Understanding Pledging of Shares

Understanding Pledging of Shares

The Hindenburg report has had a cascading effect on Adani Group Companies, causing the market to lose trust. As of February 22, 2023, Adonis promoters has pledged over 1%, 1.06%, and 0.55% of its shares in Adani Green, Adani Ports, and Adani Transmission, respectively, to keep the collateral lent by SBI.

In light of this downfall, knowing about pledging and how it affects investors and the market is imperative. This article aims to guide you through what pledging shares is, its need, how it works, its advantages, and the risks involved.

What is the pledging of shares?

Pledging of shares is a practice where investors or company promoters raise funds in exchange for the collateral of their equity holdings. It is a last resort move to raise funds for personal expenses, market trading, starting new ventures, or for a company's working capital.

So in many senses, pledging is similar to taking a loan in exchange for your own assets. You offer your stocks/equity to brokers/banks as collateral to raise funds.

What is the need for pledging of shares?

Pledging is of great incentive for individual investors as it enables them to keep the profit from dividends and selling shares but also provides quick funds for their immediate use.

For instance, suppose you have invested 1 Lakh rupees in ITC and believe that the value of the stock will rise soon. In that case, you might want to hold the stocks of ITC. However, you spot another opportunity to invest in Reliance, which you believe will give you good returns.

Since you don't have any excess funds, investing in Reliance becomes difficult. In such cases, you could pledge your ITC shares with your broker in exchange for margins for trading. You lend the shares to the broker but keep earning through dividends of the stock.

The broker will lend you the margin for trading based on the current value of stocks and haircut percentage. With the received funds, you can invest in Reliance and have a chance to earn a profit.

In the case of promoters, they often use pledging shares to raise capital for their companies. Promoters may pledge their shares to obtain financing for expansion, acquisition, or other business purposes. Companies may also pledge their shares to secure loans for working capital requirements or to fund capital expenditures. This information is public and easily accessible through BSE and NSE websites.

How does pledging of shares work?

When stocks are pledged to a broker, the broker generally doesn't charge interest on the loaned amount, and only a basic fee is charged for processing the pledged transaction.

After utilising the funds and hopefully earning a profit, you could return the margin and un-pledge the stock. Generally, no fees are charged for the un-pledging of stocks. However, you should check this with your broker.

Doesn’t everything seem green on this side of the fence with no downside to pledging? Well, there are significant risks to pledging shares, which are discussed below.

Haircut Percentage:

The broker won't give you the exact value of the stocks as a margin for trading due to the volatile nature of the market. So, for safety reasons, the funds allocated are less than the value of the current price of stocks.

So if you receive 80,000 Rs for keeping stocks worth 1,00,000 Rs as collateral, the haircut percentage will be 20%. This percentage depends from broker to broker  according to their set criteria.

What are the advantages of pledging shares?

Some of the advantages of pledging of shares are,

Access to Capital

Pledging of shares provides borrowers with access to capital without having to sell their shares, allowing promoters and companies to maintain control over their business and operations.

Low-Interest Rates

The interest rates on loans obtained through the pledging of shares are often lower than the interest rates on unsecured loans because the lender has the security of the pledged shares, which reduces their risk.

Flexible Repayment Terms

The repayment terms of loans obtained through the pledging of shares are often more flexible than those of other loans, allowing borrowers to tailor their repayment schedule to their cash flow and business needs.

No Dilution of Ownership

Pledging shares does not dilute the borrower's ownership. This means that the borrower can continue to enjoy their own benefits without sharing them with others.

What are the risks involved with pledging shares?

Pledging is generally regarded as a last resort by promoters as it creates a bad impression in the markets. It equates to a situation where there are little to no ways of raising funds for a company, and hence you should always look for promoters' pledged shares before investing in that company.

Some risks of investing in a company where the majority of shares are pledged are

Market Volatility

The value of shares pledged as collateral can fluctuate with market conditions. If the value of the pledged shares falls below the loan's value, the promoter may have to provide additional shares as collateral.

Forced Liquidation

If the promoter fails to pay the loan, the lender has the right to sell the pledged shares to recover their money. This can lead to forced liquidation of shares, increasing the supply of shares in the public market.

However, since their demand won't keep up with the supply, the stock price will drop drastically. So before investing in a company, it's important for you to check the percentage of stocks pledged by the promoters.

Reduced Control

Pledging of shares can result in reduced control over the company. As the promoter gives the shares to the bank, the promoter is losing the share in the company (at least temporarily). This might lead to an imbalance in voting power in the company.

Negative Perception

Pledging of shares can create a negative perception of the borrower. This is because it is often seen as an act of desperation and can raise questions about the borrower's financial health.

As a thumb rule, if the promoters have pledged more than 50% of their holdings, it should raise some red flags for you. It could be interpreted as the company not having funds for its expenses or the promoters trying to create an exit for themselves by offloading their shares in the public.

In summary

Pledging of shares can be a handy practice for both individual investors and promoters. It earns them additional capital to make money while keeping the ownership of the collateralised asset, that too at a very low cost. However, the risk of volatility, negative perception, and reduced control should be considered while investing in any company where the promoter has pledged shares in high amount.