Danger for small investors as promoters continue taking debt on share pledges

Very few financial instruments have such a heady mix of information asymmetry and built-in moral hazard issues like promoter lending secured by promoter’s share pledge. This is true even when considered globally. Now suppose, these products are made accessible to a set of promoters, who are not known for upholding the best governance practices. It will result in significant shareholder value erosion as well as shock to the non-banking financial system. A look at the data on such financing in India shows that India may be facing such a situation.

That this type of lending is popular in India, driven by its relative (perceived) simplicity, is reflected in the fact that currently promoters of over 550 listed entities have pledged their shares to raise debt. (See tablesfor Nifty companies here and full list here )

Just the largest 50 share pledge transactions (by market value of the shares pledged) would possibly have raised an amount of Rs 25,000 crore as debt. This is assuming a slightly conservative share value to loan ratio, by benchmarking against market norms, of 3.0. Thus, the overall lending under this scheme is a number which is much higher than this!

Before we take the discussion further, let’s understand the broad contours of this product.

Product structure: The promoters of listed companies, either in personal capacity or through a holding company, raise debt from lenders (usually NBFC), and pledge as security the shares of the underlying company. The value of the shares pledged is usually two-to-three times the value of the loan (share cover).

In addition, there are typical trigger clauses to the effect that a fall in value of share collateral due to fall in share prices must be made good by the promoter by pledging more shares to restore the loan-to-value (LTV) ratio to the initial level. If the promoter is unable to maintain the LTV or ultimately fails to service the debt, the lenders are expected to sell the pledged shares to recover the debt amount.

Given the special powers of the borrower with respect to the listed company whose shares are pledged, at least from a theoretical perspective, one may not rule out the moral hazards the borrower (the promoter) may face while servicing the loan.

Additionally, it may be argued that the lender and parties associated with the lender have privileged information, which in this case is the first knowledge of promoters default behaviour. Thus, the worst affected are the minority shareholders who have invested in the shares of such a company.

If the promoter buys or sells shares, in most of the cases, it is taken as a signal on whether the promoter is bullish or bearish on his/her own company. In cases where the sale of shares by the promoter was followed by significantly weak financial results, the promoter’s actions were criticised. However, possibly due to the lack of awareness of issues among retail investors, pledging of promoter shares per se does not lead to questioning by minority shareholders.

There may be a case of exercising more caution on the part of regulators and minority shareholders, in cases of at least some companies. It may be argued that the possibility exists where prior to the share pledge transaction or the loan maturity date, the promoters may feel that their stake is actually worth lesser than the value of the promoter loan. Under these circumstances, the promoter may behave ‘rationally’ and not service the debt thereby allowing the lenders to try and sell the promoter’s stake.

Here, the simplistic expectation that the promoter’s holding in the company will fall down along with the promoter’s control has not always been found to be true. This is because it is often found that the lenders are unable to sell such large number of shares in the open market over a few days even for Group 1 Securities. As the news of the sale of promoter shares spreads, executing a block deal may also become difficult. Thus, the lender performs the face saving act of becoming a ‘strategic investor’ in the company.

In such a scenario, the promoter wins hands down. The effective control of the company remains with the promoter since the lender will now have to bank on him to see that the company turns around and hopefully, the share price recovers as well. Potentially, parties related to the promoter may actually undertake some bottom-fishing to indirectly increase the promoter’s stake.

Hazard to small investors

Whatever may or may not be the plans of the promoter with respect to servicing the promoter debt, the lenders are the first entities to know of the same. At any rate, the lenders will know upfront the share price at which the promoter will be contractually required to top up the security by adding more shares or the promoter loan will be recalled or the pledged shares will be off loaded in the market.

These share price points are critical information for the market. Say for instance, due to market activity, the share price falls below the level of these triggers (share top-up or loan recall), an uninformed market participant may see ‘more value’ and buy the stock but will be immediately shocked by a further sharp correction in share price because of the action of the lenders. This uncertainty, driven mostly by limited disclosure with respect to the promoter lending transaction, may be easily addressed by the regulator.

Regulator’s role

To be fair to the banking regulator as well as the market regulator, they have to an extent taken ‘baby steps’ in addressing some of the issues. Currently, it is required that the occurrence of share pledging by the promoters as well as the amount of shares they are pledging be reported to the exchanges immediately.

However, given the moral hazard and information asymmetry issues which the minority shareholders face, much more information may need to be disclosed to the exchanges. This includes the following:

a) Disclosure of the contractually agreed share price, a fall below which will require the promoter to top up the security with further shares

b) Disclosure of the contractually agreed share price, a fall below which will provide the lenders a right to off load the promoter shares in the market

c) The lenders, to the extent they are regulated NBFC or brokerages, should mandatory disclose, immediately to the relevant exchange about the promoter’s default in servicing the loan. At any rate, it is patently unfair on the market participants that they have to ‘figure out’ the event of the promoter default from the share price crash that follows the lenders offloading their shares in the market

d) The promoter should disclose the purpose for taking the loan. This may be identified in the following broad categories:

i) The proceeds to be invested in the company as warrants

ii) The proceeds to be invested as ’equity contribution’ in a company which is a subsidiary (fully or partially held by the listed company (whose shares are pledged)) or in a privately held company which does frequent transactions with the listed entity

iii) The proceeds would be used entirely at a personal capacity by the promoter or in projects which have no connection whatsoever with the listed company whose shares are pledged.

iv) Banks extending loans to the company and requiring promoter loans as pledge (suggestion)

The promoters of many prominent Indian companies have resorted to share pledge-based lending without any doubts being raised on the governance front. However, the same cannot be said about all promoters resorting to this form of borrowing.

This product, with its potential challenges, is a uniquely Indian product, with scale of usage incomparable to any major global market. So, while one may not be pushing for regulatory action to discontinue such products or asking exchanges to respond why stocks where promoter lending is rampant should at all be a part of various indices, a lot more transparency may be demanded by market participants, particularly the minority shareholders of such companies.

The author is senior director - corporate ratings, India Ratings and Research. Views are personal