Everything about promoter pledging that you should know

The Reserve Bank of India (RBI) in its Financial Stability Report dated June 27, 2019, expressed its concern over the high level of promoter pledging. The report argued that a high level of promoter pledging indicates the poor financial health of a company and probably a situation that a company is unable to raise funding from other sources.

In the past, many stocks such as Zee Group, Apollo Hospitals, and Reliance ADAG group have tumbled due to promoter pledging.

What is Promoter Pledging? Why do Promoters go for the Pledging of shares? How does it impact share prices? Read on and find below.

What is Promoter Pledging?

If you have ever approached a bank intending to obtain a loan, the bank must have asked you to offer something as collateral. The collateral could be in the form of gold, property, shares, etc.

Now think of a promoter of a listed company who wishes to expand his business, fund new ventures, or fulfill his personal goals approaches a bank for a loan. The bank can ask the Promoter to offer his equity shareholding in the company as collateral. This is what is meant by Promoter Pledging. 
Stated, "Promoter Pledging refers to a situation where the promoter pledges some or all of his shares with the lenders to obtain loans." 

How does Promoter Pledging work?

The bank usually pledges the share at a price below the market price of the share. For example, if the share is trading at Rs 10 in the market, the bank will extend a loan at Rs 5 per share. The margin between the market price and the loan amount is kept as security.

This means that as soon as the market price of the share falls, the banks will call for additional security since the value of the collateral has shrunk. The promoters will pay for the shortfall either by pledging additional shares or by spending more cash. This is known as the Margin Call.
If the promoters fail to address the margin call, the bank can sell the pledged shares in the market to maintain the margin.

Why is it risky for you?

Promoter Pledging is observed in a company where promoters have high equity shareholding. Thus, Pledging is the easiest way for promoters to raise funds.

Promoter Pledging is of no risk for the investors as long as the market price of the share is rising. Some amount of promoter pledging is always acceptable, but in a situation where stocks have high pledged promoter holding, Pledging can create havoc since if the price of the share falls considerably, the lenders will resort to the selling of pledged shares to maintain the margin. The excess supply created due to invoking will further reduce the share prices, thereby leading to huge losses.

Therefore, as an investor, you need to keep an eye on promoter pledging since it can negatively affect your returns in periods of high volatility.

Promoter Pledging as a shortcut to insider trading

There have been times when promoters have messed up badly and have known that their stock is not going to perform well. In that situation, if the Promoter starts selling his shares, he will be violating insider trading norms. So to avoid this, the Promoter will go for Pledging of his shares. When the shares lose value, it will ultimately be the responsibility of the lenders to recover their loans by selling off the pledged shares.

The IL&FS turmoil had already affected the financial markets when on January 25, 2019, the shares of Zee group tanked, wiping out Rs 13,000 crore of market capitalization. While we will further discuss why this massive fall took place, it is essential to know that the enormous sale of pledged shares led to such a huge downfall. 

What happened on January 25?

The shares of Zee Entertainment Limited slumped 26 percent and of Dish TV fell 33 percent after a report that Serious Fraud Investigation Office (SFIO) was investigating a company named Nityank Infrapower for deposits over 3000 crores just after November 8, 2016 demonetization announcement. The report said that Nityank Infrapower along with few other shell companies had carried out financial transactions with some companies of Essel Group between 2015-2017.

Subhash Chandra, the founder of Essel Group, had pledged a substantial amount of his shares in Zee Entertainment and Dish TV to expand into several businesses such as Infrastructure Sector. As a result, these two shares were hit during the January 25 crisis. 
To prevent further chaos, founder Subhash Chandra penned an open letter where he was compelled to apologize to banks, NBFCs and Mutual Funds.

He accepted his wrong business decisions, saying that false bids in infrastructure sector along with IL&FS chaos which made it incapable of servicing debt repayments had resulted in Rs 4000 to Rs 5000 crores losses
He even mentioned that the acquisition of Videocon D2H was another wrong decision he made.
The primary reason behind penning such a letter was to seek lenders' patience since 6.5 million pledged shares were sold during the January 25 fiasco.

How was the situation tackled?

A meeting between the lenders and the promoters took place over the weekend after the share prices crashed wherein it was:

• Decided that the lenders would not declare an event of default until September 30, 2019, due to a steep fall in prices.

• It was further decided that there would be synergy and cooperation among the lenders leading to a unified approach. 

• Also, the promoters have comforted the lenders by promising a strategic sale of Zee Entertainment Limited in a time-bound manner.

Even though the above situation was brought under control, it works as a sort of an eye-opener. As per a few sources, the promoters’ stake in Zee Entertainment is 41.6% while the amount of pledged shares is 59.3%.

Such a vast number of pledged shares ultimately indicate the riskiness of this particular share. Therefore, it is usually said that investors should avoid companies where 50 percent or more shares are pledged.

In the wake of such turmoil in the market, SEBI has issued new norms to increase transparency concerning pledged shares. In its board meeting on June 27, 2019, SEBI has tightened disclosure norms stating that any direct or indirect lien on shares will qualify as encumbered shares. (Encumbered shares refer to shares, which have been pledged for a mortgage.)

SEBI has widened the scope of encumbrance and said it would include pledge, lien or any other transaction by whatever named called.
Also, promoters would have to disclose separate reasons for encumbrance if the combined hindrance crosses 20 percent of the share capital or 50 percent of the total promoter holding. A company's audit panels will have to be kept informed of any undisclosed encumbrance.

This is a welcome move by SEBI to enhance transparency. Further, the widening of the definition will also prevent promoters from hiding behind dubious names for pledged shares. 
It will also prevent promoters from fulfilling selfish motives, decide their investment avenues with caution since they will be under the close watch of the investment watchdog.

Present Scenario

As of July 16, 2019 pledging of shares by promoters has reduced in June 2019 and hit a six-year low. Data shows that the percentage of pledged shares at NSE companies has decreased from 10.2 percent as of May 31 to 10.17 percent on June 30, 2019. 
As on June 30, 2019, shares were pledged in 495 of the 1,621 main-board companies listed on NSE, as compared to 500 companies on May 31, 2019.

Promoters of seven companies reduced their pledged shares to zero in June 2019. They were Sterlite Technologies, Mangalam Drugs and Organics, Himatsingka Seide, Indiabulls Real Estate, Indiabulls Housing Finance, Byke Hospitality, and Cigniti Technologies. Overall, there were 45 companies where the percentage of pledged shares were reduced in June 2019.

Nifty 200 companies that saw a decrease in promoter pledging are Max Financial Services, Ajanta Pharma, JSW Energy, Manappuram Finance, Adani Power, Reliance Infrastructure, GMR Infrastructure, Reliance Capital, Jubilant Foodworks, Asian Paints and Adani Ports & Special Economic Zone, among others. However, 31 companies in Nifty 200 also saw a rise in promoter pledging.

Our Take

As long as a promoter is pledging a reasonable amount of holding to venture into sensible investments, Pledging certainly would not hurt the shares.
Reduced Pledging in companies is undoubtedly a welcome sign. However, it is essential not to ignore other fundamentals completely.

Although retail investors must keep a watch on pledged shares, in our opinion, it is even vital for companies’ promoters to compensate their retail investors for their wrong decisions. Since most of the retail investors get access to pledged shares through investments in debt mutual funds, it becomes the responsibility of mutual funds to protect them. Deliberations among Mutual Fund Industry and SEBI are thus the need of the hour.