Pledging of Shares

Pledging of shares is a financial practice where shareholders use their shares as collateral to secure loans. This method has gained popularity among companies looking to raise funds for expansion or other financial needs. However, pledging shares carries potential risks for both the company and its shareholders. Understanding the implications, benefits, and drawbacks of this approach is crucial before entering such agreements.

What is pledging of shares?

Pledging of shares refers to a type of financial arrangement in which company promoters pledge their shares as collateral to obtain a loan. In essence, it means taking a loan against securities by offering the company’s shares as collateral. Pledging of shares is a popular way for companies to raise capital and meet their financial needs.

While pledging shares, promoters still hold ownership in the company. The value of the collateral can change due to fluctuations in the market value of the pledged shares. Promoters are required to maintain the minimum agreed-upon collateral value outlined in the contract. If the market value of the pledged shares falls below the minimum limit in the contract, promoters need to pledge more shares or pay cash to bridge the shortfall.

How does the pledging of shares work?

Pledging shares operates much like a secured borrowing arrangement. Financial institutions extend credit to promoters by taking their shares as collateral. The sanctioned loan amount depends on the prevailing market value of the pledged shares, after applying a haircut. In line with Reserve Bank of India (RBI) guidelines, a maximum loan-to-value ratio of 50% is permitted, meaning only half of the shares’ market value is eligible for lending.

Impact of Pledging Shares on Stock Valuation

While a small proportion of pledged promoter shares may not raise concerns, a high level of pledging can introduce risks that influence a company’s stock valuation and investor sentiment. Some key implications include:

highly volatile stock price
Consider a company that pledges a large portion of promoter shares as collateral when its stock trades at ₹100. If market conditions push the price down to ₹70, lenders may issue a margin call. The company might need to pledge additional shares. If it fails to do so, lenders may sell the pledged shares to recover dues, increasing supply in the market and triggering further price fluctuations. This can lead to heightened volatility and make the stock’s fair valuation difficult to determine.

pressure on earnings
When promoters pledge shares to raise funds, the borrowed capital typically carries interest obligations. Servicing these loans can increase financial strain on the company. High interest payments may reduce net profits and affect earnings performance, especially if the company is already facing operational or financial challenges.

loss of management control
Promoters who pledge a significant portion of their holdings risk losing control over the company if they default on repayment. In such cases, lenders may sell the pledged shares in the open market to recover their funds. This can reduce promoter ownership and potentially weaken their influence over the company’s management and strategic decisions.

market perception
A high level of promoter share pledging can negatively influence market perception. Investors may interpret it as a sign of financial stress or uncertainty about the company’s future prospects. As a result, investor confidence may decline, which could affect demand for the company’s shares and put downward pressure on the stock price.

value trap for investors
Stocks with a high percentage of pledged shares may appear undervalued and attract value investors. However, elevated interest costs and limited growth prospects can restrict long-term returns. In such situations, the stock may fail to deliver meaningful value to investors, turning it into a potential value trap.

As mentioned earlier, promoters pledge shares to fulfil different financial requirements like working capital requirements, personal needs, business expansion, or acquisitions. While pledging of shares is considered to be a safer method of raising capital than borrowing, it is often the last resort for company promoters. Most promoters pledge their shares only when other fundraising options have been exhausted.

What Does Pledging of Promoters’ Shares Mean?

Pledging promoters’ shares is a common practice in corporate India.

A promoter refers to an individual or entity responsible for establishing a company. In the early stages, promoters usually hold a significant portion of the company’s shares. In India, promoters are often the majority shareholders who also oversee the company’s management and daily operations.

When a company requires funds for operations or expansion, it can raise capital through various options such as issuing equity, offering corporate bonds, or obtaining bank loans. However, lenders generally require collateral before granting loans.

In many cases, banks and financial institutions accept promoters’ shares as collateral. When promoters offer their shareholdings to secure a loan, it is known as pledging promoters’ shares.

Companies generally adopt this option when other fundraising avenues become difficult or unavailable. Therefore, a high level of promoter share pledging may sometimes indicate financial stress within the company.

In India, the Securities and Exchange Board of India (SEBI) regulates the pledging of shares for listed companies. However, such regulatory restrictions are limited for unlisted companies.

For unlisted companies, pledging shares typically requires approval through a board resolution. Once approved, the promoters can pledge their shares to lenders as collateral for raising funds.

What is a haircut in share pledging?

While we briefly mentioned the term ‘haircut’, it is important to understand its significance. After pledging your shares, you do not receive funds corresponding to the market value of the shares you pledge. This is because, in the event of a fall in market value, the broker suffers a loss. Therefore, the broker deducts a small percentage, and this difference between the amount loaned and the actual market value is known as a ‘haircut’.

Thus, this haircut margin protects the lender’s interests at the time of pledging shares. It is used as a precautionary measure against the volatile nature of the stock market.

Furthermore, for overnight positions, the exchanges mandate that traders maintain 50% of the margin in cash and the other 50% in non-cash collateral margin.

Initiating the pledging process

You can initiate the pledging process through your broker using the trading terminal. The request is then sent to the depositories (NSDL/CDSL) for execution. You must then authenticate the request by providing the one-time password. After getting the approval, you can access the collateral margin for trading.

Furthermore, maintaining a minimum margin of 20% is made mandatory by the regulator before carrying out any trade. The trade is settled on the basis of T+1 (that is, one day after the trading day). For example, if you wish to buy stocks worth Rs. 50,000, you must have a Rs. 10,000 margin, even if you sell the stock within a day.

Pledging of shares offers the following advantages:

• Access to liquidity – Allows investors to secure funds without selling their shares, preserving ownership and potential capital gains.
• Investment opportunities – Enables quick access to funds for new investments or averaging down existing stock holdings.
• Flexible repayment terms – Loans against shares often come with more lenient repayment options compared to personal loans.
• Leverage for growth – Enhances investment capacity, allowing investors to engage in larger trades or business ventures.

Disadvantages of pledging shares

While the advantages of pledging shares are quite evident, this strategy also has certain disadvantages:

• Margin calls – A decline in share prices may trigger margin calls, requiring additional collateral or immediate loan repayment.
• Risk of asset loss – Failure to repay the loan could lead to the forced sale of pledged shares, resulting in permanent asset loss.
• Interest costs – The loan carries interest charges, which may reduce returns if the borrowed funds are not utilised effectively.
• Market volatility risk – Since the loan is backed by fluctuating share prices, it becomes highly risky in volatile market conditions.

Points to remember

Here are some of the important points you must remember pertaining to pledging.

1. The shares remain in your Demat account until they are sold.
2. While stocks remain in your Demat account, you can access margins through pledging.
3. The entire pledging process is seamless and digital.
4. As the stocks remain in your Demat account, you continue to earn interest and capital gains on the pledged stocks.

Conclusion

Pledging involves using securities in your holding as collateral to secure a loan or margin, allowing you to access funds for trading while the securities remain in your account. Now that you know what margin pledging is, you can easily access collateral margins and leverage positions to increase your profits.