Pledging Of Shares

Key takeaways

• Share pledging is the practice of securing a loan against the shares you own.
• Pledging of shares helps borrowers gain margin access while retaining ownership rights and earning dividend income.
• Selling of shares by the lender in case of default carries the risk of triggering a downward price spiral for the stock in question.

Businesses and company promoters meet their capital requirements in different ways. Share pledging is one of the easiest ways of securing capital. Share pledging is the practice of using your shares as collateral to obtain a secured loan. The funds raised through a share pledge may be used for various purposes like company expansion, R&D efforts, and other such activities.

Share pledging has significant implications for the borrowers as well as the general shareholders of a company. This article outlines what share pledging is and its advantages, disadvantages, and risks to help investors make informed decisions.

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Share pledging means securing loans against the shares you hold as an investor. Company promoters pledge their shares as collateral to secure a loan and meet various financial requirements of the business. It essentially translates to creating a lien on the shares held by the promoter to gain access to finance.

Even after pledging shares, promoters retain their ownership rights on the shares. Additionally, it is important to note that the market value of shares is dynamic. Since it is contingent on market changes, the value of the pledged collateral is also subject to change in keeping with market fluctuations. That’s why share pledging agreements outline the minimum collateral value that promoters must maintain at all times.

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Now that we have covered what share pledging is, it’s time to understand how pledging of shares works. Share pledging allows investors to secure capital without liquidating their ownership stakes in the said company. It also allows investors to avoid missing out on trading opportunities due to a paucity of funds. To pledge shares, promoters approach lenders that offer this facility. The lender evaluates the value of the proposed collateral (pledged shares) to ascertain the loan terms. Lenders also evaluate the creditworthiness of the pledging entity to finalise the terms of the pledge contract. Once the terms are decided, a lien on the shares is created, and the sum is disbursed. It is essential to note here that the market value is discounted for possible price volatility before arriving at their collateral value.

Investors and promoters raising capital through share pledges must remember that the market value of shares is subject to volatility, which, in turn, impacts the collateral value. In other words, a fall in the market value of the pledged shares leads to a fall in the collateral’s overall value, triggering a margin call. If this happens, the promoter needs to fund the deficit with additional shares or extra cash.

The meaning of a share pledge is essentially using your asset–shares–as collateral to obtain a secured loan. Thus, like all other secured loans, the lender has the right to sell the pledged shares if the promoter defaults on the loan. However, if the loan is repaid in keeping with the contract terms, the pledged shares are returned to the promoter.

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Promoters pledge their shares as a last resort option. Typically, share pledging occurs when promoters have exhausted all other fundraising options. Company promoters pledge shares to obtain capital for various fiscal requirements of the business. The funds raised may be used to raise money for the working capital needs of the business, expansion purposes, acquisitions, etc. Promoters may also pledge shares to raise funds and capitalise on trading opportunities. In general, pledging of shares is considered a safer option than borrowing because it is a form of secured loan.

As mentioned earlier, lenders do not consider the entire market value of the shares as collateral value when sanctioning the loan amount. Instead, they use a discounting method to arrive at the final sum. The difference between the market value of the shares and the collateral value sanctioned is called a haircut margin.

The haircut margin is used as a precautionary measure to protect the lender’s interests. Since share prices are subject to market volatility, a sudden drop in prices can lower the value of the collateral as well, resulting in significant losses for the lender. A haircut margin helps create a hedge for the lender against such volatile market fluctuations.

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Share pledging is advantageous for investors and promoters in the following ways:

• Share pledging allows promoters to raise capital through a secured loan against the shares they own. Secured loans come with a lower interest rate, which means the overall cost of borrowing is lower than obtaining an unsecured loan.
• Through share pledges, promoters can obtain instant access to funds without having to liquidate their ownership stake in the company.
• They continue to reap the other benefits associated with equity ownership, like dividend income and voting rights.
• They gain access to funds, which can be used for various purposes, such as company expansion and financing trading margins.
• Share pledging does not require promoters to sell their shares. Therefore, the market value of shares also appreciates with rising markets. At the same time, investors can access additional cash.
• Pledging of shares does not attract any tax liabilities. Alternatively, if the investor decides to sell the shares to raise funds, a capital gains tax will apply to such sales. 

Despite its advantages, share pledging also comes with the following disadvantages:

• The default risk is the most prominent disadvantage of share pledging. If the promoter fails to repay the loan on time, the lender can sell the pledged shares to recoup the loaned sum.
• Lenders selling shares of high-net-worth investors can further destabilise the market price of the shares, affecting all shareholders.
• Company promoters defaulting on share pledging can create negative investor sentiment about the company and its financial standing, further lowering share prices.
• If the share prices fall below the limit agreed upon in the pledge contract, the promoter will have to fund the margin with extra shares or funds. 

Share pledging carries some inherent risks, including the possibility of margin calls, impact of market fluctuations on the collateral value of the pledged shares, and the potential loss of voting rights. Investors pledging shares must understand these risks carefully before pledging their shares to obtain funds.

In a bullish market, share pledging is relatively less risky since the market moves in a positive direction. However, the risks of share pledging become pronounced during bear markets when investors tend to panic. With a downward trend in the market, stock prices fluctuate, leading to a potential drop in the collateral value of the pledged shares. To finance this deficit, promoters need to pledge more shares or pay extra cash. However, if the borrower cannot meet this deficit, the lender sells the shares to cover the shortfall. Selling of shares owned by major company promoters can trigger panic sells and create a negative investor sentiment. Both result in further plummeting of the company’s stock. Additionally, selling of shares by the lender alters the shareholding pattern of the company, reducing controlling and voting powers. 

Share pledging means the practice of using shares as collateral to secure a loan. Promoters often pledge shares as a strategic tool to meet financial requirements of the company without losing out on their profits. Investors also pledge shares to capitalise on trading opportunities and access higher margins. Understanding what share pledging is can help promoters and investors plan and strategise better to reap its benefits.