What Are Pledged Shares? Risks & Red Flags Every Investor Must Know

Pledging of shares is a common practice in corporate finance where the promoters of the company offer their shares as collateral for securing loans. While this can benefit companies and promoters, it also carries significant risks that investors should understand.

What is pledging of shares?

Share pledging is when a company’s promoters (owners or major shareholders) use their shares as collateral to borrow money, usually for business expansion or to meet urgent financial needs. Even one pledged share can trigger concerns if it signals deeper financial issues.

Suppose there is a company named XYZ Ltd. One of its promoters, who owns 60% of the company’s shares, wants a ₹10 crore loan to build a new factory. Instead of selling his shares, he pledges 30% of them to a bank. That means he gives the bank temporary control over those shares as security.

If the concerned promoter repays the loan on time, he returns his pledged shares. But if he fails to repay, the bank can sell those shares to recover the money.

Risks associated with pledged shares

Here are some risks that companies with high pledged shares face:

• Forced selling by lenders

When share prices fall below a threshold, lenders can liquidate the pledged shares without the company’s or promoter’s consent. This forced selling can trigger a sudden crash in the stock price, shake investor confidence, and cause panic selling, severely damaging the company’s reputation and market capitalisation.

• Loss of control

Promoters who pledge a large portion of their shares risk losing control over the company. If lenders sell these shares due to a default, the promoter holding drops, possibly resulting in a change in management. This can alter the company’s strategic direction and even invite hostile takeovers.

• Creditworthiness concerns

A company with a high level of pledged promoter shares often signals financial stress. It raises questions about the promoters’ liquidity and the company’s access to funds. Credit rating agencies may downgrade such companies, making future borrowing more difficult and expensive, thus impacting business growth.

• Negative market sentiment

Pledged shares usually carry a negative perception among retail and institutional investors. A rising trend in pledging suggests cash flow problems. This often results in lower investor confidence, affecting the stock’s performance regardless of the company’s actual fundamentals or earnings.

• Stock liquidity

When lenders offload a large number of pledged shares, especially in thinly traded stocks, it can flood the market with supply. This oversupply reduces liquidity and pushes the share price lower, making it difficult for other shareholders to exit without incurring losses.

• Regulatory scrutiny

High levels of pledged shares can invite regulatory attention, especially if disclosures are not made transparently. Any non-compliance with the Securities and Exchange Board of India’s (SEBI) disclosure norms regarding pledging can result in penalties and reputational damage to the company and its promoters, affecting long-term investor trust.

• Limited flexibility

Lenders often impose conditions that limit business freedom when a large portion of promoter shares is pledged. Promoters may be restricted from making strategic changes, such as acquisitions or restructuring, without lender approval. This affects the agility and autonomy required for running the business efficiently.

Red flags associated with pledged shares

Some of the red flags to look out for in a company with high pledged shares are:

• High debt-to-equity ratio

A company already burdened with high debt and pledged promoter shares is walking a tightrope. It shows over-leveraging and increases financial risk. You must stay alert because debt obligations may outweigh the company’s earning capacity in tough times.

• Negative cash flow

If a company consistently posts negative cash flow while its promoters pledge shares, that is a double warning sign. It indicates operational inefficiency and a possible liquidity crunch. You should be cautious because such firms may struggle to meet obligations.

• Weak corporate governance

Companies that don’t follow good governance practices often have high promoter pledging. Poor governance means weak internal controls, and as an investor, you could be left in the dark during critical situations, especially if lenders take sudden action on pledged shares.

• Delay in commitments

A company that delays salaries, vendor payments, or interest obligations, and has promoters pledging shares, indicates a liquidity problem. This can be a clear sign of operational distress and should make you rethink your investment in such a company.

• Frequent change in auditors

If a company keeps changing its auditors and also has high promoter pledging, it’s a warning sign. Frequent auditor exits may mean attempts to hide financial issues, especially around borrowings and pledged shares.

• Falling institutional holding

If mutual funds, foreign investors, or other institutions are gradually exiting a company with high pledged shares, that is a red flag. Institutional investors often spot trouble early. Their exit could mean upcoming trouble that retail investors might not yet be aware of.

• Pledging for non-core activities

Sometimes, shares are pledged to fund unrelated businesses or personal investments. When the borrowed money does not support the core operations, it puts the main business at risk. As an investor, this misuse can lead to poor performance and increased liabilities.

Tips to mitigate risks associated with pledged shares

Here is how you can minimise the risk associated with investing in a company with high pledged shares:

• Holding even a single pledged share in small- or mid-cap companies can carry risks. These stocks are less liquid, so any forced selling due to pledging can cause steep price drops. If you invest in such stocks, analyse the risks and have an exit plan.

• Go beyond financial statements; check audit reports and credit rating agency views. Auditors often flag risky pledging practices or related-party transactions. A downgrading credit rating because of high pledging can be a useful early warning sign for potential trouble.

• Don’t put a large portion of your portfolio in one company or sector, especially if it involves pledged shares. Diversification across different industries and market caps can cushion your losses if one of your investments suffers from promoter-related issues.

• Don’t hold onto hope if you see repeated negative developments, such as rising pledging, falling promoter stake, loan defaults, or stock price crashes.

Conclusion

Pledged shares may offer short-term benefits to promoters, but they often signal deeper financial troubles. As an investor, you must stay alert to the risks, like forced selling, falling stock value, and loss of promoter control. Look out for red flags and always do your homework before investing. Smart, well-informed decisions and diversification are your best defences against the hidden dangers of pledged shares.

Also Read: Share Pledge by Promoters

Sources

WallStreetMojo
5 Paisa