Would you loan money to someone who is neck deep in debt?
Now think of a situation wherein a promoter of a company taking debt by offering their equity shareholding in their very own company as collateral. This is in essence is called ‘promoter pledging’. Will you invest in such a company whose promoters have ‘pledged their shares’?
Well, stocks such as Zee Group, Apollo Hospitals, Yes Bank, DHFL, ADAG among others have tumbled due to promoter pledging in the past. Post the Satyam scandal, share pledging is seen as a critical factor in picking up stocks.
Pledging by itself is not illegal or bad. The motive could be either noble or questionable. As long as a promoter is pledging a reasonable amount of holding for sensible investments, pledging would not hurt. Companies generally use promoter pledge against loans when all sources of finance are non-feasible. Thus, a promoter pledge could be a sign of possible financial troubles in the company.
Apart from the volatility in stocks, it could also be a value trap for investors. Investors who look for undervalued stocks might find companies with a high percentage of promoter’s shares being pledged trading lower. This makes them look attractive to value investors.
Usually, high promoter pledging can lead to high volatility in the stock price. Let’s assume the promoter of a hypothetical company Paramount, decides to pledge 10% of his shares when the price of Paramount’s stock is Rs 100 per share. The bank may call for additional security if the price falls below 80. If the promoters fail to address the margin call, the bank can sell the pledged shares to maintain the margin.
The process could go on till the pledging reaches 100% or the promoter repays the loan. The excess supply created due to invoking will further reduce the share prices, thereby leading to huge losses. This is where the catch lies. If the promoter is unable to pay the loan or pledge any more shares, then the bank has the right to sell the shares in the open market to recover the loan. A bulk sale of this sort could send prices crashing. Such an event reflects poorly on the promoter because it questions their ability to repay their loans.
There have been instances in the past where the promoter has given importance to his own interest rather than shareholder’s or firm’s interest. One such fraudulent cases was of Satyam Computer Services.
In 2009 the promoters had pledged their entire shares with the lenders and had taken a loan of Rs 1,258 crore on it. And most of the lenders required the borrowers to pledge about 2.25 times the value of the loan as security. When the promoters failed to repay the loan, the entire stake was sold in the open market. This led to a massive decline in the shareholding of the promoters. Satyam promoters at last owned 3.6% of the company.
Another case of Zee Entertainment was reported in 2019 when promoters took a loan from multiple lenders by pledging shares. When the entire pledged holding was sold, the promoter was left with a 0.89% stake. The promoters and the companies owed over Rs 17,000 crore to lenders. Ultimately, the shareholders of Zee paid a heavy price when the share price declined over time.
Before the Satyam case, it was not necessary for the promoters to disclose the shares pledged. However, it turned out that it was a very vital piece of information. Therefore, the regulators made it mandatory for the promoters of all the listed companies to disclose the level of pledging since then.
These examples make it clear that promoter pledging can turn out to be a major investment risk. Therefore, investors would do well to check the level of promoter holding that a company has. However, the pledging of promoter’s shares is not necessarily bad.
Even if a company has a high percentage of promoter’s shares pledged, if its operating cash flow is healthy and the company fundamentals are good, it can be worth investing in.
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