/722832/

[2] http://www.caclubindia.com/articles/pledging-of-shares-2246.aspca

3 http://taxguru.in/company-law/pledging-shares.html