This article has been written by Seerat Kaur, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
What is promoter pledging?
Promoters of a company are the majority shareholders who manage the day-to-day affairs and hold the power to decide upon the rules and regulations which will be abided by the company. When we need money, we go to the bank and take hold of some loan in exchange for some collateral that we let the bank hold. In case we fail to pay back the loan amount along with the added interest, the bank sells off our collateral in the hopes of earning back the loan amount. Further, if the value of the collateral decreases, then the bank calls upon us to give it more collateral to make up for the losses. Similarly, when the company promoters need some money, they often tend to pledge all or a part of their shares with lenders. It is important to note that this only happens with listed companies. This means that the shares held by the promoters are pledged as collateral to the bank in exchange for the loan amount. This is however just one of the many sources of borrowing money in a volatile market with tough liquidity conditions.
In other words, pledging of shares by promoters is a process of mortgaging some part of or the entire share held by them in order to exchange it for the money which is required for more capital investments, daily company functions, or even personal use. This is not a rare phenomenon, it has been seen that most of the listed companies have a significant number of promoters who pledge their shares in order to meet personal or professional requirements. Most of the promoters strike a deal where, despite putting the shares in the name of the lender in the paper, the promoter continues to retain the ownership.
This gives the promoter the authority to still be a significant shareholder with powers to make important company decisions and the positive reinforcement to pay back the amount to the lender. Retaining the ownership does not only motivate the promoter to repay back the loan but it also keeps the prices of the company’s shares in the stock market stable in order to avoid sudden panic among investors and retail traders, which can cause a huge downfall in the share prices of the company. When a promoter wishes to pledge his or her shares, the bank will usually pledge the same shares at a price that is below the market price of those shares. This means that in case the share is turning out to be Rs. 20 in the market, the bank will extend a loan of Rs.10 per share. The margin between the market price and the loan amount is generally kept as the security
As a result, when the market price of the share falls down due to any reason, the bank will make a call for additional security to keep up with the value of the collateral. Thus, the promoters will have to pay more cash or shares to fulfill the ‘margin call’. In case the promoter fails to complete the margin call by paying the additional cash or transferring shares, the bank will be forced to sell the pledged shares in the market to make up for their loss.
Why is it important to know about promoter pledging of a company?
Those who invest in the share market are often solely focused on looking up the balance sheets and profit and loss (P&L) account to decide the financials of the company. But while doing the data crunching, they often forget to look at one of the most important aspects which can give them a huge shock by destroying their wealth despite getting all the basics covered. This important aspect is the extent of promoter pledging that the company is involved in. It is a fact that 1 out of every 10 stocks listed on the Bombay stock exchange is a victim of more than 50% promoter pledging. This shows the high number of indebtedness and thus, poses a huge risk to the market value of the shares. In case the promoters are not able to pay back the loan amount, then the pledge will be invoked and the shares will be ruthlessly sold off at lower prices by the bank. As a result, a domino effect will take place and the value of all the shares will roll downwards. This is the actual risk involved with investing in companies with high promoter pledging.
In the share market, demand and supply are two factors that will always decide the value of the company’s shares. When a huge number of shares are sold, the supply increases and the demand decreases as there aren’t enough people ready to risk buying the shares. As a result, the value of the shares will fall and all of this will snowball into a chain reaction where other pledges may also be invoked and the shares will face a steep downward spiral, leaving the investors disappointed. Suzlon and Kingfisher Airlines faced a similar situation where a continuous supply of shares in the market, by the lenders resulted in huge destruction of the share prices. Hence, it becomes necessary to properly analyze and go through the promoter pledging of a company before investing in it for a profitable and intelligent investment. Shares of companies with high promoter pledging tend to be more volatile and susceptible to rumors as well. In its latest Financial Stability Report, the Reserve Bank of India recently flagged concern regarding share pledges. According to RBI, “Pledging of shares by promoters could pose a concern in both, falling or rising market scenarios, when large-scale pledging of promoter equity could pose concerns for retail investors’ wealth,”. As prices of the shares fall, the overall value of the pledged collateral also falls. The prices fall either because of non-repayment of loans by the promoters or the fear of it. Knowing that the promoters of a company are facing financial losses alerts the buyers and hence, the trust in them falls tremendously. The stock market is especially susceptible to rumors and the fear caused by them. While in a bear market, promoter pledging can be a smart way to expand and improve business, in a bull market, it would collectively result in huge destruction of share prices in case the company loses trust among the investors.
In India, out of 5000 listed companies in totality, around 4274 companies had promoter pledging as per SEBIs records. Out of these, the promoters of 286 companies had pledged more than 50% of their shares which is highly alarming. Further, around 90% of these companies are a part of the small-cap category. All these factors make the circumstances even worse. Hence, it is extremely important to do a fair background check before investing in shares of listed companies. Investors should check the annual reports, P&L records, balance sheets, and promoter pledging wisely.
An analysis on Zee entertainment and Dish TV’s case
Financial crises caused by promoter pledging are common in the share market and there is a reason for the same. Except for the occasional need for liquidation to pay back a lender or expand the business geographically and qualitatively, promoters often use it to hide behind a curtain. Many promoters already sense a bad situation before it exists. When promoters realize that their shares will be performing badly in the market due to whatever reason, they know that it is important to sell off their shares at the right time while the market price is still suitable. But suddenly selling off their shares would mean risking invoking provisions for insider trading violations. Hence, in order to avoid being personally liable for any offense, they go and pledge their shares instead. When eventually the shares start losing their value, the responsibility to recover loans lands upon the lender. On 29 January 2019, the shares of Zee Group faced tremendous downfall and wiped away around Rs. 13,000 Cr of market capitalization.
The shares of Zee Entertainment Ltd. tanked down 26% and Dish TV’s shares fell down by 33% after a report that the Serious Fraud Investigation Office was investigating Nityank Infrapower for deposits amassing to be Rs. 3000 Cr in value right after the demonetization proclamation. Further reports mentioned that Nityank, along with some other companies that carried out some transactions with companies of the Essel Group.
A major promoter and founder of the Essel Group had pledged some shares of his in the Zee entertainment and Dish Tv Group to expand his business. Thus, just like a chain reaction, these two companies faced huge hits and their shares fell tremendously.
Present scenario and conclusion
In wake of the turmoil caused by the IL&FS and Zee and Dish Tv crises, SEBI issued new norms to ensure transparency regarding promoter pledging in a board meeting which took place on 27th June 2019. SEBI further went on to take measures to tighten disclosure norms by stating that all direct or indirect lien on shares will be referred to as encumbered shares. It decided to include pledged shares under the definition of encumbered shares, promising the investors more clarity If the combined hindrance is over 20%, then the promoters also need to give reasons for the encumbrances. The audit panels will also need to be kept abreast with the promoter pledging. As of date, promoter pledging has reduced. The difference is not much, but investors are more aware than in the past. As long as the promoted pledging is reasonable in amount and principle, it should not be looked at negatively. Many companies have used pledging wisely in order to expand their businesses as well. Problems occur when there is no transparency and the investors are unaware of the same. It should be an ethical responsibility to keep the investors aware of the promoter pledging that a company has in its name. When the shares pledged to exceed the 50% mark, the company tends to fall in the high-risk category. Thus, increased vigilance is the key to successful investment.
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