Last Updated on May 24, 2022 by Aradhana Gotur
Most of us have approached a bank for a home loan, a car loan, for education or other purposes. The loaning system works on providing tangible collateral such as property or gold. Did you know that shares too can be used as collateral? Any individual or promoter of companies can get loans by pledging their shareholding. These pledged shares become the collateral for acquiring funds for the company’s growth or personal use. This article delves into what is pledged shares, how it works and what it means for the investors.
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What is Pledging of shares?
Pledging of shares refers to taking loans against the shares held by a person. Like real estate and gold, shares are also considered assets, and investors can avail loans using shares as collateral. Pledging is an arrangement wherein an individual or the promoters of a company use their portion of shares to secure loans to meet a range of requirements.
As pledged shares are treated as collateral, failure of the promised payment could result in the shares being forfeited, i.e., handed out as sold.
While anyone can pledge their holding, the practice is prevalent in companies where the promoters own a high number of shares or a high percentage of shareholding. The advantage of pledging shares is that the borrower or the promoter of the pledged shares retains the right to the shares as an asset and can continue to earn interest and capital gains on the said shares even when they are pledged shares.
While pledging shares allows individuals to meet needs, a promoter pledge can be risky for the shareholders. With a continuously fluctuating market, the price of the shares also changes rapidly. Promoters of the company are required to make up for the value of pledged shares in case of a shortfall or if they fall below a specific level – triggering a phenomenon popularly called ‘margin call.’
Why do promoters pledge shares?
Promoters of a company may decide to pledge shares of the company for a range of reasons listed as follows:
- Meet working capital requirements
- Fund sister ventures
- Carry out new acquisitions
- Raise money for a new business
- Raising money for regular operations and/or expansion.
How does share pledging works?
The fundamental guiding principle of any banking institution offering a loan to an entity with collateral is to ensure a sense of security. The same is the case with pledged shares.
Banking institutions will accept pledged shares as collateral when extending a loan to a company. In case the individual or company fails to clear its dues, the bank can sell the pledged shares to recover its dues.
Let us assume that a company wants a loan of Rs 1 cr from a bank. The market price of the company’s share is Rs 500, and the company wants to pledge the promoter’s shares to raise funds. In this case, the promoters will need to pledge 20,000 shares (worth Rs 1 cr) to receive the loan.
As per RBI norms, the borrowing company will be required to maintain a Loan to Value (LTV) ratio of 50% during the loan tenure. This means, to get a loan of Rs 1 cr, the individual or the company will need to pledge a double – 40,000 shares worth Rs 2 cr.
In a trending market, there is no real impact. However, let’s assume that the aforementioned company’s shares in the market fall to Rs 400 from Rs 500. Now, the value of the collateral falls from the mandatory levels. The promoters will then be called to repay the balance or pledge another 10,000 shares to overcome this shortfall.
If the individuals or promoters cannot maintain the 50% LTV ratio by either pledging more shares or funnelling cash, the banking institution will be driven to sell the pledged shares in the market. Now, why will anyone risk pledging shares? Simply because banks charge a lesser interest on loans against shares than the interest they charge on personal loans or business loans.
Why should investors be concerned about promoter pledge?
Retail investors must always watch what percentage of shares a company they have invested in has pledged to banks. This becomes even more important in a volatile market. While it is not uncommon for companies to pledge shares with a bank, it does raise speculations that the company may not have enough disposable funds to conduct business.
It is also important to note that pledging of shares in a bullish market might not raise many eyebrows, but the same in a bearish market can be a cause of concern. Some investors prefer to invest in companies that have a low percentage of pledged shares as it gives some sense of relief about the strength in the financials of the company.
Risk in pledging of shares
The pledging of shares has a direct impact on the company’s share price. If the promoter pledges shares in high numbers, the risk of volatility also grows. If the share price falls for any reason, the collateral value will fall, driving the company to pledge more shares, and the share price can further tank in a domino effect.
Conversely, suppose the company is unable to repay the loan. In that case, the bank will sell the promoter shares and recover losses- a move that can create panic about the company in the market and further plummet the share price.
If a company’s pledged shares are on the higher side, it may seem unfavourable to investors.
Pledging of shares is a fairly common practice among companies and is finding favour among individuals too, given the attractive interest rates banks offer these at. A loan on shares attracts a lesser interest than personal loans or business loans. However, shares of companies with a high percentage of pledged shares tend to be more volatile than their peers. When choosing stocks for a portfolio, investors must also carefully glance at the percentage of pledged shares to make sure they are aware of the financial standing of the company before taking a call to invest.