or example, the promoters of the
company may hold 60% of the shares, but what if all those shares are pledged
with a financier as collateral for getting additional loan funds? That’s a
dangerous situation.
WHY ?
Promoters, in order to raise funds for either personal or company needs,
pledge their holding shares to any financial institution.
Non-banking financial institutions are more active than banks in
providing such loans. Sometimes,
promoters collateralize their shares for converting warrants into shares. Also,
they might find share prices in the secondary market quite lucrative for fresh
purchase and adopt this route for garnering funds for the consideration to be
paid for open market purchase. So there are lots of reasons why promoters
pledge their shares. Generally, pledging shares is not a good sign.
As a general rule, if promoters
raise the money for the betterment of the business, investors should take it
positively but if the money is raised for any personal needs, it imparts
negative signal. Even if the funds are raised for improving the business it
indicates a liquidity problem.
WHAT DOES PLEDGING INDICATE?
Low credit-worthiness of the company
Businesses need money to grow and
invest in resources. The most preferred ways to do this is to go for debt or
equities. Going for equities is not a frequent event and hence most of the
companies need debt to finance their business expenses. However, some companies
do not have enough credit worthiness to secure required debt for their needs.
Hence pledging shares is the only way to get loan.
High debt in the company
Companies do not get further debt if
they already have high debt in their balance sheet. This could be a reason for
companies to pledge the share against loan. A high debt in the balance sheet
will increase the interest expenses of the company. Hence major part of the profit
will go towards paying the debt holders, leaving very little for shareholders.
This will hurt investors in two ways. First, it may eliminate the option of
dividends completely. Second, because of low earnings per share, the stock
price appreciation is also less.
Its even more dangerous in a falling
market.
Bankers or financiers give loan
taking the shares as collateral. When the market is in bull phase, pledging
doesn’t create issue because promoters can count on rising value of their
stake. Banks too do not mind lending against shares because of rising value of
shares as collateral. The problem occurs when the market enters in a bear
phase. whenever the prices of shares come down to a certain level in the
secondary market, the promoter is required to either make some payment or
pledge more shares. If the promoter cannot do either, the lender keeps the
right to sell pledged shares in the market. Apart from this, promoters always
have the risk of a hostile takeover.
NBFC`s -The preferred lenders:
Under Section 19(2) of the Banking
Regulation Act 1949, it is provided that no banking company shall hold shares
in any company whether as pledgee, mortgagee or absolute owner of an amount
exceeding 30% of the paid-up capital of that company or 30% of its own paid-up
capital and reserves, whichever is less.So, NBFC`s or other lenders are
preferred by promoters as lenders as such loans will give them greater
flexibility.
WHERE TO GET THE INFORMATION?
Before the Satyam debacle, there
were no disclosure norms made by SEBI (Securities and Exchange Board of India)
for promoters to disclose their pledged shares. But post satyam, disclosure
regarding Pledging of shares by their promoters has been made mandatory by the
Securities exchange board of India. Sebi has asked promoters to disclose
details of pledged shares if the same exceeds 25,000 shares in a quarter or 1
per cent of the total shareholding or voting rights of the company, whichever
is lower.
WAYS TO HIDE THE INFORMATION.
Many promoters are uncomfortable
with their share-pledge details put in the public domain due to the stigma
attached to such information and the attention it draws from short sellers.
In order to keep such borrowings away from the market glare, a promoter
often parks a slice of his holding — which is to be used to borrow — into a
separate demat account and creates a ‘negative lien’ on it. It’s a mechanism to
ensure the shares cannot be pledged or sold to anyone else. Non-banking finance
companies (NBFCs) and finance arms of brokerages lend against such an
arrangement.
Another transaction to circumvent the rule is to transfer some of the
shares to a special purpose vehicle (SPV) controlled by the promoters or
members of the promoter group, and raise money by pledging shares of the SPV.
It’s also common to give lenders power of attorney that can be exercised
to sell shares if borrowers default or certain triggers are breached. Often
these are arrangements entered into between the borrower, the brokerage and the
NBFC arm of the same brokerage.
CONCLUSION
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