Is promoter’s pledging their shares really bad for investors?

Promoter pledging blog banner Is promoters pledging their shares really bad for investors?

The risk of pledged shares is nothing new. In the last few years we saw like Zee Entertainment, RCOM, Cox & Kings, Yes Bank, and several other companies come under pressure due to sale of pledged shares. When promoters pledge shares and raise funds and if they are not able to service the loan, the financers have no choice but to sell the shares to recover their money. Back in 2009 and 2010 we saw some famous cases of companies like Orchid Pharma and later GTL and GTL Infra come under attack due to pledged shares. That was the time, SEBI first made disclosure of pledged shares mandatory for companies; especially if it entailed pledge of shares above a certain threshold.

Pledging is a big chunk of promoter stake

As per the pledge data put out by the BSE, there are over 800 listed companies on the BSE where promoters have pledged shares in different proportions. The total value of pledged shares as per the BSE is in excess of Rs.210,000 crore, surely a sizable value. In the case of most mid cap and small cap stocks, this is enough to create panic in the stock price. Out of these promoters’ pledges, 5% companies saw promoters pledging 100% of promoter holding. Nearly 30% of the companies had more than 70% of promoter stake pledged. The 50% pledge level is considered to be a sort of warning signal for investors to be cautious.

How should you interpret and act on pledge data?

The million dollar question is how should investors react to a stock when they see a sharp spike or a sharp fall in the proportion of pledged shares?

  • If promoter pledge is more than 50% then it is essential to be cautious and ideally if it crosses 70% then the investor should exit the stock. That is when the stock becomes vulnerable to sudden movements in price. The cut off limit should be set much lower in case of small cap companies.
  • Try to check the reason why the promoters have pledged these shares. Promoters pledging shares to meet bridge financing requirement is understandable. This is normal in case of a sudden delay in inflows or excess payments. Often promoters use the shares as a temporary pledge and exit the pledge by repaying the loan when the issue is addressed. This is acceptable as long as the pledge proportion does not go above 50%.
  • There are two cases where investors need to be a tad cautious. First, be cautious about promoters using pledges to get working capital funding. That is not sustainable. Secondly, be cautious if the promoter has a past track record of defaulting on pledge loans. This is a red flag.

How to ensure better reporting and monitoring of pledged shares data?

One of the key challenges here is appropriate and timely reporting. Sensitive data disclosure once a quarter just does not serve the purpose. Here are a few points to ponder:

  • SEBI must insist that if the pledge percentage crosses 70%, such data should be immediately disclosed on the website of the borrower and also of the exchanges and banks. The onus for this disclosure can either be on the promoters or on the bank or NBFC financing the stake.
  • Any default by the promoters must be disclosed on a T+1 basis. This would include even a single day delay in the payment of interest. That will force greater discipline on the promoters and the financers. Today the issue is more of reporting discipline and the onus must be on the bank and the promoters too. This includes restructuring of loans too.
  • There must be a credit rating methodology for promoter funding on the lines of the CRAMEL model. This is still largely unregulated because it is secured and done by NBFCs. These ratings are essential to protect the interests of the minority shareholders.
  • Promoter funding should only be permitted through the traditional bank and NBFC route and not via mutual funds. We are talking of the quasi promoter pledge funding that the Essel Group managed to obtain from mutual funds. When mutual funds finance promoters under the guise of debt investment they create risks for the unit holders and for the shareholders.

NSDL and SEBI must also clamp down on quasi-pledge funding. Often, promoters give a Power of Attorney on shares against their loans. Here the demat shares don’t get pledged but the risks are the same as the financer can invoke the POA at any point of time. This is a hidden risk and must be explicitly prevented by regulation.

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