Pledged shares: Promoters staring down the barrel of a gun

If the downturn in the stock market continues for some more time, promoters of quite a few mid-cap companies risk losing control of their empires. According to a report by rating agency CRISIL, promoters of nearly a third of the 1200-plus listed companies have pledged their shares with finance companies to raise money. Of these, promoters of around 45 companies have pledged between 80-100% of their holdings. As a way of raising money, promoters pledge shares for a number of reasons, including expansion. While, according to SEBI guidelines, they have to make known the amount of shares pledged, they don’t have to reveal the price at which it was pledged, i.e. in a volatile market when a share hits a margin call, a promoter will have to pledge more shares or make a payment.

 Share prices of some mid-cap firms-Parsvanath Developers being a notable example-have halved in the last few weeks, as lenders liquidated a part of the pledged shares to recover their money. But it is not a pretty picture for the non-banking finance companies (NBFCs) which have lent money to promoters, either. That is because many promoters are running out of stock to put up as additional collateral if share prices continue to tumble at the pace they have been over the last month.

More from Investing

MSMEs are breaking the traditional convention. Look who’s funding them Scale-up your startup without an investor! Here’s how

Liquidity in mid-cap shares dries up rapidly in a falling market. So technically, even if a lender holds 10 lakh shares of the promoter worth a certain amount, it will not be able to realize that value by selling those shares if there are not enough buyers.

Buzz in the market is that some of lenders have already started sounding out institutional investors for negotiated deals, where promoters are hard pressed to give additional collateral. This is beneficial to the lenders as well, as the value of the stock would diminish significantly if they were to sell it in the open market. But the fruition of such deals would depend on the track record of the promoter and the company’s fundamentals. Institutional investors would be wary to buy into stocks where the promoter has borrowed money from multiple lenders.

The coming days could see some hectic wheeling-dealing as promoters frantically try to retain control of their firms, and lenders try to ensure that they are able to recover their loans.

Typically, a promoter looking to raise money by pledging shares, has to deposit2-2.5 times the value of the loan as collateral with the NBFC. Better the promoter/company’s track record, lower the collateral. Interest rates on loans to non-real estate companies vary between 14-18% and those for real estate companies could be as high as 18-22%.

The moment the share price weakens and the value of the collateral drops to say, 1.8 times the loan value, the lender will ask the promoter to either offer additional shares or repay a part of the loan. In market parlance, this is known as margin call. If the promoter is unable to do either, the lender will dump a part of the shares to recover his money. In a fragile market, this could very well set off a vicious cycle where the lender’s selling could push share prices further down, and trigger more margin calls.

In situations where promoters have already pledged 90% or more of their holdings, they have little additional collateral to offer by way of shares. So in such cases, promoters may have to pledge other assets, so that lenders don’t dump the stock at the first signs of weakness.

Shares of firms with a significant chunk of pledged promoter holdings are vulnerable to attacks by cartels of bear traders. Where the stock is eligible for futures & options trading, these players hammer the price by short selling the stock futures. This in turn puts pressure on the stock price, and triggers margin calls from lenders. If the promoter is financially weak, he will be unable to meet the margin calls, causing lenders to dump the shares.

This is not to say that every promoter with 90% shares pledged is in for trouble. If the company is operationally doing well, and the promoter is financially sound, the stock price is unlikely to fall sharply. There will be enough takers for the stock at lower levels because of the company’s strong fundamentals. Also, promoters will be in a position to pledge other assets so that the lenders do not dump the shares. For instance, it is hard to imagine the Tatas losing control of Tata Coffee, though more than 90% of the promoters’ holding is pledged.

However, that is not the case with many promoters who right now appear to be in the midst of a perfect storm. Their stocks are falling due to the overall bearishness in the market. With weak demand and high cost of funds, there is pressure both on revenues as well as profit margins. And this is giving bear traders the confidence to hammer the stocks. Again, because of high interest rates, promoters are unable to refinance the loans they have taken by pledging their shares.

Some market participants suggest there should be a cap on how much promoters can borrow by pledging their own shares. That is because share prices nosedive due to selling by lenders when promoters are unable to honour margin calls. Caught unawares by the sudden fall, many retail investors sell out in panic. Sometimes, the promoter may lose control (Orchid Chemicals’ promoter Raghavendra Rao came close to losing his company in 2008 when lenders dumped his shares) which in turn could more selling in the stock.

But capping the borrowing limit on promoter shares would mean micro-management by the regulator, something which should be avoided. Besides, it is not as if promoters pledged 80-100% of their holdings at one go: they have been forced to deposit additional collateral at regular intervals because of the falling stock price. Given that, companies have to disclose details on pledged shares, it is then reasonable to assume that if investors think the promoter is over-leveraged, they should just avoid the stock.